Conducted by: Mr. Koy Chumnith

The Income Statement and Statement of Cash Flows

4

2011, Royal University of Law and EconomicsMcGraw-Hill/Irwin

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An income statement for a

hypothetical manufacturing

company that you can refer to as we proceed through

the chapter.

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Expenses

Outflows of resources incurred in generating revenues.

Revenues

Inflows of resources resulting

from providing goods or

services to customers.

Gains and Losses

Increases or decreases in equity from

peripheral or incidental

transactions of an entity.

Income from Continuing OperationsIncome from Continuing Operations

Income Tax Expense

Because of its

importance and size,

income tax expense is a

separate item.

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Operating Income

Nonoperating Income

Operating versus Nonoperating Income

Includes revenues and expenses

directly related to the principal

revenue-generating

activities of the company

Includes gains and losses and revenues and

expenses related to peripheral or

incidental activities of the

company

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Income Statement (Single-Step)

Expenses & Losses

Revenues & Gains

Proper Heading

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Income Statement (Multiple-Step)

Non- operating Items

Gross Profit

Operating Expenses

Proper Heading

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U. S. GAAP vs. IFRS

• Has no minimum requirements.

SEC requires that expenses be classified by function.

• “Bottom line” called net income or net loss.

• Report extraordinary items separately.

There are more similarities than differences between income statements prepared according to U.S. GAAP

and those prepared applying IFRS. Some differences are highlighted below.

• Specifies certain minimum information to be reported on the face of the income statement.

• Allows expenses classified by function or natural description.

• “Bottom line” called profit or loss.

• Prohibits reporting extraordinary items.

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Earnings Quality

Earnings quality refers to the ability of reported earnings to predict a company’s future earnings.

Transitory Earningsversus

Permanent Earnings

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Manipulating Income and Income Smoothing

Two ways to manipulate income:

1. Income shifting

2. Income statement classification

“Most executives prefer to report earnings that follow a smooth, regular, upward path.”

~Ford S. Worthy, “Manipulating Profits: How It’s Done”, Fortune

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Operating Income and Earnings Quality

Restructuring CostsCosts associated with shutdown or

relocation of facilities or downsizing of operations are

recognized in the period incurred.

Goodwill Impairment and Long-lived Asset

Impairment

Involves asset impairment losses or charges.

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Nonoperating Income and Earnings Quality

Gains and losses generated from the sale of investments often can significantly inflate or

deflate current earnings.

ExampleAs the stock market boom reached

its height late in the year 2000, many companies recorded large gains from sale of investments

that had appreciated significantly in value.

How should those gains be interpreted

in terms of their relationship to

future earnings? Are they transitory

or permanent?

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Separately Reported Items

Reported separately, net of taxes:

Discontinued operations

Extraordinary items

A third separately reported item, the cumulative effect of a change in accounting principle, might be included for certain mandated changes in

accounting principles.

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Intraperiod Income Tax Allocation

Income Tax Expense must be associated with each component of income that causes it.

Income Tax Expense must be associated with each component of income that causes it.

Show Income Tax Expense related to

Income from Continuing Operations.

Show Income Tax Expense related to

Income from Continuing Operations.

Report effects of Discontinued Operations and

Extraordinary Items net of related income tax effect.

Report effects of Discontinued Operations and

Extraordinary Items net of related income tax effect.

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Reporting Discontinued Operations

The FASB and IASB worked together to develop a common definition of discontinued operations and a

common set of disclosures for disposals of components of an entity.

A “component” of an entity for this purpose is defined as either:1.An operating segment that has either been disposed of or is classified as “held for sale”; or2.A business that meets the criteria to be classified as held for sale on acquisition.

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Reporting Discontinued Operations

Reporting for Components Sold

Operating income or loss of the component from the beginning of the reporting period to

the disposal date.

Gain or loss on the disposal of the

component’s assets.

Reporting for Components Held For Sale

Operating income or loss of the component from the beginning of the reporting period to the end of the reporting

period.

An “impairment loss” if the carrying value of

the assets of the component is more than the fair value minus cost to sell.

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An extraordinary item is a material event or transaction that is both:

1.Unusual in nature, and

2.Infrequent in occurrence

Extraordinary items are reported net of related taxes

Extraordinary Items

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U. S. GAAP vs. IFRS

• Report extraordinary items separately in the income statement.

The scarcity of extraordinary gains and losses reported in corporate income statements and the desire to converge U.S. and international accounting standards could guide

the FASB to the elimination of the extraordinary item classification.

• Prohibits reporting extraordinary items in the income statement or notes.

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Unusual or Infrequent Items

Items that are material and are either unusual or infrequent—but not

both—are included as separate items in continuing operations.

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Type of Accounting Change Definition

Change in Accounting Principle

Change from one GAAP method to another GAAP method

Change in Accounting Estimate

Revision of an estimate because of new information or new experience

Change in Reporting Entity

Preparation of financial statements for an accounting entity other than the entity that existed in the previous period

Accounting Changes

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Change in Accounting Principle

• Occurs when changing from one GAAP method to another GAAP method, for example, a change from LIFO to FIFO

• GAAP requires that most voluntary accounting changes be accounted for retrospectively by revising prior years’ financial statements.

• For mandated changes in accounting principles, the FASB often allows companies to choose to account for the change retrospectively or as a separately reported item below extraordinary items.

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Change in Depreciation, Amortization, or Depletion Method

A change in depreciation, amortization, or depletion

method is treated the same as a change in accounting estimate.

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Change in Accounting Estimate

Revision of a previous accounting estimate

Use new estimate in current and future

periods

Includes changes in depreciation,

amortization, and depletion methods

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Change in Reporting Entity

The prior-period financial statements that are

presented for comparative purposes should be

restated to appear as if the new entity existed in those

periods.

When one company acquires another one, the financial statements of the acquirer

include the acquiree as of the date of acquisition, and the

acquirer’s prior-period financial statements that are presented for comparative purposes are

not restated.

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Correction of Accounting Errors

Errors occur when transactions are either recorded incorrectly or not recorded at all.

Errors Discovered in

Same Year

Reverse original erroneous journal entry and record the appropriate

journal entry.

Record a prior period adjustment to the beginning retained earnings

balance in a statement of shareholders’ equity.

Previous years’ financial statements that are incorrect as a result of the error are retrospectively restated to

reflect the correction.

Material Errors Discovered in Subsequent

Year

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Earnings per Share Disclosure

One of the most widely used ratios is earnings per share (EPS), which shows the amount of income

earned by a company expressed on a per share basis.

Basic EPS

Net income less preferred dividends

Weighted-average number of common shares outstanding for the

period

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.

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Earnings per Share Disclosure

Report EPS data separately for:

1. Income or Loss from Continuing Operations

2. Separately Reported Items

a) discontinued operations

b) extraordinary Items

3. Net Income or Loss

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Comprehensive Income

An expanded version of income that includes four types of gains and

losses that traditionally have not been included

in income statements.

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Other Comprehensive IncomeComprehensive income includes traditional net income as well as four additional gains and losses that change

shareholders’ equity.

1. Net unrealized holding gains (losses) from investments (net of tax).

2. Gains and losses due to reviewing assumptions or market returns differing from expectations and prior service cost from amending the postretirement benefit plan.

3. When a derivative is designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction.

4. Gains or losses from changes in foreign currency exchange rates. The amount could be an addition to or reduction in shareholders’ equity. (This item is discussed elsewhere in your accounting curriculum).

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U. S. GAAP vs. IFRS

• Includes four possible Other Comprehensive Income items.

As part of a joint project with the FASB, the International Accounting Standards Board (IASB) in 2007 issued a new version of IAS No. 146 that revised the standard to bring

international reporting of comprehensive income largely in line with U.S. standards.

• Includes same four.

• Includes a fifth possible item, changes in revaluation surplus, from the optional revaluation of property, plant, and equipment and intangible assets.

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Accumulated Other Comprehensive Income

In addition to reporting comprehensive income that occurs in the current period, we must also report these amounts on a cumulative basis in the balance sheet as

an additional component of shareholders’ equity.

In addition to reporting comprehensive income that occurs in the current period, we must also report these amounts on a cumulative basis in the balance sheet as

an additional component of shareholders’ equity.

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The Statement of Cash Flows

• Provides relevant information about a company’s cash receipts and cash disbursements.

• Helps investors and creditors to assess future net cash flows liquidity long-term solvency.

• Required for each income statement period reported.

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Operating Activities

Cash Flows from

Operating Activities

Cash Flows from

Operating Activities

Inflows from: sales to customers. interest and dividends

received.

Inflows from: sales to customers. interest and dividends

received. +

Outflows for: purchase of inventory. salaries, wages, and other

operating expenses. interest on debt. income taxes.

Outflows for: purchase of inventory. salaries, wages, and other

operating expenses. interest on debt. income taxes.

_

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Direct and Indirect Methods of Reporting

Two Formats for Reporting Operating Activities

Reports the cash effects of each operating

activity

Direct Method

Starts with accrual net income and converts to cash basis

Indirect Method

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Direct MethodUnder the direct method, the cash effect of each

operating activity is reported directly in the statement.

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Indirect MethodBy the indirect method, 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.

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Cash Flows from

Investing Activities

Cash Flows from

Investing Activities

+

Investing Activities

Inflows from: sale of long-lived assets used in

the business. sale of investment securities

(stocks and bonds). collection of nontrade

receivables.

_Outflows for:

purchase of long-lived assets used in the business.

purchase of investment securities (stocks and bonds).

loans to other entities.

Outflows for: purchase of long-lived assets

used in the business. purchase of investment

securities (stocks and bonds). loans to other entities.

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Cash Flows from

Financing Activities

+

_

Financing Activities

Inflows from: sale of shares to owners. borrowing from creditors

through notes, loans, mortgages, and bonds.

Outflows for: owners in the form of dividends

or other distributions. owners for the reacquisition of

shares previously sold. creditors as repayment of the

principal amounts of debt.

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ALC’s Statement of Cash Flows

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Noncash Investing and Financing Activities

Significant investing and financing transactions not involving cash

also are reported.

Acquisition of equipment (an investing activity) by issuing a long-term note

payable (a financing activity).

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Like U.S. GAAP, international standards also require a statement of cash flows. Consistent with U.S. GAAP, cash flows are classified as operating, investing, or financing.

U. S. GAAP vs. IFRS

• Operating Activities– Dividends Received– Interest Received– Interest Paid

• Investing Activities

• Financing Activities– Dividends Paid

• Operating Activities

• Investing Activities– Dividends Received– Interest Received

• Financing Activities– Dividends Paid– Interest Paid

Typical Classification of Cash Flows from Interest and Dividends

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U. S. GAAP vs. IFRSThe FASB and IASB are working together on a project,

Financial Statement Presentation, to establish a common standard for presenting information in the financial

statements.

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End of Chapter 4