Financial Statement I: The Income Statement

CHAPTER
Financial Statement I:
The Income Statement
The financial reporting environment in the United States consists of various groups
that are affected by and have a stake in the financial reporting requirements of the
FASB and the SEC. These groups include investors, creditors, securities analysts,
regulators, management, and auditors. Investors in equity securities are the central
focus of the financial reporting environment. Investment involves forgoing current
uses of resources for ownership interests in companies. These ownership interests
are claims to uncertain future cash flows. Consequently, investment involves
giving up current resources for future, uncertain resources, and investors require
information that will help them assess future cash flows from securities.
The Economic Consequences of Financial Reporting

In Chapter 1, we introduced the concept of economic consequences. Income mea-
surement and financial reporting also involve economic consequences, including
the following:
• 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.
• Financial information can affect the level of risk accepted by a firm. As
discussed in Chapter 4, focusing on short-term, less risky projects can have
long-term detrimental effects.
• 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.
• Financial information can affect how investment is allocated among firms.
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184 Chapter 6 • Financial Statement I: The Income Statement
Because economic consequences can affect different users of information

differently, the selection of financial reporting methods by the FASB and the
SEC involves trade-offs. The deliberations of accounting standard setters should
consider these economic consequences.
Income Statement Elements

The FASB’s Statement of Financial Accounting Concepts (SFAC) No. 8 indicates that the
primary purpose of financial reporting is to provide financial information about
the reporting entity that is useful to present and potential equity investors,
lenders, and other creditors in making decisions about providing resources to the
entity.1 The income statement is of primary importance in this endeavor because
of its predictive value, a qualitative characteristic also defined in SFAC No. 8.
Income reporting also has value as a measure of future cash flows, as a measure
of management efficiency, and as a guide to the accomplishment of managerial
objectives.
The emphasis on corporate income reporting as the vehicle for relaying
performance assessments to investors has caused a continuing dialogue among
accountants about the proper identification of revenues, gains, expenses, and
losses. These financial statement elements are defined in SFAC No. 6 as follows:
• Revenues. Inflows or other enhancements of assets of an entity or settlement
of its liabilities (or a combination of both) during a period from delivering or
producing goods, rendering services, or other activities that constitute the
entity’s ongoing major or central operations.
• Gains. Increases in net assets from peripheral or incidental transactions of an
entity and from all other transactions and other events and circumstances
affecting the entity during a period except those that result from revenues
or investments by owners.
• Expenses. Outflows or other using up of assets or incurrences of liabilities (or
a combination of both) 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.
• Losses. Decreases in net assets from peripheral or incidental transactions
of an entity and from all other transactions and other events and
circumstances affecting the entity during a period except from expenses
or distributions to owners.2
Notice that each of these terms is defined as changes in assets and/or liabili-
ties. This represents a change in emphasis by the FASB from previous definitions
provided by the Accounting Principles Board (APB) that stressed inflows and
outflows, realization, and the matching concept. Consequently, current recogni-
tion and measurement criteria for revenues, expenses, gains, and losses are more
1. Financial Accounting Standards Board, “Chapter 1, The Objective of General

Purpose Financial Reporting,” and “Chapter 3, Qualitative Characteristics of Useful
Financial Information,” in SFAC No. 8, Conceptual Framework for Financial Reporting
(Norwalk, CT: FASB, 2010).
2. Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 6,
“Elements of Financial Statements” (Stamford, CT: FASB, 1985), paras. 79–88.
Statement Format 185
closely associated with asset and liability valuation issues, and the balance sheet
has become more than a place to store residual values in the income determina-
tion process. Although he regarded the new definitions as a distinct improvement,
David Solomons, a former member of the Wheat Committee, suggested that they
were not sufficiently robust to deal with some of the most difficult accounting
problems.3
Robison4 highlighted some differences between the changes in assets and/or
liabilities and the inflows and outflows definitions of income. These differences
are summarized as follows:
• The changes in assets and/or liabilities approach determines earnings as a
measure of the change in net economic resources for a period, whereas the
inflows and outflows definition views income as a measure of effectiveness.
• The changes in assets and/or liabilities approach depends on the definition
of assets and liabilities to define earnings, whereas the inflows and outflows
approach depends on definitions of revenues and expenses and matching
them to determine income.
• The inflows and outflows approach results in the creation of deferred
charges, deferred credits, and reserves when measuring periodic income; the
changes in assets and/or liabilities approach recognizes deferred items only
when they are economic resources or obligations.
• Both approaches agree that because investors look to financial statements
to provide information from which they can extrapolate future resource
flows, the income statement is more useful to investors than is the
balance sheet.
• The changes in assets and/or liabilities approach limits the population from
which the elements of financial statements can be selected to net economic
resources and to the transactions and events that change measurable
attributes of those net resources. Under the inflows and outflows ap-
proach, revenues and expenses may include items necessary to match costs
with revenues, even if they do not represent changes in net resources.
An important distinction between revenues and gains and expenses and losses is
whether or not they are associated with ongoing operations. Over the years, this
distinction has generated questions concerning the nature of income reporting
desired by various users of financial statements. Two viewpoints have dominated
this dialogue and are termed the current operating performance concept and the all-
inclusive concept of income reporting. These viewpoints are summarized in the
following paragraphs.
Statement Format
Proponents of the current operating performance concept of income base their
arguments on the belief that only changes and events controllable by manage-
ment that result from current-period decisions should be included in income.
3. David Solomons, “The FASB’s Conceptual Framework: An Evaluation,” Journal of

Accountancy 161, no. 6 (1986): 120–121.
4. L. E. Robinson, “The Time Has Come to Report Comprehensive Income,” Accounting
Horizons (June 1991), 110
This concept implies that normal and recurring items, termed sustainable income,
should constitute the principal measure of enterprise performance. That is, net
income should reflect the day-to-day, profit-directed activities of the enterprise,
and the inclusion of other items of profit or loss distorts the meaning of the
term net income.
Alternatively, advocates of the all-inclusive concept of income hold that net
income should reflect all items that affected the net increase or decrease in stock-
holders’ equity during the period, with the exception of capital transactions. This
group believes that the total net income for the life of an enterprise should be
determinable by summing the periodic net income figures.
The underlying assumption behind the current operating performance versus
all-inclusive concept controversy is that the manner in which financial informa-
tion is presented is important. In essence, both viewpoints agree on the informa-
tion to be presented but disagree on where to disclose certain revenues, expenses,
gains, and losses. As discussed in Chapters 4 and 5, research indicates that inves-
tors are not influenced by where items are reported in financial statements so
long as the statements disclose the same information. So, perhaps, the concern
over the current operating performance versus the all-inclusive concept of in-
come is unwarranted. The following paragraphs review the history of the issue.
APB Opinion No. 9

One of the first issues the APB studied was what to include in net income. An APB
study revealed that business managers were exercising a great deal of discretion in
determining which revenues and expenses, and gains and losses, to include on
the income statement or on the retained earnings statement. The lack of formal
guidelines concerning adjustments to retained earnings resulted in the placement
of most items of revenue or gain on the income statement, whereas many expense
and loss items that were only remotely related to previous periods were treated as
adjustments to retained earnings.
The APB’s study of these reporting abuses and its general review of the
overall nature of income resulted in the release of APB Opinion No. 9, “Reporting
the Results of Operations.” This opinion took a middle position between the
current operating performance and all-inclusive concepts by stating that net
income should reflect all items of profit and loss recognized during the period,
with the exception of prior-period adjustments. In addition, the APB’s pre-
scribed statement format included two income figures: net income from opera-
tions and net income from operations plus extraordinary items. APB Opinion No. 9
required preparers of financial statements to determine whether revenues and
expenses and gains and losses were properly classified as normal recurring
items, extraordinary items, or prior period adjustments according to established
criteria. In general, the opinion’s provisions specified that all items were to
be considered normal and recurring unless they met the stated requirements
for classification as either extraordinary items or prior-period adjustments (dis-
cussed later in the chapter).
Separating the income statement into net income from operations and net
income after extraordinary items allowed the disclosure of most items of revenue
and expense and gains and losses on the income statement during any period. It
also gave financial statement users the ability to evaluate the results of normal
operations or total income according to their needs.
The FASB noted in SFAC No. 5 that the all-inclusive income statement is
intended to avoid discretionary omissions from the income statement, even
though “inclusion of unusual or non-recurring gains or losses might reduce
the usefulness of an income statement for one year for predictive purposes.”5
The FASB has also stated that because the effects of an entity’s activities vary
in terms of stability, risks, and predictability, there is a need for information
about the various components of income. In the following paragraphs, we
examine the elements of the income statement, introduce the accounting
principles currently being used in measuring these elements, and discuss how
they are disclosed on the income statements of The Hershey Company and
Tootsie Roll Industries, Inc., illustrated on pages 188 and 189.
The Hershey Company engages in the manufacture, distribution, and sale
of confectionery, snack, refreshment, and grocery products in the United
States and internationally. The company sells its products primarily to whole-
sale distributors, chain grocery stores, mass merchandisers, chain drug stores,
vending companies, wholesale clubs, convenience stores, and concessionaires
through sales representatives, food brokers, and retail sales merchandisers.
Tootsie Roll Industries, Inc., through its subsidiaries, engages in the manufac-
ture and sale of confectionery products. The company’s customers include
wholesale distributors of candy and groceries, supermarkets, variety stores,
dollar stores, chain grocers, drug chains, discount chains, cooperative grocery
associations, warehouse and membership club stores, vending machine opera-
tors, the U.S. military, and fund-raising charitable organizations. It operates
primarily in the United States, Canada, and Mexico, as well as distributing its
products through candy and grocery brokers.
The two companies’ income statements disclose the aggregate financial re-
sults of these activities and include comparative information for the 2011, 2010,
and 2009 fiscal years6 as shown in Exhibits 6.1 and 6.2.
The SEC requires all companies to provide three-year comparative income
statements and two-year comparative balance sheets. Consequently, most pub-
licly held companies also provide similar data in their annual reports. The com-
ponents of the traditional income statement exclusive of the elements of other
comprehensive income are discussed in the following paragraphs. The elements
of other comprehensive income are discussed later in the chapter.
Income from Continuing Operations

The amounts disclosed to arrive at income from continuing operations are the
company’s normal and recurring revenues and expenses. The resulting income
figure represents the amount expected to recur in the future, often referred to
as the company’s sustainable income. Sustainable income is the amount investors
should use as a starting point to predict future earnings. In addition, the
amount of income tax disclosed in this section of the income statement is the
amount of income tax the company would have reported if no nonrecurring
5. Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 5,

“Recognition and Measurement in Financial Statements of Business Enterprises”
(Stamford, CT: FASB, 1984), para. 35.
6. Summary segmental performance information is required to be disclosed by FASB
ASC 280-10, as discussed in Chapter 15.
income items had been incurred. Hershey’s 2011 income statement reports “In-
come before Income Taxes” of $962,845,000 and income tax on this amount of
$333,883,000; the net amount, $628,962,000, is Hershey’s income from con-
tinuing operations. Similarly, Tootsie Roll’s income from continuing operations
is reported as the company’s “Net Earnings.” In 2011 Tootsie Roll reported net
earnings of $43,938,000.
Nonrecurring Items of Income

Three nonrecurring items of income may also be incurred by a company. These
items are discontinued operations, extraordinary items, and accounting changes.
These items are discussed in the following paragraphs.
Discontinued Operations
Study of the results of the application of APB Opinion No. 9 by various entities
disclosed some reporting abuses. For example, some companies were reporting
the results of the disposal of segment assets as extraordinary while including the
EXHIBIT 6.1 The Hershey Company Consolidated Statements of Income

For the Years Ended December 31,
in Thousands of Dollars Except
per-Share Amounts 2011 2010 2009
Net Sales
Costs and Expenses: $6,080,788 $5,671,009 $5,298,668
Cost of sales 3,548,896 3,255,801 3,245,531

Selling, marketing, and 1,477,750 1,426,477 1,208,672
administrative
Business realignment and
impairment (credits) charges, net (886) 83,433 82,875
Total costs and expenses 5,025,760 4,765,711 4,537,078
Income before Interest and 1,055,028 905,298 761,590
Income Taxes
Interest expense, net 92,183 96,434 90,459
Income before Income Taxes 962,845 808,864 671,131
Provision for income taxes 333,883 299,065 235,137
Net Income $ 628,962 $ 509,799 $ 435,994
Net Income per Share—Basic—

Class B Common Stock $ 2.58 $ 2.08 $ 1.77
Net Income per Share—Diluted—
Class B Common Stock $ 2.56 $ 2.07 $ 1.77
Net Income per Share—Basic—
Common Stock $ 2.85 $ 2.29 $ 1.97
Net Income per Share—Diluted—
Common Stock $ 2.74 $ 2.21 $ 1.90
Cash Dividends Paid per Share:
Common Stock $ 1.3800 $ 1.2800 $ 1.1900
Class B Common Stock 1.2500 1.1600 1.07120
EXHIBIT 6.2 Tootsie Roll Industries, Inc. and Subsidiaries Consolidated Statement
of Earnings, Comprehensive Earnings, and Retained Earnings
For the Years Ended December 31,
in Thousands of Dollars Except
per-Share Data 2011 2010 2009
Net product sales $528,369 $517,149 $495,592

Rental and royalty revenue 4,136 4,299 3,739
Total revenue 532,505 521,448 499,331
Product cost of goods sold 365,225 349,334 319,775
Rental and royalty cost 1,038 1,088 852
Total costs 366,263 350,422 320,627
Product gross margin 163,144 167,815 175,817
Rental and royalty gross margin 3,098 3,211 2,887
Total gross margin 166,242 171,026 178,704
Selling, marketing, and
administrative expenses 108,276 106,316 103,755
Impairment charges — — 14,000
Earnings from operations 57,966 64,710 60,949
Other income (expense), net 2,946 8,358 2,100
Earnings before income taxes 60,912 73,068 63,049
Provision for income taxes 16,974 20,005 9,892
Net earnings $ 43,938 $ 53,063 $ 53,157
Net earnings $ 43,938 $ 53,063 $ 53,157

Other comprehensive
earnings (loss) (8,740) 1,183 2,845
Comprehensive earnings $ 35,198 $ 54,246 $ 56,002
Retained earnings at beginning $135,866 $147,687 $144,949

of year
Net earnings 43,938 53,063 53,157
Cash dividends (18,360) (18,078) (17,790)
Stock dividends (47,175) (46,806) (32,629)
Retained earnings at end of year $114,269 $135,866 $147,687
Earnings per share $ 0.76 $ 0.90 $ 0.89

Average Common and Class B
Common shares outstanding 57,892 58,685 59,425
revenue from these segments during the disposal period as ordinary income. In
Opinion No. 30, the APB concluded that additional criteria were necessary to
identify disposed segments of a business. This release required the separate pre-
sentation of (1) the results of operations of the disposed segment and (2) gain or
loss on the sale of assets for disposed segments including any operating gains or
losses during the disposal period. This information was seen as necessary to
users to allow them to evaluate the past and expected future operations of a
business entity. The total gain or loss is determined by summing any gains or
losses on disposal of segment assets, and gains or losses incurred by the opera-
tions of the disposed segment during the period of disposal.
Opinion No. 30 was later amended by SFAS No. 144, “Accounting for the
Impairment or Disposal of Long-Lived Assets” (see FASB ASC 360). To qualify for
treatment as a discontinued operation, an item must meet several criteria. First,
the unit being discontinued must be considered a component of the business.
The definition of component is based on the notion of distinguishable operations
and cash flows. Specifically, FASB ASC 205-10-20 defines a component of an
entity as comprising operations and cash flows that can be clearly distinguished,
operationally and for financial reporting purposes, from the rest of the entity.
Certain units—segments, operating divisions, lines of business,
subsidiaries—are usually considered components. But depending on
the business in which an entity operates, other units may be consid-
ered components as well.7
Assuming the unit to be discontinued is a component of the business, it must meet
two additional criteria before the transaction can be reported as a discontinued
operation. First, the operations and cash flows of the component being disposed
of must be eliminated from the operations and cash flows of the entity as a result
of the transaction. The company is not allowed to retain an interest in the cash
flows of the operation and still account for it as a discontinued operation. Second,
and finally, the entity must retain no significant involvement in the operations of
the component after the disposal takes place.
Once management decides to sell a component, its assets and liabilities are classi-
fied as “held for sale” on its balance sheet. Then, if a business has a component classi-
fied as held for sale, or if it actually disposes of the component during the accounting
period, it is to report the results of the operations of the component in that period, and
in all periods presented on a comparative income statement, as a discontinued opera-
tion. It should report these results directly under the income subtotal “Income from
Continuing Operations.” These results would be reported net of applicable income
taxes or benefit. In the period in which the component is actually sold (or otherwise
disposed of), the results of operations and the gain or loss on the sale should be com-
bined and reported on the income statement as the gain or loss from the operations of
the discontinued unit.8 The gain or loss on disposal may then be disclosed on the face
of the income statement or in the notes to the financial statements.
7. By employing the “component” concept, the FASB meant to broaden the allowable
business units that could be reported as a discontinued operation. Under APB No. 30,
the discontinued operation had to be a segment before it could qualify for treatment as
a discontinued operation.
8. This treatment differs significantly from the treatment afforded to discontinued
operations under APB No. 30. Under APB No. 30, a firm was required to estimate the fu-
ture income or loss from the operations of the discontinued operation as well as the fu-
ture gain or loss on disposal, if the sale crossed accounting periods. If the estimated future
results of operations and the estimated future gain or loss on the sale resulted in an esti-
mated future net loss, the entity was to report the loss on disposal in the current period as a
separate line item in the discontinued operations section of the Income Statement. The
effect of this treatment was to recognize future operating and disposal losses before they
occurred and to measure the discontinued operation on a net-realizable-value basis. This
treatment has been superseded by SFAS No. 144 (see FASB ASC 360-10-05), which both
simplified the accounting for discontinued operations and made it more consistent with
the accounting model for the impairment of long-lived assets.
Accounting for discontinued operations is under continuing review. In

September 2008, the FASB issued an Exposure Draft, Amending the Criteria for
Reporting a Discontinued Operations, and the IASB also issued an Exposure Draft,
Discontinued Operations, which proposes amendments to IFRS No. 5 (discussed
later in the chapter) that parallel those outlined in the FASB proposal. The two
boards noted that at that time, the definitions of a discontinued operation in
SFAS No. 144 (discussed in Chapter 9) and in IFRS No. 5 were not convergent.
That is, SFAS No. 144 defined a discontinued operation as a component of an
entity that has been disposed of or is classified as held for sale provided that
(1) the operations and cash flows of the component have been (or will be)
eliminated from the ongoing operations of the entity as a result of the disposal
transaction and (2) the entity will have no significant continuing involvement
in the operations of the component after the disposal transaction. SFAS No. 144
indicated that a component of an entity may be a reportable segment or an
operating segment, a reporting unit, a subsidiary, or an asset group. IFRS No. 5
defines a discontinued operation as a component of an entity that either has
been disposed of or is classified as held for sale and that (1) represents a
separate major line of business or geographical area of operations, (2) is part
of a single coordinated plan to dispose of a separate major line of business or
geographical area of operations, or (3) is a subsidiary acquired exclusively
with a view to resale.
As a part of their joint project on financial statement presentation, the two
boards decided to develop a common definition of a discontinued operation and
require common disclosures for all components of an entity that have been dis-
posed of or are classified as held for sale. The proposal defines a discontinued
operation as a component of an entity that is
a. An operating segment (as that term is defined in SFAS No. 131, FASB ASC
280-10-20; see Chapter 16) and either has been disposed of or is classified
as held for sale; or
b. A business (as that term is defined in SFAS No. 141, “Business Combinations,”
(see FASB ASC 805-10-20) that meets the criteria to be classified as held for
sale on acquisition (see Chapter 16).
On February 3, 2010, after reviewing the comments received on the expo-
sure drafts, the Boards decided that discontinued operations should continue to
be presented in a separate section on the face of an entity’s financial statements
and came to an agreement on the following points:
1. Definition of a discontinued operation. A discontinued operation is a component
that has either been disposed of or is classified as held for sale, and
a. Represents a separate major line of business or major geographical area
of operations,
b. Is part of a single coordinated plan to dispose of a separate major line of
business or geographical area of operations, or
c. Is a business that meets the criteria in paragraph 360-10-45-9 to be
classified as held for sale on acquisition.
2. Disclosure. The disclosure requirements for discontinued operations are
outlined as follows: An entity should provide the following disclosures
about a disposal of a component of an entity that meets the definition of
a discontinued operation for current and prior periods presented in the

financial statements:
a. The major income and expense items constituting the profit or loss from
a discontinued operation
b. The major classes of cash flows (operating, investing, and financing) of
the discontinued operation
c. The profit or loss attributable to the parent if the discontinued operation
includes a noncontrolling interest
d. A reconciliation of the major classes of assets and liabilities of the
discontinued operation classified as held for sale that are disclosed in the
notes to the financial statements to total assets and total liabilities of the
discontinued operation classified as held for sale that are presented
separately on the face of the statement of financial position
e. A reconciliation of the major income and expense items from the
discontinued operation that are disclosed in the notes to the financial
statements to the after-tax profit or loss from discontinued operations
presented on the face of the income statement.
On December 12, 2012, the FASB met to resume redeliberations on the project.
The project had been inactive since early 2010 while the Board focused on its higher-
priority projects. At this meeting, the Board reaffirmed its previous decision about
the definition of a discontinued operation, modified certain disclosure requirements,
and directed its staff to issue a revised exposure draft as soon as possible.
Neither Hershey nor Tootsie Roll disclosed any discontinued operation for the
three fiscal years covered by their income statements.
Extraordinary Items
Extraordinary items were originally defined in APB Opinion No. 9 as events and trans-
actions of material effect that would not be expected to recur frequently and that
would not be considered as recurring factors in any evaluation of the ordinary oper-
ating processes of the business.9 This release provided the following examples of these
events and transactions: gains or losses from the sale or abandonment of a plant or a
significant segment of the business; gains or losses from the sale of an investment not
held for resale; the write-off of goodwill owing to unusual events during the period;
the condemnation or expropriation of properties; and major devaluations of curren-
cies in a foreign country in which the company was operating.
The usefulness of the then-prevailing definition of extraordinary items came
under review in 1973, and the APB concluded that similar items of revenues and
expenses were not being classified in the same manner across the spectrum of busi-
ness enterprises. The Board also concluded that businesses were not interpreting
APB Opinion No. 9 in a similar manner and that more specific criteria were needed to
ensure a more uniform interpretation of its provisions. In APB Opinion No. 30,
“Reporting the Results of Operations,” extraordinary items were defined as events
and transactions that are distinguished by both their unusual nature and their infre-
quency of occurrence. These characteristics were originally defined as follows:
9. Accounting Principles Board, APB Opinion No. 9, “Reporting the Results of Opera-
tions” (New York: American Institute of Certified Public Accountants, 1966).
• Unusual nature. The event or transaction should possess a high degree of

abnormality and be unrelated or only incidentally related to ordinary
activities.
• Infrequency of occurrence. The event or transaction would not reasonably be
expected to recur in the foreseeable future.10
In APB Opinion No. 30, several types of transactions were defined as not meeting
these criteria. These included write-downs and write-offs of receivables, invento-
ries, equipment leased to others, deferred research and development costs, or other
intangible assets; gains or losses in foreign currency transactions or devaluations;
gains or losses on disposals of segments of a business; other gains or losses on the
sale or abandonment of property, plant, and equipment used in business; effects of
strikes; and adjustments of accruals on long-term contracts. The position expressed
in Opinion No. 30 was, therefore, somewhat of a reversal in philosophy; some items
previously defined as extraordinary in APB Opinion No. 9 were now specifically ex-
cluded from that classification. The result was the retention of the extraordinary
item classification on the income statement. However, the number of revenue and
expense items allowed to be reported as extraordinary was significantly reduced.
The separation of extraordinary items from other items on the income statement
does not result in a separation of recurring from nonrecurring items. An item that
is infrequent but not unusual is classified as nonoperating income in the other gains
and losses section of the income statement. Research has indicated that this
requirement is not consistent with the FASB’s predictive ability criterion. Classifying
nonrecurring items tends to increase the variability of earnings per share before
extraordinary items and to decrease the predictive ability of earnings.11 If this evidence
is proved correct, the FASB should consider revising income statement reporting
practices so that they provide increased predictive ability when nonrecurring items
are in evidence. One possible method of achieving this result might be to require
footnote disclosure of the effect of nonrecurring items on income and earnings per
share. Neither Hershey Company nor Tootsie Roll reported any extraordinary items
for the three fiscal years covered by their income statements.12
The classification of an event as extraordinary is also affected by the reporting
entity’s ability to measure it. Consider what happened following the September 11,
2001, terrorist attacks. Shortly after the attacks, the Emerging Issues Task Force (EITF)
met to consider the accounting and reporting issues raised by the terrorist attacks.
Firms suffering from the attacks had requested guidance from the FASB concerning
10. Accounting Principles Board, Accounting Principles Board Opinion No. 30, “Report-
ing the Results of Operations” (New York: American Institute of Certified Public
Accountants, 1973), para. 20.
11. A. B. Cameron and L. Stephens, “The Treatment of Non-Recurring Items in the
Income Statement and Their Consistency with the FASB Concept Statements,” Abacus
(September 1991), 81–96.
12. The requirements for reporting an extraordinary item are difficult to meet. In a survey
of 600 firms, the AICPA found that only seven (1.17 percent) firms reported an extraordi-
nary item in 2000 that was not associated with the early extinguishment of debt. Until SFAS
No. 145, which became effective in May 2002, gains or losses from the early extinguishment
of debt, if material, were to be classified as extraordinary items. SFAS No. 145 (see FASB ASC
470-50-45) changed this requirement so that now early debt extinguishment must meet the
unusual and infrequent criteria in order to qualify for treatment as an extraordinary item.
certain financial reporting issues. At its September 21, 2001, meeting, the EITF tenta-
tively agreed that the losses sustained by companies as a result of the attacks should
be considered extraordinary. All the EITF members agreed that the events were both
unusual in nature and infrequent. But at the September 28 meeting, the task force
decided against treating losses associated with the attack as extraordinary because the
events were so extensive and pervasive that it would be impossible to capture them
in any one financial statement line item. Therefore, attempting to record them as
extraordinary would result in only a part, and perhaps a relatively small part, of the
real effect of these events.13
Accounting Changes
The accounting standard of consistency indicates that similar transactions should
be reported in the same manner each year. Stated differently, management should
choose the set of accounting practices that most correctly presents the resources
and performance of the reporting unit and continue to use those practices each
year. However, companies might occasionally find that reporting is improved by
changing the methods and procedures previously used or that changes in reporting
may be dictated by the FASB or the SEC. Even though the results of efficient mar-
ket research indicate that changes in income due to changed accounting methods
do not affect stock prices, when changes in reporting practices occur, the compara-
bility of financial statements between periods is impaired. The accounting standard
of disclosure dictates that the effect of these changes should be reported. The major
question surrounding changes in accounting practices is the proper method to use
in disclosing them. That is, should previously issued financial statements be
changed to reflect the new method or procedure?
The APB originally studied this problem and issued its findings in APB
Opinion No. 20, “Accounting Changes” (superseded). This release identified
three types of accounting changes, discussed the general question of errors in
the preparation of financial statements, and defined these changes and errors
as follows:
1. Change in an accounting principle. This type of change occurs when an entity
adopts a GAAP that differs from one previously used for reporting purposes.
Examples of such changes are a change from LIFO to FIFO inventory pricing
or a change in depreciation methods.
2. Change in an accounting estimate. These changes result from the necessary
consequences of periodic presentation. That is, financial statement
presentation requires estimation of future events, and such estimates
are subject to periodic review. Examples of such changes are the
life of depreciable assets and the estimated collectability of
receivables.
3. Change in a reporting entity. Changes of this type are caused by changes
in reporting units, which may be the result of consolidations, changes
13. Financial Accounting Standards Board, “FASB’s Emerging Issues Task Force
Decides against Extraordinary Treatment for Terrorist Attack Costs,” News release,
1 October 2001.
in specific subsidiaries, or a change in the number of companies

consolidated.
4. Errors. Errors are not viewed as accounting changes; rather, they are the
result of mistakes or oversights such as the use of incorrect accounting
methods or mathematical miscalculations.14
The Board then specified the accounting treatment required to satisfy disclosure
requirements in each instance. The basic question was the advisability of retroactive
presentation. The following paragraphs summarize the accounting requirements of
APB Opinion No. 20.
Change in an Accounting Principle

Under the provisions of APB Opinion No. 20, when an accounting principle was
changed, it was treated currently. That is, the company presented its previ-
ously issued financial statements as they were before the change occurred,
with the cumulative prior effects of the change shown as a component of net
income for the period in which the change occurred. This requirement neces-
sitated determining the yearly changes in net income of all prior periods at-
tributable to changing from one GAAP to another. For example, if a company
changed from straight-line to sum-of-year’s-digits depreciation, the cumula-
tive effect of this change on all years prior to the change was calculated and
disclosed (net of tax) as a separate figure between extraordinary items and net
income. The cumulative effect (net of tax) was then disclosed as a separate
figure between extraordinary items and net income. In addition, per-share
data for all comparative statements included the results of the change as if the
change had been consistently applied. This requirement resulted in the disclo-
sure of additional pro forma, per-share figures for each period presented in
which the change affected net income.
The general conclusion of APB Opinion No. 20 was that previously issued
financial statements need not be revised for changes in accounting principles.
However, the FASB revisited this issue, and in May 2005, it issued SFAS No. 154,
“Accounting Changes and Error Corrections—A Replacement of APB Opinion
No. 20 and FASB Statement No. 3” (see FASB ASC 250). This pronouncement
required retrospective application to prior periods’ financial statements of
changes in accounting principles. Retrospective application was defined in SFAS
No. 154 (see FASB ASC 250-10-20) as follows:
The application of a different accounting principle to one or more
previously issued financial statements, or to the statement of financial
position at the beginning of the current period, as if that principle had
always been used, or a change to financial statements of prior accounting
periods to present the financial statements of a new reporting entity as if
it had existed in those prior years.
When it is impracticable to determine the period-specific effects of an account-
ing change on one or more prior periods presented, or to determine the cumulative
effect, FASB ASC 250 requires that the new accounting principle must be applied to
14. Accounting Principles Board, APB Opinion No. 20, “Accounting Changes” (New
York: AICPA, 1971).
the balances of the appropriate assets and liabilities as of the beginning of the earliest
period for which retrospective application is practicable, and a corresponding adjust-
ment must be made to the opening balance of retained earnings for that period
rather than being reported in an income statement. Finally, the guidelines contained
at FASB ASC 250 require that a change in depreciation, amortization, or depletion
method for long-lived nonfinancial assets be accounted for as a change in accounting
estimate (discussed later) effected by a change in accounting principle.
The guidelines contained at FASB ASC 250 are an example of the effort by the
FASB to improve the comparability of cross-border financial reporting by working
with the IASB to develop a single set of high-quality accounting standards. As part
of that effort, the two bodies identified opportunities to improve financial report-
ing by eliminating certain narrow differences between their existing accounting
standards. Reporting accounting changes was identified as an area in which finan-
cial reporting in the United States could be improved by eliminating differences
between Opinion 20 and IAS No. 8, “Accounting Policies, Changes in Accounting
Estimates and Errors.” FASB ASC 250 (predecessor literature SFAS No. 154) was
also seen as improving financial reporting, because its provisions enhance the con-
sistency of financial information between periods, resulting in more useful finan-
cial information that facilitates the analysis and understanding of comparative
accounting data.
Change in Estimates
Estimated changes are handled prospectively. They require no adjustments to pre-
viously issued financial statements. These changes are accounted for in the period
of the change, or if more than one period is affected, in both the period of change
and in the future. For example, assume that a company originally estimated that
an asset would have a useful service life of ten years, and after three years of ser-
vice the total service life of the asset was estimated to be only eight years. The
remaining book value of the asset would be depreciated over the remaining useful
life of five years. The effects of changes in estimates on operating income, extraor-
dinary items, and the related per-share amounts must be disclosed in the year
they occur. As with accounting changes to LIFO, the added disclosures should aid
users in their judgments regarding comparability.
Change in Reporting Entities

Changes in reporting entities must be disclosed retroactively by restating all
financial statements presented as if the new reporting unit had been in existence
at the time the statements were first prepared. That is, previously issued state-
ments are recast to reflect the results of a change in reporting entity. The finan-
cial statements should also indicate the nature of the change and the reason for
the change. In addition, the effect of the change on operating income, net
income, and the related per-share amounts must be disclosed for all comparative
statements presented. A change in reporting entity can materially alter financial
statements. For example, if a previously unconsolidated subsidiary is consoli-
dated, the investment account is removed and the assets and liabilities of the
subsidiary are added to those of the parent company. When this occurs, total
assets, debt, and most financial ratios are typically affected. Without retroactive
restatement for an accounting change in reporting entity, the investor would
find it difficult, if not impossible, to compare company performance before and
after the accounting change.
Errors
Errors are defined as prior period adjustments (discussed later in the chapter) by
FASB ASC 250. In the period the error is discovered, the nature of the error and
its effect on operating income, net income, and the related per-share amounts
must be disclosed. In the event the prior period affected is reported for compara-
tive purposes, the corrected information must be disclosed for the period in which
it occurred. This requirement is a logical extension of the retroactive treatment
required for accounting changes. To continue to report information known to be
incorrect would purposefully mislead investors. By providing retroactive correc-
tions, users can better assess the actual performance of the company over time.
The following are examples of errors:
1. A change from an accounting practice that is not generally acceptable to a
practice that is generally acceptable
2. Mathematical mistakes
3. The failure to accrue or defer revenues and expenses at the end of any
accounting period
4. The incorrect classification of costs and expenses
Earnings per Share

Analysts, investors, and creditors often look for some way to condense a firm’s per-
formance into a single figure, some quick and efficient way to compare firms’ perfor-
mance. Earnings per share (EPS) serves this purpose: It allows users to summarize the
firm’s performance in a single number. Additionally, the use of the income statement
as the primary source of information by decision makers has resulted in a need to
disclose the amount of earnings that accrue to different classes of investors. The
amount of earnings accruing to holders of debt and preferred stock (termed senior
securities) is generally fixed. Common stockholders are considered residual owners.
Their claim to corporate profits depends on the levels of revenues and associated
expenses. The income remaining after the distribution of interest and preferred divi-
dends is available to common stockholders; it is the focus of accounting income
determination. The amount of corporate income accruing to common stockholders is
reported on the income statement on a per-share basis.
The basic calculation of EPS is relatively easy. The net income available to
common stockholders is divided by the weighted average number of common
shares outstanding during the accounting period. A company’s net income is
already net of interest expense (the claims of debt holders). If the company also
has preferred shares outstanding, the claims of these senior securities (dividends)
must be subtracted from net income to determine the company’s income avail-
able to common stockholders. Thus the numerator for basic EPS is net income less
the preferred dividends. Basic EPS is intended to measure the amount that a
share of common stock has earned during an accounting period. Because compa-
nies often have numerous stock transitions during the accounting period, the
denominator is the arithmetic mean of the number of shares outstanding,
weighted by time.
Basic EPS is historical. It measures the performance that actually occurred
during the accounting period from the perspective of a single share of common
stock. However, reporting basic EPS is considered insufficient to meet investor
needs because of the potential impact on EPS of a wide variety of securities issued
by corporations. For example, many companies have issued stock options, stock
warrants, and convertible securities that can be converted into common stock at the
option of the holders of the securities. In the event these types of securities are ex-
changed for common stock, they have the effect of reducing (diluting) the earnings
accruing to preexisting stockholders. The exercise of an option or warrant or the
conversion of convertible securities to common stock would increase the number of
shares of common stock outstanding, thereby having a potentially dilutive effect on
EPS. However, the effect on EPS is complicated when a company has convertible
securities outstanding, because, in addition to issuing new shares of common stock,
the amount of the company’s reported earnings would also increase. Consequently,
the effect of conversion could be either an increase or decrease in reported EPS
because the increase in common shares outstanding might be proportionately less
than or greater than the accompanying increase in net income.
The APB first discussed the ramifications of these issues in Opinion No. 9 and
developed the residual security and senior security concepts. This release stated:
When more than one class of common stock is outstanding, or when
an outstanding security has participation dividend rights, or when an
outstanding security clearly derives a major portion of its value from
its conversion rights or its common stock characteristics, such securi-
ties should be considered “residual securities” and not “senior
securities” for purposes of computing earnings per share.15
This provision of APB Opinion No. 9 was only “strongly recommended” and
not made mandatory, but the development of the concept formed the framework
for APB Opinion No. 15, “Earnings per Share.”16 The latter opinion noted the
importance placed on per-share information by investors and the marketplace
and concluded that a consistent method of computation was needed to make EPS
amounts comparable across all segments of the business environment.
APB Opinion No. 15 made mandatory the presentation of EPS figures for income
before extraordinary items and net income. This requirement was superseded by
SFAS No. 128 (see FASB ASC 260),17 which requires that EPS figures18 for income
from continuing operations and net income be presented on the face of the income
statement. In addition, EPS figures for discontinued operations, extraordinary items,
and cumulative effects of accounting changes were required to be disclosed.
Under the provisions of APB Opinion No. 15, a company had either a simple or
complex capital structure. A simple capital structure was composed solely of com-
mon stock or other securities whose exercise or conversion would not in the
aggregate dilute EPS by 3 percent or more.
Companies with complex capital structures were required to disclose dual EPS
figures: primary EPS and fully diluted EPS. Primary EPS was intended to display
the most likely dilutive effect of exercise or conversion on EPS. It included only the
15. Accounting Principles Board, APB Opinion No. 9, para. 23.

16. Accounting Principles Board, APB Opinion No. 15, “Earnings per Share” (New York:
AICPA, 1969).
17. Financial Accounting Standards Board, SFAS No. 128, “Earnings per Share” (Stamford,
CT: FASB, 1997).
18. Firms with simple capital structures report basic EPS figures. All others report
diluted EPS figures. Basic and diluted EPS are discussed later in the chapter.
dilutive effects of common stock equivalents. APB Opinion No. 15 described common
stock equivalents as securities that are not, in form, common stock, but rather contain
provisions that enable the holders of such securities to become common stockhold-
ers and to participate in any value appreciation of the common stock. For example,
stock warrants, options, and rights were considered common stock equivalents
because they exist solely to give the holder the right to acquire common stock. Dual
presentation required that EPS be recast under the assumption that the exercise or
conversion of potentially dilutive securities (common stock equivalents for primary
EPS and all securities for fully dilutive EPS) had actually occurred.
The provisions of APB Opinion No. 15 were criticized as being arbitrary, too com-
plex, and illogical. Criticisms focused mainly on the requirements for determining
whether a convertible security is a common stock equivalent. Under APB Opinion
No. 15 a convertible security was considered a common stock equivalent if, at issu-
ance, its yield was less than two-thirds of the corporate bond yield. This requirement
did not reflect the likelihood of conversion in a dynamic securities market. As a result,
changes in market prices subsequent to issuance, which can change the nature of
convertibles from senior securities to securities that are likely to be converted, were
ignored. Thus similar securities issued by different companies were likely to have
been classified differently, for common stock equivalency purposes.
In addition, the need for dual presentation as required under APB Opinion No. 15
was questioned. Companies with complex capital structures were not required
to report basic (undiluted) EPS. Critics argued that the extremes, no dilution to
full dilution, were endpoints on a continuum of potential dilution and that both
endpoints have information content. Moreover, many users contended that basic
EPS would be more useful than primary EPS because it displays what actually
occurred. Consistent with these views, a research study indicated that primary
EPS seldom differs from fully diluted EPS.19
In 1991, the FASB issued a plan to make financial statements more useful to
investors and creditors by increasing the international comparability of financial in-
formation. Subsequently, the FASB undertook a project on the calculation and pre-
sentation of EPS information.20 The International Accounting Standards Committee
had begun a similar project in 1989. Both projects were undertaken in response to
the criticisms leveled at the complexity and arbitrariness of EPS calculations as de-
scribed above. While the two bodies agreed to cooperate with each other in sharing
information, each issued a separate but similar statement: IAS No. 33 and SFAS No. 128
(see FASB ASC 260).
The FASB decided to replace primary EPS with basic EPS, citing the following
reasons:
1. Basic EPS and diluted EPS data would give users the most factually support-
able range of EPS possibilities.
2. Use of a common international EPS statistic is important because of database-
oriented financial analysis and the internationalization of business and capital
markets.
19. C. L. DeBerg and B. Murdock, “An Empirical Investigation of the Usefulness of

Earnings per Share Information,” Journal of Accounting, Auditing and Finance (Spring
1994): 249–264.
20. See FASB Highlights, “FASB’s Plan for International Activities,” January 1995, for
a discussion of this issue
3. The notion of common stock equivalents does not operate effectively in

practice.
4. The computation of primary EPS is complex and might not be well under-
stood or consistently applied.
5. Presenting basic EPS would eliminate the criticisms about the arbitrary
determination of whether a security is a common stock equivalent.21
FASB ASC 260 requires the presentation of EPS by all companies that have
issued common stock or other securities, which upon exercise or conversion would
result in the issuance of common stock when those securities are publicly traded.
Companies with simple capital structures are to report only basic EPS figures.
FASB ASC 260-10-45 defines simple capital structures as those companies with
only common stock outstanding.22 All other companies are required to present
basic and diluted EPS amounts.
Basic EPS
The objective of basic EPS is to measure a company’s performance over the report-
ing period from the perspective of the common stockholder. Basic EPS is com-
puted by dividing income available to common stockholders by the weighted av-
erage number of shares outstanding during the period. That is,
Net income 2 Preferred dividends

Basic EPS 5
Weighted average number of shares outstanding
Diluted EPS
The objective of diluted EPS is to measure a company’s pro forma performance
over the reporting period from the perspective of the common stockholder as if
the exercise or conversion of potentially dilutive securities had actually occurred.
This presentation is consistent with the conceptual framework objective of pro-
viding information on an enterprise’s financial performance, which is useful in
assessing the prospects of the enterprise. Basic EPS is historical. It reports what
enterprise performance was during the period. Diluted EPS reveals what could
happen to EPS if and when dilution occurs. Taken together, these two measures
provide users with information to project historical information into the future
and to adjust those projections for the effects of potential dilution.
The dilutive effects of call options and warrants are reflected in EPS by applying
the treasury stock method. The dilutive effects of written put options, which
require the reporting entity to repurchase shares of its own stock, are computed
by applying the reverse treasury stock method. And the dilutive effects of con-
vertible securities are computed by applying the if-converted method. Each of
these methods is described below.
21. The sections describing the reasons for issuing standards are not contained in the
FASB ASC; they are contained in Financial Accounting Standards Board, Statement of
Financial Accounting Standards No. 128, “Earnings per Share” (Stamford, CT: FASB,
1997), para. 89.
22. This definition eliminated the APB Opinion No. 15 criterion of 3 percent materiality.
Securities whose exercise or conversion is antidilutive (exercise or conver-

sion causes EPS to increase) are excluded from the computation of diluted EPS.
Diluted EPS should report the maximum potential dilution. When there is more
than one potentially dilutive security, the potential dilutive effect of individual
securities is determined first by calculating earnings per incremental share.
Securities are then sequentially included in the calculation of diluted EPS. Those
with the lowest earnings per incremental share (i.e., those with the highest
dilutive potential effect) are included first.
Call Options and Warrants

Call options and warrants give the holder the right to purchase shares of the com-
pany’s stock for a predetermined option (exercise or strike) price. In the typical
exercise of stock options and warrants, the holder receives shares of common stock
in exchange for cash. The holders exercise their options only when the market
price of common stock exceeds the option price.23
Rather than making complex assumptions regarding how the company might
use the cash proceeds from the presumed exercise of call options or warrants, the
FASB requires the use of the treasury stock method to determine the dilutive effect
on EPS.24 Under this approach, Treasury shares are presumed to be purchased
with the proceeds at the average market price occurring during the accounting
period.25 The difference between the number of shares presumed issued upon
exercise of the options and the number of treasury shares presumed to have been
purchased is termed incremental shares. The incremental shares are added to the
weighted average number of shares outstanding during the period to determine
the dilutive effect of exercising the options or warrants.
Written Put Options

Written put options and forward purchase contracts require the reporting entity
to repurchase shares of its own stock at a predetermined price. These securities are
dilutive when the exercise price is above the average market price during the
period. Hence, their dilutive effect is computed using the reverse treasury stock
method. This procedure is essentially the opposite of the treasury stock method
used for call options and warrants.
23. Alternatively, when the option price is higher than the market price of common
shares, it would be illogical to presume that dilution would occur. In this case, the op-
tions, warrants, or rights are said to be antidilutive. Under FASB ASC 260-10, antidilu-
tion occurs when the option price exceeds the average market price during the period.
24. For example, if it were assumed that the cash would be spent on operations, the
company would have to project the impact of such an investment on revenues and
expenses. This would require assumptions regarding such things as the price elasticity
of the company’s products and services and whether the present physical plant could
accommodate the presumed expanded activities.
25. The APB also required the treasury stock approach. As a safeguard against the
potential impact that a large repurchase of treasury shares might have on the market
price of common shares, the number of treasury shares was limited to 20 percent of the
outstanding shares at the end of the period. Excess cash was presumed to have been
spent to reduce debt or to purchase U.S. government securities. FASB ASC 260-10
imposes no limit on the number of treasury shares assumed repurchased. This is an
example of one of the objectives of the original pronouncement, to minimize the com-
putational complexity and arbitrary assumptions of its predecessor, APB Opinion No. 15.
Under the reverse treasury stock method, it is presumed that the company
issues enough common shares at the average market price to generate enough
cash to satisfy the contract. It is then assumed that the proceeds from the stock
issuance are used to exercise the put (buy back the shares under contract). The
incremental shares (the difference between the number of shares assumed issued
and the number of shares that would be received when the put is exercised) are
added to the denominator to calculate diluted EPS.
Convertible Securities
Convertible securities are securities (usually bonds or preferred stock) that are
convertible into other securities (usually common stock) at a predetermined ex-
change rate. To determine whether a convertible security is dilutive requires
calculation of EPS as if conversion had occurred. The “as-if-converted” figure is
then compared to EPS without conversion. If conversion would cause EPS to
decline, the security is dilutive. If not, the security would be considered antidilu-
tive, and its pro forma effect of conversion would not be included in diluted EPS.
Under the if-converted method,
1. If the company has convertible preferred stock, the preferred dividend
applicable to the convertible preferred stock is not subtracted from net
income in the EPS numerator. If the preferred stock had been converted,
the preferred shares would not have been outstanding during the period
and the preferred dividends would not have been paid. Hence there would
have been no convertible preferred stockholder claim to net income.
2. If the company has convertible debt, the interest expense applicable to the
convertible debt net of its tax effect is added to the numerator. If the
convertible debt had been converted, the interest would not have been paid
to the creditors. At the same time, there would be no associated tax benefit.
As a result, net income, and hence income to common stockholders, would
have been higher by the amount of the interest expense saved minus its tax
benefit.
3. The number of shares that would have been issued upon conversion of the
convertible security is added to the denominator.
Contingently Issuable Shares

Contingently issuable shares are shares whose issuance is contingent upon the
satisfaction of certain conditions, such as attaining a certain level of income or mar-
ket price of the common shares in the future. If all necessary conditions have not
been met by the end of the reporting period, FASB ASC 260 requires that contin-
gently issuable shares be included in the computation of diluted EPS based on the
number of shares that would be included, if any, if the reporting period were the
end of the contingency period. For example, if the shares are issuable once a given
level of net income is attained, the company must presume that the current level
of earnings will continue until the end of the agreement. Under this presumption,
if current earnings are at least as great as the target level of earnings, the contin-
gently issuable shares must be included in diluted EPS if they are dilutive.
The joint FASB-IASB Short-Term International Convergence project is recon-
sidering some of the more technical aspects of EPS computations relating to the
earnings per share treatment of options, warrants, and their equivalents classified
as equity, mandatorily convertible instruments, and convertible debt that are
treated differently in SFAS No. 128 and IASB No. 33. In 2009, the IASB decided to
pause the Earnings per Share project and resume discussions later in the year. It
was expected that the FASB and IASB would review the comments received on
the exposure draft in detail and begin redeliberations. However, at the time this
text was published no further action had been taken.
Hershey has a complex capital structure and, consequently, discloses basic as
well as diluted EPS on its fiscal 2011 income statements. Tootsie Roll has a simple
capital structure and reports only one EPS figure.
Usefulness of Earnings per Share

The overall objective of EPS data is to provide investors with an indication of the
value of the firm and expected future dividends. A major theoretical issue sur-
rounding the presentation of EPS is whether this information should be based on
historical or forecasted information. Authoritative accounting bodies have gener-
ally taken the position that financial information should be based only on historical
data. Views formerly expressed by APB Opinion No. 15 and currently contained at
FASB ASC 260 are consistent with this trend.
EPS has been termed a summary indicator—a single item that communicates
considerable information about an enterprise’s performance or financial position.
The continuing trend toward complexity in financial reporting has caused many
financial statement users to use summary indicators. EPS is especially popular,
because it is thought to contain information useful in making predictions about
future dividends and stock prices, and it is often used as a measure of manage-
ment efficiency. However, investors’ needs might be better satisfied with mea-
sures that predict future cash flows (such as current or pro forma dividends per
share). As discussed in Chapter 7, cash-flow data might provide more relevant
information to investors than earnings data using accrual-basis accounting in-
come. Many accountants discourage the use of summary indicators, such as EPS.
These accountants maintain that an understanding of a company’s performance
requires a more comprehensive analysis than a single ratio can provide.
Comprehensive Income
Issues about income reporting have been characterized broadly in terms of
a contrast between the current operating performance and the all-inclusive
income concepts. Although the FASB generally has followed the all-inclusive
income concept, it has made some specific exceptions to that concept. Several ac-
counting standards require that certain items that qualify as components of com-
prehensive income bypass the income statement. Other components are required
to be disclosed in the notes. The rationale for this treatment is that the earnings
process is incomplete. Examples of items currently not disclosed on the traditional
income statement and reported elsewhere are as follows:
1. Foreign currency translation adjustments (see Chapter 16)
2. Gains and losses on foreign currency transactions that are designated as,
and effective as, economic hedges of a net investment in a foreign entity
(see Chapter 16)
3. Gains and losses on intercompany foreign currency transactions that are
categorized as long-term investments (that is, settlement is not planned or
anticipated in the foreseeable future), when the entities to the transaction
are consolidated, combined, or accounted for by the equity method in the

reporting entity’s financial statements (see Chapter 16)
4. A change in the market value of a futures contract that qualifies as a hedge of
an asset reported at fair value unless earlier recognition of a gain or loss in
income is required because high correlation has not occurred (see Chapter 16)
5. The excess of the additional pension liability over unrecognized prior service
cost (see Chapter 14)
6. Unrealized holding gains and losses on available-for-sale securities (see
Chapter 10)
7. Unrealized holding gains and losses that result from a debt security being
transferred into the available-for-sale category from the held-to-maturity
category (see Chapter 10)
8. Subsequent decreases (if not other-than-temporary impairments) or
increases in the fair value of available-for-sale securities previously written
down as impaired (see Chapter 10)
In 1996, the FASB initiated a project designed to require the disclosure of
comprehensive income by business enterprises. This project was undertaken in
response to a variety of concerns, including the increasing use of off–balance
sheet financing, the practice of reporting some items of comprehensive income
directly in stockholders’ equity, and acknowledgment of the need to promote the
international harmonization of accounting standards. The result of this project
was SFAS No. 130, “Reporting Comprehensive Income” (see FASB ASC 220).
The issues considered in this project were organized under five general ques-
tions: whether comprehensive income should be reported, whether cumulative
accounting adjustments should be included in comprehensive income, how the
components of comprehensive income should be classified for disclosure, whether
comprehensive income should be disclosed in one or two statements of financial
performance, and whether components of other comprehensive income should
be displayed before or after their related tax effects.
Comprehensive income is defined as the change in equity [net assets] of a busi-
ness enterprise during a period from transactions and other events and circum-
stances from nonowner sources.”26 It includes all changes in equity during a period
except those resulting from investments by owners and distributions to owners.
The term comprehensive income is used to describe the total of all components of
comprehensive income, including net income. FASB ASC 220-10-20 uses the term
other comprehensive income to refer to revenues, expenses, gains, and losses included
in comprehensive income but excluded from net income. The stated purpose of
reporting comprehensive income is to report a measure of overall enterprise per-
formance by disclosing all changes in equity of a business enterprise that result
from recognized transactions and other economic events of the period other than
transactions with owners in their capacity as owners.
FASB ASC 220 requires the disclosure of comprehensive income and dis-
cusses how to report and disclose comprehensive income and its components,
including net income. However, it does not specify when to recognize or how to
measure the items that make up comprehensive income. The FASB indicated that
existing and future accounting standards will provide guidance on items that are
26. FASB ASC 220-10-20.

to be included in comprehensive income and its components. When used with

related disclosures and information in the other financial statements, the infor-
mation provided by reporting comprehensive income should help investors, cred-
itors, and others in assessing an enterprise’s financial performance and the timing
and magnitude of its future cash flows.
In addressing what items should be included in comprehensive income, the
main issue was whether the effects of certain accounting adjustments of earlier peri-
ods, such as the cumulative effects of changes in accounting principles, should be
reported as part of comprehensive income. In reaching its initial conclusions, the
FASB considered the definition of comprehensive income originally contained in
SFAC No. 5, which indicates that the concept includes all recognized changes in equity
(net assets), including cumulative accounting adjustments. The Board decided to fol-
low that definition, and thus to include cumulative accounting adjustments as part of
comprehensive income. In 2005, the FASB reversed this decision and now requires
retroactive presentation of the effect of changes in accounting principles.
With respect to the components of comprehensive income, FASB ASC 220
requires companies to disclose an amount for net income that must be accorded
equal prominence with the amount disclosed for comprehensive income. When
comprehensive income includes only net income, comprehensive income and
net income are identical. The standard does not change the components of net
income or their classifications within the income statement. As discussed earlier,
total net income includes income from continuing operations, discontinued
operations, and extraordinary items. Items included in other comprehensive
income are classified based on their nature. For example, under existing account-
ing standards, other comprehensive income may be separately classified into for-
eign currency items, minimum pension liability adjustments, and unrealized
gains and losses on certain investments in debt and equity securities.
In reporting comprehensive income, companies are required to use a gross
disclosure technique for classifications related to items of other comprehensive
income other than minimum pension liability adjustments. For those classifica-
tions, reclassification adjustments must be disclosed separately from other changes
in the balances of those items so that the total change is disclosed as two amounts.
A net disclose technique for the classification related to minimum pension liability
adjustments is required (see Chapter 14). For this classification, the reclassifica-
tion adjustment must be combined with other changes in the balance of that item
so that the total change is disclosed as a single amount.
When using the gross disclosure technique, reclassification adjustments may
be disclosed in one of two ways. One way is as part of the classification of other
comprehensive income to which those adjustments relate, such as within a clas-
sification for unrealized securities gains and losses. The other way is to disclose a
separate classification consisting solely of reclassification adjustments in which all
reclassification adjustments for a period are disclosed.
Prior to 2011, FASB ASC 220 required the total for comprehensive income to
be reported in a financial statement that is displayed with the same prominence
as other financial statements. The components of other comprehensive income
were allowed to be displayed below the total for net income in an income state-
ment, a separate statement that begins with net income, or a statement of changes
in equity. However, in June 2011 the FASB issued ASU 2011-05, Comprehensive
Income, amending this requirement. The stated objective of ASU 2011-05 is to
improve the comparability, consistency, and transparency of financial reporting
and to increase the prominence of items reported in other comprehensive income.

In order to increase the prominence of items reported in other comprehensive
income and to facilitate the convergence of U.S. GAAP and International Financial
Reporting Standards (IFRS), the FASB decided to eliminate the option of present-
ing the components of other comprehensive income as part of the statement of
changes in stockholders’ equity. The ASU requires that all nonowner changes in
stockholders’ equity be presented either in a single continuous statement of com-
prehensive income or in two separate but consecutive statements. In the two-
statement approach, the first statement should present total net income and its
components followed consecutively by a second statement that should present
total other comprehensive income, the components of other comprehensive in-
come, and the total of comprehensive income.
The method of disclosing comprehensive income may be important to inves-
tors. A study by Hirst and Hopkins indicated that financial analysts detected earnings
management on selected items only when this information was presented in a sepa-
rate statement of comprehensive income,27 and Maines and McDaniel found that
the corporate performance evaluation of nonprofessional investors (the general
public) was affected by the method of presentation.28 These authors argue that ac-
cording to their results, nonprofessional investors will use comprehensive income
information only if it is included in a separate statement rather than as a component
of stockholders’ equity. Taken together, these results provide evidence that the pre-
sentation format for comprehensive income can influence decision making. These
findings are consistent with the FASB’s previous contention that the placement of
comprehensive income provides a signal to investors about its importance.29
The total of other comprehensive income, for elements not reported as part
of traditional net income for a period, must be transferred to a separate compo-
nent of equity in a statement of financial position at the end of an accounting
period. A descriptive title such as accumulated other comprehensive income is to be
used for that component of equity. A company must also disclose accumulated
balances for each classification in that separate component of equity on the face
of a statement of financial position, in a statement of changes in equity, or in notes
accompanying the financial statements. Those classifications must correspond to
classifications used for components of other comprehensive income in a state-
ment of financial performance.
The overriding question regarding the disclosure of comprehensive income on
corporate financial reports is, “Does this amount provide investors with additional
information that allows better predictions?” The evidence so far is mixed. The pre-
viously cited study by Hirst and Hopkins found that the presentation of compre-
hensive income influenced financial analysts’ estimates of the value of a company
engaged in earnings management.30 However, Dhaliwal, Subramanyam, and
Trezevant did not find that comprehensive income was associated with the market
27. D. Eric Hirst and Patrick Hopkins. “Comprehensive Income Reporting: Financial
Analyst’s Judgments,” Journal of Accounting Research (Supplement, 1998): 47–75.
28. Laureen A. Maines and Linda S. McDaniel, “Effects of Comprehensive-Income
Characteristics on Nonprofessional Investor Judgments: The Role of Financial-
Statement Presentation Format,” The Accounting Review (April 2000), 179–207.
29. Financial Accounting Standards Board, “Exposure Draft—Reporting Comprehen-
sive Income,” 1996, paras. 50 and 63.
30. Hirst and Hopkins, “Comprehensive Income Reporting.”
EXHIBIT 6.3 Hershey Company, Inc. Comprehensive Income as Disclosed in Its

Footnotes for the Fiscal Year December 31, 2011
Pre-Tax
For the Year Ended December 31, 2011, (Expense) Tax After-Tax
in Thousands of Dollars Amount Benefit Amount
Net income $ 628,962

Other comprehensive income (loss):
Foreign currency translation adjustments $ (21,213) $ — (21,213)
Pension and post-retirement benefit plans (137,918) 52,095 (85,823)
Cash flow hedges:
Losses on cash flow–hedging derivatives (175,011) 67,298 (107,713)
Reclassification adjustments (20,282) 7,767 (12,515)
Total other comprehensive loss $ (354,424) $ 127,160 (227,264)
Comprehensive income $ 401,698
value of a firm’s stock or that it was a better predictor of future cash flows than net
income.31 Additional research is needed to further assess this relationship.
Hershey Company discloses changes in other comprehensive income in its
consolidated statement of shareholder’s equity as a single net amount and elabo-
rates on the individual components of this amount in the footnotes. Tootsie Roll
includes the calculation of other comprehensive income on its income statement
as shown on p. 189. The disclosure of Hershey Company’s items of other compre-
hensive income is illustrated in Exhibit 6.3.
Prior Period Adjustments

Occasionally, companies make mistakes in their accounting records. Sometimes
these “mistakes” occur because of intentional or fraudulent misapplication of ac-
counting rules, principles, or estimates. For example, in the spring of 2002, internal
auditors at WorldCom uncovered a massive accounting fraud in which the company
capitalized operating expenses and began depreciating them rather than expensing
them in the year they occurred.32 In a case like this, the company has to restate its
financial statements and adjust numerous accounts in order to clean up its books.
Generally, mistakes are unintentional and arise because of errors in arithme-
tic, double entries, transposed numbers, or failure to record a transaction or
adjustment. If the company discovers the mistake in the period when it occurred,
an adjustment is made to the accounts affected to correct it. If, however, the mis-
take is not discovered until a later period, the company needs to make a prior
period adjustment. Prior period adjustments involve adjusting the beginning re-
tained earnings balance and reporting the adjustment in either the statement of
31. Dan Dhaliwal K. R. Subramanyam, and Robert Trezevant, “Is Comprehensive

Income Superior to Net Income as a Measure of Firm Performance?” Journal of
Accounting and Economics 26, nos. 1–3 (January 1999): 43–67.
32. The Wall Street Journal published an excellent article on how WorldCom’s internal
auditors uncovered the fraud; see “How Three Unlikely Sleuths Exposed Fraud at
WorldCom,” Wall Street Journal, 30 October 2002, 1, http://online.wsj.com/article/0,,
SB1035929943494003751.djm,00.html.
stockholders’ equity or a separate statement of retained earnings. Because the er-

ror occurred in a prior period, it does not affect the current income statement, so
it is not reported in the income statement in the period of correction. Also, be-
cause the prior period’s net income was closed to retained earnings at the end of
that period, the retained earnings total is misstated in the current period and must
be adjusted to remove the effect of the error.
The reporting requirements for disclosing prior period adjustments have evolved
over time. The test for classifying an item as a prior period adjustment (adjustment to
retained earnings) was originally made quite rigid in APB Opinion No. 9. For events
and transactions to be classified as prior period adjustments, they must have been
. . . specifically identified and directly related to the business activities
of particular prior periods, (b) not attributable to economic events
occurring subsequent to the date of the financial statements for the
prior period, (c) dependent primarily on determination by persons
other than management, (d) not susceptible of reasonable estimation
prior to such determination.33
At the time Opinion No. 9 was issued, the APB took the position that prior-
period adjustments that are disclosed as increases or decreases in the beginning
retained earnings balance should have been related to events of previous periods
that were not susceptible to reasonable estimation at the time they occurred. In
addition, because these amounts were material by definition, it is expected that
the auditor’s opinion would be at least qualified on the financial statements issued
when the event or transaction took place. Examples of prior-period adjustments
under APB Opinion No. 9 were settlements of income tax cases or other litigations.
The category of errors was later added to this classification. Errors would, of
course, not result in an opinion qualification because they would not be known
to the auditors when the financial statements were released.
In 1976, the SEC released Staff Accounting Bulletin No. 8, which concluded that
litigation is inevitably an economic event and that settlements of litigation consti-
tute economic events of the period in which they occur. This conclusion created a
discrepancy between generally accepted accounting principles and the reporting
requirements for companies registered with the SEC. Before the release of Staff
Accounting Bulletin No. 8, the FASB had undertaken a study of prior period adjust-
ment reporting of 600 companies and also concluded that a clarification of the
criteria outlined in APB Opinion No. 9 was required.
Subsequently, the FASB issued SFAS No. 16, “Prior Period Adjustments” (see
FASB ASC 250), which indicated that the only items of profit and loss that should
be reported as prior period adjustments were
a. Correction of an error in the financial statements of a prior period
b. Adjustments that result from the realization of income tax benefits of
preacquisition operating loss carry-forwards of purchased subsidiaries34
The restrictive criteria for the classification of an item of revenue or expense
to be categorized as a prior period adjustment have greatly reduced their inclusion
on financial statements. Neither Hershey Company nor Tootsie Roll disclosed any
33. Accounting Principles Board, APB Opinion No. 9, para. 23.

34. Financial Accounting Standards Board, SFAS No. 16, “Prior Period Adjustments”
(Stamford, CT: FASB, 1977), para. 11.
Proposed Format of the Statement of Comprehensive Income 209
prior period adjustments for the fiscal years covered by their income statements.
However, during 2011, Extra Space Storage, Inc., a self-storage company in Salt
Lake City, Utah, determined that a prior period adjustment was required because
an asset management fee of $885,000 owed to the company by the SPI joint ven-
ture had not been recorded by for the five-year period ended December 31, 2010.
Proposed Format of the Statement

of Comprehensive Income
The FASB and the IASB are working on a proposal to recast financial statements
into a new format. One possible result is the elimination of the current definition
of net income. In its place, financial statement users might find a number of profit
figures that correspond to different corporate activities. The rationale for the new
presentation is that focusing on the net profit number has been seen as one cause
for the fraud and stock market excesses that characterize the past several years.
That is, many of the major accounting scandals earlier this decade centered on the
manipulation of net income. The stock market bubble of the 1990s was the result
of investors’ assumptions that corporate net profits would grow rapidly for years
to come. As a result, beating quarterly earnings estimates became a distraction or
worse for companies’ managers and investors. Although it isn’t known whether
the new format would reduce attempts to fudge the numbers, companies would
be required to give a more detailed breakdown of their activities.
The new proposed income statement has separate categories for the disclosure
of a company’s operating business, financing activities, investing activities, and tax
payments. Each category also contains an income subtotal. The proposal adopts a
single statement of comprehensive income format that combines income statement
elements and components of other comprehensive income into a single statement.
Items of other comprehensive income are to be presented in a separate section fol-
lowing the income statement elements. This presentation format includes a subto-
tal of net income and a total of comprehensive income in the period. The Boards
eliminated the current alternative presentation format that allows items of other
comprehensive income to be presented in one of three ways: on a separate state-
ment, on a combined statement of comprehensive income, or on the statement of
stockholder’s equity. This change was made because research studies suggested that
investors and other users’ ability to process the information will be enhanced if a
uniform format of comprehensive income statement is presented.
According to the proposal, all income and expense items are to be classified
into operating, investing, and financing categories. Within those categories, an en-
tity disaggregates line items by function. Within those functions, an entity should
further disaggregate line items by nature when such presentation will enhance the
usefulness of the information in predicting future cash flows. Function refers to the
primary activities in which an entity is engaged. For example, an entity’s operating
activities consist of selling goods, marketing, or administration. Nature refers to the
economic characteristics or attributes that distinguish assets, liabilities, and income
and expense items that do not respond equally to similar economic events.
Examples of disaggregation by nature include disaggregating total sales into whole-
sale and retail or disaggregating total cost of sales into materials, labor, transport,
and energy costs. These desegregations will result in more subtotals than are now
required on the income statement and therefore facilitate the comparison of the
effects of operating, investing, and financing activities across financial statements.
The boards agreed on retaining the current intraperiod tax allocation method.35
The boards did not support allocation of income tax expense or benefit to the op-
erating, investing, financing asset, or financing liability categories because they
determined that the cost of doing so would exceed the benefit. Similarly, there are
no proposed changes in the current reporting format for discontinued operations,
extraordinary items, and changes in accounting principles. The exposure draft did
not provide guidance on which items should be included in the comprehensive
income, because they are discussed in other exposure drafts. The proposed revi-
sions to the statement of financial position outlined in the FASB–IASB Financial
Statement Presentation Project are illustrated in Exhibit 6.4.
EXHIBIT 6.4 Proposed Statement of Comprehensive Income

For the Years Ended
31 December
2012 2011
BUSINESS
Operating
sales—wholesale $ 2,790,080 $ 2,591,400
Sales—retail 697,520 647,850
Total revenue $ 3,487,600 $ 3,239,250
Cost of goods sold
Materials (1,043,100) (925,000)
Labor (405,000) (450,000)
Overhead—depreciation (219,300) (215,000)
Overhead—transport (128,640) (108,000)
Overhead—other (32,160) (27,000)
Change in inventory (60,250) (46,853)
Pension (51,975) (47,250)
Loss on obsolete and damaged inventory (29,000) (9,500)
Total cost of goods sold (1,969,425) (1,828,603)
Gross profit $ 1,518,175 $ 1,410,647
Selling expenses $
Advertising (60,000) (50,000)
Wages, salaries, and benefits (56,700) (52,500)
Bad debt (23,068) (15,034)
Other (13,500) (12,500)
Total selling expenses $ (153,268) $ (130,034)
General and administrative expenses
Wages, salaries, and benefits (321,300) (297,500)
Depreciation (59,820) (58,500)
Pension (51,975) (47,250)
Share-based remuneration (22,023) (17,000)
Interest on lease liability (14,825) (16,500)
Research and development (8,478) (7,850)
Other (15,768) (14,600)
Total general and administrative expenses $ (494,189) $ (459,200)
Income before other operating items $ 870,718 $ 821,413
Other operating income (expense)
35. See Chapter 12.

Proposed Format of the Statement of Comprehensive Income 211
EXHIBIT 6.4 (Continued)

For the Years Ended
31 December
2012 2011
Share of profit of associate A 23,760 22,000

Gain on disposal of property, plant, and equipment 22,650 —
Realized gain on cash-flow hedge 3,996 3,700
Loss on sale of receivables (4,987) (2,025)
Impairment loss on goodwill — (35,033)
Total other operating income (expense) 45,419 (11,358)
Total operating income $ 916,137 $ 810,055
Investing
Dividend income 54,000 50,000
Realized gain on available-for-sale securities 18,250 7,500
Share of profit of associate B 7,500 3,250
Total investing income $ 79,750 $ 60,750
Total business income $ 995,887 $ 870,805
Financing
Interest income on cash 8,619 5,500
Total financing asset income 8,619 5,500
Interest expense (111,352) (110,250)
Total financing liability expense $ (111,352) $ (110,250)
Total net financing expense $ (102,733) $ (104,750)
Profit from continuing operations
before taxes and other comprehensive income 893,154 766,055
Income taxes
Income tax expense (333,625) (295,266)
Net profit from continuing operations $ 559,529 $ 470,789
Discontinued operations
Loss on discontinued operations (32,400) (35,000)
Tax benefit 11,340 12,250
Net loss from discontinued $ (21,060) $ (22,750)
Operations
Net profit $ 538,469 $ 448,039
Other comprehensive income (after tax)
Unrealized gain on available-for-sale 17,193 15,275
securities (investing)
Revaluation surplus (operating) 3,653 —
Foreign currency translation adjust— 2,094 (1,492)
consolidated subsidiary
Unrealized gain on cash-flow hedge (operating) 1,825 1,690
Foreign currency translation adjust— (1,404) (1,300)
associate A (operating)
Total other comprehensive income $ 23,361 $ 14,173
Total comprehensive income $ 561,830 $ 462,212
Basic earnings per share $ 7.07 $ 6.14

Diluted earnings per share $ 6.85 $ 5.96
Source: Adapted from Preliminary Views on Financial Statement Presentation (FASB, October 2008).
In October 2010 the Boards indicated that they did not have the capacity to
devote the time necessary to deliberate the project issues. Consequently, the
Boards decided to not issue an Exposure Draft in the near term as originally
planned. The Boards indicated they will return to the project when they have the
requisite capacity. No further progress on the project had been reported at the
time this text was published.
The Value of Corporate Earnings

The income statement allows users to evaluate a firm’s current performance, esti-
mate its future performance, and predict future cash flows. For analytical purposes,
and to evaluate the quality of earnings, it is important for users to understand and
be able to identify revenue and expense items that are likely to continue into the
future (sustainable earnings) and those that are not (transitory components). For
this reason, the distinction between operating and nonoperating revenues, ex-
penses, gains, and losses is important. It is also important to understand the nature
and amounts of special items, as well as equity items not reflected on the income
statement but still appearing in comprehensive income. Some techniques users
might employ in conducting these analyses are outlined in the following paragraphs.
The financial analysis of a company’s income statement focuses on a company’s
operating performance by posing questions like these:
1. What are the company’s major sources of revenue?

2. What is the persistence of a company’s revenues?
3. What is the company’s gross profit ratio?
4. What is the company’s operating profit margin?
5. What is the relationship between earnings and the market price of the
company’s stock?
The analysis and interpretation of the operating performance of a company

is illustrated by using examples from Hershey Company and Tootsie Roll. The
following information has been extracted from the companies’ financial state-
ments for the years 2007–2011. (All amounts are stated in thousands of dollars.)
Hershey Company Sales Gross Profit Net Income

2011 $6,080,788 $2,531,892 $628,962
2010 5,671,009 2,415,208 509,799
2009 5,298,668 2,053,137 435,994
2008 5,132,768 1,757,718 311,405
2007 4,946,716 1,631,569 214,154
Tootsie Roll Sales Gross Profit Net Income

2011 $532,505 $166,242 $43,938
2010 521,448 171,026 53,063
2009 499,331 178,704 53,157
2008 496,016 161,781 38,777
2007 497,717 168,673 51,625
The Value of Corporate Earnings 213
Sources of Revenue
Many of the largest corporations are highly diversified, which means that they sell
a variety of products. Each of these products has an individual rate of profitability,
expected growth patterns, and degree of risk. One measure of the degree of risk is
a company’s reliance on major customers. If a company’s revenues from a single
customer are equal to or greater than 10 percent of its total revenues, that fact
must be disclosed. The financial analysis of a diversified company requires a
review of the impact of various business segments on the company as a whole.
Hershey Company reports segmental information for two segments, domestic and
international, in its financial statements. Tootsie Roll’s segments are identified as
U.S. and foreign.
Persistence of Revenues
The persistence of a company’s revenues can be assessed by analyzing the trend of its
revenues over time and by reviewing Management’s Discussion and Analysis (MD&A).
Exhibit 6.5 contains a revenue trend analysis for Hershey Company and Tootsie Roll
for the five-year period beginning with the 2007 fiscal year-end. For purposes of this
analysis, year 2007 data are set at 100 percent. This analysis shows that Hershey
experienced a greater growth trend in net revenues from 2007 through 2011.
EXHIBIT 6.5 Revenue Trend Analysis, 2007–2011

2007 2008 2009 2010 2011
Hershey Company 100.0% 103.8% 107.1% 114.6% 122.9%

Tootsie Roll 100.0% 100.0% 100.3% 104.8% 107.0%
Management’s Discussion and Analysis

The MD&A section of a company’s annual report can provide valuable informa-
tion on the persistence of a company’s earnings and its related costs.36 The SEC
requires companies to disclose any changes or potential changes in revenues and
expenses to assist in the evaluation of period-to-period deviations. Examples of
these disclosures include unusual events, expected future changes in revenues
and expenses, the factors that caused current revenues and expenses to increase
or decrease, and trends not otherwise apparent from a review of the company’s
financial statements. For example, Hershey indicated that its revenue increase
was driven by favorable price realization, improved U.S. marketplace performance
for its products, and sales gains from their international businesses, which was
offset somewhat by reduced sales volume in the United States.
Gross Profit Analysis

The analysis of a company’s gross profit focuses on explaining variations in sales,
cost of goods sold, and their effect on gross profit. This analysis can be enhanced
by separating it into product lines. Annual changes in gross profit are caused by
changes in sales volume, changes in unit selling price, and changes in unit costs.
36. An expanded discussion of the MD&A section of the annual report is contained in
Chapter 17.
A company’s gross profit percentage is calculated as follows:

Gross profit
Gross profit percentage 5
Net sales
The gross profit percentages for Hershey Company and Tootsie Roll for the
period 2007–2011 are provided in Exhibit 6.6. Hershey’s gross profit percentage
increased from 33.8 percent in 2007 to 41.6 percent in 2011. Tootsie Roll’s
gross profit declined by about 8 percent during the 2007–2011 five-year period.
These results indicate that the costs to produce the company’s products have
risen significantly.
EXHIBIT 6.6 Gross Profit Percentages, 2007–2011

2007 2008 2009 2010 2011
Hershey Company 33.0% 34.2% 38.7% 42.6% 41.6%

Tootsie Roll 33.9 32.6 35.8 32.8 31.2
One popular method of analysis compares a company’s ratios with industry

averages. Industry averages are available from several sources, such as Standard
& Poor’s Industry Surveys or Reuters Investor. This comparison asks the question, “Is
the company’s performance better than that of the industry as a whole?” Hershey
and Tootsie Roll are in the sugar and confectionary products (SIC 2064) industry.
The five-year average gross profit percentage for this industry in 2011 was
28.34 percent. The two companies’ results exceed this average for every year
covered by this analysis.
Net Profit Analysis

A company’s net profit percentage, an indicator of the effectiveness of its overall
performance, is calculated as follows:
Net income
Net profit percentage 5
Net sales
The net profit percentages for Hershey Company and Tootsie Roll for the pe-
riod 2007–2011 are presented in Exhibit 6.7.
EXHIBIT 6.7 Net Profit Percentages, 2007–2011

2007 2008 2009 2010 2011
Hershey Company 4.3 6.1% 8.2% 9.0% 10.3%

Tootsie Roll 10.4 7.8 10.6 10.2 8.3
Hershey’s net profit percentage has steadily risen over the five-year period,
whereas Tootsie Roll’s has fluctuated. The five-year industry average for this met-
ric is 5.78 percent. Hershey has outperformed this average for the last four years,
and Tootsie Roll outperformed the industry average in all five years.
To get a sense of the company’s performance from its core operations, some ana-
lysts compute the operating profit percentage (also termed earnings before interest
The Value of Corporate Earnings 215
and taxes, or EBIT). Operating profit is gross margin minus operating (general, selling,
and administrative) expenses. Here is the operating profit percentage calculation:
Operating profit
Operating profit percentage 5
Net sales
Exhibit 6.8 provides the operating profit percentages for the years 2007–2011.
EXHIBIT 6.8 Operating Profit Percentages, 2007–2011

2007 2008 2009 2010 2011
Hershey Company 14.9% 13.3% 15.9% 17.4% 17.3%

Tootsie Roll 14.2 13.4 15.0 12.4 10.9
These percentages reveal an improvement in performance for Hershey over

the five-year period, but Tootsie Roll experienced a decline over the five-year
period. These results indicate a potential erosion in profitability for Tootsie Roll’s
recurring core business operations.
In Chapter 5 it was noted that investors are interested in assessing the amount,
timing, and uncertainty of future cash flows and that accounting earnings have been
found to be more useful than cash-flow information in making this assessment.
Future cash-flow and earnings assessments affect the market price of a company’s
stock. Over the past three decades, accounting researchers have examined the rela-
tionship between corporate earnings and a company’s stock prices. One measure that
has been found useful in assessing this relationship is a company’s price-to-earnings
ratio (P/E ratio), which is calculated as follows:
Current market price per share
P/E ratio 5
Earnings per share
This ratio provides an earnings multiple at which a company’s stock is cur-
rently trading. A firm’s beta (β) or earnings volatility (as discussed in Chapter 4)
affects its stock price. In addition, research has indicated that the components of
earnings income from continuing operations, discontinued operations, extraordi-
nary items, and earnings per share are also incorporated into the determination of
market prices.37 In other words, all things being equal, a firm that reports only
income from continuing operations will be valued more highly than a firm with
an equal amount of risk and the same earnings that reports one or more of the
other components of income. This occurs because investors are most interested in
a company’s sustainable earnings, and investors view income components other
than income from continuing operations as nonsustainable.
The P/E ratio for Hershey Company, using the company’s market price per
share of $61.78 on December 31, 2011, and its basic earnings per share on common
stock amount of $2.85, was 21.68:
$61.78
5 21.68
$2.85
37. Ram T. S. Ramakrishman and Jacob K. Thomas, “Valuation of Permanent, Transi-

tory and Price Irrelevant Components of Reported Earnings,” Journal of Accounting
Auditing and Finance (Summer 1998): 301–336.
The P/E ratio for Tootsie Roll, using the company’s market price per share of
$23.67 on December 31, 2011, and its basic earnings per share from continuing
operations amount of $0.76, was 31.14:
$23.67
5 31.14
$0.76
The P/E ratios for the two companies over the five-year period covered by
our analysis are provided in Exhibit 6.9.
EXHIBIT 6.9 Price-Earnings Ratios, 2007–2011

2007 2008 2009 2010 2011
Hershey Company 25.35 45.39 18.17 20.59 21.68

Tootsie Roll 30.80 37.66 30.76 32.19 31.14
Exhibit 6.9 indicates that the market has generally been more impressed with
Tootsie Roll’s potential. The five-year industry average P/E ratio was 22.54.
Hershey’s P/E ratio has been below that average for the last three years, whereas
Tootsie Roll’s P/E ratio exceeded the industry average for all five years.
An overall interpretation of the earnings information reveals mixed results.
Both companies’ revenues have increased above their 2007 levels, but Hershey’s
increase was more impressive. Hershey’s gross profit percentage increased by
more than 20 percent, whereas Tootsie Roll’s declined by about 8 percent.
Hershey’s net profit percentage more than doubled, while Tootsie Roll’s declined.
Hershey’s operating profit percentage increased while Tootsie Roll’s declined; nev-
ertheless, the marker tended to view Tootsie Roll more favorably.
International Accounting Standards

In addition to the release of IAS No. 33 on earnings per share, the International
Accounting Standards Board has
1. Defined performance and income in “Framework for the Preparation and
Presentation of Financial Statements”
2. Discussed the objective of and the information to be presented on an
income statement in IAS No. 1, “Presentation of Financial Statements”
3. Discussed some components of the income statement in an amended IAS
No. 8, now titled “Accounting Policies, Changes in Accounting Estimates
and Errors”
4. Defined concept of revenue in IAS No. 18, “Revenue”
5. Amended IAS No. 33
6. Discussed the required presentation and disclosure of a discontinued
operation in IFRS No. 5, “Non-Current Assets Held for Sale and Discontinued
Operations”
7. Issued an amendment to IAS No. 1
In discussing performance, the IASB noted that profit is used to measure perfor-
mance or as the basis for other measures such as return on investment or earnings per
share. The elements relating to the measurement of profit are income and expenses,
International Accounting Standards 217
but the measurements of income and expenses and ultimately profit depend on the
concepts of capital and capital maintenance used by the enterprise in preparing its
financial statements. The concepts of capital maintenance, physical capital mainte-
nance, and financial capital maintenance were defined by the IASB in a manner
similar to how they were defined earlier in this chapter.
IAS No. 1 was originally issued in 2003 and later amended in 2007. The
standard has also been affected by the improvements project and some inter-
pretations since it was originally issued. The objective of IAS No. 1 is to pre-
scribe the basis for presentation of general-purpose financial statements, to
ensure comparability both with the entity’s financial statements of previous
periods and with the financial statements of other entities. IAS No. 1 delineates
the overall requirements for the presentation of financial statements, guide-
lines for their structure, and minimum requirements for their content. The
standards for recognizing, measuring, and disclosing specific transactions are
addressed in other IASB standards and Interpretations. IAS No. 1 indicates that
a complete set of financial statements should include a statement of compre-
hensive income for the period (or an income statement and a statement of
comprehensive income).
An entity has the choice of presenting a single statement of comprehensive
income or two statements: an income statement displaying components of profit
or loss and a statement of comprehensive income that begins with profit or loss
and displays components of other comprehensive income. It requires that as a
minimum, the statement of comprehensive income include line items that pres-
ent the following amounts for the period: revenue, finance costs, share of the
profit or loss of associates and joint ventures accounted for using the equity
method, tax expense, a single amount comprising the total of the post-tax profit
or loss of discontinued operations, and the post-tax gain or loss recognized on the
measurement to fair value less costs to sell or on the disposal of the assets or dis-
posal group(s) constituting the discontinued operation, profit or loss, each com-
ponent of other comprehensive income classified by nature, share of the other
comprehensive income of associates and joint ventures accounted for using the
equity method, and total comprehensive income.
The IASB stated that the goal of IAS No. 8 is to prescribe the classification, dis-
closure, and accounting treatment of certain items in the income statement so that
all entities prepare and present their income statements in a consistent manner.
IAS No. 8 states that when a standard or an interpretation specifically applies to a
transaction, other event, or condition, the accounting policy or policies applied to
that item must be determined by applying the standard or interpretation and con-
sidering any relevant implementation guidance issued by the IASB for the stan-
dard or interpretation. However, in the absence of a standard or an interpretation
that specifically applies to a transaction, judgment should be used in developing
and applying an accounting policy that results in relevant and reliable information.
IAS No. 8 indicates that in making that judgment, the following sources should be
considered in descending order:
1. The requirements and guidance in IASB standards and interpretations
dealing with similar and related issues
2. The definitions, recognition criteria, and measurement concepts for assets,
liabilities, income, and expenses in the Framework for the Presentation of
Financial Statements
3. The most recent pronouncements of other standard-setting bodies that use a

similar conceptual framework to develop accounting standards
4. Other accounting literature and accepted industry practices, to the extent
that these do not conflict with the sources in paragraph three.
Companies are required to select and apply accounting policies on a consis-
tent basis for similar transactions. Additionally, a company may change an adopted
accounting policy only if the change either
• Is required by a standard or interpretation
• Results in the financial statements providing reliable and more relevant
information about the effects of transactions, other events, or conditions on
the entity’s financial position, financial performance, or cash flows
If a change in accounting policy is required by a new IASB pronouncement, the
change should be accounted for by the requirements of the new pronouncement.
However, if the new pronouncement does not include specific transition provisions,
then the change in accounting policy is applied retroactively. That is, a company
adjusts the opening balance of each affected component of equity for the earliest
prior period presented and the other comparative amounts disclosed for each prior
period presented as if the new accounting policy had always been applied. Changes
in accounting estimates are to be recognized prospectively by including them in
profit or loss in the period of the change, if the change affects that period only, or in
the period of the change and future periods, if the change affects both.
Errors are defined as mathematical mistakes, mistakes in applying account-
ing policies, oversights or misinterpretations of facts, and fraud. IAS No. 8 indi-
cates that all material errors are to be corrected retrospectively in the first set of
financial statements authorized for issue after their discovery by restating the
comparative amounts for the prior period(s) presented in which the error
occurred. Alternatively, if the error occurred before the earliest prior period
presented, a company must restate the opening balances of assets, liabilities,
and equity for the earliest prior period presented. However, if it is impracticable
to determine the period-specific effects of an error on comparative information,
a company should restate the opening balances of assets, liabilities, and equity
for the earliest period for which retrospective restatement is practicable. If it is
impracticable to determine the cumulative effect, at the beginning of the cur-
rent period, of an error on all prior periods, the company should restate the
comparative information to correct the error prospectively from the earliest
date practicable.
In IAS No. 18, the IASB discussed the concept of revenue measurement. The
objective of IAS No. 18 is to prescribe the accounting treatment for revenue arising
from certain types of transactions and events. Revenue is defined as the gross in-
flow of economic benefits (cash, receivables, other assets) arising from the ordinary
operating activities of an entity (such as sales of goods, sales of services, interest,
royalties, and dividends). IAS No. 18 indicates that revenue should be measured at
the fair value of the consideration received or receivable and when all of the follow-
ing conditions have been satisfied:
1. The enterprise has transferred to the buyer the significant risks and rewards
of ownership of the goods.
International Accounting Standards 219
2. The enterprise retains neither continuing managerial involvement to the degree

usually associated with ownership nor effective control over the goods sold.
3. The amount of revenue can be measured reliably.
4. It is probable that the economic benefits associated with the transaction will
flow to the enterprise.
5. The costs incurred or to be incurred in respect to the transaction can be
measured reliably.
As indicated in Chapter 5, a current FASB–IASB project is addressing the

concept of revenue recognition.
The objective of IAS No. 33 is to prescribe principles for determining and
presenting earnings per share (EPS) amounts to thereby improving perfor-
mance comparisons between different entities in the same reporting period and
between different reporting periods for the same entity. It applies to entities
whose securities are publicly traded or that are in the process of issuing securi-
ties to the public.
IAS No. 33 outlines the following disclosures and guidelines:
1. Basic and diluted EPS must be presented for (a) profit or loss from continu-
ing operations and for (b) net profit or loss, on the face of the income
statement for each class of ordinary shares, for each period presented.
2. Potential ordinary shares are dilutive only when their conversion to
ordinary shares would decrease EPS from continuing operations.
3. Contracts that may be settled in cash or shares includes a rebuttable
presumption that the contract will be settled in shares.
4. If an entity purchases (for cancellation) its own preference shares for more
than their carrying amount, the excess (premium) should be treated as a
preferred dividend in calculating basic EPS (deducted from the numerator
of the EPS computation).
5. Guidance is provided on how to calculate the effects of contingently issuable
shares; potential ordinary shares of subsidiaries, joint ventures, or associ-
ates; participating securities; written put options; and purchased put and
call options.
IFRS No. 5 replaced IAS No. 35. It outlines the accounting treatment for non-
current assets held for sale (or for distribution to owners). In general terms, as-
sets (or disposal groups) held for sale are not depreciated, are measured at the
lower of carrying amount and fair value less costs to sell, and are presented
separately in the balance. It defines discontinued operations as the sum of the
post-tax profit or loss of the discontinued operation and the post-tax gain or loss
recognized on the measurement of fair value, less cost to sell or fair value adjust-
ments on the disposal of the assets (or disposal group). This amount should be
presented as a single amount on the face of the income statement. Detailed dis-
closure of revenue, expenses, pretax profit or loss, and related income taxes is
required to be reported either in the notes or on the face of the income state-
ment in a section distinct from continuing operations. Such detailed disclosures
must cover both the current and all prior periods presented in the financial
statements. IFRS No. 5 prohibits the retroactive classification as a discontinued
operation, when the discontinued criteria are met after the balance sheet date.
In addition, the following disclosures are required:
1. Adjustments made in the current period to amounts disclosed as a discontinued

operation in prior periods must be separately disclosed.
2. If an entity ceases to classify a component as held for sale, the results of that
component previously presented in discontinued operations must be
reclassified and included in income from continuing operations for all
periods presented.
Currently, the definitions of a discontinued operation in FASB ASC 360 and

in IFRS No. 5, “Non-Current Assets Held for Sale and Discontinued Operations,”
are not convergent. FASB ASC 360 defines a discontinued operation as a com-
ponent of an entity that has been disposed of or is classified as held for sale
provided that (1) the operations and cash flows of the component have been (or
will be) eliminated from the ongoing operations of the entity as a result of the
disposal transaction, and (2) the entity will not have any significant continuing
involvement in the operations of the component after the disposal transaction.
IFRS No. 5 defines a discontinued operation as a component of an entity that
either has been disposed of or is classified as held for sale, and (1) represents a
separate major line of business or geographical area of operations, (2) is part of
a single coordinated plan to dispose of a separate major line of business or geo-
graphical area of operations, or (3) is a subsidiary acquired exclusively with a
view to resale.
In their joint project on financial statement presentation, the FASB and the
IASB decided to attempt to develop a common definition of a discontinued opera-
tion and require common disclosures for all components of an entity that have
been disposed of or are classified as held for sale. However, constituents asked the
Boards to accelerate the issuance of guidance on discontinued operations sepa-
rately from the joint financial statement presentation project. As a result, the
FASB has issued proposed FASB Staff Position (FSP) No. FAS 144-d, “Amending
the Criteria for Reporting a Discontinued Operation.” The intent of this FSP is to
develop a definition of a discontinued operation, and disclosure requirements for
all components of an entity that have been disposed of or are classified as held for
sale, that are convergent with the definition and disclosure requirements of IFRS.
Concurrently, the IASB has issued an Exposure Draft, Discontinued Operations,
which proposes amendments to IFRS No. 5 that are identical to those proposed in
the FASB’s FSP.
The IASB’s proposed amendment to IAS No. 1 is similar to the FASB’s pro-
posed Accounting Standards Update on the Statement of Comprehensive Income;
however, there are some differences. The IASB chose to title the new statement
“The Statement of Profit or Loss and other Comprehensive Income.” Addition-
ally, the new guidance would not change those components that are recognized
in other comprehensive income under either accounting framework, and the two
frameworks differ on the treatment of some of those components and total con-
vergence is not achieved. However, the Boards believe that the proposals are an
important step in enhancing comparability and providing greater transparency.
As noted earlier in the chapter, the IASB–FASB joint project on discontinued
operation was reassessed as a lower-priority endeavor, and further action is not
expected in the near future.
Cases 221
Cases
• Case 6-1 Income Recognition in the Motion Picture Industry

The motion picture industry has undergone significant changes since the 1960s.
Originally, companies such as Paramount Pictures had to rely solely on domestic
and foreign screenings of their movies for their revenues. The birth of the televi-
sion industry in the 1960s resulted in opportunities for broadcasting rights to net-
works and individual stations. Moreover, the introduction of cable television in
the 1970s opened up substantial new sources of revenue. In addition, the unsatu-
rated demand for new films resulted in a market for made-for-television films.
And the invention of the video recorder opened yet another revenue source for
these companies.
The production of a film involves four phases:
1. Acquisition of the story rights
2. Preproduction, including script development, set design, cost selection,
costume design, and selection of a filming location
3. Actual filming
4. Postproduction, including film editing, adding the musical score, and
special effects
Warmen Brothers Production Company has just finished the production of
Absence of Forethought, a movie that is expected to be successfully distributed to all
available markets.
Required:
a. What markets are available to Warmen Brothers for this film?
b. In what order would you suggest Warmen Brothers attempt to enter each
market? Why?
c. How should revenues be recognized from each market?
d. How should costs be matched against these revenues?
e. What effect will your decisions have on Warmen Brothers’ income state-
ments for the year’s revenue?38
• Case 6-2 Extraordinary Charges

Goods Company is a major manufacturer of foodstuffs. The company’s products
are sold in grocery and convenience stores throughout the United States. Goods’
name is well known and respected because its products have been marketed
nationally for more than 50 years.
In April 2014, Goods was forced to recall one of its major products. A total
of thirty-five persons in Chicago were treated for severe intestinal pain, and
eventually three people died from complications. All these people had consumed
Goods’ product.
38. You might wish to consult FASB ASC 926-605 and the proposed ASU on this
topic.
The product causing the problem was traced to one specific lot. Goods keeps
samples from all lots of foodstuffs. After thorough testing, Goods and the legal
authorities confirmed that the product had been tampered with after it had left
the company’s plant and was no longer under the company’s control.
The entire product was recalled from the market—the only time a Goods
product has been recalled nationally and the only time for reasons of tamper-
ing. People who still had the product in their homes, even though it was not
from the affected lot, were encouraged to return it for credit or refund. The
company designed and implemented a media campaign to explain what had
happened and what the company was doing to minimize any chance of recur-
rence. Goods decided to continue the product with the same trade name and
the same wholesale price. However, the packaging was redesigned completely
to be tamper-resistant and safety sealed. This required the purchase and instal-
lation of new equipment.
The corporate accounting staff recommended that the costs associated with
the tampered product be treated as an extraordinary charge on the 2014 financial
statements. Corporate accounting was asked to identify the various costs that
could be associated with the tampered product and related recall. These costs
($000 omitted) are as follows.
Credits and refunds to stores and consumers $30,000
Insurance to cover lost sales and idle plant costs for
possible future recalls 6,000
Transportation costs and off-site warehousing of
returned product 1,000
Future security measures for other products 4,000
Testing of returned product and inventory 700
Destroying returned product and inventory 2,400
Public relations program to reestablish brand credibility 4,200
Communication program to inform customers,
answer inquiries, prepare press releases, and so on 1,600
Higher cost arising from new packaging 700
Investigation of possible involvement of employees,
former employees, competitors, and the like 500
Packaging redesign and testing 2,000
Purchase and installation of new packaging equipment 6,000
Legal costs for defense against liability suits 600
Lost sales revenue due to recall 32,000
Goods’ estimated earnings before income taxes and before consideration of any of
the above items for the year ending December 31, 2014, were $230 million.
Required:
a. Goods Company plans to recognize the costs associated with the product
tampering and recall as an extraordinary charge.
i. Explain why Goods could classify this occurrence as an extraordinary
charge.
Cases 223
ii. Describe the placement and terminology used to present the

extraordinary charge in the 2014 income statement.
b. Refer to the fourteen cost items identified by the corporate accounting staff
of Goods Company.
i. Identify the cost items by number that should be included in the
extraordinary charge for 2014.
ii. For any item that is not included in the extraordinary charge, explain
why it would not be included in the extraordinary
charge.
(CMA adapted)
• Case 6-3 Income Statement Format

Accountants have advocated two types of income statements based on differing
views of the concept of income: the current operating performance and all-inclusive
concepts of income.
Required:
a. Discuss the general nature of these two concepts of income.
b. How would the following items be handled under each concept?
i. Cost of goods sold
ii. Selling expenses
iii. Extraordinary items
iv. Prior period adjustments
• Case 6-4 Accounting Changes

It is important in accounting theory to be able to distinguish the types of account-
ing changes.
Required:
a. If a public company desires to change from the sum-of-year’s-digits depre-
ciation method to the straight-line method for its fixed assets, what type of
accounting change will this be? How would it be treated? Discuss the
permissibility of this change.
b. If a public company obtained additional information about the service lives
of some of its fixed assets that showed that the service lives previously used
should be shortened, what type of accounting change would this be?
Include in your discussion how the change should be reported in the
income statement of the year of the change and what disclosures should be
made in the financial statements or notes.
c. Changing specific subsidiaries comprising the group of companies for which
consolidated financial statements are presented is an example of what
type of accounting change? What effect does it have on the consolidated
income statements?
• Case 6-5 Earnings per Share

Progresso Corporation, one of your new audit clients, has not reported EPS data
in its annual reports to stockholders in the past. The president requested that you
furnish information about the reporting of EPS data in the current year’s annual
report in accordance with GAAP.
Required:
a. Define the term earnings per share as it applies to a corporation with a
capitalization structure composed of only one class of common stock. Then
explain how EPS should be computed and how the information should be
disclosed in the corporation’s financial statements.
b. Explain the meanings of the terms senior securities and residual securities
(terms often used in discussing EPS), and give examples of the types of
items that each term includes.
c. Discuss the treatment, if any, that should be given to each of the following
items in computing EPS for financial statement reporting:
i. The declaration of current dividends on cumulative preferred stock
ii. The acquisition of some of the corporation’s outstanding common
stock during the current fiscal year (the stock was classified as
treasury stock)
iii. A two-for-one stock split of common stock during the current fiscal
year
iv. A provision created out of retained earnings for a contingent liability
from a possible lawsuit
v. Outstanding preferred stock issued at a premium with a par value
liquidation right
vi. The exercise at a price below market value but above book value of a
common stock option issued during the current year to officers of the
corporation
vii. The replacement of a machine immediately before the close of the
current year at a cost 20 percent above the original cost of the replaced
machine (the new machine will perform the same function as the old
machine, which was sold for its book value)
• Case 6-6 Accounting Changes

APB Opinion No. 20 was concerned with accounting changes. SFAS No. 154
(see FASB ASC 250) changes the accounting treatment for some accounting
changes.
Required:
a. Define, discuss, and illustrate each of the following in such a way that one
can be distinguished from the other:
i. An accounting change
ii. A correction of an error in previously issued financial statements
b. Discuss the justification for a change in accounting principle.
Cases 225
c. Discuss the reporting of accounting changes that was required by APB

Opinion No. 20.
d. Discuss how accounting changes are to be reported under the provisions of
FASB ASC 250.
• Case 6-7 Identifying Accounting Changes

Sometimes a business entity changes its method of accounting for certain items.
The change may be classified as a change in accounting principle, a change in
accounting estimate, or a change in reporting entity. Listed below are three inde-
pendent, unrelated sets of facts relating to accounting changes.
Situation 1
A company determined that the depreciable lives of its fixed assets were currently
too long to fairly match the cost of the fixed assets with the revenue produced.
The company decided at the beginning of the current year to reduce the depre-
ciable lives of all its existing fixed assets by five years.
Situation 2
On December 31, 2013, Gary Company owned 51 percent of Allen Company, at
which time Gary reported its investment using the cost method owing to political
uncertainties in the country in which Allen was located. On January 2, 2014, the
management of Gary Company was satisfied that the political uncertainties were
resolved and that the assets of the company were in no danger of nationalization.
Accordingly, Gary will prepare consolidated financial statements for Gary and
Allen for the year ended December 31, 2014.
Situation 3
A company decides in January 2014 to adopt the straight-line method of depre-
ciation for plant equipment. This method will be used for new acquisitions as
well as for previously acquired plant equipment for which depreciation had been
provided on an accelerated basis.
Required:
For each of the preceding situations, provide the information indicated below.
Complete your discussion of each situation before going on to the next situation.
a. Type of accounting change
b. Manner of reporting the change under current GAAP, including a discus-
sion, where applicable, of how amounts are computed
c. Effects of the change on the statement of financial position and earnings
statement
d. Required e disclosures
• Case 6-8 Classification of Accounting Changes

Morgan Company grows various crops and then processes them for sale to retail-
ers. Morgan has changed its depreciation method for its processing equipment
from the double-declining-balance method to the straight-line method effective
January 1 of this year.
In the latter part of this year, a large portion of Morgan’s crops were destroyed
by a hailstorm. Morgan has incurred substantial costs in raising the crops that
were destroyed. Severe damage from hailstorms is rare in the locality where the
crops are grown.
Required:
a. How should Morgan calculate and report the effect(s) of the change in
depreciation method in this year’s income statement?
b. Where should Morgan report the effects of the hailstorm in its income
statement? Why?
c. How does the classification in the income statement of an extraordinary
item differ from that of an operating item? Why?
• Case 6-9 Comprehensive Income

Earnings as defined in SFAC No. 5 are consistent with the current operating
performance concept of income. Comprehensive income is consistent with the
all-inclusive concept of income.
Required:
a. Discuss the current operating performance concept of income.
b. Explain how earnings, as defined in SFAC No. 5, are consistent with the
current operating performance concept of income.
c. Discuss the all-inclusive concept of income.
d. Explain how comprehensive income is consistent with the all-inclusive
concept of income.
e. Explain how comprehensive income is consistent with the financial capital
maintenance concept.
f. What additional changes in reporting practices would have to occur
for financial reporting to be consistent with the physical capital
maintenance concept? Have some similar changes already occurred?
Give an example.
FASB ASC Research
For each of the following FASB ASC research cases, search the FASB ASC
database for information to address the issues. Cut and paste the FASB para-
graphs that support your responses. Then summarize briefly what your
responses are, citing the pronouncements and paragraphs used to support
your responses.
• FARS 6-1 Extraordinary Items

Several FASB and EITF pronouncements dealt with accounting for
extraordinary items. Search the FASB ASC database to identify all of the FASB
and EITF pronouncements dealing with extraordinary items and then
summarize them.
Cases 227
• FARS 6-2 Comprehensive Income

SFAS No. 130 (see FASB ASC 220) establishes the guidelines for reporting
comprehensive income. Search the FASB ASC database for the requirements for
reporting comprehensive income.
• FASB ASC 6-3 Net Income

The definition of net income is contained in the FASB ASC. Find this definition,
cite the paragraph, and copy it.
• FASB ASC 6-4 APB Opinion No. 9

Several parts of APB Opinion No. 9 are still GAAP. Find three of these references in
the FASB ASC.
• FASB ASC 6-5 Extraordinary Items

The definition of extraordinary items is contained in the FASB ASC. Find this
definition, cite the paragraph, and copy it.
• FASB ASC 6-6 Discontinued Operations

The definition of discontinued operations is contained in the FASB ASC. Find this
definition, cite the paragraph, and copy it.
• FASB ASC 6-7 Accounting Changes

The topic of accounting changes is discussed in the FASB ASC. Find this discussion,
cite the paragraph, and copy it.
• FASB ASC 6-8 Earnings Per Share

The topic of earnings per share is contained in the FASB ASC. Find, cite the
paragraph, and copy the objectives of earnings per share and the glossary of terms
associated with earnings per share.
Room for Debate
• Debate 6-1 Comprehensive Income

The FASB requires that financial statements report comprehensive income.
Team Debate:
Team 1: Defend comprehensive income. Your defense should relate to the con-
ceptual framework and to the concept of capital maintenance where
appropriate.
Team 2: Oppose comprehensive income. Your opposition should relate to the

conceptual framework and to the concept of capital maintenance where
appropriate.
• Debate 6-2 Income Concepts

The all-inclusive and current operating performance concepts of income repre-
sent opposing views regarding the inclusion of items to be reported in earnings on
the income statement.
Team Debate:
Team 1: Defend the all-inclusive concept of income.
Team 2: Defend the current operating performance concept of income.

Financial Statement I: The Income Statement

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CHAPTER

The Economic Consequences of Financial Reporting

Because economic consequences can affect different users of information

Income Statement Elements

1. Financial Accounting Standards Board, “Chapter 1, The Objective of General

3. David Solomons, “The FASB’s Conceptual Framework: An Evaluation,” Journal of

APB Opinion No. 9

Income from Continuing Operations

5. Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 5,

Nonrecurring Items of Income

EXHIBIT 6.1 The Hershey Company Consolidated Statements of Income

Cost of sales 3,548,896 3,255,801 3,245,531

Net Income per Share—Basic—

Net product sales $528,369 $517,149 $495,592

Net earnings $ 43,938 $ 53,063 $ 53,157

Retained earnings at beginning $135,866 $147,687 $144,949

Earnings per share $ 0.76 $ 0.90 $ 0.89

Accounting for discontinued operations is under continuing review. In

a discontinued operation for current and prior periods presented in the

• Unusual nature. The event or transaction should possess a high degree of

in specific subsidiaries, or a change in the number of companies

Change in an Accounting Principle

Change in Reporting Entities

Earnings per Share

15. Accounting Principles Board, APB Opinion No. 9, para. 23.

19. C. L. DeBerg and B. Murdock, “An Empirical Investigation of the Usefulness of

3. The notion of common stock equivalents does not operate effectively in

Net income 2 Preferred dividends

Securities whose exercise or conversion is antidilutive (exercise or conver-

Call Options and Warrants

Written Put Options

Contingently Issuable Shares

Usefulness of Earnings per Share

are consolidated, combined, or accounted for by the equity method in the

26. FASB ASC 220-10-20.

to be included in comprehensive income and its components. When used with

and to increase the prominence of items reported in other comprehensive income.

EXHIBIT 6.3 Hershey Company, Inc. Comprehensive Income as Disclosed in Its

Net income $ 628,962

Prior Period Adjustments

31. Dan Dhaliwal K. R. Subramanyam, and Robert Trezevant, “Is Comprehensive

stockholders’ equity or a separate statement of retained earnings. Because the er-

33. Accounting Principles Board, APB Opinion No. 9, para. 23.

Proposed Format of the Statement

EXHIBIT 6.4 Proposed Statement of Comprehensive Income

35. See Chapter 12.

EXHIBIT 6.4 (Continued)

Share of profit of associate A 23,760 22,000

Basic earnings per share $ 7.07 $ 6.14

The Value of Corporate Earnings

1. What are the company’s major sources of revenue?

The analysis and interpretation of the operating performance of a company

Hershey Company Sales Gross Profit Net Income

Tootsie Roll Sales Gross Profit Net Income

EXHIBIT 6.5 Revenue Trend Analysis, 2007–2011

Hershey Company 100.0% 103.8% 107.1% 114.6% 122.9%

Management’s Discussion and Analysis

Gross Profit Analysis