These lectures cover CPA questions covering income statement including discontinued operation, income from continuous operation, single step and multiple steeps income statement.
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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.) The business and investment community uses the income statement to determine profitability, investment value, and creditworthiness. It provides investors and creditors with information that helps them predict the amounts, timing, and uncertainty of future cash flows.
Usefulness of the Income Statement
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:
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.
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.
Help assess the risk or uncertainty of achieving future cash flows. Information on the various components of income—revenues, expenses, gains, and losses—highlights 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 IBM‘s operating performance from other non-recurring 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 non-recurring activities and events.
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:
- 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 company’s 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 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.
- 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.
- 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 result 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.
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. Companies try to meet or beat Wall Street expectations so that the market price of their stock and the value of management’s stock compensation packages 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 chairperson, “Managing may be giving way to manipulation; integrity may be losing out to illusion.” 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 in order to boost earnings. As one commentator noted, “it’s 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.
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. the statement can further classify income by customer, product line, or function, or by operating and nonoperating, continuing and discontinued, and regular and non-recurring categories. The following lists more formal definitions of income-related items, referred to as the major elements of the income statement.
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, and 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 McDonald’s sells a hamburger, it records the selling price as revenue. However, when McDonald’s 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 McDonald’s 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.
Intermediate Components of the Income Statement
- OPERATING SECTION. A report of the revenues and expenses of the company’s principal operations.
- (a)Sales or Revenue. 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. 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 company’s efforts to make sales.
- (d)Administrative or General Expenses. A subsection reporting expenses of general administration.7
- 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, or both, are normally reported in this section. Generally these items break down into two main subsections:
- (a)Other Revenues and Gains. A list of the revenues recognized or gains incurred, generally net of related expenses, from nonoperating transactions.
- (b)Other Expenses and Losses. A list of the expenses or losses incurred, generally net of any related incomes, from nonoperating transactions.
- 3.INCOME TAX. A 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 component of the business.
- 5.NONCONTROLLING INTEREST. Allocation of income to noncontrolling shareholders.
- 6.EARNINGS PER SHARE. A measure of performance over the reporting period.
- The disclosure of net sales is useful because Cabrera reports regular revenues as a separate item. It discloses non-recurring 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 non-recurring or incidental activities. This disclosure helps users recognize that incidental or non-recurring activities are unlikely to continue at the same level. Furthermore, disclosure of operating earnings may assist in comparing different companies and assessing operating efficiencies.
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.
Single-Step Income Statements
In reporting revenues, gains, expenses, and losses, some companies often use a format known as the single-step income statement instead of a multiple-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.”
A discontinued operation occurs when two things happen:
- 1.A company eliminates the results of operations of a component of the business. A component comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes.
- 2.The elimination of a component that represents a strategic shift, having a major effect on the company’s operations and financial results. A strategic shift generally includes the disposal of (1) a major line of business, (2) a major geographical area, or (3) a major equity method investment.
To illustrate, Softso has the following product lines that it manufactures and sells—beauty care, health care, and baby care. Within these product lines, it has a total of 18 brands. Each brand is considered a separate component because each brand comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes. Each product line represents a major line of business. Softso decides to eliminate the baby-care product line because it is suffering substantial losses. Softso should report the elimination of the baby-care product line as a discontinued operation because the baby-care line represents a major line of business and its disposal represents a major part of Softso’s operations (a strategic shift).
On the other hand, assume that Softso decides to remain in the baby-care business but will discontinue one brand in this product line because it is very unprofitable. Softso should not report the elimination of this brand as a discontinued operation because it does not represent a major part of Softso’s operations (disposing of it is not considered a strategic shift).
As indicated, the reporting of a discontinued operation involves strategic shifts that are substantial in nature. Here are some additional examples:
- 1.The sale of a product line that represents 15 percent of a company’s total revenues.
- 2.The sale of a geographical area that represents 20 percent of a company’s total assets.
- 3.The sale of a component that is an equity investment that represents 20 percent of a company’s total assets.
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 discontinued operations net of tax as a separate category, after continuing operations.