FINANCIAL ACCOUNTING

THEORY AND ANALYSIS:

TEXT AND CASES
11TH EDITION

RICHARD G. SCHROEDER
MYRTLE W. CLARK
JACK M. CATHEY

1
CHAPTER 6

Financial Statements I:
The Income Statement

2
 Ch06
CH06: Financial Statement I: The Income Statement

I. The Economic Consequences of Financial Reporting

II. Income Statements Element
III. Statement Format
1. Income from continuing operations
2. Nonrecurring items of income
 Discontinued operations
 Extraordinary items
 Accounting Changes
3. Earning per share
4. Comprehensive income

3
 Ch06

Introduction
Various groups are affected by, and have a stake in, the financial reporting
requirements of the FASB and the SEC

4
 Ch06

Introduction
Investors in equity securities are the central focus of the
financial reporting environment

5
 Ch06

Introduction

 Investing involves
 Giving up current resources

 For future uncertain resources.

 Therefore, investors require information assessing future

cash flows.

6
 Ch06

I. The Economic Consequences of

Financial Reporting
 Financial reporting has economic consequences including:
1 Financial information can affect the distribution of wealth among investors.
 More informed investors, or investors employing security analysts, may
be able to increase their wealth at the expense of less informed
investors.

7
 Ch06

I. The Economic Consequences of

Financial Reporting
2 Financial information can affect the level of risk accepted
by a firm.
 Focusing on short-term, less risky, projects may have long-
term detrimental effects.

3 Financial information
 Can affect the rate of capital formation in the economy
 And result in a reallocation of wealth between consumption and investment
within the economy. 8
 Ch06

I. The Economic Consequences of

Financial Reporting

4 Financial information can affect how investment is allocated among firms.

 These economic consequences may have a differential impact on different

user groups and future deliberations of standards must consider these
economic consequences 9
 Ch06

II. Income Statement Elements

 SFAC No. 8 indicates that the primary

focus of financial reporting is to
provide information about a
company’s performance

10
 Ch06

II. Income Statement Elements

 Vehicle for relaying performance assessments to investors
 SFAC No. 6: defined the elements of the income statement:

Gains
Revenues
Increases in net assets from
Inflows or other enhancements of
peripheral or incidental
assets of an entity or settlement
transactions of an entity and from
of its liabilities during a period
all other transactions and other
from delivering or producing
events and circumstances
goods, rendering services, or
affecting the entity during a
other activities that constitute the
period except those that result
entity’s ongoing major or central
from revenues or investments by
operations
owners

11
 Ch06

II. Income Statement Elements

 Vehicle for relaying performance assessments to investors
 SFAC No. 6: defined the elements of the income statement:

Expenses Losses
Outflows or other using-up of Decreases in net assets from
assets or incurrences of liabilities peripheral or incidental
during a period from delivering or transactions of an entity and from
producing goods, rendering all other transactions and other
services, or carrying out other events and circumstances
activities that constitute the affecting the entity during a
entity’s ongoing major or central period except from expenses or
operations distributions to owners

12
 Ch06

III. Statement Format

 The preparation of the income statement has been

impacted by differences of opinion on the definition
of ongoing operations.
 Two views:

1 All inclusive
2 Current operating performance
13
 Ch06

Current Income Statement Format

Revenues
Less: Cost of goods sold
= Gross profit
Less: Administrative and selling expenses
Plus: Other gains
Less: Other losses
Excludes prior-period
= Income from continuing operations adjustments
Discontinued operations
Extraordinary items

= Net income

14
 Ch06

1. Income From Continuing Operations

 Normal and recurring revenues and expenses

 Sustainable income
 Income tax (recurring items)
 Nonrecurring items (Each net of their tax effect)
 Discontinued operations
 Extraordinary items

15
 Ch06

2. Nonrecurring items of income

Discontinued Extraordinary Accounting

Operations Items Changes

16
 Ch06

2. Nonrecurring items of income

Discontinued operations:
A discontinued operation occurs when two things happen:
(a) a company eliminates the results of operations and cash
flows of a component from its ongoing operations, and
(b) there is no significant continuing involvement in that
component after the disposal transaction.

The intent of such classification is to give the reader the sense of what
income might be reasonably be expected from ongoing operations.

Amount reported “net of tax.”

17
 Ch06

Discontinued operations:

Illustration: KC Corporation had after tax income from continuing

operations of $55,000,000 in 2008. During 2008, it disposed of its
restaurant division at a pretax loss of $270,000. Prior to disposal, the
division operated at a pretax loss of $450,000 in 2008. Assume a tax rate
of 30%. Prepare a partial income statement for KC.
Income from continuing operations $55,000,000
Discontinued operations:
Loss from operations, net of $135,000 tax 315,000
Loss on disposal, net of $81,000 tax 189,000
Total loss on discontinued operations 504,000
Net income $54,496,000

18
 Ch06

Discontinued operations:

Income Statement (in thousands)

Discontinued Operations Sales $ 285,000
are reported after “Income Cost of goods sold 149,000
from continuing
operations.” Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Previously labeled as Income tax expense 24,000
Income from continuing operations 55,000
“Net Income”.
Discontinued operations:
Loss from operations, net of tax 315
Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Moved to
Net income $ 54,496

19
 Ch06

Extra-ordinary items:
• Include events and transactions that are both infrequent (or
nonrecurring) and unusual (or not related to normal operations).
• Both criteria must be met in the classification of extraordinary items.
• Amount reported “net of tax.”
• Items that are infrequent but not unusual, or vice versa should be shown
as a separate line in income from operations and reported in a separate
section just above “Income from continuing operations before income
taxes.”

Examples can include:

Write-downs of inventories
Foreign exchange transaction gains and losses

Amount not reported net-of-tax for these items.

20
 Ch06

Examples of Extraordinary items:

(a) A large portion of a tobacco manufacturer’s crops are destroyed by

a hail storm. Severe damage from hail storms in the locality where
the manufacturer grows tobacco is rare.
(b) A company sells a block of common stock of a publicly traded
company. The block of shares, which represents less than 10% of
the publicly-held company, is the only security investment the
company has ever owned.
(c) An earthquake destroys one of the oil refineries owned by a large
multi-national oil company. Earthquakes are rare in this
geographical location.

21
 Ch06

Extra-ordinary items:

Illustration: KC Corporation had after tax income from continuing

operations of $55,000,000 in 2007. In addition, it suffered an unusual
and infrequent pretax loss of $770,000 from a volcano eruption. The
corporation’s tax rate is 30%. Prepare a partial income statement for KC
Corporation beginning with income from continuing operations.

Income from continuing operations $55,000,000

Extraordinary loss, net of $231,000 tax (539,000)
Net income $54,461,000

($770,000 x 30% = $231,000 tax)

22
 Ch06

Income Statement (in thousands)

Extraordinary Items are Sales $ 285,000
reported after “Income Cost of goods sold 149,000
from continuing
operations.” Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Previously labeled as
Income from continuing operations 55,000
“Net Income”.
Extraordinary loss, net of tax 539
Net income $ 54,461
Moved to

23
 Ch06

Reporting when both Discontinued Operations and Extraordinary:

Income Statement (in thousands)

Sales $ 285,000
Cost of goods sold 149,000

Interest expense (21,000)

Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Income from continuing operations 55,000
Discontinued operations:
Discontinued Loss from operations, net of tax 315
Operations Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Income before extraordinary item 54,496
Extraordinary Item Extraordinary loss, net of tax 539
Net income $ 53,957

24
 Ch06

Accounting Changes:
Include 3 kinds of change:
- Changes in an accounting principle
- Changes in an accounting estimate
- Corrections of error

25
 Ch06

Changes in Accounting Principles

Retrospective adjustment
Cumulative effect adjustment to beginning retained earnings
Approach preserves comparability
Examples include:
 change from FIFO to average cost
 change from the percentage-of-completion to the
completed-contract method

26
 Ch06

Change in Accounting Principle: Gaubert Inc. decided in March 2010 to

change from FIFO to weighted-average inventory pricing. Gaubert’s income
before taxes, using the new weighted-average method in 2010, is $30,000.

Pretax Income Data

27
 Ch06

Changes in Estimate
Accounted for in the period of change and future periods
Not handled retrospectively
Not considered errors or extraordinary items
Examples include:
 Useful lives and salvage values of depreciable assets

 Allowance for uncollectible receivables

 Inventory obsolescence

28
 Ch06

Change in Estimate:
Arcadia HS, purchased equipment for $510,000 which was estimated
to have a useful life of 10 years with a salvage value of $10,000 at the
end of that time. Depreciation has been recorded for 7 years on a
straight-line basis. In 2010 (year 8), it is determined that the total
estimated life should be 15 years with a salvage value of $5,000 at the
end of that time.
Questions:
 What is the journal entry to correct the prior No Entry
Required
years’ depreciation?
 Calculate the depreciation expense for 2010.

29
 Ch06

Equipment cost $510

510,,000 First, establish NBV at
Salvage value - 10
10,,000 date of change in
Depreciable base 500,,000
500 estimate.
Useful life (original) 10 years
Annual depreciation 50,,000 x 7 years = $350
$ 50 350,,000

Balance Sheet (Dec. 31

31,, 2009
2009))
Fixed Assets:
Equipment $510
510,,000
Accumulated depreciation 350,,000
350
Net book value (NBV) $160
160,,000

30
 Ch06

Net book value $160

160,,000 Depreciation Expense
Salvage value (new) 5,000 calculation for 2010
2010..
Depreciable base 155,,000
155
Useful life remaining 8 years
Annual depreciation $ 19
19,,375

Journal entry for 2010

Depreciation expense 19,375

Accumulated depreciation 19,375

31
 Ch06

Corrections of Errors
Result from:
 mathematical mistakes
 mistakes in application of accounting principles
 oversight or misuse of facts

Corrections treated as prior period adjustments

Adjustment to the beginning balance of retained earnings

32
 Ch06

Corrections of Errors: To illustrate, in 2011, Hillsboro Co.

determined that it incorrectly overstated its accounts receivable
and sales revenue by $100,000 in 2010. In 2011, Hillboro
makes the following entry to correct for this error (ignore
income taxes).

Retained earnings 100,000

Accounts receivable 100,000

33
 Ch06

3. Earning per Share:

Earnings per share indicates the income earned by each ordinary share.

 Companies report earnings per share only for ordinary shares.

 When the income statement contains discontinued operations,

companies are required to report earnings per share from
continuing operations and net income on the face of the income
statement.

34
 Ch06

3. Earning per Share:

 Simple Structure--Only ordinary shares; no potentially

dilutive securities.

 Complex Structure--Potentially dilutive securities are

present.

 “Dilutive” means the ability to influence the EPS in a

downward direction.

35
 Ch06

3. Earning per Share:

Preferred Stock Dividends

Subtracts the current-year preference share dividend from net
income to arrive at income available to ordinary shareholders.

Preference dividends are subtracted on cumulative preference

shares, whether declared or not.

36
 Ch06

3. Earning per Share:

Weighted-Average Number of Shares

Companies must weight the shares by the fraction of the period
they are outstanding.
When share dividends or share splits occur, companies need to
restate the shares outstanding before the share dividend or split.

37
 Ch06

3. Earning per Share:

Illustration: Sabrina Company has the following changes in its ordinary
shares during the year.

Compute the weighted-average number of shares outstanding for

Sabrina Company.

38
 Ch06

3. Earning per Share:

Illustration 16-17

39
 Ch06

4. Comprehensive Income:
• Defined as the total change in proprietorship recognized by the
recording of transactions or the revaluation of the firm during a
specific period, except for dividend distributions and capital
transactions.

• Comprehensive income is boarder than net income because it

includes other changes in net assets like holding gains and losses.

Other comprehensive income

Revenues, expenses, gains, and losses included in comprehensive
income but excluded from net income.

40
 Ch06

Comprehensive Income:

Income Statement (in thousands)

Other Comprehensive
Sales $ 285,000
Income
Cost of goods sold 149,000
Gross profit 136,000 Unrealized gains and
Operating expenses: + losses on available-for-
Selling expenses 10,000 sale securities.
Administrative expenses 43,000
Translation gains and
Total operating expense 53,000
Income from operations 83,000
losses on foreign
Other revenue (expense):
currency.
Interest revenue 17,000 Plus others
Interest expense (21,000)
Total other (4,000) Reported in Stockholders’
Income before taxes 79,000 Equity
Income tax expense 24,000
Net income $ 55,000

41
 Ch06

4. Comprehensive Income:
Review

Gains and losses that bypass net income but affect stockholders' equity
are referred to as
a. comprehensive income.
b. other comprehensive income.
income.
c. prior period income.
income.
d. unusual gains and losses.
losses.

42
 Ch06

Comprehensive Income

43
 Ch06

Comprehensive Income - Balance Sheet Presentation

The accumulated other comprehensive income of $90 90,,000 is

reported in the stockholders’ equity section of the balance sheet
sheet..
44
 Ch06

Exercises:
Ex 1: Finley Corporation had income from continuing operations of $10,600,000 in 2010.
During 2010, it disposed of its restaurant division at an after-tax loss of $189,000. Prior to
disposal, the division operated at a loss of $315,000 (net of tax) in 2010.
Required:
Prepare a partial income statement for Finley beginning with income from continuing
operations.

Ex 2: Stacy Corporation had income before income taxes for 2010 of $6,300,000. In addition,
it suffered an unusual and infrequent pretax loss of $770,000 from a volcano eruption. The
corporation’s tax rate is 30%.
Required:
Prepare a partial income statement for Stacy beginning with income before income taxes.

Ex 3: During 2010 Williamson Company changed from FIFO to weighted-average inventory

pricing. Pretax income in 2009 and 2008 (Williamson’s first year of operations) under FIFO
was $160,000 and $180,000, respectively. Pretax income using weighted-average pricing in
the prior years would have been $145,000 in 2009 and $170,000 in 2008. In 2010, Williamson
Company reported pretax income (using weighted-average pricing) of $180,000.
Required:
Show comparative income statements for Williamson Company, beginning with “Income
before income tax,” as presented on the 2010 income statement. (The tax rate in all years is
30%.)
 Ch06

Exercises:
Ex 4: Vandross Company has recorded bad debt expense in the past at a rate of 1.5% of
net sales. In 2010, Vandross decides to increase its estimate to 2%. If the new rate had
been used in prior years, cumulative bad debt expense would have been $380,000
instead of $285,000. In 2010, bad debt expense will be $120,000 instead of $90,000. If
Vandross’s tax rate is 30%.
Required:
What amount should it report as the cumulative effect of changing the estimated bad
debt rate?

Ex 5: On January 1, 2010, Richards Inc. had cash and common stock of $60,000. At that
date the company had no other asset, liability or equity balances. On January 2, 2010, it
purchased for cash $20,000 of equity securities that it classified as available-for-sale. It
received cash dividends of $3,000 during the year on these securities. In addition, it has
an unrealized holding gain on these securities of $4,000 net of tax.
Required:
Determine the following amounts for 2010: (a) net income; (b) comprehensive income;
(c) other comprehensive income; and (d) accumulated other comprehensive income
(end of 2010).
46
 Ch06

Exercises:
Ex 6: Zehms Company began operations in 2008 and adopted weighted-average pricing
for inventory. In 2010, in accordance with other companies in its industry, Zehms
changed its inventory pricing to FIFO. The pretax income data is reported below.

Year Weighted FIFO

Average
2008 $ 370,000 $ 395,000
2009 390,000 420,000
2010 410,000 460,000

Required
(a) What is Zehms’s net income in 2010? Assume a 35% tax rate in all years.
(b) Compute the cumulative effect of the change in accounting principle from weighted-
average to FIFO inventory pricing.
(c) Show comparative income statements for Zehms Company, beginning with income
before income tax, as presented on the 2010 income statement.
47
 Ch06

Exercises:
Ex 7: Armstrong Corporation reported the following for 2010: net sales $1,200,000;
cost of goods sold $720,000; selling and administrative expenses $320,000; and an
unrealized holding gain on available-for-sale securities $15,000.
Required:
Prepare a statement of comprehensive income, using the two-income statement
format. Ignore income taxes.

Ex 8:
Bryant Co. reports the following information for 2010: sales revenue $750,000; cost
of goods sold $500,000; operating expenses $80,000; and an unrealized holding loss
on available-for-sale securities for 2010 of $50,000. It declared and paid a cash
dividend of $10,000 in 2010. Bryant Co. has January 1, 2010, balances in common
stock $350,000; accumulated other comprehensive income $80,000; and retained
earnings $90,000. It issued no stock during 2010.
Required
Prepare a statement of comprehensive income, and the equity section on the
balance sheet.
48
 Ch06

Exercises:
Ex 9: Kalin Corporation had 2014 net income of $1,000,000. During 2014, Kalin paid a
dividend of $2 per share on 100,000 shares of preferred stock. During 2014, Kalin had
outstanding 250,000 shares of common stock.
Required:
Compute Kalin’s 2014 earnings per share.

Ex 10: Douglas Corporation had 120,000 shares of stock outstanding on January 1,

2014. On May 1, 2014, Douglas issued 60,000 shares. N July 1, Douglas purchased
10,000 treasury shares, which were reissued on October 1.
Required:
Compute Douglas’s weighted-average number of shares outstanding for 2014.

Ex11: Tomba Corporation had 300,000 shares of common stock outstanding on January
1, 2014. On May 1, Tomba issued 30,000 shares.
Required:
(a) Compute the weighted-average number of shares outstanding if the 30,000 shares
were issued for cash.
(b) Compute the weighted-average number of shares outstanding if the 30,000 shares
were issued in a stock dividend.
49