Ch 4: Income Statement, Comp. Income, Statement of Cash Flows

Other Comprehensive Income items include (4)

•Net unrealized holding gains, and losses on investments •Gains (losses) from postretirement benefit plans •Deferred gains (losses) from derivatives •Foreign currency translation adjustment

Operating Activities Cash Outflows (4)

•Purchase of inventory •Salaries, wages, and other operating expenses •Interest on debt •Income taxes

Earnings per share

•Ratio that indicates the amount of income earned by a company expressed on a per share basis

Change in accounting principle

•Refers to a change from one acceptable accounting method to another

Multi Step Income statement

•Separately classifies income statement items by operating and nonoperating •Reports series of intermediate subtotals

Long lived asset impairments (2)

•Tangible or intangible •Asset balance reduced if there has been a significant impairment of value

Restructuring Cost Examples

•Termination benefits payable to employees to be terminated: -To be accrued in the period(s) the employees render their service •Costs associated with closing facilities: -Recognized when services or goods associated with those activities are received

Why are non-GAAP expenses controversial?

•since the expenses to exclude are at the discretion of management •The Sarbanes-Oxley Act requires reconciliation between non-GAAP earnings and earnings determined according to GAAP

Single step income statement steps

**first lists all the revenues and gains included in income from continuing operations. **Then, expenses and losses are grouped, subtotaled, and subtracted—in a single step—from revenues and gains to derive income from continuing operations. **In a departure from that, though, companies usually report income tax expense in a separate line in the statement

Prior period adjustment requires that the company record a journal entry that (2)

-Adjusts any balance sheet accounts to their appropriate levels -Accounts for the income effects of the error by increasing or decreasing the beginning retained earnings balance

Examples of non operating items

-Interest income or interest expense -Gains or losses on sale of investments

Classification Shifting

-Shifting operating expenses to a nonoperating expense classification to report fewer operating expenses and higher operating income

Examples of change in accounting estimate

-The amount of future bad debts on existing accounts receivable -The useful life and residual value of a depreciable asset -Future warranty expenses

Income Smoothing

-Within GAAP, creates smoother pattern in earnings over time by altering assumptions and estimates -Overestimate expenses in current year to reduce net income, and then reverse those estimates in future years to increase net income

For example, suppose the Fetzer Corporation reported net income of $600,000 for its fiscal year ended December 31, 2021. Preferred stock dividends of $75,000 were declared during the year. Fetzer had one million shares of common stock outstanding at the beginning of the year and issued an additional one million shares on March 31, 2021. The shares issued on March 31, 2021 will only be outstanding for 9 months of the year. Basic EPS of $0.30 per share for 2021 is computed as shown here.

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On the other hand, if future work by the employee is not required to receive the termination benefits, the liability and corresponding expense for benefits are recognized at the time the company communicates the arrangement to employees. Similarly, costs associated with closing facilities and relocating employees are recognized when goods or services associated with those activities are received.

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Suppose, as part of a restructuring plan, employees to be terminated are offered various benefits but only if they complete a certain period of work for the company. In that case, a liability for termination benefits, and corresponding expense, should be accrued in the required period(s) of work.

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Because estimates require the prediction of future events, it's not unusual for them to turn out to be wrong. **When an estimate is modified as new information comes to light, account for the change in estimate by

. We do not revise prior years' financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate in any related accounting determinations from that point on; that is, we account for a change in accounting estimate prospectively

Discontinued operations are reported when (2)

1. A component of an entity or group of components has been sold or disposed of, or is considered held for sale. 2. If the disposal represents a strategic shift that has, or will have, a major effect on a company's operations and financial results.

The three major components of income from continuing operations include the following:

1. Operating income 2. Nonoperating income 3. Income tax expense

Which of the following captions would more likely be found in a single-step income statement? a.Total revenues and gains b.Gross profit c.Operating income d.All of these answers are incorrect

A. a single step income statement groups together all revenues and gains

Buffalo Manufacturing Company is restructuring and closing the platinum mining division. The mine will be closed and its assets sold off over the course of the next three years. When should the costs related to closing of the mine be recognized? a.In the year the restructuring plan is announced to the board of directors b.In the year(s) the costs are actually incurred c.In the year the restructuring is complete d.All of these answers are incorrect

B **Restructuring costs are recognized in the period the exit or disposal cost obligation actually is incurred.

The Cansela Baseball Bat Company reported income before taxes of $375,000. This amount included a $75,000 loss on discontinued operations. The amount reported as income from continuing operations, assuming a tax rate of 25%, is: a.$375,000 b.$112,500 c.$300,000 d.$225,000

B **[$375,000 (income before income taxes) + $75,000 (loss on discontinued operations)] × [1.0 - 0.25 (tax rate)] = $112,500

2 EPS on the face of the income statement

Basic Diluted

Basic EPS formula

Basic EPS = (Net Income - Preferred Dividends) / Wtd. Avg. # of Shares Outstanding

On October 1, 2021, American Medical Inc. adopted a plan to discontinue its generic drug division, which qualifies as a separate component of the business according to GAAP regarding discontinued operations. The disposal of the division was expected to be concluded by March 30, 2022. On December 31, 2021, the company's year-end, the following information relative to the discontinued division was accumulated: Operating loss for 2021 $195 millionExcess of book value over fair value, less costs to sell, at year-end 25 million In its income statement for the year ended December 31, 2021, American would report a before-tax loss on discontinued operations of: a.$170 million b.$195 million c.$220 million d.All of these answers are incorrect

C $195 million operating loss plus a $25 million impairment loss

Direct Method

Cash effect of each operating activity is reported directly in the statement

Errors discovered in the same year are corrected by

Erroneous journal entry is reversed and the appropriate entry is recorded

Restructuring Costs

Include costs associated with management's plans to materially change the scope of business operations

When the discontinued component is sold before the end of the reporting period, the income effects will include

Income or loss from operations of the component from the beginning of the reporting period to the disposal date + Gain or loss on disposal of the component's assets

When the discontinued component has not been sold when the reporting period ends, the income effects are reported but modified "held for sale"

Income or loss from operations of the component from the beginning of the reporting period to the end of the reporting period + An impairment loss if the book value of the assets of the component is more than the fair value minus cost to sell

Operating Activities

Inflows and outflows of cash that result from activities reported in the income statement

Indirect Method

Net cash flow is derived indirectly by starting with reported net income and working backwards to convert that amount to a cash basis

errors discovered in subsequent years are corrected

Prior period adjustment recorded (if material)

3 change in accounting principle approaches

Retrospective modified retrospective prospective

Information in the income statement and other comprehensive income items can be presented as either

Single, continuous statement of comprehensive income OR Two separate, but consecutive statements (income statement and statement of comprehensive income)

Nonoperating items

Some items in an income statement relate only tangentially to normal operations.

Comprehensive Income

The change in equity from nonowner transactions

Accounting changes fall into 1 of 3 categories

a change in accounting principle a change in estimate a change in reporting entity **The correction of an error is another adjustment that is accounted for in the same way as certain accounting changes.

Examples of gains/losses

a company sells investments or property, plant, and equipment for an amount that differs from their recorded amount.

Earnings Quality Definition

ability of reported earnings (income) to predict a company's future earnings **The relevance of any historical-based financial statement hinges on its predictive value. To enhance predictive value, analysts try to separate a company's temporary earnings from its permanent earnings.

change in depreciation, amortization, or depletion method are considered to be a change in

accounting estimate achieved by a change in accounting principle

Report OCI on a cumulative basis in the

balance sheet *reported as an additional component of SHE

Statement of cash flows are required for each period when

balance sheet and income statement are presented

Advantage of multiple step format is that

by separately classifying operating and nonoperating items, it provides information that might be useful in analyzing trends. Similarly, the classification of expenses by function also provides useful information.

Most companies voluntarily provide non-GAAP earnings, which exclude

certain revenues and expenses ex: -Restructuring costs, acquisition costs, write-downs of impaired assets, and stock-based compensation

most changes in estimates don't require a

clear justification as to why the new method is preferable

Component of an entity includes activities and cash flows that can be

clearly distinguished, operationally and for financial reporting purposes, from the rest of the company. **A component could include an operating segment, a reporting unit, a subsidiary, or an asset group.

A few types of gains and losses are excluded from the income statement but are included in the broader concept of

comprehensive income **refer to these as other comprehensive income

2 formats to report operating activities

direct or indirect

Examples of strategic shifts

disposal of operations in a major geographical area, a major line of business, a major equity method investment, or other major parts of the company.

Two other expenses in Hershey's income statements that warrant additional scrutiny are

goodwill impairments and asset impairments

operating income is often presents as

gross profit - operating expenses gp= sales revenue - COGS

illustration 4-2

illustration 4-2

IF relationship can be determined expenses are reported

in the same period the related revenue is recognized

Operating Income

includes revenues, expenses, gains, and losses directly related to the primary revenue-generating activities of the company

Nonoperating income

includes revenues, expenses, gains, and losses related to peripheral or incidental activities of the company.

ncome or loss from discontinued operations is reported separately, below

income from continuing operations

permanent earnings are included in

income from continuing operations

Income or loss from operations of the component from the beginning of the reporting period to the disposal date would consist primarily of

income from daily operations of this discontinued component of the company. This would include typical revenues from sales to customers and ordinary expenses such as cost of goods sold, salaries, rent, and insuranc

Diluted EPS

incorporates the dilutive effect of all potential common shares **•Refers to the reduction in EPS that occurs as the number of common shares outstanding increases.

Gains/Losses are

increases or decreases in equity from peripheral or incidental transactions of an entity. **In general, these gains and losses do not reflect normal operating activities

Revenues

inflow of resources resulting from providing goods or services to customers

Permanent Earnings relate from transactions

likely to generate similar profits in the future

Income tax benefit

losses from discontinued operations are tax deductible and would reduce overall taxes owed, thereby providing a benefit.

Prior period adjustments are required when

material error is discovered in the statements that have been published and distributed to shareholders

Comprehensive income = ___ + ___

net income + other comprehensive income

Temporary Earnings result from transactions that are

not likely to occur again in the foreseeable future likely to have a different impact on earnings in the future

3 categories in SCF

operatinv investing financing

Expenses

outflows of resources incurred while generating revenue **cost of providing g/s

If a relationship cannot be determined we relate the expense to a

particular period, allocate it over several periods or expense as incurred

income statement measures over a

period of time **during the reporting period

Restructuring costs are recognized in

period the exit or disposal cost obligation actually is incurred

changes in depreciation amortization or depletion are accounted for

prospectively

changes in accounting method are accounted for

prospectively **•If the effect of the change is material, a disclosure note is needed to describe the change and its effect on both income and earnings per share

Income statement reports

reports a company's profit during a particular reporting period. **Profit equals revenues and gains minus expenses and losses.

Discontinued Operations

result from the disposal of a major component of the business and are reported net of income tax effects

GAAP typically requires that voluntary accounting changes be accounted for _____

retrospectively ex: change in inventory (FIFO to LIFO)

When recognizing expenses, we attempt to establish a causal relationship between

revenues and expenses

Income from continuing operations includes

revenues, expenses (including income taxes), gains, and losses arising from operations that are more likely to continue

Operating Activities Cash Inflows (2)

sale of good or service interest and dividends from investments

Gain or loss on disposal of the component's assets would include things such as

selling a building or office equipment of this discontinued component.

In a single-step income statement, operating and nonoperating items are not

separately classified.

Income taxes are levied on

taxpayers in proportion to the amount of taxable income that is reported to taxing authorities

Statement of cash flow provides information about

the cash receipts and cash payments of a company during a particular reporting period

Revenue issues affecting earnings quality (3)

•A company loses a major customer that can't be replaced •Misstatement of revenue •Premature revenue recognition

Changes in accounting estimate

•Changes due to modification of estimate as new information comes to light

Investing Activities

•Inflows and outflows of cash related to the acquisition and disposition of: 1.Long-lived assets used in the operations of the business 2.Investment assets -Purchase and sale of inventory are not investing activities

2 types of net income adjustments

1.Components of net income that do not affect operating cash are reversed. That means that noncash revenues and gains are subtracted, while noncash expenses and losses are added. For example, depreciation expense does not reduce cash, but it is subtracted in the income statement. To reverse this, then, we add back depreciation expense to net income to arrive at the amount that we would have had if depreciation had not been subtracted in the first place. 2.Net income is adjusted for changes in operating assets and liabilities during the period. These changes represent amounts that are included as components of net income but that are not cash flows. For instance, suppose accounts receivable increases during the period because revenue from credit sales is greater than cash collected from customers. This increase in accounts receivable would then be subtracted from net income to arrive at cash flow from operating activities. In the indirect method, positive adjustments to net income are made for decreases in related assets and increases in related liabilities, while negative adjustments are made for increases in those assets and decreases in those liabilities.

Retrospective Approach

1.The new standard is applied to all periods presented in the financial statements. That is, we restate prior period financial statements as if the new accounting method had been used in those prior periods. We revise the balance of each account affected to make those statements appear as if the newly adopted accounting method had been applied all along.

Modified retrospective approach

1.The new standard is applied to the adoption period only. Prior period financial statements are not restated. The cumulative effect of the change on prior periods' net income is shown as an adjustment to the beginning balance of retained earnings in the adoption period.

Investing cash outflows (3)

1.The purchase of long-lived assets used in the business 2.The purchase of investment securities like stocks and bonds of other entities (other than those classified as cash equivalents and trading securities) 3.Loans to other entities

Investing cash inflows (3)

1.The sale of long-lived assets used in the business 2.The sale of investment securities (other than cash equivalents and trading securities) 3.The collection of a nontrade receivable (excluding the collection of interest, which is an operating activity)

Prospective approach

1.This approach requires neither a modification of prior period financial statements nor an adjustment to account balances. Instead, the change is simply implemented in the current period and all future periods.

Statement of Cash Flows

A financial statement that provides financial information about the cash receipts and cash payments of a business for a specific period of time. *cash refers to cash + cash equivalent