ACC 3110 - Chapter 4 - The Income Statement, Comprehensive Income, and the Statement of Cash Flows

Primary differences between U.S. GAAP and IFRS with respect to the income statement, statement of comprehensive income, and statement of cash flows:

- International standards require certain minimum information to be reported on the face of the income statement. U.S. GAAP has no minimum requirements. - International standards allow expenses to be classified either by function (e.g., cost of goods sold, general and administrative, etc.) or by natural description (e.g., salaries, rent, etc.) SEC regulations require that expenses be classified by function. - In the United States, the "bottom line" of the income statement usually is called either net income or net loss. The descriptive term for the bottom line of the income statement prepared according to international standards is either profit or loss.

Other comprehensive income examples:

- gain (loss) on debt securities - gain (loss) on projected benefit obligation - gain (loss) on derivatives - Foreign currency translation adjustment

Accounting changes fall into one of three categories:

1. A change in an accounting principle 2. a change in estimate 3. a change in reporting entity

discontinued operations are reported when

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.

U.S. GAAP requires that public companies report two specific calculations of EPS:

1. Basic EPS 2. diluted EPS

If the situation indicates that the component is likely to be sold within a year, the component is considered "held for sale". The income effects of the discontinued operation still are reported, but the two components of the reported amount are modified as follows:

1. Income or loss from operations (revenues, expenses, gains and losses) of the component from the beginning of the reporting period to the end of the reporting period. 2. An impairment loss if the book value (sometimes called carrying value or carrying amount) of the assets of the component is more than fair value minus cost to sell.

When the discontinued component is sold before the end of the reporting period, the reported income effects of a discontinued operation will include two elements:

1. Income or loss from operations (revenues, expenses, gains, and losses) of the component from the beginning of the reporting period to the disposal date. 2. Gain or loss on disposal of the component's assets.

Mandated changes in accounting principles has various approaches such as:

1. Retrospective approach 2. Modified retrospective approach 3. Prospective approach

So, there are two possibilities:

1. When the component has been sold 2. When the component is considered held for sale

The revenues, expenses, gains, losses, and income tax related to a discontinued operation must be removed from continuing operations and reported separately for all years presented.

Because the results of a company's operations that will continue is informative, then, for companies to separate the effects of the discontinued operations from the results of operations that will continue.

Managers often alter income upwards in one year but downward in other years.

By shifting income in this manner, managers effectively smooth the pattern in reported income over time, portraying a steadier income stream to investors, creditors, and other financial statement users.

Change in Accounting Estimate

Change in an accounting estimate is reflected in the financial statements of current and future periods.

The FASB has established no conceptual basic for determining which gains and losses qualify for net income versus other comprehensive income.

Companies are required to provide a reconciliation from net income to comprehensive income. The reconciliation simply extends net income from the income statement to include other comprehensive income items, reported new of tax.

Losses

Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from expenses or distributions to owners.

Gain (loss) on projected benefit obligation

Gain or loss due to revising assumptions of the employee pension plan.

These two elements can be combined or reported separately, net of their tax effects.

If combined, the gain or loss component must be indicated.

The two income elements can be combined or reported separately, net of their tax effects.

In addition, if the amounts are combined and there is an impairment loss, the loss must be disclosed, either parenthetically on the face of the statement or in a disclosure note.

Income statement includes:

Income from continuing operations, discontinued operations, earnings per share.

Two financial statements that are critical for understanding the company's ability to earn profits and generate cash in the future are

Income statement (also called statement of operations or statement of earnings), statement of cash flows.

Gains

Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners.

Sometimes a discontinued component actually has been sold by the end of a reporting period.

Often, though, the disposal transaction has not yet been completed as of the end of the reporting period.

Expenses

Outflows or other using up of assets or incurrences of liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations. (are outflows of resources incurred while generating revenue.)

Statement of cash flows

Provides information about the cash receipts and cash payments of a company during a particular reporting period. (Change statement summarizing the transactions that caused cash to change during the period.)

nonoperating items

Revenues, expenses, gains, and losses that do not relate to the company's primary operations. (interest or the gains and losses on the sale of investments relate only tangentially to normal operations.)

Retrospective approach

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

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.

Important information about discontinued operations, whether sold or held for sale, is reported in a disclosure note.

The note provides additional details about the discontinued component, including its identity, its major classes of assets and liabilities, the major revenues and expenses constituting pretax income or loss from operations, the reason for the discontinuance, and the expected manner of disposition if held for sale.

Prospective approach

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.

Companies are required to report earnings based on Generally Accepted Accounting Principles (GAAP).

This number includes all revenues and expenses.

Change in estimate is quite straightforward.

We do not revise prior years' financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate prospectively. If the effect of the change is material, a disclosure note is needed to describe the change and its effect on both net income and earnings per share.

Not all items of revenue and expense included in operating income be considered indicative of a company's permanent earning.

We report them as part of operating income because they are so closely related to the company's core business.

A change in accounting principle refers to

a change from one acceptable accounting method to another. There are many situations that allow alternative treatments for similar transactions.

Other comprehensive income (OCI)

a few types of gains and losses are excluded from the income statement but are included in the broader concept of comprehensive income. (Changes in stockholders' equity other than transactions with owners and other than items that affect net income.)

In multiple-step format

a primary advantage is that by separately classifying operating and non operating items, it provides information that might be useful in analyzing trends. Also, the classification of expenses by function also provides useful information.

If material errors that are discovered in subsequent periods require

a prior period adjustment.

Non-GAAP earnings (management's assessment of permanent earnings)

actual (GAAP) earnings reduced by any expenses the reporting company feels are unusual and should be excluded. (exclude certain expenses and sometimes certain revenues.)

Prior period adjustment

addition to or reduction in the beginning retained earnings balance in a statement of shareholders' equity due to a correction of an error.

In contrast, permanent earnings arise from operations that

are expected to generate similar profit in the future.

Temporary earnings arise from transactions or events that

are not likely to occur again in the foreseeable future or that are likely to have a different impact on earnings in the future.

Non-GAAP earnings are controversial

because determining which expenses to exclude is at the discretion of management. By removing certain expenses from reported GAAP earnings, management has the potential to report misleadingly higher profits.

Many restructuring costs represent long-term liabilities

because it usually takes considerable time to sell or terminate a line of business, or to close a location or facility.

When the income statement includes discontinued operations, we report per-share amounts for

both income (loss) from continuing operations and for net income (loss), as well as for the discontinued operations.

Comprehensive income

change in shareholder's equity for the period from nonowner sources; equal to net income plus other comprehensive income. Traditional net income plus other nonowner changes in equity. (is total change in equity for a reporting period other than from transactions with owners.)

Comprehensive income

change in shareholders' equity for the period from nonowner sources; equal to net income plus other comprehensive income. Traditional net income plus other nonowner changes in equity.

Other comprehensive income (OCI)

changes in stockholders' equity other than transactions with owners and other than items that affect net income. (There are few gains and losses that are not reported in the income statement but nevertheless affect equity.)

Gain (loss) on debt securities

changes in the fair value of investments in debt securities.

Another way that managers affect reported income is through

classification shifting in the income statement.

All other changes in equity during the period arise from nonowner sources and represent

comprehensive income.

Basic EPS

computed by dividing income available to common stockholders (net income less any preferred stock dividends) by the weighted-average number of common shares outstanding for the period.

Change in depreciation, amortization, or depletion method is

considered to be a change in accounting estimate that is achieved by a change in accounting principle. (are accounted for the same way as a change in an accounting estimate.)

Income smoothing behavior is

controversial.

Classification shifting inflates

core performance of operations.

Restructuring costs (reorganization costs or realignment costs)

costs associated with plans by management to materially change either the scope or manner in which its company's operations are conducted. (Restructuring costs include costs associated with shutdown or relocation of facilities or downsizing of operations.)

While income smoothing may help investors to

credit future performance but it could also hide underlying risk (volatility) of operations.

Errors occur when transactions are

either recorded incorrectly or not recorded at all.

The single-step format

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.

Restructuring costs are recognized

in the period the exit or disposal cost obligation actually is incurred. (GAAP required that restructuring costs be recognized only in the period incurred.)

Supposedly, non-GAAP earnings are management's view of "permanent earnings,"

in the sense of being a better long-run measure of its company's performance.

Operating income

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

Nonoperating income

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

Diluted EPS

incorporates the dilutive effect of all potential common shares in the calculation of EPS. Dilution refers to the reduction in EPS that occurs as the number of common shares outstanding increases.

Transactions with owners include events such as

increasing equity by issuing stock to shareholders or decreasing equity by purchasing stock from shareholders and paying dividends.

Revenues

inflows of assets or settlements of liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations. (are inflows of resources resulting from providing goods or services to customers.)

Non-operating items includes

interest and investment income (selling products companies), interest expense (interest pay for several years of a long-term debt.) (interest expense represents a type of non operating item that is expected by investors to be a more permanent component of future profitability.)

For manufacturer, non operating income would include

interest revenue, gains and losses from selling investments, and interest expense. (other income)

Income Tax Expense (sometimes called provision for income taxes)

is reported in a separate line in the income statement. Income tax are levied on taxpayers in proportion to the amount of taxable income that is reported to taxing authorities. Corporations are income-tax-paying entities.

Any long-lived asset, whether tangible or intangible, should have

its balance reduced if there has been a significant impairment of value.

Comprehensive income =

net income + Other comprehensive income (comprehensive income includes net income plus other changes in shareholders' equity from non owner sources.)

Income statement formats

no specific standards dictate how income from continuing operations must be displayed, so companies have considerable latitude in how they present the components of income from continuing operations.

The difference between the single-step and multiple-step income statement is

one of presentation. The bottom line, net income, is the same regardless of the format used.

The ratio of stock price per share to earnings per share (the PE ratio) is

one of the most widely used financial metrics in the investment word. EPS also makes it easier to compare the performance of the company over time or with other companies.

In a single-step income statement,

operating and non operating items are not separately classified. Companies usually report income tax expense in a separate line in the statement.

Earnings quality (in operating income) is affected by

operating expenses; the write-down of inventory that can occur with obsolete or damaged inventory; losses from natural disasters such as earthquakes and floods and gains and losses from litigation settlements; the way a company records income from investments and accounts for its pension plans; revenue issue; the international misstatement of revenue.

Three major components of income from continuing operations include

operating income, nonoperating income, income tax expense.

intraperiod tax allocation

process of associating income tax effects with the income statement components that create those effects. (losses from discontinued operations are tax deductible and would reduce overall taxes owed, thereby providing a benefit-income tax benefit.)

The Sarbanes-Oxley Act requires

reconciliation between non-GAAP earnings and earnings determined according to GAAP. (If non-GAAP earnings are included in any periodic or other report filed with the SEC or in any public disclosure or press release, the company also must provide a reconciliation with earnings determined according to GAAP.)

Because discontinued operations represent a material component of the company, the results from discontinued operations are

reported separately in the income statement to allow financial statement users to more clearly understand results from continuing operations. Separate reporting includes taxes as well (the income tax expense associated with continuing operations is reported separately from the income tax of discontinued operations.)

Income statement

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

The multiple-step format

reports a series of intermediate subtotals such as gross profit, operating income, and income before taxes. (that includes a number of intermediate subtotals before arriving at income from continuing operations.)

Common expenses excluded in non-GAAP earnings are

restructuring costs, acquisition costs, write-downs of impaired assets, and stock-based compensation.

Income from Continuing Operations includes

revenues, expenses (including income taxes), gains and losses,(excluding those related to discontinued operations and extraordinary items) that have occurred during the reporting period or will probably continue in future periods (over a period of time)

The transactions and events that lead to changes in equity from non owner sources are recorded as

revenues, expenses, gains, and losses for the period.

For manufacturing company, operating income includes

sales revenue from selling the products it manufactures minus cost of goods sold and operating expenses related to its primary activities.

Intrapreriod tax allocation is

separately reporting income tax expense of a company associated with operations that are continuing separately from income tax expense associated with operation that are being discontinued.

For a service company, operating income would include

service revenue minus operating expenses (and no cost of goods sold.)

If the error are not material and are, therefore,

simply corrected in the year discovered.

To enhance predictive value, analysts try to separate a company's

temporary earnings from its permanent earnings.

Earnings quality refers to

the ability of reported earnings (income) to predict a company's future earnings

If an error is discovered in a year subsequent to the year the error is made,

the accounting treatment depends on whether or not the error is material with respect to its effect on the financial statements.

Earning per share (EPS)

the amount of income earned by a company expressed on a per share basis.

Discontinued operations

the discontinuance of a component of an entity whose operations and cash flows can be clearly distinguishes from the rest of the entity. (sell or dispose of a component of their business)

If errors are discovered in the same year that they are made,

the original erroneous journal entry is reversed and the appropriate entry is recorded.

Income Statement formats can identify two general approaches

the single-step and the multiple-step formats, that might be considered the two extremes, with the income statements of most companies falling somewhere in between.

Changes in shareholders' equity arise from two sources:

transactions with owners (shareholders) and transactions with nonowners.

For certain investments in debt securities (known as available-for-sale debt securities),

unrealized gains and losses are reported as other comprehensive income in shareholders' equity.

To improve comparability and consistency, GAAP typically requires that

voluntary accounting changes be accounted for retrospectively.

gain (loss) on derivatives

when a derivative designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction.

Most companies, however, also voluntarily provide non-GAAP earnings

when they announce annual or quarterly earnings.

GAAP requires initial measurement of these liabilities to be at fair value

which often is determined as the present value of future estimated cash outflows.

Profits from these discontinued operations

will not continue.