Transcript Chap004

4
The Income Statement and
Statement of Cash Flows
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
An income
statement for a
hypothetical
manufacturing
company that you
can refer to as we
proceed through
the chapter.
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Income from Continuing Operations
Revenues
Expenses
Inflows of
resources
resulting
from
providing
goods or
services to
customers.
Outflows of
resources
incurred in
generating
revenues.
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Gains and
Losses
Income Tax
Expense
Increases or
decreases in
equity from
peripheral or
incidental
transactions
of an entity.
Because of
its
importance
and size,
income tax
expense is a
separate
item.
Operating versus Nonoperating Income
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Operating
Income
Nonoperating
Income
Includes revenues
and expenses
directly related to
the principal
revenuegenerating
activities of the
company
Includes gains
and losses and
revenues and
expenses related
to peripheral or
incidental
activities of the
company
Income Statement (Single-Step)
Proper Heading
Revenues
& Gains
Expenses
& Losses
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Income Statement (Multiple-Step)
Proper
Heading
Gross
Profit
Operating
Expenses
Nonoperating
Items
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U. S. GAAP vs. IFRS
There are more similarities than differences between
income statements prepared according to U.S. GAAP
and those prepared applying IFRS.
Some differences are highlighted below.
• Has no minimum
requirements.
SEC requires that expenses be
classified by function.
• “Bottom line” called net income
or net loss.
• Report extraordinary items
separately.
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• Specifies certain minimum
information to be reported on
the face of the income
statement.
• Allows expenses classified by
function or natural description.
• “Bottom line” called profit or
loss.
• Prohibits reporting
extraordinary items.
Earnings Quality
Earnings quality refers to the ability of
reported earnings to predict
a company’s future earnings.
Transitory Earnings
versus
Permanent Earnings
4-8
Manipulating Income and
Income Smoothing
“Most executives prefer to report earnings
that follow a smooth, regular, upward path.”
~Ford S. Worthy, “Manipulating Profits: How It’s Done”, Fortune
Two ways to manipulate
income:
1. Income shifting
2. Income statement
classification
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Operating Income and Earnings Quality
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Restructuring Costs
Costs associated with shutdown or
relocation of facilities or
downsizing of operations are
recognized in the period incurred.
Goodwill Impairment
and Long-lived Asset
Impairment
Involves asset impairment losses
or charges.
Nonoperating Income and
Earnings Quality
Gains and losses generated from the sale of
investments often can significantly inflate or
deflate current earnings.
How should those
Example
As the stock market boom reached gains be interpreted
in terms of their
its height late in the year 2000,
relationship to
many companies recorded large
future earnings?
gains from sale of investments
that had appreciated significantly Are they transitory
or permanent?
in value.
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Separately Reported Items
Reported separately, net of taxes:
Discontinued
operations
Extraordinary
items
A third separately reported item, the cumulative effect of a change in
accounting principle, might be included for certain mandated changes in
accounting principles.
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Intraperiod Income Tax Allocation
Income Tax Expense must be associated with
each component of income that causes it.
Show Income Tax
Expense related to
Income from Continuing
Operations.
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Report effects of
Discontinued Operations and
Extraordinary Items net of
related income tax effect.
Reporting Discontinued Operations
The FASB and IASB worked together to develop a
common definition of discontinued operations and a
common set of disclosures for disposals of components
of an entity.
A “component” of an entity for this purpose
is defined as either:
1. An operating segment that has either been
disposed of or is classified as “held for
sale”; or
2. A business that meets the criteria to be
classified as held for sale on acquisition.
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Reporting Discontinued Operations
Reporting for Components Sold
Operating income or
loss of the component
from the beginning of
the reporting period to
the disposal date.
Gain or loss on the
disposal of the
component’s assets.
Reporting for Components Held For Sale
Operating income or
loss of the component
from the beginning of
the reporting period to
the end of the reporting
period.
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An “impairment loss” if
the carrying value of
the assets of the
component is more
than the fair value
minus cost to sell.
Extraordinary Items
An extraordinary item is a material
event or transaction that is both:
1. Unusual in nature, and
2. Infrequent in occurrence
Extraordinary items are reported net of
related taxes
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U. S. GAAP vs. IFRS
The scarcity of extraordinary gains and losses reported in
corporate income statements and the desire to converge
U.S. and international accounting standards could guide
the FASB to the elimination of the extraordinary item
classification.
• Report extraordinary items
separately in the income
statement.
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• Prohibits reporting
extraordinary items in the
income statement or notes.
Unusual or Infrequent Items
Items that are material and are
either unusual or infrequent—but not
both—are included as separate
items in continuing operations.
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Accounting Changes
Type of Accounting
Change
Change in Accounting
Principle
Change from one GAAP method
to another GAAP method
Change in Accounting
Estimate
Revision of an estimate
because of new information or
new experience
Preparation of financial
statements for an accounting
entity other than the entity that
existed in the previous period
Change in Reporting
Entity
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Definition
Change in Accounting Principle
• Occurs when changing from one GAAP method
to another GAAP method, for example, a change
from LIFO to FIFO
• GAAP requires that most voluntary accounting
changes be accounted for retrospectively by
revising prior years’ financial statements.
• For mandated changes in accounting principles,
the FASB often allows companies to choose to
account for the change retrospectively or as a
separately reported item below extraordinary
items.
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Change in Depreciation, Amortization,
or Depletion Method
A change in depreciation,
amortization, or depletion
method is treated the
same as a change in
accounting estimate.
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Change in Accounting Estimate
Revision of a previous
accounting estimate
Use new estimate in
current and future
periods
Includes changes in
depreciation,
amortization, and
depletion methods
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Change in Reporting Entity
The prior-period financial
statements that are
presented for comparative
purposes should be
restated to appear as if the
new entity existed in those
periods.
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When one company acquires
another one, the financial
statements of the acquirer
include the acquiree as of the
date of acquisition, and the
acquirer’s prior-period financial
statements that are presented
for comparative purposes are
not restated.
Correction of Accounting Errors
Errors occur when transactions are either
recorded incorrectly or not recorded at all.
Errors
Discovered in
Same Year
Material Errors
Discovered in
Subsequent Year
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Reverse original erroneous journal
entry and record the appropriate
journal entry.
Record a prior period adjustment to
the beginning retained earnings
balance in a statement of
shareholders’ equity.
Previous years’ financial statements
that are incorrect as a result of the
error are retrospectively restated to
reflect the correction.
Earnings per Share Disclosure
One 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
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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.
Earnings per Share Disclosure
Report EPS data separately for:
1. Income or Loss from Continuing
Operations
2. Separately Reported Items
a) discontinued operations
b) extraordinary Items
3. Net Income or Loss
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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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Other Comprehensive Income
Comprehensive income includes traditional net income
as well as four additional gains and losses that change
shareholders’ equity.
1. Net unrealized holding gains (losses) from investments (net of tax).
2. Gains and losses due to reviewing assumptions or market returns
differing from expectations and prior service cost from amending the
postretirement benefit plan.
3. When a derivative is 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. (This item is discussed elsewhere in your accounting
curriculum).
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U. S. GAAP vs. IFRS
As part of a joint project with the FASB, the International
Accounting Standards Board (IASB) in 2007 issued a new
version of IAS No. 146 that revised the standard to bring
international reporting of comprehensive income largely in
line with U.S. standards.
• Includes four possible Other
Comprehensive Income items.
• Includes same four.
• Includes a fifth possible item,
changes in revaluation surplus,
from the optional revaluation of
property, plant, and equipment
and intangible assets.
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Accumulated Other Comprehensive Income
In addition to reporting comprehensive income that
occurs in the current period, we must also report these
amounts on a cumulative basis in the balance sheet as
an additional component of shareholders’ equity.
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The Statement of Cash Flows
• Provides relevant information about a company’s
cash receipts and cash disbursements.
• Helps investors and creditors to assess
 future net cash flows
 liquidity
 long-term solvency.
• Required for each income statement period
reported.
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Operating Activities
Inflows from:

sales to customers.
 interest and dividends
received.
+
Outflows for:




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purchase of inventory.
salaries, wages, and other
operating expenses.
interest on debt.
income taxes.
_
Cash
Flows
from
Operating
Activities
Direct and Indirect Methods of
Reporting
Two Formats for Reporting Operating Activities
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Direct Method
Indirect Method
Reports the
cash effects of
each operating
activity
Starts with
accrual net
income and
converts to
cash basis
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Direct Method
Under the direct method, the cash effect of each
operating activity is reported directly in the
statement.
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Indirect Method
By the indirect method, we arrive at net cash flow from
operating activities indirectly by starting with reported net
income and working backwards to convert that amount to a
cash basis.
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Investing Activities
Inflows 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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_
Cash
Flows
from
Investing
Activities
Financing Activities
Inflows from:


sale of shares to owners.
borrowing from creditors
through notes, loans,
mortgages, and bonds.
Outflows for:



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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.
+
_
Cash
Flows
from
Financing
Activities
ALC’s Statement of Cash Flows
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Noncash Investing and Financing
Activities
Significant investing and financing
transactions not involving cash
also are reported.
Acquisition of equipment (an investing
activity) by issuing a long-term note
payable (a financing activity).
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U. S. GAAP vs. IFRS
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.
Typical Classification of Cash Flows from
Interest and Dividends
•
Operating Activities
– Dividends Received
– Interest Received
– Interest Paid
•
Investing Activities
•
Financing Activities
– Dividends Paid
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•
Operating Activities
•
Investing Activities
– Dividends Received
– Interest Received
•
Financing Activities
– Dividends Paid
– Interest Paid
U. S. GAAP vs. IFRS
The FASB and IASB are working together on a project,
Financial Statement Presentation, to establish a common
standard for presenting information in the financial
statements.
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End of Chapter 4
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