Ebook Principles of accounting (11th edition): Part 2

(BQ) Part 2 book Principles of accounting has contents: The statement of cash flows, financial performance measurement, the changing business environment - a manager’s perspective, cost concepts and cost allocation, cost behavior analysis, the budgeting process, capital investment analysis, short run decision analysis,...and other contents.

CHAPTER 14 Making a Statement INCOME STATEMENT The Corporate Income Statement and the Statement of Stockholders’ Equity A s we pointed out in an earlier chapter, earnings management—the practice of manipulating revenues and expenses to achieve a specific outcome—is unethical when companies use it Revenues to create misleading financial statements Users of financial state- – Expenses ments consider the possibility of earnings management by assess- = Net Income ing the quality, or sustainability, of a company’s earnings To so, they evaluate how the components of the company’s income STATEMENT OF RETAINED EARNINGS Beginning Balance + Net Income – Dividends statement affect earnings In this chapter, we focus on those components We also cover earnings per share, the statement of stockholders’ equity, stock dividends and stock splits, and book value per share = Ending Balance LEARNING OBJECTIVES BALANCE SHEET Assets Liabilities LO1 Define quality of earnings, and identify the components of a corporate income statement Stockholders’ Equity A = L + OE STATEMENT OF CASH FLOWS Operating activities + Investing activities + Financing activities = Change in Cash + Beginning Balance = Ending Cash Balance The corporate income statement aids in the analysis of profitability and links to stockholders’ equity, which in turn links to the stockholders’ equity section of the balance sheet 614 (pp 616–621) LO2 Show the relationships among income taxes expense, deferred income taxes, and net of taxes LO3 Compute earnings per share (pp 621–625) (pp 625–627) LO4 Define comprehensive income, and describe the statement of stockholders’ equity (pp 627–630) LO5 Account for stock dividends and stock splits LO6 Calculate book value per share (pp 635–636) (pp 630–635) DECISION POINT Ǡ A USER’S FOCUS Ǡ Should Kowalski, Inc., declare a stock split? Ǡ Should the company raise capital by issuing preferred stock? Ǡ Should the company pay cash dividends or use cash to buy back its own stock? KOWALSKI, INC Walter Kowalski is the chief executive officer of Kowalski, Inc., a manufacturing company that his father founded 25 years ago The company’s fiscal year just ended on June 30, 2010, and Walter is now considering what steps to take in the next fiscal year with regard to stockholders’ equity The current status of the company’s stockholders’ equity is as follows: Contributed capital Common stock, no par value, $6 stated value, 500 shares authorized, 125 shares issued and outstanding $ 750,000 Additional paid-in capital 410,000 Total contributed capital $1,160,000 Retained earnings 485,000 Total stockholders’ equity $1,645,000 Among the questions Walter is wrestling with are whether the company should declare a stock split, whether it should issue preferred stock to raise capital, and whether it should pay cash dividends or use cash to buy back its own stock In this chapter, you will learn about these issues, as well as about the structure and content of the corporate income statement and its interpretation 615 616 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity Performance Measurement: Quality of Earnings Issues LO1 Define quality of earnings, and identify the components of a corporate income statement Net income (net earnings) is the measure most commonly used to evaluate a company’s performance In fact, a survey of 2,000 members of the Association for Investment Management and Research indicated that the two most important economic measures in evaluating common stocks were expected changes in earnings per share and expected return on equity.1 Net income is a key component of both measures Because of the importance of net income, or the “bottom line,” in measuring a company’s prospects, there is significant interest in evaluating the quality of the net income figure, or the quality of earnings The quality of a company’s earnings refers to the substance of earnings and their sustainability into future accounting periods For example, if earnings increase because of a gain on the sale of an asset, this portion of earnings will not be sustained in the future The accounting estimates and methods that a company uses affect the quality of its earnings, as these components of the income statement: Ǡ Gains and losses on transactions Ǡ Write-downs and restructurings Ǡ Non-operating items Study Note It is important to know which items included in earnings are recurring and which are one-time items Income from continuing operations before nonoperating items gives a clear signal about future results In assessing a company’s future earnings potential, nonoperating items are excluded because they are not expected to continue Because management has choices in the content and positioning of these income statement components, there is a potential for managing earnings to achieve specific income targets It is therefore critical for users of income statements to understand these factors and take them into consideration when evaluating a company’s performance Exhibit 14-1 shows the components of a typical corporate income statement Net income or loss (the “bottom line” of the income statement) includes all revenues, expenses, gains, and losses over the accounting period When a company has both continuing and discontinued operations, the operating income section is called income from continuing operations Income from continuing operations before income taxes may include gains or losses on the sale of assets, writedowns, and restructurings The income taxes expense section of the statement is subject to special accounting rules As you can see in Exhibit 14-1, the section of a corporate income statement that follows income taxes contains such nonoperating items as discontinued operations and extraordinary gains (or losses) Another item that may appear in this section is the write-off of goodwill when its value has been impaired Earnings per share information appears at the bottom of the statement FOCUS ON BUSINESS PRACTICE Why Do Investors Study Quality of Earnings? Analysts for Twentieth Century Mutual Funds, a major investment company now merged with American Century Investments Corporation, make adjustments to a company’s reported financial performance to create a more accurate picture of the company’s ongoing operations For example, suppose a paper manufacturer reports earnings of $1.30 per share Further investigation, however, shows that the per share number includes a one-time gain on the sale of assets, which accounts for an increase of $0.25 per share Twentieth Century would list the company as earning only $1.05 per share “These kinds of adjustments help assure long-term decisions aren’t based on one-time events.”2 Performance Measurement: Quality of Earnings Issues 617 EXHIBIT 14-1 Corporate Income Statement Vistula Corporation Income Statement For the Year Ended December 31, 2010 Operating items before income taxes Income taxes Nonoperating items Earnings per share information Revenues Costs and expenses Gain on sale of assets Write-downs of assets Restructurings Income from continuing operations before income taxes Income taxes expense Income from continuing operations Discontinued operations Income from operations of discontinued segment (net of taxes, $70,000) Loss on disposal of segment (net of taxes, $84,000) Income before extraordinary items Extraordinary gain (net of taxes, $24,000) Net income Earnings per common share: Income from continuing operations Discontinued operations (net of taxes) Income before extraordinary items Extraordinary gain (net of taxes) Net income $ 1,850,000 (1,100,000) 300,000 (50,000) (150,000) $ $ 850,000 289,000 561,000 $ 180,000 (146,000) $ $ $ $ $ 34,000 595,000 74,000 669,000 2.81 0.17 2.98 0.37 3.35 The Effect of Accounting Estimates and Methods Users of financial statements need to be aware of the impact that accounting estimates and methods have on the income that a firm reports As you know, to comply with the matching rule, accountants must assign revenues and expenses to the periods in which they occur If they cannot establish a direct relationship between revenues and expenses, they systematically allocate the expenses among the accounting periods that benefit from them, and in doing so, they must make estimates and exercise judgment An accounting estimate should be based on realistic assumptions, but there is latitude in making the estimate, and the final judgment will affect the net income that appears on a company’s income statement For example, when a company acquires an asset, the accountant must estimate the asset’s useful life Technological obsolescence could shorten the asset’s expected useful life, and regular maintenance and repairs could lengthen it Although the actual useful life cannot be known with certainty until some future date, the accountant’s estimate of it affects both current and future operating income Other areas that require accounting estimates include the residual value of assets, uncollectible accounts receivable, sales returns, total units of production, total recoverable units of natural resources, amortization periods, warranty claims, and environmental cleanup costs 618 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity Study Note Although companies in the same industry may have comparable earnings, their quality of earnings may not be comparable To assess the quality of a company’s reported earnings, you must know the estimates and methods it uses to compute income Generally accepted accounting principles allow several methods, all yielding different results Accounting estimates are not equally important to all firms Their importance depends on the industry in which a firm operates For example, estimated uncollectible receivables for a credit card firm, such as American Express, or for a financial services firm, such as Bank of America, can have a material impact on earnings, but estimated useful life may be less important because depreciable assets represent only a small percentage of the firm’s total assets Walgreens has very few receivables, but it has substantial investments in depreciable assets Thus, estimates of useful life and residual value are much more important to Walgreens than an estimate of uncollectible accounts receivable The accounting methods a firm uses also affect its operating income Generally accepted accounting methods include uncollectible receivable methods (percentage of net sales and aging of accounts receivable), inventory methods (LIFO, FIFO, and average-cost), depreciation methods (accelerated, production, and straight-line), and revenue recognition methods All these methods are designed to match revenues and expenses, but the expenses are estimates, and the period or periods benefited cannot be demonstrated conclusively In practice, it is hard to justify one method of estimation over another Different accounting methods have different effects on net income Some methods are more conservative than others because they tend to produce a lower net income in the current period For example, suppose that two companies have similar operations, but one uses FIFO for inventory costing and the straight-line (SL) method for computing depreciation, whereas the other uses LIFO for inventory costing and the double-declining-balance (DDB) method for computing depreciation The income statements of the two companies might appear as follows: FIFO and SL LIFO and DDB Net sales $462,500 $462,500 Cost of goods available for sale $200,000 $200,000 30,000 25,000 Cost of goods sold $170,000 $175,000 Gross margin $292,500 $287,500 Less depreciation expense $ 20,000 $ 40,000 85,000 85,000 Total operating expenses $105,000 $125,000 Income from continuing operations before income taxes $187,500 $162,500 Less ending inventory Less other expenses The income from continuing operations before income taxes (operating income) for the firm that uses LIFO and DDB is lower because in periods of rising prices, the LIFO inventory costing method produces a higher cost of goods sold, and in the early years of an asset’s useful life, accelerated depreciation yields a higher depreciation expense The result is lower operating income However, future operating income should be higher Although the choice of accounting method does not affect cash flows except for possible differences in income taxes, the $25,000 difference in operating income stems solely from the choice of accounting methods Estimates of the useful lives and residual values of plant assets could lead to an even greater difference In practice, of course, differences in net income occur for many reasons, but the user of financial statements must be aware of the discrepancies that can occur as a result of the accounting methods used in preparing the statements In Performance Measurement: Quality of Earnings Issues 619 FOCUS ON BUSINESS PRACTICE Beware of the Bottom Line! In the second quarter of 2007, McDonald’s posted its second-ever loss: $711.7 million Is this cause for concern? In fact, it is misleading: The company is actually in a period of rapidly growing revenues and profits The loss resulted from a one-time, noncash impairment of $1.6 billion related to investments in Latin America In another example, Campbell Soup showed unrealistically positive results in a recent year Its income jumped by 31 percent due to a tax settlement and an accounting restatement Without these items, its revenue and income would have been up less than percent, and soup sales—its main product—actually dropped by percent The lesson to be learned is to look beyond the “bottom line” to the components of the income statement when evaluating a company’s performance.3 general, an accounting method or estimate that results in lower current earnings produces a better quality of operating income The latitude that companies have in their choice of accounting methods and estimates could cause problems in the interpretation of financial statements were it not for the conventions of full disclosure and consistency As noted in an earlier chapter, full disclosure requires management to explain the significant accounting policies used in preparing the financial statements in a note to the statements Consistency requires that the same accounting procedures be followed from year to year If a change in procedure is made, the nature of the change and its monetary effect must be explained in a note Gains and Losses When a company sells or otherwise disposes of operating assets or marketable securities, a gain or loss generally results Although these gains or losses appear in the operating section of the income statement, they usually represent one-time events They are not sustainable, ongoing operations, and management often has some choice as to their timing Thus, from an analyst’s point of view, they should be ignored when considering operating income Write-Downs and Restructurings Management has considerable latitude in deciding when an asset is no longer of value to the company When management makes this judgment, a write-down or restructuring occurs Ǡ A write-down, also called a write-off, is a reduction in the value of an asset below its carrying value on the balance sheet Ǡ A restructuring is the estimated cost of a change in a company’s operations It usually involves the closing of facilities and the laying off of personnel Both write-downs and restructurings reduce current operating income and boost future income by shifting future costs to the current accounting period They are often an indication of poor management decisions in the past, such as paying too much for the assets of another company or making operational changes that not work out Companies sometimes take all possible losses in the current year so that future years will be “clean” of these costs Such “big baths,” as they are called, commonly occur when a company is having a bad 620 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity FOCUS ON BUSINESS PRACTICE Can You Believe “Pro Forma” Earnings? Companies must report earnings in accordance with GAAP, but many also report “pro forma” earnings Pro forma reporting of earnings, in the words of one analyst, means that they “have thrown out the bad stuff.”4 In other words, when companies report pro forma earnings, they are telling the investment community to ignore one-time losses and nonoperating items, which may reflect bad decisions in the past In the late 1990s, technology firms with high growth rates and volatile or low earnings and firms that unexpectedly missed earnings targets widely relied on pro forma results More recent research has shown that after the bubble burst in 2001–2002 and after the Enron collapse, the number of companies reporting pro forma earnings declined significantly.5 The investment community learned that GAAP earnings are a better benchmark of a company’s performance because they are based on recognized standards used by all companies, whereas there is no generally accepted way to report pro forma earnings They are whatever the company wants you to see year They also often occur in years when there is a change in management The new management takes a “big bath” in the current year so it can show improved results in future years In a recent year, 35 percent of 600 large companies had write-downs of tangible assets, and 42 percent had restructurings Another 12 percent had write-downs or charges related to intangible assets, often involving goodwill.6 Nonoperating Items The nonoperating items that appear on the income statement include discontinued operations and extraordinary gains and losses, both of which can significantly affect net income In Exhibit 14-1, earnings per common share for income from continuing operations is $2.81, but when all the nonoperating items are taken into consideration, net income per share is $3.35 Discontinued operations are segments of a business, such as a separate major line of business or ones that serve a separate class of customer, that are no longer part of a company’s operations To make it easier to evaluate a company’s ongoing operations, generally accepted accounting principles require that gains and losses from discontinued operations be reported separately on the income statement In Exhibit 14-1, the disclosure of discontinued operations has two parts One part shows that after the decision to discontinue, the income from operations of the disposed segment was $180,000 (net of $70,000 taxes) The other part shows that the loss from the disposal of the segment was $146,000 (net of $84,000 tax savings) (The computation of the gains or losses involved in discontinued operations is covered in more advanced accounting courses.) Extraordinary items are “events or transactions that are distinguished by their unusual nature and by the infrequency of their occurrence.”7 Items usually treated as extraordinary include the following: An uninsured loss from flood, earthquake, fire, or theft A gain or loss resulting from the passage of a new law The expropriation (taking) of property by a foreign government In Exhibit 14-1, the extraordinary gain was $74,000 after taxes of $24,000 Income Taxes STOP 621 & APPLY Assume the following data apply to Ace, Inc.: net sales, $180,000; cost of goods sold, $87,500; loss from discontinued operations (net of taxes of $17,500), $50,000; loss on disposal of discontinued operations (net of taxes of $4,000), $12,500; operating expenses, $32,500; income taxes expense on continuing operations, $25,000 From this information, prepare the company’s income statement for the year ended December 31, 2011 (Ignore earnings per share information.) SOLUTION Ace, Inc Income Statement For the Year Ended December 31, 2011 Net sales Cost of goods sold Gross margin Operating expenses Income from continuing operations before income taxes Income taxes expense Income from continuing operations Discontinued operations Loss from discontinued operations (net of taxes, $17,500) Loss on disposal of discontinued operations (net of taxes, $4,000) Net loss Income Taxes LO2 Show the relationships among income taxes expense, deferred income taxes, and net of taxes Study Note Many people think it is illegal to keep accounting records on a different basis from income tax records However, the Internal Revenue Code and GAAP often not agree To work with two conflicting sets of guidelines, the accountant must keep two sets of records $180,000 87,500 $ 92,500 32,500 $ 60,000 25,000 $ 35,000 ($50,000) (12,500) (62,500) ($ 27,500) Corporations determine their taxable income (the amount on which they pay taxes) by deducting allowable expenses from taxable income The federal tax laws determine which expenses corporations may deduct (Rules for calculating and reporting taxable income in specialized industries, such as banking, insurance, mutual funds, and cooperatives, are highly technical and may vary significantly from the ones we discuss in this chapter.) Table 14-1 shows the tax rates that apply to a corporation’s taxable income A corporation with taxable income of $70,000 would have a federal income tax liability of $12,500: $7,500 (the tax on the first $50,000 of taxable income) plus $5,000 (25 percent of the $20,000 earned in excess of $50,000) Income taxes expense is recognized in the accounting records on an accrual basis It may or may not equal the amount of taxes a corporation actually pays The amount a corporation pays is determined by the rules of the income tax code As we noted earlier in the text, small businesses often keep both their accounting records and tax records on a cash basis, so that the income taxes expense on their income statements equals their income taxes This practice is accrual as long as the difference between the income calculated on an accrual basis and the income calculated for tax purposes is not material However, the purpose of accounting is not to determine taxable income and tax liability, but to determine net income in accordance with GAAP Management has an incentive to use methods that minimize its firm’s tax liability But accountants, who are bound by accrual accounting and the materiality 622 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity TABLE 14-1 Taxable Income Tax Rate Schedule for Corporations, 2008 Tax Liability But Not Over Over $ $ 50,000 75,000 100,000 335,000 10,000,000 15,000,000 18,333,333 50,000 75,000 100,000 335,000 10,000,000 15,000,000 18,333,333 — Of the Amount Over ϩ 15% 7,500 ϩ 25% 13,750 ϩ 34% 22,250 ϩ 39% 113,900 ϩ 34% 3,400,000 ϩ 35% 5,150,000 ϩ 38% 6,416,667 ϩ 35% $ — 50,000 75,000 100,000 335,000 10,000,000 15,000,000 18,333,333 $ Note: Tax rates are subject to change by Congress concept, cannot let tax procedures dictate their method of preparing financial statements if the result would be misleading The difference between accounting income and taxable income, especially in large businesses, can be material This discrepancy can result from differences in the timing of the recognition of revenues and expenses under accrual accounting and the tax method The following table shows some possible variations: Expense recognition Accounts receivable Inventories Depreciation Study Note The discrepancy between GAAP-based tax expense and Internal Revenue Code-based tax liability creates the need for the Deferred Income Taxes account A ‫؍‬ L ؉ SE Ϫ184,000 ϩ289,000 Ϫ105,000 Accrual Accounting Accrual or deferral Allowance Average-cost Straight-line Tax Method At time of expenditure Direct charge-off FIFO Accelerated cost recovery Deferred Income Taxes Income tax allocation is the method used to accrue income taxes expense on the basis of accounting income when accounting income and taxable income differ The account used to record the difference between income taxes expense and income taxes payable is called Deferred Income Taxes For example, in the income statement in Exhibit 14-1, Vistula Corporation has income taxes expense of $289,000 Suppose, however, that Vistula’s actual income taxes payable are $184,000 The following T account and entry show how income tax allocation would treat this situation: Assets ϭ Liabilities ϩ Stockholders’ Equity INCOME T AXES PAYABLE INCOME TAXES EXPENSE Dr Cr Dr Cr Dec 31 184,000 Dec 31 289,000 DEFERRED I NCOME T AXES Dr Cr Dec 31 105,000 Entry in Journal Form: 2010 Dec 31 Income Taxes Expense Income Taxes Payable Deferred Income Taxes To record estimated current and deferred income taxes Dr 289,000 Cr 184,000 105,000 Income Taxes Study Note Deferred Income Taxes is classified as a liability when it has a credit balance and as an asset when it has a debit balance It is further classified as either current or longterm depending on when it is expected to reverse 623 In other years, Vistula’s Income Taxes Payable may exceed its Income Taxes Expense In this case, the entry is the same except that Deferred Income Taxes is debited The Financial Accounting Standards Board has issued specific rules for recording, measuring, and classifying deferred income taxes.8 Deferred income taxes are recognized for the estimated future tax effects resulting from temporary differences in the valuation of assets, liabilities, equity, revenues, expenses, gains, and losses for tax and financial reporting purposes Temporary differences include revenues and expenses or gains and losses that are included in taxable income before or after they are included in financial income In other words, the recognition point for revenues, expenses, gains, and losses is not the same for tax and financial reporting For example, advance payments for goods and services, such as magazine subscriptions, are not recognized as income until the products are shipped However, for tax purposes, advance payments are usually recognized as revenue when cash is received As a result, taxes paid exceed taxes expense, which creates a deferred income taxes asset (or prepaid taxes) Classification of deferred income taxes as current or noncurrent depends on the classification of the asset or liability that created the temporary difference For example, the deferred income taxes asset mentioned above would be classified as current if unearned subscription revenue were classified as a current liability On the other hand, the temporary difference arising from depreciation is related to a long-term depreciable asset Therefore, the resulting deferred income taxes would be classified as long-term If a temporary difference is not related to an asset or liability, it is classified as current or noncurrent based on its expected date of reversal (Temporary differences and the classification of deferred income taxes that results are covered in depth in more advanced courses.) Each year, the balance of the Deferred Income Taxes account is evaluated to determine whether it still accurately represents the expected asset or liability in light of legislated changes in income tax laws and regulations In any given year, the amount a company pays in income taxes is determined by subtracting (or adding) the deferred income taxes for that year from (or to) income taxes expense In subsequent years, the amount of deferred income taxes can vary based on changes in tax laws and rates A survey of the financial statements of 600 large companies indicates the importance of deferred income taxes to financial reporting About 68 percent reported deferred income taxes with a credit balance in the long-term liability section of their balance sheets.9 Net of Taxes The phrase net of taxes indicates that taxes (usually income taxes) have been taken into account in reporting an item in the financial statements The phrase is used in a corporate income statement when a company has items that must be disclosed in a separate section Each such item should be reported net of the applicable income taxes to avoid distorting the income taxes expense associated with ongoing operations and the resulting net operating income For example, assume that a corporation with operating income before income taxes of $240,000 has a total tax expense of $132,000 and that the total income includes a gain of $200,000 on which a tax of $60,000 is due Also assume that the gain is not part of the corporation’s normal operations and must be disclosed separately on the income statement as an extraordinary ... ($0.05) 0.03 ($0. 02) $1.33 0.17 $1.50 ($1.87) ($0.05) 0.03 ($0. 02) $1.30 0.16 $1.46 2, 265.40 2, 265.40 2, 3 12. 70 2, 3 12. 70 2, 446.30 2, 504 .20 ($1.87) ($1.87) Diluted: Continuing operations Discontinued... income 20 07 20 06 $1,779,474 $ 348 ,25 1 $1, 125 ,639 (553,490) (464,171) 40, 522 179,348 ($ 797,791) $ 981,683 645 ,20 2 589,566 (175) (22 9,514) $1,005,079 $1,353,330 588,150 8, 327 (194) (3 ,21 6) $ 593,097... taxes expense, and net income for 20 10 and 20 11: Income before income taxes Income taxes expense Net income 20 10 $ 42, 000 13 ,24 5 $28 ,755 20 11 $ 42, 000 13 ,24 5 $28 ,755 On the balance sheet, deferred