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CHAPTER 6 – Part 1
THEINCOME
STATEMENT
Introduction
Various groups are affected by, and have a stake in, the financial reporting requirements of the FASB and the SEC
Introduction
Investors in equity securities are the central focus of the financial reporting environment
Introduction
Investing involves giving up current resources
for future uncertain resources.
Therefore, investors require information assessing future cash flows.
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.
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.
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
Elements of the Income Statement
SFAC No. 1 indicates that the primary focus of financial reporting is to provide information about a company’s performance
The income statement reports on performance and the elements of the income statement were defined in SFAC No. 6 as:
Revenues
GainsExpenses
Losses
Each Term Is Defined As Changes in Assets and Liabilities
Differences between changes in assets approach and inflow and outflow definition are:
Change in net economic resources
1. VSMeasure of effectiveness
Earnings
2.
VS Revenue & Expenses
Definition of Assets and Liabilities
Creation of deferred charges when measuring
income
3. VSRecognition when they are economic resources
or obligations
Each Term Is Defined As Changes in Assets and Liabilities
4. Both agree on importance of income statement
The change in asset approach limits the
population from which elements can be selected
to net economic resources.
5. VSThe flows method
includes items necessary to match
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
= Net income
= Income from continuing operations Discontinued operations
Extraordinary items Change in accounting principle
= Gross profit Less: Administrative and selling expenses Plus: Other gains Less: Other losses
Current Income Statement Format
Proscribed in APB Opinion No. 9 as:Revenues
Less: Cost of goods sold
Income From Continuing Operations
Normal and recurring revenues and expenses
Sustainable income
Income tax
Nonrecurring itemsDiscontinued operations
Extraordinary items
Change in accounting principle
Best Buy and Circuit City
Best Buy Co., Inc. is a specialty retailer of consumer electronics, home office equipment, entertainment software and appliances.
Circuit City Stores, Inc. is a national retailer of brand name consumer electronics, personal computers and entertainment software.
We will use information from the two companies’ fiscal 2003 annual reports to illustrate the disclosure of information in this and subsequent chapters.
Discontinued Operations
Why special treatment?
Arise from a disposal of a segment of a business
Comprised of two elements
Gain or loss on disposed assets
Gain or loss on operations during the disposal periods
When to report
Measurement date
Disposal date
Circuit City previously owned the CarMax auto superstore, but it was spun off from on October 1, 2002
Extraordinary Items
Original definitionProblems APB No. Opinion No. 301 Unusual nature2 Infrequency of occurrence
Problem: Requirements do not always separate recurring and non-recurring itemsAs a result, there is a tendency to increase the variability of operating income and decrease the predictive ability of earnings
The events of 9/11Neither company discloses any extraordinary items for the years presented
Accounting Changes
The accounting standard of consistency requires that similar transactions should be reported similarly each year
Occasionally an entity may find that reporting needs are better served by changing a method of accounting
If so, the comparability of financial statements is impaired
Basic question: Should previously issued financial statements be amended?
Types of Accounting Changes
Change in accounting principleHow reported
Best Buy changed its method of accounting for goodwill (discussed in Chapter 10) and vendor allowances in fiscal 2003
Change in accounting estimate
How reported
Change in accounting entityHow reported
ErrorHow reported
Earnings Per Share
Basic calculation
APB No. 15Simple vs. complex capital structureRequired calculation of primary and fully diluted earnings per shareCriticism of APB No. 15The FASB and IASC project
Net income - Preferred dividends Average # of common shares outstanding
SFAS No. 128
Reasons for the change
1 Basic EPS and diluted EPS data would give users the most factually range of possibilities
2 Use of a common international method is important due to the data based oriented financial analysis and internationalization of business
3 The notion of common stock equivalents does not operate efficiently in practice
4 The computation of primary EPS is complex and not well understood or consistently applied
5 Presenting basic EPS eliminates criticism about the arbitrary nature of the determination of common stock equivalents
SFAS No. 128
Requires presentation of EPS by all publicly traded companies issuing common stock
Companies with a simple capital structure will only report basic earnings per share. All others will report basic and diluted
Calculation of basic EPS
Net income - Preferred dividends Average # of common shares outstanding
Diluted Earnings Per Share
Objective Historical - basic Pro forma - diluted
Calculation: Includes all potential dilutive securities
1 Options and warrants - treasury stock method2 Convertible securities3 Continently issuable securities
Usefulness of EPS
Objectives of EPS reporting are to provide investors an indication of :
1 Value of the firm
2 Expected future dividends
Question: Historical or forecasted?
Summary indicator
Both Best Buy and Circuit City have complex capital structure
disclose basic as well as diluted earnings per share on their their fiscal 2003 income statements
SFAC No. 5 - Recognition and Measurement
Comprehensive income definition:
The change in net assets of an entity from non-owner transactions
Attempts to combine Hicksian capital maintenance approach with traditional accounting transactions approach
SFAC No. 5 - Recognition and Measurement
A full set of financial statements shall show:
Financial
positionComprehensive
income
Earnings
Investments by and
distributions to ownersCash
flows
SFAS No. 5 - Recognition and Measurement
Comprehensive incomeRevenues EarningsLess: Expenses Plus or minus cumulative accounting
adjustmentsPlus: Gains Plus or minus other nonowner
changes in equityLess: Losses= Earnings = Comprehensive income
Measurement Issues
Definitions. The item meets the definition of an element contained in SFAC No. 6.
Measurability. It has a relevant attribute, measurable with sufficient reliability.
Relevance. The information about the item is capable of making a difference in user decisions.
Reliability. The information is representationally faithful, verifiable, and neutral.
SFAS No 130 - Reporting Comprehensive Income
Reasons for the initial project
1 Off-balance sheet financing
2 The practice of reporting some items of comprehensive income in stockholders’ equity
3 Acknowledged need for harmonization of accounting standards
Definitions
Comprehensive incomethe change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from nonowner sources.
Other comprehensive incomerevenues, expenses, gains, and losses included in comprehensive income but excluded from net income.
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Prepared by Richard Schroeder, PhDKathryn Yarbrough, MBA