© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 4 The Income Statement and Statement of Cash Flows

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Chapter 4

The Income Statement and Statement of

Cash Flows


Slide4-2

Comprehensive Income

Proponents argue that certain

changes in equity should be included

in the determination of

net income.


Slide4-3

Comprehensive Income

Statement of Financial Accounting Standards No. 130

Comprehensive income includes traditional net income and changes in equity from nonowner

transactions.

Statement of Financial Accounting Standards No. 130

Comprehensive income includes traditional net income and changes in equity from nonowner

transactions.

Examples of nonowner transactions:

•Foreign currency translation adjustment, net of tax

•Unrealized gains(losses) on investment securities, net of tax

•Minimum pension liability adjustment, net of tax

Examples of nonowner transactions:

•Foreign currency translation adjustment, net of tax

•Unrealized gains(losses) on investment securities, net of tax

•Minimum pension liability adjustment, net of tax


Slide4-4

Expenses

Outflows of resources incurred in generating revenues.

Revenues

Inflows of resources resulting

from providing goods or

services to customers.

Gains and Losses

Increases or decreases in equity from

peripheral or incidental

transactions of an entity.

Income from Continuing OperationsIncome from Continuing Operations

Income Tax Expense

Because of its

importance and size,

income tax expense is a

separate item.


Slide4-5

Operating Income

Nonoperating Incomevs.

Income Statement


Slide4-6

Income Statement (Single-Step)

Expenses & Losses {

{Revenues & Gains

{Proper Heading


Slide4-7

Income Statement (Multiple-Step)

{Non- operating Items

{Gross Margin

{Proper Heading

Operating Expenses {


Slide4-8

Earnings Quality

Earnings quality refers to the ability of reported earnings to predict a company’s future.

The relevance of any historical-based financial statement hinges on its

predictive value.


Slide4-9 Manipulating Income and

Income Smoothing

“Most managers prefer to report earnings that follow a smooth, regular, upward path.”

Two ways to manipulate income:

1. Income shifting

2. Income statement classification


Slide4-10

Separately Reported Items

Three types of events are reported separately, net of taxes:

1.

2.

3.


Slide4-11 Intraperiod Income Tax

Allocation

Income Tax Expense must be associated with each component of income that causes it.

Income Tax Expense must be associated with each component of income that causes it.

Show Income Tax Expense related to

Income from Continuing Operations.

Show Income Tax Expense related to

Income from Continuing Operations.

Report effects of Discontinued Operations, Extraordinary

Items, and Cumulative Effect of Accounting Changes NET OF

INCOME TAXES.

Report effects of Discontinued Operations, Extraordinary

Items, and Cumulative Effect of Accounting Changes NET OF

INCOME TAXES.


Slide4-12

Sale or disposal of a component of an entity.A component includes:

Reportable segments Operating segments Reporting units Subsidiaries Asset groups

Discontinued Operations


Slide4-13

Report results of operations separately if two conditions are met:

1. The operations and cash flows of the component have been (or will be) eliminated from the ongoing operations.

2. The entity will not have any significant continuing involvement in the operations of the component after the disposal transaction.



Slide4-14

Results of operations include two items:

1. The income or loss stream for the period from the identifiable discontinued operation.

2. The actual gain or loss from disposal of the component

or

an “impairment loss” if the component is held for resale.



Slide4-15

Results of operations include two items:

1. The income or loss stream for the period from the identifiable discontinued operation.

2. The actual gain or loss from disposal of the component

or

an “impairment loss” if the component is held for resale.


Carrying Value of Assets < (Fair Value of Assets - Cost to Sell)


Slide4-16

During the year, Apex Co. sold an unprofitable component of the company. The

component had a net loss from operations during the period of $150,000 and its assets

sold at a loss of $100,000. Apex reported income from continuing operations of $128,387. All items are taxed at 30%.

How will this appear on the income statement?

Discontinued Operations Example


Slide4-17


Computation of Loss from Discontinued Operations (Net of Tax Effect):


Slide4-18

Income Statement Presentation:



Slide4-19

Material in amount

Gains or losses that are unusual in nature and infrequent in occurrence. required by GAAP.

Reported net of related taxes

Extraordinary Items


Slide4-20

During the year, Apex Co. experienced a loss of $75,000 due to an earthquake at one

of its manufacturing plants in Nashville. This was considered an extraordinary item.

The company reported income before extraordinary item of $128,387. All gains and losses are subject to a 30% tax rate.

How would this item appear on the income statement?

Extraordinary Items Example


Slide4-21


Extraordinary Items Example


Slide4-22

Unusual or Infrequent Items

Items that are material and are either unusual or infrequent—but not both—

are included as a separate item in continuing operations.


Slide4-23

Type of Accounting Change Definition

Change in Accounting Principle

Replaces one GAAP with another

Change in Accounting Estimate

Revision of an estimate because of new information or new experience

Change in Reporting Entity

Change from reporting as one type of entity to another type of entity

Accounting Changes


Slide4-24

Change in Accounting Principle

Occurs when Changing from one GAAP method to another

GAAP method, or Changing the method of application of an

existing principle.

Make a catch-up adjustment known as the cumulative effect of a change in accounting principle.The cumulative effect is reported net of taxes and after extraordinary items.


Slide4-25

Change in Accounting Principle Example

During the year, Apex Co. decided to change from the double-declining balance to the

straight-line method for depreciation. The effect of this change is an increase in net

income of $65,000. Apex reported income of $128,387 during the year. All items of income are subject to a 30% tax rate.

How would this item appear on the income statement?


Slide4-26

Computation:


Change in Accounting Principle Example


Slide4-27

Change in Estimates

Revision of a previous accounting estimate.

The new estimate should be used in the current and future periods.

The prior accounting results should not be be restated.


Slide4-28

Change in EstimatesExampleOn January 1, 2000, we purchased

equipment costing $30,000, with a useful life of 10 years and no salvage value.

During 2003, we determine that the remaining useful is 5 years (8-year total life). We use straight-line depreciation.

Compute the revised depreciation expense for 2003.


Slide4-29

Asset cost 30,000$ Accumulated depreciation 12/31/02 - ($3,000 × 3 years) (9,000) Remaining to be depreciated 21,000 Remaining useful life ÷ 5 yearsRevised annual depreciation 4,200$

Record depreciation expense of $4,200 for2003 and subsequent years.

Change in EstimatesExample


Slide4-30


Financial statements

are prepared for separate

entities.


Slide4-31


If two entities combine, a single set of consolidated financial statements

is generally required.


Slide4-32


If two entities combine:

1. Prepare a single set of consolidated financial statements.

2. Retroactively restate financial statements of prior periods.


Slide4-33

Corrections of errors from a previous period.

Appear on the Statement of Retained Earnings as an adjustment to beginning retained earnings.

Must show the adjustment net of income taxes.

Prior Period Adjustments


Slide4-34

Prior Period Adjustments Example

While reviewing the depreciation entries for 2001-2004, the controller found that

in 2003 depreciation expense was incorrectly debited for $150,000 when in

fact it should have been debited $125,000. All items are taxed at 30%.

Prepare the necessary journal entry in 2004 to correct this prior period error.


Slide4-35

GENERAL JOURNAL Page: 180Date Description PR Debit Credit

12/31/03 Depreciation Expense 150,000

Accumulated Depreciation 150,000

If this was the original entry, how do we correct it?

Can we just reverse it? Why or why not?

If this was the original entry, how do we correct it?

Can we just reverse it? Why or why not?



Slide4-36


2004 Accumulated Depreciation 25,000

2004 Entry

To correct the 2003 error in 2004, we can debit Accumulated Depreciation since it is

a permanent account.

To correct the 2003 error in 2004, we can debit Accumulated Depreciation since it is

a permanent account.



Slide4-37



Retained Earnings 17,500

2004 Entry

We can’t credit Depreciation Expensesince it was closed in 2003, so we credit

Retained Earnings.

We can’t credit Depreciation Expensesince it was closed in 2003, so we credit

Retained Earnings.



Slide4-38



Income Taxes Payable 7,500

Retained Earnings 17,500

2004 Entry

Remember to consider the tax effects:$25,000 × 30% = $7,500 taxes payableRemember to consider the tax effects:$25,000 × 30% = $7,500 taxes payable



Slide4-39

Basic Earnings Per Share


Slide4-40

Earnings Per Share Disclosure

Report EPS data separately for:

1. Income from Continuing Operations

2. Discontinued Operations

3. Extraordinary Items

4. Cumulative Effect of a Change in Accounting Principle

5. Net Income


Slide4-41

Statement of Cash Flows

Provides relevant information about a company’s inflows and outflows of cash.

Helps investors and creditors to assess future net cash flows liquidity long-term solvency.


Slide4-42

Outflows to: Purchase of goods for resale

and services. Salaries and wages. Interest on debt. Income taxes.

Outflows to: Purchase of goods for resale

and services. Salaries and wages. Interest on debt. Income taxes.

Inflows from: Sales to customers. Interest and dividends

received.

Inflows from: Sales to customers. Interest and dividends

received.

Cash Flows from Operating Activities

Cash Flows from

Operating Activities

Cash Flows from

Operating Activities

+

_


Slide4-43 Direct and Indirect Methods of

Reporting

Two Formats for Reporting Operating Activities

Reports the cash effects of each

operating activity

Direct Method

Starts with accrual net income and

converts to cash basis

Indirect Method


Slide4-44

Cash Flows from

Investing Activities

Cash Flows from

Investing Activities

+

_

Cash Flows from Investing Activities

Inflows from: Sale of property, plant, and

equipment. Sale or maturity of investment

securities (stocks and bonds). Collection of nontrade

receivables.

Inflows from: Sale of property, plant, and

equipment. Sale or maturity of investment

securities (stocks and bonds). Collection of nontrade

receivables.

Outflows to: Purchase of property, plant, and

equipment. Purchase of investment

securities (stocks and bonds). Loans to other entities.

Outflows to: Purchase of property, plant, and

equipment. Purchase of investment

securities (stocks and bonds). Loans to other entities.


Slide4-45

Cash Flows from

Financing Activities

Cash Flows from

Financing Activities

+

_

Cash Flows from Financing Activities

Inflows from: Borrowing on notes,

mortgages, bonds, etc. from creditors.

Issuing stock to owners.

Inflows from: Borrowing on notes,

mortgages, bonds, etc. from creditors.

Issuing stock to owners.

Outflows to: Repay principal to creditors

(excluding interest). Repurchase stock from owners. Dividends to owners.

Outflows to: Repay principal to creditors

(excluding interest). Repurchase stock from owners. Dividends to owners.


Slide4-46

End of Chapter 4

Documents

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 4 The Income Statement and Statement of Cash Flows