Chapter 19 Edition th Income Statement Intermediate Accounting James D Stice Earl K Stice PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University © 2014 Cengage Learning 4-1 What It Is and What It Isn’t • Income is not equal to the amount of cash generated from the successful operation of the business • Income is a return over and above the investment • It is the amount that an entity could return to its investors and still leave the entity as well-off at the end of the period as it was at the beginning 4-2 Financial Capital Maintenance Concept of Income Determination The financial capital maintenance concept assumes that a company has income “only if the dollar amount of an enterprise’s net assets at the end of the period exceeds the dollar amount of net assets at the beginning of the period after excluding the effects of transactions with owners (continued) 4-3 Financial Capital Maintenance Concept of Income Determination Kreidler, Inc had the following assets and liabilities at the beginning and at the end of a period Total assets Total liabilities Net assets (owners’ equity) Beginning of Period End of Period $510,000 $560,000 430,000 390,000 Income is $90,000 $ 80,000 $170,000 (continued) 4-4 Financial Capital Maintenance Concept of Income Determination If the owners invested $40,000 in the business and received dividends of $15,000, what would be the income? Net assets, end of period Net assets, beginning of period Change (increase) in net assets Deduct investment by owners Add dividends to owners Income $170,000 80,000 $ 90,000 (40,000) 15,000 $ 65,000 4-5 Physical Capital Maintenance Concept of Income Determination • Income per physical capital maintenance • • occurs only if physical production capacity at the end of the period exceeds the physical production capacity at the beginning of the period This concept requires that productive assets be valued at fair market value Productive capital is maintained only if the current costs of these capital assets are maintained 4-6 Physical Capital Maintenance Concept of Income Determination Practical Practical Difficulties Difficulties a) Difficulty in estimating depreciation lives b) Difficulty in implementing internal control procedures c) Difficulty in providing cash flow information d) Difficulty in obtaining fair market values of The FASBand adopted the financial capital maintenance assets liabilities concept as part of the conceptual framework 4-7 Why is a Measure of Income Important? The recognition, measurement, and reporting (display) of business income and its components are considered by many to be the most important tasks of accountants For example: • • • Has the activity been profitable? What is the trend of profitability? Is it increasing profitable, or is there a downward trend? (continued) 4-8 Why is a Measure of Income Important? In the United States, the FASB has specified that financial accounting information is designed with investors and creditors in mind, while at the same time recognizing that many other groups will find the resulting information useful as well Accrual-based financial accounting information is not suited for every possible use (continued) 4-9 Why is a Measure of Income Important? • In code law countries, such as Germany and Japan, accounting standards have historically been set by legal processes • In a common law country, such as the United States and the United Kingdom, accounting standards are set in response to market forces 4-10 Extraordinary Items Extraordinary items are events and transactions that are both unusual in nature and infrequent in occurrence Thus, they must contain “a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity [and] be of a type that would not reasonably be expected to recur in the foreseeable future .”¹ ¹Opinions of the Accounting Principles Board No 30, “Reporting the Results of Operations (NY: AICPA, 1973), par 20 (continued) 4-38 Not Extraordinary • • • • • • The write-down or write-off of receivables, inventories, equipment leased to others, etc The gains or losses from exchange or remeasurement of foreign currencies The gains or losses on disposal of business segment Other gains or losses from sale or abandonment of productive assets The effects of a strike Adjustment of accruals on long-term contracts (continued) 4-39 Changes in Accounting Principles • The conditions of some occasions justify a change from one accounting principle to another • Occasionally a company will change an accounting principle because a change in economic conditions suggests that an accounting change will provide better information (continued) 4-40 Changes in Accounting Principles • More frequently, a change in accounting principle occurs because the FASB issues a new pronouncement requiring a change in principle • To improve compatibility, income statements for all years presented must be restated using the new accounting method (continued) 4-41 Changes in Estimate • In reporting periodic revenues and in attempting to properly match those expenses incurred to generate current-period revenues, accountants must continually make judgments • Estimates are required for such factors as the number of years of useful life for depreciable assets, the amount of uncollectible accounts expected, and the amount of warrant liability to be recorded on the books • No retroactive adjustments (continued) 4-42 Net Income or Loss Income or loss from continuing operations combined with the results of discontinued operations and extraordinary items provides a summary measure of the firm’s performance for a period: net income or net loss 4-43 Earnings Per Share Earnings per share = Income from continuing operations Weighted average number of shares of common stock outstanding (continued) 4-44 Earnings Per Share When presenting earnings-per-share figures: • Earnings per share amounts are computed for income from continuing operations and for each unusual or extraordinary item • If necessary, companies display basic and diluted earnings per share 4-45 Price-Earnings (P/E) Ratio The price-earnings (P/E) ratio expresses the market value of common stock as a multiple of earnings and allows investors to evaluate the attractiveness of a firm’s common stock P/E ratio = Market value per share Earnings per share (continued) 4-46 Price-Earnings (P/E) Ratio In general, the following types of firms have higher than average P/E ratios: • Firms with strong future growth possibilities • Firms with earnings for the year lower than average because of a nonrecurring event • Firms with substantial unrecorded assets (continued) 4-47 Price-Earnings (P/E) Ratio In general, the following types of firms have lower than average P/E ratios: • Firms with earnings for the year higher than average because of a nonrecurring event • Firms perceived as being very risky 4-48 Comprehensive Income • • • Comprehensive income is the number used to reflect an overall measure of the change in a company’s wealth during the period In addition to net income, it includes items that arise from changes in market conditions unrelated to the business operations of a company Most companies include a report of comprehensive income as part of the statement of stockholders’ equity (continued) 4-49 Forecasting Future Performance • • • • Financial statements report the past, but are used to predict the future Key to a good forecast involves identifying factors that determine a certain level of revenue or expense Forecasting starts with a forecast for sales It indicates how fast the company is expected to grow and represents the general volume of activity expected in the company (continued) 4-50 Chapter ₵ The The End End $ 4-51 4-52 ... Accrual-based financial accounting information is not suited for every possible use (continued) 4-9 Why is a Measure of Income Important? • In code law countries, such as Germany and Japan, accounting standards... accounting standards have historically been set by legal processes • In a common law country, such as the United States and the United Kingdom, accounting standards are set in response to market... from net sales – Cost of goods sold = Gross profit Gross profit percentage is computed by dividing gross profit by revenue from net sales The gross profit percentage provides a measure of profitability