57 St of CI Textbook

Question 1

The change in a company’s equity during a period of time resulting
from transactions, events, and circumstances other than transactions with owners is known as ____________.

Answer 1

comprehensive income

Question 2

Comprehensive income does not include new issues of __________ or dividend distributions.

Answer 2

shares.

Question 3

What two parts is comprehensive income composed of?

Answer 3

net income and other comprehensive income.

Question 4

What is the formula for comprehensive income?

Answer 4

Comprehensive income = Net income + Other Comprehensive Income

Question 5

A measure of financial performance resulting from the aggregation of revenues,
expenses, gains, and losses that are not items of other comprehensive income is known as ____________________

Answer 5

net income (also known as net earnings)

Question 6

Revenues, expenses, gains, and losses that are explicitly excluded from net income in specific accounting standards is Other _______________ income.

Answer 6

Other comprehensive income (OCI)

Question 7

What do standard setters
specify that other comprehensive income includes?

Answer 7

• unrealized gains and losses on an available-for-sale debt investment portfolio
• unrealized gains and losses on cash flow hedges
• foreign currency translation adjustments
• certain pension adjustments

Question 8

What are the two ways that entities may report comprehensive income?

Answer 8

• In one statement usually called the statement of comprehensive income, or
• In two consecutive statements: the statement of net income and the statement of comprehensive
  income.

The computation of net income and comprehensive income are the same under either
alternative—only the format of the presentation differs.

Question 9

What are the three ways that income statements provide useful information to financial statement users?

Answer 9

1.** Evaluate past performance.** Income statements enable financial statement users to evaluate the entity’s past performance. By disclosing separate components of revenues and expenses, income statements provide useful information about the entity’s overall past performance (i.e., the earnings) and identify the main factors that influence performance.
2. Predict future performance. Income statements have predictive value because they provide a basis for estimating future performance. Predictive value is an aspect of relevance. For example, a firm with a trend of earnings growth over the last 10 years may continue that growth in the future.
3. Assess risks or uncertainties of achieving future cash flows. Income statements provide information that is useful in assessing the risks or uncertainties of achieving future cash flows. Some items of income are more persistent in nature than others, making them strong indicators of future cash flows. For example, revenue from normal sales tends to persist from year to year. However, a gain from the sale of a specialized piece of equipment is unlikely to reoccur in the following year.

Question 10

What are three main limitations of income statements?

Answer 10

1. **Exclude certain items. **Companies cannot measure certain revenues, expenses, gains, and losses reliably and therefore do not report them on the income statements. Unreliable information would result in financial statements that lack faithful representation, one of the fundamental qualitative characteristics identified in the conceptual framework. For example, assume an entity has been sued and a loss is likely. If the firm cannot reasonably estimate the loss, it would not report it on the income statement.
2. Depend on accounting methods selected. The measurement of income is dependent upon the accounting methods selected. For example, identical companies that purchase the same asset but depreciate that asset using different depreciation methods will report a different net income, resulting in reduced comparability.
3. Require extensive judgment and estimation. In general, allowing managers to use judgment when making accounting policy choices that best reflect the economic reality of a transaction will enhance the usefulness of the financial statements. However, due to significant subjectivity and estimation uncertainties involved in financial reporting, management can bias their judgments to enhance the entity’s financial performance by manipulating revenues, gains, expenses, and losses. Even if management is not intentionally biasing reported earnings, different judgments will lead to different income numbers, resulting in reduced comparability.

Question 11

The degree to which reported income provides financial statement users with useful information for predicting future firm performance is known as _________________________.

Answer 11

Earnings quality

Question 12

What are two factors impacting earnings quality?

Answer 12

1. Earnings quality is dependent upon whether the components of earnings presented are permanent or transitory in nature.
2. Management will sometimes engage in earnings management by using the discretion afforded under the accounting standards to manipulate earnings to meet desired goals.

Question 13

In assessing earnings quality, financial statement users gauge the portion of reported earnings that is permanent versus those that are __________________.

Answer 13

transitory.

Question 14

Permanent components of earnings are likely to continue into the ____________. For example, earnings from sales revenue from regular customers are likely to continue into the ______________.

Answer 14

future.

Question 15

Transitory components of earnings are unlikely to continue in the _______________. For example, gains or losses from the sale of equipment are usually transitory.

Answer 15

future

Question 16

Permanent earnings result in ___________ earnings quality whereas transitory earnings result in ____________ earnings quality.

Answer 16

higher; lower

Question 17

Elements presented _______________in the statement of comprehensive income are typically more permanent than those included _____________ in the statement.

Answer 17

earlier; later

Question 18

Show a chart of line items commonly viewed as permanent and transitory.

Answer 18

Question 19

Earnings Management Approaches Used in Practice

Answer 19

A survey of auditors provides a summary of the approaches management uses to manipulate earnings. The most common approach is through the manipulation of expenses and losses (52% of the occurrences of an earnings management attempt) followed by the manipulation of revenues (22% of the occurrences) and opportunities around business combinations (13%), as illustrated in Exhibit 5.2.8

Question 20

Accounting standards allow managers to make judgments that affect the reported earnings number so that they can report the firm’s financial position and performance in the most accurate and informative manner possible. A company’s management understands the company’s financial position and performance best. Thus, managers who are honest and have
a desire to communicate accurate information to their stakeholders can do so.

Question 21

However, some managers may use the areas of judgment inherent in financial reporting
to manage earnings in an opportunistic—and sometimes fraudulent—fashion. For example, managers must determine which expenditures for equipment are material enough to record as an asset as opposed to an expense. They will likely expense a stapler but record a tractor as an asset. There is a gray area in this type of decision that provides an opportunity for earnings management. For example, should we expense a chair or record it as an asset? Of course, recording an asset for a material expenditure that the authoritative literature clearly designates as an expense constitutes fraud. Extreme forms of earnings management are fraudulent and thus illegal.

Question 22

The flexibility in accounting standards gives management the ability to manipulate its reported earnings to meet company objectives.

Question 23

One of managers’ overriding goals for the earnings presentation is to meet or exceed analysts’ earnings
forecasts. Financial analysts are trained to analyze a company, summarize relevant financial information for investors, and provide an opinion about whether investors should buy or sell stock in
a company. In addition, financial analysts publish forecasts of a company’s sales and earnings. If
the company’s actual earnings fall below this forecast, the market will most often react negatively,
causing a drop in stock price.

Question 24

Managers are also motivated to manage earnings to:

Answer 24

1. Beat benchmarks such as prior-quarter earnings or earnings from the same quarter of a prior year.
2. Avoid reporting a loss.
3. Present a firm’s earnings as a smooth, upward trend.
4. Increase their own compensation when bonus plans are based on the net income (or stock
   price) of the firm.

Question 25

Managers employ __________management techniques when actual earnings are either lower or higher than expected.

Answer 25

earnings

Question 26

When low earnings are expected, the big ___________ earnings management technique involves increasing a net loss to allow the firm to show increased net income in the future.

Answer 26

bath

Managers can intentionally report very low or negative earnings in a period by accelerating the recognition of expenses into current-period earnings or deferring revenue recognition to the future reporting periods. This then allows them to report higher earnings in future periods than they would otherwise have reported because they have shifted expenses back to the prior period or shifted revenues to the future period.

Question 27

When earnings are higher than expected in the current period, managers may elect to reduce earnings to create cookie jar _________.

Answer 27

reserves.

Cookie jar reserves are used in future periods to increase earnings as needed, possibly to exceed analysts’ forecasts.

Question 28

What are the four primary elements on the statement of net income?

Answer 28

revenues, expenses, gains, and losses

Question 29

Show a chart showing the four Statement of Net Income Elements

Answer 29

Question 30

Managers make several decisions regarding the presentation, format, and the elements to include
on the income statement, such as:

Answer 30

• Aggregating and summarizing accounts into financial statement components or line items.
• Grouping, or classifying, the components.
• Providing subtotals and totals.

Question 31

Firms aggregate and summarize expenses by either ___________or _____________.

Answer 31

nature; function

Question 32

The nature approach refers to classification by the source of the expense such as:

Answer 32

• payroll costs,
• cost of raw materials used, or
• depreciation expense.

Question 33

The functional approach refers to classification by the use of the expense such as:

Answer 33

• cost of goods sold (manufacturing or merchandising function),
• sales expenses (selling function), or
• administration expenses (administrative function).

Question 34

The choice between the presentation by nature or function depends on factors such as the
industry and company experience. Management selects the presentation that is faithfully representative and most ____________.

Answer 34

relevant.

Question 35

U.S. GAAP allows firms to choose to group revenues and expenses
either by the nature or functional approach. However, the _________ requires reporting by function. Companies using a functional presentation must include specific disclosures in the financial statement notes about the nature of the expenses.

Answer 35

SEC

Question 36

What are the two acceptable income statement formats?

Answer 36

• Multiple-step income statement format
• Single-step income statement format

Question 37

The __________________ income statement format which reports several critical subtotals before computing income from continuing operations (when discontinued operations included) and net income.

Answer 37

Multiple-step income statement format

Question 38

The _________________ income statement format, which combines all revenues and gains and all expenses and losses into single categories.

Answer 38

Single-step income statement format

Question 39

Income statement elements are commonly grouped by and subtotaled into key ______________ measures.

Answer 39

key performance measures

Question 40

What are the key performance measures on the statement of net income?

Answer 40

1. Gross profit
2. Operating income
3. Income before tax (income from continuing operations before tax when discontinued operations
   included)
4. Income from continuing operations (when discontinued operations included)
5. Net income
6. Earnings per share

These subtotals help financial statement users evaluate past performance, predict future performance, and assess risks or uncertainties of achieving future cash flows.

Question 41

The multiple-step income statement format provides more useful information for evaluating
and predicting performance than the single-step net income statement because a multiple-step
format clearly separates key ____________ measures.

Answer 41

key performance measures

Question 42

Because a multiple-step income statement clearly separates key ______________ measures, over
85% of U.S. companies use this format.10 Therefore, we first focus our discussion on the multiplestep
format and then describe the single-step format.

Answer 42

key performance measures

Question 43

What are the five common sections for reporting key performance measures on the multiple-step income statement?

Answer 43

• operating section
• non-operating sections
• income tax provision
• discontinued operations
• net income and earnings per share

Question 44

Show a chart of the five common sections of a multiple-step net income statement.

Answer 44

Question 45

What are the key performance measures in a multiple-step statement of net income?

Answer 45

• gross profit
• operating income
• income from continuing operations before tax
• income from continuing operations
• net income
• earnings per share

Question 46

Show a multiple-step statement of net income and six key performance measures.

Answer 46

Question 47

Show a condensed statement of net income.

Answer 47

Exhibit 5.6 presents a sample condensed, multiple-step statement of net income for Puppini Products.

Question 48

Why do companies use condensed income statements?

Answer 48

Companies use condensed income statements when a large number of line items limits the usefulness of the net income statement. That is, too much detail distracts the user from identifying key measures and relationships on the net income statement. Rather than present a cluttered income statement, many companies will provide a condensed income statement and disclose the details of significant revenues and expenses in the footnotes or supporting schedules.

Question 49

Approximately 15% of reporting entities use a single-step format, which combines all revenues and
gains and all expenses and losses into single categories. _____________ is arrived at in a “single step” by
subtracting aggregate expenses and losses from aggregate revenues and gains.

Answer 49

Net income

Question 50

Show a Single-Step Statement of Net Income

Answer 50

Exhibit 5.9 illustrates the shortcomings of the single-step format. Puppini combines operating and non-operating items. Specifically, total revenues and gains include sales revenue (operating) and interest income (non-operating revenue). The single-step statement also fails to separate items
by function. For example, the cost of goods sold is a critical part of Puppini’s manufacturing function, and sales salaries and advertising expenses are part of the selling function. Finally, Puppini’s net income statement does not include key performance measures such as gross profit and operating income.

Question 51

What are the drawbacks to the single-step format that limit the transparency of information of information for financial statement users?

Answer 51

• It combines revenues and gains and expenses and losses without classification.
• It does not separate operating and non-operating items.
• It does not classify expenses by function, such as selling expenses and general and administrative
  expenses.
• It does not identify key performance measures.

Question 52

Income from portions of the business that are expected to continue into the future is income from continuing _______________.

Answer 52

operations

Question 53

Therefore, income from continuing operations does not include _____________ operations, which are portions of a company that have been disposed of or that are held for sale.

Answer 53

discontinued

Question 54

Firms typically calculate income from continuing operations as the sum of three income statement items. What are these items?

Answer 54

1. Operating income
2. Non-operating items or non-operating revenues/gains and expenses/losses
3. Income tax provision

Question 55

Income includes revenues and expenses from the entity’s principal operations is known as ____________ income.

Answer 55

operating income

Question 56

Gross profit, net sales revenue less cost of goods sold, represents the amount of sales revenue available to cover operating and other expenses and contributes to overall net income that can potentially be distributed to shareholders.

Question 57

Financial statement users analyze the firm’s gross profit to assess trends in profit margins.

Question 58

Operating income is gross profit less all operating expenses (i.e., selling expenses and general and administrative expenses).

Question 59

Operating income is a key financial performance measure because it:

Answer 59

1. Reflects the results of the core operations of the business.
2. Assists a financial statement user in comparing different firms’ operations before considering
   sources of financing and their costs.
3. Provides a measure of income available to all outside stakeholders. The entity’s stakeholders
   are the providers of capital (both debt and equity holders) and the government (through
   taxation).

Question 60

Non-operating income items include gains and losses along with revenues and expenses resulting
from a company’s peripheral activities.

Question 61

Non-operating income items are less useful than operating income items for predicting future earnings.
Consequently, companies separate non-operating income items from the operating items on the statement of net income. For example, a gain or loss on the sale of a specialized piece of equipment is not likely to reoccur and is not part of the core operations of the business.

Question 62

Specific non-operating items include interest revenue, interest expense, dividend revenue, and gains and items with an unusual nature and/or infrequency in occurrence.

Question 63

Items with an unusual nature are transactions or events possessing a high degree of abnormality and unrelated—or only remotely related—to the company’s ordinary activities.

Question 64

Items that are infrequent in occurrence are transactions or events not reasonably expected to reoccur in the foreseeable future.

Question 65

If a gain or loss results from a transaction that is either unusual in nature and/or infrequent in occurrence, then companies report the event as a separate line item within income from continuing operations or disclose the item in the notes.

Question 66

Examples of transactions or events that are unusual or infrequent
include:
* Restructuring charges.
* Losses on asset impairments.
* Gains and losses on disposals of assets.
* Losses due to natural disasters such as an earthquake or hurricane.

Question 67

Typically, companies sum operating income with the non-operating items to determine income before tax.

Question 68

The income tax provision reports the tax expense determined by considering the income tax
effects of operating in all jurisdictions. Specifically, it includes U.S. federal, state, local, and
foreign income taxes.

Question 69

The income tax provision does not include other types of taxes. For example, payroll tax and
property taxes are included in operating expenses. Also, note that companies report discontinued
operations net of tax. Consequently, companies do not report the income tax expense associated
with discontinued operations in the income tax provision.

Question 70

Companies deduct the income tax provision from income before taxes to report net income. For many companies, net income is the final line on the income statement. As we address in the sections that follow, if companies report any discontinued operations, they include these gains,
losses, and income following net income. As a result, income after the income tax provision is
then called income from continuing operations, and the line item before income tax expense is
called income from continuing operations before tax.

Question 71

Discontinued operations are portions of the business that a company has disposed of or is in the process of disposing of. The discontinued operations section of the statement of net income includes any income from components of an entity or a group of components of an entity that have been disposed of, abandoned during the reporting period, or are classified as held for sale as of the end of the reporting period.

Discontinued Operations

Question 72

A component of an entity has three main characteristics:

Discontinued Operations

Answer 72

It is
(1) a portion of the entity
(2) comprising operations and cash flows
(3) that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity.

Question 73

A component of an entity can be:

Discontinued Operations

Answer 73

• a reportable segment,
• an operating segment,
• a reporting unit,
• a subsidiary, or
• an asset group.

Question 74

That is, a company must be able to separate the discontinued component’s operations and cash flows from the continuing operations’ earnings and cash flows. It should also be able to separately report discontinued operations in its financial statements. After a company has determined that a portion of a business is a component of an entity or a group of components of an entity, the company must also demonstrate that the disposal represents a strategic shift that has or will have a major effect on the entity’s operations and financial results.

Discontinued Operations

Answer 74

Criteria and Reporting for Discontinued Operations

Question 75

Companies report income from discontinued operations and continuing operations separately.

Discontinued Operations

Question 76

The separate reporting provides financial statement users with a measure of income from continuing operations, which is a preferred basis for predicting future performance. Clearly, a discontinued portion of a business will no longer generate future earnings and cash flows.

Question 77

Companies report three main types of income, gain, or loss under discontinued operations on the income statement:

Answer 77

1. Income or loss from operations of discontinued segment, unit or group, net of tax.
2. Loss on initial remeasurement of net assets held for sale to fair value less disposal costs, net of tax. In subsequent remeasurements, a loss or gain up to previously recognized losses can be reported.
3. Gain or loss on disposal of assets or disposal group(s) constituting the discontinued operation, net of tax.

Question 78

Companies present the operating income, loss, or gain from the discontinued operation and income from continuing operations separately.

Question 79

If the company has sold the discontinued operation, it includes the operating income from the beginning of the reporting period to the date of disposal in the discontinued operations section of the statement of net income.

Question 80

If the company is holding the discontinued operation for sale as of the end of the reporting period, it presents the operating income from the entire reporting period in the discontinued operations section of the statement of net income. For example, assume a company earned $22 million of net income of which $3 million was from a loss on discontinued operations. The company would report income from continuing operations of $25 million and a $3 million loss from discontinued operations.

Question 81

When a company decides to discontinue an operation, it remeasures the assets and liabilities of that operation to their fair values less selling costs if this amount is lower than their carrying value. Because the assets and liabilities are being held for sale, their value in the market is the most relevant value to financial statement users. In the first period that the company remeasures the assets and liabilities of the operation, only a loss is permitted. If a write-down is necessary, the loss is equal to the difference between the book value of the net assets and their fair value net of selling costs.

Question 82

If the company writes down the net assets to fair value net of selling costs in one period and still holds the net assets in the next period, the company will report a gain in the subsequent period if the fair value net of selling costs increased. However, the write-up cannot result in a carrying value greater than the carrying value of the net assets before the write-down.

Question 83

When the company sells the discontinued operation, there could be a realized gain or loss on the sale. Companies present all amounts on the income statement related to discontinued operations net of tax.

Question 84

Net of tax means that the amount of income, gain, or loss, reported includes any income tax effects. As noted earlier, the income tax expense (or benefit) related to discontinued operations is not included in the tax provision related to continuing operations.

Question 85

Companies are also required to disclose the following other income and expense items related to discontinued operations in the footnotes to the financial statements:

Answer 85

1. Pre-tax income (loss)
2. Pre-tax income (loss) attributable to the company’s shareholders
3. Major line items to arrive at pre-tax income (loss) such as revenues and cost of sales, depreciation, and interest expense
4. Reconciliation of the major items making up the pre-tax profit (loss) disclosed in the notes to financial statements to the after-tax profit (loss) presented in the income statement
5. Carrying amounts of the major classes of assets and liabilities included as part of a discontinued operations and classified as held for sale
6. Gain or loss on remeasurement of net assets held for disposal
7. Reconciliation of the carrying amounts of major classes of assets and liabilities disclosed in the notes to financial statements to total assets and liabilities classified as held for sale on the balance sheet
8. Either total operating and investing cash flows related to the discontinued operation, or the depreciation, amortization, capital expenditures, and significant operating and investing noncash items associated with the discontinued operation.

Question 86

Reporting requirements for discontinued requirements:

Answer 86

Question 87

Companies commonly separate net income into net income attributable to their stockholders and net income attributable to the noncontrolling interests. Companies close net income attributable to their shareholders to retained earnings.

Question 88

There is a noncontrolling interest when one company controls another company (e.g., a subsidiary) but owns less than 100% of its voting shares. The controlling company adds all of the subsidiary’s income to its own because it controls the subsidiary’s ability to generate income. However, because it does not own 100% of the subsidiary, the controlling company must identify the amount that is attributable to noncontrolling owners. The noncontrolling interest line item on the income statement represents the income attributable to the portion of a subsidiary owned by others.24 The portion of income (loss) attributed to the noncontrolling interest is deducted (added) on the income statement to arrive at income attributed to the controlling interest. Exhibit 5.8 shown previously presents the net income statement of Kimberly-Clark Corporation. Kimberly-Clark reported $2,219 million of net income in 2016.25 Of this, $2,166 million is attributable to its shareholders and will be added to retained earnings, and $53 million is attributable to the noncontrolling interests.

Question 89

Earnings per share represents the amount of earnings assigned to each outstanding share of the company’s common stock. Companies report earnings per share for continuing operations, discontinued operations, and net income in a supplemental section of the income statement, directly below net income or loss for the period. Companies report earnings per share on both a basic and diluted basis.

Question 90

So far we have focused our discussion on the statement of net income, which does not include other comprehensive income (OCI). Companies may choose to report comprehensive income in one statement (usually called the statement of comprehensive income) or in two consecutive statements (the statement of net income and the statement of comprehensive income). The primary difference is whether a firm presents the income statement(s) on one page or two. In this section, we outline the elements presented and the format used for the statement of comprehensive income; note that these areas are consistent between the one- and two-statement alternatives. Companies presenting in two statements are required to include the statement of comprehensive income immediately after the statement of net income (i.e., on the next page of the financial report). The statement of comprehensive income begins with net income and then presents the components of other comprehensive income, ultimately arriving at a figure for comprehensive income. Firms presenting one statement of comprehensive income combine the statement of net income with a presentation of OCI.

Question 91

Statement of Comprehensive Income Elements The Codification does not clearly define the concepts of net income versus OCI. However, U.S. GAAP provides a full list of the elements that should be included in OCI.27 The key line items consist of:

Answer 91

1. Unrealized gains and losses from the available-for-sale portfolio of debt investment securities and derivatives classified as cash flow hedges.
2. Foreign currency translation gains and losses.
3. Unrecognized pension costs (benefits) from adjustments needed to bring the accounting pension asset or liability to the funded status of the pension plan.

Question 92

The items reported as other comprehensive income typically have at least one of these three characteristics:

Answer 92

1. There is a low probability of cash realization in the short run.
2. These items are transitory components of income; excluding them from the income statement reduces earnings volatility.
3. The majority of these items are not part of the entity’s normal operations. Although not included in the net income statement, the disclosure of OCI items significantly improves the usefulness of the financial statements. For example, the disclosure of the unrealized gain or loss on available-for-sale investments can enhance an analyst’s ability to understand how effectively a company is managing its investment portfolio. This information also assists the analyst in identifying potential realized gains or losses on future disposals of the investments. Similarly, OCI will provide information regarding future realized gains or losses from the sale of assets held by foreign subsidiaries or the liquidation of significant pension obligations.