Chapter 4

THE INCOME STATEMENT AND STATEMENT OF CASH FLOWS

McGraw-Hill /Irwin

2009 The McGraw-Hill Companies, Inc.

Slide 2

Income from Continuing Operations

Revenues Inflows of resources resulting from providing goods or services to customers.

Expenses Outflows of resources incurred in generating revenues.

Gains and Losses Increases or decreases in equity from peripheral or incidental transactions of an entity.

Income Tax Expense Because of its importance and size, income tax expense is a separate item.
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Slide 3

Operating Versus Nonoperating Income

Operating Income
Includes revenues and expenses directly related to the principal revenuegenerating activities of the company

Nonoperating Income
Includes gains and losses and revenues and expenses related to peripheral or incidental activities of the company

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Slide 4

Income Statement (Single-Step)

Proper Heading Revenues & Gains

{ {

MAXWELL GEAR CORPORATION Income Statement For the Year Ended December 31, 2009
$ 573,522 26,400 5,500 605,422

Revenues and gains: Sales Interest and dividends Gain on sale of opearting assets Total revenues and gains Expenses and losses: Cost of goods sold Selling General and administrative Research and development Interest Loss on sale of investment Income taxes Total expenses & losses Net income

Expenses & Losses

302,371 47,341 24,888 16,300 6,200 8,322 80,000 $ 485,422 120,000

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Slide 5

Income Statement (Multiple-Step)

Proper Heading

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MAXWELL GEAR CORPORATION Income Statement For the Year Ended December 31, 2009
Sales revenue Cost of goods sold Gross profit Operating expenses: Selling General and administrative Research and development Operating income Other income (expense): Interest and dividend revenue Gain on sale of operating assets Interest expense Loss on sale of investments Income before income taxes Income tax expense Net income $ 573,522 302,371 271,151 $ 47,341 24,888 16,300

Gross Profit
Operating Expenses Nonoperating Items

88,529 182,622

$ 26,400 5,500 (6,200) (8,322)

17,378 200,000 80,000 $ 120,000

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Slide 6

Earnings Quality Earnings quality refers to the ability of reported earnings to predict a companys future earnings.

Transitory Earnings versus Permanent Earnings

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Slide 7

Manipulating Income and Income Smoothing

Two ways to manipulate income:

1. Income shifting
2. Income statement classification

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Slide 8

Operating Income and Earnings Quality

Restructuring Costs Goodwill Impairment and Long-lived Asset Impairment
Costs associated with shutdown or relocation of facilities or downsizing of operations are recognized in the period incurred.

Involves asset impairment losses or charges.

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Slide 9

Nonoperating Income and Earnings Quality

Gains and losses from the sale of operational assets and investments often can significantly inflate or deflate current earnings.
How should those gains be interpreted in terms of their relationship to future earnings? Are they transitory or permanent?
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Example As the stock market boom reached its height late in the year 2000, many companies recorded large gains from sale of investments that had appreciated significantly in value.

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Separately Reported Items

Reported separately, net of taxes:

Discontinued operations

Extraordinary items

Income from continuing operations before income taxes and extraordinary items Income tax expense Income from continuing operations before extraordinary items Discontinued operations (net of $xx in taxes) Extraordinary items (net of $xx in taxes) Net Income

$ xxx xx xxx xx xx $ xxx

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Slide 11

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.

Report effects of Discontinued Operations and Extraordinary Items NET OF RELATED INCOME TAXES.

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Discontinued Operations

A discontinued operation is the sale or disposal of a component of an entity. A component comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. A component could include: reportable segments operating segments reporting units subsidiaries asset groups
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Discontinued Operations
Report results of operations separately if two conditions are met:
The operations and cash flows of the component have been (or will be) eliminated from the ongoing operations. The entity will not have any significant continuing involvement in the operations of the component after the disposal transaction.

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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 components 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. 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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Extraordinary Items
Material events or transactions Unusual in nature Infrequent in occurrence Reported net of related taxes

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Unusual or Infrequent Items

Items that are material and are either unusual or infrequentbut not bothare included as separate items in continuing operations.

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Slide 17

Accounting Changes
Type of Accounting Change
Change in Accounting Principle Change in Accounting Estimate Change in Reporting Entity

Definition
Change from one GAAP method to another GAAP method 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

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Change in Accounting Principle

Occurs when changing from one GAAP method to another GAAP method, for example, a change from LIFO to FIFO Most voluntary changes in accounting principles are accounted for retrospectively by revising prior years financial statements. Changes in depreciation, amortization, or depletion methods are accounted for in a similar way 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 treatment for changes in depreciation, amortization, and depletion methods

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Slide 20

Change in Reporting Entity

If two entities combine, a single set of consolidated financial statements is generally required.

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Correction of Accounting Errors

Correction of errors from a previous period Appear in the Statement of Retained Earnings as an adjustment to beginning retained earnings (show the adjustment net of income taxes) Previous years financial statements that are incorrect are retrospectively restated to reflect the correction.

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Slide 22

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

Diluted EPS

Net income less preferred dividends Weighted-average number of common shares outstanding for the period

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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Slide 23

Earnings Per Share Disclosure

Report EPS data separately for:

1. Income from Continuing Operations

2. Separately Reported Items

a) discontinued operations
b) extraordinary Items 3. Net Income

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Slide 24

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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Slide 25

Other Comprehensive Income

Statement of Financial Accounting Standards No. 130 Comprehensive income includes traditional net income and changes in equity from nonowner transactions.
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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Slide 26

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.
JABIL CIRCUITS INC. Consolidated Balance Sheets (in part) Yesrs Ended August 31 (In thousands) Shareholders' equity: Common stock Additional paid-in capital Retained earnings Accumulated other comprehensive income Treasury stock Total shareholders' equity 2007 $ 212 $ 1,340,687 1,131,403 170,960 (200,251) 2,443,011 $ 2006 211 1,265,382 1,116,035 109,898 (200,251) 2,291,275

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The Statement of Cash Flows

Provides relevant information about a companys 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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Slide 28

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.

Cash Flows from Operating Activities

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Slide 29

Direct and Indirect Methods of Reporting

Two Formats for Reporting Operating Activities

Direct Method

Indirect Method Starts with accrual net income and converts to cash basis

Reports the cash effects of each operating activity

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Slide 30

Direct and Indirect Methods

ARLINGTON LAWN CARE Statement of Cash Flows For the Year Ended December 31, 2009 ($ in thousands) Cash flows from Operating Activities Cash received from customers Cash paid for administrative expenses Net cash flows from operating activities

78 (29) $ 49

Direct Method

Indirect Method

ARLINGTON LAWN CARE Statement of Cash Flows For the Year Ended December 31, 2009 ($ in thousands) Cash flows from Operating Activities Net income $ Adjustments for noncash effects: Depreciation expense $ 8 Increase in prepaid insurance (4) Increase in accounts receivable (12) Increase in accounts payable 7 Increase in income taxes payable 15 Net cash flows from operating activities $

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14 49 4-30

Slide 31

Investing Activities
Inflows from:

sale of long-term assets used in the business. sale of investment securities (stocks and bonds). collection of nontrade receivables.

Outflows for:

purchase of long-term assets used in the business. purchase of investment securities (stocks and bonds). loans to other entities.

Cash Flows from Investing Activities

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Slide 32

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.

Cash Flows from Financing Activities

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Slide 33

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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End of Chapter 4

McGraw-Hill /Irwin

2009 The McGraw-Hill Companies, Inc.