This chapter covers the preparation of the income statement and retained earnings statement and the reporting of other comprehensive income.
Uses and Limitations of Income Statement
Income Statement: Content and Format
Discontinued Operation| Unusual Gains and Losses (Pt 1)
Discontinued Operation| Unusual Gains and Losses (Pt 2)
Intro to Earnings Per Share
Changes in Accounting Principles/Estimates
Statement of Retained Earnings
Statement of Other Comprehensive Income (OCI)
Example: E4-14 | Change in Accounting Principle/Estimate
Chapter 4 presents a detailed discussion of the concepts and techniques that underlie the preparation of the income statement and retained earnings statement and the reporting of other comprehensive income. The requirements for adequate presentation of reported net income are described and illustrated throughout the chapter.
The income statement helps users of financial statements (1) evaluate the past performance of the company, (2) provide a basis for predicting future performance, and (3) help assess the risk or uncertainty of achieving future cash flows. The limitations of the income statement include (1) companies omit items from the income statement that they cannot measure, (2) income numbers are affected by the accounting methods employed, and (3) income measurement involves judgment.
Quality of earnings is important because markets are based on trust and it is imperative that investors have faith in the numbers reported. If that trust is damaged, capital markets will be damaged.
Elements of the Income Statement
The major elements of net income are: revenues, expenses, gains, and losses, previously discussed in Chapter 2. The distinction between revenues and gains and the distinction between expenses and losses depend to a great extent on the typical activities of a business enterprise. When inflows or enhancements of assets result from typical business activities (generally the activities the entity is in business to perform, or its primary operations), revenues result. Likewise, outflows or the using up of assets resulting from typical business activities will generate expenses. Nontypical business activities resulting in inflows or outflows of assets will normally generate transactions classified as gains or losses. Gains and losses result from peripheral transactions
Income Statement Formats
The income statement may be presented in the single-step format or the multiple-step format. Single-step income statements derive their name from the fact that total costs and expenses are subtracted from total revenues in a “single step” to arrive at net income. Income taxes are normally shown as a separate item among the expenses (usually last) to indicate their relationship to income before taxes. The multiple-step format separates results achieved by regular operations of the entity from those obtained by nonoperating activities. Expenses are also classified by function such as cost of sales, selling, and administrative. The multiple-step format provides more information to financial statement users than does the single-step format; however, both are found in actual practice.
An income statement is composed of various sections that relate to different aspects of the earning process. The seven sections identified in the chapter, in the general order of their appearance in the income statement, are:
Operating Section. Revenues and expenses from the entity’s principal operations.
- Sales or revenue section.
- Cost of goods sold section.
- Selling expenses.
- Administrative or general expenses.
Nonoperating Section. Revenues (gains) and expenses (losses) resulting from secondary or auxiliary activities of the company.
- Other revenues and gains.
- Other expenses and losses.
- Income Tax. All taxes levied on income from continuing operations.
- Discontinued Operations. Material gains and losses resulting from disposal of a segment of the business.
- Noncontrolling Interest.
- Earnings per Share.
- Condensed income statements. Includes only totals of expense groups. Supplementary schedules support the totals.
Reporting Various Income Items
For the most part, accountants tend to agree on the composition of items included on the income statement. However, certain unusual items (Non-recurring gains/losses) have stirred controversy in regard to the effect they should have on the presentation of net income. Some accountants favor reporting the unusual items directly in the income statement. Those who support the current operating performance concept to income measurement believe that the unusual items should be closed directly to retained earnings (not included in computing net income). The accounting profession adopted a modified all-inclusive concept and requires application of this approach in practice.
In an attempt to provide financial statement users with the ability to better determine the long-range earning power of an enterprise, certain professional pronouncements require that the following unusual and infrequent items be highlighted in the financial statements.
- Discontinued operations.
- Unusual and infrequent gains and losses.
- Changes in estimates.
- Corrections of errors.
Unusual and infrequent Gains and Losses
Companies that have unusual or infrequent gains or losses or both are required to disclose this information in the income statement or in the notes to the financial statements. Gains and losses from unusual or infrequent items are not reported net of tax. Companies generally itemize each gain or loss on the income statement or show one amount and then itemize each gain or loss on the income statement or show one amount and then itemize these items in the financial statement notes.
Discontinued operation occurs when (a) a company eliminates the results of operations of a component of the business, and (b) the elimination of a component represents a strategic shift, having a major effect on the company’s operations and financial 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.
Intraperiod Tax Allocation
Intraperiod tax allocation is the process of relating the income tax effect of an unusual item to that item when it appears on the income statement. Income tax expense related to continuing operations is shown on the income statement at its appropriately computed amount. All other items included in the determination of net income should be shown net of their related tax effect. The tax amount may be disclosed in the income statement or in a footnote.
Noncontrolling interest is the portion of equity (net assets) interest in a subsidiary not attributable to the parent company. When a company prepares a consolidated income statement, GAAP requires the net income be allocated to the controlling and noncontrolling interest.
Earnings per Share
In general, earnings per share represents the ratio of net income minus preferred dividends (income available to common shareholders) divided by the weighted-average number of common shares outstanding. It is considered by many financial statement users to be the most significant statistic presented in the financial statements, and must be disclosed on the face of the income statement. Per share amounts for gain or loss on discontinued operations must be disclosed on the face of the income statement or in the notes to the financial statements.
Changes in Accounting Principle
A change in accounting principle results when a company adopts a new accounting principle that is different from the one previously used. 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.
Changes in Estimates
Accountants make extensive use of estimates in preparing financial statements. Adjustments that grow out of the use of estimates in accounting are used in the determination of income for the current period and future periods and are not charged or credited directly to Retained Earnings. It should be noted that changes in estimates are not considered errors (prior period adjustments).
Corrections of Errors
Companies must correct errors by making proper entries in the accounts and reporting corrections in the financial statements. Corrections of errors are treated as prior period adjustments, similar to changes in accounting principles. Companies record an error in the year in which it is discovered. They report the effect of the error 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.
Retained Earnings Statement:
The retained earnings statement serves to reconcile the balance of the retained earnings account from the beginning to the end of the year. The important information communicated by the retained earnings statement includes: (a) prior period adjustments (income or loss related to corrections of errors in the financial statements of a prior period net of tax), (b) changes in accounting principle, (c) the relationship of dividend distributions to net income for the period, and (d) any transfers to and from retained earnings.
Items that bypass the income statement are included under the concept of comprehensive income. Comprehensive income includes all changes in equity during
a period except those resulting from investments by owners and distributions to owners.
The FASB requires that the components of other comprehensive income must be displayed in one of two ways: (1) a one statement approach, or (2) a two statement approach. In the one statement 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. The two statement format reports comprehensive income in a separate statement, which indicates that the gains and losses identified as other comprehensive income have the same status as traditional gains and losses.
Statement of Stockholders’ Equity
This statement reports the changes in each stockholders’ equity account and in total stockholders’ equity during the year. Both contributions (issuances of shares) and distributions (dividends) to owners, and a reconciliation of the carrying amount of each component of stockholders’ equity from the beginning to the end of the period are disclosed in the statement.
The income statement is a required statement for IFRS, as in GAAP. The content and presentation of an IFRS income statement is similar to the one used for GAAP. Presentation of the income statement under GAAP. Presentation of the income statement under GAAP follows either a single-step or multiple-step format. IFRS does not mention a single-step or multiple-step approach.