The Income The Income StatementStatement

2

Define the concept of income. Explain why an income measure is

important. Explain how income is measured,

including the revenue recognition and expense-matching concepts.

Understand the format of an income statement.

Learning Objectives

3

Learning Objectives Describe the specific components of an

income statement. Describe the specific components of an

income statement. Compute comprehensive income and prepare

the statement of stockholders’ equity. Construct simple forecasts of income for

future periods.

4

• Income per financial capital maintenance:– Results only if ending balance of owners’

equity (in monetary units) is greater than beginning balance (in monetary units).

– When trading a specific item, income equals difference of historical cost and net realizable value.

Capital Maintenance

5

Capital Maintenance

Kreidler, Inc., had the following assets and liabilities at the beginning

and at the end of a period.

Beginning of Period

End of Period

Total assets $510,000 $560,000

Total liabilities 430,000 390,000

Net assets (owners’ equity) $ 80,000 $170,000

Income is $90,000

6

Capital Maintenance

If the owners invested $40,000 in the business and received dividends of

$15,000, what would be the income?

Net assets, end of period $170,000 Net assets, beginning of period 80,000 Increase in net assets $ 90,000 Deduct investment by owners (40,000)Add dividends to owners 15,000 Income $ 65,000

7

• Income per physical capital maintenance:– Results only if production capacity at the end of the

period exceeds capacity at the beginning of the period.

– Capacity is measured by replacement cost of net assets.

– Income/loss is the difference between replacement cost and net realizable valuable.

– Difference between historical cost and replacement cost is considered a capital maintenance adjustment and not part of income.

Capital Maintenance

8

• Assume purchase of a house:– Purchase price $ 50,000– Replacement cost (Year 5) 150,000– Sale price (Year 5) 175,000

• Calculate income under financial capital maintenance and under physical capital maintenance assumptions.

Example of Capital Maintenance

9

Date Assets Liabilities Equity1/1/X0

1/1/X5

$ 50,000

$175,000

-0-

-0-

$ 50,000

$175,000

Income (difference of beginning equity and ending equity) $125,000

Financial Capital Maintenance

10

Date Assets Liabilities Equity1/1/X0

1/1/X5

$ 50,000

$175,000

-0-

-0-

$ 50,000

$ 175,000

Change in owners’ equityChange necessary to allow for replacement of home ($150,000 - $50,000)Income

$ 125,000

100,000$ 25,000

Physical Capital Maintenance

11Why Is a Measure of Income Important?

The recognition, measurement, and reporting of business income and its components are considered by many to be the most important

tasks of accountants.

12Why Is a Measure of Income Important?

Has the activity been profitable?

What is the trend of

profitability?

What is the most probable result for

future years?

Will the company be profitable enough to pay interest on its debt

and dividends to it stockholders and still grow at the desired rate?

13

How Is Income Measured?

Income is measured as the difference between resources inflows (revenues and gains) and outflows (expenses and losses) over a period of time.

14

Elements of Income

• Revenue: Inflows or other enhancements of assets of an entity or settlements of its liabilities from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing, major or central operations (SFAC 6.78).

15

• Expense: Outflows or other “using up” of assets or incurrence of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations (SFAC 6.80).

Elements of Income

16

• Gain: Increase in equity from peripheral or incidental transactions of an entity and from all other transactions . . . except those that result from revenues or investments by owners (SFAC 6.82).

Elements of Income

17

• Loss: Decrease in equity from peripheral or incidental transactions of an entity and from all other transactions . . . except those that result from expenses or distributions to owners (SFAC 6.83).

Elements of Income

18

• Recognition: The process of formally recording or incorporating an item in the financial statements of an entity (SFAC 6.143).

• Realization: The process of converting noncash resources and rights into money refers to sales of assets for cash or claims to cash.

Elements of Income

19

Elements of Income

Revenues are recognized when the company generating the revenue has

provided the bulk of the goods or services it promised for the customer and when the customer has provided payment or least a

valid promise of payment.

20Recognition Criteria:Expenses and Losses (SFAC 5.86)

Direct matching. Systematic and

rational allocation. Immediate

recognition.

21

• Direct Matching: Expenses are recognized upon recognition of revenues that result directly and jointly from the same transaction or other events as the expenses.

Recognition Criteria:Expenses and Losses (SFAC 5.86)

Direct expenses include not only those that have already been incurred but

should also include anticipated expenses related to revenues of the current period.

22

• Systematic and Rational Allocation: Costs are allocated by systematic and rational procedures to periods during which the related assets are expected to provide benefits (i.e., depreciation).

Recognition Criteria:Expenses and Losses (SFAC 5.86)

This category involves assets that benefit more than one

accounting period.

23

• Immediate Recognition: Expenses are recognized during the period in which cash is spent or liabilities are incurred for goods and services (i.e., selling and administrative salaries).

Recognition Criteria:Expenses and Losses (SFAC 5.86)

This category involves expenses for goods and services that are

used almost immediately.

24

Form of the Income Statement

GAAP requires certain income

statement disclosures.

Right, but GAAP does not require a specific format.

25

Form of the Income Statement

Revenue $xxxCosts and expenses:

Costs of sales $xxxSelling and administrative xxxInterest expense xxxOther income/expense, net xxxRestructuring charge xxx Total costs and expenses $xxx

Income before income taxes $ xxIncome taxes xxNet income $ xx

Single-Step Single-Step Income Income

StatementStatement

26

Form of the Income Statement

Revenue $xxxCosts of goods sold:

Beginning inventory $xxxNet purchases xxxCost of goods available for sale $xxxLess ending inventory xxx xxx

Gross profit on sales $xxxOperating expenses:

Selling expenses $xxxGeneral expenses xxx xxx

Operating income $xxx

Multiple-Step Multiple-Step Income Income

StatementStatement

Continued on next slideContinued on next slide

27

Form of the Income Statement

Other revenue and gains $xxx Other expenses and losses (xxx)Income from continuing operations before income taxes $xxx Income taxes on continuing operations (xxx)Discontinued operations:

Loss from operations of discontinued business segment (net of tax) $xxxLoss on disposal of segment (net of tax) xxx (xxx)

Extraordinary gain (net of tax) xxx Net income $xxx

28

“Below the Line” Items

GAAP requires certain items be reported “below the line” and net of tax.

“Below the line,” or following Income from Continuing Operations.

Net of tax requires the tax effect of the event be shown.

29

“Below the Line” Items

Discontinued Operations Extraordinary Items Changes in Accounting

Principles

30

Discontinued Operations--Phases

1/1/02 7/1/02

Operating Loss(net of tax)

$24,500

MeasurementDate

DisposalDate

12/31/02Statement

Date

Phase-out Period

Loss on Disposal(net of tax;

includes operatingresults 7/1 through11/17 and loss on

final disposal)$11,200

11/17/02

31Discontinued Operations--Disclosure

• Income statement section consists of two parts:– Income (loss) from operations--disclosed

only if decision to discontinue operations is made after beginning of the year.

– Gain (loss) on disposal of operations-- consisting of income (loss) during phase- out and gain (loss) from disposal of segment assets.

32Discontinued Operations--Disposal Date After Year End

4/29/02

DisposalDate

Loss on Disposal$5,000 (including$2,000 expectedoperating loss)

Phase-out Period

8/26/01

MeasurementDate

8/31/01

Operating Loss$4,000

Statement Date

12/31/02

33Discontinued Operations--Disposal Date After Year End

Special rules when disposal date is in year following measurement date.

A realized “loss on disposal” may be increased by an estimated loss or it may be reduced by an estimated gain.

A realized “gain on disposal” may be reduced by an estimated loss but cannot be increased by an estimated gain.

34Extraordinary Items--Characteristics

35Extraordinary Items--Characteristics

Extraordinary items must be

both unusual and infrequent...

36Extraordinary Items--Characteristics

…and material, or extraordinary by

definition.

37

Extraordinary by Definition• Gain or loss from extinguishment of debt.• Application of tax carry-forward when tax

benefits are not recognized until realized in subsequent period.

• If in prior years an item is reported as (1) disposal of business segment, or (2) as an extraordinary item, the effect of a reversal is disclosed in the same manner.

• Unamortized costs of interstate operating rights.

38

NEVER ExtraordinaryWrite-down or write-off of receivables,

inventory, etc.Translation of foreign exchange or devaluation.Disposal of business segment.Sale of productive assets.Effects of a strike.Adjustment of accruals on long-term contracts.

39Changes inAccounting Principle

• Report after Extraordinary Items.• Criteria for change: change only if

the new principle is preferable:– provides more useful information.– is less costly per benefit.

40Changes in Accounting Principle--Disclosure Requirements

Report current year’s income components on the new basis.

Report the cumulative effect of the adjustment in the current income statement--direct effect only; net of tax.

Present prior period financial statements as previously reported.

Include pro forma information as if the change were retroactive--direct and indirect effects.

Present earnings per share data for all prior periods presented.

41

Change of Estimates Employ current and prospective approach. Report current and future financial statements on

new basis. Present prior periods as previously reported. Make no adjustments to current period opening

balances. Present no pro forma data.

42

If there is both a change in principle and a change in estimate for an item, the event is treated as

a change in estimate.

Change of Principle andChange of Estimate

43

Return on Sales

AT&T 12.1% 8.6% 11.4%

McDonald’s 12.5% 14.4% 14.7%

IBM 7.8% 7.8% 7.2%

Nike 4.2% 8.7% 8.6%

1998 1997 1996

44

Comprehensive Income

Comprehensive income is the amount that reflects the change in a company’s wealth during the period. In addition

to net income, it includes items that, in general, arise from changes in market conditions unrelated to the business

operations of a company.

45

Comprehensive Income

The more common adjustments made in arriving at comprehensive income are:

Foreign currency translation adjustments.

Unrealized gains and losses on available-for-sale securities.

Deferred gains and losses on derivative financial instruments.

46

Comprehensive Income

Most companies include a report of comprehensive

income as part of the statement of stockholders’ equity.

47Earnings, Net Income, and Comprehensive Income

RevenueExpensesOperating IncomeGainsLossesEarningsCumulative Accounting AdjustmentNet IncomeUnrecognized Holding GainsUnrecognized Foreign Exchange ChangesComprehensive Income

$100 80$ 20 3 (8)$ 15 (2)$ 13 2 1$ 16

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The End