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Chapter 11


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Chapter 11

  1. 1. Chapter 11 The Income Statement & The Statement of Stockholders’ Equity
  2. 2. Learning Objectives <ul><li>Analyze a complex income statement </li></ul><ul><li>Account for a corporation’s income tax </li></ul><ul><li>Analyze a statement of stockholders’ equity </li></ul><ul><li>Understand managers’ and auditors’ responsibilities for the financial statements </li></ul>
  3. 3. Income Statement <ul><li>Periodically Prepared to report Financial Consequences of Activities Undertaken </li></ul><ul><ul><li>By Accounting Entity </li></ul></ul><ul><ul><li>Within a Certain Period of Time </li></ul></ul><ul><li>Profit </li></ul><ul><ul><li>More resources available at end-of-period then beginning-of-period </li></ul></ul><ul><li>Loss </li></ul><ul><ul><li>Consumed more resources by the end-of-period then it generated </li></ul></ul>
  4. 4. Income Statement <ul><li>Summary of Revenues and Expenses </li></ul><ul><li>For a Specific Period of Time </li></ul><ul><li>Grouped by Class </li></ul><ul><ul><li>Sales </li></ul></ul><ul><ul><ul><li>Returns and Allowances </li></ul></ul></ul><ul><ul><ul><li>Discounts </li></ul></ul></ul><ul><ul><li>Cost of Goods Sold </li></ul></ul><ul><ul><li>Gross Margin/Profit </li></ul></ul><ul><ul><li>Operating Expenses </li></ul></ul><ul><ul><ul><li>Selling Expenses </li></ul></ul></ul><ul><ul><ul><ul><li>Salaries </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Advertising </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Travel </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Telephone </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Supplies </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Depreciation </li></ul></ul></ul></ul><ul><ul><li>Administrative </li></ul></ul><ul><ul><ul><li>Salaries </li></ul></ul></ul><ul><ul><ul><li>Telephone </li></ul></ul></ul><ul><ul><ul><li>Legal & Professional </li></ul></ul></ul><ul><ul><ul><li>Supplies </li></ul></ul></ul><ul><ul><ul><li>Depreciation – Bldg & Equip </li></ul></ul></ul><ul><ul><ul><li>Misc. </li></ul></ul></ul><ul><ul><li>Net Income from Operations </li></ul></ul><ul><ul><li>Other </li></ul></ul><ul><ul><ul><li>Interest Expense </li></ul></ul></ul><ul><ul><ul><li>Interest Income </li></ul></ul></ul><ul><ul><li>Discontinued Operations </li></ul></ul><ul><ul><li>Extraordinary Events </li></ul></ul><ul><ul><li>Cumulative Effect of Change </li></ul></ul><ul><ul><li>Net Income </li></ul></ul><ul><ul><li>Earnings Per Share </li></ul></ul>
  5. 5. Accounting Principles <ul><li>Matching </li></ul><ul><li>Revenue Realization </li></ul>
  6. 6. 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
  7. 7. 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
  8. 8. 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
  9. 9. Income from Continuing Operations <ul><li>A measure of the part of the business expected to be ongoing. </li></ul><ul><li>Used to predict future income. </li></ul>
  10. 10. Predicting Future Profits Estimated value of Common Stock = Estimated annual income in the future Investment capitalization rate Sell the stock Is less than Hold the stock Equals Buy the stock Current market Value of the Company Exceeds Decision If estimated value of the company:
  11. 11. Estimated Value of Common Stock
  12. 12. Continuing Operations <ul><li>The company restructured operations at a loss of $8,000. </li></ul><ul><li>Report as “Other” item – part of continuing operations, but falls outside of main business endeavor </li></ul>
  13. 13. Other Income Statement Items <ul><li>Discontinued Operations </li></ul><ul><li>Extraordinary Gains and Losses (Extraordinary Items) </li></ul><ul><ul><li>Must be both infrequent </li></ul></ul><ul><ul><ul><li>seldom happening or occurring </li></ul></ul></ul><ul><ul><li>and Unusual </li></ul></ul><ul><ul><ul><li>not ordinarily encountered </li></ul></ul></ul><ul><li>Cumulative Effect of a Change in Accounting Method </li></ul>
  14. 14. Discontinued Operations <ul><li>Segment – identifiable division of a company </li></ul><ul><ul><li>Sold or </li></ul></ul><ul><ul><li>Closed </li></ul></ul>
  15. 15. Extraordinary Items <ul><li>Unusual for the company and infrequent </li></ul><ul><ul><li>Losses due to natural disasters </li></ul></ul><ul><ul><li>Expropriations </li></ul></ul><ul><ul><ul><li>the action of the state in taking or modifying the property rights of an individual in the exercise of its sovereignty </li></ul></ul></ul><ul><li>An Exception </li></ul><ul><ul><li>Material gains/losses from extinguishment of debt (to be reported as extraordinary item) </li></ul></ul>
  16. 16. Cumulative Effect of a Change in Accounting Principle <ul><li>From double-declining-balance (DBB) to straight-line depreciation </li></ul><ul><li>From first-in, first-out (FIFO) to weighted-average cost for inventory </li></ul><ul><li>Report in a special section of the income statement after extraordinary items </li></ul>
  17. 17. Earnings Per Share <ul><li>Earnings per share is disclosed separately for: </li></ul><ul><ul><li>continuing operations </li></ul></ul><ul><ul><li>discontinued operations (do not subtract pfd) </li></ul></ul><ul><ul><li>Extraordinary items (don not subtract pfd) </li></ul></ul><ul><ul><li>Cumulative effect of change in accounting method (do not subtract pfd) </li></ul></ul>Earnings per share = Net Income - Preferred dividends Average number of shares of common outstanding
  18. 18. Income Statement - Earnings per Share Earnings per share of common stock (20,000 shares outstanding): Income from continuous operations (54000)/20000 $2.70 Income from discontinued operations (21000/20000) 1.05 Income before extraordinary item and cumulative effect of change in depreciation method (75000/20000) $3.75 Extraordinary loss (12000/20000) (0.60) Cumulative effect of change in depreciation method (6000/20000) 0.30 Net income (69000/20000) $3.45
  19. 19. Earnings Per Share <ul><li>Effect of preferred stock </li></ul><ul><ul><li>preferred dividends must be paid before distributions of earnings to common stockholders. </li></ul></ul><ul><li>Dilution </li></ul><ul><ul><li>Convertible items could result in diluted eps. </li></ul></ul><ul><ul><li>Diluted EPS is disclosed on the income statement. </li></ul></ul>
  20. 20. Comprehensive Income <ul><li>Change in total stockholders’ equity from all sources other than from the owners of the business. </li></ul><ul><ul><li>Unrealized gains (losses) on available-for-sale investments </li></ul></ul><ul><ul><li>Foreign-currency translation adjustments </li></ul></ul>
  21. 21. Corporate Income Taxes <ul><li>Must measure </li></ul><ul><ul><li>Income tax expense </li></ul></ul><ul><ul><li>Income tax payable </li></ul></ul>Income tax expense = Income before income tax (from the income statement) X Income Tax Rate Income tax payable = Taxable income from the income tax return filed with the IRS X Income Tax Rate
  22. 22. Corporate Income Taxes <ul><li>Difference between income tax expense and income tax payable is a deferred tax liability or deferred tax asset. </li></ul>
  23. 23. <ul><li>Suppose for 20x5, Nike, Inc., has pretax accounting income of $900 million on the income statement. </li></ul><ul><li>Taxable income is $800 million on the company’s income tax return. </li></ul><ul><li>The tax rate is 40%. </li></ul>Accounting for Corporate Income Taxes
  24. 24. 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
  25. 25. 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.
  26. 26. Retained Earnings <ul><li>Prior period adjustments </li></ul><ul><ul><li>corrections of errors that occurred in prior periods. </li></ul></ul><ul><li>Since the temporary accounts have been closed to retained earnings, errors from prior periods must be made to retained earnings. </li></ul>
  27. 27. 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
  28. 28. Restrictions on Retained Earnings <ul><li>Dividends and purchases of treasury stock require payments by the corporation to its stockholders </li></ul><ul><li>Creditors may restrict a corporation’s dividend payments and treasury stock purchases </li></ul><ul><li>Companies report any retained earnings restrictions in notes to the financial statements </li></ul>
  29. 29. Statement of Stockholders’ Equity <ul><li>Reports all changes in equity for the period. </li></ul><ul><li>Issuance of stock </li></ul><ul><li>Net income </li></ul><ul><li>Cash dividends </li></ul><ul><li>Stock dividends </li></ul><ul><li>Treasury stock transactions </li></ul><ul><li>Accumulated other comprehensive income </li></ul>
  30. 30. Statement of Stockholders’ Equity
  31. 31. Responsibility for the Financial Statements <ul><li>Management </li></ul><ul><ul><li>issues a statement of responsibility with financial statements </li></ul></ul><ul><ul><li>declares responsibility for financial statements and states that they conform to GAAP </li></ul></ul>
  32. 32. Auditor Report <ul><li>Typically contains three paragraphs: </li></ul><ul><li>Identifies the audited financial statements </li></ul><ul><li>Describes how the audit was performed </li></ul><ul><li>States the auditor’s opinion - financial statements conform to GAAP and people can rely on them for decision making </li></ul>
  33. 33. Auditor Report <ul><li>Unqualified (Clean) </li></ul><ul><ul><li>the financial statements presented are free of material misstatements and are in accordance with GAAP </li></ul></ul><ul><li>Qualified </li></ul><ul><ul><li>the financial statements are fairly presented with a certain exception which is otherwise misstated </li></ul></ul><ul><li>Adverse </li></ul><ul><ul><li>the information contained is materially incorrect, unreliable, and inaccurate in order to assess the auditee’s financial position and results of operations </li></ul></ul><ul><li>Disclaimer </li></ul><ul><ul><li>the auditor could not form, and consequently refuses to present, an opinion on the financial statements </li></ul></ul>