Chapter Four Lecture Notes

Statements of Income and Retained Earnings


I. The Statement of Income

A. Importance of the Income Statement

1. The income statement provides investors and creditors with information that helps them predict the amounts , timing, and uncertainty of future cash flows.

2. How does the statement help predict future cash flows?

a. First of all it provides information to evaluate the past performance of the enterprise.

b. Second of all it provides information to help users determine the risk of not achieving particular cash flows.

B. Capital Maintenance

1. The economist J. R. Hicks defined income as the maximum amount an entity could consume during a period and still be as well off at the end as at the beginning. This is known as the capital maintenance concept of income.

a. The problem is how do you define well offednes?

b. Capital maintenance is measured by subtracting beginning net assets from ending net assets while adjusting for any additional capital contribution by owners and for any declaration of dividends.

c. Note that the capital maintenance method does not supply us with information about the firm's revenues and expenses. This method does not generate detailed information about the composition of income. For this reason, accountants do not use the capital maintenance approach.

2. Accountants use the transaction approach to measure income.

a. Throughout the period each income related transaction is measured.

b. These transactions are then summarized

c. and an income statement is generated which discloses not only income, but also the components of income.

3. Elements of the Income Statement

a. Concepts Statement Six identified four elements of the income statement.

(1) revenues

(2) expenses

(3) gains

(4) and losses

b. We covered the definitions of these elements in our lecture of chapter 2.

4. Single-Step Income Statements

a. In the single step income statement just two groups exist

(1) revenues

(2 )and expenses

b. As you see in the example on page 135, all revenues are grouped together in one section

c .and all expenses are grouped together in another section

d. The advantage of the single step income statement is simplicity of presentation.

5. Multiple-Step Income Statements

a. Please refer to page 138.

b. This format classifies revenues and expenses by function.

(1) sales revenue is presented in a separate section from other revenues and gains

(2)Expenses and costs are also shown in separate sections

(a)Cost of Goods Sold is separate from

(b) operating expenses and

(c) other expenses and losses

(3)Note that there is a line called gross profit on the multiple step income statement, but there is no such line on the single step income statement.

c. The value of the multiple step income statement is that it separates operating and non-operating transactions, and matches costs and expenses with related revenues.

6. Intermediate Components of the Income Statement

a. The operating section presents

(1)Sales revenue

(2 )cost of goods sold

(3) selling expenses

(4) and G&A expenses

b. The non-operating section reports revenues and expenses resulting from secondary or auxiliary activities of the company. Gains and losses are presented here too.

c. Income tax expense is subtracted from pre-tax income from continuing operations to derive income from continuing operations

d. Discontinued operations deals with both

(1)The income earned by the discontinued operation and

(2) The gain or loss on the disposal of spinning off an entire segment of the business.

e. Extraordinary items are gains and losses which are both infrequent and unusual.

f. Now we net out at net income

g.  Finally earnings per share information is presented for each class of income. Refer to page 151.

7. Condensed Income Statements such as the one on page 139 may be presented as long as the missing detail is supplied in a supporting schedule in the notes to the financial statements.

8. Professional Pronouncements and the Income Statement

a. The chief controversy over the years was that of the current operating performance measure of income vs. the all inclusive measure of income.

b. The current operating argument is that only recurrent items are relevant to potential investors in valuing the firm.

c. The all inclusive income argument is that anything which impacts retained earnings (other than dividends) should first show up on the income statement.

d. APB Opinion No. 9 adopted a modified all-inclusive concept. This Statement was amended by SFAS 154.

(1)As a result two special non-recurrent items show up on the income statement in their own sections. The so called D & E items.  

(2)Discontinued operations are the topic of APB Opinion No. 30.

(a) This item concerns the disposal of a component of a business.

(b)Both the gain or loss from the disposal as well as

(c)The results of operation of the discontinued component are reported, net of tax effect, in this special section.

(3)APB Opinion 30 discusses extraordinary items

(a)  these are material gains or losses which are both infrequent and unusual.

 (b)Extraordinary items are reported separately on the income statement net of tax effect. as is illustrated on page 148 .

(4)Change in accounting principle

(a)Frequently, firms will switch from one acceptable accounting principle to another.

(b)Examples would include a switch in depreciation method or a switch in the cost flow assumption.

(c)These changes require a retrospective adjustment to the financial statements.

(d)This topic is covered in Chapter 22. This is an Intermediate II topic. See page 1182.

(5)Changes in estimates do not have a special section but they do work their way onto the income statement.

(a) Such changes are always handled prospectively,

i) which means when new information relative to an estimate becomes available to the accountant,

ii)  he will use it from then on,

iii)  but he will not go back and change any of the statements from previous years.

9. Intraperiod tax allocation

a. Most accountants believe that it is desirable to associate an item with its corresponding tax effect. Therefore, whenever we present a D & E item, we will also present its corresponding tax effect.

b. Adhering to the philosophy to "let the tax follow the income", intraperiod tax allocation results in the tax being allocated amongst three income items and one retained earnings item.

(1)Income from continuing operations

(2)Discontinued operations

(3)Extraordinary items

 (4)and prior period adjustments

C. Earnings per share

1. Net income summarizes the results of a company's operations.

2. The financial world frequently looks at another figure, earnings per share, as being a summary indicator.

a. Earnings per share is of course a ratio.

b. The formula for eps is income available for common stockholders divided by the weighted average of common shares outstanding.

(1)Income available for common consists of net income less preferred dividends.

(2) weighted average number of shares takes into account that there may be a different number of shares outstanding at different points in time.

(3)Note in the example on page 151 that eps figures must be presented for each major class of income.

3. Sometimes firms issue convertible securities. Firms also issue stock options and warrants.

a. These are examples of securities which are not common stock, but which may transform into common stock.

b. In Chapter 16 you will study APB Opinion No. 15 and SFAS No. 128 in detail in order to learn how to calculate eps when these sorts of securities are outstanding.

D. Comprehensive Income

1. Subsequent to the issuance of APB Opinion 9, various accounting pronouncements have called for the exclusion of certain exceptional items from the determination of net income.

2. This defeats the purpose of the all-inclusive income concept.

3. Therefore FASB issued SFAS No. 130 which requires that firms report other comprehensive income.

4. Please refer to the examples on page 153 & 154.  

II. Statement of Retained Earnings

A. The statement of retained earnings is a reconciliation of the beginning and ending balances of retained earnings.

B. The retained earnings statement also provides the link between the income statement and the balance sheet for the period.

C. Sometimes an error in a revenue or expense item from a previous period is discovered this period. The problem is that previous periods nominal accounts were closed into income summary, which was then closed into retained earnings. This sort of error is corrected by a prior period adjustment.

1.Prior period adjustments, net of tax effect, are charged or credited to the opening balance of retained earnings.

D. Appropriations of retained earnings are a way to "earmark" a certain amount of retained earnings for a specific purpose.

1.Appropriated retained earnings is still part of retained earnings.

2.The journal entry to appropriate is

a. Debit unappropriated retained earnings

b. and credit appropriated retained earnings

c. This entry is just reversed when it comes time to unappropriate the retained earnings.


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