4-income-statement-and-related-information
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4-income-statement-and-related-information

Course Number: ACC 360, Spring 2011

College/University: Grand Canyon

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CHAPTER 4 I N COME STATE ME NT AN D R E L ATE D I N FO R M ATI O N LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 5 6 7 8 Understand the uses and limitations of an income statement. Prepare a single-step income statement. Prepare a multiple-step income statement. Explain how to report irregular items. Explain intraperiod tax allocation. Identify where to report earnings per...

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N CHAPTER 4 I COME STATE ME NT AN D R E L ATE D I N FO R M ATI O N LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 2 3 4 5 6 7 8 Understand the uses and limitations of an income statement. Prepare a single-step income statement. Prepare a multiple-step income statement. Explain how to report irregular items. Explain intraperiod tax allocation. Identify where to report earnings per share information. Prepare a retained earnings statement. Explain how to report other comprehensive income. Which Income Number? Pro forma reporting, in which companies provide investors a choice in reported income numbers, has been very popular among companies in the S&P 500. For example, in 2001, in addition to income measured according to generally accepted accounting principles (GAAP), 77 percent of S&P 500 companies also reported an income measure that they adjusted for certain items. Companies make these adjustments because they believe the items are not representative of operating results. Characteristic of pro forma reporting practices is Amazon.com. It has adjusted for items such as stock-based compensation, amortization of goodwill and intangibles, impairment charges, and equity in losses of investees. All of these adjustments make pro forma earnings higher than GAAP income. In its earnings announcement, Amazon defended its pro forma reporting, saying that it gives better insight into the fundamental operations of the business. An update to this earlier report on non-GAAP reporting indicates a decline in pro forma income reporting. In 2003, the percentage of companies practicing pro forma reporting dropped to 54 percent, and the flavor of pro forma reporting also changed between these two periods. For example, in 2003, there were fewer income-increasing pro forma reports, and there was a narrowing in the magnitude of the gap between the pro forma and GAAP earnings (Entwistle et al., 2006). 130 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark What happened? Several commentators point to a couple of factors. First, Sarbanes-Oxley was passed in 2002, and it put a new focus on more transparent reporting. Second, the SEC issued Regulation G, which requires companies to reconcile non-GAAP financial measures to GAAP. This regulation provides investors with a roadmap to analyze adjustments companies make to their GAAP numbers to arrive at pro forma results. Regulation G addresses the concern that investors have a hard time comparing one companys pro forma measures with results reported by another company that has a different idea of what is fundamental to its business. Also, there is concern that companies may use pro forma reporting to deflect investor attention from bad news. This trend toward more transparent income reporting is encouraging, but managers still like pro forma reporting, as indicated by a recent survey in response to the FASB financial statement presentation project. Over 55 percent polled indicated they would continue to practice pro forma reporting, even with a revised income statement format (Stuart, 2008). Sources: G. Entwistle, G. Feltham, and C. Mbagwu, Financial Reporting Regulation and the Reporting of Pro Forma Earnings, Accounting Horizons (March 2006) pp. 3955; and A. Stuart, A New Vision for Accounting: Robert Herz and FASB Are Preparing a Radical New Format for Financial Statements, CFO Magazine (February 2008), pp. 4953. See also SEC Regulation G, Conditions for Use of Non-GAAP Financial Measures, Release No. 33-8176 (March 28, 2003). PREVIEW OF CHAPTER 4 As we indicate in the opening story, investors need complete and comparable information on income and its components to assess company profitability correctly. In this chapter we examine the many different types of revenues, expenses, gains, and losses that affect the income statement and related information, as follows. I N C O M E S TAT E M E N T A N D R E L AT E D I N F O R M AT I O N I N C O M E S TAT E M E N T Usefulness Limitations Quality of earnings F O R M AT O F T H E I N C O M E S TAT E M E N T Elements Single-step Multiple-step Condensed income statements REPORTING IRREGULAR ITEMS Discontinued operations Extraordinary items Unusual gains and losses Changes in accounting principle Changes in estimates Corrections of errors SPECIAL REPORTING ISSUES Intraperiod tax allocation Earnings per share Retained earnings statement Comprehensive income 131 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 132 Chapter 4 Income Statement and Related Information INCOME STATEMENT The income statement is the report that measures the success of company operations for a given period of time. (It is also often called the statement of income or statement of earnings.1) The business and investment community uses the income Objective1 statement to determine profitability, investment value, and creditworthiness. It Understand the uses and limitations provides investors and creditors with information that helps them predict the of an income statement. amounts, timing, and uncertainty of future cash flows. Usefulness of the Income Statement Ford Toyota Revenues Expenses $ Profits < The income statement helps users of financial statements predict future cash flows in a number of ways. For example, investors and creditors use the income statement information to: Revenues Expenses $ Profits Which company did better last year? GE Profits ? ? Past Now Future Hmm....Where am I headed? IBM Income for Year Ended 12/31/10 Revenues Operating expenses Operating income Unusual or extraordinary items $ Net Income Recurring? Yes No ? Recurring items are more certain in the future. 1. Evaluate the past performance of the company. Examining revenues and expenses indicates how the company performed and allows comparison of its performance to its competitors. For example, analysts use the income data provided by Ford to compare its performance to that of Toyota. 2. Provide a basis for predicting future performance. Information about past performance helps to determine important trends that, if continued, provide information about future performance. For example, General Electric at one time reported consistent increases in revenues. Obviously past success does not necessarily translate into future success. However, analysts can better predict future revenues, and hence earnings and cash flows, if a reasonable correlation exists between past and future performance. 3. Help assess the risk or uncertainty of achieving future cash flows. Information on the various components of incomerevenues, expenses, gains, and losseshighlights the relationships among them. It also helps to assess the risk of not achieving a particular level of cash flows in the future. For example, investors and creditors often segregate IBMs operating performance from other nonrecurring sources of income because IBM primarily generates revenues and cash through its operations. Thus, results from continuing operations usually have greater significance for predicting future performance than do results from nonrecurring activities and events. In summary, information in the income statementrevenues, expenses, gains, and losseshelps users evaluate past performance. It also provides insights into the likelihood of achieving a particular level of cash flows in the future. Limitations of the Income Statement Because net income is an estimate and reflects a number of assumptions, income statement users need to be aware of certain limitations associated with its information. Some of these limitations include: Exp Exp Rev Rev Rev Profits Unrealized Earnings Brand value You left something out! 1. Companies omit items from the income statement that they cannot measure reliably. Current practice prohibits recognition of certain items from the determination of income even though the effects of these items can arguably affect the companys performance. For example, a company may not record unrealized gains and losses on certain investment securities in income when there is uncertainty that it will ever realize the changes in value. In addition, more and more companies, like 1 Accounting Trends and Techniques2007 (New York: AICPA) indicates that out of 600 companies surveyed, 260 used the term income in the title of income statements, 252 used operations (many companies had net losses), and 87 used earnings. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Income Statement 133 Cisco Systems and Microsoft, experience increases in value due to brand recognition, customer service, and product quality. A common framework for identifying and reporting these types of values is still lacking. 2. Income numbers are affected by the accounting methods employed. One company may depreciate its plant assets on an accelerated basis; another chooses straight-line depreciation. Assuming all other factors are equal, the first company will report lower income. In effect, we are comparing apples to oranges. 3. Income measurement involves judgment. For example, one company in good faith may estimate the useful life of an asset to be 20 years while another company uses a 15-year estimate for the same type of asset. Similarly, some companies may make optimistic estimates of future warranty costs and bad debt write-offs, which results in lower expense and higher income. In summary, several limitations of the income statement reduce the usefulness of its information for predicting the amounts, timing, and uncertainty of future cash flows. Income Using: Straight-line Depreciation Accelerated Depreciation Hmm... Is the income the same? Estimates High useful lives Low warranty costs Low bad debts $ High Income Hey...you might be too optimistic! Quality of Earnings So far, our discussion has highlighted the importance of information in the income statement for investment and credit decisions, including the evaluation of the company and its managers.2 Companies try to meet or beat Wall Street expectations so that the market price of their stock and the value of managements stock options increase. As a result, companies have incentives to manage income to meet earnings targets or to make earnings look less risky. The SEC has expressed concern that the motivations to meet earnings targets may override good business practices. This erodes the quality of earnings and the quality of financial reporting. As indicated by one SEC chairman, Managing may be giving way to manipulation; integrity may be losing out to illusion.3 As a result, the SEC has taken decisive action to prevent the practice of earnings management. What is earnings management? It is often 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. For example, they prematurely recognize sales (i.e., before earned) in order to boost earnings. As one commentator noted, . . . its like popping a cork in [opening] a bottle of wine before it is ready. Companies also use earnings management to decrease current earnings in order to increase income in the future. The classic case is the use of cookie jar reserves. Companies establish these reserves by using unrealistic assumptions to estimate liabilities for such items as loan losses, restructuring charges, and warranty returns. The companies then reduce these reserves in the future to increase reported income in the future. Such earnings management negatively affects the quality of earnings if it distorts the information in a way that is less useful for predicting future earnings and cash flows. Markets rely on trust. The bond between shareholders and the company must remain strong. Investors or others losing faith in the numbers reported in the financial statements will damage U.S. capital markets. As we mentioned in the opening story, we need heightened scrutiny of income measurement and reporting to ensure the quality of earnings and investors confidence in the income statement. 2 In support of the usefulness of income information, accounting researchers have documented an association between the market prices of companies and reported income. See W. H. Beaver, Perspectives on Recent Capital Markets Research, The Accounting Review (April 2002), pp. 453474. 3 A. Levitt,The Numbers Game. Remarks to NYU Center for Law and Business, September 28, 1998 (Securities and Exchange Commission, 1998). PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 134 Chapter 4 Income Statement and Related Information MANAGE UP, MANAGE DOWN Managing earnings up or down adversely affects the quality of earnings. For example, in one of the earliest and most notable cases, W. R. Grace managed earnings down by taking excess cookie jar reserves in good earnings years. During the early 1990s, Grace was growing fast, with profits increasing 30 percent annually. Analysts targets had Grace growing 24 percent each year. Worried about meeting these growth expectations, Grace began stashing away excess profits in an allpurpose reserve (a cookie jar). In 1995, when profits fell below expectations, Grace wanted to reduce this reserve and so increase income. The SEC objected, noting this violated generally accepted accounting principles. As another example, MicroStrategy managed earnings up by booking revenue for future software upgrades, even though it had not yet delivered them. And Rent-Way, Inc. managed its earnings up by understating some $65 million in expenses relating to such items as automobile maintenance and insurance payments. Does the market value accounting quality? Apparently so: The stock of each of these companies took a beating in the marketplace when the earnings management practices came to light. For example, Rent-Ways stock price plummeted from above $25 per share to below $10 per share when it announced restatements for its improper expense accounting. So, whether managing earnings up or down, companies had better be prepared to pay the price for poor accounting quality. What do the numbers mean? FORMAT OF THE INCOME STATEMENT Elements of the Income Statement Net income results from revenue, expense, gain, and loss transactions. The income statement summarizes these transactions. This method of income measurement, the transaction approach, focuses on the income-related activities that have occurred during the period.4 The statement can further classify income by customer, product line, or function or by operating and nonoperating, continuing and discontinued, and regular and irregular categories.5 The following lists more formal definitions of income-related items, referred to as the major elements of the income statement. ELEMENTS OF FINANCIAL STATEMENTS 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 entitys ongoing major or central operations. 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 entitys ongoing major or central operations. 4 The most common alternative to the transaction approach is the capital maintenance approach to income measurement. Under this approach, a company determines income for the period based on the change in equity, after adjusting for capital contributions (e.g., investments by owners) or distributions (e.g., dividends). The main drawback associated with the capital maintenance approach is that the components of income are not evident in its measurement. The Internal Revenue Service uses the capital maintenance approach to identify unreported income and refers to this approach as the net worth check. 5 The term irregular encompasses transactions and other events that are derived from developments outside the normal operations of the business. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Format of the Income Statement 135 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.6 Revenues take many forms, such as sales, fees, interest, dividends, and rents. Expenses also take many forms, such as cost of goods sold, depreciation, interest, rent, salaries and wages, and taxes. Gains and losses also are of many types, resulting from the sale of investments or plant assets, settlement of liabilities, write-offs of assets due to impairments or casualty. The distinction between revenues and gains, and between expenses and losses, depend to a great extent on the typical activities of the company. For example, when McDonalds sells a hamburger, it records the selling price as revenue. However, when McDonalds sells land, it records any excess of the selling price over the book value as a gain. This difference in treatment results because the sale of the hamburger is part of McDonalds regular operations. The sale of land is not. We cannot overemphasize the importance of reporting these elements. Most decision makers find the parts of a financial statement to be more useful than the whole. As we indicated earlier, investors and creditors are interested in predicting the amounts, timing, and uncertainty of future income and cash flows. Having income statement elements shown in some detail and in comparison with prior years data allows decision makers to better assess future income and cash flows. Single-Step Income Statements In reporting revenues, gains, expenses, and losses, companies often use a format known as the single-step income statement. The single-step statement consists of just two groupings: revenues and expenses. Expenses are deducted from revenues to arrive at net income or loss, hence the expression single-step. Frequently companies report income tax separately as the last item before net income to indicate its relationship to income before income tax. Illustration 4-1 shows the single-step income statement of Dan Deines Company. DAN DEINES COMPANY INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2010 Revenues Net sales Dividend revenue Rental revenue Total revenues Expenses Cost of goods sold Selling expenses Administrative expenses Interest expense Income tax expense Total expenses Net income Earnings per common share 1,982,541 453,028 350,771 126,060 66,934 2,979,334 $ 164,489 $1.74 $2,972,413 98,500 72,910 3,143,823 Objective2 Prepare a single-step income statement. ILLUSTRATION 4-1 Single-Step Income Statement 6 Elements of Financial Statements, Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, 1985), pars. 7889. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 136 Chapter 4 Income Statement and Related Information Companies that use the single-step income statement in financial reporting typically do so because of its simplicity. In recent years, though, the multiple-step form has gained popularity.7 The primary advantage of the single-step format lies in its simple presentation and the absence of any implication that one type of revenue or expense item has priority over another. This format thus eliminates potential classification problems. Objective3 Prepare a multiple-step income statement. Multiple-Step Income Statements Some contend that including other important revenue and expense classifications makes the income statement more useful. These further classifications include: 1. A separation of operating and nonoperating activities of the company. For example, companies often present income from operations followed by sections entitled Other revenues and gains and Other expenses and losses. These other categories include such transactions as interest revenue and expense, gains or losses from sales of long-term assets, and dividends received. 2. A classification of expenses by functions, such as merchandising (cost of goods sold), selling, and administration. This permits immediate comparison with costs of previous years and with other departments in the same year. Companies use a multiple-step income statement to recognize these additional relationships. This statement separates operating transactions from nonoperating transactions, and matches costs and expenses with related revenues. It highlights certain intermediate components of income that analysts use to compute ratios for assessing the performance of the company. Intermediate Components of the Income Statement When a company uses a multiple-step income statement, it may prepare some or all of the following sections or subsections. INCOME STATEMENT SECTIONS 1 OPERATING SECTION. A report of the revenues and expenses of the companys principal operations. (a) Sales or Revenue Section. A subsection presenting sales, discounts, allowances, returns, and other related information. Its purpose is to arrive at the net amount of sales revenue. (b) Cost of Goods Sold Section. A subsection that shows the cost of goods that were sold to produce the sales. (c) Selling Expenses. A subsection that lists expenses resulting from the companys efforts to make sales. (d) Administrative or General Expenses. A subsection reporting expenses of general administration. 7 Accounting Trends and Techniques2007 (New York: AICPA). Of the 600 companies surveyed by the AICPA, 518 employed the multiple-step form, and 82 employed the single-step income statement format. This is a reversal from 1983, when 314 used the single-step form and 286 used the multiple-step form. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Format of the Income Statement 137 2 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, but not 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 earned 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. 3 INCOME TAX. A short section reporting federal and state taxes levied on income from continuing operations. 4 DISCONTINUED OPERATIONS. Material gains or losses resulting from the disposition of a segment of the business. 5 EXTRAORDINARY ITEMS. Unusual and infrequent material gains and losses. 6 EARNINGS PER SHARE. Although the content of the operating section is always the same, the organization of the material can differ. The breakdown above uses a natural expense classification. Manufacturing concerns and merchandising companies in the wholesale trade commonly use this. Another classification of operating expenses, recommended for retail stores, uses a functional expense classification of administrative, occupancy, publicity, buying, and selling expenses. Usually, financial statements provided to external users have less detail than internal management reports. Internal reports include more expense categoriesusually grouped along lines of responsibility. This detail allows top management to judge staff performance. Irregular transactions such as discontinued operations and extraordinary items are reported separately, following income from continuing operations. Dan Deines Companys statement of income illustrates the multiple-step income statement. This statement, shown in Illustration 4-2 (on page 138), includes items 1, 2, 3, and 6 from the list above.8 Note that in arriving at net income, the statement presents three subtotals of note: 1. Net sales revenue 2. Gross profit 3. Income from operations The disclosure of net sales revenue is useful because Deines reports regular revenues as a separate item. It discloses irregular or incidental revenues elsewhere in the income statement. As a result, analysts can more easily understand and assess trends in revenue from continuing operations. Similarly, the reporting of gross profit provides a useful number for evaluating performance and predicting future earnings. Statement readers may study the trend in gross profits to determine how successfully a company uses its resources. They also may use that information to understand how competitive pressure affected profit margins. Finally, disclosing income from operations highlights the difference between regular and irregular or incidental activities. This disclosure helps users recognize that incidental or irregular activities are unlikely to continue at the same level. Furthermore, 8 Companies must include earnings per share or net loss per share on the face of the income statement. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 138 Chapter 4 Income Statement and Related Information disclosure of operating earnings may assist in comparing different companies and assessing operating efficiencies. ILLUSTRATION 4-2 Multiple-Step Income Statement DAN DEINES COMPANY INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2010 Sales Revenue Sales Less: Sales discounts Sales returns and allowances $3,053,081 $ 24,241 56,427 80,668 2,972,413 1,982,541 989,872 i es o Net sales revenue Cost of goods sold Gross profit Operating Expenses Selling expenses Sales salaries and commissions Sales office salaries Travel and entertainment Advertising expense Freight and transportation-out Shipping supplies and expense Postage and stationery Telephone and Internet expense Depreciation of sales equipment Administrative expenses Officers salaries Office salaries Legal and professional services Utilities expense Insurance expense Depreciation of building Depreciation of office equipment Stationery, supplies, and postage Miscellaneous office expenses Income from operations Other Revenues and Gains Dividend revenue Rental revenue Other Expenses and Losses Interest on bonds and notes Income before income tax Income tax Net income for the year Earnings per common share 98,500 72,910 w co llege/k Income Statements for Real Companies PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile y. c o m / 202,644 59,200 48,940 38,315 41,209 24,712 16,788 12,215 9,005 186,000 61,200 23,721 23,275 17,029 18,059 16,000 2,875 2,612 453,028 350,771 803,799 186,073 171,410 357,483 126,060 231,423 66,934 $ 164,489 $1.74 Condensed Income Statements In some cases a single income statement cannot possibly present all the desired expense detail. To solve this problem, a company includes only the totals of expense groups in the statement of income. It then also prepares supplementary schedules to support the totals. This format may thus reduce the income statement itself to a few lines on a single sheet. For this reason, readers who wish to study all the reported data on operations must give their attention to the supporting schedules. For example, consider the income statement shown in Illustration 4-3 for Dan Deines Company. This statement is a condensed version of the more detailed multiple-step statement presented earlier. It is more representative of the type found in practice. Reporting Irregular Items 139 ILLUSTRATION 4-3 Condensed Income Statement DAN DEINES COMPANY INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2010 Net sales Cost of goods sold Gross profit Selling expenses (see Note D) Administrative expenses Income from operations Other revenues and gains Other expenses and losses Income before income tax Income tax Net income for the year Earnings per share $453,028 350,771 $2,972,413 1,982,541 989,872 803,799 186,073 171,410 357,483 126,060 231,423 66,934 $ 164,489 $1.74 Illustration 4-4 shows an example of a supporting schedule, cross-referenced as Note D and detailing the selling expenses. ILLUSTRATION 4-4 Sample Supporting Schedule Note D: Selling expenses Sales salaries and commissions Sales office salaries Travel and entertainment Advertising expense Freight and transportation-out Shipping supplies and expense Postage and stationery Telephone and Internet expense Depreciation of sales equipment Total Selling Expenses $202,644 59,200 48,940 38,315 41,209 24,712 16,788 12,215 9,005 $453,028 How much detail should a company include in the income statement? On the one hand, a company wants to present a simple, summarized statement so that readers can readily discover important factors. On the other hand, it wants to disclose the results of all activities and to provide more than just a skeleton report. As we showed above, the income statement always includes certain basic elements, but companies can present them in various formats. REPORTING IRREGULAR ITEMS Objective4 As the use of a multiple-step or condensed income statement illustrates, GAAP Explain how to report irregular allows flexibility in the presentation of the components of income. However, the items. FASB developed specific guidelines in two important areas: what to include in income and how to report certain unusual or irregular items. What should be included in net income has been a controversy for many years. For example, should companies report irregular gains and losses, and corrections of revenues and expenses of prior years, as part of retained earnings? Or should companies first present them in the income statement and then carry them to retained earnings? This issue is extremely important because the number and magnitude of irregular items are substantial. For example, Illustration 4-5 (on page 140) identifies the most common types and number of irregular items reported in a survey of 600 large companies. Notice that more than 40 percent of the surveyed firms reported restructuring charges, PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 140 Chapter 4 Income Statement and Related Information ILLUSTRATION 4-5 Number of Irregular Items Reported in a Recent Year by 600 Large Companies 1,500 429 250 200 150 100 50 4 0 Extraordinary Items Discontinued Operations Restructuring Charges Write-downs, Gains on Asset Sales 119 238 which often contain write-offs and other one-time items. About 20 percent of the surveyed firms reported either an extraordinary item or a discontinued operation charge. And many companies recorded an asset write-down or a gain on a sale of an asset.9 As our opening story discusses, we need consistent and comparable income reporting practices to avoid promotional information reported by companies. Developing a framework for reporting irregular items is important to ensure reliable income information.10 Some users advocate a current operating performance approach to income reporting. These analysts argue that the most useful income measure reflects only regular and recurring revenue and expense elements. Irregular items do not reflect a companys future earning power. In contrast, others warn that a focus on operating income potentially misses important information about a companys performance. Any gain or loss experienced by the company, whether directly or indirectly related to operations, contributes to its longrun profitability. As one analyst notes, write-offs matter. . . . They speak to the volatility ARE ONE-TIME CHARGES BUGGING YOU? Which numbernet income or income from operationsshould an analyst use in evaluating companies that have unusual items? Some argue that operating income better represents what will happen in the future. Others note that special items are often no longer special. For example, one study noted that in 2001, companies in the Standard & Poors 500 index wrote off items totaling $165 billionmore than in the prior five years combined. A study by Multex.com and the Wall Street Journal indicated that analysts should not ignore these charges. Based on data for companies taking unusual charges from 19962001, the study documented that companies reporting the largest unusual charges had more negative stock price performance following the charge, compared to companies with smaller charges. Thus, rather than signaling the end of bad times, these unusual charges indicated poorer future earnings. In fact, some analysts use these charges to weed out stocks that may be headed for a fall. Following the cockroach theory, any charge indicating a problem raises the probability of more problems. Thus, investors should be wary of the increasing use of restructuring and other one-time charges, which may bury expenses that signal future performance declines. Source: Adapted from J. Weil and S. Liesman, Stock Gurus Disregard Most Big Write-offs, But They Often Hold Vital Clues to Outlook, Wall Street Journal Online (December 31, 2001). What do the numbers mean? 9 Accounting Trends and Techniques2007 (New York: AICPA). 10 The FASB and the IASB are working on a joint project on financial statement presentation, which is studying how to best report income as well as information presented in the balance sheet and the statement of cash flows. See http://www.fasb.org/project/financial_ statement_presentation.shtml. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Reporting Irregular Items 141 of (past) earnings.11 As a result, analysts can use some nonoperating items to assess the riskiness of future earnings. Furthermore, determining which items are operating and which are irregular requires judgment. This might lead to differences in the treatment of irregular items and to possible manipulation of income measures. So, what to do? The accounting profession has adopted a modified all-inclusive concept and requires application of this approach in practice. This approach indicates that companies record most items, including irregular ones, as part of net income.12 In addition, companies are required to highlight irregular items in the financial statements so that users can better determine the long-run earning power of the company. Irregular items fall into six general categories, which we discuss in the following sections: I NTERNATIONAL I NSIGHT In many countries the modified all-inclusive income statement approach does not parallel that of the U.S. For example, companies in these countries take some gains and losses directly to owners equity accounts instead of reporting them on the income statement. 1. 2. 3. 4. 5. 6. Discontinued operations. Extraordinary items. Unusual gains and losses. Changes in accounting principle. Changes in estimates. Corrections of errors. Discontinued Operations As Illustration 4-5 shows, one of the most common types of irregular items is discontinued operations. A discontinued operation occurs when two things happen: (a) a company eliminates the results of operations and cash flows of a component from its ongoing operations, and (b) there is no significant continuing involvement in that component after the disposal transaction. To illustrate a component, S. C. Johnson manufactures and sells consumer products. It has several product groups, each with different product lines and brands. For S. C. Johnson, a product group is the lowest level at which it can clearly distinguish the operations and cash flows from the rest of the companys operations. Therefore each product group is a component of the company. If a component were disposed of, S. C. Johnson would classify it as a discontinued operation. Here is another example. Assume that Softso Inc. has experienced losses with certain brands in its beauty-care products group. As a result, Softso decides to sell that part of its business. It will discontinue any continuing involvement in the product group after the sale. In this case, Softso eliminates the operations and the cash flows of the product group from its ongoing operations, and reports it as a discontinued operation. On the other hand, assume Softso decides to remain in the beauty-care business but will discontinue the brands that experienced losses. Because Softso cannot differentiate the cash flows from the brands from the cash flows of the product group as a whole, it cannot consider the brands a component. Softso does not classify any gain or loss on the sale of the brands as a discontinued operation. Companies report as discontinued operations (in a separate income statement category) the gain or loss from disposal of a component of a business. In addition, companies report the results of operations of a component that has been or will be disposed of separately from continuing operations. Companies show the effects of 11 D. McDermott, Latest Profit Data Stir Old Debate Between Net and Operating Income, Wall Street Journal (May 3, 1999). A recent survey of 600 large public companies (Accounting Trends and Techniques2007 (New York: AICPA) documented that 197 (almost one-third) of the 600 survey companies reported a write-down of assets (see also Illustration 4-5). This highlights the importance of good reporting for these irregular items. The FASB issued a statement of concepts that offers some guidance on this topic Recognition and Measurement in Financial Statements of Business Enterprises, Statement of Financial Accounting Concepts No. 5 (Stamford, Conn.: FASB, 1984). 12 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 142 Chapter 4 Income Statement and Related Information See the FASB Codification section (page 157). discontinued operations net of tax as a separate category, after continuing operations but before extraordinary items. [1] To illustrate, Multiplex Products, Inc., a highly diversified company, decides to discontinue its electronics division. During the current year, the electronics division lost $300,000 (net of tax). Multiplex sold the division at the end of the year at a loss of $500,000 (net of tax). Multiplex shows the information on the current years income statement as follows. Income from continuing operations Discontinued operations Loss from operation of discontinued electronics division (net of tax) Loss from disposal of electronics division (net of tax) Net income $20,000,000 ILLUSTRATION 4-6 Income Statement Presentation of Discontinued Operations $300,000 500,000 800,000 $19,200,000 Companies use the phrase Income from continuing operations only when gains or losses on discontinued operations occur. Extraordinary Items Extraordinary items are nonrecurring material items that differ significantly from a companys typical business activities. The criteria for extraordinary items are as follows. Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence. Classifying an event or transaction as an extraordinary item requires meeting both of the following criteria: (a) Unusual Nature. The underlying event or transaction should possess 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 company, taking into account the environment in which it operates. (b) Infrequency of Occurrence. The underlying event or transaction should be of a type that the company does not reasonably expect to recur in the foreseeable future, taking into account the environment in which the company operates. [2] For further clarification, the following gains and losses are not extraordinary items. (a) Write-down or write-off of receivables, inventories, equipment leased to others, deferred research and development costs, or other intangible assets. (b) Gains or losses from exchange or translation of foreign currencies, including those relating to major devaluations and revaluations. (c) Gains or losses on disposal of a component of an entity (reported as a discontinued operation). (d) Other gains or losses from sale or abandonment of property, plant, or equipment used in the business. (e) Effects of a strike, including those against competitors and major suppliers. (f) Adjustment of accruals on long-term contracts. [3] I NTERNATIONAL I NSIGHT Special reporting for extraordinary items is prohibited under international financial reporting standards (iGAAP). The above items are not considered extraordinary because they are usual in nature and may be expected to recur as a consequence of customary and continuing business activities. Only rarely does an event or transaction clearly meet the criteria for an extraordinary item.13 For example, a company classifies gains or losses such as (a) and (d) above as extraordinary if they resulted directly from a major casualty (such as an earthquake), an expropriation, or a prohibition under a newly enacted law 13 Accounting Trends and Techniques2007 (New York: AICPA) indicates that just 4 of the 600 companies surveyed reported an extraordinary item. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Reporting Irregular Items 143 or regulation. Such circumstances clearly meet the criteria of unusual and infrequent. For example, Weyerhaeuser Company (forest and lumber) incurred an extraordinary item (an approximate $36 million loss) as a result of volcanic activity at Mount St. Helens. The eruption destroyed standing timber, logs, buildings, equipment, and transportation systems covering 68,000 acres. In determining whether an item is extraordinary, a company must consider the environment in which it operates. The environment includes such factors as industry characteristics, geographic location, and the nature and extent of governmental regulations. Thus, the FASB accords extraordinary item treatment to the loss from hail damages to a tobacco growers crops if hailstorm damage in its locality is rare. On the other hand, frost damage to a citrus growers crop in Florida does not qualify as extraordinary because frost damage normally occurs there every three or four years. Similarly, when a company sells the only significant security investment it has ever owned, the gain or loss meets the criteria of an extraordinary item. Another company, however, that has a portfolio of securities acquired for investment purposes would not report such a sales as an extraordinary item. Sale of such securities is part of its ordinary and typical activities. In addition, considerable judgment must be exercised in determining whether to report an item as extraordinary. For example, the government condemned the forestlands of some paper companies to preserve state or national parks or forests. Is such an event extraordinary, or is it part of a paper companys normal operations? Such determination is not easy. Much depends on the frequency of previous condemnations, the expectation of future condemnations, materiality, and the like.14 EXTRAORDINARY TIMES No event better illustrates the difficulties of determining whether a transaction meets the definition of extraordinary than the financial impacts of the terrorist attack on the World Trade Center on September 11, 2001. To many, this event, which resulted in the tragic loss of lives, jobs, and in some cases, entire businesses, clearly meets the criteria for unusual and infrequent. For example, in the wake of the terrorist attack that destroyed the World Trade Center and turned much of lower Manhattan including Wall Street into a war zone, airlines, insurance companies, and other businesses recorded major losses due to property damage, business disruption, and suspension of airline travel and of securities trading. But, to the surprise of many, the FASB did not permit extraordinary item reporting for losses arising from the terrorist attacks. The reason? After much deliberation, the Emerging Issues Task Force (EITF) of the FASB decided that measurement of the possible loss was too difficult. Take the airline industry as an example: What portion of the airlines losses after September 11 was related to the terrorist attack, and what portion was due to the ongoing recession? Also, the FASB did not want companies to use the attack as a reason for reporting as extraordinary some losses that had little direct relationship to the attack. Indeed, energy company AES and shoe retailer Footstar, who both were experiencing profit pressure before 9/11, put some of the blame for their poor performance on the attack. Source: Julie Creswell, Bad News Bearers Shift the Blame, Fortune (October 15, 2001), p. 44. What do the numbers mean? Companies must show extraordinary items net of taxes in a separate section in the income statement, usually just before net income. After listing the usual revenues, expenses, and income taxes, the remainder of the statement shows the following. 14 Because assessing the materiality of individual items requires judgment, determining what is extraordinary is difficult. However, in making materiality judgments, companies should consider extraordinary items individually, and not in the aggregate. [4] PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 144 Chapter 4 Income Statement and Related Information ILLUSTRATION 4-7 Income Statement Placement of Extraordinary Items Income before extraordinary items Extraordinary items (less applicable income tax of $______) Net income For example, Illustration 4-8 shows how Keystone Consolidated Industries reported an extraordinary loss. ILLUSTRATION 4-8 Income Statement Presentation of Extraordinary Items Keystone Consolidated Industries, Inc. Income before extraordinary item Extraordinary itemflood loss (Note E) Net income $11,638,000 1,216,000 $10,422,000 Note E: Extraordinary Item. The Keystone Steel and Wire Divisions Steel Works experienced a flash flood on June 22. The extraordinary item represents the estimated cost, net of related income taxes of $1,279,000, to restore the steel works to full operation. Unusual Gains and Losses Because of the restrictive criteria for extraordinary items, financial statement users must carefully examine the financial statements for items that are unusual or infrequent but not both. Recall that companies cannot consider items such as writedowns of inventories and transaction gains and losses from fluctuation of foreign exchange as extraordinary items. Thus, companies sometimes show these items with their normal recurring revenues and expenses. If not material in amount, companies combine these with other items in the income statement. If material, companies must disclose them separately, and report them above Income (loss) before extraordinary items. For example, PepsiCo, Inc. presented an unusual charge in its income statement, as Illustration 4-9 shows. ILLUSTRATION 4-9 Income Statement Presentation of Unusual Charges PepsiCo, Inc. (in millions) Net sales Costs and expenses, net Cost of sales Selling, general, and administrative expenses Amortization of intangible assets Unusual items (Note 2) Operating income Note 2 (Restructuring Charge) Dispose and write down assets Improve productivity Strengthen the international bottler structure Net loss $183 94 13 $290 $20,917 8,525 9,241 199 290 $ 2,662 The net charge to strengthen the international bottler structure includes proceeds of $87 million associated with a settlement related to a previous Venezuelan bottler agreement, which were partially offset by related costs. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Reporting Irregular Items 145 Restructuring charges, like the one PepsiCo reported, have been common in recent years (see also Illustration 4-5). A restructuring charge relates to a major reorganization of company affairs, such as costs associated with employee layoffs, plant closing costs, write-offs of assets, and so on. A company should not report a restructuring charge as an extraordinary item, because these write-offs are part of a companys ordinary and typical activities. Companies tend to report unusual items in a separate section just above Income from operations before income taxes and Extraordinary items, especially when there are multiple unusual items. For example, when General Electric Company experienced multiple unusual items in one year, it reported them in a separate Unusual items section of the income statement below Income before unusual items and income taxes. When preparing a multiple-step income statement for homework purposes, you should report unusual gains and losses in the Other revenues and gains or Other expenses and losses section unless you are instructed to prepare a separate unusual items section.15 In dealing with events that are either unusual or nonrecurring but not both, the profession attempted to prevent a practice that many believed was misleading. Companies often reported such transactions on a net-of-tax basis and prominently displayed the earnings per share effect of these items. Although not captioned Extraordinary items, companies presented them in the same manner. Some had referred to these as first cousins to extraordinary items. As a consequence, the Board specifically prohibited a net-of-tax treatment for such items, to ensure that users of financial statements can easily differentiate extraordinary itemsreported net of taxfrom material items that are unusual or infrequent, but not both. Changes in Accounting Principle Changes in accounting occur frequently in practice, because important events or conditions may be in dispute or uncertain at the statement date. One type of accounting change results when a company adopts a different accounting principle. Changes in accounting principle include a change in the method of inventory pricing from FIFO to average cost, or a change in accounting for construction contracts from the percentage-of-completion to the completedcontract method. [5]16 A company recognizes a change in accounting principle by making a retrospective adjustment to the financial statements. Such an adjustment recasts the prior years statements on a basis consistent with the newly adopted principle. The company records the cumulative effect of the change for prior periods as an adjustment to beginning retained earnings of the earliest year presented. To illustrate, Gaubert Inc. decided in March 2010 to change from FIFO to weightedaverage inventory pricing. Gauberts income before taxes, using the new weightedaverage method in 2010, is $30,000. Illustration 4-10 (on page 146) presents the pretax income data for 2008 and 2009 for this example. Underlying Concepts Companies can change principles, but they must demonstrate that the newly adopted principle is preferable to the old one. Such changes result in lost consistency from period to period. 15 Many companies report one-time items. However, some companies take restructuring charges practically every year. Citicorp (now Citigroup) took restructuring charges six years in a row; Eastman Kodak Co. did so five out of six years. Research indicates that the market discounts the earnings of companies that report a series of nonrecurring items. Such evidence supports the contention that these elements reduce the quality of earnings. J. Elliott and D. Hanna, Repeated Accounting Write-offs and the Information Content of Earnings, Journal of Accounting Research (Supplement, 1996). In Chapter 22, we examine in greater detail the problems related to accounting changes. 16 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 146 Chapter 4 Income Statement and Related Information ILLUSTRATION 4-10 Calculation of a Change in Accounting Principle Year 2008 2009 Total FIFO $40,000 30,000 WeightedAverage Method $35,000 27,000 Excess of FIFO over WeightedAverage Method $5,000 3,000 $8,000 Illustration 4-11 shows the information Gaubert presented in its comparative income statements, based on a 30 percent tax rate. ILLUSTRATION 4-11 Income Statement Presentation of a Change in Accounting Principle 2010 Income before taxes Income tax Net income $30,000 9,000 $21,000 2009 $27,000 8,100 $18,900 2008 $35,000 10,500 $24,500 Thus, under the retrospective approach, the company recasts the prior years income numbers under the newly adopted method. This approach thus preserves comparability across years. Changes in Estimates Estimates are inherent in the accounting process. For example, companies estimate useful lives and salvage values of depreciable assets, uncollectible receivables, inventory obsolescence, and the number of periods expected to benefit from a particular expenditure. Not infrequently, due to time, circumstances, or new information, even estimates originally made in good faith must be changed. A company accounts for such changes in estimates in the period of change if they affect only that period, or in the period of change and future periods if the change affects both. To illustrate a change in estimate that affects only the period of change, assume that DuPage Materials Corp. consistently estimated its bad debt expense at 1 percent of credit sales. In 2010 however, DuPage determines that it must revise upward the estimate of bad debts for the current years credit sales to 2 percent, or double the prior years percentage. The 2 percent rate is necessary to reduce accounts receivable to net realizable value. Using 2 percent results in a bad debt charge of $240,000, or double the amount using the 1 percent estimate for prior years, DuPage records the provision at December 31, 2010, as follows. Bad Debt Expense Allowance for Doubtful Accounts 240,000 240,000 DuPage includes the entire change in estimate in 2010 income because the change does not affect future periods. Companies do not handle changes in estimate retrospectively. That is, such changes are not carried back to adjust prior years. (We examine changes in estimate that affect both the current and future periods in greater detail in Chapter 22.) Changes in estimate are not considered errors or extraordinary items. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Reporting Irregular Items 147 Corrections of Errors Errors occur as a result of mathematical mistakes, mistakes in the application of accounting principles, or oversight or misuse of facts that existed at the time financial statements were prepared. In recent years, many companies have corrected for errors in their financial statements. For example, one consulting group noted that over 1,300 companies (10 percent of U.S. public companies) reported error-driven restatements in 2007. The errors involved such items as improper reporting of revenue, accounting for stock options, allowances for receivables, inventories, and loss contingencies.17 Companies must correct errors by making proper entries in the accounts and reporting the corrections in the financial statements. 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. If a company prepares comparative financial statements, it should restate the prior statements for the effects of the error. To illustrate, in 2011, Hillsboro Co. determined that it incorrectly overstated its accounts receivable and sales revenue by $100,000 in 2010. In 2011, Hillboro makes the following entry to correct for this error (ignore income taxes). Retained Earnings Accounts Receivable 100,000 100,000 Retained Earnings is debited because sales revenue, and therefore net income, was overstated in a prior period. Accounts Receivable is credited to reduce this overstated balance to the correct amount. Summary of Irregular Items The public accounting profession now tends to accept a modified all-inclusive income concept instead of the current operating performance concept. Except for changes in accounting principle and error corrections, which are charged or credited directly to retained earnings, companies close all other irregular gains or losses or nonrecurring items to Income Summary and include them in the income statement. Of these irregular items, companies classify discontinued operations of a component of a business as a separate item in the income statement, after Income from continuing operations. Companies show the unusual, material, nonrecurring items that significantly differ from the typical or customary business activities in a separate Extraordinary items section below Discontinued operations. They separately disclose other items of a material amount that are of an unusual or nonrecurring nature and are not considered extraordinary. Because of the numerous intermediate income figures created by the reporting of these irregular items, readers must carefully evaluate earnings information reported by the financial press. Illustration 4-12 (on page 148) summarizes the basic concepts that we previously discussed. Although simplified, the chart provides a useful framework for determining the treatment of special items affecting the income statement. Underlying Concepts The AICPA Special Committee on Financial Reporting indicates a companys core activitiesusual and recurring eventsprovide the best historical data from which users determine trends and relationships and make their predictions about the future. Therefore, companies should separately display the effects of core and non-core activities. 17 While the growth of restatements appears to have slowed in 2007, these are still important signals to the market. One study documented a significant increase in the cost of borrowing for companies that report a restatement. See. A. Osterland, The SarBox: The Bill for Restatements Can Be Costly, Financial Week (January 14, 2008). PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 148 Chapter 4 Income Statement and Related Information Type of Situationa Discontinued operations Criteria Disposal of a component of a business for which the company can clearly distinguish operations and cash flows from the rest of the companys operations. Examples Sale by diversified company of major division that represents only activities in electronics industry. Food distributor that sells wholesale to supermarket chains and through fast-food restaurants decides to discontinue the division that sells to one of two classes of customers. Gains or losses resulting from casualties, an expropriation, or a prohibition under a new law. Write-downs of receivables, inventories; adjustments of accrued contract prices; gains or losses from fluctuations of foreign exchange; gains or losses from sales of assets used in business. Change in the basis of inventory pricing from FIFO to average cost. Changes in the realizability of receivables and inventories; changes in estimated lives of equipment, intangible assets; changes in estimated liability for warranty costs, income taxes, and salary payments. Error in reporting revenue. Placement on Income Statement Show in separate section after continuing operations but before extraordinary items. (Shown net of tax.) Extraordinary items Material, and both unusual and infrequent (nonrecurring). Material; character typical of the customary business activities; unusual or infrequent but not both. Show in separate section entitled Extraordinary items. (Shown net of tax.) Show in separate section above income before extraordinary items. Often reported in Other revenues and gains or Other expenses and losses section. (Not shown net of tax.) Recast prior years income statements on the same basis as the newly adopted principle. Show change only in the affected accounts. (Not shown net of tax.) Unusual gains or losses, not considered extraordinary Changes in principle Changes in estimates Change from one generally accepted principle to another. Normal, recurring corrections and adjustments. Corrections of errors a Mistake, misuse of facts. Restate prior years income statements to correct for error. This summary provides only the general rules to be followed in accounting for the various situations described above. Exceptions do exist in some of these situations. ILLUSTRATION 4-12 Summary of Irregular Items in the Income Statement SPECIAL REPORTING ISSUES Intraperiod Tax Allocation Companies report irregular items (except for unusual gains and losses) on the income statement or statement of retained earnings net of tax. This procedure is called intraperiod tax allocation, that is, allocation within a period. It relates the income tax expense (sometimes referred to as the income tax provision) of the fiscal period to the specific items that give rise to the amount of the tax provision. Intraperiod tax allocation helps financial statement users better understand the impact of income taxes on the various components of net income. For example, readers of financial statements will understand how much income tax expense relates to income from continuing operations and how much relates to certain irregular transactions and events. This approach should help users to better predict the amount, timing, and uncertainty of future cash flows. In addition, intraperiod tax allocation discourages statement readers from using pretax measures of performance when evaluating financial results, and thereby recognizes that income tax expense is a real cost. Companies use intraperiod tax allocation on the income statement for the following items: (1) income from continuing operations, (2) discontinued operations, and (3) extraordinary items. The general concept is let the tax follow the income. To compute the income tax expense attributable to Income from continuing operations, a company would find the income tax expense related to both the revenue and Objective5 Explain intraperiod tax allocation. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Special Reporting Issues 149 expense transactions used in determining this income. (In this computation, the company does not consider the tax consequences of items excluded from the determination of Income from continuing operations.) Companies then associate a separate tax effect with each irregular item (e.g., discontinued operations and extraordinary items). Here we look in more detail at calculation of intraperiod tax allocation for extraordinary gains and losses. Extraordinary Gains In applying the concept of intraperiod tax allocation, assume that Schindler Co. has income before income tax and extraordinary item of $250,000. It has an extraordinary gain of $100,000 from a condemnation settlement received on one its properties. Assuming a 30 percent income tax rate, Schindler presents the following information on the income statement. Income before income tax and extraordinary item Income tax Income before extraordinary item Extraordinary gaincondemnation settlement Less: Applicable income tax Net income $100,000 30,000 $250,000 75,000 175,000 70,000 $245,000 ILLUSTRATION 4-13 Intraperiod Tax Allocation, Extraordinary Gain Schindler determines the income tax of $75,000 ($250,000 30%) attributable to Income before income tax and extraordinary item from revenue and expense transactions related to this income. Schindler omits the tax consequences of items excluded from the determination of Income before income tax and extraordinary item. The company shows a separate tax effect of $30,000 related to the Extraordinary gain condemnation settlement. Extraordinary Losses To illustrate the reporting of an extraordinary loss, assume that Schindler Co. has income before income tax and extraordinary item of $250,000. It suffers an extraordinary loss from a major casualty of $100,000. Assuming a 30 percent tax rate, Schindler presents the income tax on the income statement as shown in Illustration 4-14. In this case, the loss provides a positive tax benefit of $30,000. Schindler, therefore, subtracts it from the $100,000 loss. Income before income tax and extraordinary item Income tax Income before extraordinary item Extraordinary itemloss from casualty Less: Applicable income tax reduction Net income $100,000 30,000 $250,000 75,000 175,000 70,000 $105,000 ILLUSTRATION 4-14 Intraperiod Tax Allocation, Extraordinary Loss Companies may also report the tax effect of an extraordinary item by means of a note disclosure, as illustrated below. Income before income tax and extraordinary item Income tax Income before extraordinary item Extraordinary item, less applicable income tax reduction (Note 1) Net income $250,000 75,000 175,000 70,000 $105,000 ILLUSTRATION 4-15 Note Disclosure of Intraperiod Tax Allocation Note 1: During the year the Company suffered a major casualty loss of $70,000, net of applicable income tax reduction of $30,000. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 150 Chapter 4 Income Statement and Related Information Objective6 Identify where to report earnings per share information. Earnings per Share A company customarily sums up the results of its operations in one important figure: net income. However, the financial world has widely accepted an even more distilled and compact figure as the most significant business indicatorearnings per share (EPS). The computation of earnings per share is usually straightforward. Earnings per share is net income minus preferred dividends (income available to common stockholders), divided by the weighted average of common shares outstanding.18 To illustrate, assume that Lancer, Inc. reports net income of $350,000. It declares and pays preferred dividends of $50,000 for the year. The weighted average number of common shares outstanding during the year is 100,000 shares. Lancer computes earnings per share of $3, as shown in Illustration 4-16. ILLUSTRATION 4-16 Equation Illustrating Computation of Earnings per Share Net Income Preferred Dividends Weighted Average of Common Shares Outstanding $350,000 $50,000 100,000 $3 Earnings per Share Note that EPS measures the number of dollars earned by each share of common stock. It does not represent the dollar amount paid to stockholders in the form of dividends. Prospectuses, proxy material, and annual reports to stockholders commonly use the net income per share or earnings per share ratio. The financial press, statistical services like Standard & Poors, and Wall Street securities analysts also highlight EPS. Because of its importance, companies must disclose earnings per share on the face of the income statement. A company that reports a discontinued operation or an extraordinary item must report per share amounts for these line items either on the face of the income statement or in the notes to the financial statements. [6] To illustrate, consider the income statement for Poquito Industries Inc. shown in Illustration 4-17 (on page 151). Notice the order in which Poquito shows the data, with per share information at the bottom. Assume that the company had 100,000 shares outstanding for the entire year. The Poquito income statement, as Illustration 4-17 shows, is highly condensed. Poquito would need to describe items such as Unusual charge, Discontinued operations, and Extraordinary item fully and appropriately in the statement or related notes. Many corporations have simple capital structures that include only common stock. For these companies, a presentation such as Earnings per common share is appropriate on the income statement. In many instances, however, companies earnings per share are subject to dilution (reduction) in the future because existing contingencies permit the issuance of additional common shares. [7]19 In summary, the simplicity and availability of EPS figures lead to their widespread use. Because of the importance that the public, even the well-informed public, attaches to earnings per share, companies must make the EPS figure as meaningful as possible. 18 In calculating earnings per share, companies deduct preferred dividends from net income if the dividends are declared or if they are cumulative though not declared. We discuss the computational problems involved in accounting for these dilutive securities in earnings per share computations in Chapter 16. 19 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Special Reporting Issues 151 POQUITO INDUSTRIES INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2010 Sales revenue Cost of goods sold Gross profit Selling and administrative expenses Income from operations Other revenues and gains Interest revenue Other expenses and losses Loss on disposal of part of Textile Division Unusual chargeloss on sale of investments Income from continuing operations before income tax Income tax Income from continuing operations Discontinued operations Income from operations of Pizza Division, less applicable income tax of $24,800 Loss on disposal of Pizza Division, less applicable income tax of $41,000 Income before extraordinary item Extraordinary itemloss from earthquake, less applicable income tax of $23,000 Net income Per share of common stock Income from continuing operations Income from operations of discontinued division, net of tax Loss on disposal of discontinued operation, net of tax Income before extraordinary item Extraordinary loss, net of tax Net income $1,420,000 600,000 820,000 320,000 500,000 10,000 $ (5,000) (45,000) ILLUSTRATION 4-17 Income Statement (50,000) 460,000 184,000 276,000 54,000 (90,000) (36,000) 240,000 (45,000) $ 195,000 $2.76 0.54 (0.90) 2.40 (0.45) $1.95 Retained Earnings Statement Net income increases retained earnings. A net loss decreases retained earnings. Objective7 Both cash and stock dividends decrease retained earnings. Changes in accountPrepare a retained earnings ing principles (generally) and prior period adjustments may increase or decrease statement. retained earnings. Companies charge or credit these adjustments (net of tax) to the opening balance of retained earnings. This excludes the adjustments from the determination of net income for the current period. Companies may show retained earnings information in different ways. For example, some companies prepare a separate retained earnings statement, as Illustration 4-18 shows. TIGER WOODS INC. RETAINED EARNINGS STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2010 Retained earnings, January 1, as reported Correction for understatement of net income in prior period (inventory error) Retained earnings, January 1, as adjusted Add: Net income Less: Cash dividends Stock dividends Retained earnings, December 31 $100,000 200,000 $1,050,000 50,000 1,100,000 360,000 1,460,000 300,000 $1,160,000 ILLUSTRATION 4-18 Retained Earnings Statement PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 152 Chapter 4 Income Statement and Related Information The reconciliation of the beginning to the ending balance in retained earnings provides information about why net assets increased or decreased during the year. The association of dividend distributions with net income for the period indicates what management is doing with earnings: It may be plowing back into the business part or all of the earnings, distributing all current income, or distributing current income plus the accumulated earnings of prior years.20 Restrictions of Retained Earnings Companies often restrict retained earnings to comply with contractual requirements, board of directors policy, or current necessity. Generally, companies disclose in the notes to the financial statements the amounts of restricted retained earnings. In some cases, companies transfer the amount of retained earnings restricted to an account titled Appropriated Retained Earnings. The retained earnings section may therefore report two separate amounts(1) retained earnings free (unrestricted) and (2) retained earnings appropriated (restricted). The total of these two amounts equals the total retained earnings. Comprehensive Income Companies generally include in income all revenues, expenses, and gains and losses recognized during the period. These items are classified within the income statement so that financial statement readers can better understand the significance of various components of net income. Changes in accounting principles and corrections of errors are excluded from the calculation of net income because their effects relate to prior periods. In recent years, there is increased use of fair values for measuring assets and liabilities. Furthermore, possible reporting of gains and losses related to changes in fair value have placed a strain on income reporting. Because fair values are continually changing, some argue that recognizing these gains and losses in net income is misleading. The FASB agrees and has identified a limited number of transactions that should be recorded directly to stockholders equity. One example is unrealized gains and losses on available-for-sale securities.21 These gains and losses are excluded from net income, thereby reducing volatility in net income due to fluctuations in fair value. At the same time disclosure of the potential gain or loss is provided. Companies include these items that bypass the income statement in a measure called comprehensive income. Comprehensive income includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Comprehensive income, therefore, includes the following: all revenues and gains, expenses and losses reported in net income, and all gains and losses that bypass net income but affect stockholders equity. These itemsnon-owner changes in equity that bypass the income statementare referred to as other comprehensive income. The FASB decided that companies must display the components of other Objective8 comprehensive income in one of three ways: (1) a second income statement; Explain how to report other com(2) a combined statement of comprehensive income; or (3) as a part of the stateprehensive income. ment of stockholders equity. [8]22 Regardless of the format used, companies 20 Accounting Trends and Techniques2007 (New York: AICPA) indicates that most companies (591 of 600 surveyed) present changes in retained earnings either within the statement of stockholders equity (588 firms) or in a separate statement of retained earnings. Only 3 of the 600 companies prepare a combined statement of income and retained earnings. 21 We further discuss available-for-sale securities in Chapter 17. Additional examples of other comprehensive items are translation gains and losses on foreign currency and unrealized gains and losses on certain hedging transactions. 22 Accounting Trends and Techniques2007 (New York: AICPA) indicates that for the 600 companies surveyed, report 581 comprehensive income. Most companies (485 of 580) include comprehensive income as part of the statement of stockholders equity. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Special Reporting Issues 153 must add net income to other comprehensive income to arrive at comprehensive income. Companies are not required to report earnings per share information related to comprehensive income.23 To illustrate, assume that V. Gill Inc. reports the following information for 2010: sales revenue $800,000; cost of goods sold $600,000; operating expenses $90,000; and an unrealized holding gain on available-for-sale securities of $30,000, net of tax. Second Income Statement Illustration 4-19 shows the two-income statement format based on the above information for V. Gill. Reporting comprehensive income in a separate statement indicates that the gains and losses identified as other comprehensive income have the same status as traditional gains and losses. Placing net income as the starting point in the comprehensive income statement highlights the relationship of the statement to the traditional income statement. V. GILL INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2010 Sales revenue Cost of goods sold Gross profit Operating expenses Net income $800,000 600,000 200,000 90,000 $110,000 ILLUSTRATION 4-19 Two-Statement Format: Comprehensive Income V. GILL INC. COMPREHENSIVE INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2010 Net income Other comprehensive income Unrealized holding gain, net of tax Comprehensive income $110,000 30,000 $140,000 Combined Statement of Comprehensive Income The second approach to reporting other comprehensive income provides a combined statement of comprehensive income. In this approach, the traditional net income is a subtotal, with total comprehensive income shown as a final total. The combined statement has the advantage of not requiring the creation of a new financial statement. However, burying net income as a subtotal on the statement is a disadvantage. Statement of Stockholders Equity A third approach reports other comprehensive income items in a statement of stockholders equity (often referred to as statement of changes in stockholders equity). This statement reports the changes in each stockholders equity account and in total stockholders equity during the year. Companies often prepare in columnar form the statement of stockholders equity. In this format, they use columns for each account and for total stockholders equity. 23 A company must display the components of other comprehensive income either (1) net of related tax effects, or (2) before related tax effects, with one amount shown for the aggregate amount of tax related to the total amount of other comprehensive income. Both alternatives must show each component of other comprehensive income, net of related taxes either in the face of the statement or in the notes. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 154 Chapter 4 Income Statement and Related Information To illustrate, assume the same information for V. Gill. The company had the following stockholder equity account balances at the beginning of 2010: Common Stock $300,000; Retained Earnings $50,000; and Accumulated Other Comprehensive Income $60,000. No changes in the Common Stock account occurred during the year. Illustration 4-20 shows a statement of stockholders equity for V. Gill. ILLUSTRATION 4-20 Presentation of Comprehensive Income Items in Stockholders Equity Statement V. GILL INC. STATEMENT OF STOCKHOLDERS EQUITY FOR THE YEAR ENDED DECEMBER 31, 2010 Accumulated Other Comprehensive Income $60,000 Total Beginning balance Comprehensive income Net income Other comprehensive income Unrealized holding gain, net of tax Comprehensive income Ending balance $550,000 $410,000 110,000 Comprehensive Income Retained Earnings $ 50,000 Common Stock $300,000 $110,000 110,000 30,000 30,000 $140,000 $160,000 30,000 $90,000 $300,000 co llege/k i es o Most companies use the statement of stockholders equity approach to provide information related to other comprehensive income. Because many companies already provide a statement of stockholders equity, adding additional columns to display information related to comprehensive income is not costly. w Examples of Comprehensive Income Reporting ILLUSTRATION 4-21 Presentation of Accumulated Other Comprehensive Income in the Balance Sheet You will want to read the CONVERGENCE CORNER on page 155 for discussion of how international convergence efforts relate to the income statement. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile y. c o m / Balance Sheet Presentation Regardless of the display format used, V. Gill reports the accumulated other comprehensive income of $90,000 in the stockholders equity section of the balance sheet as follows. V. GILL INC. BALANCE SHEET AS OF DECEMBER 31, 2010 (STOCKHOLDERS EQUITY SECTION) Stockholders equity Common stock Retained earnings Accumulated other comprehensive income Total stockholders equity $300,000 160,000 90,000 $550,000 By providing information on the components of comprehensive income, as well as accumulated other comprehensive income, the company communicates information about all changes in net assets.24 With this information, users will better understand the quality of the companys earnings. 24 Corrections of errors and changes in accounting principles are not considered other comprehensive income items. CONVERGENCE CORNER INCOME STATEMENT As in U.S. GAAP, the income statement is a required statement for iGAAP. In addition, the content and presentation of an iGAAP income statement is similar to the one used for U.S. GAAP. IAS 1, Presentation of Financial Statements, provides general guidelines for the reporting of income statement information. Subsequently, a number of international standards have been issued that provide additional guidance to issues related to income statement presentation. R E L E VA N T FA C T S Under iGAAP, companies must classify expenses by either nature or function. Classification by nature leads to descriptions such as the following: salaries, depreciation expense, utilities expense, and so on. Classification by function leads to descriptions like administration, distribution, and manufacturing. If a company uses the functional expense method on the income statement, disclosure by nature is required in the notes to the financial statements. Presentation of the income statement under U.S. GAAP follows either a single-step or multiple-step format. iGAAP does not mention a single-step or multiplestep approach. In addition, under U.S. GAAP, companies must report an item as extraordinary if it is unusual in nature and infrequent in occurrence. Extraordinary items are prohibited under iGAAP. Under iGAAP, companies are required to prepare as a primary financial statement either a statement of stockholders equity similar to the one prepared under U.S. GAAP or a statement of recognized income and expense (called a SoRIE ). ABOUT THE NUMBERS As indicated, under iGAAP companies can prepare a statement of recognized income and expense (SoRIE). A SoRIE reports the net income or loss for the period and all the income and expense items that are included in comprehensive income but not net income until realized. Here is a SoRIE for Hulce Inc. Hulce Inc. Statement of Recognized Income and Expense For the Year Ended 2010 (in million of U.S. dollars) Unrealized gain related to revaluation of land Unrealized loss related to available for sale securities Unrealized gain related to revaluation of intangibles Items not recognized on the income statement Net income Total recognized income and expense Cumulative effect of a change in accounting principle $100 (60) 80 120 400 $520 $118 (Supplementary information in the notes to the financial statements is required to show other changes in capital accounts resulting from transactions with owners as well as changes in retained earnings.) Both iGAAP and U.S. GAAP have items that are If a company presents information by means of a SoRIE, it would recognized in equity as part of comprehensive income not prepare a traditional statement of stockholders equity. but do not affect net income. U.S. GAAP provides three possible formats for presenting this information: single income statement, combined income statement of comprehensive income, in the statement of stockholders equity. iGAAP allows either the statement of stockholders equity approach or the SoRIE format. Under iGAAP revaluation of land, buildings, and intangible assets is permitted. The effect of this difference is that application of iGAAP results in more transactions affecting equity but not net income. ON TH E HORIZON The IASB and FASB are working on a project that would rework the structure of financial statements. In phase 1 of this project, a major focus is on the reporting of revenues and expenses. What appears likely is an amendment to IAS 1 that would bring it largely into line with the equivalent U.S.GAAP, on reporting of comprehensive income, as discussed in this chapter. A proposed amendment to IAS 1 would present all income and expenses separately from changes in equity that arise from transactions with its owners. Companies would have a choice of presenting income and expenses in a single statement or in two statements (the two approaches discussed in this chapter). The option to report this information solely in the statement of stockholders equity or by use of the SoRIE approach would not be permitted. The second stage of this project will address the issue of how to classify various items in the income statement. A main goal of this new approach is to provide information that better represents how businesses are run. In addition, this approach draws attention away from just one numbernet income. 155 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 156 Chapter 4 Income Statement and Related Information KEY TERMS accumulated other comprehensive income, 154 appropriated retained earnings, 152 capital maintenance approach, 134 (n) changes in estimates, 146 comprehensive income, 152 current operating performance approach, 140 discontinued operation, 141 earnings management, 133 earnings per share, 150 extraordinary items, 142 income statement, 132 intraperiod tax allocation, 148 irregular items, 141 modified all-inclusive concept, 141 multiple-step income statement, 136 other comprehensive income, 152 prior period adjustments, 147 quality of earnings, 133 single-step income statement, 135 statement of stockholders equity, 153 transaction approach, 134 SUMMARY OF LEARNING OBJECTIVES 1 Understand the uses and limitations of an income statement. The income statement provides investors and creditors with information that helps them predict the amounts, timing, and uncertainty of future cash flows. Also, the income statement helps users determine the risk (level of uncertainty) of not achieving particular cash flows. The limitations of an income statement are: (1) The statement does not include many items that contribute to general growth and well-being of a company. (2) Income numbers are often affected by the accounting methods used. (3) Income measures are subject to estimates. The transaction approach focuses on the activities that occurred during a given period. Instead of presenting only a net change in net assets, it discloses the components of the change. The transaction approach to income measurement requires the use of revenue, expense, loss, and gain accounts. 2 Prepare a single-step income statement. In a single-step income statement, just two groupings exist: revenues and expenses. Expenses are deducted from revenues to arrive at net income or lossa single subtraction. Frequently, companies report income tax separately as the last item before net income. 3 Prepare a multiple-step income statement. A multiple-step income statement shows two further classifications: (1) a separation of operating results from those obtained through the subordinate or nonoperating activities of the company; and (2) a classification of expenses by functions, such as merchandising or manufacturing, selling, and administration. 4 Explain how to report irregular items. Companies generally include irregular gains or losses or nonrecurring items in the income statement as follows: (1) Discontinued operations of a component of a business are classified as a separate item, after continuing operations. (2) The unusual, material, nonrecurring items that are significantly different from the customary business activities are shown in a separate section for extraordinary items, below discontinued operations. (3) Other items of a material amount that are of an unusual or nonrecurring nature and are not considered extraordinary are separately disclosed as a component of continuing operations. Changes in accounting principle and corrections of errors are adjusted through retained earnings. 5 Explain intraperiod tax allocation. Companies should relate the tax expense for the year to specific items on the income statement to provide a more informative disclosure to statement users. This procedure, intraperiod tax allocation, relates the income tax expense for the fiscal period to the following items that affect the amount of the tax provisions: (1) income from continuing operations, (2) discontinued operations, and (3) extraordinary items. 6 Identify where to report earnings per share information. Because of the inherent dangers of focusing attention solely on earnings per share, the profession concluded that companies must disclose earnings per share on the face of the income statement. A company that reports a discontinued operation or an extraordinary item must report per share amounts for these line items either on the face of the income statement or in the notes to the financial statements. 7 Prepare a 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. 8 Explain how to report other comprehensive income. Companies report the components of other comprehensive income in a second statement, a combined statement of comprehensive income, or in a statement of stockholders equity. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Questions 157 FASB CODIFICATION FASB Codification References [1] FASB ASC 205-20-45. [Predecessor literature: Accounting for the Impairment or Disposal of Long-lived Assets, Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001), par. 4.] [2] FASB ASC 225-20-45-2. [Predecessor literature: Reporting the Results of Operations, Opinions of the Accounting Principles Board No. 30 (New York: AICPA, 1973), par. 20.] [3] FASB ASC 225-20-45-4. [Predecessor literature: Reporting the Results of Operations, Opinions of the Accounting Principles Board No. 30 (New York: AICPA, 1973), par. 23, as amended by Accounting for the Impairment or Disposal of Long-lived Assets, Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001).] [4] FASB ASC 225-20-45-3. [Predecessor literature: Reporting the Results of Operations, Opinions of the Accounting Principles Board No. 30 (New York: AICPA, 1973), par. 24, as amended by Accounting for the Impairment or Disposal of Long-lived Assets, Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001).] [5] FASB ASC 250. [Predecessor literature: Accounting Changes and Error Corrections, Statement of Financial Accounting Standards No. 154 (Norwalk, Conn.: FASB, 2005).] [6] FASB ASC 260. [Predecessor literature: Earnings Per Share, Statement of Financial Accounting Standards No. 128 (Norwalk, Conn.: FASB, 1996).] [7] FASB ASC 260-10-10-2. [Predecessor literature: Earnings Per Share, Statement of Financial Accounting Standards No. 128 (Norwalk, Conn.: FASB, 1996), par. 11.] [8] FASB ASC 220. [Predecessor literature: Reporting Comprehensive Income, Statement of Financial Accounting Standards No. 130 (Norwalk, Conn.: FASB, 1997).] Exercises Access the FASB Codification at http://asc.fasb.org/home to prepare responses to the following exercises. Provide Codification references for your responses. CE4-1 Access the glossary (Master Glossary) to answer the following. (a) What is a change in accounting estimate? (b) How is a change in accounting principle distinguished from a change in accounting estimate effected by a change in accounting principle? (c) What is the formal definition of comprehensive income? CE4-2 What distinguishes an item that is unusual in nature from an item that is considered extraordinary? CE4-3 Enyart Company experienced a catastrophic loss in the second quarter of the year. The loss meets the criteria for extraordinary item reporting, but Enyarts controller is unsure whether this item should be reported as extraordinary in the second quarter interim report. Advise the controller. CE4-4 What guidance does the SEC provide for public companies with respect to the reporting of the effect of preferred stock dividends and accretion of carrying amount of preferred stock on earnings per share? An additional Codification case can be found in the Using Your Judgment section, on page 175. es o Be sure to check the companion website for a Review and Analysis Exercise, with solution. co llege/k i w QUESTIONS 1. What kinds of questions about future cash flows do investors and creditors attempt to answer with information in the income statement? 3. Identify at least two situations in which important changes in value are not reported in the income statement. 4. Identify at least two situations in which application of different accounting methods or accounting estimates results in difficulties in comparing companies. 2. How can information based on past transactions be used to predict future cash flows? PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile y. c o m / 158 Chapter 4 Income Statement and Related Information 5. Explain the transaction approach to measuring income. Why is the transaction approach to income measurement preferable to other ways of measuring income? previously, additional depreciation of $425,000 would have been charged. (b) In 2010 a flood destroyed a warehouse that had a book value of $1,600,000. Floods are rare in this locality. (c) In 2010 the company wrote off $1,000,000 of inventory that was considered obsolete. (d) An income tax refund related to the 2007 tax year was received. (e) In 2007, a supply warehouse with an expected useful life of 7 years was erroneously expensed. (f) Boleyn, Inc. changed from weighted-average to FIFO inventory pricing. 6. What is earnings management? 7. How can earnings management affect the quality of earnings? 8. Why should caution be exercised in the use of the net income figure derived in an income statement? What are the objectives of generally accepted accounting principles in their application to the income statement? 9. A Wall Street Journal article noted that MicroStrategy reported higher income than its competitors by using a more aggressive policy for recognizing revenue on future upgrades to its products. Some contend that MicroStrategys quality of earnings is low. What does the term quality of earnings mean? 17. Indicate the section of a multiple-step income statement in which each of the following is shown. (a) Loss on inventory write-down. (b) Loss from strike. (c) Bad debt expense. (d) Loss on disposal of a component of the business. (e) Gain on sale of machinery. (f) Interest revenue. (g) Depreciation expense. (h) Material write-offs of notes receivable. 10. What is the major distinction (a) between revenues and gains and (b) between expenses and losses? 11. What are the advantages and disadvantages of the singlestep income statement? 12. What is the basis for distinguishing between operating and nonoperating items? 13. Distinguish between the modified all-inclusive income statement and the current operating performance income statement. According to present generally accepted accounting principles, which is recommended? Explain. 18. Perlman Land Development, Inc. purchased land for $70,000 and spent $30,000 developing it. It then sold the land for $160,000. Sheehan Manufacturing purchased land for a future plant site for $100,000. Due to a change in plans, Sheehan later sold the land for $160,000. Should these two companies report the land sales, both at gains of $60,000, in a similar manner? 14. How should correction of errors be reported in the financial statements? 15. Discuss the appropriate treatment in the financial statements of each of the following. (a) An amount of $113,000 realized in excess of the cash surrender value of an insurance policy on the life of one of the founders of the company who died during the year. (b) A profit-sharing bonus to employees computed as a percentage of net income. (c) Additional depreciation on factory machinery because of an error in computing depreciation for the previous year. (d) Rent received from subletting a portion of the office space. (e) A patent infringement suit, brought 2 years ago against the company by another company, was settled this year by a cash payment of $725,000. (f) A reduction in the Allowance for Doubtful Accounts balance, because the account appears to be considerably in excess of the probable loss from uncollectible receivables. 19. You run into Greg Norman at a party and begin discussing financial statements. Greg says, I prefer the single-step income statement because the multiple-step format generally overstates income. How should you respond to Greg? 20. Santo Corporation has eight expense accounts in its general ledger which could be classified as selling expenses. Should Santo report these eight expenses separately in its income statement or simply report one total amount for selling expenses? 21. Cooper Investments reported an unusual gain from the sale of certain assets in its 2010 income statement. How does intraperiod tax allocation affect the reporting of this unusual gain? 22. What effect does intraperiod tax allocation have on reported net income? 23. Neumann Company computed earnings per share as follows. Net income Common shares outstanding at year-end Neumann has a simple capital structure. What possible errors might the company have made in the computation? Explain. 16. Indicate where the following items would ordinarily appear on the financial statements of Boleyn, Inc. for the year 2010. (a) The service life of certain equipment was changed from 8 to 5 years. If a 5-year life had been used PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Brief Exercises 159 24. Qualls Corporation reported 2010 earnings per share of $7.21. In 2011, Qualls reported earnings per share as follows. On income before extraordinary item On extraordinary item On net income $6.40 1.88 $8.28 30. What major types of items are reported in the retained earnings statement? 31. Generally accepted accounting principles usually require the use of accrual accounting to fairly present income. If the cash receipts and disbursements method of accounting will clearly reflect taxable income, why does this method not usually also fairly present income? Is the increase in earnings per share from $7.21 to $8.28 a favorable trend? 32. State some of the more serious problems encountered in seeking to achieve the ideal measurement of periodic net income. Explain what accountants do as a practical alternative. 25. What is meant by tax allocation within a period? What is the justification for such practice? 26. When does tax allocation within a period become necessary? How should this allocation be handled? 33. What is meant by the terms elements and items as they relate to the income statement? Why might items have to be disclosed in the income statement? 27. During 2010, Liselotte Company earned income of $1,500,000 before income taxes and realized a gain of $450,000 on a government-forced condemnation sale of a division plant facility. The income is subject to income taxation at the rate of 34%. The gain on the sale of the plant is taxed at 30%. Proper accounting suggests that the unusual gain be reported as an extraordinary item. Illustrate an appropriate presentation of these items in the income statement. 34. What are the three ways that other comprehensive income may be displayed (reported)? 35. How should the disposal of a component of a business be disclosed in the income statement? 36. What are the iGAAP requirements with respect to expense classification? 37. Bradshaw Company experienced a loss that was deemed to be both unusual in nature and infrequent in occurrence. How should Bradshaw report this item in accordance with iGAAP? 28. On January 30, 2009, a suit was filed against Frazier Corporation under the Environmental Protection Act. On August 6, 2010, Frazier Corporation agreed to settle the action and pay $920,000 in damages to certain current and former employees. How should this settlement be reported in the 2010 financial statements? Discuss. 38. Explain the iGAAP reporting guidelines for items recognized in comprehensive income but that do not affect net income. 29. Linus Paper Company decided to close two small pulp mills in Conway, New Hampshire, and Corvallis, Oregon. Would these closings be reported in a separate section entitled Discontinued operations after income from continuing operations? Discuss. 39. Gribble Company reported the following amounts in 2010: Net income, $150,000; Unrealized gain related to revaluation to buildings, $10,000; Unrealized loss related to available-for-sale securities, $(35,000). Determine Gribbles total recognized income and expense for 2010. BRIEF EXERCISES 2 BE4-1 Starr Co. had sales revenue of $540,000 in 2010. Other items recorded during the year were: Cost of goods sold Wage expense Income tax expense Increase in value of company reputation Other operating expenses Unrealized gain on value of patents $330,000 120,000 25,000 15,000 10,000 20,000 Prepare a single-step income statement for Starr for 2010. Starr has 100,000 shares of stock outstanding. 2 BE4-2 Brisky Corporation had net sales of $2,400,000 and interest revenue of $31,000 during 2010. Expenses for 2010 were: cost of goods sold $1,450,000; administrative expenses $212,000; selling expenses $280,000; interest expense $45,000. Briskys tax rate is 30%. The corporation had 100,000 shares of common stock authorized and 70,000 shares issued and outstanding during 2010. Prepare a single-step income statement for the year ended December 31, 2010. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 160 Chapter 4 Income Statement and Related Information 3 BE4-3 Using the information provided in BE4-2, prepare a condensed multiple-step income statement for Brisky Corporation. BE4-4 Finley Corporation had income from continuing operations of $10,600,000 in 2010. During 2010, it disposed of its restaurant division at an after-tax loss of $189,000. Prior to disposal, the division operated at a loss of $315,000 (net of tax) in 2010. Finley had 10,000,000 shares of common stock outstanding during 2010. Prepare a partial income statement for Finley beginning with income from continuing operations. BE4-5 Stacy Corporation had income before income taxes for 2010 of $6,300,000. In addition, it suffered an unusual and infrequent pretax loss of $770,000 from a volcano eruption. The corporations tax rate is 30%. Prepare a partial income statement for Stacy beginning with income before income taxes. The corporation had 5,000,000 shares of common stock outstanding during 2010. BE4-6 During 2010 Williamson Company changed from FIFO to weighted-average inventory pricing. Pretax income in 2009 and 2008 (Williamsons first year of operations) under FIFO was $160,000 and $180,000, respectively. Pretax income using weighted-average pricing in the prior years would have been $145,000 in 2009 and $170,000 in 2008. In 2010, Williamson Company reported pretax income (using weighted-average pricing) of $180,000. Show comparative income statements for Williamson Company, beginning with Income before income tax, as presented on the 2010 income statement. (The tax rate in all years is 30%.) BE4-7 Vandross Company has recorded bad debt expense in the past at a rate of 112% of net sales. In 2010, Vandross decides to increase its estimate to 2%. If the new rate had been used in prior years, cumulative bad debt expense would have been $380,000 instead of $285,000. In 2010, bad debt expense will be $120,000 instead of $90,000. If Vandrosss tax rate is 30%, what amount should it report as the cumulative effect of changing the estimated bad debt rate? BE4-8 In 2010, Hollis Corporation reported net income of $1,000,000. It declared and paid preferred stock dividends of $250,000. During 2010, Hollis had a weighted average of 190,000 common shares outstanding. Compute Holliss 2010 earnings per share. BE4-9 Portman Corporation has retained earnings of $675,000 at January 1, 2010. Net income during 2010 was $1,400,000, and cash dividends declared and paid during 2010 totaled $75,000. Prepare a retained earnings statement for the year ended December 31, 2010. BE4-10 Using the information from BE4-9, prepare a retained earnings statement for the year ended December 31, 2010. Assume an error was discovered: land costing $80,000 (net of tax) was charged to repairs expense in 2007. BE4-11 On January 1, 2010, Richards Inc. had cash and common stock of $60,000. At that date the company had no other asset, liability or equity balances. On January 2, 2010, it purchased for cash $20,000 of equity securities that it classified as available-for-sale. It received cash dividends of $3,000 during the year on these securities. In addition, it has an unrealized holding gain on these securities of $4,000 net of tax. Determine the following amounts for 2010: (a) net income; (b) comprehensive income; (c) other comprehensive income; and (d) accumulated other comprehensive income (end of 2010). 3 4 4 5 4 4 6 7 4 7 8 EXERCISES 2 E4-1 (Computation of Net Income) Presented below are changes in all the account balances of Jackson Furniture Co. during the current year, except for retained earnings. Increase (Decrease) Cash Accounts Receivable (net) Inventory Investments $ 69,000 45,000 127,000 (47,000) Accounts Payable Bonds Payable Common Stock Additional Paid-in Capital Increase (Decrease) $(51,000) 82,000 125,000 13,000 Instructions Compute the net income for the current year, assuming that there were no entries in the Retained Earnings account except for net income and a dividend declaration of $24,000 which was paid in the current year. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Exercises 161 2 E4-2 (Income Statement Items) Presented below are certain account balances of Wade Products Co. $ 6,500 12,700 114,400 134,000 71,000 12,400 Sales discounts Selling expenses Sales Income tax Cost of goods sold Administrative expenses $ 7,800 99,400 400,000 26,600 184,400 82,500 Rental revenue Interest expense Beginning retained earnings Ending retained earnings Dividend revenue Sales returns Instructions From the foregoing, compute the following: (a) total net revenue, (b) net income, (c) dividends declared during the current year. 2 E4-3 (Single-step Income Statement) The financial records of Dunbar Inc. were destroyed by fire at the end of 2010. Fortunately the controller had kept certain statistical data related to the income statement as presented below. 1. 2. 3. 4. 5. 6. 7. 8. The beginning merchandise inventory was $92,000 and decreased 20% during the current year. Sales discounts amount to $17,000. 30,000 shares of common stock were outstanding for the entire year. Interest expense was $20,000. The income tax rate is 30%. Cost of goods sold amounts to $500,000. Administrative expenses are 18% of cost of goods sold but only 8% of gross sales. Four-fifths of the operating expenses relate to sales activities. Instructions From the foregoing information prepare an income statement for the year 2010 in single-step form. 2 3 E4-4 (Multiple-step and Single-step) Two accountants for the firm of Allen and Wright are arguing about the merits of presenting an income statement in a multiple-step versus a single-step format. The discussion involves the following 2010 information related to Webster Company ($000 omitted). Administrative expense Officers salaries Depreciation of office furniture and equipment Cost of goods sold Rental revenue Selling expense Transportation-out Sales commissions Depreciation of sales equipment Sales Income tax Interest expense $ 4,900 3,960 63,570 17,230 2,690 7,980 6,480 96,500 7,580 1,860 Instructions (a) Prepare an income statement for the year 2010 using the multiple-step form. Common shares outstanding for 2010 total 40,550 (000 omitted). (b) Prepare an income statement for the year 2010 using the single-step form. (c) Which one do you prefer? Discuss. 3 4 E4-5 (Multiple-step and Extraordinary Items) The following balances were taken from the books of Parnevik Corp. on December 31, 2010. Interest revenue Cash Sales Accounts receivable Prepaid insurance Sales returns and allowances Allowance for doubtful accounts Sales discounts Land Equipment Building Cost of goods sold Accumulated depreciationequipment $ 86,000 51,000 1,280,000 150,000 20,000 150,000 7,000 45,000 100,000 200,000 140,000 621,000 40,000 Accumulated depreciationbuilding Notes receivable Selling expenses Accounts payable Bonds payable Administrative and general expenses Accrued liabilities Interest expense Notes payable Loss from earthquake damage (extraordinary item) Common stock Retained earnings $ 28,000 155,000 194,000 170,000 100,000 97,000 32,000 60,000 100,000 120,000 500,000 21,000 Assume the total effective tax rate on all items is 34%. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 162 Chapter 4 Income Statement and Related Information Instructions Prepare a multiple-step income statement; 100,000 shares of common stock were outstanding during the year. 2 3 E4-6 (Multiple-step and Single-step) The accountant of Weatherspoon Shoe Co. has compiled the following information from the companys records as a basis for an income statement for the year ended December 31, 2010. Rental revenue Interest expense Market appreciation on land above cost Wages and salariessales Materials and suppliessales Income tax Wages and salariesadministrative Other administrative expenses Cost of goods sold Net sales Depreciation on plant assets (70% selling, 30% administrative) Cash dividends declared $ 29,000 18,000 31,000 114,800 17,600 30,600 135,900 51,700 516,000 980,000 65,000 16,000 There were 20,000 shares of common stock outstanding during the year. Instructions (a) Prepare a multiple-step income statement. (b) Prepare a single-step income statement. (c) Which format do you prefer? Discuss. 2 4 6 E4-7 (Income Statement, EPS) Presented below are selected ledger accounts of McGraw Corporation as of December 31, 2010. Cash Administrative expenses Selling expenses Net sales Cost of goods sold Cash dividends declared (2010) Cash dividends paid (2010) Discontinued operations (loss before income taxes) Depreciation expense, not recorded in 2009 Retained earnings, December 31, 2009 Effective tax rate 30% $ 50,000 100,000 80,000 540,000 260,000 20,000 15,000 40,000 30,000 90,000 Instructions (a) Compute net income for 2010. (b) Prepare a partial income statement beginning with income from continuing operations before income tax, and including appropriate earnings per share information. Assume 20,000 shares of common stock were outstanding during 2010. 3 4 5 E4-8 (Multiple-step Statement with Retained Earnings) Presented below is information related to 6 7 Brokaw Corp. for the year 2010. Net sales Cost of goods sold Selling expenses Administrative expenses Dividend revenue Interest revenue $1,200,000 780,000 65,000 48,000 20,000 7,000 Write-off of inventory due to obsolescence Depreciation expense omitted by accident in 2009 Casualty loss (extraordinary item) before taxes Cash dividends declared Retained earnings at December 31, 2009 Effective tax rate of 34% on all items $ 80,000 40,000 50,000 45,000 980,000 Instructions (a) Prepare a multiple-step income statement for 2010. Assume that 60,000 shares of common stock are outstanding. (b) Prepare a retained earnings statement for 2010. 6 E4-9 (Earnings Per Share) The stockholders equity section of Sosa Corporation appears below as of December 31, 2010. 6% preferred stock, $50 par value, authorized 100,000 shares, outstanding 90,000 shares Common stock, $1 par, authorized and issued 10 million shares Additional paid-in capital Retained earnings Net income $ 4,500,000 10,000,000 20,500,000 $134,000,000 33,000,000 167,000,000 $202,000,000 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Exercises 163 Net income for 2010 reflects a total effective tax rate of 34%. Included in the net income figure is a loss of $12,000,000 (before tax) as a result of a major casualty, which should be classified as an extraordinary item. Preferred stock dividends of $270,000 were declared and paid in 2010. Dividends of $1,000,000 were declared and paid to common stockholders in 2010. Instructions Compute earnings per share data as it should appear on the income statement of Sosa Corporation. 3 4 5 E4-10 (Condensed Income StatementPeriodic Inventory Method) Presented below are selected 6 ledger accounts of Woods Corporation at December 31, 2010. Cash Merchandise inventory Sales Advances from customers Purchases Sales discounts Purchase discounts Travel and entertainmentsales Accounting and legal services Insurance expenseoffice Advertising Transportation-out Depreciation of office equipment Depreciation of sales equipment $ 185,000 535,000 4,175,000 117,000 2,786,000 34,000 27,000 69,000 33,000 24,000 54,000 93,000 48,000 36,000 Sales salaries Office salaries Purchase returns Sales returns Transportation-in Accounts receivable Sales commissions Telephonesales Utilitiesoffice Miscellaneous office expenses Rental revenue Extraordinary loss (before tax) Interest expense Common stock ($10 par) $284,000 346,000 15,000 79,000 72,000 142,500 83,000 17,000 32,000 8,000 240,000 60,000 176,000 900,000 Woodss effective tax rate on all items is 34%. A physical inventory indicates that the ending inventory is $686,000. Instructions Prepare a condensed 2010 income statement for Woods Corporation. 7 E4-11 (Retained Earnings Statement) McEntire Corporation began operations on January 1, 2007. During its first 3 years of operations, McEntire reported net income and declared dividends as follows. Net income 2007 2008 2009 $ 40,000 125,000 160,000 Dividends declared $ 0 50,000 50,000 The following information relates to 2010. Income before income tax Prior period adjustment: understatement of 2008 depreciation expense (before taxes) Cumulative decrease in income from change in inventory methods (before taxes) Dividends declared (of this amount, $25,000 will be paid on Jan. 15, 2011) Effective tax rate $220,000 $ 25,000 $ 45,000 $100,000 40% Instructions (a) Prepare a 2010 retained earnings statement for McEntire Corporation. (b) Assume McEntire Corp. restricted retained earnings in the amount of $70,000 on December 31, 2010. After this action, what would McEntire report as total retained earnings in its December 31, 2010, balance sheet? 4 5 6 E4-12 (Earnings per Share) At December 31, 2009, Schroeder Corporation had the following stock outstanding. 8% cumulative preferred stock, $100 par, 107,500 shares Common stock, $5 par, 4,000,000 shares $10,750,000 20,000,000 During 2010, Schroeder did not issue any additional common stock. The following also occurred during 2010. Income from continuing operations before taxes Discontinued operations (loss before taxes) Preferred dividends declared Common dividends declared Effective tax rate $21,650,000 3,225,000 860,000 2,200,000 35% Instructions Compute earnings per share data as it should appear in the 2010 income statement of Schroeder Corporation. (Round to two decimal places.) PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 164 Chapter 4 Income Statement and Related Information 4 5 6 E4-13 (Change in Accounting Principle) Zehms Company began operations in 2008 and adopted weighted-average pricing for inventory. In 2010, in accordance with other companies in its industry, Zehms changed its inventory pricing to FIFO. The pretax income data is reported below. Year 2008 2009 2010 WeightedAverage $370,000 390,000 410,000 FIFO $395,000 420,000 460,000 Instructions (a) What is Zehmss net income in 2010? Assume a 35% tax rate in all years. (b) Compute the cumulative effect of the change in accounting principle from weighted-average to FIFO inventory pricing. (c) Show comparative income statements for Zehms Company, beginning with income before income tax, as presented on the 2010 income statement. 3 8 E4-14 (Comprehensive Income) Armstrong Corporation reported the following for 2010: net sales $1,200,000; cost of goods sold $720,000; selling and administrative expenses $320,000; and an unrealized holding gain on available-for-sale securities $15,000. Instructions Prepare a statement of comprehensive income, using the two-income statement format. Ignore income taxes and earnings per share. 7 8 E4-15 (Comprehensive Income) Bryant Co. reports the following information for 2010: sales revenue $750,000; cost of goods sold $500,000; operating expenses $80,000; and an unrealized holding loss on available-for-sale securities for 2010 of $50,000. It declared and paid a cash dividend of $10,000 in 2010. Bryant Co. has January 1, 2010, balances in common stock $350,000; accumulated other comprehensive income $80,000; and retained earnings $90,000. It issued no stock during 2010. Instructions Prepare a statement of stockholders equity. 2 4 5 6 7 8 E4-16 (Various Reporting Formats) The following information was taken from the records of Gibson Inc. for the year 2010. Income tax applicable to income from continuing operations $119,000; income tax applicable to loss on discontinued operations $25,500; income tax applicable to extraordinary gain $32,300; income tax applicable to extraordinary loss $20,400; and unrealized holding gain on available-for-sale securities $15,000. Extraordinary gain Loss on discontinued operations Administrative expenses Rent revenue Extraordinary loss $ 95,000 75,000 240,000 40,000 60,000 Cash dividends declared Retained earnings January 1, 2010 Cost of goods sold Selling expenses Sales $ 150,000 600,000 850,000 300,000 1,700,000 Shares outstanding during 2010 were 100,000. Instructions (a) Prepare a single-step income statement for 2010. (b) Prepare a retained earnings statement for 2010. (c) Show how comprehensive income is reported using the second income statement format. llege/k i es o co See the books companion website, www.wiley.com/college/kieso, for a set of B Exercises. w 3 4 5 6 7 P4-1 (Multiple-step Income, Retained Earnings) Presented below is information related to Dickinson Company for 2010. Retained earnings balance, January 1, 2010 Sales Cost of goods sold Interest revenue $ 980,000 25,000,000 16,000,000 70,000 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile y. c o m / PROBLEMS Problems 165 Selling and administrative expenses Write-off of goodwill Income taxes for 2010 Gain on the sale of investments (normal recurring) Loss due to flood damageextraordinary item (net of tax) Loss on the disposition of the wholesale division (net of tax) Loss on operations of the wholesale division (net of tax) Dividends declared on common stock Dividends declared on preferred stock $4,700,000 820,000 1,244,000 110,000 390,000 440,000 90,000 250,000 80,000 Instructions Prepare a multiple-step income statement and a retained earnings statement. Dickinson Company decided to discontinue its entire wholesale operations and to retain its manufacturing operations. On September 15, Dickinson sold the wholesale operations to Rogers Company. During 2010, there were 500,000 shares of common stock outstanding all year. 2 6 7 P4-2 (Single-step Income, Retained Earnings, Periodic Inventory) Presented below is the trial balance of Thompson Corporation at December 31, 2010. THOMPSON CORPORATION TRIAL BALANCE DECEMBER 31, 2010 Debits Purchase Discounts Cash Accounts Receivable Rent Revenue Retained Earnings Salaries Payable Sales Notes Receivable Accounts Payable Accumulated DepreciationEquipment Sales Discounts Sales Returns Notes Payable Selling Expenses Administrative Expenses Common Stock Income Tax Expense Cash Dividends Allowance for Doubtful Accounts Supplies Freight-in Land Equipment Bonds Payable Gain on Sale of Land Accumulated DepreciationBuilding Merchandise Inventory Building Purchases Totals $ $ 189,700 105,000 18,000 160,000 18,000 1,100,000 110,000 49,000 28,000 14,500 17,500 70,000 232,000 99,000 300,000 53,900 45,000 5,000 14,000 20,000 70,000 140,000 100,000 30,000 19,600 89,000 98,000 610,000 $1,907,600 $1,907,600 Credits 10,000 A physical count of inventory on December 31 resulted in an inventory amount of $64,000; thus, cost of goods sold for 2010 is $645,000. Instructions Prepare a single-step income statement and a retained earnings statement. Assume that the only changes in retained earnings during the current year were from net income and dividends. Thirty thousand shares of common stock were outstanding the entire year. 4 5 6 P4-3 (Irregular Items) Maher Inc. reported income from continuing operations before taxes during 2010 of $790,000. Additional transactions occurring in 2010 but not considered in the $790,000 are as follows. 1. The corporation experienced an uninsured flood loss (extraordinary) in the amount of $90,000 during the year. The tax rate on this item is 46%. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 166 Chapter 4 Income Statement and Related Information 2. At the beginning of 2008, the corporation purchased a machine for $54,000 (salvage value of $9,000) that had a useful life of 6 years. The bookkeeper used straight-line depreciation for 2008, 2009, and 2010 but failed to deduct the salvage value in computing the depreciation base. Sale of securities held as a part of its portfolio resulted in a loss of $57,000 (pretax). When its president died, the corporation realized $150,000 from an insurance policy. The cash surrender value of this policy had been carried on the books as an investment in the amount of $46,000 (the gain is nontaxable). The corporation disposed of its recreational division at a loss of $115,000 before taxes. Assume that this transaction meets the criteria for discontinued operations. The corporation decided to change its method of inventory pricing from average cost to the FIFO method. The effect of this change on prior years is to increase 2008 income by $60,000 and decrease 2009 income by $20,000 before taxes. The FIFO method has been used for 2010. The tax rate on these items is 40%. 3. 4. 5. 6. Instructions Prepare an income statement for the year 2010 starting with income from continuing operations before taxes. Compute earnings per share as it should be shown on the face of the income statement. Common shares outstanding for the year are 120,000 shares. (Assume a tax rate of 30% on all items, unless indicated otherwise.) 3 4 6 7 P4-4 (Multiple- and Single-step Income, Retained Earnings) The following account balances were included in the trial balance of Twain Corporation at June 30, 2010. Sales Sales discounts Cost of goods sold Sales salaries Sales commissions Travel expensesalespersons Freight-out Entertainment expense Telephone and Internet expensesales Depreciation of sales equipment Building expenseprorated to sales Miscellaneous selling expenses Office supplies used Telephone and Internet expense administration $1,578,500 31,150 896,770 56,260 97,600 28,930 21,400 14,820 9,030 4,980 6,200 4,715 3,450 2,820 Depreciation of office furniture and equipment Real estate and other local taxes Bad debt expenseselling Building expenseprorated to administration Miscellaneous office expenses Sales returns Dividends received Bond interest expense Income taxes Depreciation understatement due to error2007 (net of tax) Dividends declared on preferred stock Dividends declared on common stock $ 7,250 7,320 4,850 9,130 6,000 62,300 38,000 18,000 102,000 17,700 9,000 37,000 The Retained Earnings account had a balance of $337,000 at July 1, 2009. There are 80,000 shares of common stock outstanding. Instructions (a) Using the multiple-step form, prepare an income statement and a retained earnings statement for the year ended June 30, 2010. (b) Using the single-step form, prepare an income statement and a retained earnings statement for the year ended June 30, 2010. 4 5 6 P4-5 (Irregular Items) Presented below is a combined single-step income and retained earnings state7 ment for Nerwin Company for 2010. (000 omitted) Net sales Costs and expenses Cost of goods sold Selling, general, and administrative expenses Other, net Income before income tax Income tax Net income Retained earnings at beginning of period, as previously reported Adjustment required for correction of error Retained earnings at beginning of period, as restated Dividends on common stock Retained earnings at end of period 141,000 (7,000) 134,000 (12,200) $159,400 $640,000 $500,000 66,000 17,000 583,000 57,000 19,400 37,600 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Problems 167 Additional facts are as follows. 1. 2. Selling, general, and administrative expenses for 2010 included a charge of $8,500,000 that was usual but infrequently occurring. Other, net for 2010 included an extraordinary item (charge) of $6,000,000. If the extraordinary item (charge) had not occurred, income taxes for 2010 would have been $21,400,000 instead of $19,400,000. Adjustment required for correction of an error was a result of a change in estimate (useful life of certain assets reduced to 8 years and a catch-up adjustment made). Nerwin Company disclosed earnings per common share for net income in the notes to the financial statements. 3. 4. Instructions Determine from these additional facts whether the presentation of the facts in the Nerwin Company income and retained earnings statement is appropriate. If the presentation is not appropriate, describe the appropriate presentation and discuss its theoretical rationale. (Do not prepare a revised statement.) 4 5 7 P4-6 (Retained Earnings Statement, Prior Period Adjustment) Below is the retained earnings account for the year 2010 for Acadian Corp. Retained earnings, January 1, 2010 Add: Gain on sale of investments (net of tax) Net income Refund on litigation with government, related to the year 2007 (net of tax) Recognition of income earned in 2009, but omitted from income statement in that year (net of tax) Deduct: Loss on discontinued operations (net of tax) Write-off of goodwill (net of tax) Cumulative effect on income of prior years in changing from LIFO to FIFO inventory valuation in 2010 (net of tax) Cash dividends declared Retained earnings, December 31, 2010 $257,600 $41,200 84,500 21,600 25,400 172,700 430,300 35,000 60,000 23,200 32,000 150,200 $280,100 Instructions (a) Prepare a corrected retained earnings statement. Acadian Corp. normally sells investments of the type mentioned above. FIFO inventory was used in 2010 to compute net income. (b) State where the items that do not appear in the corrected retained earnings statement should be shown. 4 5 6 P4-7 (Income Statement, Irregular Items) Wade Corp. has 150,000 shares of common stock outstanding. In 2010, the company reports income from continuing operations before income tax of $1,210,000. Additional transactions not considered in the $1,210,000 are as follows. 1. 2. In 2010, Wade Corp. sold equipment for $40,000. The machine had originally cost $80,000 and had accumulated depreciation of $30,000. The gain or loss is considered ordinary. The company discontinued operations of one of its subsidiaries during the current year at a loss of $190,000 before taxes. Assume that this transaction meets the criteria for discontinued operations. The loss from operations of the discontinued subsidiary was $90,000 before taxes; the loss from disposal of the subsidiary was $100,000 before taxes. An internal audit discovered that amortization of intangible assets was understated by $35,000 (net of tax) in a prior period. The amount was charged against retained earnings. The company had a gain of $125,000 on the condemnation of much of its property. The gain is taxed at a total effective rate of 40%. Assume that the transaction meets the requirements of an extraordinary item. 3. 4. Instructions Analyze the above information and prepare an income statement for the year 2010, starting with income from continuing operations before income tax. Compute earnings per share as it should be shown on the face of the income statement. (Assume a total effective tax rate of 38% on all items, unless otherwise indicated.) PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 168 Chapter 4 Income Statement and Related Information CONCEPTS FOR ANALYSIS CA4-1 (Identification of Income Statement Deficiencies) OMalley Corporation was incorporated and began business on January 1, 2010. It has been successful and now requires a bank loan for additional working capital to finance expansion. The bank has requested an audited income statement for the year 2010. The accountant for OMalley Corporation provides you with the following income statement which OMalley plans to submit to the bank. OMALLEY CORPORATION INCOME STATEMENT Sales Dividends Gain on recovery of insurance proceeds from earthquake loss (extraordinary) Less: Selling expenses Cost of goods sold Advertising expense Loss on obsolescence of inventories Loss on discontinued operations Administrative expense Income before income tax Income tax Net income $850,000 32,300 38,500 920,800 $101,100 510,000 13,700 34,000 48,600 73,400 780,800 140,000 56,000 $ 84,000 Instructions Indicate the deficiencies in the income statement presented above. Assume that the corporation desires a single-step income statement. CA4-2 (Income Reporting Deficiencies) Boeing Company. The following represents a recent income statement for ($ in millions) Sales Costs and expenses Income from operations Other income Interest and debt expense Earnings before income taxes Income taxes Net income $ $21,924 20,773 1,151 122 (130) 1,143 (287) 856 It includes only five separate numbers (two of which are in billions of dollars), two subtotals, and the net earnings figure. Instructions (a) Indicate the deficiencies in the income statement. (b) What recommendations would you make to Boeing to improve the usefulness of its income statement? CA4-3 (Extraordinary Items) Derek Lee, vice-president of finance for Chicago Company, has recently been asked to discuss with the companys division controllers the proper accounting for extraordinary items. Derek Lee prepared the factual situations presented below as a basis for discussion. 1. 2. An earthquake destroys one of the oil refineries owned by a large multinational oil company. Earthquakes are rare in this geographical location. A publicly held company has incurred a substantial loss in the unsuccessful registration of a bond issue. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Concepts for Analysis 169 3. 4. 5. A large portion of a cigarette manufacturers tobacco crops are destroyed by a hailstorm. Severe damage from hailstorms is rare in this locality. A large diversified company sells a block of shares from its portfolio of securities acquired for investment purposes. A company that operates a chain of warehouses sells the excess land surrounding one of its warehouses. When the company buys property to establish a new warehouse, it usually buys more land than it expects to use for the warehouse with the expectation that the land will appreciate in value. Twice during the past 5 years the company sold excess land. A company experiences a material loss in the repurchase of a large bond issue that has been outstanding for 3 years. The company regularly repurchases bonds of this nature. A railroad experiences an unusual flood loss to part of its track system. Flood losses normally occur every 3 or 4 years. A machine tool company sells the only land it owns. The land was acquired 10 years ago for future expansion, but shortly thereafter the company abandoned all plans for expansion but decided to hold the land for appreciation. 6. 7. 8. Instructions Determine whether the foregoing items should be classified as extraordinary items. Present a rationale for your position. CA4-4 (Earnings Management) Bobek Inc. has recently reported steadily increasing income. The company reported income of $20,000 in 2007, $25,000 in 2008, and $30,000 in 2009. A number of market analysts have recommended that investors buy the stock because they expect the steady growth in income to continue. Bobek is approaching the end of its fiscal year in 2010, and it again appears to be a good year. However, it has not yet recorded warranty expense. Based on prior experience, this years warranty expense should be around $5,000, but some managers have approached the controller to suggest a larger, more conservative warranty expense should be recorded this year. Income before warranty expense is $43,000. Specifically, by recording a $7,000 warranty accrual this year, Bobek could report an increase in income for this year and still be in a position to cover its warranty costs in future years. Instructions (a) What is earnings management? (b) Assume income before warranty expense is $43,000 for both 2010 and 2011 and that total warranty expense over the 2-year period is $10,000. What is the effect of the proposed accounting in 2010? In 2011? (c) What is the appropriate accounting in this situation? CA4-5 (Earnings Management) Charlie Brown, controller for the Kelly Corporation, is preparing the companys income statement at year-end. He notes that the company lost a considerable sum on the sale of some equipment it had decided to replace. Since the company has sold equipment routinely in the past, Brown knows the losses cannot be reported as extraordinary. He also does not want to highlight it as a material loss since he feels that will reflect poorly on him and the company. He reasons that if the company had recorded more depreciation during the assets lives, the losses would not be so great. Since depreciation is included among the companys operating expenses, he wants to report the losses along with the companys expenses, where he hopes it will not be noticed. Instructions (a) What are the ethical issues involved? (b) What should Brown do? CA4-6 (Income Reporting Items) Simpson Corp. is an entertainment firm that derives approximately 30% of its income from the Casino Knights Division, which manages gambling facilities. As auditor for Simpson Corp., you have recently overheard the following discussion between the controller and financial vice-president. VICE-PRESIDENT: If we sell the Casino Knights Division, it seems ridiculous to segregate the results of the sale in the income statement. Separate categories tend to be absurd and confusing to the stockholders. I believe that we should simply report the gain on the sale as other income or expense without detail. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 170 Chapter 4 Income Statement and Related Information CONTROLLER: Professional pronouncements would require that we disclose this information separately in the income statement. If a sale of this type is considered unusual and infrequent, it must be reported as an extraordinary item. VICE-PRESIDENT: What about the walkout we had last month when employees were upset about their commission income? Would this situation not also be an extraordinary item? CONTROLLER: I am not sure whether this item would be reported as extraordinary or not. VICE-PRESIDENT: Oh well, it doesnt make any difference because the net effect of all these items is immaterial, so no disclosure is necessary. Instructions (a) On the basis of the foregoing discussion, answer the following questions: Who is correct about handling the sale? What would be the correct income statement presentation for the sale of the Casino Knights Division? (b) How should the walkout by the employees be reported? (c) What do you think about the vice-presidents observation on materiality? (d) What are the earnings per share implications of these topics? CA4-7 (Identification of Income Statement Weaknesses) The following financial statement was prepared by employees of Walters Corporation. WALTERS CORPORATION INCOME STATEMENT YEAR ENDED DECEMBER 31, 2010 Revenues Gross sales, including sales taxes Less: Returns, allowances, and cash discounts Net sales Dividends, interest, and purchase discounts Recoveries of accounts written off in prior years Total revenues Costs and expenses Cost of goods sold, including sales taxes Salaries and related payroll expenses Rent Freight-in and freight-out Bad debt expense Total costs and expenses Income before extraordinary items Extraordinary items Loss on discontinued styles (Note 1) Loss on sale of marketable securities (Note 2) Loss on sale of warehouse (Note 3) Total extraordinary items Net income Net income per share of common stock $1,044,300 56,200 988,100 30,250 13,850 1,032,200 465,900 60,500 19,100 3,400 27,800 576,700 455,500 71,500 39,050 86,350 196,900 $ 258,600 $2.30 Note 1: New styles and rapidly changing consumer preferences resulted in a $71,500 loss on the disposal of discontinued styles and related accessories. Note 2: The corporation sold an investment in marketable securities at a loss of $39,050. The corporation normally sells securities of this nature. Note 3: The corporation sold one of its warehouses at an $86,350 loss. Instructions Identify and discuss the weaknesses in classification and disclosure in the single-step income statement above. You should explain why these treatments are weaknesses and what the proper presentation of the items would be in accordance with GAAP. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Using Your Judgment 171 CA4-8 (Classification of Income Statement Items) As audit partner for Grupo and Rijo, you are in charge of reviewing the classification of unusual items that have occurred during the current year. The following material items have come to your attention. 1. 2. 3. A merchandising company incorrectly overstated its ending inventory 2 years ago. Inventory for all other periods is correctly computed. An automobile dealer sells for $137,000 an extremely rare 1930 S type Invicta which it purchased for $21,000 10 years ago. The Invicta is the only such display item the dealer owns. A drilling company during the current year extended the estimated useful life of certain drilling equipment from 9 to 15 years. As a result, depreciation for the current year was materially lowered. A retail outlet changed its computation for bad debt expense from 1% to 12 of 1% of sales because of changes in its customer clientele. A mining concern sells a foreign subsidiary engaged in uranium mining, although it (the seller) continues to engage in uranium mining in other countries. A steel company changes from the average-cost method to the FIFO method for inventory costing purposes. A construction company, at great expense, prepared a major proposal for a government loan. The loan is not approved. A water pump manufacturer has had large losses resulting from a strike by its employees early in the year. Depreciation for a prior period was incorrectly understated by $950,000. The error was discovered in the current year. A large sheep rancher suffered a major loss because the state required that all sheep in the state be killed to halt the spread of a rare disease. Such a situation has not occurred in the state for 20 years. A food distributor that sells wholesale to supermarket chains and to fast-food restaurants (two distinguishable classes of customers) decides to discontinue the division that sells to one of the two classes of customers. 4. 5. 6. 7. 8. 9. 10. 11. Instructions From the foregoing information, indicate in what section of the income statement or retained earnings statement these items should be classified. Provide a brief rationale for your position. CA4-9 (Comprehensive Income) Willie Nelson, Jr., controller for Jenkins Corporation, is preparing the companys financial statements at year-end. Currently, he is focusing on the income statement and determining the format for reporting comprehensive income. During the year, the company earned net income of $400,000 and had unrealized gains on available-for-sale securities of $15,000. In the previous year net income was $410,000, and the company had no unrealized gains or losses. Instructions (a) Show how income and comprehensive income will be reported on a comparative basis for the current and prior years, using the separate income statement format. (b) Show how income and comprehensive income will be reported on a comparative basis for the current and prior years, using the combined income statement format. (c) Which format should Nelson recommend? USING YOUR JUDGMENT FI NANCIAL REPORTI NG Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B or can be accessed at the books companion website, www.wiley.com/college/kieso. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 172 Chapter 4 Income Statement and Related Information es o llege/k i Instructions Refer to P&Gs financial statements and the accompanying notes to answer the following questions. (a) What type of income statement format does P&G use? Indicate why this format might be used to present income statement information. (b) What are P&Gs primary revenue sources? (c) Compute P&Gs gross profit for each of the years 20052007. Explain why gross profit increased in 2007. (d) Why does P&G make a distinction between operating and nonoperating revenue? (e) What financial ratios did P&G choose to report in its Financial Summary section covering the years 19972007? w co co llege/k i es o PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile ile y. c o m / y. c o m / Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. Instructions Go to the books companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) What type of income format(s) is used by these two companies? Identify any differences in income statement format between these two companies. (b) What are the gross profits, operating profits, and net incomes for these two companies over the 3-year period 20052007? Which company has had better financial results over this period of time? (c) Identify the irregular items reported by these two companies in their income statements over the 3-year period 20052007. Do these irregular items appear to be significant? w Financial Statement Analysis Cases Case 1 Bankruptcy Prediction The Z-score bankruptcy prediction model uses balance sheet and income information to arrive at a Z-Score, which can be used to predict financial distress: Z Working capital Total assets MV equity Total liabilities 1.2 0.6 Retained earnings Total assets 1.4 EBIT Total assets 3.3 Sales Total assets .99 EBIT is earnings before interest and taxes. MV Equity is the market value of common equity, which can be determined by multiplying stock price by shares outstanding. Following extensive testing, it has been shown that companies with Z-scores above 3.0 are unlikely to fail; those with Z-scores below 1.81 are very likely to fail. While the original model was developed for publicly held manufacturing companies, the model has been modified to apply to companies in various industries, emerging companies, and companies not traded in public markets. Instructions (a) Use information in the financial statements of a company like Walgreens or Deere & Co. to compute the Z-score for the past 2 years. (b) Interpret your result. Where does the company fall in the financial distress range? (c) The Z-score uses EBIT as one of its elements. Why do you think this income measure is used? Using Your Judgment 173 Case 2 Dresser Industries Dresser Industries provides products and services to oil and natural gas exploration, production, transmission and processing companies. A recent income statement is reproduced below. Dollar amounts are in millions. Sales Service revenues Share of earnings of unconsolidated affiliates Total revenues Cost of sales Cost of services Total costs of sales and services Gross earnings Selling, engineering, administrative and general expenses Special charges Other income (deductions) Interest expense Interest earned Other, net Earnings before income taxes and other items below Income taxes Minority interest Earnings from continuing operations Discontinued operations Earnings before extraordinary items Extraordinary items Net earnings $2,697.0 1,933.9 92.4 4,723.3 1,722.7 1,799.9 3,522.6 1,200.7 (919.8) (70.0) (47.4) 19.1 4.8 187.4 (79.4) (10.3) 97.7 (35.3) 62.4 (6.3) $56.1 Instructions Assume that 177,636,000 shares of stock were issued and outstanding. Prepare the per-share portion of the income statement. Remember to begin with Earnings from continuing operations. Case 3 P/E Ratios One of the more closely watched ratios by investors is the price/earnings or P/E ratio. By dividing price per share by earnings per share, analysts get insight into the value the market attaches to a companys earnings. More specifically, a high P/E ratio (in comparison to companies in the same industry) may suggest the stock is overpriced. Also, there is some evidence that companies with low P/E ratios are underpriced and tend to outperform the market. However, the ratio can be misleading. P/E ratios are sometimes misleading because the E (earnings) is subject to a number of assumptions and estimates that could result in overstated earnings and a lower P/E. Some analysts conduct revenue analysis to evaluate the quality of an earnings number. Revenues are less subject to management estimates and all earnings must begin with revenues. These analysts also compute the price-to-sales ratio (PSR price per share sales per share) to assess whether a company is performing well compared to similar companies. If a company has a price-to-sales ratio significantly higher than its competitors, investors may be betting on a stock that has yet to prove itself. [Source: Janice Revell, Beyond P/E, Fortune (May 28, 2001), p. 174.] Instructions (a) Identify some of the estimates or assumptions that could result in overstated earnings. (b) Compute the P/E ratio and the PSR for Tootsie Roll and Hersheys for 2007. (c) Use these data to compare the quality of each companys earnings. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark 174 Chapter 4 Income Statement and Related Information International Reporting Case Presented below is the income statement for a British company, Avon Rubber PLC. Avon prepares its financial statements in accordance with iGAAP. Avon Rubber PLC Consolidated Income Statement for the year ended 30 September 2007 000 Continuing operations Revenues Cost of sales Gross profit Distribution costs Administrative expenses Other operating income Operating profit from continuing operations Operating profit is analysed as: Before exceptional items Exceptional operating items Finance income Finance costs Other finance income Profit before taxation Taxation Profit/(loss) for the year from continuing operations Discontinued operations Loss for the year from discontinued operations Profit/(loss) for the year Earnings/(loss) per share Basic Diluted Earnings/(loss) per share from continuing operations Basic Diluted 66,715 (52,742) 13,973 (3,873) (10,633) 1,771 1,238 2006 000 63,112 (47,821) 15,291 (4,016) (9,923) 1,114 2,466 1,238 114 (915) 2,489 2,926 (717) 2,209 (1,114) 1,095 (79) 2,545 123 (3,493) 2,151 1,247 (2,045) (798) (18,329) (19,127) 3.9p 3.8p (68.9)p (68.9)p 7.9p 7.7p (2.1)p (2.1)p Instructions (a) Review the Avon Rubber income statement and identify at least three differences between the iGAAP income statement and an income statement of a U.S. company as presented in the chapter. (b) Identify any irregular items reported by Avon Rubber. Is the reporting of these irregular items in Avons income statement similar to reporting of these items in U.S. companies income statements? Explain. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark Using Your Judgment 175 BRI DGE TO TH E PROFESSION Professional Research: FASB Codification Your client took accounting a number of years ago and was unaware of comprehensive income reporting. He is not convinced that any accounting standards exist for comprehensive income. Instructions Access the FASB Codification at http://asc.fasb.org/home to conduct research using the Codification Research System to prepare responses to the following items. Provide Codification references for your responses. (a) What authoritative literature addresses comprehensive income? When was it issued? (b) Provide the definition of comprehensive income. (c) Define classifications within net income; give examples. (d) Define classifications within other comprehensive income; give examples. (e) What are reclassification adjustments? Professional Simulation Go to the books companion website, at www.wiley.com/college/kieso, to find an interactive problem that simulates the computerized CPA exam. The professional simulation for this chapter asks you to compute various amounts and answer questions related to the income statement. KWW_Professional _Simulation Income Statement Time Remaining 3 hours 30 minutes copy paste calculator sheet standards help ? spliter done co Remember to check the books companion website to find additional resources for this chapter. llege/k i es o w PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark ile y. c o m /

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Grand Canyon - ACC - 360
The Income Statement and Statement of Cash Flows4Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.4 -2Learning ObjectivesExplain the difference between net income and comprehensive income and how we report components of the diffe
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Chapt er 5Client Acceptance and Continuance and Preliminary Engagement ProceduresL ear ning Object ives1. Under st and t he pur pose and r ole of client accept ance and cont inuance act ivit ies. 2. Recognize t he pr ofessional st andar ds r elat ing t
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CHAPTER5BALANCE SH EET AN D STATEMENT OF CASH FLOWSLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7 8 9Explain the uses and limitations of a balance sheet. Identify the major classifications of the balance sheet. P
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Income Measurement a nd Profitability Analysis5Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.5 -2Learning ObjectivesDiscuss the general objective of the timing of revenue recognition, list the two general criteria that must be
Grand Canyon - ACC - 360
Chapter 6Audit Planning and Risk AssessmentLearning Objectives1. Learn the steps of the planning process for an integrated audit. 2. Become familiar with the components that impact the audit strategy and audit plan. 3. Understand the relationship of ri
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CHAPTER6ACCOU NTI NG AN D TH E TIME VALU E OF MON EYLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7 8 9Identify accounting topics where the time value of money is relevant. Distinguish between simple and compound
Grand Canyon - ACC - 360
Time Value of Money Concepts6Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.6 -2Time Value of MoneyInterest is the rent paid for the use of money over time.Thats right! A dollar today is more valuable than a dollar to be recei
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Chapter 7Understanding Internal Control over Financial Reporting and Auditing Design EffectivenessLearning Objectives1. Understand the value of effective internal control. 2. Learn the components and mechanisms of internal control. 3. Describe the inte
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CHAPTER7CAS H AN D R E C E IVAB L E SLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7 8 9Identify items considered cash. Indicate how to report cash and related items. Define receivables and identify the different
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Cash and ReceivablesInsert Book Cover Picture7Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.7 -2CashCoins and currencyPetty cash Cashiers checksCertified checks Amounts on deposit with financial institutionsMoney orders7
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Chapter 8Planning and Testing Operating Effectiveness of Internal Control over Financial ReportingPrepared by Richard J. CampbellCopyright 2011, Wiley and SonsLearning Objectives1. Learn the relationships of a control, evidence available, and tests o
Grand Canyon - ACC - 360
Inventories: Measurement8Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.8 -2InventoryThose assets that a company:1. Intends to sell in the normal course of business. 2. Has in production (work in process) for future sale. 3.
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CHAPTER8VALUATION OF I NVE NTOR I E S : A COST-BASIS APPROAC HLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7 8 9 10Identify major classifications of inventory. Distinguish between perpetual and periodic inventory
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Chapter 9Substantive Procedures and the Financial Statement AuditPrepared by Richard J. CampbellCopyright 2011, Wiley and SonsLearning Objectives1. Recognize the audit associations of transaction cycles, account balances, management assertions, and a
Grand Canyon - ACC - 360
Inventories: Additional Issues9Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.9 -2Learning ObjectiveUnderstand and apply the lower-of-costor-market rule used to value inventories.9 -3Lower of Cost or Market (LCM)GAAP require
Grand Canyon - ACC - 360
CHAPTER9I NVE NTOR I E S: ADDITIONAL VALUATI ON ISSU ESLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7Describe and apply the lower-of-cost-or-market rule. Explain when companies value inventories at net realizable
Grand Canyon - ACC - 360
Chapter 10Auditing Revenue Processes: Sales, Billing, and Collection in the Health-Care Provider and Retailing IndustriesPrepared by Richard J. CampbellCopyright 2011, Wiley and SonsLearning Objectives1. Understand the revenue-producing, billing, and
Grand Canyon - ACC - 360
CHAPTER10ACQ U ISITION AN D DISPOSITION OF PROPERTY, PL A NT, AN D E QU I PM E NTLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7Describe property, plant, and equipment. Identify the costs to include in initial val
Grand Canyon - ACC - 360
Operational Assets: Acquisition and DispositionInsert Book Cover Picture10Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.10-2Types of Operational AssetsActively Used in OperationsExpected to Benefit Future Periods Tangible Pr
Grand Canyon - ACC - 360
Chapter 11Completing the Integrated Audit and ReportingPrepared by Richard J. CampbellCopyright 2011, Wiley and SonsLearning Objectives1. Learn the various topics and steps addressed in the final phase of an integrated audit, including the integrated
Grand Canyon - ACC - 360
CHAPTER11DEPR EC IATION, IM PAI R ME NTS, AN D D E PLE TIONLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7Explain the concept of depreciation. Identify the factors involved in the depreciation process. Compare act
Grand Canyon - ACC - 360
Operational Assets: Utilization and ImpairmentInsert Book Cover Picture11Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.11-2Learning ObjectivesExplain the concept of cost allocation as it pertains to operational assets.11-3C
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Chapter 12Auditing Acquisitions and Payments Processes: Cash Disbursements and Related Activities in the Automotive IndustriesPrepared by Richard J. CampbellCopyright 2011, Wiley and SonsLearning Objectives1. Learn the activities, transactions, risks
Grand Canyon - ACC - 360
CHAPTER12I NTANGI B LE ASSETSLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7 8 9 10Describe the characteristics of intangible assets. Identify the costs to include in the initial valuation of intangible assets. Ex
Grand Canyon - ACC - 360
Investments12Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.12-2Accounting for Investment SecuritiesBonds and notes (Debt securities) Common and preferred stock (Equity (Equity securities) securities)Investments can be accoun
Grand Canyon - ACC - 360
Chapter 13Auditing Human Resources Processes: Personnel and Payroll in Service IndustriesPrepared by Richard J. CampbellCopyright 2011, Wiley and SonsLearning Objectives1. Be familiar with the human resources activities in a public accounting firm. 2
Grand Canyon - ACC - 360
CHAPTER13CU R R ENT LIAB I LITI ES AN D CONTI NGE NC I E SLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6Describe the nature, type, and valuation of current liabilities. Explain the classification issues of short-te
Grand Canyon - ACC - 360
Current Liabilities and ContingenciesInsert Book Cover Picture13Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.13-2Learning ObjectivesDefine liabilities and distinguish between current and long-term liabilities.13-3Liabiliti
Grand Canyon - ACC - 360
Chapter 14Auditing Inventory Processes: Tracking and Costing Products in the Land Development and Home Building IndustryPrepared by Richard J. CampbellCopyright 2011, Wiley and SonsLearning Objectives1. Be familiar with inventory activities in the la
Grand Canyon - ACC - 360
Bonds and Long-Term Notes14Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.14-2Learning ObjectivesIdentify the underlying characteristics of debt instruments and describe the basic approach to accounting for debt.14-3Nature of
Grand Canyon - ACC - 360
CHAPTER14LONG-TE RM LIAB I LITI E SLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7 8Describe the formal procedures associated with issuing long-term debt. Identify various types of bond issues. Describe the accoun
Grand Canyon - ACC - 360
Chapter 15Auditing Assets, Liabilities, and Equity Related to the Financing CyclePrepared by Richard J. CampbellCopyright 2011, Wiley and SonsLearning Objectives1. Describe the activities, controls, accounting standards, and audit steps for cash, nea
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Leases15Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.15-2Learning ObjectivesIdentify and describe the operational, financial, and tax objectives that motivate leasing.15-3Basic Lease TermsA lease is an agreement where the
Grand Canyon - ACC - 360
CHAPTER15STOC KHOLDERS EQU ITYLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1 2 3 4 5 6 7 8 9Discuss the characteristics of the corporate form of organization. Identify the key components of stockholders equity. Explain the a
Grand Canyon - ACC - 360
Chapter 16Topics Beyond the Integrated AuditPrepared by Richard J. CampbellCopyright 2011, Wiley and SonsLearning Objectives1. Describe forensic accounting and contrast it with ICFR and financial statement audits. 2. Understand internal audit activit
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Pensions and Other Postretirement Benefits17Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.17-2Nature of Pension PlansI agree to make payments agree into a fund for future retirement benefits for employee services. employeeI a
Grand Canyon - ACC - 360
Shareholders EquityInsert Book Cover Picture18Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.18-2Learning ObjectivesDescribe the components of shareholders equity and explain how they are reported in a statement of shareholder
Grand Canyon - ACC - 360
Share-Based Compensation and Earnings Per Share19Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.19-2Learning ObjectivesExplain and implement the accounting for stock award plans.19-3Stock Award PlansRestricted stock award pl
Grand Canyon - ACC - 360
Accounting Changes and Error CorrectionsInsert Book Cover Picture20Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.20-2Learning ObjectivesDifferentiate between the three types of accounting changes and between the retrospective
Grand Canyon - ACC - 360
TheStatement ofCashFlows Revisited21 McGrawHill/Irwin2007TheMcGrawHillCompanies,Inc.Chapter21StatementofCash FlowsRevisited McGrawHill/Irwin2007TheMcGrawHillCompanies,Inc.Slide 22-3CASH INFLOWSOperating Activities Cash received from revenues Inv
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DerivativesAppendix ACopyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.A -2DerivativesDerivatives are financial instruments that derive their values from some other security or index. They serve as a form of insurance against ris
Grand Canyon - ACC - 360
Slide 1 -11Introduction to Business Combinations and the Conceptual FrameworkAdvanced Accounting, Fourth EditionSlide 1 -2Learning Objectives1. 2. 3. 4. 5. 6. 7.De scribehistorical tre in type of busine com nds s ss binations. I de ntify them re aj
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Slide 2 -12Accounting for Business Accounting Combinations CombinationsAdvanced Accounting, Fourth EditionSlide 2 -2Learning Objectives1.De scribethem change in theaccounting for busine com ajor s ss binations passe by theFAS in De m r 2007, and th
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Slide 3 -13Consolidated Financial Consolidated StatementsDate of Acquisition StatementsDateAdvanced Accounting, Fourth EditionSlide 3 -2Learning Objectives1. 2. 3. 4. 5. 6. 7. 8. 9. 10.Unde rstand theconce of control as use in re re to consolidatio
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Slide 4 -14Consolidated Financial Consolidated Statements After Acquisition StatementsAdvanced Accounting, Fourth EditionSlide 4 -2Learning Objectives1.De scribetheaccounting tre e re atm nt quire unde curre GAAP for varying le ls of influe or cont
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Slide 5 -15Allocation and Depreciation of Allocation Differences Between Implied and Book Values Acquisition BookAdvanced Accounting, Fourth EditionSlide 5 -2Learning Objectives1. 2. 3. 4. 5.C alculatethediffe ncebe e im d and book value and alloca
Grand Canyon - ACC - 360
Slide 6 -16Elimination of Unrealized Profit on Intercompany Profit Sales of Inventory SalesAdvanced Accounting, Fourth EditionSlide 6 -2Learning Objectives1. 2. 3. 4. 5. 6. 7.Describethefinancialreportingobjectivesforintercompanysalesofinventory. D
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Slide 7 -17Elimination of Unrealized Gains or Losses on Intercompany Sales of Property and EquipmentAdvanced Accounting, Fourth EditionSlide 7 -2Learning Objectives1.Unde rstand thefinancial re porting obje s in accounting for inte pany sale ctive
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Slide 8 -18Changes in Ownership InterestAdvanced Accounting, Fourth EditionSlide 8 -2Learning Objectives1. 2. 3. 4. 5. 6. I de ntify thetype of transactions that changethepare com s nt panys owne rship inte st in a re subsidiary. De scribetheproce n
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Slide 9 -19Intercompany Intercompany Bond Holdings and Miscellaneous Topics Miscellaneous Consolidated Financial Consolidated Statements StatementsAdvanced Accounting, Fourth EditionSlide 9 -2Learning Objectives1. 2.De scribethete constructivere m
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Slide 10-110InsolvencyLiquidation and Liquidation Reorganization ReorganizationAdvanced Accounting, Fourth EditionSlide 10-2Learning Objectives1. 2.Distinguish be e a C twe n hapte 7 and a C r hapte 11 bankruptcy. r De scribethefivepriority cate s
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Slide 11-111International Accounting and the International Global Economy GlobalAdvanced Accounting, Fourth EditionSlide 11-2Learning Objectives1. 2. 3. 4. 5. 6. 7. Describe how the changing world environment is leading to an increased focus on inte
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Slide 12-112Accounting for Foreign Currency Accounting Transactions and Hedging Foreign Exchange Risk ForeignAdvanced Accounting, Fourth EditionSlide 12-2Learning Objectives1. 2. 3. 4. Distinguish be e thete s m asure and de inate twe n rm e d nom d
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Slide 13-113Translation of Financial Statements of Foreign AffiliatesAdvanced Accounting, Fourth EditionSlide 13-2Learning Objectives1. 2. 3. 4. 5. Distinguishbetweenthecurrentexchangerateandthehistoricalexchangerate. Understandtheobjectivesoffinanc
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Slide 14-114Reporting for Segments and for Interim Financial PeriodsAdvanced Accounting, Fourth EditionSlide 14-2Learning Objectives1. 2. 3. 4. 5. 6. Unde rstand thene d for disaggre d financial data. e gate De scribethebasic re quire e of public co
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Slide 15-115Partnerships: Formation, Operation and Ownership ChangesAdvanced Accounting, Fourth EditionSlide 15-2Learning Objectives1. De scribethecharacte ristics of a ge ral partne ne rship, a lim d partne ite rship, and a joint ve nture . List so
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Slide 16-116Partnerships LiquidationAdvanced Accounting, Fourth EditionSlide 16-2Learning Objectives1. 2. 3. 4. 5. 6. De scribetheste use to distributeavailablepartne ps d rship asse in liquidation ts unde theUniformPartne r rship Act (UPA). List th
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Slide 17-117Introduction to Fund AccountingAdvanced Accounting, Fourth EditionSlide 17-2Learning Objectives1. 2. 3. 4. 5. Distinguishbetweenanonbusinessorganizationandaprofitoriented enterprise. Explaintheroleoffundaccounting. Distinguishamongthecon
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Chapter 18-118Introduction to Accounting For State and Local Governmental UnitsAdvanced Accounting, Fourth EditionChapter 18-2Learning Objectives1. I de ntify theissue involve in de loping standards for nonprofit s d ve organizations. De scribethebr
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Chapter 19-119Accounting For Nongovernment Nonbusiness Organizations: Colleges And Universities, Hospitals And Other Health Care OrganizationsAdvanced Accounting, Fourth EditionChapter 19-2Learning Objectives1. 2. 3. 4. 5. 6. 7. De scribethesourceof
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Chapter 1 Federal Income Taxation - An Overview2009 Edition Questions 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 Topic Adam Smith's system requirements How well income tax and employment taxes meet Adam Smith's requirements Proportional,