Chapter 4 Flashcards
Income Statement - Usefulness
- Evaluate past performance of the company
- Provide a basis for predicting future performance
- Help assess the risk or uncertainty of achieving future cash flows
Income Statement - Limitations
- Companies omit items they cannot measure reliably
- Income is affected by the accounting methods employed
- Income measurement involves judgment
Income Statement - Quality of Earnings
Companies have incentives to manage income to meet or beat Wall Street expectations, so that
- market price of stock increases and
- value of stock options increase.
Quality of earnings is reduced if earnings management results in information that is less useful for predicting future earnings and cash flows.
Revenues
Inflows or other enhancements of assets of an entity or settlements of its liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.
Examples include sales, fees, interest, dividends, and rents.
Expenses
Outflows or other using-up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.
Examples include cost of goods sold, depreciation, interest, rent, salaries and wages, and taxes.
Gains
Increases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from revenues or investments by owners.
Losses
Decreases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from expenses or distributions to owners.
Multiple-Step Income Statement
- Separates operating transactions from non-operating transactions
- Matches costs and expenses with related revenues
- Highlights certain components of income that analysts use assessing financial performance
Intermediate Components
Operating Section
- Operating Section. A report of the revenues and expenses of the company’s principal operations.
a. Sales or Revenue.
b. Cost of Goods Sold.
c. Selling Expenses.
d. Administrative or General Expenses
Companies are required to report unusual and infrequent items as part of net income so users can better determine the long-run earning power of the company.
These income items fall into four general categories:
- Unusual gains and losses
- Discontinued operations
- Noncontrolling interest
- Earnings per share
Unusual and Infrequent Gains and Losses
a. Unusual. High degree of abnormality and of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the company, taking into account the environment in which it operates.
b. Infrequency of occurrence. Type of transaction that is not reasonably expected to recur in the foreseeable future, taking into account the environment in which the company operates.
Reported in “Other revenues and gains” or “Other expenses and losses” section. (Not shown net of tax.)
Common types of unusual or infrequent gains and losses:
- Losses on write-down (impairment) of receivables; inventories; property, plant, and equipment; goodwill or other intangible assets
- Restructuring charges
- Gains and losses from sale or abandonment of property, plant and equipment
- Effects of a strike
- Gains and losses on extinguishment (redemption) of debt obligations.
- Gains and losses related to casualties such as fires, floods, and earthquakes.
- Gains or losses on sale of investment securities.
Intraperiod Tax Allocation
- Allocation of tax within a period
- Helps users understand impact of income taxes on various components of net income
Intraperiod tax allocation is used for:
- Income from continuing operations
- discontinued operations
Accounting Changes and Errors
Changes in Accounting Principle
- Retrospective adjustment
- Cumulative effect adjustment to beginning retained earnings
- Approach preserves comparability across years
- Examples include:
- change from F I F O to average cost
- change from percentage-of-completion to completed–contract method
Accounting Changes and Errors
Change in Accounting Estimates
- Corrections of errors are treated as prior period adjustments, similar to changes in accounting principles.
- Companies record a correction of an error in the year in which it is discovered.
- They report the error in the financial statements as an adjustment to the beginning balance of retained earnings.
- Examples include:
- Useful lives and salvage values of depreciable assets
- Allowance for uncollectible receivables
- Inventory obsolescence
Accounting Errors
Corrections of Errors
Result from:
- mathematical mistakes
- mistakes in application of accounting principles
- oversight or misuse of facts
- Corrections treated as prior period adjustments
- Adjustment to the beginning balance of retained earnings
Retained Earnings Statement
The retained earnings statement should disclose net income (loss), dividends, adjustments due to changes in accounting principles, error corrections, and restrictions of retained earnings. Increase -Net income -Change in accounting principle -Prior period adjustments
Decrease
- Net loss
- Dividends
- Change in accounting principles
- Prior period adjustments
Comprehensive Income
All changes in equity during a period except those resulting from investments by owners and distributions to owners.
Includes:
-all revenues and gains, expenses and losses reported in net income, and
-all gains and losses that bypass net income but affect stockholders’ equity
Other Comprehensive Income
Gains and losses that bypass net income but affect stockholders’ equity
Statement of Stockholders’ Equity
This statement reports the change in each stockholders’ equity account (including Accumulated Other Comprehensive Income) and in total stockholders’ equity for the period.
- Following items are disclosed in the statement:
- Contributions (issuances of shares) and distributions (dividends) to owners
- Reconciliation of carrying amount of each component of stockholders’ equity from beginning to end of period
Income Statement
Report that measures the success of company operations for a given period of time.
The business and investment community uses the income statement to determine profitability, investment value, and creditworthiness.
It provides investors and creditors with information that helps them predict the amounts, timing, and uncertainty of future cash flows.
Earnings Management
Defined as the planned timing of revenues, expenses, gains, and losses to smooth out bumps in earnings.
In most cases, companies use earnings management to increase income in the current year at the expense of income in future years.
Intermediate Components of the Income Statement
Nonoperating Section
A report of revenues and expenses resulting from secondary or auxiliary activities of the company. In addition, special gains and losses that are infrequent or unusual, or both, are normally reported in this section. Generally these items break down into two main subsections:
a. Other Revenues and Gains. A list of the revenues recognized or gains incurred, generally net of related expenses, from nonoperating transactions. b. Other Expenses and Losses. A list of the expenses or losses incurred, generally net of any related incomes, from nonoperating transactions.
Intermediate Components of the Income Statement
Income Tax
A section reporting federal and state taxes levied on income from continuing operations.
