The Income Statement and the Statement of Stockholders’ Equity Chapter 11

Learning Objective 1 Analyze a complex income statement.

Analyze a complex income statement.

Income Statement - Continuing Operations Allied Electronics Corporation Income Statement Year Ended December 31, 20x5 Sales revenue $500,000 Cost of goods sold –240,000 Gross margin $260,000 Operating expenses 181,000 Operating income $ 79,000

Income Statement - Continuing Operations Operating income $79,000 Other gains (losses): Loss on restructuring operations ( 8,000) Gain on sale of machinery 19,000 Income from continuing operations before income tax $90,000 Income tax expense 36,000 Income from continuing operations $54,000

Income Statement - Special Items Discontinued operations: $35,000, less income tax of $14,000 21,000 Income before extraordinary items and cumulative effect of change in depreciation method $75,000 Extraordinary flood loss, $20,000, less income tax savings of $8,000 (12,000) Cumulative effect of change in depreciation method, $10,000, less income tax of $4,000 6,000 Net income $69,000

Income Statement - Earnings per Share Earnings per share of common stock (20,000 shares outstanding): Income from continuous operations $2.70 Income from discontinued operations 1.05 Income before extraordinary item and cumulative effect of change in depreciation method $3.75 Extraordinary loss (0.60) Cumulative effect of change in depreciation method 0.30 Net income $3.45

Continuing Operations The company restructured operations at a loss of $8,000. Report as “Other” item – part of continuing operations, but falls outside of main business endeavor

The company restructured operations at a loss of $8,000.

Report as “Other” item – part of continuing operations, but falls outside of main business endeavor

Continuing Operations Investment capitalization rate – used to estimate the value of an investment in the capital stock of another company

Investment capitalization rate – used to estimate the value of an investment in the capital stock of another company

Continuing Operations Assume an interest rate (i) of 12% to valuate Allied. Estimated value of Allied Electronics common stock = Estimated annual income in the future Investment capitalization rate ÷ = $54,000 ÷ 0.12 = $450,000

Continuing Operations Current market value of the company Current market price per share = × $513,000 $4.75 = × # of shares of common stock outstanding 108,000 ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Continuing Operations: Investment Decision Decision Rule: Estimated value > market value? BUY Estimated value = market value? HOLD Estimated value < market value? SELL In the Allied Electronics case: Estimated value of the company $450,000 < Current market value $513,000 Sell the stock

Decision Rule:

Estimated value > market value? BUY

Estimated value = market value? HOLD

Estimated value < market value? SELL

Continuing Operations: Investment Decision Estimated value of one share of common stock Estimated annual earnings per share = Investment capitalization rate ÷

Irregular Items Discontinued operations Extraordinary items Cumulative effect of a change in accounting principle

Discontinued operations

Extraordinary items

Cumulative effect of a change in accounting principle

Discontinued Operations Segment – identifiable division of a company

Segment – identifiable division of a company

Extraordinary Items Unusual for the company and infrequent Losses due to natural disasters Expropriations Exception Material gains/losses from extinguishment of debt (to be reported as extraordinary item)

Unusual for the company and infrequent

Losses due to natural disasters

Expropriations

Exception

Material gains/losses from extinguishment of debt (to be reported as extraordinary item)

Cumulative Effect of a Change in Accounting Principle From double-declining-balance (DBB) to straight-line depreciation From first-in, first-out (FIFO) to weighted-average cost for inventory Report in a special section of the income statement after extraordinary items

From double-declining-balance (DBB) to straight-line depreciation

From first-in, first-out (FIFO) to weighted-average cost for inventory

Report in a special section of the income statement after extraordinary items

Earnings per Share of Common Stock Earnings per Share (Net Income – Preferred Dividends) ÷ Average Number of Common Shares Outstanding =

Earnings per Share of Common Stock Required to be disclosed on the income statement for all major sections Earnings per share is subject to dilution ( reduction), if issue of additional shares is possible in the future

Required to be disclosed on the income statement for all major sections

Earnings per share is subject to dilution ( reduction), if issue of additional shares is possible in the future

Comprehensive Income Change in total stockholders’ equity from all sources other than from owners of the business Includes net income plus unrealized gains (losses) on available-for-sale investments and foreign-currency translation adjustments

Change in total stockholders’ equity from all sources other than from owners of the business

Includes net income plus unrealized gains (losses) on available-for-sale investments and foreign-currency translation adjustments

Statement of Comprehensive Income Net income $69,000 Other comprehensive income: Unrealized gain on investment $ 6,500 Less income tax (40%) 2,600 3,900 Foreign-currency translation adjustment (loss) $(9,000) Less income tax (40%) 3,600 ( 5,400) Comprehensive income $67,500 ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Learning Objective 2 Account for a corporation’s income tax.

Account for a corporation’s income tax.

Accounting for Corporate Income Taxes Income tax expense – expense on income statement Income tax payable – liability on balance sheet

Income tax expense – expense on income statement

Income tax payable – liability on balance sheet

Accounting for Corporate Income Taxes In general, income tax expense and income tax payable can be computed as follows: Income tax payable Taxable income (from the income tax return filed with the IRS) Income tax rate = × Income tax expense Income before income tax (from the income statement ) Income tax rate = ×

Suppose for 20x5, Nike, Inc., has pretax accounting income of $900 million on the income statement. Taxable income is $800 million on the company’s income tax return. The tax rate is 40%. Accounting for Corporate Income Taxes

Suppose for 20x5, Nike, Inc., has pretax accounting income of $900 million on the income statement.

Taxable income is $800 million on the company’s income tax return.

The tax rate is 40%.

Accounting for Corporate Income Taxes Dec 31 Income Tax Expense ($900 x .40) 360 Income Tax Payable ($800 x .40) 320 Deferred Tax Liability 40 Recorded income tax for the year ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Accounting for Corporate Income Taxes Income statement Income before income tax $900 Income tax expense 360 Net income $540 Balance sheet Current Liabilities: Income tax payable $320 Long-term liabilities: Deferred tax liability 40 * Total $360 * Assumes beginning tax liability was zero.

C orrections to the beginning balance of Retained Earnings for errors of an earlier period Prior-Period Adjustments

C orrections to the beginning balance of Retained Earnings for errors of an earlier period

Reporting a Prior-Period Adjustment ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren CNN Corporation Statement of Retained Earnings Year Ended December 31, 2005 Retained Earnings, Dec. 31, 2004 (original) $390,000 Prior-period adjustment – debit to correct error in recording income tax expense of 2004 ( 10,000) Retained earnings, Dec. 31, 2004, adjusted $380,000 Net income for 2005 114,000 Total $494,000 Deduct: Dividends for 2005 ( 41,000) Retained earnings balance, Dec. 31, 2005 $453,000

Restrictions on Retained Earnings Dividends and purchases of treasury stock require payments by the corporation to its stockholders Creditors may restrict a corporation’s dividend payments and treasury stock purchases Companies report any retained earnings restrictions in notes to the financial statements

Dividends and purchases of treasury stock require payments by the corporation to its stockholders

Creditors may restrict a corporation’s dividend payments and treasury stock purchases

Companies report any retained earnings restrictions in notes to the financial statements

Learning Objective 3 Analyze a statement of stockholders’ equity.

Analyze a statement of stockholders’ equity.

Analyzing the Statement of Stockholder’s Equity ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Analyzing the Statement of Stockholder’s Equity

Learning Objective 4 Understand managers’ and auditors’ responsibilities for the financial statements.

Understand managers’ and auditors’ responsibilities for the financial statements.

Responsibility for the Financial Statements Management issues a statement of responsibility with financial statements declares responsibility for financial statements and states that they conform to GAAP

Management

issues a statement of responsibility with financial statements

declares responsibility for financial statements and states that they conform to GAAP

Auditor Report Typically contains three paragraphs: Identifies the audited financial statements Describes how the audit was performed States the auditor’s opinion - financial statements conform to GAAP and people can rely on them for decision making

Typically contains three paragraphs:

Identifies the audited financial statements

Describes how the audit was performed

States the auditor’s opinion - financial statements conform to GAAP and people can rely on them for decision making

Auditor Report Unqualified (Clean) Qualified Adverse Disclaimer

Unqualified (Clean)

Qualified

Adverse

Disclaimer

End of Chapter 11