ACCY 111 Ch 4
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The income statement is a change statement that reports transactions — revenues, expenses,gains and losses — that cause owners’ equity to change during a specified reporting period.
includes net income as well as a few gains and losses that are not part of net income and are considered other comprehensive income items instead. A few types of gains and losses are excluded from the determination of net income and the income statement but are included in the broader concept of comprehensive income. other comprehensive income (OCI) or loss. Comprehensive income can be reported in one of two ways: (1) in a single, continuous statement of comprehensive income or (2) in two separate but consecutive statements—an income statement and a statement of comprehensive income that begins with net income and then reports OCI items to combine for comprehensive income.
statement of cash flows
is to provide information about the cash receipts and cash disbursements of an enterprise that occurred during the period.
allocating resources within our economy
Ideally, resources should be allocated to private enterprises that will (1) provide the goods and services our society desires and (2) at the same time provide a fair rate of return to those who supply the resources
Income statement, Balance sheet, Statement of Cash Flows
Unlike the balance sheet, which is a position statement, the income statement and the statement of cash flows are change statements.
probably will continue into the future that are the best predictors of future cash flows. The components of income from continuing operations are revenues, expenses (including income taxes), gains, and losses, excluding those related to discontinued operations and extraordinary items
If a causal relationship cannot be established
we relate the expense to a particular period, allocate it over several periods, or expense it as incurred
Income Tax Expense
Income taxes are levied on taxpayers in proportion to the amount of taxable income that is reported to taxing authorities. Income tax expense is shown as a separate expense in the income statement.Taxable income comprises revenues, expenses, gains, and losses as measured according to the regulations of the appropriate taxing authority. When tax rules and GAAP differ regarding the timing of revenue or expense recognition, the actual payment of taxes may occur in a period different from when income tax expense is reported in the income statement. EXdeducting more depreciation in the early years of an asset's life on its federal income tax return than it reports in its income statement
Operating income includes revenues and expenses directly related to the primary revenue-generating activities of the company EX operating income for a manufacturing company includes sales revenues from selling the products it manufactures as well as all expenses related to this activity. operating income might also include gains and losses from selling equipment and other assets used in the manufacturing process
Nonoperating income relates to peripheral or incidental activities of the company. ex a manufacturer would include interest and dividend revenue, gains and losses from selling investments, and interest expense in nonoperating income.
Income Statement Formats
two general approaches, the single-step and the multiple-step formats
The single-step format - income statement
- A single-step income statement format groups all revenues and gains together and all expenses and losses together.
- An advantage of the single-step format is its simplicity. Revenues and expenses are not classified or prioritized.
multiple-step format - Incomce Statement
- multiple-step income statement format includes a number of intermediate subtotals before arriving at income from continuing operations.
- A primary advantage of the multiple-step format is that, by separately classifying operating and nonoperating items, it provides information that might be useful in analyzing trends
- Sales rev xxx
- COGS xxx
- Gross Profit xxx
- Operating Expenses xxx
- Operating Income
- Other INcome expense
- Net income
International Financial Reporting Standards - Income Statement Presentation.
There are more similarities than differences between income statements prepared according to U.S. GAAP and those prepared applying international standards
- International standards require certain minimum information to be reported on the face of the income statement. U.S. GAAP has no minimum requirements.
- International standards allow expenses to be classified either by function (e.g., cost of goods sold, general and administrative, etc.), or by natural description (e.g., salaries, rent, etc.).
- SEC regulations require that expenses be classified by function.
- In the United States, the “bottom line” of the income statement usually is called either net income or net loss.
- The descriptive term for the bottom line of the income statement prepared according to international standards is either profit or loss.
- As we discuss later in the chapter, we report “extraordinary items” separately in an income statement prepared according to U.S. GAAP.
- International standards prohibit reporting “extraordinary items.”
The term earnings quality refers to the ability of reported earnings (income) to predict a company's future earnings. The relevance of any historical-based financial statement hinges on its predictive value
To enhance predictive value, analysts try to separate a company's transitory earnings effects from its permanent earnings. Transitory earnings effects result from transactions or events that are not likely to occur again in the foreseeable future or that are likely to have a different impact on earnings in the future.
Manipulating Income and Income Smoothing
Many believe that corporate earnings management practices reduce the quality of reported earnings. As a result, some companies ‘bank’ earnings by understating them in particularly good years and use the banked profits to polish results in bad years.”6
As a result, some companies ‘bank’ earnings by understating them in particularly good years and use the banked profits to polish results in bad years.”6
- (1) income shifting: accelerating or delaying the recognition of revenues or expenses. “channel stuffing” accelerates revenue recognition by persuading distributors to purchase more of your product than necessary near the end of a reporting period.
- (2) income statement classification: inclusion of recurring operating expenses in “special charge” categories such as restructuring costs. “big bath” accounting. restructuring costs result in large reductions in income that might otherwise appear as normal operating expenses either in the current or future years.
Should all items of revenue and expense included in operating income be considered indicative of a company's permanent earnings?
No, not necessarily. Sometimes, for example, operating expenses include some unusual items that may or may not continue in the future.
It's not unusual for a company to reorganize its operations to attain greater efficiency. When this happens, the company often incurs significant associated restructuring costs. Facility closings and related employee layoffs translate into costs incurred for severance pay and relocation costs.
Disclosure of Restructuring Costs
A disclosure note accompanying the company's financial statements indicates workforce reductions as well as manufacturing transfer costs resulting from plant closures and consolidation of operations.
Recognition of exit or disposal cost obligation
Restructuring costs are recognized in the period the exit or disposal cost obligation actually is incurred. In that case, a liability for termination benefits, and corresponding expense, should be accrued in the period(s) the employees render their service. Fair value is the objective for the initial measurement of a liability associated with restructuring costs. GAAP requires that restructuring costs be recognized only in the period incurred
Should investors attempting to forecast future earnings consider restructuring costs to be part of a company's permanent earnings stream, or are they transitory in nature?
an analyst must interpret restructuring charges in light of a company's past history. In general, the more frequently these sorts of unusual charges occur, the more appropriate it is that analysts include them in the company's permanent earnings stream. Information in disclosure notes describing the restructuring and management plans related to the business involved also can be helpful
impairment of goodwill and impairment of long-lived assets
Any long-lived asset, whether tangible or intangible, should have its balance reduced if there has been a significant impairment of value.
Nonoperating Income and Earnings Quality
and gains or losses are only tangentially related to normal operations. These we refer to as nonoperating items. gains and losses generated from the sale of investments
pro forma earnings
actual (GAAP) earnings reduced by any expenses the reporting company feels are unusual and should be excluded. Many companies voluntarily provide pro forma earnings —management's assessment of permanent earnings. The Sarbanes-Oxley Act requires reconciliation between pro forma earnings and earnings determined according to GAAP.
two types of events that, if they have a material effect13 on the income statement, require separate reporting below income from continuing operations as well as separate disclosure:
(1) discontinued operations, and (2) extraordinary items.
intraperiod income tax allocation.
The process of associating income tax effects with the income statement components that create them. Intraperiod tax allocation is not an issue of measurement but an issue of presentation. Net income comes out the same.
intraperiod income tax allocation.
Each of the items following continuing operations (discontinued operations and extraordinary items) are presented net of their tax effect. No individual items included in the computation of income from continuing operations are reported net of tax.
WHAT CONSTITUTES AN OPERATION?
FASB issued a standard that defined an operation as a component of an entity whose operations and cash flows can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. International standards are the same as FASB but not the IFRS.
The proposed ASU defines a discontinued operation
- as a “component” that either (a) has been disposed of or (b) is classified as held for sale, and represents one of the following:.
- 1.a separate major line of business or major geographical area of operations,
- 2. part of a single coordinated plan to dispose of a separate major line of business or geographical area of operations, or
- 3. a business that meets the criteria to be classified as held for sale on acquisition.20
REPORTING DISCONTINUED OPERATIONS
- By definition, the income or loss stream from a discontinued operation no longer will continue.For this reason, the revenues, expenses, gains, losses, and income tax related to a discontinued operation must be removed from continuing operations and reported separately for all years presented
- ***The net-of-tax income effects of a discontinued operation are reported separately in the income statement, below income from continuing operations.
When the component has been sold - discontinued operations
- When the discontinued component is sold before the end of the reporting period, the reported income effects of a discontinued operation will include two elements:
- 1. Income or loss from operations (revenues, expenses, gains, and losses) of the component from the beginning of the reporting period to the disposal date.
- 2. Gain or loss on disposal of the component's assets.
When the component is considered held for sale- discontinued operations
- In that case, the income effects of the discontinued operation still are reported, but the two components of the reported amount are modified as follows:
- 1. Income or loss from operations (revenues, expenses, gains and losses) of the component from the beginning of the reporting period to the end of the reporting period.
- 2. An “impairment loss” if the carrying value (book value) of the assets of the component is more than fair value minus cost to sell.
Extraordinary items are material gains and losses that are both unusual in nature and infrequent in occurrence. The determination of whether an item is unusual and infrequent should consider the environment in which the company operates.
Extraordinary Loss Disclosure
Extraordinary gains and losses are presented, net of tax, in the income statement below discontinued operations.
IFRS Extraordinary Items.
.S. GAAP provides for the separate reporting, as an extraordinary item, of a material gain or loss that is unusual in nature and infrequent in occurrence. In 2003, the IASB revised IAS No. 1.26 The revision states that neither the income statement nor any notes may contain any items called “extraordinary.”
Very few extraordinary gains and losses are reported in corporate income statements.The extraordinary item classification could soon be eliminated.
Unusual or Infrequent Items
If the income effect of an event is material and the event is either unusual or infrequent—but not both—the item should be included in continuing operations but reported as a separate income statement component. This method of reporting, including note disclosure, enhances earnings quality by providing information to the statement user to help assess the events' relationship with future profitability.
Accounting changes fall into one of three categories: (1) a change in an accounting principle, (2) a change in estimate, or (3) a change in reporting entity. The correction of an error is another adjustment that is accounted for in the same way as certain accounting changes.
Change in Accounting Principle
A change in accounting principle refers to a change from one acceptable accounting method to another. There are many situations that allow alternative treatments for similar transactions. Common examples of these situations include the choice among FIFO, LIFO, and average cost for the measurement of inventory and among alternative revenue recognition methods. New accounting standard updates issued by the FASB also may require companies to change their accounting methods.VOLUNTARY CHANGES IN ACCOUNTING PRINCIPLES.
VOLUNTARY CHANGES IN ACCOUNTING PRINCIPLES
Occasionally, a company will change from one generally accepted treatment to another. Voluntary changes in accounting principles are accounted for retrospectively by revising prior years' financial statements.
MANDATED CHANGES IN ACCOUNTING PRINCIPLES
Therefore, when a mandated change in accounting principle occurs, it is important to check the accounting standards update to determine how companies might account for the change.
Change in Depreciation, Amortization, or Depletion Method
is considered to be a change in accounting estimate that is achieved by a change in accounting principle. We account for this change prospectively, almost exactly as we would any other change in estimate. One difference is that most changes in estimate don't require a company to justify the change. However, this change in estimate is a result of changing an accounting principle and therefore requires a clear justification as to why the new method is preferable
Change in Accounting Estimate
Because estimates require the prediction of future events, it's not unusual for them to turn out to be wrong. When an estimate is modified as new information comes to light, accounting for the change in estimate is quite straightforward. We do not revise prior years' financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate in any related accounting determinations from that point on, that is, we account for a change in accounting estimate prospectively.32 If the effect of the change is material, a disclosure note is needed to describe the change and its effect on both net income and earnings per share.
Correction of Accounting Errors
If an error is discovered in a year subsequent to the year the error is made, the accounting treatment depends on whether or not the error is material with respect to its effect on the financial statements. In practice, the vast majority of errors are not material and are, therefore, simply corrected in the year discovered. However, material errors that are discovered in subsequent periods require a prior period adjustment.
Prior Period Adjustments
In addition to reporting the prior period adjustment to retained earnings, previous years' financial statements that are incorrect as a result of the error are retrospectively restated to reflect the correction. Also, a disclosure note communicates the impact of the error on prior periods' net income.
Earnings per Share Disclosures
All corporations whose common stock is publicly traded must disclose EPS. Diluted EPS reflects the potential dilution that could occur for companies that have certain securities outstanding that are convertible into common shares or stock options that could create additional common shares if the options were exercised.
Income from continuing operations
Income from continuing operations includes the revenue, expense, gain, and loss transactions that will probably continue in future periods. It is important to segregate the income effects of these items because they are the most important transactions in terms of predicting future cash flows.
THE STATEMENT OF CASH FLOWS (SCF)
The purpose of the SCF is to provide information about the cash receipts and cash disbursements of an enterprise that occurred during a period. Similar to the income statement, it is a change statement, summarizing the transactions that caused cash to change during a reporting period. The term cash refers to cash plus cash equivalents. Cash equivalents, include highly liquid (easily converted to cash) investments such as Treasury bills.
Usefulness of the Statement of Cash Flows
It was pointed out and illustrated that over short periods of time, operating cash flows may not be indicative of the company's long-run cash-generating ability, and that accrual-based net income provides a more accurate prediction of future operating cash flows. Nevertheless, information about cash flows from operating activities, when combined with information about cash flows from other activities, can provide information helpful in assessing future profitability, liquidity, and long-term solvency. After all, a company must pay its debts with cash, not with income. Of particular importance is the amount of cash generated from operating activities. In the long run, a company must be able to generate positive cash flow from activities related to selling its product or service. These activities must provide the necessary cash to pay debts, provide dividends to shareholders, and provide for future growth.
Classifying Cash Flows
A list of cash flows is more meaningful to investors and creditors if they can determine the type of transaction that gave rise to each cash flow. Toward this end, the statement of cash flows classifies all transactions affecting cash into one of three categories: (1) operating activities, (2) investing activities, and (3) financing activities.
- The inflows and outflows of cash that result from activities reported in the income statement are classified as cash flows from operating activities. In other words, this classification of cash flows includes the elements of net income reported on a cash basis rather than an accrual basis. Operating activities are inflows and outflows of cash related to the transactions entering into the determination of net operating income.
- Cash inflows include cash received from:
- 1. Customers from the sale of goods or services.
- 2. Interest and dividends from investments.
- These amounts may differ from sales and investment income reported in the income statement. EX, sales revenue measured on the accrual basis reflects revenue earned during the period, not necessarily the cash actually collected. Revenue will not equal cash collected from customers if receivables from customers or unearned revenue changed during the period.
- Cash outflows include cash paid for:
- 1. The purchase of inventory.Salaries, wages, and other operating expenses.
- 2. Interest on debt.
- 3. Income taxes.
- Likewise, these amounts may differ from the corresponding accrual expenses reported in the income statement. Expenses are reported when incurred, not necessarily when cash is actually paid for those expenses. Also, some revenues and expenses, like depreciation expense, don't affect cash at all and aren't included as cash outflows from operating activities.
The difference between the inflows and outflows is called net cash flows
from operating activities. This is equivalent to net income if the income statement had been prepared on a cash basis rather than an accrual basis.
Cash flow from interest and dividends for US GAAP
- Operating activities: dividends received, interest received, interest paid
- Investing activities: 0
- Financing activities: Dividends paid
Cash flow from interest and dividends for IFRS
- Operating activities: 0
- Investing activities: Dividends received, Interest recieved
- Financing activities: Dividends paid, Interest paid
DIRECT AND INDIRECT METHODS OF REPORTING
Two generally accepted formats can be used
to report operating activities
, the direct method
and the indirect method
, the cash effect of each operating activity is reported directly in the statement. EX, cash received from customers is reported as the cash effect of sales activities. Income statement transactions that have no cash flow effect, such as depreciation, are simply not reported
.By the direct method , the cash effect of each operating activity is reported directly in the SCF.
, on the other hand, we arrive at net cash flow from operating activities indirectly by starting with reported net income and working backwards to convert that amount to a cash basis
. Two types of adjustments to net income are needed. First, components of net income that do not affect cash are reversed. That means that noncash revenues and gains are subtracted, while noncash expenses and losses are added. For example, depreciation expense does not reduce cash, but it is subtracted in the income statement. To reverse this, then, we add back depreciation expense to net income to arrive at the amount that we would have had if depreciation had not been subtracted
- By the indirect method ,
- cash flow from operating activities is derived indirectly by starting with reported net income and adding or subtracting items to convert that amount to a cash basis.
- Second, we make adjustments for changes in operating assets and liabilities during the period that indicate that amounts included as components of net income are not the same as cash flows for those components.
- For instance, suppose accounts receivable increases during the period because cash collected from customers is less than sales revenue. This increase in accounts receivable would then be subtracted from net income to arrive at cash flow from operating activities.
- In the indirect method, positive adjustments to net income are made for decreases in related assets and increases in related liabilities, while negative adjustments are made for increases in those assets and decreases in those liabilities.
- Here, we start with account balances, so the direct method requires a bit more reasoning. From the income statement, we see that ALC's net income has four components. Three of those—service revenue, general and administrative expenses, and income tax expense—affect cash flows, but not by the accrual amounts reported in the income statement. One component—depreciation—reduces net income but not cash; it's simply an allocation over time of a prior year's expenditure for a depreciable asset. So, to report these operating activities on a cash basis, rather than an accrual basis, we take the three items that affect cash and adjust the amounts to reflect cash inflow rather than revenue earned and cash outflows rather than expenses incurred. Let's start with service revenue.Service revenue is $90,000, but ALC did not collect that much cash from its customers. We know that because accounts receivable increased from $0 to $12,000, ALC must have collected to date only $78,000 of the amount earned.
- Similarly, general and administrative expenses of $32,000 were incurred, but $7,000 of that hasn't yet been paid. We know that because accounts payable increased by $7,000. Also, prepaid insurance increased by $4,000 so ALC must have paid $4,000 more cash for insurance coverage than the amount that expired and was reported as insurance expense. That means cash paid thus far for general and administrative expenses was only $29,000 ($32,000 less the $7,000 increase in accounts payable plus the $4,000 increase in prepaid insurance). The other expense, income tax, was $15,000, but that's the amount by which income taxes payable increased so no cash has yet been paid for income taxes.
- To report operating cash flows using the indirect method, we take a different approach. We start with ALC's net income but realize that the $35,000 includes both cash and noncash components. We need to adjust net income, then, to eliminate the noncash effects so that we're left with only the cash flows. We start by eliminating the only noncash component of net income in our illustration—depreciation expense. Depreciation of $8,000 was subtracted in the income statement, so we simply add it back in to eliminate it. Depreciation expense does not reduce cash, but is subtracted in the income statement. So, we add back depreciation expense to net income to eliminate it.We make adjustments for changes in assets and liabilities that indicate that components of net income are not the same as cash flows.
- That leaves us with the three components that do affect cash but not by the amounts reported.
- For those, we need to make adjustments to net income to cause it to reflect cash flows rather than accrual amounts. For instance, we saw earlier that only $78,000 cash was received from customers even though $90,000 in revenue is reflected in net income. That means we need to include an adjustment to reduce net income by $12,000, the increase in accounts receivable. In a similar manner, we include adjustments for the changes in accounts payable, income taxes payable, and prepaid insurance to cause net income to reflect cash payments rather than expenses incurred. For accounts payable and taxes payable, because more was subtracted in the income statement than cash paid for the expenses related to these two liabilities, we need to add back the differences. Note that if these liabilities had decreased, we would have subtracted, rather than added, the changes. For prepaid insurance, because less was subtracted in the income statement than cash paid, we need to subtract the difference—the increase in prepaid insurance. If this asset had decreased, we would have added, rather than subtracted, the change.
Both the direct and the indirect methods produce the same net cash flows from operating activities ($49 thousand in our illustration); they are merely alternative approaches to reporting the cash flows. The FASB, in promulgating GAAP for the statement of cash flows, stated its preference for the direct method
. However, while both methods are used in practice, the direct method is infrequently used.The choice of presentation method for cash flow from operating activities has no effect on how investing activities and financing activities are reported. We now look at how cash flows are classified into those two categories.
- Cash flows from investing activities include inflows and outflows of cash related to the acquisition and disposition of long-lived assets used in the operations of the business (such as property, plant, and equipment) and investment assets (except those classified as cash equivalents and trading securities).
- The purchase and sale of inventories are not considered investing activities. Inventories are purchased for the purpose of being sold as part of the company's operations, so their purchase and sale are included with operating activities rather than investing activities.
- Investing activities involve the acquisition and sale of
- (1) long-term assets used in the business and
- (2) nonoperating investment assets.
- Cash outflows from investing activities include cash paid for:
- The purchase of long-lived assets used in the business.
- The purchase of investment securities like stocks and bonds of other entities (other than those classified as cash equivalents and trading securities).
- Loans to other entities.
- Later, when the assets are disposed of, cash inflow from the sale of the assets (or collection of loans and notes) also is reported as cash flows from investing activities.
- As a result, cash inflows from these transactions are considered investing activities:
- The sale of long-lived assets used in the business.
- The sale of investment securities (other than cash equivalents and trading securities).
- The collection of a nontrade receivable (excluding the collection of interest, which is an operating activity).
- Net cash flows from investing activities represents the difference between the inflows and outflows.
- The only investing activity indicated in Illustration 4-17 is ALC's investment of $40,000 cash for equipment
Financing activities relate to the external financing of the company.
- Cash inflows occur when cash is borrowed from creditors or invested by owners.
- Cash outflows occur when cash is paid back to creditors or distributed to owners.
- The payment of interest to a creditor, however, is classified as an operating activity.
- Financing activities involve cash inflows and outflows from transactions with creditors and owners.
- Cash inflows include cash received from:Owners when shares are sold to them.Creditors when cash is borrowed through notes, loans, mortgages, and bonds.
- Cash outflows include cash paid to:Owners in the form of dividends or other distributions.Owners for the reacquisition of shares previously sold.Creditors as repayment of the principal amounts of debt (excluding trade payables that relate to operating activities).
- Net cash flows from financing activities is the difference between the inflows and outflows.
- The only financing activities indicated in Illustration 4-17 are ALC's receipt of $50,000 cash from issuing common stock and the payment of $5,000 in cash dividends.
Noncash Investing and Financing Activities
- There may be significant investing and financing activities occurring during the period that do not involve cash flows at all. In order to provide complete information about these activities, any significant noncash investing and financing activities (that is, noncash exchanges) are reported either on the face of the SCF or in a disclosure note.
- An example of a significant noncash investing and financing activity is the acquisition of equipment (an investing activity) by issuing either a long-term note payable or equity securities (a financing activity).Significant investing and financing transactions not involving cash also are reported.
How is interest (received and paid) classified?
How is loans (loan out, or borrow) classified?
Investing Activities,,, Principal!!!!!
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