CHAPTER 4 Income Statement and Related Information

INCOME STATEMENT

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.¹) 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:

1. 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.

   

2. 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.

   

3. 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 nonrecurring 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 nonrecurring activities and events.

In summary, information in the income statement—revenues, expenses, gains, and losses—helps users evaluate past performance. It also provides insights into the likelihood of achieving a particular level of cash flows in the future.

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:

1. 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.

   

2. 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.

   

3. 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.² Companies try to meet or beat Wall Street expectations so that the market price of their stock and the value of management's stock options 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.”³ 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.

FORMAT OF 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.⁴ The statement can further classify income by customer, product line, or function, or by operating and nonoperating, continuing and discontinued, and regular and irregular categories.⁵ 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

It is common for companies to present some or all of the following sections and totals within the income statement as shown in Illustration 4-1. This format is often referred to as the multiple-step income statement.

As indicated, companies report all revenues, gains, expenses, and losses on the income statement. This statement separates operating transactions from nonoperating transactions, and matches costs and expenses with related revenues. It highlights certain intermediate components of income that analysts use to compute ratios for assessing the performance of the company. Companies present nonoperating revenues, gains, expenses, and losses in a separate section, before income taxes and income from operations. Companies report irregular items, such as discontinued operations of a component of a business and extraordinary items, as separate elements in the income statement. Segregating income with different characteristics and providing intermediate income figures helps readers evaluate earnings information in assessing the amounts, timing, and uncertainty of future cash flows.

Illustration 4-2 presents an income statement for Cabrera Company. Cabrera's income statement includes all of the major items shown in Illustration 4-1, except for discontinued operations, extraordinary items, and noncontrolling interest. In arriving at net income, the statement presents the following subtotals and totals: gross profit, income from operations, income before income tax, and net income.⁸

The disclosure of net sales is useful because Cabrera reports regular revenues as a separate item. It discloses irregular 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 irregular or incidental activities. This disclosure helps users recognize that incidental or irregular 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. For example, consider the income statement shown in Illustration 4-3 for Cabrera Company. This statement is a condensed version of the more detailed multiple-step statement presented in Illustration 4-2 (page 165). It is more representative of the type found in practice. Illustration 4-4 then shows an example of a supporting schedule, cross-referenced as Note D and detailing the selling expenses.

How much detail should a company include in the income statement? On the one hand, a company wants to present a simple, summarized statement so that readers can readily discover important factors. On the other hand, it wants to disclose the results of all activities and to provide more than just a skeleton report. As we showed in Illustrations 4-3 and 4-4, the income statement always includes certain basic elements, but companies can present them in various formats.

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.” Frequently, companies report income tax separately as the last item before net income to indicate its relationship to income before income tax. Illustration 4-5 (page 168) shows the single-step income statement of Cabrera Company.

Companies that use the single-step income statement in financial reporting typically do so because of its simplicity. That is, the primary advantage of the single-step format lies in its simple presentation and the absence of any implication that one type of revenue or expense item has priority over another. This format thus eliminates potential classification problems.⁹

REPORTING VARIOUS INCOME ITEMS

GAAP allows flexibility in the presentation of the components of income. However, the FASB developed specific guidelines in two important areas: what to include in income and how to report certain unusual or irregular items.

What should be reported in net income and where it should be reported is controversial. For example, should companies report a gain or loss on sale of an investment as part of net income or report it directly in retained earnings? Should a company report a loss on discontinued operations differently than interest expense? What we therefore need is consistent and comparable income reporting practices. Developing a framework for reporting income components is important to ensure useful information.

Furthermore, as our opening story discusses, we need consistent and comparable income reporting practices to avoid “promotional” information reported by companies.¹⁰ Some users advocate a current operating performance approach to income reporting. These analysts argue that the most useful income measure reflects only regular and recurring revenue and expense elements. Some irregular items do not reflect a company's future earning power.

In contrast, others warn that a focus on operating income potentially misses important information about a company's performance. Any gain or loss experienced by the company, whether directly or indirectly related to operations, contributes to its long-run profitability. As one analyst notes, “write-offs matter. … They speak to the volatility of (past) earnings.”¹¹ As a result, analysts can use some nonoperating items to assess the riskiness of future earnings. Furthermore, determining which items are operating and which are irregular or unusual requires judgment. This might lead to differences in the treatment of irregular items and to possible manipulation of income measures.

So, what to do? The accounting profession has adopted a modified all-inclusive concept. In this approach, companies record most items, including unusual or irregular ones, as part of net income.¹² In addition, companies are required to highlight these items in the financial statements so that users can better determine the long-run earning power of the company. These income items fall into four general categories, which we discuss in the following sections:

1. Unusual gains and losses.
2. Discontinued operations.
3. Extraordinary items.
4. Noncontrolling interest.

Unusual Gains and Losses

The following items may need separate disclosure in the income statement to help users predict the amounts, timing, and uncertainty of future cash flows.

• Losses on the write-down or write-off of receivables; inventories; property, plant, and equipment; deferred research and development costs; or other intangible assets.
• Gains or losses from exchange or translation of foreign currencies, including those relating to major devaluations and revaluations.
• Restructuring charges.
• Other gains or losses from sale or abandonment of property, plant, or equipment used in the business.
• Effects of a strike, including those against competitors and major suppliers.
• Adjustment of accruals on long-term contracts. [1]

Illustration 4-6 identifies the most common types of unusual gains and losses reported in a survey of 500 large companies. Note that more than 40 percent of the surveyed firms reported restructuring charges, and nearly 60 percent of the companies reported write-downs or gains or losses on asset sales.

Companies sometimes show these unusual gains and losses with their normal recurring revenues and expenses. For example, PepsiCo, Inc. presented an unusual charge in its income statement, as Illustration 4-7 (page 170) shows.

Restructuring charges, like the one PepsiCo reported in Note 2 above, are common in recent years (see also Illustration 4-6 on page 169). A restructuring charge relates to a major reorganization of company affairs, such as costs associated with employee layoffs, plant closing costs, write-offs of assets, and so on. A company should not report a restructuring charge as an extraordinary item because these write-offs are part of a company's ordinary and typical activities.

Companies tend to report unusual items in a separate section just above “Income from operations before income taxes,” especially when there are multiple unusual items. For example, when General Electric experienced multiple unusual items in one year, it reported them in a separate “Unusual items” section of the income statement below “Income before unusual items and income taxes.” When preparing a multiple-step income statement for homework purposes, you should report unusual gains and losses in the “Other revenues and gains” or “Other expenses and losses” section unless you are instructed to prepare a separate unusual items section.¹³

Discontinued Operations

A discontinued operation occurs when two things happen: (1) a company eliminates the results of operations of a component of the business, and (2) there is no significant involvement in that component after the disposal transaction. [2]

To illustrate a component, S. C. Johnson manufactures and sells consumer products. It has several product groups, each with different product lines and brands. For S. C. Johnson, a product group is the lowest level at which it can clearly distinguish the operations and cash flows from the rest of the company's operations. Therefore, each product group is a component of the company. If a component were disposed of, S. C. Johnson would classify it as a discontinued operation.

Here is another example. Assume that Softso Inc. has experienced losses with certain brands in its beauty-care products group. As a result, Softso decides to sell that part of its business. It will discontinue any continuing involvement in the product group after the sale. In this case, Softso eliminates the operations and the cash flows of the product group from its ongoing operations and reports it as a discontinued operation.

On the other hand, assume Softso decides to remain in the beauty-care business but will discontinue the brands that experienced losses. Because Softso cannot differentiate the cash flows from the brands from the cash flows of the product group as a whole, it cannot consider the brands a component. Softso does not classify any gain or loss on the sale of the brands as a discontinued operation.

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. [3]

To illustrate, Multiplex Products, Inc., a highly diversified company, decides to discontinue its electronics division. During the current year, the electronics division lost $300,000 (net of tax). Multiplex sold the division at the end of the year at a loss of $500,000 (net of tax). Illustration 4-8 shows the reporting of discontinued operations for Multiplex.

Companies use the phrase “Income from continuing operations” only when gains or losses on discontinued operations occur.¹⁴

A company that reports a discontinued operation must report per share amounts for discontinued operations either on the face of the income statement or in the notes to the financial statements. To illustrate, consider the income statement for Poquito Industries Inc., shown in Illustration 4-9 (page 172). Poquito had 100,000 shares outstanding for the entire year. Notice the order in which Poquito shows the data, with per share information at the bottom. The Poquito income statement, as Illustration 4-9 shows, is highly condensed. Poquito would need to describe items such as “Other expenses and losses” and “Discontinued operations” fully and appropriately in the statement or related notes.

Intraperiod Tax Allocation

As indicated in Illustration 4-8, companies report discontinued operations on the income statement net of tax. The allocation of tax to this item is called intraperiod tax allocation, that is, allocation within a period. It relates the income tax expense (sometimes referred to as the income tax provision) of the fiscal period to the specific items that give rise to the amount of the income tax provision.

Intraperiod tax allocation helps financial statement users better understand the impact of income taxes on the various components of net income. For example, readers of financial statements will understand how much income tax expense relates to “Income from continuing operations” and how much to discontinued operations. This approach helps users to better predict the amount, timing, and uncertainty of future cash flows. In addition, intraperiod tax allocation discourages statement readers from using pretax measures of performance when evaluating financial results, and thereby recognizes that income tax expense is a real cost.

Companies use intraperiod tax allocation on the income statement for the following items: (1) income from continuing operations, (2) discontinued operations, and (3) extraordinary items (discussed below). The general concept is “let the tax follow the income.”

To compute the income tax expense attributable to “Income from continuing operations,” a company computes the income tax expense related to both the revenue and expense transactions as well as other income and expense used in determining this income subtotal. (In this computation, the company does not consider the tax consequences of items excluded from the determination of “Income from continuing operations.”) Companies then associate a separate tax effect (e.g., for discontinued operations). Here, we look in more detail at the calculation of intraperiod tax allocation for a discontinued gain or discontinued loss.

Discontinued Operations (Gain)

In applying the concept of intraperiod tax allocation, assume that Schindler Co. has income before income tax of $250,000. It has a gain of $100,000 from a discontinued operation. Assuming a 30 percent income tax rate, Schindler presents the following information on the income statement.

Schindler determines the income tax of $75,000 ($250,000 × 30%) attributable to “Income before income tax” from revenue and expense transactions related to this income. Schindler omits the tax consequences of items excluded from the determination of “Income before income tax.” The company shows a separate tax effect of $30,000 related to the “Gain on discontinued operations.”

Discontinued Operations (Loss)

To illustrate the reporting of a loss from discontinued operations, assume that Schindler Co. has income before income tax of $250,000. It also has a loss from discontinued operations of $100,000. Assuming a 30 percent tax rate, Schindler presents the income tax on the income statement as shown in Illustration 4-11. In this case, the loss provides a positive tax benefit of $30,000. Schindler, therefore, subtracts it from the $100,000 loss.

Companies may also report the tax effect of a discontinued item by means of a note disclosure, as illustrated below.

Extraordinary Items

Extraordinary items are nonrecurring material items that differ significantly from a company's typical business activities. The criteria for extraordinary items are as follows.

Only rarely does an event or transaction clearly meet the criteria for an extraordinary item.¹⁵ For example, a company classifies gains or losses as extraordinary if they resulted directly from a major casualty (such as an earthquake), an expropriation, or a prohibition under a newly enacted law or regulation. Such circumstances clearly meet the criteria of unusual and infrequent. For example, Weyerhaeuser Company (forest and lumber) incurred an extraordinary item (an approximate $36 million loss) as a result of volcanic activity at Mount St. Helens. The eruption destroyed standing timber, logs, buildings, equipment, and transportation systems covering 68,000 acres.

In determining whether an item is extraordinary, a company must consider the environment in which it operates. The environment includes such factors as industry characteristics, geographic location, and the nature and extent of governmental regulations. Thus, the FASB accords extraordinary item treatment to the loss from hail damages to a tobacco grower's crops if hailstorm damage in its locality is rare. On the other hand, frost damage to a citrus grower's crop in Florida does not qualify as extraordinary because frost damage normally occurs there every three or four years.

Similarly, when a company sells the only significant security investment it has ever owned, the gain or loss meets the criteria of an extraordinary item. Another company, however, that has a portfolio of securities acquired for investment purposes would not report such a sale as an extraordinary item. Sale of such securities is part of its ordinary and typical activities.

In addition, considerable judgment must be exercised in determining whether to report an item as extraordinary. For example, the government condemned the forestlands of some paper companies to preserve state or national parks or forests. Is such an event extraordinary, or is it part of a paper company's normal operations? Such determination is not easy. Much depends on the frequency of previous condemnations, the expectation of future condemnations, materiality, and the like.¹⁶

Extraordinary Gains

To illustrate the reporting of an extraordinary gain, assume that Logan Co. has income before income tax and extraordinary item of $250,000. It has an extraordinary gain of $100,000 from a condemnation settlement received on one its properties. Assuming a 30 percent income tax rate, Logan presents the following information on the income statement.

Logan determines the income tax of $75,000 ($250,000 × 30%) attributable to “Income before income tax and extraordinary item” from revenue and expense transactions related to this income. Logan omits the tax consequences of items excluded from the determination of “Income before income tax and extraordinary item.” The company shows a separate tax effect of $30,000 related to the “Extraordinary gain—condemnation settlement.”

Extraordinary Losses

To illustrate the reporting of an extraordinary loss, assume that Logan Co. has income before income tax and extraordinary item of $250,000. It suffers an extraordinary loss from a major casualty of $100,000. Assuming a 30 percent tax rate, Logan presents the income tax on the income statement as shown in Illustration 4-14. In this case, the loss provides a positive tax benefit of $30,000. Logan, therefore, subtracts it from the $100,000 loss.

Companies may also report the tax effect of an extraordinary item by means of a note disclosure, as illustrated below.

A presentation showing both discontinued operations and extraordinary items is shown in Illustration 4-19 (page 178).¹⁷

Noncontrolling Interest

A company like The Coca-Cola Company owns substantial interests in other companies. Coca-Cola generally consolidates the financial results of these companies into its own financial statements. In these cases, Coca-Cola is referred to as the parent, and the other companies are referred to as subsidiaries. Noncontrolling interest is then the portion of equity (net assets) interest in a subsidiary not attributable to the parent company.

To illustrate, assume that Coca-Cola acquires 70 percent of the outstanding stock of Koch Company. Because Coca-Cola owns more than 50 percent of Koch, it consolidates Koch's financial results with its own. Consolidated net income is then allocated to the controlling (Coca-Cola) and noncontrolling shareholders' percentage of ownership in Koch. In other words, under this arrangement, the ownership of Koch is divided into two classes: (1) the majority interest represented by stockholders who own the controlling interest and (2) the noncontrolling interest (sometimes referred to as the minority interest) represented by stockholders who are not part of the controlling group. When Coca-Cola prepares a consolidated income statement, GAAP requires that net income be allocated to the controlling and noncontrolling interest. This allocation is reported at the bottom of the income statement, after net income.

An example of how Coca-Cola reports its noncontrolling interest is shown in Illustration 4-16.

The noncontrolling interest amounts are not an expense or dividend, but are allocations of net income (loss) to the noncontrolling interest. [6]

Summary of Various Income Items

Because of the numerous intermediate income figures created by the reporting of irregular items, readers must carefully evaluate earnings information reported by the financial press. Illustration 4-17 summarizes the basic concepts that we previously discussed. Although simplified, the chart provides a useful framework for determining the treatment of special items affecting the income statement.

Earnings per Share

A company customarily sums up the results of its operations in one important figure: net income. However, the financial world has widely accepted an even more distilled and compact figure as the most significant business indicator—earnings per share (EPS).

The computation of earnings per share is usually straightforward. Earnings per share is net income minus preferred dividends (income available to common stockholders), divided by the weighted average of common shares outstanding.¹⁸

To illustrate, assume that Lancer, Inc. reports net income of $350,000. It declares and pays preferred dividends of $50,000 for the year. The weighted-average number of common shares outstanding during the year is 100,000 shares. Lancer computes earnings per share of $3, as shown in Illustration 4-18.

Note that EPS measures the number of dollars earned by each share of common stock. It does not represent the dollar amount paid to stockholders in the form of dividends.

Prospectuses, proxy material, and annual reports to stockholders commonly use the “net income per share” or “earnings per share” ratio. The financial press, statistical services like Standard & Poor's, and Wall Street securities analysts also highlight EPS. Because of its importance, companies must disclose earnings per share on the face of the income statement. A company that reports a discontinued operation or an extraordinary item must report per share amounts for these line items either on the face of the income statement or in the notes to the financial statements. [7]

To illustrate, consider the income statement for Poquito Industries Inc. shown in Illustration 4-19. Notice the order in which Poquito shows the data, with per share information at the bottom. Assume that the company had 100,000 shares outstanding for the entire year. The Poquito income statement, as Illustration 4-19 shows, is highly condensed. Poquito would need to describe items such as “Loss on disposal of part of Textile Division,” “Discontinued operations,” and “Extraordinary item” fully and appropriately in the statement or related notes.

Many corporations have simple capital structures that include only common stock. For these companies, a presentation such as “Earnings per common share” is appropriate on the income statement. In many instances, however, companies' earnings per share are subject to dilution (reduction) in the future because existing contingencies permit the issuance of additional common shares. [8]¹⁹

OTHER REPORTING ISSUES

In this section, we discuss reporting issues related to (1) accounting changes and errors, (2) retained earnings statement, and (3) comprehensive income.

Accounting Changes and Errors

Changes in accounting principle, change in estimates, and corrections of errors require unique reporting provisions.

Changes in Accounting Principle

Changes in accounting occur frequently in practice because important events or conditions may be in dispute or uncertain at the statement date. One type of accounting change results when a company adopts a different accounting principle. Changes in accounting principle include a change in the method of inventory pricing from FIFO to average-cost, or a change in accounting for construction contracts from the percentage-of-completion to the completed-contract method. [9]²⁰

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.

To illustrate, Gaubert Inc. decided in March 2014 to change from FIFO to weighted-average inventory pricing. Gaubert's income before income tax, using the new weighted-average method in 2014, is $30,000. Illustration 4-20 (page 180) presents the pretax income data for 2012 and 2013 for this example.

Illustration 4-21 shows the information Gaubert presented in its comparative income statements, based on a 30 percent tax rate.

Thus, under the retrospective approach, the company recasts the prior years' income numbers under the newly adopted method. This approach therefore preserves comparability across years.

Changes in Accounting Estimates

Changes in accounting estimates are inherent in the accounting process. For example, companies estimate useful lives and salvage values of depreciable assets, uncollectible receivables, inventory obsolescence, and the number of periods expected to benefit from a particular expenditure. Not infrequently, due to time, circumstances, or new information, even estimates originally made in good faith must be changed. A company accounts for such changes in estimates in the period of change if they affect only that period, or in the period of change and future periods if the change affects both.

To illustrate a change in estimate that affects only the period of change, assume that DuPage Materials Corp. consistently estimated its bad debt expense at 1 percent of credit sales. In 2014, however, DuPage determines that it must revise upward the estimate of bad debts for the current year's credit sales to 2 percent, or double the prior years' percentage. The 2 percent rate is necessary to reduce accounts receivable to net realizable value. Using 2 percent results in a bad debt charge of $240,000, or double the amount using the 1 percent estimate for prior years. DuPage records the bad debt expense and related allowance at December 31, 2014, as follows.

DuPage includes the entire change in estimate in 2014 income because the change does not affect future periods. Companies do not handle changes in estimate retrospectively. That is, such changes are not carried back to adjust prior years. Changes in estimate are not considered errors.

Corrections of Errors

Errors occur as a result of mathematical mistakes, mistakes in the application of accounting principles, or oversight or misuse of facts that existed at the time financial statements were prepared. In recent years, many companies have corrected for errors in their financial statements. The errors involved such items as improper reporting of revenue, accounting for stock options, allowances for receivables, inventories, and other provisions.

Companies correct errors by making proper entries in the accounts and reporting the corrections in the financial statements. Corrections of errors are treated as prior period adjustments, similar to changes in accounting principles. Companies record a correction of an error in the year in which it is discovered. They report the error in the financial statements 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.

To illustrate, in 2015, Hillsboro Co. determined that it incorrectly overstated its accounts receivable and sales revenue by $100,000 in 2014. In 2015, Hillsboro makes the following entry to correct for this error (ignore income taxes).

Beginning retained earnings is debited in 2015 because sales revenue, and therefore net income, was overstated in 2014 (hence, Retained Earnings was overstated). Accounts Receivable is credited to reduce this overstated balance to the correct amount.

Summary

The impact of changes in accounting principle and error corrections are debited or credited directly to retained earnings for the amounts related to prior periods. Illustration 4-22 summarizes the basic concepts related to these two items, as well as the accounting and reporting for changes in estimates. Although simplified, the chart provides a useful framework for determining the treatment of special items affecting the income statement.

Retained Earnings Statement

Net income increases retained earnings. A net loss decreases retained earnings. Both cash and stock dividends decrease retained earnings. Changes in accounting principles (generally) and prior period adjustments may increase or decrease retained earnings. Companies charge or credit these adjustments (net of tax) to the opening balance of retained earnings. This excludes the adjustments from the determination of net income for the current period.

Companies may show retained earnings information in different ways. For example, some companies prepare a separate retained earnings statement, as Illustration 4-23 (page 182) shows.

The reconciliation of the beginning to the ending balance in retained earnings provides information about why net assets increased or decreased during the year.²¹ The association of dividend distributions with net income for the period indicates what management is doing with earnings: It may be “plowing back” into the business part or all of the earnings, distributing all current income, or distributing current income plus the accumulated earnings of prior years.

Restrictions of Retained Earnings

Companies often restrict retained earnings to comply with contractual requirements, board of directors' policy, or current necessity. Generally, companies disclose in the notes to the financial statements the amounts of restricted retained earnings. In some cases, companies transfer the amount of retained earnings restricted to an account titled Appropriated Retained Earnings. The retained earnings section may therefore report two separate amounts—(1) retained earnings free (unrestricted) and (2) retained earnings appropriated (restricted). The total of these two amounts equals the total retained earnings.

Comprehensive Income

Companies generally include in income all revenues, expenses, gains, and losses recognized during the period. These items are classified within the income statement so that financial statement readers can better understand the significance of various components of net income. Changes in accounting principles and corrections of errors are excluded from the calculation of net income because their effects relate to prior periods.

In recent years, there is increased use of fair values for measuring assets and liabilities. Furthermore, possible reporting of gains and losses related to changes in fair value have placed a strain on income reporting. Because fair values are continually changing, some argue that recognizing these gains and losses in net income is misleading. The FASB agrees and has identified a limited number of transactions that should be recorded in other comprehensive income, which affects accumulated other comprehensive income reported in stockholders' equity. One example is unrealized gains and losses on available-for-sale securities.²² These gains and losses are excluded from net income, thereby reducing volatility in net income due to fluctuations in fair value. At the same time, disclosure of the potential gain or loss is provided.

Companies include these items that bypass the income statement in a measure called comprehensive income. Comprehensive income includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Comprehensive income, therefore, includes the following: all revenues and gains, expenses and losses reported in net income, and all gains and losses that bypass net income but affect stockholders' equity. These items—non-owner changes in equity that bypass the income statement—are referred to as other comprehensive income.

Companies must display the components of other comprehensive income in one of two ways: (1) a single continuous statement (one statement approach) or (2) two separate, but consecutive statements of net income and other comprehensive income (two statement approach). The one statement approach is often referred to as the statement of comprehensive income. The two statement approach uses the traditional term income statement for the first statement and the comprehensive income statement for the second statement. [10]

Under either approach, companies display each component of net income and each component of other comprehensive income. In addition, net income and comprehensive income are reported. Companies are not required to report earnings per share information related to comprehensive income.²³

We illustrate these two alternatives in the next two sections. In each case, assume that V. Gill Inc. reports the following information for 2014: sales revenue $800,000; cost of goods sold $600,000; operating expenses $90,000; and an unrealized holding gain on available-for-sale securities of $30,000, net of tax.

One Statement Approach

In this 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. However, burying net income as a subtotal on the statement is a disadvantage. Illustration 4-24 shows the one statement format for V. Gill.

Two Statement Approach

Illustration 4-25 shows the two statement format for V. Gill. Reporting comprehensive income in a separate statement indicates that the gains and losses identified as other comprehensive income have the same status as traditional gains and losses.

Statement of Stockholders' Equity

In addition to a comprehensive income statement, companies also present a statement of stockholders' equity (often referred to as statement of changes in stockholders' equity). This statement reports the changes in each stockholders' equity account and in total stockholders' equity during the year. Companies often prepare in columnar form the statement of stockholders' equity. In this format, they use columns for each account and for total stockholders' equity. Stockholders' equity is generally comprised of contributed capital (common and preferred stock and additional paid-in capital), retained earnings, and the accumulated balances in other comprehensive income. The statement reports the change in each stockholders' equity account and in total stockholders' equity for the period. The following items are disclosed in this statement.

1. Contributions (issuances of shares) and distributions (dividends) to owners.
2. Reconciliation of the carrying amount of each component of stockholders' equity from the beginning to the end of the period.

To illustrate, assume the same information for V. Gill (on page 183). The company has the following stockholders' equity account balances at the beginning of 2014: Common Stock $300,000, Retained Earnings $50,000, and Accumulated Other Comprehensive Income $60,000. No changes in the Common Stock account occurred during the year. Illustration 4-26 shows a statement of stockholders' equity for V. Gill.

Balance Sheet Presentation

Regardless of the display format used, V. Gill reports accumulated other comprehensive income of $90,000 in the stockholders' equity section of the balance sheet as follows.

By providing information on the components of comprehensive income, as well as accumulated other comprehensive income, the company communicates information about all changes in net assets. With this information, users will better understand the quality of the company's earnings.

SUMMARY OF LEARNING OBJECTIVES

Understand the uses and limitations of an income statement. The income statement provides investors and creditors with information that helps them predict the amounts, timing, and uncertainty of future cash flows. Also, the income statement helps users determine the risk (level of uncertainty) of not achieving particular cash flows. The limitations of an income statement are as follows. (1) The statement does not include many items that contribute to general growth and well-being of a company. (2) Income numbers are often affected by the accounting methods used. (3) Income measures are subject to estimates.

The transaction approach focuses on the activities that occurred during a given period. Instead of presenting only a net change in net assets, it discloses the components of the change. The transaction approach to income measurement requires the use of revenue, expense, loss, and gain accounts.

Describe the content and format of the income statement. The major elements of the income statement are as follows. (1) Revenues: Inflows or other enhancements of assets of an entity or settlements of its liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations. (2) Expenses: Outflows or other using-up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations. (3) Gains: Increases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from revenues or investments by owners. (4) Losses: Decreases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from expenses or distributions to owners.

Prepare an income statement. In a single-step income statement, just two groupings exist: revenues and expenses. Expenses are deducted from revenues to arrive at net income or loss—a single subtraction. Frequently, companies report income tax separately as the last item before net income.

A multiple-step income statement shows two further classifications: (1) a separation of operating results from those obtained through the subordinate or nonoperating activities of the company, and (2) a classification of expenses by functions, such as merchandising or manufacturing, selling, and administration.

Explain how to report various income items. Companies generally include irregular gains or losses or nonrecurring items in the income statement as follows. (1) Other items of a material amount that are of an unusual or nonrecurring nature and are not considered extraordinary are separately disclosed as a component of continuing operations. (2) Discontinued operations of a component of a business are classified as a separate item, after continuing operations. (3) The unusual, material, nonrecurring items that are significantly different from the customary business activities are shown in a separate section for extraordinary items, below discontinued operations. If a company holds a noncontrolling interest in a subsidiary company, it must present an allocation of net income or loss that is attributable to the noncontrolling interest.

Identify where to report earnings per share information. Because of the inherent dangers of focusing attention solely on earnings per share, the profession concluded that companies must disclose earnings per share on the face of the income statement. A company that reports a discontinued operation or an extraordinary item must report per share amounts for these line items either on the face of the income statement or in the notes to the financial statements.

Understand the reporting of accounting changes and errors. Changes in accounting principle and corrections of errors are adjusted through retained earnings. Changes in estimates are a normal part of the accounting process. The effects of these changes are handled prospectively, with the effects recorded in income in the period of change and in future periods without adjustment to retained earnings.

Prepare a retained earnings statement. The retained earnings statement should disclose net income (loss), dividends, adjustments due to changes in accounting principles, error corrections, and restrictions of retained earnings.

Explain how to report other comprehensive income. Companies report the components of other comprehensive income in one of two ways: (1) a single statement of comprehensive income (one statement format) or (2) in a second statement (two statement format).

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