Companies must report both net income and comprehensive income and reconcile the difference between the two. The following items are part of comprehensive income:
Changes in the market value of securities available for sale (described in Chapter 12).
Gains, losses, and amendment costs for pensions and other postretirement plans (described in Chapter 17).
When a derivative is designated as a cash flow hedge is adjusted to fair value and 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 Chapter 14).
Gains or losses from changes in foreign currency exchange rates (discussed elsewhere in your accounting curriculum).
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The Income Statement and Statement of Cash Flows4 Learning ObjectivesExplain the difference between net income and comprehensive income and how we report components of the difference.LO1Comprehensive IncomeAn expanded version of income that includes four types of gains and losses that traditionally have not been included in income statements.Other Comprehensive IncomeStatement of Financial Accounting Standards No. 130Comprehensive income includes traditional net income and changes in equity from nonowner transactions.Changes in the market value of securities available for sale (described in Chapter 12).Gains, losses, and amendment costs for pensions and other postretirement plans (described in Chapter 17).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 (described in Chapter 14).Gains or losses from changes in foreign currency exchange rates (discussed elsewhere in your accounting curriculum).Accumulated Other Comprehensive IncomeIn 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.Learning ObjectivesDiscuss the importance of income from continuing operations and describe its components.LO2ExpensesOutflows of resources incurred in generating revenues.RevenuesInflows of resources resulting from providing goods or services to customers.Gains and LossesIncreases or decreases in equity from peripheral or incidental transactions of an entity.Income from Continuing OperationsIncome Tax ExpenseBecause of its importance and size, income tax expense is a separate item. Operating IncomeNonoperating IncomeOperating Income Versus Nonoperating IncomeIncludes revenues and expenses directly related to the principal revenue-generating activities of the companyIncludes gains and losses and revenues and expenses related to peripheral or incidental activities of the companyIncome Statement (Single-Step)Expenses & Losses{{Revenues & Gains{Proper HeadingIncome Statement (Multiple-Step){Non- operating Items{Gross Profit{Proper HeadingOperating Expenses{Learning ObjectivesDescribe earnings quality and how it is impacted by management practices to manipulate earnings.LO3Earnings QualityEarnings quality refers to the ability of reported earnings to predict a company’s future.The relevance of any historical-based financial statement hinges on its predictive value.Manipulating Income and Income Smoothing“Most managers prefer to report earnings that follow a smooth, regular, upward path.”1Two ways to manipulate income:Income shiftingIncome statement classification1 Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 168.Learning ObjectivesDiscuss the components of operating and nonoperating income and their relationship to earnings quality.LO4Operating Income and Earnings QualityShould all items of revenue and expense included in operating income be considered indicative of a company’s permanent earnings? No, not necessarily.Operating expenses may include the following unusual items that may or may not continue in the future: Restructuring costs Goodwill impairment Long-lived asset impairment In-process research and development Operating Income and Earnings QualityRestructuring CostsCosts associated with shutdown or relocation of facilities or downsizing of operations are recognized in the period incurred.Goodwill Impairment and Long-lived Asset ImpairmentInvolves asset impairment losses or charges (discussed further in Chapters 10 & 11).In-process Research and DevelopmentResults from certain business combinations (discussed further in Chapter 10).Nonoperating Income and Earnings QualityGains and losses from the sale of operational assets and investments often can significantly inflate or deflate current earnings.ExampleAs 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. How should those gains be interpreted in terms of their relationship to future earnings? Are they transitory or permanent?Pro Forma EarningsCompanies often voluntarily provide a pro forma earnings number when they announce annual or quarterly earnings. Pro forma earnings are management’s assessment of permanent earnings.The Sarbanes-Oxley Act Section 401 requires a reconciliation between pro forma earnings and earnings determined according to GAAP.Separately Reported ItemsReported separately, net of taxes:Discontinued operationsExtraordinary itemsA third item, the cumulative effect of a change in accounting principle, was eliminated from separate reporting by a new accounting standard in 2005. Intraperiod Income Tax AllocationIncome 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.Learning ObjectivesDefine what constitutes discontinued operations and describe the appropriate income statement presentation for these transactions.LO5A 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 segmentsOperating segmentsReporting unitsSubsidiariesAsset groupsDiscontinued OperationsDiscontinued OperationsReport 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. Discontinued OperationsReporting for Components SoldOperating 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.Reporting for Components Held For SaleOperating 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.During the year, Apex Co. sold an unprofitable component of the company. The component had a net loss from operations during the period of $150,000 and its assets sold at a loss of $100,000. Apex reported income from continuing operations of $128,387. All items are taxed at 30%. How will this appear in the income statement?Discontinued Operations ExampleDiscontinued Operations ExampleComputation of Loss from Discontinued Operations (Net of Tax Effect):Income Statement Presentation:Discontinued Operations ExampleLearning ObjectivesDefine extraordinary items and describe the appropriate income statement presentation for these transactions.LO6Material events or transactionsUnusual in natureInfrequent in occurrenceReported net of related taxesExtraordinary ItemsDuring the year, Apex Co. experienced a loss of $75,000 due to an earthquake at one of its manufacturing plants in Nashville. This was considered an extraordinary item. The company reported income before extraordinary item of $128,387. All gains and losses are subject to a 30% tax rate.How would this item appear in the income statement?Extraordinary Items ExampleIncome Statement Presentation:Extraordinary Items ExampleComputation of Loss from Extraordinary Item (Net of Tax Effect):Unusual or Infrequent ItemsItems that are material and are either unusual or infrequent—but not both—are included as a separate item in continuing operations.Accounting ChangesLearning ObjectivesDescribe the measurement and reporting requirements for a change in accounting principle.LO7Change in Accounting PrincipleOccurs when changing from one GAAP method to another GAAP methodFor example, a change from LIFO to FIFO 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 the same way as a change in accounting estimate. Learning ObjectivesExplain the accounting treatments of changes in estimates and correction of errors.LO8Change in Accounting EstimateRevision of a previous accounting estimateUse new estimate in current and future periodsIncludes treatment for changes in depreciation, amortization, and depletion methodsChange in Accounting Estimate ExampleOn January 1, 2003, we purchased equipment costing $30,000, with a useful life of 10 years and no salvage value. During 2006, we determine that the remaining useful is 5 years (8-year total life). We use straight-line depreciation.Compute the revised depreciation expense for 2006.Record depreciation expense of $4,200 for2006 and subsequent years.Change in Accounting Estimate ExampleChange in Reporting EntityIf two entities combine, a single set of consolidated financial statements is generally required.Change in Reporting EntityA change in reporting entity is reported by restating all previous periods’ financial statements presented for comparative purposes as if the new reporting entity existed in those periods.Corrections of errors from a previous periodAppear in the Statement of Retained Earnings as an adjustment to beginning retained earningsMust show the adjustment net of income taxesPrior Period AdjustmentsPrior Period Adjustments ExampleWhile reviewing the depreciation entries for 2002-2007, the controller found that in 2006 depreciation expense was incorrectly debited for $150,000 when in fact it should have been debited $125,000. (Ignore income taxes.) Prepare the necessary journal entry in 2007 to correct this prior period error. Prior Period Adjustments ExampleLearning ObjectivesDefine earnings per share (EPS) and explain required disclosures of EPS for certain income statement components.LO9Earnings 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 EPSNet income less preferred dividendsWeighted-average number of common shares outstanding for the periodDiluted EPSReflects 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 DisclosureReport EPS data separately for:Income from Continuing Operations Separately Reported ItemsDiscontinued OperationsExtraordinary ItemsNet IncomeLearning ObjectivesDescribe the purpose of the statement of cash flows.LO10The Statement of Cash FlowsProvides relevant information about a company’s cash receipts and cash disbursements.Helps investors and creditors to assessfuture net cash flowsliquiditylong-term solvency.Required for each income statement period presented.Learning ObjectivesIdentify and describe the various classifications of cash flows presented in a statement of cash flows.LO11Operating ActivitiesCash Flows from Operating ActivitiesInflows from:Sales to customers.Interest and dividends received.+Outflows to:Purchase of inventory.Salaries, wages, and other operating expenses.Interest on debt.Income taxes._Direct and Indirect Methods of ReportingTwo Formats for Reporting Operating ActivitiesReports the cash effects of each operating activityDirect MethodStarts with accrual net income and converts to cash basisIndirect MethodDirect and Indirect MethodsDirect MethodIndirect MethodCash Flows from Investing Activities+Investing ActivitiesInflows from:Sale of long-term assets used in the business.Sale of investment securities (stocks and bonds).Collection of nontrade receivables._Outflows to:Purchase of long-term assets used in the business.Purchase of investment securities (stocks and bonds).Loans to other entities.Cash Flows from Financing Activities+_Financing ActivitiesInflows from:Sale of shares to owners.Borrowing from creditors through notes, loans, mortgages, and bonds.Outflows to: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.Noncash Investing and Financing ActivitiesSignificant 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).End of Chapter 4