The Income Statement, Comprehensive Income, and the Statement of Cash Flows Chapter 4 1

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The Income Statement, Comprehensive Income, and the Statement of Cash Flows

Chapter 4

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UNIT 4PROJECT

• It is the end of a reporting period. • Because there are more people than usual retiring

this year, your manager has asked your accounting department to create 2 things:

• A process documentation detailing the different methods of preparing income statements, specific sections of the income statement, and how to handle the special types of income statement items

• Basic financial statements for your company

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Individual Portion

• 1-Visit the SEC's Web site (http://www.sec.gov/edgar/searchedgar/companysearch.html). – Select a company filing of your choice that

contains a multiple-step income statement.– Communicate your selection with your group

(each of you should submit a different company).– Submit the link to this filing as proof of your

research.

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Individual Portion• 2-Prepare a process documentation that

– is prepared in a professional manner because it will be the desktop guide used by others in the event of your absence to prepare the financial statements for Music Warehouse.

– is in the form of a memorandum or as a numbered listing of items, depending on your individual preference.

– includes the following elements: • a definition and description of the specific sections of the income

statement• a description of the different methods of preparing income

statements• an explanation of the conceptual guidelines for reporting income• how to handle the special types of income statement items • Please post to the submitted assignment area

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• Using the information below, do the following:• 1-Prepare a multiple-step income statement for

Music Warehouse.• 2-Prepare a statement of changes in

stockholder's equity for Music Warehouse. • You may work together, or you may assign each

group member a different financial statement or part of the assignment to work on.

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Music Warehouse

Adjusted Trial Balance

December 31, 2008

Debit Credit

Cash $24,675

Accounts Receivable 5,625

Inventory 65,980

Land 93,000

Building 289,000

Accumulated Depreciation 75,000

Notes Payable 85,000

Accounts Payable 53,600

Interest Payable 4,750

Common Stock 10,000

Additional Paid-in Capital 120,000

Dividends 10,000

Retained Earnings 59,980

Sales 937,500

Sales Discounts 22,675

Cost of Goods Sold 723,000

Salaries 81,000

Utilities 8,900

Repairs & Maintenance 5,225

Telephone 2,850

Interest Expense 4,400

Depreciation Expense 9,500

$1,345,830 $1,345,830

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• The following is additional information needed for financial-statement preparation:

• Loss as a result of hurricane damage on the building: $17,000 (assume that the building is not located in an area that sustains frequent hurricane damage.)

• Loss because of the discontinuation of the cassette tape music segment: $26,875

• Beginning of the year balance of common stock: $8,000 (assume that changes are related to issuance of common stock.)

• Beginning of the year balance of additional paid-in capital: $102,000

• Effective income tax rate: 35%

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• Once more, here are the requirements:• 1-Prepare a multiple-step income statement

for Music Warehouse.• 2-Prepare a statement of changes in

stockholder's equity for Music Warehouse.

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• For each student, please type your name and your selected company's name and the link of the company

• Student name:

• Selected company name

• Selected company link

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Sales Less: Sales discounts Net salesCost of goods soldGross profit

Salaries expense Depreciation expense Utilities expense Repairs & maintenance expense Telephone expense Total operating expensesIncome from operations before interest and income tax expenses

Interest expenseIncome from operations before income taxesIncome tax expenseIncome from continuing operations before extraordinary loss and discontinued operations Extraordinary Loss Discontinued operationsNet income

Other expenses and losses

Music WarehouseIncome Statement

For the Year Ended December 31, 2008

Sales revenues

Operating expenses

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# of shares

ValueAdditional

Paid- In Capital

Retained Earnings

Balance, December 31, 2007Sale of common stock

Net incomeDividends

Balance, December 31, 2008

Music WarehouseStatement of Changes in Stockholder's Equity

For the Year Ended December 31, 2008Common Stock

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Learning Objectives• LO4-1 Discuss the importance of income from continuing

operations and describe itscomponents.

• LO4-2 2-Discuss the components of operating and non-operating income earnings.

• LO4-3• LO4-4 Define what constitutes discontinued operations and

describe the appropriate income statement presentation for these transactions.

• LO4-5 Define extraordinary items and describe the appropriate income statement presentation for these transactions.

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Learning Objectives• LO4-6 Define earnings per share (EPS) and explain required

disclosures of EPS for certain income statement components.

• LO4-7 Explain the difference between net income and comprehensive income and how we report components of the difference.

• LO4-8 Describe the purpose of the statement of cash flows.• LO4-9 Identify and describe the various classifications of cash

flows presented in a statement of cash flows.

• LO4-10 Discuss the primary differences between U.S. GAAP and IFRS with respect to the income statement and statement of cash flows.

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1-Discuss the importance of income statement

• Before we discuss the specific components of an income statement in depth, let’s take a quick look at the general makeup of the statement.

• The graphic on the next slide illustrates an income statement for a hypothetical manufacturing company that you can refer to as we proceed through the chapter.

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• At this point, our objective is only to gain a general perspective of the items reported and classifications contained in corporate income statements.

• Notice the three general areas include • 1- income from continuing operations,• 2- separately reported items, and • 3- earnings per share.

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An income statement for a

hypothetical manufacturing

company that you can refer to as we proceed through

the chapter.

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• The need to provide information to help analysts predict future cash flows emphasizes the importance of properly reporting the amount of income from the entity’s continuing operations. Clearly, it is the operating transactions that probably will continue into the future that are the best predictors of future cash flows.

• The components of income from continuing operations are:• 1- revenues, expenses (including income taxes), • 2- gains, and losses, excluding those related to discontinued

operations and extraordinary items.• Revenues are inflows of resources resulting from providing

goods or services to customers, such as sales revenue.

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• Expenses are outflows of resources incurred in generating revenues, such as cost of goods sold and operating expenses.

• Gains and losses are increases or decreases in equity from peripheral or incidental transactions of an entity.

• In general, these gains and losses are those changes in equity that do not result directly from operations but nonetheless are related to those activities.

• For example, gains and losses from the routine sale of equipment, buildings, or other operating assets and from the sale of investment assets normally would be included in income from continuing operations.

• Income tax expense is reported separately because of its importance and size.

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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.

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Review Questions

• 1. Intraperiod income tax presentation is primarily a matter of:

• A. Valuation.• B. Going concern.• C. Periodicity.• D. Allocation.

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Review Questions

• D. Allocation.

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Review Questions

• 2. The difference between single-step and multiple-step income statements is primarily an issue of:

• A. Consistency.• B. Presentation.• C. Measurement.• D. Valuation.

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Review Questions

• B. Presentation.

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Review Questions

• 3. Popson Inc. incurred a material loss that was not unusual in character but was clearly an infrequent occurrence. This loss should be reported as:

• A. An extraordinary loss.• B. A separate line item between income from continuing

operations and income from discontinued operations.• C. A separate line item within income from continuing

operations.• D. A separate line item in the retained earnings statement.

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Review Questions

• C. A separate line item within income from continuing operations.

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Review Questions

• 4. Provincial Inc. reported the following before-tax income statement items:

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Review Questions

• Provincial has a 30% income tax rate.

• Provincial would report the following amount of income tax expense as a separate item in the income statement:

• A. $198,000.• B. $180,000.• C. $168,000.• D. $150,000.

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Review Questions

• B. $180,000.• $600,000 x 30% = $180,000• Both extraordinary gain and loss are reported

net of tax

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Review Questions

• 5- Freda's Florist reported the following before-tax income statement items for the year ended December 31, 2013:

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Review Questions

• All income statement items are subject to a 40% income tax rate. In its 2013 income statement, Freda's separately stated income tax expense and total income tax expense would be:

• A. $128,000 and $128,000, respectively.• B. $128,000 and $100,000, respectively.• C. $100,000 and $128,000, respectively.• D. $100,000 and $100,000, respectively.

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Review Questions

C. $100,000 and $128,000, respectively

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2-Discuss the components of operating and nonoperating income

• Many corporate income statements distinguish between operating income and nonoperating income.

• Operating income includes revenues and expenses directly related to the primary revenue-generating activities of the company.

• For example, operating income for a manufacturing company includes sales revenues from selling the products it manufactures as well as all expenses related to this activity.

• Similarly, operating income might also include gains and losses from selling equipment and other assets used in the manufacturing process.

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• Nonoperating income relates to peripheral or incidental activities of the company. For example, a manufacturer would include interest and dividend revenue, gains and losses from selling investments, and interest expense in nonoperating income.

• Other income (expense) often is the classification heading companies use in the income statement for nonoperating items.

• On the other hand, a financial institution like a bank would consider those items to be a part of operating income because they relate to the principal revenue generating activities for that type of business.

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Operating Income Nonoperating Income

Operating versus Nonoperating Income

Includes revenues and expenses

directly related to the principal

revenue-generating activities of the

company

Includes certain gains and losses and

revenues and expenses related to

peripheral or incidental activities

of the company

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• 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, • 1- the single-step and • 2- the multiple-step.

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• This next slide illustrates an example of a single-step income statement for a hypothetical manufacturing company, Maxwell Gear Corporation.

• 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.

• Operating and nonoperating items are not separately classified.

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Income Statement (Single-Step)

Expenses & Losses

Revenues & Gains

Proper Heading

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• The multiple-step income statement format on the next slide includes a number of intermediate subtotals before arriving at income from operations. However, notice that the net income is the same no matter which format is used.

• A primary advantage of the multiple-step format is that, • 1- By separately classifying operating and nonoperating

items, it provides information that might be useful in analyzing trends.

• 2- Similarly, the classification of expenses by function also provides useful information.

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Income Statement (Multiple-Step)

Non- operating Items

Gross Profit

Operating Expenses

Proper Heading

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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: 1- International standards require certain minimum

information to be reported on the face of the income statement. U.S. GAAP has no minimum requirements.

2- 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.

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3. 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.

4. As we discuss later in the chapter, we report “extraordinary items” separately in an income statement prepared according to U.S. GAAP. International standards prohibit reporting “extraordinary items.”

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• 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.

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• Earnings quality refers to the ability of reported earnings 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 transitory earnings effects from its permanent earnings.

• Transitory 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.

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3-Describe earnings quality

• An often-debated contention is that, within GAAP, managers have the power, to a limited degree, to manipulate reported company income. And the manipulation is not always in the direction of higher income.

• In a Fortune article titled “Manipulating Profits: How It’s Done,” Ford S. Worthy states that “Most executives prefer to report earnings that follow a smooth, regular, upward path.

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• They hate to report declines, but they also want to avoid increases that vary wildly from year to year; it’s better to have two years of 15% earnings increases than a 30% gain one year and none the next.

• As a result, some companies ‘bank’ earnings by understating them in particularly good years and use the banked profits to polish results in bad years.”

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• How do managers manipulate income? • Two major methods are • (1) income shifting and • (2) income statement classification.• 1- Income shifting is achieved by accelerating or

delaying the recognition of revenues or expenses. For example, a practice called “channel stuffing” accelerates revenue recognition by persuading distributors to purchase more of your product than necessary near the end of a reporting period.

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• 2- The most common income statement classification manipulation involves the inclusion of recurring operating expenses in “special charge” categories such as restructuring costs.

• This practice sometimes is referred to as “big bath” accounting, a reference to cleaning up company balance sheets.

• Asset reductions, or the incurrence of liabilities, for these restructuring costs result in large reductions in income that might otherwise appear as normal operating expenses either in the current or future years.

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Manipulating Income and Income Smoothing

• Should all items of revenue and expense included in operating income be considered indicative of a company’s permanent earnings? No.

• Operating expenses may include unusual items that may or may not continue in the future.

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

• As an example, suppose terminated employees are to receive termination benefits, but only after they remain with the employer beyond a minimum retention period. In that case, a liability for termination benefits, and corresponding expense, should be accrued in the period(s) the employees render their service.

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• On the other hand, if future service beyond a minimum retention period is not required, the liability and corresponding expense for benefits are recognized at the time the company communicates the arrangement to employees. In both cases, the liability and expense are recorded at the point they are deemed incurred.

• Similarly, costs associated with closing facilities and relocating employees are recognized when goods or services associated with those activities are received. GAAP also establishes that fair value is the objective for initial measurement of the liability, and that a liability’s fair value often will be measured by determining the present value of future estimated cash outflows.

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• Goodwill impairment and long-lived asset impairment involves asset impairment losses or charges.

• Any long-lived asset, whether tangible or intangible, should have its balance reduced if there has been a significant impairment of value.

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Components of Earnings

• 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 and gains or losses are only tangentially related to normal operations. These we refer to as nonoperating items.

• Some nonoperating items have generated considerable discussion with respect to earnings quality, notably gains and losses generated from the sale of investments.

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Components of Earnings

• Companies often voluntarily provide a pro forma earnings number when they announce annual or quarterly earnings.

• Supposedly, these pro forma earnings numbers are management’s view of “permanent earnings,” in the sense of being a better long-run performance measure.

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Nonoperating Income and Earnings Quality

• GAAP requires that certain transactions be reported separately in the income statement, below income from continuing operations. There are two types of events that, if they have a material effect on the income statement, require separate reporting below income from continuing operations as well as separate disclosure:

• (1) Discontinued operations and • (2) Extraordinary items.

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Nonoperating Income and Earnings Quality

• In fact, these are the only two events that are allowed to be reported below continuing operations.

• The presentation order is as shown on the next slide. The objective is to separately report all the income effects of each of these items.

• The process of associating income tax effects with the income statement components that create them is referred to as intraperiod tax allocation, which we will address in the next section.

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Separately Reported ItemsReported separately, net of taxes:

Discontinued operations

Extraordinary items

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Separately Reported Items

• Intraperiod tax allocation associates (or allocates) income tax expense (or income tax benefits if there is a loss) with each major component of income that causes it. As a result, the two items reported separately below income from continuing operations are presented net of the related income tax effect.

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• For example, assume a company experienced an extraordinary gain during the year. The amount of income tax expense deducted from income from continuing operations is the amount of income tax expense that the company would have incurred if there were no extraordinary gain. The effect on income taxes caused by the extraordinary item is deducted from the extraordinary gain in the income statement.

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• Assume that the Maxwell Gear Corporation had income from continuing operations before income tax expense of $200,000 and an extraordinary gain of $60,000 in 2013. The income tax rate is 40% on all items of income or loss.

• Therefore, the company’s total income tax expense is $104,000 (40% × $260,000). However, as illustrated on this slide, the total tax expense of $104,000 must be allocated, $80,000 to continuing operations and $24,000 (40% × $60,000) to the extraordinary gain.

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Intraperiod Income Tax AllocationIncome 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 and Extraordinary

Items net of related income tax effect.

Report effects of Discontinued Operations and Extraordinary

Items net of related income tax effect.

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Intraperiod Income Tax Allocation

• As part of the continuing process to converge U.S. GAAP and international standards, the FASB and IASB have been working together to develop a common definition and a common set of disclosures for discontinued operations.

• A final Accounting Standards Update had not been issued, but the two Boards had expressed a new direction in an Exposure.

• The proposed defines a discontinued operation as a “component” that either

• (a) has been disposed of or • (b) is classified as held for sale, and represents one of the

following:

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Intraperiod Income Tax Allocation

1. a separate major line of business or major geographical area of operations,

2. part of a single coordinated plan to dispose of a separate major line of business or geographical area of operations, or

3. a business that meets the criteria to be classified as held for sale on acquisition.

• Many were critical of prior guidance, feeling its definition of a component of the entity was too broad. In addition to achieving convergence with international standards, the new guidance is expected to reduce the number of business segments that require separate income statement presentation as a discontinued operation.

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Review Questions

• 6. Pro forma earnings: • A. Could be considered management's view of

permanent earnings.• B. Are needed for the correction of errors.• C. Are standardized under generally accepted

accounting principles.• D. Are useful to compare two different firms'

performance.

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Review Questions

• A. Could be considered management's view of permanent earnings.

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Review Questions

• 7. The distinction between operating and nonoperating income relates to:

• A. Continuity of income.• B. Principal activities of the reporting

entity.• C. Consistency of income stream.• D. Reliability of measurements.

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Review Questions

• B. Principal activities of the reporting entity.

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Review Questions

• 8. The principal benefit of separately reporting discontinued operations and extraordinary items is to enhance:

• A. Predictive ability.• B. Consistency in reporting.• C. Intraperiod continuity.• D. Comprehensive reporting.

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Review Questions

• A. Predictive ability.

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4-Discontinued OperationsAs part of the continuing process to converge U.S. GAAP and

international standards, the FASB and IASB have been working together to develop a common definition and a common set of

disclosures for discontinued operations.

The proposed ASU defines a discontinued operation as a “component” that either (a) has been disposed of or (b) is classified as held for sale, and represents one of the following:1. a separate major line of business or major geographical area of

operations,2. part of a single coordinated plan to dispose of a separate major line of

business or geographical area of operations, or3. a business that meets the criteria to be classified as held for sale on

acquisition.

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4-Define what constitutes discontinued operations

• When a component has been sold, the reported income effects of a discontinued operation will include two elements:

• (1) income or loss from operations of the component from the beginning of the reporting period to the disposal date and

• (2) gain or loss on the disposal of the component.

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4-Define what constitutes discontinued operations

• When the component is considered held for sale, the reported income effects of a discontinued operation will include two elements:

• (1) income or loss from operations of the component from the beginning of the reporting period to the end of the reporting period and

• (2) an “impairment loss” if the carrying value of the assets of the component is more than the fair value minus cost to sell.

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Review Questions

• 9. The Claxton Company manufactures children's toys and also has a division that makes automobile parts. Due to a change in its strategic focus, the company sold the automobile parts division. The division qualifies as a component of the entity according to GAAP regarding disposal of long-lived assets. How should Claxton report the sale in its 2013 income statement?

• A. Report it as an extraordinary item.• B. Report it as a discontinued operation, reported below income

from continuing operations.• C. Report the income or loss from operations of the division in

discontinued operations below continuing operations and the gain or loss from disposal in continuing operations.

• D. None of the above.

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Review Questions

• B. Report it as a discontinued operation, reported below income from continuing operations.

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Review Questions

• 10- On November 1, 2013, Jamison Inc. adopted a plan to discontinue its barge 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 April 30, 2014. On December 31, 2013, the company's year-end, the following information relative to the discontinued division was accumulated:

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Review Questions

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Review Questions

• In its income statement for the year ended December 31, 2013, Jamison would report a before-tax loss on discontinued operations of:

• A. $65 million.• B. $50 million.• C. $130 million.• D. $145 million.

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Review Questions

• A =$65 MILLION

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Review Questions

• On October 28, 2013, Mercedes Company committed to a plan to sell a division that qualified as a component of the entity according to GAAP regarding discontinued operations and was properly classified as held for sale on December 31, 2013, the end of the company's fiscal year. The division's loss from operations for 2013 was $2,000,000.

• 11. The division's book value and fair value less cost to sell on December 31 were $3,000,000 and $2,500,000, respectively. What before-tax amount(s) should Mercedes report as loss on discontinued operations in its 2013 income statement?

• A. $2,000,000 loss.• B. $2,500,000 loss.• C. None.• D. $500,000 impairment loss included in continuing operations and a

$2,000,000 loss from discontinued operations

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Review Questions

• B. $2,500,000 loss

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Review Questions

• 12. The division's book value and fair value less cost to sell on December 31 were $3,000,000 and $3,500,000, respectively. What before-tax amount(s) should Mercedes report as loss on discontinued operations in its 2013 income statement?

• A. $2,000,000 loss.• B. $2,500,000 loss.• C. None.• D. $500,000 gain included in continuing operations

and a $2,000,000 loss from discontinued operations.

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Review Questions

• A. $2,000,000 loss. $2,000,000 loss from operations only. There is no impairment loss.

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Review Questions

• On May 1, Foxtrot Co. agreed to sell the assets of its Footwear Division to Albanese Inc. for $80 million. The sale was completed on December 31, 2013. The following additional facts pertain to the transaction:

• • The Footwear Division qualifies as a component of the entity according to GAAP

• regarding discontinued operations.• • The book value of Footwear's assets totaled $48 million on the

date of the sale.• • Footwear's operating income was a pre-tax loss of $10 million in

2013.• • Foxtrot's income tax rate is 40%.

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Review Questions

• 13. In the 2013 income statement for Foxtrot Co., it would report:

• A. Income (loss) on its total operations for the year without separation.

• B. Income (loss) on its continuing operation only.

• C. Income (loss) from its continuing and discontinued operations separately.

• D. Income and gains separately from losses.

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Review Questions

• C. Income (loss) from its continuing and discontinued operations separately.

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Review Questions

• 14. In the 2013 income statement for Foxtrot Co., it would report:

• A. All income taxes would be combined into one line item.

• B. Income taxes would be separated for continuing and discontinued operations.

• C. Income taxes would be reported for income and gains only.

• D. None of the above is correct.

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Review Questions

• B. Income taxes would be separated for continuing and discontinued operations.

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Review Questions

• 15-Cendant Corporation's results for the year ended December 31, 2013, include the following material items:

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Review Questions

• Cendant Corporation's income from continuing operations before income taxes for 2013 is:

• A. $900,000.• B. $880,000.• C. $820,000• D. $320,000

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Review Questions

• C. $820,000• $6,200,000 - 3,800,000 - 1,300,000 - 200,000 -

80,000 = $820,000

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5-Define extraordinary items

• Extraordinary items are material events and transactions that are both

• 1- Unusual in nature and • 2- Infrequent in occurrence and are reported net of

related tax effects. These criteria must be considered in light of the environment in which the entity operates.

• There is obviously a considerable degree of subjectivity involved in the determination. A key point in the definition of an extraordinary item is that determining whether an event satisfies both criteria depends on the environment in which the firm operates.

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5-Define extraordinary items

• The environment includes factors such as the type of products or services sold and the geographical location of the firm’s operations. What is extraordinary for one firm may not be extraordinary for another firm.

• For example, a loss caused by a tornado in Missouri may not be judged to be extraordinary. However, tornado damage in another state may indeed be unusual and infrequent.

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U. S. GAAP vs. IFRS

• Report extraordinary items separately in the income statement.

The scarcity of extraordinary gains and losses reported in corporate income statements and the desire to converge U.S. and

international accounting standards could guidethe FASB to the elimination of the extraordinary item classification.

• Prohibits reporting extraordinary items in the income statement or notes.

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U. S. GAAP vs. IFRS

• Items that are material and are either unusual or infrequent—but not both—are included as a separate item in continuing operations.

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Accounting Changes

• Accounting changes fall into one of three categories: • (1) a change in an accounting principle, • (2) a change in an accounting 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.

• A brief overview of a change in accounting principle, a change in estimate, and correction of errors is provided here.

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Accounting Changes

• 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.

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Accounting Changes• GAAP requires that voluntary accounting changes be accounted for

retrospectively. That is, we recast prior years’ financial statements when we report those statements again (in comparative statements, for example) to appear as if the new accounting method had been used in those prior periods.

• For each year in the comparative statements reported, 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.

• Then, a journal entry is created to adjust all account balances affected to what those amounts would have been. An adjustment is made to the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders’ equity to account for the cumulative income effect of changing to the new principle in periods prior to those reported.

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Accounting Changes• When a new FASB accounting standard update mandates a change in

accounting principle, the board often allows companies to choose among multiple ways of accounting for the changes.

• One approach generally allowed is to account for the change retrospectively, exactly as we account for voluntary changes in principles.

• The FASB may also allow companies to report the cumulative effect on the income of previous years from having used the old method rather than the new method in the income statement of the year of change as a separately reported item below extraordinary items. Other approaches might also be allowed.

• Therefore, when a mandated change in accounting principle occurs, it is important to check the accounting standards update to determine how companies might account for the change.

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Change in Accounting Principle

• 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

• 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.

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Change in Depreciation, Amortization, or Depletion Method

• 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 expense.

• 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.

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Change in Depreciation, Amortization, or Depletion Method

• If the original estimate had been based on erroneous information or calculations or had not been made in good faith, the revision of that estimate would constitute the correction of an error.

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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.

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• 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.

• n practice, the vast majority of errors are not material and are, therefore, simply corrected in the year discovered.

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• However, material errors that are discovered in subsequent periods require a prior period adjustment.

• 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.

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Review Questions

• 16. An extraordinary event for financial reporting purposes is both:

• A. Unusual and material.• B. Infrequent and significant.• C. Material and infrequent.• D. Unusual and infrequent.

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Review Questions

• D. Unusual and infrequent

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Review Questions

• 17. Major Co. reported 2013 income of $300,000 from continuing operations before income taxes and a before-tax extraordinary loss of $80,000. All income is subject to a 30% tax rate. In the 2013 income statement, Major Co. would show the following line-item amounts for income tax expense and net income:

• A. $66,000 and $210,000.• B. $90,000 and $154,000. • C. $90,000 and $276,000.• D. $66,000 and $220,000.

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Review Questions

• B. $90,000 and $154,000

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Review Questions

• 18. Howard Co.'s 2013 income from continuing operations before income taxes was $280,000. Howard Co. reported a before-tax extraordinary gain of $50,000. All tax items are subject to a 40% tax rate. In its income statement for 2013, Howard Co. would show the following line-item amounts for net income and income tax expense:

• A. $198,000 and $112,000.• B. $230,000 and $92,000.• C. $330,000 and $132,000.• D. $198,000 and $79,000.

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Review Questions

• A. $198,000 and $112,000.

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Review Questions

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Review Questions

• 19. Misty Company reported the following before-tax items during the current year:

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Review Questions

• Misty's effective tax rate is 40%.• 20. What is Misty's income before

extraordinary item(s)? • A. $198.• B. $210.• C. $330.• D. $360.

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Review Questions

• A. $198.• ($600 - 250 - 20) x (1 - .4) = $198

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Review Questions

• 21. What is Misty's net income for the current year?

• A. $148.• B. $168.• C. $112.• D. None of the amounts given are correct.

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Review Questions

• B. $168.

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Review Questions

• 22. Cal's Cookies reported 2013 before-tax income before extraordinary items of $152,000 and a before-tax extraordinary loss of $32,000. All tax items are subject to a 30% tax rate. In its 2013 income statement, Cal's reported the following amounts as separate line items for net income and income tax expense:

• A. $120,000 and $36,000.• B. $84,000 and $45,600.• C. $84,000 and $36,000.• D. $120,000 and $45,600.

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Review Questions

• B. $84,000 and $45,600.

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Review Questions

118

6-Define earnings per share (EPS)

• One of the most widely used ratios is earnings per share, which shows the amount of income earned by a company expressed on a per share basis. Companies report both basic and diluted earnings per share.

• Basic earnings per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding.

• Diluted earnings per share reflects the potential for dilution that could occur for companies that have certain securities outstanding that are convertible into common shares or stock options that could create additional common shares if the options were exercised.

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Earnings Per Share DisclosureOne of the most widely used ratios is earnings per share (EPS),

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

Basic EPS

Net income less preferred dividends

Weighted-average number of common shares outstanding for the

period

Diluted EPS

Reflects the potential dilution that could occur for companies that have certain securities

outstanding that are convertible into common shares or stock options that could create

additional common shares if the options were exercised.

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6-Define earnings per share (EPS)

• Companies must disclose per share amounts for

• (1) income or loss before any separately reported items,

• (2) each separately reported item, and • (3) net income or loss.

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Review Questions

• 23. Which of the following is not true about EPS?

• A. It must be reported by all corporations whose stock is publicly traded.

• B. It must be reported separately for discontinued operations.

• C. It must be reported separately for extraordinary items.

• D. It must be reported on operating income.

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Review Questions

• D. It must be reported on operating income.

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Review Questions

• 24. The Maytag Corporation's income statement includes income from continuing operations, a loss from discontinued operations, and extraordinary items. Earnings per share information would be provided for:

• A. Net income only.• B. Income from continuing operations and net income only.• C. Income from continuing operations, loss from discontinued

operations, and net income only.• D. Income from continuing operations, loss from discontinued

operations, extraordinary items, and net income.

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Review Questions

• D. Income from continuing operations, loss from discontinued operations, extraordinary items, and net income.

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Review Questions

• 25- Canton Corporation reported the following items in its adjusted trial balance for the year ended December 31, 2013:

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Review Questions

• Canton is subject to a 30% tax rate.• Required:• Prepare the December 31, 2013, income

statement for Canton Corporation, starting with income from continuing operations before income taxes.

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Review Questions

128

7-Explain the difference between net income and comprehensive income

• Comprehensive income is the total change in equity for a reporting period other than from transactions with owners.

• Comprehensive income includes net income as well as other gains and losses that change shareholders’ equity but are not included in traditional net income.

129

Comprehensive Income

An expanded version of income that includes four types of gains and

losses that traditionally have not been included

in income statements.

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The calculation of net income omits certain types of gains and losses that are included in comprehensive income. Companies must report both net income and comprehensive income and reconcile the difference between the two.

The following items are part of comprehensive income:

1- Changes in the market value of certain investments.

2- Gains and losses due to revising assumptions or market returns differing from expectations and prior service cost from amending the plan.

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3- 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.

4- Gains or losses from changes in foreign currency exchange rates. The amount could be an addition to or reduction in shareholders’ equity.

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• Companies must report both net income and comprehensive income and reconcile the difference between the two.

• Be sure to remember that net income actually is a part of comprehensive income. The information in the income statement and other comprehensive income items can be presented either in:

• (1) a single, continuous statement of comprehensive income or

• (2) in two separate, but consecutive statements, an income statement and a statement of comprehensive income.

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Other Comprehensive Income

($ in millions) Net income $xxx Other comprehensive income: Net unrealized holding gains (losses) on investments (net of tax)* $x Gains (losses) from and amendments to postretirement benefit plans (net of

tax)† (x) Deferred gains (losses) from derivatives (net of tax)‡ (x) Gains (losses) from foreign currency translation (net of tax)§ x xx Comprehensive income $xxx *Changes in the market value of certain investments (described in Chapter 12). †Gains and losses due to revising assumptions or market returns differing from expectations and prior service cost from amending the plan (described in Chapter 17). ‡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 (described in the Derivatives Appendix to the text). §Gains or losses from changes in foreign currency exchange rates. The amount could be an addition to or reduction in shareholders’ equity. (This item is discussed elsewhere in your accounting curriculum.)

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• Both U.S. GAAP and IFRS allow companies to report comprehensive income in either a single statement of comprehensive income or in two separate statements. Other comprehensive income items are similar under the two sets of standards.

• However, an additional OCI item, changes in revaluation surplus, is possible under IFRS.

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• If the revaluation option is chosen and fair value is higher than book value, the difference, changes in revaluation surplus, is reported as other comprehensive income and then accumulates in a revaluation surplus account in equity.

136


• In addition to reporting OCI that occurs in the current reporting period, we must also report these amounts on a cumulative basis in the balance sheet.

• This is consistent with the way we report net income that occurs in the current reporting period in the income statement and also report accumulated net income (that hasn’t been distributed as dividends) in the balance sheet as retained earnings.

• Similarly, we report OCI as it occurs in the current reporting period and also report accumulated other comprehensive income (AOCI) in the balance sheet.

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Review Questions

• 26. Each of the following would be reported as items of other comprehensive income except:

• A. Foreign currency translation gains.• B. Unrealized gains on investments

accounted for as securities available for sale.• C. Deferred gains from derivatives.• D. Gains from the sale of equipment.

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Review Questions

• D. Gains from the sale of equipment.

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Review Questions

• 27. Reporting comprehensive income can be accomplished by each of the following methods except:

• A. In the statement of shareholders' equity.• B. A single, continuous statement of

comprehensive income.• C. In two separate, but consecutive

statements.• D. All of the above are acceptable methods.

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Review Questions

• A. In the statement of shareholders' equity.

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Review Questions

• 28. Comprehensive income is the change in equity from:

• A. Owner transactions.• B. Nonowner transactions.• C. Owner or nonowner transactions.• D. Capital transactions.

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Review Questions

• B. Nonowner transactions.

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Review Questions

29. Reconciliation between net income and comprehensive income would include: • A. Unrealized losses but not unrealized gains on

available for sale securities.• B. Unrealized gains but not unrealized losses on

available for sale securities.• C. Unrealized losses and unrealized gains on available

for sale securities.• D. Neither unrealized losses nor unrealized gains on

available for sale securities.

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Review Questions

• C. Unrealized losses and unrealized gains on available for sale securities.

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8-Describe the purpose of the statement of cash flows. 9-Identify and describe the various classifications of cash

• The purpose of the statement of cash flows is to provide information about the cash receipts and cash disbursements of an enterprise that occurred during a period.

• The statement of cash flows helps investors and creditors assess future net cash flows, liquidity, and long-term solvency.

• A statement of cash flows is required for each income statement period reported.

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• Operating activities are inflows and outflows of cash related to the transactions entering into the determination of net operating income.

• A few examples of cash inflows and outflows from operating activities are listed on the next slide.

• The difference between the inflows and the outflows is called net cash flows from operating activities. This is equivalent to net income if the income statement had been prepared on a cash basis rather than an accrual basis.

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Operating Activities

Cash Flows from

Operating Activities

Inflows from: sales to customers. interest and dividends received.

+

Outflows for: purchase of inventory. salaries, wages, and other

operating expenses. interest on debt. income taxes.

_

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• Two generally accepted formats can be used to report operating activities,

• 1- the direct method and • 2- the indirect method.• Under the direct method, the cash effect of each

operating activity is reported directly in the statement of cash flows.

• Under the indirect method, cash flow from operating activities is derived indirectly by starting with reported net income and adding or subtracting items to convert that amount to a cash basis.

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• Investing activities involve the acquisition and sale of

• (1) long-lived assets used in the business and • (2) nonoperating investment assets. • A few examples of cash inflows and outflows from

investing activities are listed on the next slide. • The investing section of the statement of cash flows

is the same whether the direct or indirect method is used for preparation of the statement of cash flows.

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Cash Flows from

Investing Activities

+

Investing ActivitiesInflows from:

sale of long-lived assets used in the business.

sale of investment securities (stocks and bonds).

collection of nontrade receivables.

_Outflows for:

purchase of long-lived assets used in the business.

purchase of investment securities (stocks and bonds).

loans to other entities.

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• Financing activities involve cash inflows and outflows from transactions with creditors and owners.

• A few examples of cash inflows and outflows from financing activities are listed on the next slide.

• The financing section of the statement of cash flows is the same whether the direct or indirect method is used for preparation of the statement of cash flows.

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Cash Flows from

Financing Activities

+

_

Financing Activities

Inflows from: sale of shares to owners. borrowing from creditors

through notes, loans, mortgages, and bonds.

Outflows for: owners in the form of dividends or

other distributions. owners for the reacquisition of

shares previously sold. creditors as repayment of the

principal amounts of debt.

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• The statement of cash flows provides useful information about the investing and financing activities in which a company is engaged.

• Even though these primarily result in cash inflows and cash outflows, there may be significant investing and financing activities occurring during the period that do not involve cash flows at all.

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• In order to provide complete information about these activities, any significant noncash investing and financing activities (that is, noncash exchanges) are reported either on the face of the statement of cash flows or in a disclosure note.

• An example of a significant noncash investing and financing activity is the acquisition of equipment (an investing activity) by issuing either a long-term note payable or equity securities (a financing activity).

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8-Describe the purpose of the statement of cash flows9-Identify and describe the various classifications of cash

.

• Like U.S. GAAP, international standards also require a statement of cash flows. Consistent with U.S. GAAP, cash flows are classified as operating, investing, or financing activities.

• However, the U.S. standard designates cash outflows for interest payments and cash inflows from interest and dividends received as operating cash flows. Dividends paid to shareholders are classified as financing cash flows.

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8-Describe the purpose of the statement of cash flows9-Identify and describe the various classifications of cash

.

• IAS No. 7, on the other hand, allows more flexibility. Companies can report interest and dividends paid as either operating or financing cash flows and interest and dividends received as either operating or investing cash flows.

• Interest and dividend payments usually are reported as financing activities. Interest and dividends received normally are classified as investing activities.

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Review Questions

• 30. Change statements include a: • A. Retained earnings statement, balance

sheet, and cash flow statement.• B. Balance sheet, cash flow statement, and

income statement.• C. Cash flow statement, income statement,

and retained earnings statement.• D. Retained earnings statement, balance

sheet, and income statement.

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Review Questions

• C. Cash flow statement, income statement, and retained earnings statement.

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Review Questions

• 31. In comparing the direct method with the indirect method of preparing the statement of cash flows:

• A. Only operating activities are presented differently.• B. Only investing activities are presented differently.• C. Only financing activities are presented differently.• D. All activities are presented differently.

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Review Questions

• A. Only operating activities are presented differently.

• 32. The statement of cash flows reports cash

flows from the activities of: • A. Operating, purchasing, and investing.• B. Borrowing, paying, and investing.• C. Financing, investing, and operating.• D. Using, investing, and financing.

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Review Questions

• C. Financing, investing, and operating.

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Review Questions

• 33. Operating cash flows would exclude: • A. Interest received.• B. Interest paid.• C. Dividends paid.• D. Dividends received.

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Review Questions

• D. Dividends received.

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Review Questions

• 34. Operating cash outflows would include: • A. Purchase of investments.• B. Purchase of equipment.• C. Payment of cash dividends.• D. Purchases of inventory.

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Review Questions

• D. Purchases of inventory.

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Review Questions

• 35. Cash flows from investing do not include cash flows from:

• A. Lending money to another corporation.• B. The sale of equipment.• C. Borrowing.• D. The purchase of other corporation's

securities.

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Review Questions

• C. Borrowing.

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Review Questions

• 36. Cash flows from financing activities include:

• A. Interest received.• B. Interest paid.• C. Dividends received.• D. Dividends paid.

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Review Questions

• D. Dividends paid.

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Review Questions

• 37. Cash flows from investing activities do not include:

• A. Proceeds from issuing bonds.• B. Payment for the purchase of equipment.• C. Proceeds from the sale of marketable

securities.• D. Cash outflows from acquiring land.

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Review Questions

• B. Payment for the purchase of equipment

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Review Questions

• 38. The FASB's stated preference for reporting operating cash flows is the:

• A. Indirect method.• B. Direct method.• C. Working capital method.• D. All financial resources method.

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Review Questions

• B. Direct method.

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Review Questions

• 39. In the operating activities section of the statement of cash flows, we start with net income:

• A. In the direct method.• B. In the indirect method.• C. In both the direct and the indirect methods.• D. In neither the direct nor the indirect

methods.

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Review Questions

• B. In the indirect method.

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Review Questions

• 40. Which of the following is added to net income as an adjustment under the indirect method of preparing the statement of cash flows?

• A. Salaries payable decrease.• B. Gain on the sale of land.• C. Loss on the sale of equipment.• D. Accounts receivable increase.

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Review Questions

• C. Loss on the sale of equipment.

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Review Questions

• 41. Shively Mfg. Co. sold for $19,000 equipment that cost $40,000 and had a book value of $30,000. Shively would report:

• A. Operating cash inflows of $18,000.• B. Operating cash inflows of $8,000.• C. Financing cash inflows of $18,000.• D. Investing cash inflows of $19,000.

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Review Questions

• D. Investing cash inflows of $19,000.

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Review Questions

• 42. Arrow Printers paid $2,000 interest on short-term notes payable, $10,000 interest on long-term bonds, and $6,000 in dividends on its common stock. Arrow would report cash outflows from activities, as follows:

• A. Operating, $2,000; financing, $16,000.• B. Operating, $0; financing, $18,000.• C. Operating, $12,000; financing, $6,000.• D. Operating, $18,000; financing, $0.

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Review Questions

• C. Operating, $12,000; financing, $6,000.

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Review Questions

• 43. Lucia Ltd. reported net income of $135,000 for the year ended December 31, 2013. January 1 balances in accounts receivable and accounts payable were $29,000 and $26,000, respectively. Year-end balances in these accounts were $30,000 and $24,000, respectively. Assuming that all relevant information has been presented, Lucia's cash flows from operating activities would be:

• A. $132,000.• B. $134,000.• C. $136,000.• D. $138,000.

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Review Questions

• A. $132,000.

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Review Questions

• 44. Bird Brain Co. reported net income of $45,000 for the year ended December 31, 2013. January 1 balances in accounts receivable and accounts payable were $23,000 and $26,000 respectively. Year-end balances in these accounts were $22,000 and $28,000, respectively. Assuming that all relevant information has been presented, Bird Brain's cash flows from operating activities would be:

• A. $48,000.• B. $44,000.• C. $46,000.• D. $45,000.

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Review Questions

• A. $48,000.

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Review Questions

187

Review Questions

• 46. Jacobsen Corporation prepares its financial statement applying U.S. GAAP. During its 2013 fiscal year, the company reported before-tax income of $620,000. This amount does not include the following two items, both of which are considered to be material in amount:

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Review Questions

189

Review Questions

• The company's income tax rate is 40%. In its 2013 income statement, Jacobsen would report income from continuing operations of:

• A. $312,000.• B. $372,000.• C. $492,000.• D. $620,000.

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Review Questions

• B. $372,000. $620,000 x (1 - .40) = $372,000. Both of the additional items are reported below income from continuing operations.

Documents

The Income Statement, Comprehensive Income, and the Statement of Cash Flows Chapter 4 1