1 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Income Statement and Statement of Cash Flows 4 4-2 Learning Objectives Explain the difference between net income and comprehensive income and how we report components of the difference. 4-3 Comprehensive Income An expanded version of income that includes four types of gains and losses that traditionally have not been included in income statements. 2 4-4 Other Comprehensive Income Statement of Financial Accounting Standards No. 130 Comprehensive income includes traditional net income and changes in equity from nonowner transactions. 1. Changes in the market value of securities available for sale (described in Chapter 12). 2. Gains, losses, and amendment costs for pensions and other postretirement plans (described in Chapter 17). 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 (described in Chapter 14). 4. Gains or losses from changes in foreign currency exchange rates (discussed elsewhere in your accounting curriculum). 4-5 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 millions, except shares) 2004 2003 Common Stockholders' Investment: Common stock, $.10 par value , 800 million shares authorized, 300 million shares issued for 2004 and 299 million shares 30$ 30$ issued for 2003 Additional pa id-in capital 1,079 1,088 Retained earnings 7,001 6,250 Accumula ted other comprehensive loss (46) (30) 8,064 7,338 Less deferred compensation and treasury stock at cost 28 50 Total common stockholders' investment 8,036$ 7,288$ FedEx Corporation Balance Sheet 31-May 4-6 Learning Objectives Discuss the importance of income from continuing operations and describe its components. 3 4-7 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 Operations Income Tax Expense Because of its importance and size, income tax expense is a separate item. 4-8 Operating Income Nonoperating Income Operating Income 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 4-9 Income Statement (Single-Step) Expenses & Losses { MAXWELL GEAR COMPANY Income Statement For the Year Ended December 31, 2006 Revenues and gains: Sales 573,522$ Interest and dividends 26,400 Gain on sale of opearting assets 5,500 Total revenues and gains 605,422 Expenses and losses: Cost of goods sold 302,371$ Selling 47,341 General and administrative 24,888 Research and development 16,300 Interest 6,200 Loss on sale of investment 8,322 Income taxes 80,000 Total expenses & losses 485,422 Net income 120,000$ { Revenues & Gains { Proper Heading 4 4-10 Income Statement (Multiple-Step) { Non- operating Items MAXWELL GEAR CORPORATION Income Statement For the Year Ended December 31, 2006 Sales revenue 573,522$ Cost of goods sold 302,371 Gross profit 271,151 Operating expenses: Selling 47,341$ General and administrative 24,888 Research and development 16,300 88,529 Operating income 182,622 Other income (expense): Interest and dividend revenue 26,400$ Gain on sale of operating assets 5,500 Interest expense (6,200) Loss on sale of investments (8,322) 17,378 Income before income taxes 200,000 Income tax e xpense 80,000 Net income 120,000$ { Gross Profit { Proper Heading Operating Expenses { 4-11 Learning Objectives Describe earnings quality and how it is impacted by management practices to manipulate earnings. 4-12 Earnings Quality Earnings quality refers to the ability of reported earnings to predict a company’s future. The relevance of any historical-based financial statement hinges on its predictive value. 5 4-13 Manipulating Income and Income Smoothing “Most managers prefer to report earnings that follow a smooth, regular, upward path.” 1 Two ways to manipulate income: 1. Income shifting 2. Income statement classification 1 Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 168. 4-14 Learning Objectives Discuss the components of operating and nonoperating income and their relationship to earnings quality. 4-15 Operating Income and Earnings Quality Should all items of revenue and expense included in operating income be considered indicative of a company’s permanent earnings? No, not necessarily. Operating expenses may include the following unusual items that may or may not continue in the future: • Restructuring costs • Goodwill impairment • Long-lived asset impairment • In-process research and development 6 4-16 Operating Income and Earnings Quality Restructuring Costs Costs 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 (discussed further in Chapters 10 & 11). In-process Research and Development Results from certain business combinations (discussed further in Chapter 10). 4-17 Nonoperating Income and Earnings Quality Gains and losses from the sale of operational assets and investments often can significantly inflate or deflate current earnings. Example As 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? 4-18 Pro Forma Earnings Companies often voluntarily provide a pro forma earnings number when they announce annual or quarterly earnings. Pro forma earnings are management’s assessment of permanent earnings. The Sarbanes-Oxley Act Section 401 requires a reconciliation between pro forma earnings and earnings determined according to GAAP. 7 4-19 Separately Reported Items Reported separately, net of taxes: Discontinued operations $ xxx xx xxx xx xx Net Income $ xxx Extraordinary items (net of $xx in taxes) Income from continuing operations before income taxes and extraordinary items Income tax expense Income from continuing operations before extraordinary items Discontinued operations (net of $xx in taxes) Extraordinary items A third item, the cumulative effect of a change in accounting principle, was eliminated from separate reporting by a new accounting standard in 2005. 4-20 Intraperiod Income Tax Allocation Income Tax Expense must be associated with each component of income that causes it. Show Income Tax Expense related to Income from Continuing Operations. Report effects of Discontinued Operations and Extraordinary Items NET OF RELATED INCOME TAXES. 4-21 Learning Objectives Define what constitutes discontinued operations and describe the appropriate income statement presentation for these transactions. 8 4-22 p A discontinued operation is the sale or disposal of a component of an entity. p A component comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. p A component could include: p Reportable segments p Operating segments p Reporting units p Subsidiaries p Asset groups Discontinued Operations 4-23 Discontinued Operations Report results of operations separately if two conditions are met: The operations and cash flows of the component have been (or will be) eliminated from the ongoing operations. The entity will not have any significant continuing involvement in the operations of the component after the disposal transaction. 4-24 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. 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. 9 4-25 During the year, Apex Co. sold an unprofitable component of the company. The component had a net loss from operations during the period of $150,000 and its assets sold at a loss of $100,000. Apex reported income from continuing operations of $128,387. All items are taxed at 30%. How will this appear in the income statement? Discontinued Operations Example 4-26 Loss from discontinued operations (150,000)$ Less: Tax benefit ($150,000 × 30%) 45,000 Net loss (105,000)$ Loss on disposal of assets (100,000)$ Less: Tax benefit ($100,000 × 30%) 30,000 Net loss (70,000)$ Discontinued Operations Example Computation of Loss from Discontinued Operations (Net of Tax Effect): 4-27 Income from continuing operations 128,387$ Discontinued operations: Loss from operations of discontinued component (net of tax benefit of $45,000) (105,000) Loss on disposal of discontinued component (net of tax benefit of $30,000) (70,000) Net loss (46,613)$ Income Statement Presentation: Discontinued Operations Example 10 4-28 Learning Objectives Define extraordinary items and describe the appropriate income statement presentation for these transactions. 4-29 p Material events or transactions p Unusual in nature p Infrequent in occurrence p Reported net of related taxes Extraordinary Items 4-30 During the year, Apex Co. experienced a loss of $75,000 due to an earthquake at one of its manufacturing plants in Nashville. This was considered an extraordinary item. The company reported income before extraordinary item of $128,387. All gains and losses are subject to a 30% tax rate. How would this item appear in the income statement? Extraordinary Items Example [...]... Net Income 4-48 Learning Objectives Describe the purpose of the statement of cash flows 16 4-49 The Statement of Cash Flows p Provides relevant information about a company’s cash receipts and cash disbursements p Helps investors and creditors to assess n n n p future net cash flows liquidity long-term solvency Required for each income statement period presented 4-50 Learning Objectives Identify and. .. Method Indirect Method Reports the cash effects of each operating activity Starts with accrual net income and converts to cash basis 4-53 Direct and Indirect Methods ARLINGTON LAWN CARE Statement of Cash Flows For the Year Ended December 31, 2006 ($ in thousands) Cash flows from Operating Activities Cash received from customers Cash paid for administrative expenses Net cash flows from operating activities... mortgages, and bonds + Outflows to: l l l 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 _ Cash Flows from Financing Activities 4-56 Noncash Investing and Financing Activities Significant investing and financing transactions not involving cash also are reported Acquisition of equipment... per share (EPS) and explain required disclosures of EPS for certain income statement components 15 4-46 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... Identify and describe the various classifications of cash flows presented in a statement of cash flows 4-51 Operating Activities Inflows from: l l Sales to customers Interest and dividends received + Outflows to: l l l l Purchase of inventory Salaries, wages, and other operating expenses Interest on debt Income taxes _ Cash Flows from Operating Activities 17 4-52 Direct and Indirect Methods of Reporting Two... CARE Statement of Cash Flows For the Year Ended December 31, 2006 ($ in thousands) Cash flows from Operating Activities Net income $ Adjustments for noncash effects: Depreciation expense $ 8 Increase in accounts receivable (12) Increase in accounts payable 7 Increase in income taxes payable 15 Net cash flows from operating activities $ 35 18 53 4-54 Investing Activities Inflows from: l l l Sale of long-term... Sale of long-term assets used in the business Sale of investment securities (stocks and bonds) Collection of nontrade receivables + Outflows to: l l l Purchase of long-term assets used in the business Purchase of investment securities (stocks and bonds) Loans to other entities _ Cash Flows from Investing Activities 18 4-55 Financing Activities Inflows from: l l Sale of shares to owners Borrowing from... comparative purposes as if the new reporting entity existed in those periods 4-42 Prior Period Adjustments p Corrections of errors from a previous period in the Statement of Retained Earnings as an adjustment to beginning retained earnings p Appear p Must show the adjustment net of income taxes 14 4-43 Prior Period Adjustments Example While reviewing the depreciation entries for 2002 -2007, the controller found... Computation of Loss from Extraordinary Item (Net of Tax Effect): Extra ordina ry Loss Less: Tax Benefits ($75,000 × 30%) Net Loss $ (75,000) 22,500 $ (52,500) Income Statement Presentation: Income before extraordinary item Extraordinary Loss: Earthquake loss (net of tax benefit of $22,500) Net income $ 128,387 (52,500) $ 75,887 4-32 Unusual or Infrequent Items Items that are material and are either unusual... 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 Preparation of financial statements for an accounting entity other than the entity that existed in the previous period Change in Reporting Entity 11 4-34 Learning Objectives Describe the . 1 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. The Income Statement and Statement of Cash Flows 4 4-2 Learning Objectives Explain the difference between net income and. Net Income 4-48 Learning Objectives Describe the purpose of the statement of cash flows. 17 4-49 The Statement of Cash Flows p Provides relevant information about a company’s cash receipts and. 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