Stice | Stice | Skousen Intermediate Accounting,17E The Income Statement PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine University 4-1 © 2010 Cengage Learning Income Determination The financial capital maintenance concept assumes that a company has income “only if the dollar amount of an enterprise’s net assets at the end of the period exceeds the dollar amount of net assets at the beginning of the period after excluding the effects of transactions with owners 4-2 Financial Capital Maintenance Kreidler, Inc had the following assets and liabilities at the beginning and at the end of a period Total assets $560,000 Total liabilities 390,000 Net assets (owners’ equity) $170,000 End of Beginning Period of Period$510,000 430,000 Income is $90,000 $ 80,000 4-3 Financial Capital Maintenance If the owners invested $40,000 in the business Netreceived assets, end of periodof $15,000, what and dividends $170,000 would be the income? Net assets, beginning of period 80,000 Change (increase) in net assets 90,000 Deduct investment by owners (40,000) Add dividends to owners 15,000 Income 65,000 $ $ 4-4 Physical Capital Maintenance Income per physical capital maintenance: • Results only if production capacity at the end of the period exceeds capacity at the beginning of the period • Capacity is measured by replacement cost of net assets • Income/loss is the difference between replacement cost and net realizable value • Difference between historical cost and replacement cost is considered a capital maintenance adjustment and not part of income 4-5 Why is a Measure of Income Important? The recognition, measurement, and reporting of business income and its components are considered by many to be the most important tasks of accountants For example: • Has the activity been profitable? • What is the trend of profitability? • Is it increasing profitable, or is there a downward trend? 4-6 Transaction Approach To provide detail concerning the components of income, accountants have adopted a transaction approach to measuring income that stresses the direct computation of revenues and expenses 4-7 4-8 Revenue and Gain Recognition • Revenue is recognized when goods or services have been provided and the customer commits to payment • Revenues and gains are recognized when: They are realized or realizable, and They have been earned through substantial completion of the activities involved in the earnings process 4-9 Earlier Recognition If a market exists for a product so that its sale at an established price is practically ensured without significant selling effort, revenue may be recognized at the point of completed production (continues) 4-10 Extraordinary Items Extraordinary items are events and transactions that are both unusual in nature and infrequent in occurrence Thus, they must contain “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 [and] be of a type that would not reasonable be expected to recur in the foreseeable future .”¹ ¹Opinions of the Accounting Principles Board No 30, “Reporting the Results of Operations (NY: AICPA, 1973), par 20 4-39 Not Extraordinary • The write-down or write-off of receivables, inventories, equipment leased to others, etc • The gains or losses from exchange or remeasurement of foreign currencies • The gains or losses on disposal of business segment • Other gains or losses from sale or abandonment of productive assets • The effects of a strike • Adjustment of accruals on long-term contracts 4-40 Changes in Accounting Principles Criteria for change: Change in economic conditions suggests that an accounting change will provide better information The FASB issues a new pronouncement requiring a change in principle 4-41 Changes in Accounting Principles • When there is a change in accounting principle or method, a company is required to determine how the income statement would have been different in past years if the new accounting method had been used all along • Income statements for all years presented must be restated using the new accounting method (continues) 4-42 Changes in Accounting Principles • The beginning balance of Retained Earnings for the oldest period presented should reflect an adjustment for the cumulative income effect of the accounting change on the net income of all preceding years for which a detailed income statement is not presented • Include information as if the change were retroactive—direct and indirect effects 4-43 Change in Estimate Disclosure requirements include: • Employ current and prospective approach • Report current and future financial statements on new basis • Present prior periods as previously reported • Make no adjustments to current period opening balances • Present no data 4-44 Change in Estimate If there is both a change in principle and a change in estimate for an item, the event is treated as a change in estimate 4-45 Effects of Changing Prices Accountants have traditionally ignored the effects of changing prices, especially when gains would result from recognition McDonald’s used the following approach in its 10-K filed with the SEC 4-46 Earnings Per Share When presenting earnings-per-share figures: • Earnings per share amounts are computed for income from continuing operations • Earnings per share amounts are calculated for each irregular or extraordinary item 4-47 Earnings Per Share Earnings per share = Income from continuing operations Weighted average number of shares of common stock outstanding 4-48 Price-Earnings (P/E) Ratio The price-earnings (P/E) ratio expresses the market value of common stock as a multiple of earnings and allows investors to evaluate the attractiveness of a firm’s common stock P/E ratio = Market value per share Earnings per share 4-49 Comprehensive Income • Comprehensive income is the number used to reflect an overall measure of the change in a company’s wealth during the period • It includes items that arise from changes in market conditions unrelated to the business operations of a company • Most companies include a report of comprehensive income as part of the statement of stockholders’ equity 4-50 Comprehensive Income The more common adjustments made in arriving at comprehensive income are: • Foreign currency translation adjustments • Unrealized gains and losses on available-for-sale securities • Deferred gains and losses on derivative financial instruments 4-51 Forecasting Future Performance • Financial statements report the past, but are used to predict the future • Key to a good forecast involves identifying factors that determine a certain level of revenue or expense • Forecasting starts with a forecast for sales • Most expense forecasts are driven from sales forecasts 4-52 4-53