INTERMEDIATE ACCOUNTING I

CHAPTER 4

STATEMENT OF INCOME AND RETAINED EARNINGS

• Helps assess amounts, timing, and uncertainty of future cash flows.



• For evaluating past performance of a company.
• For determining the risk (uncertainty) of achieving future cash flows.



• Public attention focused on firm's earnings.

• "Economic income:" the maximum amount that can be consumed during the period while leaving the entity as well off at the end as at the beginning.



• Measuring "well-offness."



• Accounting income excludes items included in economic income.



• Quality of earnings - income numbers are affected by the accounting method used.



• Accounting vs. Economic profits.

• Revenue recognition, matching, periodicity.



• Approach

1. Capital maintenance approach - focuses on the difference in net assets



2. Transaction approach - focuses on underlying revenue and expense transactions

• Which of the transactions that produce changes in net assets should be included in income for the period?

1. All-inclusive approach - includes all gains or losses in computing net income



2. Current operating performance approach - net income



1. Net income includes regular, recurring earnings from normal operations



2. Irregular gains and losses and other items such as changes in accounting principle should be closed directly to retained earnings.



3. Modified all-inclusive approach - approach that has been traditionally adopted by the profession. Includes in income all changes in net assets except:
1. Capital transactions (investments by owners or distributions to owners).
2. Prior period adjustments.
3. Certain changes in net assets such as unrealized holding gains or losses on available-for-sale securities.



4. Comprehensive income - new GAAP issued in June 1997. Includes all nonowner changes in comprehensive income.



1. Suggests a single statement approach that derives net income then adjusts to show comprehensive income.



2. May also use a separate statement of comprehensive income, or may show other comprehensive income as a component of stockholders' equity.

• Intermediate components of income
• Revenues
• Expenses
• Gains
• Losses



• Items before income from continuing operations.
• Multiple-step format:

1. COGS
2. Gross Profit
3. S, G & A Expenses
4. Interest and Dividend

• Single-step format: All revenues and expenses.

• Format affects only the presentation of items before income from continuing operations.

• GAAP permits either multiple-step or single-step format.

• Items after income from continuing operations
• Includes: (presented in order):

1. "D" - Discontinued Operations
2. "E" - Extraordinary Items
3. "C" - Changes in Accounting Principle

• GAAP requires presentation of these items net of tax.

• Other comprehensive income items

• Disposals of segments - examples

1. A sale by a diversified company of a major division which represents the company's only activities in the electronic industry. The assets and results of operations of the division are clearly segregated for internal financial reporting purposes from the other assets and results of operations of the company.



2. A sale by a meat packing company of a 25% interest in a professional football team which has been accounted for under the equity method. All other activities of the company are in the meat packing business.

• Disposals that do not qualify as disposals of segments are:

1. The sale of a major foreign subsidiary engaged in silver mining by a mining company which represents all of the company's activities in that particular country. Even though the subsidiary being sold may account for a significant percentage of gross revenue of the consolidated group and all of its revenues in the particular country, the fact that the company continues to engage in silver mining activities in other countries would indicate that there was a sale of only a part of a line of business.



2. The sale by a petrochemical company of a 25% interest in a petrochemical plant which is accounted for as an investment in a corporate joint venture under the equity method. Since the remaining activities of the company are in the same line of business as the 25% interest which has been sold, thee has not been a sale of a major line of business but rather a sale of part of a line of business.

• Reporting discontinued operations

1. Income statement immediately below income from continuing operations
2. Income or loss from operation of the discontinued segment up to the measurement date, net of tax.
3. Gain or loss from disposal of the discontinued segment, net of tax.

• df - unusual in nature and infrequent in occurrence, considering the environment in which the entity operates.

1. Also includes items that are defined as extraordinary by pronouncement. Example: material gains and losses from extinguishment of debt.

• Extraordinary items - examples

1. A large portion of a tobacco manufacturer's crops are destroyed by a hail storm. Severe damage from hail storms in the locality where the manufacturer grows tobacco is rare.



2. A steel fabricating company sells the only land it owns. The land was acquired ten years ago for future expansion, but shortly thereafter the company abandoned all plans for expansion and held the land for appreciation.

• Examples of items that are not extraordinary are:

1. A citrus grower's Florida crop is damaged by frost. Frost damage is normally experienced every three or four years. The criterion of infrequency of occurrence taking into account the environment in which the company operates would not be met since the history of losses caused by frost damage provides evidence that such damage may reasonably be expected to recur in the foreseeable future.



2. A large diversified company sells a block of shares from its portfolio of securities which it has acquired for investment purposes. This is the first sale from its portfolio of securities. Since the company owns several securities for investment purposes, it should be concluded that sales of such securities are related to its ordinary and typical activities in the environment in which it operates and thus the criterion of unusual nature would not be met.

• Presented net of tax in the income statement, below discontinued operations and above changes in accounting principle.

• Unusual gains and losses - items that are unusual or infrequent but not both

1. In a multiple-step statement, these are reported in the "other revenues and gains" or "other expenses and losses" section.



2. These items may not be presented net of tax.

• Df - adoption of an (accepted) accounting method that is different from the one previously used.

• Examples:

1. Change from FIFO to average cost.
2. Change from double-declining to straight-line depreciation.

• Changes in accounting principle vs. changes in accounting estimate.

• Separately disclose the cumulative effect of the change on prior years' income

• Changes in accounting principle are disclosed net of tax in the income statement immediately before net income.

• Df - normal, recurring corrections and adjustments that result from periodic revision in estimates.

• Examples:

1. Changes in the estimated lives or salvage values of fixed assets.
2. Changes in estimated collectibility of receivables.
3. Adjustment of inventory costs or estimated realizability.

• These adjustments are not errors or extraordinary items.

• Df - the process of associating income tax expense with related income. "Let the tax follow the income."

• Interperiod tax allocation - Recognizes differences between taxable income and accounting income.

• Intraperiod tax allocation - Breaks down total income tax expense into separate components which are disclosed in different portions of the financial statements. Intraperiod tax allocation is applied to:

1. Income from continuing operations.
2. Discontinued operations.
3. Extraordinary items.
4. Changes in accounting principle.
5. Prior period adjustments.

• Df - measures net income available to common shareholders per share of stock owned - widely used measure of business performance.

• EPS = (Net income -- Preferred dividends)/(Weighted Average Common Shared Outstanding)

• Dilution - some securities (convertible securities, stock options and warrants) may reduce EPS when these securities become common stock.

• Per share figures must be disclosed in the income statement for the following amounts:

1. Income from continuing operations.
2. Income before extraordinary items and cumulative effect of changes in accounting principle.
3. Cumulative effect of changes in accounting principle.
4. Net income.

• Per share information is usually provided for:

1. Discontinued operations.
2. Extraordinary items.

• Df - a summary disclosure of the changes in the balance of the retained earnings account from the beginning of the end of the year.

• Prior period adjustments. Adjustments to the beginning balance of retained earnings.

1. Transactions that are accounted for as prior period adjustments:
1. Correction of errors in financial statements of prior period.
2. Realization of tax benefits from pre-acquisition operating loss carry forwards of purchased subsidiaries.
3. Certain accounting changes such as a change in the method of accounting for long-term construction contracts.



2. Recording a prior period adjustment usually involves the following types of accounts:
1. The retained Earnings account.
2. A balance sheet account (e.g., Accumulated Depreciation, Inventory, etc.).
3. Taxes Payable

• Dividends and net income.

• Appropriations of retained earnings.

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