313 PPT. Chapter 4
International Financial Standards- Income Statement Presentation
There are more similarities than differences between income statements prepared according to U.S. GAAP and those prepared applying international standards. Some of the differences are as follows: • 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.
Income from Continuing Operations
Unlike the balance sheet, which is a position statement at a point in time, the income statement measures activity over a period of time. The income statement reports the revenues, expenses, gains, and losses that have occurred during the reporting period. Revenues are inflows of resources resulting from providing goods or services to customers. Expenses are outflows of resources incurred while generating revenue. They represent the costs of providing goods and services.
Change in Accounting Principle
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. Common examples of these situations include the choice among FIFO, LIFO, and average cost for the measurement of inventory and among alternative revenue recognition methods. New accounting standard updates issued by the FASB also may require companies to change their accounting methods. Sometimes the FASB requires a change in accounting principle. These changes in accounting principles potentially hamper the ability of external users to compare financial information among reporting periods because information lacks consistency. The board considers factors such as this, as well as the cost and complexity of adopting new standards, and chooses among various approaches to require implementation by companies. 1.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. 2.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. 3.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. Occasionally, without being required by the FASB, a company will change from one generally accepted accounting principle to another. For example, a company may decide to change its inventory method from LIFO to FIFO. When this occurs, inventory and cost of goods sold are measured in one reporting period using LIFO, but then are measured using FIFO in a subsequent period. Inventory and cost of goods sold, and hence net income, for the two periods are not comparable. To improve comparability and consistency, GAAP typically requires that voluntary accounting changes be accounted for retrospectively.
Change in Depreciation, Amortization, or Depletion Method
A 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. We account for this change prospectively, almost exactly as we would any other change in estimate. One difference is that most changes in estimate don't require a company to justify the change. However, this change in estimate is a result of changing an accounting principle and therefore requires a clear justification as to why the new method is preferable.
Activity Ratios- Average Collection Period
A convenient extension is the average collection period. This measure is computed by dividing 365 days by the receivables turnover ratio. The result is an approximation of the number of days the average accounts receivable balance is outstanding. Monitoring the receivables turnover ratio (and average collection period) over time can provide useful information about a company's future prospects. For example, a decline in the receivables turnover ratio (an increase in the average collection period) could be an indication that sales are declining because of customer dissatisfaction with the company's products. Another possible explanation is that the company has changed its credit policy and is granting extended credit terms in order to maintain customers. Either explanation could signal a future increase in bad debts. Ratio analysis does not explain what is wrong. It does provide information that highlights areas for further investigation.
Profitability Analysis- Profitability Ratios
A fundamental element of an analyst's task is to develop an understanding of a firm's profitability. Profitability ratios attempt to measure a company's ability to earn an adequate return relative to sales or resources devoted to operations. Resources devoted to operations can be defined as total assets or only those assets provided by owners, depending on the evaluation objective. Three common profitability measures are 1.Profit margin on sales 2.Return on assets 3.Return on equity ● Notice that for all of the profitability ratios, our numerator is net income. Recall our discussion earlier in this chapter on earnings quality. The relevance of any historical-based financial statement hinges on its predictive value. To enhance predictive value, analysts often adjust net income in these ratios to separate a company's temporary earnings from its permanent earnings. Analysts begin their assessment of permanent earnings with income from continuing operations. Then, adjustments are made for any unusual, one-time gains or losses included in income from continuing operations. It is this adjusted number that they use as the numerator in these ratios. The profit margin on sales is simply net income divided by net sales. The ratio measures an important dimension of a company's profitability. It indicates the portion of each dollar of revenue that is available after all expenses have been covered. It offers a measure of the company's ability to withstand either higher expenses or lower revenues. The return on assets (ROA) ratio expresses income as a percentage of the average total assets available to generate that income. Because total assets are partially financed with debt and partially by equity funds, this is an inclusive way of measuring earning power that ignores specific sources of financing. Shareholders are concerned with how well management uses their equity to generate a profit. A closely watched measure that captures this concern is return on equity (ROE), calculated as net income divided by average shareholders' equity.
Accounting Charges
Accounting changes fall into one of three categories: (1) a change in an accounting principle, (2) a change in estimate, or (3) 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.
Accumulated Other Comprehensive Income
All items in comprehensive income accumulate into the balance of total shareholders' equity, but the specific equity account in which this accumulation occurs depends on whether the item was reported as part of net income or as part of other comprehensive income.
Activity Ratio: Inventory Turnover
An important activity measure for a merchandising company (a retail, wholesale, or manufacturing company) is the inventory turnover ratio. The ratio shows the number of times the average inventory balance is sold during a reporting period. The more frequently a business is able to sell, or turn over, its inventory, the lower its investment in inventory must be for a given level of sales. The ratio is computed by dividing the period's cost of goods sold by the average inventory balance. The denominator, average inventory, is determined by adding beginning and ending inventory and dividing by two. A relatively high ratio, compared to a competitor, usually is desirable. A high ratio indicates comparative strength, perhaps caused by a company's superior sales force or maybe a successful advertising campaign. However, it might also be caused by a relatively low inventory level, which could mean either very efficient inventory management or stockouts and lost sales in the future. On the other hand, a relatively low ratio, or a decrease in the ratio over time, usually is perceived to be unfavorable. Too much capital may be tied up in inventory. A relatively low ratio may result from overstocking, the presence of obsolete items, or poor marketing and sales efforts. Similar to the receivables turnover, we can divide the inventory turnover ratio into 365 days to compute the average days in inventory. This measure indicates the number of days it normally takes to sell inventory.
Income Smoothing and Classification Shifting
An often-debated contention is that, within the rules allowed by GAAP, managers have the power to change reported income by altering assumptions and estimates. And these alternatives are not always in the direction of higher income. Survey evidence suggests that managers often alter income upwards in one year but downward in other years. For example, in a year when income is high, managers may create reserves by overestimating certain expenses (such as future bad debts or warranties). These reserves reduce reported income in the current year. Then, in later years, they can use those reserves by underestimating expenses, which will increase reported income. 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. Management's income smoothing behavior is controversial. While some believe that a smoother income pattern helps investors and creditors to better predict future performance, others believe that managers are doing this to hide the true risk (volatility) of operations. By hiding this underlying volatility through manipulation of the income pattern over time, managers may be "fooling" investors and creditors into believing that the company's operations are lower-risk than they really are. Another way that managers affect reported income is through classification shifting in the income statement. The most common example of this involves misclassifying operating expenses as nonoperating expenses. By shifting operating expenses to a nonoperating expense classification (often referred to as "special charges" or "special items"), managers report fewer operating expenses and, therefore, higher operating income. This type of manipulation creates the appearance of stronger performance for core operations. While bottom-line net income remains unaffected, investors and creditors may believe the core business is stronger than it really is.
Total Shareholders Equity Unaffected by Classification
As mentioned previously, the FASB has outlined no conceptual basis for classifying gains and losses in net income versus other comprehensive income. How would total shareholders' equity be affected if we classified some gains or losses the other way? Not at all. If a company reports a $10 million gain (net of tax) in net income, then retained earnings will be higher by $10 million. If, instead, the company reports the $10 million gain in other comprehensive income, then accumulated other comprehensive income will be higher. Either way, total shareholders' equity is higher by $10 million. Eventually, items in accumulated other comprehensive income are reclassified to retained earnings. We'll look at the specifics of this accounting in future chapters dealing with investments, pensions, and derivatives.
Prior Period Adjustments
Assume that after its financial statements are published and distributed to shareholders, Roush Distribution Company discovers a material error in the statements. What does it do? Roush must make a prior period adjustment. Roush would record a journal entry that adjusts any balance sheet accounts to their appropriate levels and would account for the income effects of the error by increasing or decreasing the beginning retained earnings balance in a statement of shareholders' equity. Remember, net income in prior periods was closed to retained earnings so, by adjusting retained earnings, the prior period adjustment accounts for the error's effect on prior periods' net income. Simply reporting a corrected retained earnings amount might cause misunderstanding for someone familiar with the previously reported amount. Explicitly reporting a prior period adjustment in the statement of shareholders' equity (or statement of retained earnings if that's presented instead) highlights the adjustment and avoids this confusion. In addition to reporting the prior period adjustment to retained earnings, previous years' financial statements that are incorrect as a result of the error are retrospectively restated to reflect the correction. Also, a disclosure note communicates the impact of the error on prior periods' net income.
Reporting Discontinued Operations- When the Component Has Been Sold
By definition, the income or loss stream from a discontinued operation will no longer continue. A financial statement user is more interested in the results of a company's operations that will continue. It is informative, then, for companies to separate the effects of the discontinued operations from the results of operations that will continue. For this reason, 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. For example, even though Campbell Soup did not discontinue certain international operations until fiscal year 2020, it's important for comparative purposes to separate the effects for any prior years presented. This allows an apples-to-apples comparison of income from continuing operations. So, in its 2020 three-year comparative income statements, the 2019 and 2018 income statements reclassified income from the discontinued component to discontinued operations. In addition, there was a disclosure note to inform readers that prior years were reclassified. 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 The first element 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 insurance. The second element includes gains and losses on the sale of assets, such as selling a building or office equipment of this discontinued component. These two elements can be combined or reported separately, net of their tax effects. If combined, the gain or loss component must be indicated.
Profitability Analysis- Activity Ratios
Chapter 3 provided an overview of financial statement analysis and introduced some of the common ratios used in risk analysis to investigate a company's liquidity and long-term solvency. We now look at ratios related to profitability analysis. One key to profitability is how well a company manages and utilizes its assets. Some ratios are designed to evaluate a company's effectiveness in managing assets. Of particular interest are the activity, or turnover ratios, of certain assets. The greater the number of times an asset turns over—the higher the ratio—the fewer assets are required to maintain a given level of activity (revenue). Therefore, high turnovers usually are preferred. Although, in concept, the activity or turnover can be measured for any asset, activity ratios are most frequently calculated for total assets, accounts receivable, and inventory. A broad measure of asset efficiency is the asset turnover ratio. The ratio is computed by dividing a company's net sales by the average total assets available for use during a period. The denominator, average assets, is determined by adding beginning and ending total assets and dividing by two. The asset turnover ratio provides an indication of how efficiently a company utilizes all of its assets to generate revenue. The receivables turnover ratio is calculated by dividing a period's net credit sales by the average net accounts receivable. Because income statements seldom distinguish between cash sales and credit sales, this ratio usually is computed using total net sales as the numerator. The denominator, average accounts receivable, is determined by adding beginning and ending net accounts receivable (gross accounts receivable less allowance for uncollectible accounts) and dividing by two. The receivables turnover ratio provides an indication of a company's efficiency in collecting cash from customers. The ratio shows the number of times during a period that the average accounts receivable balance is collected. The higher the ratio, the shorter the average time between sales and cash collection.
Non-GAAP Earnings
Companies are required to report earnings based on Generally Accepted Accounting Principles (GAAP). This number includes all revenues and expenses. Most companies, however, also voluntarily provide non-GAAP earnings when they announce annual or quarterly earnings. Non- GAAP earnings exclude certain expenses and sometimes certain revenues. Common expenses excluded are restructuring costs, acquisition costs, write-downs of impaired assets, and stock-based compensation. 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. Nearly all major companies report non-GAAP earnings. Non-GAAP earnings are controversial because determining which expenses to exclude is at the discretion of management. By removing certain expenses from reported non-GAAP earnings, management has the potential to report misleadingly higher profits. The Sarbanes-Oxley Act addressed non-GAAP earnings in its Section 401. One of the act's important provisions requires that 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.
Discontinued Operations
Companies sometimes decide to sell or dispose of a component of their business. The operations of that business component are known as discontinued operations. 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. For the first item, a 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. For the second item, whether the disposal represents a strategic shift requires the judgment of company management. Examples of possible strategic shifts include the 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. Because discontinued operations represent a material component of the company, companies report results from discontinued operations separately in the income statement to allow financial statement users to more clearly understand results from continuing operations. An example of this reporting is shown here. The objective of this format is to inform financial statements users of which components of net income are continuing. We do this by separately reporting income from continuing operations ($750) and income from discontinued operations ($150). All else the same, investors should not expect next year's net income to be $900, because only $750 of profits from this year are part of 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. Also, in the case that there is a loss from discontinued operations, there would be an income tax benefit (instead of income tax expense); losses from discontinued operations are tax deductible and would reduce overall taxes owed, thereby providing a benefit.
Correction of Accounting Errors
Errors occur when transactions are either recorded incorrectly or not recorded at all Accountants employ various control mechanisms to ensure that transactions are accounted for correctly. In spite of this, errors occur. When errors do occur, they can affect any one or several of the financial statement elements on any of the financial statements a company prepares. In fact, many kinds of errors simultaneously affect more than one financial statement. When errors are discovered, they should be corrected. Most errors are discovered in the same year that they are made. These errors are simple to correct. The original erroneous journal entry is reversed, and the appropriate entry is recorded. 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. In practice, the vast majority of errors are not material and are, therefore, simply corrected in the year discovered. However, material errors that are discovered in subsequent periods require a prior period adjustment.
Change in Accounting Estimate
Estimates are a necessary aspect of accounting. A few of the more common accounting estimates are the amount of future bad debts on existing accounts receivable, the useful life and residual value of a depreciable asset, and future warranty expenses. 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, accounting for the 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 in any related accounting determinations from that point on; that is, we account for a change in accounting 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.
Operating Income and Earnings Quality- Other Unusual Items
Estée Lauder's financial statements also include impairments for goodwill and other assets. Any long-lived asset, whether tangible or intangible, should have its balance reduced if there has been a significant impairment of value. We explore property, plant, and equipment and intangible assets in Chapters 10 and 11. After discussing this topic in more depth in those chapters, we revisit the concept of earnings quality as it relates to asset impairment. These aren't the only components of operating expenses that call into question this issue of earnings quality. For example, in Chapter 9 we discuss the write-down of inventory that can occur with obsolete or damaged inventory. Other possibilities include losses from natural disasters such as earthquakes and floods and gains and losses from litigation settlements. Earnings quality also is influenced by the way a company records income from investments and accounts for its pension plans. Earnings quality is affected by revenue issues as well. As an example, suppose that toward the end of its fiscal year, a company loses a major customer that can't be replaced. That would mean the current year's revenue number includes a component that will not occur again next year. Of course, in addition to its effect on revenues, losing the customer would have implications for certain related expenses and net income.
Income from continuing Operations: Gains and Losses
Gains and 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 of the company, but they nevertheless represent transactions that affect a company's financial position. For example, gains and losses can arise when a company sells investments or property, plant, and equipment for an amount that differs from their recorded amount.
Partial Income statement - Home Depot
In Home Depot's partial income statement there are two nonoperating amounts reported after operating income. The first one is "Interest and investment income" that primarily includes gains on the sale of investments in another company's stock. Because Home Depot's primary business includes selling home improvement products, sales of investments are not considered normal operations. Therefore, Home Depot reports these amounts as nonoperating items. Another large nonoperating item reported by most companies is interest expense. In its 2020 report, Home Depot reported $1,201 million in interest expense. The company also reported long-term debt of approximately $35 billion in the balance sheet. Because this long-term debt will not be repaid for several years, the company will have to pay interest for several years. Therefore, interest expense represents a type of nonoperating item that is expected by investors to be a more permanent component of future profitability.
Return on Shareholder's Equity- DuPont Framework
In addition to monitoring return on equity, investors want to understand how that return can be improved. The DuPont framework provides a convenient basis for analysis that breaks return on equity into three key components: •Profitability, measured by the profit margin (Net income ÷ Sales). As discussed already, a higher profit margin indicates that a company generates more profit from each dollar of sales. •Activity, measured by asset turnover (Sales ÷ Average total assets). As discussed already, higher asset turnover indicates that a company uses its assets efficiently to generate more sales from each dollar of assets. •Financial Leverage, measured by the equity multiplier (Average total assets ÷ Average total equity). A high equity multiplier indicates that relatively more of the company's assets have been financed with debt; that is, the company is more leveraged. As discussed in Chapter 3, leverage can provide additional return to the company's equity holders. Notice that net sales and average total assets appear in the numerator of one ratio and the denominator of another, so they cancel to yield net income ÷ average total equity, or ROE. We have already seen that ROA is determined by profit margin and asset turnover, so another way to compute ROE is by multiplying ROA by the equity multiplier. We can see from this equation that an equity multiplier of greater than 1 will produce a return on equity that is higher than the return on assets. However, as with all ratio analysis, there are trade-offs. If leverage is too high, creditors become concerned about the potential for default on the company's debt and require higher interest rates. Because interest is recognized as an expense, net income is reduced, so at some point, the benefits of a higher equity multiplier are offset by a lower profit margin. Part of the challenge of managing a company is to identify the combination of profitability, activity, and leverage that produces the highest return for equity holders.
Earnings Quality
Investors, creditors, and financial analysts are concerned with more than just the bottom line of the income statement—net income. The presentation of the components of net income and the related supplemental disclosures provide clues to the user of the statement in an assessment of earnings quality. Earnings quality is used as a framework for more in-depth discussions of operating and nonoperating income. One meaning of earnings quality is the 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. Temporary earnings effects result 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. In contrast, permanent earnings relate to operations that are expected to generate similar profits in the future. Analysts begin their assessment of permanent earnings with income before discontinued operations, that is, income from continuing operations.
Operating Income and Earnings Quality- Restructuring Costs
It's not unusual for a company to reorganize its operations to attain greater efficiency. When this happens, the company often incurs significant restructuring costs (sometimes referred to as reorganization costs or realignment costs). Restructuring costs are associated with management's plans to materially change the scope of business operations or the manner in which they are conducted. For example, facility closings and related employee layoffs translate into costs incurred for severance pay and relocation costs. Estée Lauder had restructuring costs related to its shift to more online operations and realignment of its distribution network reflecting freestanding store and certain department store closures. Restructuring costs are recognized in the period the exit or disposal cost obligation actually is incurred. 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. 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. Because it usually takes considerable time to sell or terminate a line of business or to close a location or facility, many restructuring costs represent long-term liabilities. 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. Companies also are required to provide many disclosures in the notes, including the years over which the restructuring is expected to take place. Now that we understand the nature of restructuring costs, we can address the important question: Should financial statement users attempting to forecast future earnings consider these costs to be part of a company's permanent earnings stream, or are they unlikely to occur again? There is no easy answer. For example, Estée Lauder has some amount of restructuring costs nearly every year. A recent survey reports that of the 500 companies surveyed, 40% included restructuring costs in their income statements. The inference: A financial statement user must interpret restructuring charges in light of a company's past history and financial statement note disclosures that outline the plan and the period over which it will take place. In general, the more frequently these sorts of unusual charges occur, the more appropriate it is that financial statement users include them in their estimation of the company's permanent earnings stream.
Nonoperating income and Earnings Quality
Most of the components of earnings in an income statement relate directly to the ordinary, continuing operations of the company. Some, though, such as interest or the gains and losses on the sale of investments, relate only tangentially to normal operations. We refer to these as nonoperating items. How should these items be interpreted in terms of their relationship to future earnings? Are these expenses likely to occur again next year? Investors need to understand that some of these items may recur, such as interest expense, while others are less likely to recur, such as gains and losses on investments.
Income Statement Formats: Single-Step Income Statement
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. This flexibility has resulted in a variety of income statement presentations. However, we 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. 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. In a departure from that, though, companies usually report income tax expense in a separate line in the statement. In a single-step income statement, operating and nonoperating items are not separately classified. This illustration shows an example of a single-step income statement for a hypothetical manufacturing company, Motor Gear Corporation.
Comprehensive Income
Shareholders' equity represents the residual interest of owners (shareholders) in the assets of the company. This residual interest is affected by transactions between the company and its owners and by transactions between the company and nonowners. 1. Transactions with owners include events such as increasing equity by issuing stock to shareholders or decreasing equity by buying back stock from shareholders or paying dividends to shareholders. 2. Transactions with nonowners include events reported as revenues, expenses, gains, and losses. Revenues and gains increase equity, while expenses and losses decrease equity. It is the second type, transactions with nonowners, that represents comprehensive income. We use the term comprehensive income to describe the total change in shareholders' equity due to nonowner transactions. Comprehensive income consists of two components. You already have been introduced to the first component—net income. Net income consists of all revenues and expenses and most gains and losses. These items are reported in the income statement. However, there are a few gains and losses from nonowner transactions that we don't report in the income statement; instead, we report these gains and losses separately as the second component of comprehensive income known as other comprehensive income. Together, net income and other comprehensive income embody comprehensive income.
The Income Statement, Comprehensive Income, and the Statement of Cash Flows
The income statement reports a company's profit during a particular reporting period. Profit equals revenues and gains minus expenses and losses. A few types of gains and losses are excluded from the income statement but are included in the broader concept of comprehensive income. We refer to these other gains and losses as other comprehensive income (OCI). The statement of cash flows provides information about the cash receipts and cash payments of a company during a particular reporting period. The difference between cash receipts and cash payments represents the change in cash for the period. To help investors and creditors better understand the sources and uses of cash during the period, the statement of cash flows distinguishes among operating, investing, and financing activities.
Flexibility in Reporting
The information in the income statement, as well as other comprehensive income items, can be presented either 1.in a single, continuous statement of comprehensive income or 2.in two separate, but consecutive statements: •an income statement and a statement of comprehensive income
Income Statement Formats: Multi-Step Income Statement
The multiple-step format reports a series of intermediate subtotals such as gross profit, operating income, and income before taxes. Most real-world income statements are in this format. A primary advantage of the 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. It is important to note that 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. Most companies use the multiple-step format.
Earnings per Share
We've discussed that the income statement reports a company's net income for the period. Net income is reported in total dollars (total dollars of revenues minus total dollars of expenses) and represents the total profits that the company has generated for all shareholders during the period. However, for individual decision making, investors want to know how much profit has been generated for each share of common stock.. To know this, we calculate earnings per share (EPS) to relate the amount of net income a company generates to the number of common shares outstanding. EPS provides a convenient way for investors to link the company's profitability to the value of an individual share of ownership. 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 world. EPS also makes it easier to compare the performance of the company over time or with other companies. Larger companies may naturally have larger dollar amounts of net income, but they do not always generate more profit for each shareholder. U.S. GAAP requires that public companies report two specific calculations of EPS: (1)Basic EPS and (2)Diluted EPS. ● Basic EPS equals total net income (less any dividends to preferred shareholders) divided by the weighted-average number of common shares outstanding. Dividends to preferred shareholders are subtracted from net income in the numerator because those dividends are distributions of the company not available to common shareholders. The denominator is the weighted-average number of common shares outstanding, rather than the number of shares outstanding at the beginning or end of the period, because the goal is to relate performance for the period to the shares that were in place throughout that period. The number of common shares may change over the year from additional issuances or company buybacks, so a weighted average better reflects the number of shares outstanding for the period. The resulting EPS provides a measure of net income generated for each share of common stock during the period. For example, suppose the Fetzer Corporation reported net income of $600,000 for its fiscal year ended December 31, 2024. 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, 2024. The shares issued on March 31, 2024 will only be outstanding for 9 months of the year. Basic EPS of $0.30 per share for 2024 is computed as shown here.
Recognition of Expenses
When recognizing expenses, we attempt to establish a causal relationship between revenues and expenses. If causality can be determined, expenses are reported in the same period that the related revenue is recognized. If a causal relationship cannot be established, we relate the expense to a particular period, allocate it over several periods, or expense it as incurred.
EPS Disclosures- Campbell Soup Company
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. We see this demonstrated for Campbell Soup Company here.
Income from continuing operations
includes revenues, expenses (including income taxes), gains, and losses arising from operations that are more likely to continue. In contrast, income from discontinued operations will not continue into the future. The distinction between the two sources of income helps investors and creditors assess which components of net income are likely to continue into the future. The three major components of income from continuing operations include the following: 1. Operating income 2. Nonoperating income 3. Income tax expense Operating income includes revenues, expenses, gains, and losses directly related to the primary revenue-generating activities of the company. Operating income is often presented as gross profit (sales revenue minus cost of goods sold) minus operating expenses. Nonoperating income includes revenues, expenses, gains, and losses related to peripheral or incidental activities of the company. Like individuals, corporations are income-tax-paying entities. Because of the importance and size of income tax expense (sometimes called provision for income taxes), it always is reported in a separate line in corporate income statements.
