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CHAPTER
Income Statement
and Related Information
LEARNING
OBJECTIVES
W
hich Income Number?
Recently, companies have been providing investors a choice in reported
income numbers. In addition to income measured according to generally
accepted accounting principles (GAAP), companies also are reporting an
income measure that has been adjusted for certain items. Companies make
these adjustments because they believe the items are not representative of
operating results. In some cases these adjustments are quite large. As shown
in the following table, in a recent quarter the reporting of such “pro forma”
income measures put a very different spin on operating results. In some cases
(JDS-Uniphase, PMC-Sierra, and Yahoo!), a loss under GAAP
measurement rules became an operating profit after pro forma adjustments.
Company
JDS-Uniphase
Checkfree
Amazon.com
PMC-Sierra
Corning
Qualcomm
Yahoo!
Earnings Per Share
Pro Forma
GAAP
$0.14
0.04
0.22
0.02
0.29
0.29
0.01
4
$1.13
1.17
0.66
0.38
0.14
0.18
0.02
Characteristic of pro forma reporting practices is Amazon.com, which made
adjustments for items such as stock-based compensation, amortization of
goodwill and intangibles, impairment charges, and equity in losses of investees.
All of these adjustments make pro forma earnings higher than GAAP income. In
its earnings announcement, Amazon defended its pro forma reporting, saying
that it gives better insight into the fundamental operations of the business.
After studying this chapter, you
should be able to:
Identify the uses and
limitations of an income
statement.
Prepare a single-step
income statement.
Prepare a multiple-step
income statement.
Explain how irregular
items are reported.
Explain intraperiod tax
allocation.
Explain where earnings
per share information is
reported.
Prepare a retained
earnings statement.
Explain how other
comprehensive income is
reported.
So what’s wrong with focusing investors on the fundamentals of the business?
According to Ed Jenkins, former chair of the FASB, one problem is that there
are no standards for the reporting of pro forma numbers. As a result,
investors will have a hard time comparing Amazon’s pro forma measure with
that reported by another company, which has a different idea of what is
fundamental to its business. Also, there is concern that many companies use
pro forma reporting to deflect investor attention from bad news.
Rather than relying on management’s choice of the number to focus on,
GAAP income numbers are subject to the same rules for all companies, are
audited, and give investors a more complete picture of company profitability,
not the story preferred by management.1
1
Adapted from David Henry, “The Numbers Game,” Business Week (May 14, 2001),
pp. 100–110.
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PREVIEW OF CHAPTER 4
As shown in the opening story, investors need complete and comparable information
on income and its components to make valid assessments of company profitability. The
purpose of this chapter is to examine the many different types of revenues, expenses,
gains, and losses that affect the income statement and related information. The content
and organization of this chapter are as follows.
INCOME STATEMENT AND
RELATED INFORMATION
Income Statement
• Usefulness
• Limitations
• Quality of
earnings
Format of the
Income Statement
Reporting
Irregular Items
Special
Reporting Issues
• Elements
• Single-step
• Multiple-step
• Condensed income
statements
• Discontinued
operations
• Extraordinary items
• Unusual gains and
losses
• Changes in
accounting principle
• Changes in
estimates
• Intraperiod tax
allocation
• Earnings per share
• Retained earnings
statement
• Comprehensive
income
INCOME STATEMENT
OBJECTIVE
Identify the uses and
limitations of an
income statement.
The income statement, often called the statement of income or statement of earnings,2
is the report that measures the success of enterprise operations for a given period of
time. The business and investment community uses this report to determine profitability, investment value, and credit worthiness. It provides investors and creditors
with information that helps them predict the amounts, timing, and uncertainty of
future cash flows.
Usefulness of the Income Statement
The income statement helps users of financial statements predict future cash flows in
a number of ways. For example, investors and creditors can use the information in the
income statement to:
DaimlerChrysler
Revenues
– Expenses
$ Profits
<
Ford
Revenues
– Expenses
$ Profits
Evaluate the past performance of the enterprise. By examining revenues and
expenses, you can tell how the company performed and compare its performance
to its competitors. For example, the income data provided by DaimlerChrysler can
be used to compare its performance to that of Ford.
Provide a basis for predicting future performance. Information about past performance can be used to determine important trends that, if continued, provide
Which company did better
last year?
2
Accounting Trends and Techniques—2001 (New York: AICPA) indicates that for the 600 companies surveyed, the term income was employed in the title of 284 income statements. The term
operations was second in acceptance with 198, and the term earnings was used by 108 companies.
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Income Statement
information about future performance. For example, General Electric has reported
consistent increases in revenues in recent years. Although success in the past does
not necessarily mean the company will be successful in the future, predictions of
future revenues, and hence earnings and cash flows, can be made with some confidence if a reasonable correlation exists between past and future performance.
Help assess the risk or uncertainty of achieving future cash flows. Information
on the various components of income—revenues, expenses, gains, and losses—
highlights the relationships among them and can be used to assess the risk of not
achieving a particular level of cash flows in the future. For example, segregating
IBM’s operating performance from other nonrecurring sources of income is useful
because operations are usually the primary means by which revenues and cash are
generated. Thus, results from continuing operations usually have greater significance for predicting future performance than do results from nonrecurring activities and events.
125
•
GE Profits
?
?
Past
Now Future
Hmm....Where am I headed?
IBM
Income for Year Ended
12/31/03
Recurring?
Revenues
– Operating expenses
Operating income
Yes
± Unusual or
extraordinary items
$ Net Income
No
?
Recurring items are more
certain in the future.
In summary, information in the income statement—revenues, expenses, gains, and
losses—helps users evaluate past performance and provides insights into achieving a
particular level of cash flows in the future.
Limitations of the Income Statement
Because net income is an estimate and reflects a number of assumptions, income statement users need to be aware of certain limitations associated with the information contained in the income statement. Some of these limitations include:
Items that cannot be measured reliably are not reported in the income statement.
Current practice prohibits recognition of certain items from the determination of
income even though the effects of these items arguably affect the performance of
an entity from one point in time to another. For example, unrealized gains and
losses on certain investment securities may not be recorded in income when there
is uncertainty that the changes in value will ever be realized. In addition, more and
more companies, like Cisco Systems and Microsoft, have experienced increases in
value due to brand recognition, customer service, and product quality. Presently, a
common framework for identifying and reporting these types of values has not
been developed.
Income numbers are affected by the accounting methods employed. For example, one company may choose to depreciate its plant assets on an accelerated basis; another chooses straight-line depreciation. Assuming all other factors are equal,
the income for the first company will be lower, even though the companies are
essentially the same. In effect, we are comparing apples to oranges.
Income measurement involves judgment. For example, one company in good faith
may estimate the useful life of an asset to be 20 years while another company uses
a 15-year estimate for the same type of asset. Similarly, some companies may make
overly optimistic estimates of future warranty returns and bad debt write-offs,
which results in lower expense and higher income.
Exp Exp
Rev Rev Rev
Profits
Unrealized
Earnings
Brand value
You left something out!
Income Using:
Straight-line
Depreciation
Accelerated
Depreciation
Hmm... Is the income the same?
Estimates
• High useful lives
• Low warranty returns
• Low bad debts
$ High Income
In summary, several limitations of the income statement reduce the usefulness of this
statement for predicting the amounts, timing, and uncertainty of future cash flows.
Quality of Earnings
Our discussion to this point has highlighted the importance of information in the income statement for investment and credit decisions, including the evaluation of the
Hey...you might be too
optimistic!
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Chapter 4 Income Statement and Related Information
company and its managers.3 Companies try to meet or beat Wall Street expectations so
that the market price of their stock and the value of management’s stock options
increase. As a result, companies have incentives to manage income to meet earnings
targets or to make earnings look less risky.
The SEC has expressed concern that the motivations to meet earnings targets may
be overriding good business practices. As a result, the quality of earnings and the quality of financial reporting are eroding. As indicated by a former SEC chairman,
“Managing may be giving way to manipulation; integrity may be losing out to illusion.”4
What is earnings management? It is often defined as the planned timing of revenues, expenses, gains, and losses to smooth out bumps in earnings. In most cases,
earnings management is used to increase income in the current year at the expense of
income in future years. For example, companies prematurely recognize sales before
they are complete in order to boost earnings. As one commentator noted, “ . . . it’s like
popping a cork in [opening] a bottle of wine before it is ready.”
Earnings management can also be used to decrease current earnings in order to increase income in the future. The classic case is the use of “cookie jar” reserves. These
are established by using unrealistic assumptions to estimate liabilities for such items
as sales returns, loan losses, and warranty returns. These reserves can then be reduced
in the future to increase income.
Such earnings management has a negative effect on the quality of earnings if it
distorts the information in a way that is less useful for predicting future earnings and
cash flows. As indicated in Chapter 1, markets are based on trust, and it is imperative
Manage up, manage down
What do the
numbers mean?
The quality of earnings is adversely affected whether earnings are managed up or down.
For example, W. R. Grace managed earnings down by taking excess “cookie jar” reserves
in good earnings years. During the early 1990s, Grace was growing fast, with profits increasing 30 percent annually. Analysts’ targets had Grace growing 24 percent each year.
Worried that they could not continue to meet these growth expectations, management
began stashing away excess profits in an all-purpose reserve. In 1995, when profits were
not meeting expectations, Grace wanted to reduce this reserve and so increase income.
The SEC objected, noting that generally accepted accounting principles would be violated if Grace were to do so.
More recently, MicroStrategy managed earnings up by booking revenue for future
software upgrades, even though it had not yet delivered on the upgrades. And RentWay, Inc. managed its earnings up by understating some $65 million in expenses relating to such items as automobile maintenance and insurance payments.
Does the market value accounting quality? Well, each of these companies took a beating in the marketplace when its earnings management practices were uncovered. For
example, Rent-Way’s stock price plummeted from above $25 per share to below $10 per
share when it announced restatements for its improper expense accounting. So, whether
earnings are managed up or down, companies had better be prepared to pay the price
for poor accounting quality.
3
In support of the usefulness of income information, accounting researchers have documented that the market prices of companies change when income is reported to the market. See
W. H. Beaver, “The Information Content of Annual Earnings Announcements,” Empirical Research
in Accounting: Selected Studies, Journal of Accounting Research (Supplement 1968), pp. 67–92.
4
A. Levitt, the “Numbers Game.” Remarks to NYU Center for Law and Business, September 28, 1998 (Securities and Exchange Commission, 1998).
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that the bond between shareholders and the company be strong. If investors or others
lose faith in the numbers reported in the financial statements, U.S. capital markets will
be damaged. As mentioned in the opening story, heightened scrutiny of income measurement and reporting is warranted to ensure the quality of earnings and investors’
confidence in the income statement.
FORMAT OF THE INCOME STATEMENT
Elements of the Income Statement
Net income results from revenue, expense, gain, and loss transactions. These transactions are summarized in the income statement. This method of income measurement
is called the transaction approach because it focuses on the income-related activities
that have occurred during the period.5 Income can be further classified by customer,
product line, or function or by operating and nonoperating, continuing and discontinued, and regular and irregular categories.6 More formal definitions of income-related
items, referred to as the major elements of the income statement, are as follows.
ELEMENTS OF FINANCIAL STATEMENTS
REVENUES. Inflows or other enhancements of assets of an entity or settlements
of its liabilities during a period from delivering or producing goods, rendering
services, or other activities that constitute the entity’s ongoing major or central
operations.
EXPENSES. Outflows or other using-up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or carrying
out other activities that constitute the entity’s ongoing major or central operations.
GAINS. Increases in equity (net assets) from peripheral or incidental transactions
of an entity except those that result from revenues or investments by owners.
LOSSES. Decreases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from expenses or distributions to
owners.7
Revenues take many forms, such as sales, fees, interest, dividends, and rents.
Expenses also take many forms, such as cost of goods sold, depreciation, interest, rent,
salaries and wages, and taxes. Gains and losses also are of many types, resulting from
the sale of investments, sale of plant assets, settlement of liabilities, write-offs of assets
due to obsolescence or casualty, and theft.
5
The most common alternative to the transaction approach is the capital maintenance approach to income measurement. Under this approach, income for the period is determined based
on the change in equity, after adjusting for capital contributions (e.g., investments by owners) or
distributions (e.g., dividends). The main drawback associated with the capital maintenance approach is that the components of income are not evident in its measurement. The Internal Revenue Service uses the capital maintenance approach to identify unreported income and refers to
this approach as the “net worth check.”
6
The term “irregular” encompasses transactions and other events that are derived from developments outside the normal operations of the business.
7
“Elements of Financial Statements,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, 1985), pars. 78–89.
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Chapter 4 Income Statement and Related Information
International
Insight
For some nations, financial reporting is prepared on the
same basis as tax returns. In
such cases, companies have
incentives to minimize reported
income.
The distinction between revenues and gains and the distinction between expenses
and losses depend to a great extent on the typical activities of the enterprise. For example, when McDonald’s sells a hamburger, the selling price is recorded as revenue.
However, when McDonald’s sells a french-fryer, any excess of the selling price over the
book value would be recorded as a gain. This difference in treatment results because
the sale of the hamburger is part of McDonald’s regular operations while the sale of
the french-fryer is not.
The importance of reporting these elements should not be underestimated. For most
decision makers, the parts of a financial statement will often be more useful than the
whole. As indicated earlier, investors and creditors are interested in predicting the
amounts, timing, and uncertainty of future income and cash flows. Having income
statement elements shown in some detail and in comparison form with prior years’
data, decision makers are better able to assess future income and cash flows.
Single-Step Income Statements
In reporting revenues, gains, expenses, and losses, a format known as the single-step
income statement is often used. In the single-step statement, just two groupings exist:
revenues and expenses. Expenses are deducted from revenues to arrive at net income
or loss. The expression “single-step” is derived from the single subtraction necessary
to arrive at net income. Frequently income tax is reported separately as the last item
before net income to indicate its relationship to income before income tax. Illustration
4-1 shows the single-step income statement of Dan Deines Company.
ILLUSTRATION 4-1
Single-step Income
Statement
DAN DEINES COMPANY
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2004
Revenues
OBJECTIVE
Prepare a single-step
income statement.
Net sales
Dividend revenue
Rental revenue
$2,972,413
98,500
72,910
Total revenues
3,143,823
Expenses
Cost of goods sold
Selling expenses
Administrative expenses
Interest expense
Income tax expense
Total expenses
Net income
Earnings per common share
1,982,541
453,028
350,771
126,060
66,934
2,979,334
$ 164,489
$1.74
Because of its simplicity, the single-step income statement is widely used in financial
reporting. In recent years, though, the multiple-step form has become more popular.8
The primary advantage of the single-step format lies in the simplicity of presentation and the absence of any implication that one type of revenue or expense
item has priority over another. Potential classification problems are thus eliminated.
8
Accounting Trends and Techniques—2001. Of the 600 companies surveyed by the AICPA, 466
employed the multiple-step form, and 134 employed the single-step income statement format.
This is a reversal from 1983, when 314 used the single-step form and 286 used the multiple-step
form.
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Multiple-Step Income Statements
Some contend that including other important revenue and expense classifications makes
the income statement more useful. These further classifications include:
A separation of operating and nonoperating activities of the company. For example, enterprises often present an income from operations figure and then sections
entitled “Other revenues and gains” and “Other expenses and losses.” These other
categories include interest revenue and expense, gains or losses from sales of such
items as investments and plant assets, and dividends received.
A classification of expenses by functions, such as merchandising (cost of goods
sold), selling, and administration. This permits immediate comparison with costs
of previous years and with other departments in the same year.
A multiple-step income statement is used to recognize these additional relationships. This statement recognizes a separation of operating transactions from nonoperating transactions and matches costs and expenses with related revenues. It highlights
certain intermediate components of income that are used for the computation of ratios
used to assess the performance of the enterprise.
Intermediate Components of the Income Statement
When a multiple-step income statement is used, some or all of the following sections
or subsections may be prepared.
INCOME STATEMENT SECTIONS
Operating Section. A report of the revenues and expenses of the company’s
principal operations.
(a) Sales or Revenue Section. A subsection presenting sales, discounts, allowances, returns, and other related information. Its purpose is to arrive
at the net amount of sales revenue.
(b) Cost of Goods Sold Section. A subsection that shows the cost of goods
that were sold to produce the sales.
(c) Selling Expenses. A subsection that lists expenses resulting from the company’s efforts to make sales.
(d) Administrative or General Expenses. A subsection reporting expenses of
general administration.
Nonoperating Section. A report of revenues and expenses resulting from secondary or auxiliary activities of the company. In addition, special gains and
losses that are infrequent or unusual, but not both, are normally reported in
this section. Generally these items break down into two main subsections:
(a) Other Revenues and Gains. A list of the revenues earned or gains incurred, generally net of related expenses, from nonoperating transactions.
(b) Other Expenses and Losses. A list of the expenses or losses incurred,
generally net of any related incomes, from nonoperating transactions.
Income Tax. A short section reporting federal and state taxes levied on income
from continuing operations.
Discontinued Operations. Material gains or losses resulting from the disposition of a segment of the business.
Extraordinary Items. Unusual and infrequent material gains and losses.
Cumulative Effect of a Change in Accounting Principle.
Earnings Per Share.
OBJECTIVE
•
Prepare a
multiple-step
income statement.
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Although the content of the operating section is always the same, the organization
of the material need not be as described above. The breakdown above uses a natural
expense classification. It is commonly used for manufacturing concerns and for merchandising companies in the wholesale trade. Another classification of operating
expenses, recommended for retail stores, uses a functional expense classification of
administrative, occupancy, publicity, buying, and selling expenses.
Usually, financial statements that are provided to external users have less detail
than internal management reports. The latter tend to have more expense categories—
usually grouped along lines of responsibility. This detail allows top management
to judge staff performance. Furthermore, irregular transactions such as discontinued operations, extraordinary items, and cumulative effect of changes in accounting
principles should be reported separately, following income from continuing operations.
To illustrate the multiple-step income statement, Dan Deines Company’s statement
of income is presented in Illustration 4-2. Items 1, 2, 3, and 7 from the list on page 129
are shown in the statement.9 Note that in arriving at net income, three subtotals are
presented:
Net sales revenue
Gross profit
Income from operations
The disclosure of net sales revenue is useful because regular revenues are reported
as a separate item. Irregular or incidental revenues are disclosed elsewhere in the
income statement. As a result, trends in revenue from continuing operations should be
easier to understand and analyze.
Similarly, the reporting of gross profit provides a useful number for evaluating performance and assessing future earnings. A study of the trend in gross profits may show
how successfully a company uses its resources; it may also be a basis for understanding how profit margins have changed as a result of competitive pressure.
Finally, disclosing income from operations highlights the difference between regular and irregular or incidental activities. This disclosure helps users recognize that incidental or irregular activities are unlikely to continue at the same level. Furthermore,
disclosure of operating earnings may assist in comparing different companies and
assessing operating efficiencies.
Condensed Income Statements
In some cases it is impossible to present in a single income statement of convenient
size all the desired expense detail. This problem is solved by including only the totals
of expense groups in the statement of income and preparing supplementary schedules
to support the totals. With this format, the income statement itself may be reduced to
a few lines on a single sheet. For this reason, readers who wish to study all the reported
data on operations must give their attention to the supporting schedules. The income
statement shown in Illustration 4-3 on page 132 for Dan Deines Company is a condensed version of the more detailed multiple-step statement presented earlier and is
more representative of the type found in practice.
9
Earnings per share or net loss per share is required to be included on the face of the income statement.
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•
131
ILLUSTRATION 4-2
Multiple-step Income
Statement
DAN DEINES COMPANY
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2004
Sales Revenue
Sales
Less: Sales discounts
Sales returns and allowances
$3,053,081
$
24,241
56,427
Net sales revenue
80,668
2,972,413
Cost of Goods Sold
Merchandise inventory, Jan. 1, 2004
Purchases
Less: Purchase discounts
Net purchases
Freight and transportation-in
461,219
$1,989,693
19,270
1,970,423
40,612
Total merchandise available for sale
Less: Merchandise inventory, Dec. 31, 2004
2,011,035
Income Statements
for Real Companies
2,472,254
489,713
Cost of goods sold
1,982,541
Gross profit on sales
989,872
Operating Expenses
Selling expenses
Sales salaries and commissions
Sales office salaries
Travel and entertainment
Advertising expense
Freight and transportation-out
Shipping supplies and expense
Postage and stationery
ILLUSTRATION
Depreciation 4-3
of sales equipment
Condensed
Income
Telephone
and Internet expense
202,644
59,200
48,940
38,315
41,209
24,712
16,788
9,005
12,215
453,028
186,000
61,200
23,721
23,275
17,029
18,059
16,000
2,875
2,612
350,771
Statement
Administrative expenses
Officers’ salaries
Office salaries
Legal and professional services
Utilities expense
Insurance expense
Depreciation of building
Depreciation of office equipment
ILLUSTRATION
4-4
Stationery, supplies,
and postage
SampleMiscellaneous
Supporting office expenses
Schedule
Income from operations
803,799
186,073
Other Revenues and Gains
Dividend revenue
Rental revenue
OBJECTIVE
Other Expenses and Losses
Explain
how
Interest
on irregular
bonds and notes
items
are
reported.
Income
before
income tax
Income tax
Net income for the year
Earnings per common share
98,500
72,910
171,410
357,483
126,060
231,423
66,934
$ 164,489
$1.74
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Chapter 4 Income Statement and Related Information
ILLUSTRATION 4-3
Condensed Income
Statement
DAN DEINES COMPANY
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2004
Net sales
Cost of goods sold
Gross profit
Selling expenses (see Note D)
Administrative expenses
$2,972,413
1,982,541
989,872
$453,028
350,771
803,799
Income from operations
Other revenues and gains
186,073
171,410
Other expenses and losses
357,483
126,060
Income before income tax
Income tax
231,423
66,934
Net income for the year
$ 164,489
Earnings per share
$1.74
An example of a supporting schedule, cross-referenced as Note D and detailing the
selling expenses, is shown in Illustration 4-4.
ILLUSTRATION 4-4
Sample Supporting
Schedule
Note D: Selling expenses
Sales salaries and commissions
Sales office salaries
Travel and entertainment
Advertising expense
Freight and transportation-out
Shipping supplies and expense
Postage and stationery
Depreciation of sales equipment
Telephone and Internet expense
Total selling expenses
$202,644
59,200
48,940
38,315
41,209
24,712
16,788
9,005
12,215
$453,028
How much detail to include in the income statement is always a problem. On the
one hand, we want to present a simple, summarized statement so that a reader can
readily discover important factors. On the other hand, we want to disclose the results
of all activities and to provide more than just a skeleton report. Certain basic elements
are always included, but as we’ll see, they can be presented in various formats.
REPORTING IRREGULAR ITEMS
OBJECTIVE
Explain how
irregular items are
reported.
As illustrated through the use of a multiple-step or condensed income statement, flexibility in the presentation of the components of income is permitted. In two important
areas, however, specific guidelines have been developed. These two areas relate to what
is included in income and how certain unusual or irregular items are reported.
What should be included in net income has been a controversy for many years. For
example, should irregular gains and losses, and corrections of revenues and expenses
of prior years be closed directly to Retained Earnings and therefore not be reported in
the income statement? Or should they first be presented in the income statement and
then carried to Retained Earnings along with the net income or loss for the period? In
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•
general, income measurement follows an all-inclusive approach. This approach indicates that most items, even irregular ones, are recorded in income.10
One exception is errors in prior years’ income measurement. Because these items
have affected earnings already reported in a prior period, errors from prior periods are
not included in current income. Rather, these items are recorded as adjustments to
retained earnings.11
Currently there is growing debate concerning how irregular items that are part of
current income should be reported within the income statement. This issue is extremely
important, because the reporting of irregular items on the income statement is substantial. For example, Illustration 4-5 identifies the most common types and number of
irregular items reported in a survey of 600 large companies.
ILLUSTRATION 4-5
Number of Irregular
Items Reported in a
Recent Year by 600
Large Companies
250
200
150
100
50
0
Restructuring
Charges
Extraordinary
Items
Discontinued
Operations
As indicated, restructuring charges, which many times contain write-offs and other
one-time items, were reported by more than one-fourth of the surveyed firms. About
20 percent of the surveyed firms reported either an extraordinary item or a discontinued operation charge.12
As discussed in the opening story, it is important to have consistent and comparable income reporting practices so that the information that companies disseminate is
not too promotional. Developing a framework for reporting irregular items is important to ensure that financial statement users have reliable income information.13
Some users advocate a current operating performance approach to income
reporting. These analysts argue that the most useful income measure will reflect only
regular and recurring revenue and expense elements. Irregular items do not reflect an
enterprise’s future earning power. In contrast, others warn that a focus on operating
income potentially misses important information about a firm’s performance. Any gain
or loss experienced by the firm, whether directly or indirectly related to operations,
contributes to its long-run profitability. As one analyst notes, “write-offs matter. . . .
They speak to the volatility of (past) earnings.”14 As a result, some nonoperating items
10
As discussed later in this chapter, the FASB has issued a statement of concepts that offers
some guidance on this topic—“Recognition and Measurement in Financial Statements of Business Enterprises,” Statement of Financial Accounting Concepts No. 5 (Stamford, Conn.: FASB, 1984).
11
This is referred to as “prior period adjustments.” Other examples that bypass the income
statement are the gains or losses arising from certain investment securities and pension adjustments. Both examples are cases where there is uncertainty about the realization of the gains or
losses. These gains and losses are recorded in owners’ equity until they are realized.
12
Accounting Trends and Techniques—2001 (New York: AICPA).
13
The FASB and other international accounting standard setters continue to study the best
way to report income. See Reporting Financial Performance: A Proposed Approach (Norwalk, Conn.:
FASB, September 1999).
14
D. McDermott, “Latest Profit Data Stir Old Debate Between Net and Operating Income,”
Wall Street Journal (May 3, 1999).
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can be used to assess the riskiness of future earnings. Furthermore, determining which
items are operating and which items are irregular requires judgment and could lead to
differences in the treatment of irregular items and to possible manipulation of income
measures.
Are one-time charges bugging you?
Which number, net income or income from operations, should an analyst use in evaluating companies that have unusual items? Some argue that operating income is better
because it is more representative of what will happen in the future. Others note that
special items are often no longer special. For example, one study noted that in 2001,
companies in the Standard & Poors’ 500 index wrote off items totaling $165 billion—
more than in the prior five years combined. And one study by Multex.com and the Wall
Street Journal indicates that these charges should not be ignored. Based on data for companies taking unusual charges from 1996–2001, the study documented that companies
reporting the largest unusual charges had more negative stock price performance in the
period following the charge, compared to companies with smaller charges. Thus, rather
than signaling that the bad times are behind, these unusual charges indicated poorer
future earnings.
Rather than ignoring unusual charges, some analysts use these charges to weed out
stocks that may be headed for a fall. Following the “cockroach theory,” any charge indicating a problem raises the probability of more problems. Thus, investors should be
wary of the increasing use of restructuring and other one-time charges, which may bury
expenses that signal future performance declines.
What do the
numbers mean?
Source: J. Weil and S. Liesman, “Stock Gurus Disregard Most Big Write-offs, But They Often Hold
Vital Clues to Outlook,” Wall Street Journal Online (December 31, 2001).
So, what to do? The accounting profession has adopted a modified all-inclusive
concept and requires application of this approach in practice. Irregular items are
required to be highlighted so that the reader of financial statements can better determine the long-run earning power of the enterprise. These items fall into five general
categories:
Discontinued operations.
Extraordinary items.
Unusual gains and losses.
Changes in accounting principle.
Changes in estimates.
Discontinued Operations
As indicated in Illustration 4-5, one of the most common types of irregular items is discontinued operations. A discontinued operation occurs when (a) the results of operations and cash flows of a component of a company have been (or will be) eliminated
from the ongoing operations, and (b) there is no significant continuing involvement in
that component after the disposal transaction. To illustrate a component, S. C. Johnson
manufactures and sells consumer products and has several product groups, each with
different product lines and brands. For S. C. Johnson, a product group is the lowest
level at which operations and cash flows can be clearly distinguished from the rest of
the company’s operations. Therefore each product group is a component of the company, and if disposed of, would be classified as a discontinued operation.
Here is another example. Assume that Softso Inc. has experienced losses with certain brands in its beauty-care products group. As a result, Softso decides to sell the
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135
beauty-care business. It will not have any continuing involvement in the product group
after it is sold. In this case, the operations and the cash flows of the product group are
eliminated from the ongoing operations of Softso and are reported as a discontinued
operation. On the other hand, assume Softso decides to remain in the beauty-care business but will discontinue the brands that experienced losses. Because the cash flows
from the brands cannot be differentiated from the cash flows of the product group as
a whole, the brands are not considered a component. As a result, any gain or loss on
the sale of the brands is not classified as a discontinued operation.
Discontinued operations are generally reported in a separate income statement category for the gain or loss from disposal of a component of a business. In addition, the
results of operations of a component that has been or will be disposed of are also
reported separately from continuing operations. The effects of discontinued operations
are shown net of tax as a separate category, after continuing operations but before extraordinary items.15
To illustrate, Multiplex Products, Inc., a highly diversified company, decides to discontinue its electronics division. During the current year, the electronics division lost
$300,000 (net of tax) and was sold at the end of the year at a loss of $500,000 (net of
tax). The information is shown on the current year’s income statement as follows.
Income from continuing operations
Discontinued operations
Loss from operation of discontinued electronics
division (net of tax)
Loss from disposal of electronics division (net of tax)
Net income
$20,000,000
$300,000
500,000
800,000
$19,200,000
Note that the phrase “Income from continuing operations” is used only when gains
or losses on discontinued operations occur.
Extraordinary Items
Extraordinary items are defined as nonrecurring material items that differ significantly
from the entity’s typical business activities. The criteria for extraordinary items are as
follows.
Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence. Both of the following criteria must be met
to classify an event or transaction as an extraordinary item:
(a) Unusual Nature. The underlying event or transaction should possess a high degree of
abnormality and be of a type clearly unrelated to, or only incidentally related to, the
ordinary and typical activities of the entity, taking into account the environment in which
the entity operates.
(b) Infrequency of Occurrence. The underlying event or transaction should be of a type
that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates.16
15
“Accounting for the Impairment or Disposal of Long-Lived Assets,” Statement of Financial
Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001), par. 4.
16
“Reporting the Results of Operations,” Opinions of the Accounting Principles Board No. 30
(New York: AICPA, 1973), par. 20.
ILLUSTRATION 4-6
Income Statement
Presentation of
Discontinued Operations
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Under current standards, the following gains and losses are not extraordinary
items.
(a) Write-down or write-off of receivables, inventories, equipment leased to others, deferred
research and development costs, or other intangible assets.
(b) Gains or losses from exchange or translation of foreign currencies, including those relating to major devaluations and revaluations.
(c) Gains or losses on disposal of a component of an entity.
(d) Other gains or losses from sale or abandonment of property, plant, or equipment used
in the business.
(e) Effects of a strike, including those against competitors and major suppliers.
(f) Adjustment of accruals on long-term contracts.17
International
Insight
Classification of items as extraordinary differs across nations. Even in countries in
which the criteria for identifying
extraordinary items are similar,
they are not interpreted identically. Thus, what is extraordinary in the U.S. is not necessarily extraordinary elsewhere.
The items listed above are not considered extraordinary “because they are usual in nature and may be expected to recur as a consequence of customary and continuing business activities.”
Only rarely does an event or transaction clearly meet the criteria for an extraordinary item.18 For example, gains or losses such as (a) and (d) above would be classified
as extraordinary if they are a direct result of a major casualty (such as an earthquake),
an expropriation, or a prohibition under a newly enacted law or regulation. Such circumstances would clearly meet the criteria of unusual and infrequent. A good example of an extraordinary item is the approximately $36 million loss incurred by Weyerhaeuser Company (forest and lumber) as a result of volcanic activity at Mount St.
Helens. Standing timber, logs, buildings, equipment, and transportation systems covering 68,000 acres were destroyed by the volcanic eruption.
In determining whether an item is extraordinary, the environment in which the
entity operates is of primary importance. The environment includes such factors as
industry characteristics, geographic location, and the nature and extent of governmental regulations. Thus, extraordinary item treatment is accorded the loss from hail
damages to a tobacco grower’s crops because severe damage from hailstorms in its
locality is rare. On the other hand, frost damage to a citrus grower’s crop in Florida
does not qualify as extraordinary because frost damage is normally experienced
every three or four years. In this environment, the criterion of infrequency is not
met.
Similarly, when a company sells the only significant security investment it has ever
owned, the gain or loss meets the criteria of an extraordinary item. Another company,
however, that has a portfolio of securities acquired for investment purposes would not
have an extraordinary item. Sale of such securities would be considered part of its ordinary and typical activities.19
In addition, considerable judgment must be exercised in determining whether an
item should be reported as extraordinary. For example, some paper companies have
17
Ibid., par. 23, as amended by “Accounting for the Impairment or Disposal of Long-lived
Assets,” Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001).
18
Accounting Trends and Techniques—2001 (New York: AICPA) indicates that just 55 of the 600
companies surveyed reported an extraordinary item.
19
Debt extinguishments had been the most common reason for companies reporting extraordinary items. In a recent four-year period, just 11 percent of surveyed companies reported
an extraordinary item; over 90 percent of these were related to debt extinguishments (Accounting Trends and Techniques—2001, New York: AICPA). Recently the FASB eliminated extraordinary
item treatment for these gains and losses in “Rescission of FASB Statements No. 4, 44, and 64
and Technical Corrections,” Statement of Financial Accounting Standards No. 145 (Norwalk, Conn.:
FASB, 2002). Thus, reporting an extraordinary item is likely to become an even more rare event
in the future.
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had their forest lands condemned by the government for state or national parks or
forests. Is such an event extraordinary, or is it part of normal operations? Such determination is not easy; much depends on the frequency of previous condemnations, the
expectation of future condemnations, materiality, and the like.20
Extraordinary times
No recent event better illustrates the difficulties of determining whether a transaction
meets the definition of extraordinary than the financial impacts of the terrorist attacks
on the World Trade Center on September 11, 2001. To many, this event, which resulted
in the tragic loss of lives, jobs, and in some cases, entire businesses, clearly meets the
criteria for unusual and infrequent. For example, in the wake of the terrorist attacks that
destroyed the World Trade Center and turned much of lower Manhattan including Wall
Street into a war zone, airlines, insurance companies, and other businesses recorded
major losses due to property damage, business disruption, and suspension of airline
travel and of securities trading. But, to the surprise of many, extraordinary item reporting was not permitted for losses arising from the terrorist attacks.
The reason? After much deliberation, the Emerging Issues Task Force (EITF) of the
FASB decided that measurement of the possible loss was too difficult. Take the airline
industry as an example: What portion of the airlines’ losses after September 11 was related to the terrorist attack, and what portion was due to the ongoing recession? There
also was concern that some companies would use the attacks as a reason for reporting
as extraordinary some losses that had little direct relationship to the attacks. For example, shortly after the attacks, energy company AES and shoe retailer Footstar, who
both were experiencing profit pressure before 9/11, put some of the blame for their poor
performance on the attacks.
What do the
numbers mean?
Source: J. Creswell, “Bad News Bearers Shift the Blame,” Fortune (October 15, 2001), p. 44.
Extraordinary items are to be shown net of taxes in a separate section in the income statement, usually just before net income. After listing the usual revenues, costs
and expenses, and income taxes, the remainder of the statement shows the following.
Income before extraordinary items
Extraordinary items (less applicable income tax of $__________________)
Net income
For example, the reporting of an extraordinary loss for Keystone Consolidated Industries, Inc. is shown in Illustration 4-8 on page 138.
Unusual Gains and Losses
Because of the restrictive criteria for extraordinary items, financial statement users must
carefully examine the financial statements for items that are unusual or infrequent but
20
It is often difficult to determine what is extraordinary, because assessing the materiality of
individual items requires judgment. However, in making materiality judgments, extraordinary
items should be considered individually, and not in the aggregate. “Reporting the Results of
Operations,” op. cit., par. 24.
ILLUSTRATION 4-7
Income Statement
Placement of
Extraordinary Items
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ILLUSTRATION 4-8
Income Statement
Presentation of
Extraordinary Items
Keystone Consolidated Industries, Inc.
Income before extraordinary item
Extraordinary item—flood loss (Note E)
$11,638,000
1,216,000
Net income
$10,422,000
Note E: Extraordinary Item. The Keystone Steel and Wire Division’s Steel Works experienced a
flash flood on June 22. The extraordinary item represents the estimated cost, net of related income
taxes of $1,279,000, to restore the steel works to full operation.
not both. As indicated earlier, items such as write-downs of inventories and transaction gains and losses from fluctuation of foreign exchange are not considered extraordinary items. Thus, these items are sometimes shown with the normal, recurring
revenues, costs, and expenses. If they are not material in amount, they are combined
with other items in the income statement. If they are material, they must be disclosed
separately, but are shown above “Income (loss) before extraordinary items.”
For example, Pepsico, Inc. presented an unusual charge in the following manner
in its income statement.
ILLUSTRATION 4-9
Income Statement
Presentation of
Unusual Charges
Pepsico, Inc.
(in millions)
Net sales
Costs and expenses, net
Cost of sales
Selling, general, and administrative expenses
Amortization of intangible assets
Unusual items (Note 2)
$20,917
Operating income
$ 2,662
Note 2 (Restructuring Charge)
Dispose and write down assets
Improve productivity
Strengthen the international bottler structure
$183
94
13
Net loss
$290
8,525
9,241
199
290
The net charge to strengthen the international bottler structure includes proceeds of $87 million
associated with a settlement related to a previous Venezuelan bottler agreement, which were partially
offset by related costs.
Restructuring charges, like the one reported by Pepsico, have been common in recent years. A restructuring charge relates to a major reorganization of company affairs,
such as costs associated with employee layoffs, plant closing costs, write-offs of assets,
and so on. There has been a tendency to report unusual items in a separate section
just above “Income from operations before income taxes and Extraordinary items,”
especially when there are multiple unusual items. A restructuring charge should not
be reported as an extraordinary item, because these write-offs are considered part of a
company’s ordinary and typical activities.
For example, when General Electric Company experienced multiple unusual items
in one year, it reported them in a separate “Unusual items” section of the income statement below “Income before unusual items and income taxes.” When a multiple-step
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income statement is being prepared for homework purposes, unusual gains and losses
should be reported in the “Other revenues and gains” or “Other expenses and losses”
section unless you are instructed to prepare a separate unusual items section.21
In dealing with events that are either unusual or nonrecurring but not both, the
profession attempted to prevent a practice that many believed was misleading. Companies often reported such transactions on a net-of-tax basis and prominently displayed
the earnings per share effect of these items. Although not captioned extraordinary items,
they are presented in the same manner. Some had referred to these as “first cousins”
to extraordinary items. As a consequence, the Board specifically prohibited a net-oftax treatment for such items, to ensure that users of financial statements can easily differentiate extraordinary items—which are reported net of tax—from material items that
are unusual or infrequent, but not both.
Changes in Accounting Principle
Changes in accounting occur frequently in practice, because important events or conditions may be in dispute or uncertain at the statement date. One type of accounting
change, therefore, comprises the normal recurring corrections and adjustments that are
made by every business enterprise. Another accounting change results when an
accounting principle is adopted that is different from the one previously used. Changes
in accounting principle would include a change in the method of inventory pricing
from FIFO to average cost or a change in depreciation from the double-declining to the
straight-line method.22
Changes in accounting principle are recognized by including the cumulative effect
as of the beginning of the year, net of tax in the current year’s income statement. This
amount is based on a retroactive computation of changing to a new accounting principle. The effect on net income of adopting the new accounting principle should be
disclosed as a separate item following extraordinary items in the income statement.
To illustrate, Gaubert Inc. decided in March 2004 to change from an accelerated
method of computing depreciation on its plant assets to the straight-line method. The
assets originally cost $100,000 in 2002 and have a service life of four years. The data
assumed for this illustration are as shown in Illustration 4-10.
Year
Accelerated
Depreciation
Straight-Line
Depreciation
Excess of
Accelerated
over Straight-Line
Method
2002
2003
$40,000
30,000
$25,000
25,000
$15,000
5,000
Total
$20,000
21
Many companies are reporting “one-time items.” However, some companies have taken
restructuring charges practically every year. Citicorp (now Citigroup) took restructuring charges
six years in a row, between 1988 and 1993; Eastman Kodak Co. did so five out of six years in
1989 to 1994. Recent research on the market reaction to income containing “one-time” items indicates that the market discounts the earnings of companies that report a series of “nonrecurring” items. Such evidence supports the contention that these elements reduce the quality of
earnings. J. Elliott and D. Hanna, “Repeated Accounting Write-offs and the Information Content
of Earnings,” Journal of Accounting Research (Supplement, 1996).
22
“Accounting Changes,” Opinions of the Accounting Principles Board No. 20 (New York:
AICPA, 1971), par. 18. In Chapter 22, we examine in greater detail the problems related to
accounting changes.
•
139
✷
Underlying
Concepts
Companies can change principles, but it must be demonstrated that the newly adopted
principle is preferable to the
old one. Such changes mean
that consistency from period to
period is lost.
ILLUSTRATION 4-10
Calculation of a Change
in Accounting Principle
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The information presented in the 2004 financial statements is shown in Illustration
4-11. (The tax rate was 30 percent.)
ILLUSTRATION 4-11
Income Statement
Presentation of a Change
in Accounting Principle
Income before extraordinary item and cumulative effect of a
change in accounting principle
Extraordinary item—casualty loss (net of $12,000 tax)
Cumulative effect on prior years of retroactive application
of new depreciation method (net of $6,000 tax)
Net income
$120,000
(28,000)
14,000
$106,000
Changes in Estimates
Estimates are inherent in the accounting process. Estimates are made, for example, of
useful lives and salvage values of depreciable assets, of uncollectible receivables, of
inventory obsolescence, and of the number of periods expected to benefit from a particular expenditure. Not infrequently, as time passes, as circumstances change, or as
additional information is obtained, even estimates originally made in good faith must
be changed. Such changes in estimates are accounted for in the period of change if
they affect only that period, or in the period of change and future periods if the change
affects both.
To illustrate a change in estimate that affects only the period of change, assume
that DuPage Materials Corp. has consistently estimated its bad debt expense at 1 percent of credit sales. In 2003, however, DuPage’s controller determines that the estimate
of bad debts for the current year’s credit sales must be revised upward to 2 percent, or
double the prior years’ percentage. Using 2 percent results in a bad debt charge of
$240,000, or double the amount using the 1 percent estimate for prior years. The 2 percent rate is necessary to reduce accounts receivable to net realizable value. The provision is recorded at December 31, 2003, as follows.
Bad Debt Expense
Allowance for Doubtful Accounts
✷
Underlying
Concepts
The AICPA Special Committee
on Financial Reporting indicates a company’s core activities—usual and recurring
events—provide the best historical data from which users
determine trends and relationships and make their
predictions about the future.
Therefore, the effects of core
and non-core activities should
be separately displayed.
240,000
240,000
The entire change in estimate is included in 2003 income because no future periods
are affected by the change. Changes in estimate are not handled retroactively. That
is, they are not carried back to adjust prior years. (Changes in estimate that affect both
the current and future periods are examined in greater detail in Chapter 22.) Changes
in estimate are not considered errors (prior period adjustments) or extraordinary
items.
Summary of Irregular Items
The modified all-inclusive income concept is accepted in practice. Except for a couple
of items (discussed later in this chapter) that are charged or credited directly to retained
earnings, all other irregular gains or losses or nonrecurring items are closed to Income
Summary and are included in the income statement. Of these, discontinued operations
of a component of a business is classified as a separate item in the income statement
after continuing operations. The unusual, material, nonrecurring items that are significantly different from the typical or customary business activities are shown in a separate section for “Extraordinary items” below discontinued operations. Other items of
a material amount that are of an unusual or nonrecurring nature and are not considered extraordinary are separately disclosed. In addition, the cumulative adjustment
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141
that occurs when a change in accounting principles develops is disclosed as a separate
item just before net income.
Because of the numerous intermediate income figures that are created by the
reporting of these irregular items, careful evaluation of earnings information reported
by the financial press is needed. Illustration 4-12 summarizes the basic concepts previously discussed. Although the chart is simplified, it provides a useful framework for
determining the treatment of special items affecting the income statement.
ILLUSTRATION 4-12
Summary of Irregular
Items in the Income
Statement
Type of Situationa
Criteria
Examples
Placement on Financial Statements
Discontinued
operations
Disposal of a component of a
business for which the
operations and cash flows can
be clearly distinguished from
the rest of the company’s
operations.
Shown in separate section of the
income statement after continuing
operations but before
extraordinary items. (Shown net of
tax.)
Extraordinary items
Material, and both unusual and
infrequent (nonrecurring).
Unusual gains or
losses, not
considered
extraordinary
Material; character typical of the
customary business activities;
unusual or infrequent but not
both.
Sale by diversified company of
major division that represents only
activities in electronics industry.
Food distributor that sells
wholesale to supermarket chains
and through fast-food restaurants
decides to discontinue the division
that sells to one of two classes of
customers.
Gains or losses resulting from
casualties, an expropriation, or a
prohibition under a new law.
Write-downs of receivables,
inventories; adjustments of
accrued contract prices; gains or
losses from fluctuations of foreign
exchange; gains or losses from
sales of assets used in business.
Changes in
principleb
Change from one generally
accepted principle to another.
Changes in
estimates
Normal, recurring corrections
and adjustments.
Change in the basis of inventory
pricing from FIFO to average cost;
change in the method of
depreciation from accelerated to
straight-line.
Changes in the realizability of
receivables and inventories;
changes in estimated lives of
equipment, intangible assets;
changes in estimated liability for
warranty costs, income taxes, and
salary payments.
Separate section in the income
statement entitled “Extraordinary
items.” (Shown net of tax.)
Separate section in income
statement above income before
extraordinary items. Often
reported in “Other revenues and
gains” or “Other expenses and
losses” section. (Not shown net of
tax.)
Cumulative effect of the change is
reflected in the income statement
between the captions
“Extraordinary items” and “Net
income.” (Shown net of tax.)
Change in income statement only in
the account affected. (Not shown
net of tax.)
a
This summary provides only the general rules to be followed in accounting for the various situations described above. Exceptions do exist in some of these
situations.
b
The general rule per APB Opinion No. 20 is to use the cumulative effect approach. However, recent FASB pronouncements require or permit the retroactive
method whenever a new standard is adopted for the first time.
SPECIAL REPORTING ISSUES
Intraperiod Tax Allocation
We noted that certain irregular items are shown on the income statement net of tax.
Many believe that the resulting income tax effect should be directly associated with
that event or item. In other words, the tax expense for the year should be related, where
OBJECTIVE
Explain intraperiod
tax allocation.
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possible, to specific items on the income statement to provide a more informative disclosure to statement users. This procedure is called intraperiod tax allocation, that is,
allocation within a period. Its main purpose is to relate the income tax expense of the
period to the items that affect the amount of the tax expense. Intraperiod tax allocation
is used for the following items: (1) income from continuing operations, (2) discontinued operations, (3) extraordinary items, and (4) changes in accounting principle. The
general concept is “let the tax follow the income.”
The income tax expense attributable to “income from continuing operations” is
computed by finding the income tax expense related to revenue and to expense transactions used in determining this income. In this tax computation, no effect is given to
the tax consequences of the items excluded from the determination of “income from
continuing operations.” A separate tax effect is then associated with each irregular
item.
Extraordinary Gains
In applying the concept of intraperiod tax allocation, assume that Schindler Co. has
income before income tax and extraordinary item of $250,000 and an extraordinary
gain from the sale of a single stock investment of $100,000. If the income tax rate
is assumed to be 30 percent, the following information is presented on the income
statement.
ILLUSTRATION 4-13
Intraperiod Tax
Allocation, Extraordinary
Gain
Income before income tax and extraordinary item
Income tax
Income before extraordinary item
Extraordinary gain—sale of investment
Less: Applicable income tax
$250,000
75,000
175,000
$100,000
30,000
Net income
70,000
$245,000
The income tax of $75,000 ($250,000 30%) attributable to “Income before income tax
and extraordinary item” is determined from revenue and expense transactions related
to this income. In this income tax computation, the tax consequences of items excluded
from the determination of “Income before income tax and extraordinary item” are not
considered. The “Extraordinary gain—sale of investment” then shows a separate tax
effect of $30,000.
Extraordinary Losses
To illustrate the reporting of an extraordinary loss, assume that Schindler Co. has
income before income tax and extraordinary item of $250,000 and an extraordinary loss
from a major casualty of $100,000. Assuming a 30 percent tax rate, the presentation of
income tax on the income statement would be as shown in Illustration 4-14. In this case,
the loss provides a positive tax benefit of $30,000 and, therefore, is subtracted from the
$100,000 loss.
ILLUSTRATION 4-14
Intraperiod Tax
Allocation, Extraordinary
Loss
Income before income tax and extraordinary item
Income tax
Income before extraordinary item
Extraordinary item—loss from casualty
Less: Applicable income tax reduction
Net income
$250,000
75,000
175,000
$100,000
30,000
70,000
$105,000
An extraordinary item may be reported “net of tax” with note disclosure, as shown
in Illustration 4-15.
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Income before income tax and extraordinary item
Income tax
Income before extraordinary item
Extraordinary item, less applicable income
tax reduction (Note 1)
Net income
$250,000
75,000
175,000
•
143
ILLUSTRATION 4-15
Note Disclosure of
Intraperiod Tax Allocation
70,000
$105,000
Note 1: During the year the Company suffered a major casualty loss of $70,000, net of applicable
income tax reduction of $30,000.
Earnings per Share
The results of a company’s operations are customarily summed up in one important
figure: net income. As if this condensation were not enough of a simplification, the
financial world has widely accepted an even more distilled and compact figure as its
most significant business indicator—earnings per share (EPS).
The computation of earnings per share is usually straightforward. Net income
minus preferred dividends (income available to common stockholders) is divided
by the weighted average of common shares outstanding to arrive at earnings per
share.23 To illustrate, assume that Lancer, Inc. reports net income of $350,000 and
declares and pays preferred dividends of $50,000 for the year. The weighted average
number of common shares outstanding during the year is 100,000 shares. Earnings per
share is $3, as computed in Illustration 4-16.
Net Income Preferred Dividends
Earnings per Share
Weighted Average of Common Shares Outstanding
$350,000 $50,000
$3
100,000
Note that the EPS figure measures the number of dollars earned by each share of
common stock—not the dollar amount paid to stockholders in the form of dividends.
“Net income per share” or “earnings per share” is a ratio commonly used in
prospectuses, proxy material, and annual reports to stockholders. It is also highlighted
in the financial press, by statistical services like Standard & Poor’s, and by Wall Street
securities analysts. Because of its importance, earnings per share is required to be disclosed on the face of the income statement. A company that reports a discontinued
operation, an extraordinary item, or the cumulative effect of a change in accounting
principle must report per share amounts for these line items either on the face of the
income statement or in the notes to the financial statements.24
To illustrate the income statement order of presentation and the earnings per share
data, we present an income statement for Poquito Industries Inc. in Illustration 4-17
on page 144. Notice the order in which data are shown. In addition, per share information is shown at the bottom. Assume that the company had 100,000 shares outstanding for the entire year. The Poquito Industries Inc. income statement, in Illustration 4-17, is highly condensed. Items such as “Unusual charge,” “Discontinued
operations,” “Extraordinary item,” and the “Change in accounting principle” would
have to be described fully and appropriately in the statement or related notes.
Many corporations have simple capital structures that include only common
stock. For these companies, a presentation such as “earnings per common share” is
23
In the calculation of earnings per share, preferred dividends are deducted from net income
if declared or if cumulative though not declared.
24
“Earnings Per Share,” Statement of Financial Accounting Standards No. 128 (Norwalk, Conn.:
FASB, 1996).
OBJECTIVE
Explain where
earnings per share
information is reported.
ILLUSTRATION 4-16
Equation Illustrating
Computation of Earnings
per Share
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ILLUSTRATION 4-17
Income Statement
POQUITO INDUSTRIES INC.
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2004
Sales revenue
Cost of goods sold
$1,480,000
600,000
Gross profit
Selling and administrative expenses
880,000
320,000
Income from operations
Other revenues and gains
Interest revenue
Other expenses and losses
Loss on disposal of part of Textile Division
Unusual charge—loss on sale of investments
560,000
10,000
$ (5,000)
(45,000)
(50,000)
Income from continuing operations before income tax
Income tax
520,000
208,000
Income from continuing operations
Discontinued operations
Income from operations of Pizza Division, less
applicable income tax of $24,800
Loss on disposal of Pizza Division, less
applicable income tax of $41,000
312,000
Income before extraordinary item and cumulative
effect of accounting change
Extraordinary item—loss from earthquake, less
applicable income tax of $23,000
Cumulative effect on prior years of retroactive application of new
depreciation method, less applicable income tax of $30,900
Net income
Per share of common stock
Income from continuing operations
Income from operations of discontinued division, net of tax
Loss on disposal of discontinued operation, net of tax
54,000
(90,000)
(36,000)
276,000
(45,000)
(60,000)
$ 171,000
$3.12
0.54
(0.90)
Income before extraordinary item and cumulative effect
Extraordinary loss, net of tax
Cumulative effect of change in accounting principle, net of tax
2.76
(0.45)
(0.60)
Net income
$1.71
appropriate on the income statement. In many instances, however, companies’ earnings per share are subject to dilution (reduction) in the future because existing contingencies permit the issuance of additional common shares.25
In summary, the simplicity and availability of figures for per share earnings lead
inevitably to their widespread use. Because of the undue importance that the public,
even the well-informed public, attaches to earnings per share, the EPS figure must be
made as meaningful as possible.
Retained Earnings Statement
OBJECTIVE
Prepare a retained
earnings statement.
Net income increases retained earnings, and a net loss decreases retained earnings. Both
cash and stock dividends decrease retained earnings. Prior period adjustments may either increase or decrease retained earnings. A prior period adjustment is a correction
of an error in the financial statements of a prior period. Prior period adjustments (net
of tax) are charged or credited to the opening balance of retained earnings, and thus
excluded from the determination of net income for the current period.
25
Ibid. The computational problems involved in accounting for these dilutive securities in
earnings per share computations are discussed in Chapter 16.
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Information related to retained earnings may be shown in different ways. For
example, some companies prepare a separate retained earnings statement, as shown in
Illustration 4-18.
ILLUSTRATION 4-18
Retained Earnings
Statement
TIGER WOODS INC.
RETAINED EARNINGS STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2004
Balance, January 1, as reported
Correction for understatement of net income in prior period
(inventory error)
$1,050,000
50,000
Balance, January 1, as adjusted
Add: Net income
1,100,000
360,000
1,460,000
Less: Cash dividends
Stock dividends
Balance, December 31
$100,000
200,000
300,000
$1,160,000
The reconciliation of the beginning to the ending balance in retained earnings provides information about why net assets increased or decreased during the year. The
association of dividend distributions with net income for the period indicates what
management is doing with earnings: It may be “plowing back” into the business part
or all of the earnings, distributing all current income, or distributing current income
plus the accumulated earnings of prior years.
Restrictions of Retained Earnings
Retained earnings is often restricted in accordance with contractual requirements, board
of directors’ policy, or the apparent necessity of the moment. The amounts of retained
earnings restricted are generally disclosed in the notes to the financial statements. In
some cases, the amount of retained earnings restricted is transferred to Appropriated
Retained Earnings. The retained earnings section may therefore report two separate
amounts—(1) retained earnings free (unrestricted) and (2) retained earnings appropriated (restricted). The total of these two amounts equals the total retained earnings.26
Comprehensive Income
As indicated earlier, the all-inclusive income concept is used in determining financial
performance for a period of time. Under this concept, all revenues, expenses, and gains
and losses recognized during the period are included in income. However, over time,
specific exceptions to this general concept have developed. Certain items now bypass
income and are reported directly in equity.
An example of one of these items is unrealized gains and losses on available-forsale securities.27 Why are these gains and losses on available-for-sale securities excluded
from net income? Because disclosing them separately (1) reduces the volatility of net
income due to fluctuations in fair value, yet (2) informs the financial statement user of
the gain or loss that would be incurred if the securities were sold at fair value.
26
Accounting Trends and Techniques—2001 (New York: AICPA) indicates that most companies
(577 of 600 surveyed) present changes in retained earnings either within the statement of stockholders’ equity (534 firms) or in a separate statement of retained earnings. Only 10 of the 600
companies prepare a combined statement of income and retained earnings.
27
Available-for-sale securities are further discussed in Chapter 17. Other examples of other
comprehensive items are translation gains and losses on foreign currency, excess of additional
pension liability over unrecognized prior service cost, and unrealized gains and losses on certain hedging transactions.
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OBJECTIVE
Explain how other
comprehensive income
is reported.
Items that bypass the income statement are included under the concept of comprehensive income. Comprehensive income includes all changes in equity during a
period except those resulting from investments by owners and distributions to owners. Comprehensive income, therefore, includes all revenues and gains, expenses and
losses reported in net income, and in addition it includes gains and losses that bypass
net income but affect stockholders’ equity. These items that bypass the income statement are referred to as other comprehensive income.
The FASB decided that the components of other comprehensive income must be
displayed in one of three ways: (1) a second income statement; (2) a combined income
statement of comprehensive income; or (3) as a part of the statement of stockholders’ equity.28 Regardless of the format used, net income must be added to other comprehensive income to arrive at comprehensive income. Earnings per share information
related to comprehensive income is not required.29
To illustrate these presentation formats, assume that V. Gill Inc. reports the following information for 2004: sales revenue $800,000, cost of goods sold $600,000,
operating expenses $90,000, and an unrealized holding gain on available-for-sale
securities of $30,000, net of tax.
Second Income Statement
The two-income statement format is shown in Illustration 4-19 below. Reporting comprehensive income in a separate statement indicates that the gains and losses identified as other comprehensive income have the same status as traditional gains and losses.
In addition, the relationship of the traditional income statement to the comprehensive
income statement is apparent because net income is the starting point in the comprehensive income statement.
ILLUSTRATION 4-19
Two-Statement Format:
Comprehensive Income
V. GILL INC.
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2004
Sales revenue
Cost of goods sold
$800,000
600,000
Gross profit
Operating expenses
200,000
90,000
Net income
$110,000
V. GILL INC.
COMPREHENSIVE INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2004
Net income
Other comprehensive income
Unrealized holding gain, net of tax
$110,000
Comprehensive income
$140,000
30,000
28
“Reporting Comprehensive Income,” Statement of Financial Accounting Standards No. 130
(Norwalk, Conn.: FASB, June 1997). Accounting Trends and Techniques—2001 (New York: AICPA)
indicates that for the 600 companies surveyed, 519 report comprehensive income. Most companies (422 of 497) include comprehensive income as part of the statement of stockholders’ equity.
29
A company is required to display the components of other comprehensive income either
(1) net of related tax effects or (2) before related tax effects with one amount shown for the
aggregate amount of tax related to the total amount of other comprehensive income. Under either alternative, each component of other comprehensive income must be shown, net of related
taxes either in the face of the statement or in the notes.
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Combined Income Statement
The second approach provides a combined statement of comprehensive income in
which the traditional net income would be a subtotal, with total comprehensive income
shown as a final total. The combined statement has the advantage of not requiring the
creation of a new financial statement. However, burying net income in a subtotal on
the statement is a disadvantage.
Statement of Stockholders’ Equity
A third approach is to report other comprehensive income items in a statement of
stockholders’ equity (often referred to as statement of changes in stockholders’
equity). This statement reports the changes in each stockholder’s equity account and
in total stockholders’ equity during the year. The statement of stockholders’ equity
is often prepared in columnar form with columns for each account and for total stockholders’ equity.
To illustrate its presentation, assume the same information related to V. Gill Inc.
and that the company had the following stockholder equity account balances at the beginning of 2004: Common Stock $300,000; Retained Earnings $50,000; and Accumulated
Other Comprehensive Income $60,000. No changes in the Common Stock account occurred during the year. A statement of stockholders’ equity for V. Gill Inc. is shown in
Illustration 4-20.
ILLUSTRATION 4-20
Presentation of
Comprehensive Income
Items in Stockholders’
Equity Statement
V. GILL INC.
STATEMENT OF STOCKHOLDERS’ EQUITY
FOR THE YEAR ENDED DECEMBER 31, 2004
Total
Beginning balance
Comprehensive income
Net income
Other comprehensive
income
Unrealized holding
gain, net of tax
$410,000
110,000
30,000
Comprehensive income
Ending balance
Comprehensive
Income
$110,000
Retained
Earnings
Accumulated
Other
Comprehensive
Income
Common
Stock
$ 50,000
$60,000
$300,000
110,000
30,000
30,000
$140,000
$550,000
$160,000
$90,000
$300,000
Most companies use the statement of stockholders’ equity approach to provide
information related to the components of other comprehensive income. Because many
companies already provide a statement of stockholders’ equity, adding additional
columns to display information related to comprehensive income is not costly.
Balance Sheet Presentation
Regardless of the display format used, the accumulated other comprehensive income
of $90,000 is reported in the stockholders’ equity section of the balance sheet of V. Gill
Inc. as shown in Illustration 4-21.
Examples of
Comprehensive Income
Reporting
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ILLUSTRATION 4-21
Presentation of
Accumulated Other
Comprehensive Income
in the Balance Sheet
V. GILL INC.
BALANCE SHEET
AS OF DECEMBER 31, 2004
(STOCKHOLDERS’ EQUITY SECTION)
Stockholders’ equity
Common stock
Retained earnings
Accumulated other comprehensive income
$300,000
160,000
90,000
Total stockholders’ equity
$550,000
By providing information on the components of comprehensive income as well as total
accumulated other comprehensive income, the company communicates information
about all changes in net assets.30 With this information, users will be better able to understand the quality of the company’s earnings. This information should help users
predict the amounts, timing, and uncertainty of future cash flows.
SUMMARY OF LEARNING OBJECTIVES
KEY TERMS
accumulated other
comprehensive
income, 147
all-inclusive
approach, 133
appropriated retained
earnings, 145
capital maintenance
approach, (n), 127
changes in estimate, 140
comprehensive
income, 146
current operating
performance
approach, 133
discontinued
operation, 134
earnings
management, 126
earnings per share, 143
extraordinary items, 135
income statement, 124
intraperiod tax
allocation, 142
irregular items, 134
modified all-inclusive
concept, 134
multiple-step income
statement, 129
other comprehensive
income, 146
prior period
adjustments, 144
Identify the uses and limitations of an income statement. The income statement provides investors and creditors with information that helps them predict the amounts,
timing, and uncertainty of future cash flows. Also, the income statement helps users
determine the risk (level of uncertainty) of not achieving particular cash flows. The
limitations of an income statement are: (1) The statement does not include many items
that contribute to general growth and well-being of an enterprise. (2) Income numbers are often affected by the accounting methods used. (3) Income measures are subject to estimates.
The transaction approach focuses on the activities that have occurred during a given
period. Instead of presenting only a net change, it discloses the components of the
change. The transaction approach to income measurement requires the use of revenue, expense, loss, and gain accounts.
Prepare a single-step income statement. In a single-step income statement, just two
groupings exist: revenues and expenses. Expenses are deducted from revenues to
arrive at net income or loss—a single subtraction. Frequently, income tax is reported
separately as the last item before net income to indicate its relationship to income
before income tax.
Prepare a multiple-step income statement. A multiple-step income statement shows
two further classifications: (1) a separation of operating results from those obtained
through the subordinate or nonoperating activities of the company; and (2) a classification of expenses by functions, such as merchandising or manufacturing, selling,
and administration.
Explain how irregular items are reported. Irregular gains or losses or nonrecurring
items are generally closed to Income Summary and are included in the income statement. These are treated in the income statement as follows: (1) Discontinued operation of a component of a business is classified as a separate item, after continuing operations. (2) The unusual, material, nonrecurring items that are significantly different
from the customary business activities are shown in a separate section for extraordinary items, below discontinued operations. (3) Other items of a material amount that
30
Note that prior period adjustments and the cumulative effect of changes in accounting
principle are not considered other comprehensive income items.
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Questions
are of an unusual or nonrecurring nature and are not considered extraordinary are
separately disclosed. (4) The cumulative adjustment that occurs when a change in
accounting principles develops is disclosed as a separate item, just before net income.
Explain intraperiod tax allocation. The tax expense for the year should be related,
where possible, to specific items on the income statement, to provide a more informative disclosure to statement users. This procedure is called intraperiod tax allocation, that is, allocation within a period. Its main purpose is to relate the income tax
expense for the fiscal period to the following items that affect the amount of the tax
provisions: (1) income from continuing operations, (2) discontinued operations, (3)
extraordinary items, and (4) changes in accounting principle.
•
149
quality of earnings, 126
restructuring charge, 138
single-step income
statement, 128
statement of stockholders’
equity, 147
transaction approach, 127
Explain where earnings per share information is reported. Because of the inherent
dangers of focusing attention solely on earnings per share, earnings per share must
be disclosed on the face of the income statement. A company that reports a discontinued operation, an extraordinary item, or the cumulative effect of a change in accounting principle must report per share amounts for these line items either on the
face of the income statement or in the notes to the financial statements.
Prepare a retained earnings statement. The retained earnings statement should disclose net income (loss), dividends, prior period adjustments, and restrictions of
retained earnings.
Explain how other comprehensive income is reported. The components of other comprehensive income are reported in a second statement, a combined income statement
of comprehensive income, or in a statement of stockholders’ equity.
QUESTIONS
1. What kinds of questions about future cash flows do investors and creditors attempt to answer with information in the income statement?
future upgrades to its products. Some contend that
MicroStrategy’s quality of earnings is low. What does the
term “quality of earnings” mean?
2. How can information based on past transactions be used
to predict future cash flows?
10. What is the major distinction (a) between revenues and
gains and (b) between expenses and losses?
3. Identify at least two situations in which important
changes in value are not reported in the income statement.
11. What are the advantages and disadvantages of the
single-step income statement?
4. Identify at least two situations in which application of
different accounting methods or accounting estimates
results in difficulties in comparing companies.
5. Explain the transaction approach to measuring income.
Why is the transaction approach to income measurement
preferable to other ways of measuring income?
6. What is earnings management?
7. How can earnings management affect the quality of
earnings?
8. Why should caution be exercised in the use of the income figure derived in an income statement? What are
the objectives of generally accepted accounting principles in their application to the income statement?
9. A Wall Street Journal article noted that MicroStrategy
reported higher income than its competitors by using
a more aggressive policy for recognizing revenue on
12. What is the basis for distinguishing between operating
and nonoperating items?
13. Distinguish between the all-inclusive income statement
and the current operating performance income statement. According to present generally accepted accounting principles, which is recommended? Explain.
14. How should prior period adjustments be reported in the
financial statements? Give an example of a prior period
adjustment.
15. Discuss the appropriate treatment in the financial statements of each of the following.
(a) An amount of $113,000 realized in excess of the cash
surrender value of an insurance policy on the life of
one of the founders of the company who died during the year.
(b) A profit-sharing bonus to employees computed as a
percentage of net income.
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(c) Additional depreciation on factory machinery because
of an error in computing depreciation for the previous year.
single-step income statement because the multiple-step
format generally overstates income.” How should you
respond to Rex?
(d) Rent received from subletting a portion of the office
space.
(e) A patent infringement suit, brought 2 years ago
against the company by another company, was settled this year by a cash payment of $725,000.
20. Federov Corporation has eight expense accounts in its
general ledger which could be classified as selling expenses. Should Federov report these eight expenses
separately in its income statement or simply report one
total amount for selling expenses?
(f) A reduction in the Allowance for Doubtful Accounts
balance, because the account appears to be considerably in excess of the probable loss from uncollectible
receivables.
21. Jose DeLeon Investments reported an unusual gain from
the sale of certain assets in its 2004 income statement.
How does intraperiod tax allocation affect the reporting
of this unusual gain?
16. Indicate where the following items would ordinarily appear on the financial statements of Allepo, Inc. for the
year 2004.
22. What effect does intraperiod tax allocation have on reported net income?
(a) The service life of certain equipment was changed
from 8 to 5 years. If a 5-year life had been used previously, additional depreciation of $425,000 would
have been charged.
23. Letterman Company computed earnings per share as
follows.
Net income
Common shares outstanding at year-end
(b) In 2004 a flood destroyed a warehouse that had a
book value of $1,600,000. Floods are rare in this locality.
Letterman has a simple capital structure. What possible
errors might the company have made in the computation? Explain.
(c) In 2004 the company wrote off $1,000,000 of inventory that was considered obsolete.
24. Maria Shriver Corporation reported 2004 earnings per
share of $7.21. In 2005, Maria Shriver reported earnings
per share as follows.
(d) An income tax refund related to the 2001 tax year was
received.
(e) In 2001, a supply warehouse with an expected useful life of 7 years was erroneously expensed.
(f) Allepo, Inc. changed its depreciation from doubledeclining to straight-line on machinery in 2004. The
cumulative effect of the change was $925,000 (net of
tax).
17. Give the section of a multiple-step income statement in
which each of the following is shown.
(a) Loss on inventory write-down.
(b) Loss from strike.
(c) Bad debt expense.
(d) Loss on disposal of a component of the business.
(e) Gain on sale of machinery.
(f) Interest revenue.
(g) Depreciation expense.
(h) Material write-offs of notes receivable.
18. Barry Bonds Land Development, Inc. purchased land for
$70,000 and spent $30,000 developing it. It then sold the
land for $160,000. Tom Glavine Manufacturing purchased land for a future plant site for $100,000. Due to a
change in plans, Glavine later sold the land for $160,000.
Should these two companies report the land sales, both
at gains of $60,000, in a similar manner?
19. You run into Rex Grossman at a party and begin discussing financial statements. Rex says, “I prefer the
On income before extraordinary item
On extraordinary item
$6.40
1.88
On net income
$8.28
Is the increase in earnings per share from $7.21 to $8.28
a favorable trend?
25. What is meant by “tax allocation within a period”? What
is the justification for such practice?
26. When does tax allocation within a period become necessary? How should this allocation be handled?
27. During 2004, Natsume Sozeki Company earned income
of $1,000,000 before income taxes and realized a gain of
$450,000 on a government-forced condemnation sale of
a division plant facility. The income is subject to income
taxation at the rate of 34%. The gain on the sale of the
plant is taxed at 30%. Proper accounting suggests that
the unusual gain be reported as an extraordinary item.
Illustrate an appropriate presentation of these items in
the income statement.
28. On January 30, 2003, a suit was filed against Pierogi Corporation under the Environmental Protection Act. On
August 6, 2004, Pierogi Corporation agreed to settle the
action and pay $920,000 in damages to certain current
and former employees. How should this settlement be
reported in the 2004 financial statements? Discuss.
29. Tiger Paper Company decided to close two small pulp
mills in Conway, New Hampshire, and Corvallis, Oregon. Would these closings be reported in a separate sec-
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151
tion entitled “Discontinued operations after income from
continuing operations”? Discuss.
income. Explain what accountants do as a practical alternative.
30. What major types of items are reported in the retained
earnings statement?
33. What is meant by the terms components, elements, and
items as they relate to the income statement? Why
might items have to be disclosed in the income statement?
31. Generally accepted accounting principles usually require
the use of accrual accounting to “fairly present” income.
If the cash receipts and disbursements method of accounting will “clearly reflect” taxable income, why does
this method not usually also “fairly present” income?
32. State some of the more serious problems encountered in
seeking to achieve the ideal measurement of periodic net
34. What are the three ways that other comprehensive income may be displayed (reported)?
35. How should the disposal of a component of a business
be disclosed in the income statement?
BRIEF EXERCISES
BE4-1
Tim Allen Co. had sales revenue of $540,000 in 2004. Other items recorded during the year were:
Cost of goods sold
Wage expense
Income tax expense
Increase in value of company reputation
Other operating expenses
Unrealized gain on value of patents
$320,000
120,000
25,000
15,000
10,000
20,000
Prepare a single-step income statement for Allen for 2004. Allen has 100,000 shares of stock outstanding.
BE4-2 Turner Corporation had net sales of $2,400,000 and interest revenue of $31,000 during 2004. Expenses for 2004 were: cost of goods sold $1,250,000; administrative expenses $212,000; selling expenses
$280,000; interest expense $45,000. Turner’s tax rate is 30%. The corporation had 100,000 shares of common stock authorized and 70,000 shares issued and outstanding during 2004. Prepare a single-step income statement for the year ended December 31, 2004.
BE4-3 Using the information provided in BE4-2, prepare a condensed multiple-step income statement
for Turner Corporation.
BE4-4 Green Day Corporation had income from continuing operations of $12,600,000 in 2004. During
2004, it disposed of its restaurant division at an after-tax loss of $189,000. Prior to disposal, the division
operated at a loss of $315,000 (net of tax) in 2004. Green Day had 10,000,000 shares of common stock outstanding during 2004. Prepare a partial income statement for Green Day beginning with income from continuing operations.
BE4-5 Boyz II Men Corporation had income before income taxes for 2004 of $7,300,000. In addition, it
suffered an unusual and infrequent pretax loss of $770,000 from a volcano eruption. The corporation’s tax
rate is 30%. Prepare a partial income statement for Boyz II Men beginning with income before income
taxes. The corporation had 5,000,000 shares of common stock outstanding during 2004.
BE4-6 Shawn Bradley Company changed from straight-line depreciation to double-declining balance depreciation at the beginning of 2004. The plant assets originally cost $1,500,000 in 2002. Using straight-line
depreciation, depreciation expense is $60,000 per year. Under the double-declining balance method,
depreciation expense would be $120,000, $110,400, and $101,568 for 2002, 2003, and 2004. If Bradley’s tax
rate is 30%, by what amount would the cumulative effect of a change in accounting principle increase or
decrease 2004 net income?
BE4-7 Jana Kingston Company has recorded bad debt expense in the past at a rate of 11⁄2% of net sales.
In 2004, Kingston decides to increase its estimate to 2%. If the new rate had been used in prior years, cumulative bad debt expense would have been $380,000 instead of $285,000. In 2004, bad debt expense will
be $120,000 instead of $90,000. If Kingston’s tax rate is 30%, what amount should it report as the cumulative effect of changing the estimated bad debt rate?
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BE4-8 In 2004, Kirby Puckett Corporation reported net income of $1,200,000. It declared and paid preferred stock dividends of $250,000. During 2004, Puckett had a weighted average of 190,000 common
shares outstanding. Compute Puckett’s 2004 earnings per share.
BE4-9 Lincoln Corporation has retained earnings of $675,000 at January 1, 2004. Net income during 2004
was $2,400,000, and cash dividends declared and paid during 2004 totaled $75,000. Prepare a retained
earnings statement for the year ended December 31, 2004.
BE4-10 Using the information from BE4-9, prepare a retained earnings statement for the year ended
December 31, 2004. Assume an error was discovered: land costing $80,000 (net of tax) was charged to
repairs expense in 2001.
BE4-11 On January 1, 2004, Creative Works Inc. had cash and common stock of $60,000. At that date the
company had no other asset, liability or equity balances. On January 2, 2004, it purchased for cash $20,000
of equity securities that it classified as available-for-sale. It received cash dividends of $3,000 during the
year on these securities. In addition, it has an unrealized holding gain on these securities of $5,000 net of
tax. Determine the following amounts for 2004: (a) net income; (b) comprehensive income; (c) other comprehensive income; and (d) accumulated other comprehensive income (end of 2004).
EXERCISES
E4-1 (Computation of Net Income) Presented below are changes in all the account balances of Fritz
Reiner Furniture Co. during the current year, except for retained earnings.
Increase
(Decrease)
Cash
Accounts Receivable (net)
Inventory
Investments
$ 79,000
45,000
127,000
(47,000)
Increase
(Decrease)
Accounts Payable
Bonds Payable
Common Stock
Additional Paid-in Capital
$(51,000)
82,000
125,000
13,000
Instructions
Compute the net income for the current year, assuming that there were no entries in the Retained Earnings account except for net income and a dividend declaration of $19,000 which was paid in the current
year.
E4-2
(Income Statement Items)
Presented below are certain account balances of Paczki Products Co.
Rental revenue
Interest expense
Beginning retained earnings
Ending retained earnings
Dividend revenue
Sales returns
$
6,500
12,700
114,400
134,000
71,000
12,400
Sales discounts
Selling expenses
Sales
Income tax
Cost of goods sold
Administrative expenses
$
7,800
99,400
390,000
31,000
184,400
82,500
Instructions
From the foregoing, compute the following: (a) total net revenue, (b) net income, (c) dividends declared
during the current year.
E4-3 (Single-step Income Statement) The financial records of LeRoi Jones Inc. were destroyed by fire
at the end of 2004. Fortunately the controller had kept certain statistical data related to the income statement as presented below.
1.
2.
3.
4.
5.
6.
7.
8.
The beginning merchandise inventory was $92,000 and decreased 20% during the current year.
Sales discounts amount to $17,000.
20,000 shares of common stock were outstanding for the entire year.
Interest expense was $20,000.
The income tax rate is 30%.
Cost of goods sold amounts to $500,000.
Administrative expenses are 20% of cost of goods sold but only 8% of gross sales.
Four-fifths of the operating expenses relate to sales activities.
Instructions
From the foregoing information prepare an income statement for the year 2004 in single-step form.
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Exercises
E4-4 (Multiple-step and Single-step) Two accountants for the firm of Elwes and Wright are arguing
about the merits of presenting an income statement in a multiple-step versus a single-step format. The
discussion involves the following 2004 information related to P. Bride Company ($000 omitted).
Administrative expense
Officers’ salaries
Depreciation of office furniture and equipment
Cost of goods sold
Rental revenue
Selling expense
Transportation-out
Sales commissions
Depreciation of sales equipment
Sales
Income tax
Interest expense
$ 4,900
3,960
60,570
17,230
2,690
7,980
6,480
96,500
9,070
1,860
Instructions
(a) Prepare an income statement for the year 2004 using the multiple-step form. Common shares outstanding for 2004 total 40,550 (000 omitted).
(b) Prepare an income statement for the year 2004 using the single-step form.
(c) Which one do you prefer? Discuss.
E4-5 (Multiple-step and Extraordinary Items) The following balances were taken from the books of
Maria Conchita Alonzo Corp. on December 31, 2004.
Interest revenue
Cash
Sales
Accounts receivable
Prepaid insurance
Sales returns and allowances
Allowance for doubtful
accounts
Sales discounts
Land
Equipment
Building
Cost of goods sold
$
86,000
51,000
1,380,000
150,000
20,000
150,000
7,000
45,000
100,000
200,000
140,000
621,000
Accumulated depreciation—equipment
Accumulated depreciation—building
Notes receivable
Selling expenses
Accounts payable
Bonds payable
Administrative and general
expenses
Accrued liabilities
Interest expense
Notes payable
Loss from earthquake damage
(extraordinary item)
Common stock
Retained earnings
$ 40,000
28,000
155,000
194,000
170,000
100,000
97,000
32,000
60,000
100,000
150,000
500,000
21,000
Assume the total effective tax rate on all items is 34%.
Instructions
Prepare a multiple-step income statement; 100,000 shares of common stock were outstanding during the
year.
E4-6 (Multiple-step and Single-step) The accountant of Whitney Houston Shoe Co. has compiled the
following information from the company’s records as a basis for an income statement for the year ended
December 31, 2004.
Rental revenue
Interest on notes payable
Market appreciation on land above cost
Wages and salaries—sales
Materials and supplies—sales
Income tax
Wages and salaries—administrative
Other administrative expenses
Cost of goods sold
Net sales
Depreciation on plant assets (70% selling, 30% administrative)
Dividends declared
There were 20,000 shares of common stock outstanding during the year.
Instructions
(a) Prepare a multiple-step income statement.
(b) Prepare a single-step income statement.
(c) Which format do you prefer? Discuss.
$ 29,000
18,000
31,000
114,800
17,600
37,400
135,900
51,700
496,000
980,000
65,000
16,000
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Chapter 4 Income Statement and Related Information
E4-7 (Income Statement, EPS) Presented below are selected ledger accounts of Tucker Corporation as
of December 31, 2004.
Cash
Administrative expenses
Selling expenses
Net sales
Cost of goods sold
Cash dividends declared (2004)
Cash dividends paid (2004)
Discontinued operations (loss before income taxes)
Depreciation expense, not recorded in 2003
Retained earnings, December 31, 2003
Effective tax rate 30%
$ 50,000
100,000
80,000
540,000
210,000
20,000
15,000
40,000
30,000
90,000
Instructions
(a) Compute net income for 2004.
(b) Prepare a partial income statement beginning with income from continuing operations before income tax, and including appropriate earnings per share information. Assume 10,000 shares of
common stock were outstanding during 2004.
E4-8 (Multiple-step Statement with Retained Earnings) Presented below is information related to Ivan
Calderon Corp. for the year 2004.
Net sales
Cost of goods sold
Selling expenses
Administrative expenses
Dividend revenue
Interest revenue
$1,300,000
780,000
65,000
48,000
20,000
7,000
Write-off of inventory due to obsolescence
Depreciation expense omitted by accident in 2003
Casualty loss (extraordinary item) before taxes
Dividends declared
Retained earnings at December 31, 2003
Effective tax rate of 34% on all items
$ 80,000
55,000
50,000
45,000
980,000
Instructions
(a) Prepare a multiple-step income statement for 2004. Assume that 60,000 shares of common stock
are outstanding.
(b) Prepare a separate retained earnings statement for 2004.
E4-9 (Earnings Per Share) The stockholders’ equity section of Tkachuk Corporation appears below as
of December 31, 2004.
8% cumulative preferred stock, $50 par value, authorized
100,000 shares, outstanding 90,000 shares
Common stock, $1.00 par, authorized and issued 10 million shares
Additional paid-in capital
Retained earnings
Net income
$
$134,000,000
33,000,000
4,500,000
10,000,000
20,500,000
167,000,000
$202,000,000
Net income for 2004 reflects a total effective tax rate of 34%. Included in the net income figure is a
loss of $18,000,000 (before tax) as a result of a major casualty.
Instructions
Compute earnings per share data as it should appear on the income statement of Tkachuk Corporation.
E4-10 (Condensed Income Statement—Periodic Inventory Method) Presented below are selected
ledger accounts of Spock Corporation at December 31, 2004.
Cash
Merchandise inventory
Sales
Advances from customers
Purchases
Sales discounts
Purchase discounts
Sales salaries
Office salaries
Purchase returns
Sales returns
Transportation-in
Accounts receivable
Sales commissions
$ 185,000
535,000
4,275,000
117,000
2,786,000
34,000
27,000
284,000
346,000
15,000
79,000
72,000
142,500
83,000
Travel and entertainment
Accounting and legal services
Insurance expense
Advertising
Transportation-out
Depreciation of office equipment
Depreciation of sales equipment
Telephone—sales
Utilities—office
Miscellaneous office expenses
Rental revenue
Extraordinary loss (before tax)
Interest expense
Common stock ($10 par)
$ 69,000
33,000
24,000
54,000
93,000
48,000
36,000
17,000
32,000
8,000
240,000
70,000
176,000
900,000
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Exercises
Spock’s effective tax rate on all items is 34%. A physical inventory indicates that the ending inventory is
$686,000.
Instructions
Prepare a condensed 2004 income statement for Spock Corporation.
E4-11 (Retained Earnings Statement) Eddie Zambrano Corporation began operations on January 1,
2001. During its first 3 years of operations, Zambrano reported net income and declared dividends as
follows.
Net income
2001
2002
2003
$ 40,000
125,000
160,000
Dividends declared
$ –0–
50,000
50,000
The following information relates to 2004.
Income before income tax
Prior period adjustment: understatement of 2002 depreciation expense (before taxes)
Cumulative decrease in income from change in inventory methods (before taxes)
Dividends declared (of this amount, $25,000 will be paid on Jan. 15, 2005)
Effective tax rate
$240,000
$ 25,000
$ 35,000
$100,000
40%
Instructions
(a) Prepare a 2004 retained earnings statement for Eddie Zambrano Corporation.
(b) Assume Eddie Zambrano Corp. restricted retained earnings in the amount of $70,000 on December
31, 2004. After this action, what would Zambrano report as total retained earnings in its December 31, 2004, balance sheet?
E4-12 (Earnings per Share)
outstanding.
At December 31, 2003, Shiga Naoya Corporation had the following stock
10% cumulative preferred stock, $100 par, 107,500 shares
Common stock, $5 par, 4,000,000 shares
$10,750,000
20,000,000
During 2004, Shiga Naoya’s only stock transaction was the issuance of 400,000 shares of common on
April 1. The following also occurred during 2004.
Income from continuing operations before taxes
Discontinued operations (loss before taxes)
Preferred dividends declared
Common dividends declared
Effective tax rate
$23,650,000
$ 3,225,000
$ 1,075,000
$ 2,200,000
35%
Instructions
Compute earnings per share data as it should appear in the 2004 income statement of Shiga Naoya
Corporation.
E4-13 (Change in Accounting Principle) Tom Kothe Company placed an asset in service on January
2, 2002. Its cost was $450,000 with an estimated service life of 6 years. Salvage value was estimated to be
$30,000. Using the double-declining-balance method of depreciation, the depreciation for 2002, 2003, and
2004 would be $150,000, $100,000, and $66,667 respectively. During 2004 the company’s management
decided to change to the straight-line method of depreciation. Assume a 35% tax rate.
Instructions
(a) How much depreciation expense will be reported in the income from continuing operations of
the company’s income statement for 2004? (Hint: Use the new depreciation in the current year.)
(b) What amount will be reported as the cumulative effect of the change in accounting principle for
2004?
E4-14 (Comprehensive Income) Roxanne Carter Corporation reported the following for 2004: net sales
$1,200,000; cost of goods sold $750,000; selling and administrative expenses $320,000; and an unrealized
holding gain on available-for-sale securities $18,000.
Instructions
Prepare a statement of comprehensive income, using the two-income statement format. Ignore income
taxes and earnings per share.
E4-15 (Comprehensive Income) C. Reither Co. reports the following information for 2004: sales revenue $700,000; cost of goods sold $500,000; operating expenses $80,000; and an unrealized holding loss
on available-for-sale securities for 2004 of $60,000. It declared and paid a cash dividend of $10,000 in 2004.
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Chapter 4 Income Statement and Related Information
C. Reither Co. has January 1, 2004, balances in common stock $350,000; accumulated other comprehensive income $80,000; and retained earnings $90,000. It issued no stock during 2004.
Instructions
Prepare a statement of stockholders’ equity.
E4-16 (Various Reporting Formats) The following information was taken from the records of Roland
Carlson Inc. for the year 2004. Income tax applicable to income from continuing operations $187,000;
income tax applicable to loss on discontinued operations $25,500; income tax applicable to extraordinary
gain $32,300; income tax applicable to extraordinary loss $20,400; and unrealized holding gain on availablefor-sale securities $15,000.
Extraordinary gain
Loss on discontinued operations
Administrative expenses
Rent revenue
Extraordinary loss
$ 95,000
75,000
240,000
40,000
60,000
Cash dividends declared
Retained earnings January 1, 2004
Cost of goods sold
Selling expenses
Sales
$ 150,000
600,000
850,000
300,000
1,900,000
Shares outstanding during 2004 were 100,000.
Instructions
(a) Prepare a single-step income statement for 2004.
(b) Prepare a retained earnings statement for 2004.
(c) Show how comprehensive income is reported using the second income statement format.
PROBLEMS
P4-1 (Multi-step Income, Retained Earnings) Presented below is information related to American
Horse Company for 2004.
Retained earnings balance, January 1, 2004
Sales for the year
Cost of goods sold
Interest revenue
Selling and administrative expenses
Write-off of goodwill (not tax deductible)
Income taxes for 2004
Gain on the sale of investments (normal recurring)
Loss due to flood damage—extraordinary item (net of tax)
Loss on the disposition of the wholesale division (net of tax)
Loss on operations of the wholesale division (net of tax)
Dividends declared on common stock
Dividends declared on preferred stock
$ 980,000
25,000,000
17,000,000
70,000
4,700,000
820,000
905,000
110,000
390,000
440,000
90,000
250,000
70,000
Instructions
Prepare a multi-step income statement and a retained earnings statement. American Horse Company
decided to discontinue its entire wholesale operations and to retain its manufacturing operations. On
September 15, American Horse sold the wholesale operations to Rogers Company. During 2004, there
were 300,000 shares of common stock outstanding all year.
P4-2 (Single-step Income, Retained Earnings, Periodic Inventory) Presented below is the trial balance of Mary J. Blige Corporation at December 31, 2004.
MARY J. BLIGE CORPORATION
TRIAL BALANCE
YEAR ENDED DECEMBER 31, 2004
Debits
Purchase Discounts
Cash
Accounts Receivable
Rent Revenue
Retained Earnings
Salaries Payable
Sales
Credits
$
10,000
$ 205,100
105,000
18,000
260,000
18,000
1,000,000
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Problems
Notes Receivable
Accounts Payable
Accumulated Depreciation—Equipment
Sales Discounts
Sales Returns
Notes Payable
Selling Expenses
Administrative Expenses
Common Stock
Income Tax Expense
Cash Dividends
Allowance for Doubtful Accounts
Supplies
Freight-in
Land
Equipment
Bonds Payable
Gain on Sale of Land
Accumulated Depreciation—Building
Merchandise Inventory
Building
Purchases
Totals
110,000
49,000
28,000
14,500
17,500
70,000
232,000
99,000
300,000
38,500
45,000
5,000
14,000
20,000
70,000
140,000
100,000
30,000
19,600
89,000
98,000
610,000
$1,907,600
$1,907,600
A physical count of inventory on December 31 resulted in an inventory amount of $124,000.
Instructions
Prepare a single-step income statement and a retained earnings statement. Assume that the only changes
in retained earnings during the current year were from net income and dividends. Thirty thousand shares
of common stock were outstanding the entire year.
P4-3 (Irregular Items) Tony Rich Inc. reported income from continuing operations before taxes during
2004 of $790,000. Additional transactions occurring in 2004 but not considered in the $790,000 are as
follows.
The corporation experienced an uninsured flood loss (extraordinary) in the amount of $80,000 during the year. The tax rate on this item is 46%.
2. At the beginning of 2002, the corporation purchased a machine for $54,000 (salvage value of $9,000)
that had a useful life of 6 years. The bookkeeper used straight-line depreciation for 2002, 2003, and
2004 but failed to deduct the salvage value in computing the depreciation base.
3. Sale of securities held as a part of its portfolio resulted in a loss of $57,000 (pretax).
4. When its president died, the corporation realized $110,000 from an insurance policy. The cash surrender value of this policy had been carried on the books as an investment in the amount of $46,000
(the gain is nontaxable).
5. The corporation disposed of its recreational division at a loss of $115,000 before taxes. Assume that
this transaction meets the criteria for discontinued operations.
6. The corporation decided to change its method of inventory pricing from average cost to the FIFO
method. The effect of this change on prior years is to increase 2002 income by $60,000 and decrease
2003 income by $20,000 before taxes. The FIFO method has been used for 2004. The tax rate on
these items is 40%.
1.
Instructions
Prepare an income statement for the year 2004 starting with income from continuing operations before
taxes. Compute earnings per share as it should be shown on the face of the income statement. Common
shares outstanding for the year are 80,000 shares. (Assume a tax rate of 30% on all items, unless indicated
otherwise.)
P4-4 (Multiple- and Single-step Income, Retained Earnings) The following account balances were
included in the trial balance of J.R. Reid Corporation at June 30, 2004.
Sales
Sales discounts
Cost of goods sold
Sales salaries
$1,678,500
31,150
896,770
56,260
Depreciation of office furniture
and equipment
Real estate and other local taxes
Bad debt expense—selling
$ 7,250
7,320
4,850
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Chapter 4 Income Statement and Related Information
Sales commissions
Travel expense—salespersons
Freight-out
Entertainment expense
Telephone and Internet expense—sales
Depreciation of sales equipment
Building expense—prorated to sales
Miscellaneous selling expenses
Office supplies used
Telephone and Internet expense—
administration
97,600
28,930
21,400
14,820
9,030
4,980
6,200
4,715
3,450
2,820
Building expense—prorated
to administration
Miscellaneous office expenses
Sales returns
Dividends received
Bond interest expense
Income taxes
Depreciation understatement due
to error—2001 (net of tax)
Dividends declared on
preferred stock
Dividends declared on common
stock
9,130
6,000
62,300
38,000
18,000
133,000
17,700
9,000
32,000
The Retained Earnings account had a balance of $337,000 at June 30, 2004, before closing. There are
80,000 shares of common stock outstanding.
Instructions
(a) Using the multiple-step form, prepare an income statement and a retained earnings statement for
the year ended June 30, 2004.
(b) Using the single-step form, prepare an income statement and a retained earnings statement for
the year ended June 30, 2004.
P4-5 (Irregular Items) Presented below is a combined single-step income and retained earnings statement for Sandy Freewalt Company for 2004.
(000 omitted)
Net sales
$640,000
Costs and expenses
Cost of goods sold
Selling, general, and administrative expenses
Other, net
500,000
66,000
17,000
583,000
Income before income tax
Income tax
Net income
Retained earnings at beginning of period, as previously reported
Adjustment required for correction of error
57,000
19,400
37,600
$141,000
(7,000)
Retained earnings at beginning of period, as restated
Dividends on common stock
134,000
(12,200)
Retained earnings at end of period
$159,400
Additional facts are as follows.
1.
2.
3.
4.
“Selling, general, and administrative expenses” for 2004 included a usual but infrequently occurring charge of $10,500,000.
“Other, net” for 2004 included an extraordinary item (charge) of $9,000,000. If the extraordinary
item (charge) had not occurred, income taxes for 2004 would have been $22,400,000 instead of
$19,400,000.
“Adjustment required for correction of an error” was a result of a change in estimate (useful life
of certain assets reduced to 8 years and a catch-up adjustment made).
Sandy Freewalt Company disclosed earnings per common share for net income in the notes to the
financial statements.
Instructions
Determine from these additional facts whether the presentation of the facts in the Sandy Freewalt Company income and retained earnings statement is appropriate. If the presentation is not appropriate, describe
the appropriate presentation and discuss its theoretical rationale. (Do not prepare a revised statement.)
P4-6 (Retained Earnings Statement, Prior Period Adjustment) Below is the retained earnings account
for the year 2004 for LeClair Corp.
Retained earnings, January 1, 2004
Add:
Gain on sale of investments (net of tax)
Net income
$257,600
$41,200
84,500
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Conceptual Cases
Refund on litigation with government, related to the year 2001
(net of tax)
Recognition of income earned in 2003, but omitted from income
statement in that year (net of tax)
21,600
25,400
172,700
430,300
Deduct:
Loss on discontinued operations (net of tax)
Write-off of goodwill (net of tax)
Cumulative effect on income in changing from straight-line
depreciation to accelerated depreciation in 2004 (net of tax)
Cash dividends declared
25,000
60,000
18,200
32,000
Retained earnings, December 31, 2004
135,200
$295,100
Instructions
(a) Prepare a corrected retained earnings statement. LeClair Corp. normally sells investments of the
type mentioned above.
(b) State where the items that do not appear in the corrected retained earnings statement should be
shown.
P4-7 (Income Statement, Irregular Items) Rap Corp. has 100,000 shares of common stock outstanding. In 2004, the company reports income from continuing operations before taxes of $1,210,000. Additional transactions not considered in the $1,210,000 are as follows.
1.
2.
3.
4.
5.
In 2004, Rap Corp. sold equipment for $40,000. The machine had originally cost $80,000 and had
accumulated depreciation of $36,000. The gain or loss is considered ordinary.
The company discontinued operations of one of its subsidiaries during the current year at a loss
of $190,000 before taxes. Assume that this transaction meets the criteria for discontinued operations. The loss on operations of the discontinued subsidiary was $90,000 before taxes; the loss from
disposal of the subsidiary was $100,000 before taxes.
In 2004, the company reviewed its accounts receivable and determined that $26,000 of accounts
receivable that had been carried for years appeared unlikely to be collected.
An internal audit discovered that amortization of intangible assets was understated by $35,000 (net
of tax) in a prior period. The amount was charged against retained earnings.
The company sold its only investment in common stock during the year at a gain of $145,000. The
gain is taxed at a total effective rate of 40%. Assume that the transaction meets the requirements
of an extraordinary item.
Instructions
Analyze the above information and prepare an income statement for the year 2004, starting with income
from continuing operations before income taxes. Compute earnings per share as it should be shown on
the face of the income statement. (Assume a total effective tax rate of 38% on all items, unless otherwise
indicated.)
CONCEPTUAL CASES
C4-1 (Identification of Income Statement Deficiencies) John Amos Corporation was incorporated and
began business on January 1, 2004. It has been successful and now requires a bank loan for additional
working capital to finance expansion. The bank has requested an audited income statement for the year
2004. The accountant for John Amos Corporation provides you with the following income statement which
John Amos plans to submit to the bank.
JOHN AMOS CORPORATION
INCOME STATEMENT
Sales
Dividends
Gain on recovery of insurance proceeds from
earthquake loss (extraordinary)
$850,000
32,300
38,500
920,800
Less:
Selling expenses
$101,100
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Chapter 4 Income Statement and Related Information
Cost of goods sold
Advertising expense
Loss on obsolescence of inventories
Loss on discontinued operations
Administrative expense
510,000
13,700
34,000
48,600
73,400
Income before income tax
Income tax
780,800
140,000
56,000
Net income
$ 84,000
Instructions
Indicate the deficiencies in the income statement presented above. Assume that the corporation desires a
single-step income statement.
C4-2 (Income Reporting Deficiencies) The following represents a recent income statement for Boeing
Company.
($ in millions)
Sales
Costs and expenses
$21,924
20,773
Income from operations
Other income
Interest and debt expense
1,151
122
(130)
Earnings before income taxes
Income taxes
1,143
(287)
Net income
$
856
It includes only five separate numbers (two of which are in billions of dollars), two subtotals, and the net
earnings figure.
Instructions
(a) Indicate the deficiencies in the income statement.
(b) What recommendations would you make to Boeing to improve the usefulness of its income statement?
C4-3 (All-inclusive vs. Current Operating) Information concerning the operations of a corporation is
presented in an income statement. Some believe that income statements should be prepared on a “current
operating performance” basis (earning power concept), whereas others prefer an “all-inclusive” basis (historical concept). Proponents of the two types of income statements do not agree upon the proper treatment of material nonrecurring charges and credits.
Instructions
(a) Define “current operating performance” and “all-inclusive” as used above.
(b) Explain the differences in content and organization of a “current operating performance” income
statement and an “all-inclusive” income statement. Include a discussion of the proper treatment
of material nonrecurring charges and credits.
(c) Give the principal arguments for the use of the “all-inclusive” income statement and the “current
operating performance” income statement.
(AICPA adapted)
C4-4 (Extraordinary Items) Jeff Foxworthy, vice-president of finance for Red Neck Company, has
recently been asked to discuss with the company’s division controllers the proper accounting for
extraordinary items. Jeff Foxworthy prepared the factual situations presented below as a basis for
discussion.
1.
2.
3.
4.
5.
An earthquake destroys one of the oil refineries owned by a large multinational oil company. Earthquakes are rare in this geographical location.
A publicly held company has incurred a substantial loss in the unsuccessful registration of a bond
issue.
A large portion of a cigarette manufacturer’s tobacco crops are destroyed by a hailstorm. Severe
damage from hailstorms is rare in this locality.
A large diversified company sells a block of shares from its portfolio of securities acquired for
investment purposes.
A company sells a block of common stock of a publicly traded company. The block of shares, which
represents less than 10% of the publicly held company, is the only security investment the company has ever owned.
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Conceptual Cases
A company that operates a chain of warehouses sells the excess land surrounding one of its warehouses. When the company buys property to establish a new warehouse, it usually buys more land
than it expects to use for the warehouse with the expectation that the land will appreciate in value.
Twice during the past 5 years the company sold excess land.
7. A company experiences a material loss in the repurchase of a large bond issue that has been outstanding for 3 years. The company regularly repurchases bonds of this nature.
8. A railroad experiences an unusual flood loss to part of its track system. Flood losses normally occur
every 3 or 4 years.
9. A machine tool company sells the only land it owns. The land was acquired 10 years ago for future
expansion, but shortly thereafter the company abandoned all plans for expansion but decided to
hold the land for appreciation.
6.
Instructions
Determine whether the foregoing items should be classified as extraordinary items. Present a rationale
for your position.
C4-5 (Earnings Management) Grace Inc. has recently reported steadily increasing income. The company reported income of $20,000 in 2001, $25,000 in 2002, and $30,000 in 2003. A number of market analysts have recommended that investors buy the stock because they expect the steady growth in income
to continue. Grace is approaching the end of its fiscal year in 2004, and it again appears to be a good year.
However, it has not yet recorded warranty expense.
Based on prior experience, this year’s warranty expense should be around $5,000, but some managers
have approached the controller to suggest a larger, more conservative warranty expense should be
recorded this year. Income before warranty expense is $43,000. Specifically, by recording an $8,000 warranty accrual this year, Grace could report an increase in income for this year and still be in a position to
cover its warranty costs in future years.
Instructions
(a) What is earnings management?
(b) What is the effect of the proposed accounting in 2004? In 2005? Assume income before warranty
expense is $43,000 and that total warranty expense over the 2-year period is $10,000.
(c) What is the appropriate accounting in this situation?
C4-6 (Earnings Management) Arthur Miller, controller for the Salem Corporation, is preparing the
company’s income statement at year-end. He notes that the company lost a considerable sum on the sale
of some equipment it had decided to replace. Since the company has sold equipment routinely in the past,
Miller knows the losses cannot be reported as extraordinary. He also does not want to highlight it as a
material loss since he feels that will reflect poorly on him and the company. He reasons that if the company had recorded more depreciation during the assets’ lives, the losses would not be so great. Since
depreciation is included among the company’s operating expenses, he wants to report the losses along
with the company’s expenses, where he hopes it will not be noticed.
Instructions
(a) What are the ethical issues involved?
(b) What should Miller do?
C4-7 (Income Reporting Items) Woody Allen Corp. is an entertainment firm that derives approximately 30% of its income from the Casino Royale Division, which manages gambling facilities. As auditor for Woody Allen Corp., you have recently overheard the following discussion between the controller
and financial vice-president.
VICE-PRESIDENT: If we sell the Casino Royale Division, it seems ridiculous to segregate the results
of the sale in the income statement. Separate categories tend to be absurd and
confusing to the stockholders. I believe that we should simply report the gain on
the sale as other income or expense without detail.
CONTROLLER:
Professional pronouncements would require that we disclose this information
separately in the income statement. If a sale of this type is considered unusual and
infrequent, it must be reported as an extraordinary item.
VICE-PRESIDENT: What about the walkout we had last month when employees were upset about
their commission income? Would this situation not also be an extraordinary item?
CONTROLLER:
I am not sure whether this item would be reported as extraordinary or not.
VICE-PRESIDENT: Oh well, it doesn’t make any difference because the net effect of all these items is
immaterial, so no disclosure is necessary.
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Instructions
(a) On the basis of the foregoing discussion, answer the following questions: Who is correct about
handling the sale? What would be the income statement presentation for the sale of the Casino
Royale Division?
(b) How should the walkout by the employees be reported?
(c) What do you think about the vice-president’s observation on materiality?
(d) What are the earnings per share implications of these topics?
C4-8 (Identification of Income Statement Weaknesses) The following financial statement was
prepared by employees of Cynthia Taylor Corporation.
CYNTHIA TAYLOR CORPORATION
INCOME STATEMENT
YEAR ENDED DECEMBER 31, 2004
Revenues
Gross sales, including sales taxes
Less: Returns, allowances, and cash discounts
Net sales
Dividends, interest, and purchase discounts
Recoveries of accounts written off in prior years
Total revenues
Costs and expenses
Cost of goods sold, including sales taxes
Salaries and related payroll expenses
Rent
Freight-in and freight-out
Bad debt expense
$1,044,300
56,200
988,100
30,250
13,850
1,032,200
465,900
60,500
19,100
3,400
27,800
Total costs and expenses
576,700
Income before extraordinary items
455,500
Extraordinary items
Loss on discontinued styles (Note 1)
Loss on sale of marketable securities (Note 2)
Loss on sale of warehouse (Note 3)
Total extraordinary items
Net income
Net income per share of common stock
71,500
39,050
86,350
196,900
$ 258,600
$2.30
Note 1: New styles and rapidly changing consumer preferences resulted in a $71,500 loss on the disposal of
discontinued styles and related accessories.
Note 2: The corporation sold an investment in marketable securities at a loss of $39,050. The corporation normally
sells securities of this nature.
Note 3: The corporation sold one of its warehouses at an $86,350 loss.
Instructions
Identify and discuss the weaknesses in classification and disclosure in the single-step income statement
above. You should explain why these treatments are weaknesses and what the proper presentation of the
items would be in accordance with recent professional pronouncements.
C4-9 (Classification of Income Statement Items) As audit partner for Noriyuki and Morita, you
are in charge of reviewing the classification of unusual items that have occurred during the current year.
The following material items have come to your attention.
A merchandising company incorrectly overstated its ending inventory 2 years ago. Inventory for
all other periods is correctly computed.
2. An automobile dealer sells for $137,000 an extremely rare 1930 S type Invicta which it purchased
for $21,000 10 years ago. The Invicta is the only such display item the dealer owns.
3. A drilling company during the current year extended the estimated useful life of certain drilling
equipment from 9 to 15 years. As a result, depreciation for the current year was materially lowered.
4. A retail outlet changed its computation for bad debt expense from 1% to 1⁄2 of 1% of sales because
of changes in its customer clientele.
1.
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Using Your Judgment
5.
6.
7.
8.
9.
10.
11.
A mining concern sells a foreign subsidiary engaged in uranium mining, although it (the seller)
continues to engage in uranium mining in other countries.
A steel company changes from straight-line depreciation to accelerated depreciation in accounting for its plant assets.
A construction company, at great expense, prepared a major proposal for a government loan. The
loan is not approved.
A water pump manufacturer has had large losses resulting from a strike by its employees early
in the year.
Depreciation for a prior period was incorrectly understated by $950,000. The error was discovered in the current year.
A large sheep rancher suffered a major loss because the state required that all sheep in the state
be killed to halt the spread of a rare disease. Such a situation has not occurred in the state for
20 years.
A food distributor that sells wholesale to supermarket chains and to fast-food restaurants (two
distinguishable classes of customers) decides to discontinue the division that sells to one of the
two classes of customers.
Instructions
From the foregoing information, indicate in what section of the income statement or retained earnings
statement these items should be classified. Provide a brief rationale for your position.
C4-10 (Comprehensive Income) Ferguson Arthur, Jr., controller for Jenkins Corporation, is preparing
the company’s financial statements at year-end. Currently, he is focusing on the income statement and
determining the format for reporting comprehensive income. During the year, the company earned net
income of $400,000 and had unrealized gains on available-for-sale securities of $20,000. In the previous
year net income was $410,000, and the company had no unrealized gains or losses.
Instructions
(a) Show how income and comprehensive income will be reported on a comparative basis for the
current and prior years, using the separate income statement format.
(b) Show how income and comprehensive income will be reported on a comparative basis for the
current and prior years, using the combined income statement format.
(c) Which format should Arthur recommend?
USING YOUR JUDGMENT
FINANCIAL REPORTING PROBLEM
3M Company
The financial statements of 3M are presented in Appendix 5B or can be accessed on the Take Action! CD.
Instructions
Refer to 3M’s financial statements and the accompanying notes to answer the following questions.
(a) What type of income statement format does 3M use? Indicate why this format might be used to present income statement information.
(b) What are 3M’s primary revenue sources?
(c) Compute 3M’s gross profit for each of the years 1999–2001. Explain why gross profit declined in
2001.
(d) Why does 3M make a distinction between operating and nonoperating revenue?
(e) What financial ratios did 3M choose to report in its “Financial Summary” section covering the years
1991–2001?
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Chapter 4 Income Statement and Related Information
FINANCIAL STATEMENT ANALYSIS CASES
Case 1: Bankruptcy Prediction
The Z-score bankruptcy prediction model uses balance sheet and income information to arrive at a
Z-Score, which can be used to predict financial distress:
Sales
Working capital
Retained earnings
EBIT
Z 1.2 1.4 3.3 .99
Total assets
Total assets
Total assets
Total assets
MV equity
0.6
Total liabilities
EBIT is earnings before interest and taxes. MV Equity is the market value of common equity, which can
be determined by multiplying stock price by shares outstanding.
Following extensive testing, it has been shown that companies with Z-scores above 3.0 are unlikely to
fail; those with Z-scores below 1.81 are very likely to fail. While the original model was developed for
publicly held manufacturing companies, the model has been modified to apply to companies in various
industries, emerging companies, and companies not traded in public markets.
Instructions
(a) Use information in the financial statements of a company like PepsiCo or Coca-Cola to compute the
Z-score for the past 2 years.
(b) Interpret your result. Where does the company fall in the financial distress range?
(c) The Z-score uses EBIT as one of its elements. Why do you think this income measure is used?
Case 2: Dresser Industries
Dresser Industries provides products and services to oil and natural gas exploration, production, transmission and processing companies. A recent income statement is reproduced below. Dollar amounts are
in millions.
Sales
Service revenues
Share of earnings of unconsolidated affiliates
$2,697.0
1,933.9
92.4
Total revenues
4,723.3
Cost of sales
Cost of services
1,722.7
1,799.9
Total costs of sales and services
Gross earnings
Selling, engineering, administrative and general expenses
Special charges
Other income (deductions)
Interest expense
Interest earned
Other, net
3,522.6
1,200.7
(919.8)
(70.0)
(47.4)
19.1
4.8
Earnings before income taxes and other items below
Income taxes
Minority interest
187.4
(79.4)
(10.3)
Earnings from continuing operations
Discontinued operations
97.7
(35.3)
Earnings before extraordinary items and accounting changes
Extraordinary items
Cumulative effect of accounting changes
Net earnings (loss)
62.4
(6.3)
(393.8)
$(337.7)
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Instructions
Assume that 177,636,000 shares of stock were issued and outstanding. Prepare the per-share portion of
the income statement. Remember to begin with “Income from continuing operations.”
COMPARATIVE ANALYSIS CASE
The Coca-Cola Company and PepsiCo, Inc.
Instructions
Go to the Take Action! CD and use information found there to answer the following questions related to
The Coca-Cola Company and PepsiCo, Inc.
(a) What type of income format(s) is used by these two companies? Identify any differences in income
statement format between these two companies.
(b) What are the gross profits, operating profit, and net income for these two companies over the 3-year
period 1999–2001? Which company has had better financial results over this period of time?
(c) Identify the irregular items reported by these two companies in their income statements over the
3-year period 1999–2001. Do these irregular items appear to be significant?
(d) Refer to PepsiCo’s Management Analysis section under “Items Affecting Comparability:” Briefly
discuss how these items affect the comparability and consistency of PepsiCo’s income over 1999–2001.
RESEARCH CASES
Case 1
Most libraries maintain the annual reports of large companies on file or on microfiche.
Instructions
Obtain the 2001 annual reports for UAL Corp. and The Boeing Company, and answer the following questions concerning their income statements. (Note: Larger libraries may have CD-ROM products such as
Laser Disclosure or Compact Disclosure. UAL and Boeing are also on the Take Action! CD or can be found
online in the SEC EDGAR database.)
(a) Describe the major differences between the income statement formats.
(b) Identify any irregular items on either of the income statements.
(c) UAL includes a separate line for depreciation expense, while Boeing does not. Why is this the case?
Does Boeing’s depreciation expense appear on another financial statement?
(d) UAL’s income statement includes significantly more detail than Boeing’s. Which presentation do you
prefer? Why?
Case 2
The April 1996 issue of the Journal of Accountancy includes an article by Dennis R. Beresford, L. Todd Johnson, and Cheri L. Reither, entitled “Is a Second Income Statement Needed?”
Instructions
Read the article and answer the following questions.
(a) On what basis would the “second income statement” be prepared? Briefly describe this basis.
(b) Why is there a perceived need for a second income statement?
(c) Identify three alternatives for reporting the proposed measure of income.
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Chapter 4 Income Statement and Related Information
INTERNATIONAL REPORTING CASE
Presented below is the income statement for a British company, Avon Rubber PLC.
Avon Rubber PLC
Consolidated Profit and Loss Account
for the year ended 30 September 2000
2000
Turnover
Cost of sales
Gross profit
Net operating expenses
(including £623,000
goodwill amortisation)
Share of profits/(losses) of joint
ventures and associates
Before
exceptional
items
£’000
Exceptional
items
(note 5)
£’000
Total
£’000
277,997
(231,842)
—
(1,984)
277,997
(233,826)
46,155
(1,984)
44,171
(30,891)
(4,688)
(35,579)
161
—
161
Operating profit
Profit on disposal of fixed assets
15,425
—
(6,672)
25
8,753
25
Profit on ordinary activities
before interest
Interest receivable
Interest payable
15,425
2,871
(5,911)
(6,647)
—
—
8,778
2,871
(5,911)
Profit on ordinary activities
before taxation
Taxation
12,385
(4,360)
(6,647)
1,400
5,738
(2,960)
Profit on ordinary activities
after taxation
Minority interests
8,025
717
(5,247)
—
2,778
717
8,742
(6,735)
(5,247)
—
3,495
(6,735)
2,007
(5,247)
(3,240)
Profit for the year
Dividends
(Loss)/retained profit for the year
Basic earnings per ordinary share
12.4p
Instructions
(a) Review the Avon Rubber income statement and identify at least three differences between the British
income statement and an income statement of a U.S. company as presented in the chapter.
(b) Identify any irregular items reported by Avon Rubber. Is the reporting of these irregular items in
Avon’s income statement similar to reporting of these items in U.S. companies’ income statements?
Explain.
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PROFESSIONAL SIMULATION
Accounting — Income Statement
Directions
Situation
Explanation
Measurement
Research
Resources
Directions
In this simulation, you will be asked to compute various income amounts. Assume a tax rate of 30%
and 100,000 shares of common stock outstanding during the year. Prepare responses to all parts.
Situation
Ritter Corporation provides you with the following pre-tax information for the period.
Sales
Cost of goods sold
Interest revenue
Loss from abandonment of plant assets
Selling expenses
Administrative expenses
Effect of change from declining-balance
to straight-line depreciation
Loss from earthquake (unusual and infrequent)
Gain on disposal of a component of
Ritter’s business
$3,200,000
1,650,000
10,000
40,000
340,000
280,000
50,000
40,000
90,000
Explanation
Explain the proper accounting treatment for loss on abandonment of plant assets and gain on disposal
of a component of a business.
Measurement
Compute the following five items.
(a) Gross profit.
(b) Income from operations.
(c) Income from continuing operations before income taxes.
(d) Net income.
(e) Earnings per share.
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Remember to check the Take Action! CD
and the book’s companion Web site
to find additional resources for this chapter.
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