MGT 220 Chapter 4

Uses and Limitations of the Income Statement

Uses:• Evaluate past

performance• Assist in predicting

future performance• Assess potential risk

in achieving future cash flows

Limitations:• Items are excluded if

they cannot be reliably measured

• Amounts reported are affected by accounting methods used

• Use of estimates

• Displays only two groupings:

– Revenues

– Expenses

• Income tax expense may be reported as a separate deduction to arrive at net income

• Advantages:

– Ease of preparation

– Elimination of classification problems for various revenue and expense items

• Disadvantages:

– Lack of additional information for users/decision making

– Failure to separate operating from non-operating activities

Single-Step Income Statement

I/S - SINGLE STEPRevenue

- operating expenses

+/- Material unusual items

- income tax expense

= income before extraordinary items

+/- Extraordinary items (net)

= Net income

Multiple-Step Income Statement

• Operating and non-operating activities displayed as separate sections of the income statement

• Expenses classified by function (e.g. cost of goods sold)

• Income tax expense always shown as a separate item for, and within, each section of the statement

• Advantages of this method include:– provides greater insight into the performance of the enterprise

– provides better opportunity for comparison within the industry

– information provided seen as ‘higher’ quality due to greater predictive and feedback values

I/S - MULTIPLE STEPRevenue- Cost of goods sold= Gross Profit- Operating expenses Selling expenses Administrative expenses+/- Material unusual items- Income tax expense= Income before extraordinary items+/- Extraordinary items (net)= Net income

Condensed Income Statement• Expenses are reported on the income

statement in group totals• Details of the various expense groups are

reported on separate schedules• Provides the advantage of a concise income

statement– All information is still available to statement

users– Useful when inclusion of all expense detail on

the income statement would make the statement ‘cluttered’

• Presented separately on the Income Statement (net of tax); generally following Discontinued Operations

• Characteristics:– Material amounts– Non-recurring events– Differ significantly from the typical business

activities

Extraordinary Items

• Three qualifying criteria:– Infrequent– Atypical of normal business activities– Not primarily dependent on management or

owners’ decisions

• All three of these must be met in order to qualify as an Extraordinary Item

Extraordinary Items

Extraordinary Items

• CICA Handbook, Section 3480 lists the following as not qualifying as Extraordinary Items:1) Losses, or loss provisions, from bad debts

and inventories2) Foreign exchange gains and losses3) Contract price adjustments4) Gains and losses from investment write

downs5) Income tax adjustments6) Income tax rate or law changes

Unusual Gains and Losses

• Gains and losses that do not qualify as an Extraordinary Item, but are material in amount

• Disclosed separately on the income statement, immediately above Income (Loss) before Extraordinary Items

• Alternative presentation is to display a separate section – “Unusual Items”

Intraperiod Tax Allocation• Refers to the reporting of amounts Net of Tax• Specifically the allocation of Income Taxes within

a fiscal period• Income Tax expense (or benefit) is calculated

separately for each of:– income from continuing operations– discontinued operations (Don’t worry about)– extraordinary items

Quality of Earnings• High quality earnings information has the

following attributes:1. Content

– Contains less judgement and less bias– Represents economic reality (all significant events have

been measured and appropriately reported)– Has greater predictive and feedback value (i.e.

represent ongoing operations)– Can be correlated with cash flows from operations– Based on sound business strategy/model

2. Presentation– No attempt made to disguise or mislead (Transparent)– Information presented is Understandable

Earnings per Share

• Earnings per share (EPS) is probably the most important business indicator figure

• Indicates dollars earned per common share; it does not report the dollars paid (or to be paid) per common share

• Earnings per share is required to be disclosed on the income statement for all the major sections

•Calculated as:

Earnings per Share

•Preferred dividends are those dividends that have been declared (non-cumulative) or in arrears (cumulative) for one year only

•Earnings per share is subject to dilution (reduction), if issue of additional shares is possible in the future

Net Income less Preferred DividendsWeighted Average of Common Shares Outstanding

Retained Earnings Statement• Retained earnings are increased by net

income and decreased by net loss and dividends for the year.

• Changes in accounting policy and corrections of errors in prior period financial statements are shown as prior period adjustments to the beginning balance in retained earnings

STATEMENT OF RETAINED EARNINGS

Opening balance

+/- adjustments (change in accounting policy, error correction [net of taxes])

= Opening balance, restated

+ Net income

(- Net loss, or)

- Dividends

= Ending balance

Comprehensive Income

• Includes any item that causes a change in equity– Except for investments (distributions) by (to) owners

• Under all-inclusive income approach following items reported/recorded as other comprehensive income– Unrealized gains/losses on available-for-sale securities– Certain translation gains/losses on foreign currency– Unrealized gains/losses on certain hedging transactions

Comprehensive Income• Separate disclosure of these equity items

would:1. Tend to reduce fair value fluctuations in net income

2. Inform users of potential gains/losses

• AcSB disclosure for Comprehensive Income items requires:

– Expanded Income Statement or additional statement

– Comprehensive EPS not required to be disclosed