The Income

Statement
Chapter 3

Intermediate
Financial Accounting
Earl K. Stice James D. Stice
 What It Is and What It Isn’t

• Income is not equal to the amount of cash

generated from the successful operation of the
business.
• Income is a return over and above the
investment.
• It is the amount that an entity could return to
its investors and still leave the entity as well-
off at the end of the period as it was at the
beginning.
FINANCIAL CAPITAL MAINTENANCE
CONCEPT OF INCOME DETERMINATION
The financial capital maintenance concept assumes that a company
has income “only if the dollar amount of an enterprise’s net assets at
the end of the period exceeds the dollar amount of net assets at the
beginning of the period after excluding the effects of transactions
with owners.

(continued)
FINANCIAL CAPITAL MAINTENANCE
CONCEPT OF INCOME DETERMINATION
Kreidler, Inc. had the following assets and
liabilities at the beginning and at the end of a
period.
Beginning End of
of Period Period
Total assets $510,000 $560,000
Total liabilities 430,000 390,000
Income is $90,000
Net assets
(owners’ equity) $ 80,000 $170,000

(continued)
FINANCIAL CAPITAL MAINTENANCE
CONCEPT OF INCOME DETERMINATION
If the owners invested $40,000 in the
business and received dividends of $15,000,
what would be the income?
Net assets, end of period $170,000
Net assets, beginning of period 80,000
Change (increase) in net assets $ 90,000
Deduct investment by owners (40,000)
Add dividends to owners 15,000
Income $ 65,000
 Physical Capital Maintenance
Concept of Income Determination
• Income per physical capital maintenance occurs
only if physical production capacity at the end of
the period exceeds the physical production capacity
at the beginning of the period.
• This concept requires that productive assets be
valued at fair market value.
• Productive capital is maintained only if the current
costs of these capital assets are maintained.
 Physical Capital Maintenance
Concept of Income Determination
Practical
Practical Difficulties
Difficulties
a) Difficulty in estimating depreciation lives
b) Difficulty in implementing internal control
procedures
c) Difficulty in providing cash flow information
d) Difficulty in obtaining fair market values of
assets and liabilities
The FASB adopted the financial capital maintenance
concept as part of the conceptual framework.
 Why is a Measure of
Income Important?
The recognition, measurement, and
reporting (display) of business income and
its components are considered by many to
be the most important tasks of accountants.
For example:
• Has the activity been profitable?
• What is the trend of profitability?
• Is it increasing profitable, or is there a
downward trend?

(continued)
 Why is a Measure of
Income Important?
In the United States, the FASB has
specified that financial accounting
information is designed with investors and
creditors in mind, while at the same time
recognizing that many other groups will find
the resulting information useful as well.
Accrual-based financial
accounting information is not
suited for every possible use.

(continued)
 Why is a Measure of
Income Important?
• In code law countries, such as Germany
and Japan, accounting standards have
historically been set by legal processes.
• In a common law country, such as the
United States and the United Kingdom,
accounting standards are set in response
to market forces.
TRANSACTION APPROACH
• To provide detail concerning the components of
income, accountants have adopted a transaction
approach to measuring income that stresses the
direct computation of revenues and expenses .
• The transaction approach, sometimes referred to as the matching method,
focuses on business events that effect certain elements of the financial
statements.

(continued)
REVENUE AND GAIN RECOGNITION

• Under GAAP of accrual accounting, revenue

recognition does not necessarily occur when
cash is received.
• Revenues and gains are recognized when:
1. they are realized or realizable, and
2. they have been earned through substantial completion of the activities involved in
the earnings process.

(continued)
 Revenue and Gain Recognition
• Revenues are recognized when the
company generating the revenue has
provided the bulk of the goods or services it
promised for the customer and when the
customer has provided payment or at least a
valid promise of payment to the company.
• In order for revenue to be recognized,
inventory or other assets must be
exchanged for cash or claims to cash, such
as accounts receivable.
 Expense and Loss Recognition

Direct
Direct Matching
Matching
• Relating expenses to specific revenues is
often referred to as the matching process.
• For example, shipping costs and sales
commissions usually relate directly to
revenues.
• Certain expenses have to be estimated to be
matched against recognized revenue for the
period.
(continued)
Expense and Loss Recognition

Systematic
Systematic and
and
Rational
Rational Allocation
Allocation
The cost of assets that benefit more
than one period, such as buildings,
equipment, patents, and prepaid
insurance, are spread across the
periods of expected benefit in some
systematic and rational way.
 Expense and Loss Recognition

Immediate
Immediate Recognition
Recognition
• Many expenses are not related to specific
revenues but are incurred to obtain goods
and services that indirectly help to
generate revenues.
• Examples include office salaries, utilities,
and general advertising. These are
recognized as expenses in the period in
which they are incurred.
 Gains and Losses from Changes
in Market Values
• An exception to the transaction approach in
the recognition of gains and losses arises
when gains or loss are recognized in the
wake of changes in market value.
• When a long-term asset, such as a building,
has decreased substantially in value (an
impairment), a loss is recognized even
though the building has not been sold and no
transaction has occurred.
FORM OF THE INCOME STATEMENT

• Traditionally, the income from the

continuing operations category has
been presented in multiple-step form.
• Using this format, the income statement
is divided into separate sections, and
various subtotals reflect different levels
of profitability.

(continued)
FORM OF THE INCOME STATEMENT

• Comparative financial statements

present several years’ financial
statements side by side. This enables
users to analyze performance over
multiple periods and identify significant
trends.
• Consolidated financial statements
combine the financial results of the “parent
company” with other companies that it
owns, called subsidiaries.
INCOME FROM
CONTINUING OPERATIONS
1. Revenue
2. Cost of goods sold
3. Operating expenses
4. Other revenues and gains
5. Other expenses and losses
6. Income taxes on continuing operations

(continued)
INCOME FROM
CONTINUING OPERATIONS

Determining
Determining Subtotals
Subtotals

Gross profit =
(Revenue – Cost of goods sold)
Operating income =
(Gross profit – Operating expenses)

(continued)
INCOME FROM
CONTINUING OPERATIONS

Determining
Determining Subtotals
Subtotals
Income from continuing operations before taxes
(Operating income + Other revenues and gains
– Other expenses and losses)

Income from continuing operations (Income from

continuing operations before income taxes –
Income taxes on continuing operations)

(continued)
INCOME FROM
CONTINUING OPERATIONS

Revenue
Revenue
• Revenue reports the total sales to
customers for the period less any sales
returns and allowances or discounts.
• Sales returns and allowances and sales
discounts should be subtracted from gross
sales revenue in arriving at net sales
revenue.

(continued)
 Income from Continuing
Operations

Cost
Cost of
of Goods
Goods Sold
Sold
Beginning inventory
+ Net purchases
+ Freight-in
+ Other inventory acquisition costs
= Cost of goods available for sale
– Ending inventory
= Cost of goods sold
(continued)
 Income from Continuing
Operations

Cost
Cost of
of Goods
Goods Sold
Sold
• Cost of goods sold is a significant item on
merchandising and manufacturing companies’
income statements.
• A manufacturing company has three
inventories rather than one: raw materials,
goods in process, and finished goods.

(continued)
 Income from Continuing
Operations
Gross
Gross Profit
Profit
• Revenue from net sales – Cost of goods
sold = Gross profit
• Gross profit percentage is computed by
dividing gross profit by revenue from net
sales.
• The gross profit percentage provides a
measure of profitability that allows
comparisons for a firm from year to year.
(continued)
 Income from Continuing
Operations
Operating
Operating Expenses
Expenses
Operating expenses may be reported in two
parts:
• Selling expenses
 Sales salaries and commissions
 Related payroll taxes
 Advertising and store displays
 Store supplies used
 Depreciation on store furniture
(continued)
 Income from Continuing
Operations
• General and administrative expenses
 Officers’ and office salaries
 Related payroll taxes
 Office supplies used
 Telephone, business licenses, etc.
 Depreciation on office furniture

(continued)
 Income from Continuing
Operations
Operating
Operating Income
Income
Operating income measures the
performance of the fundamental
business operations conducted by a
company.
Gross profit
– Operating expenses
= Operating income

(continued)
 Income from Continuing
Operations
Other
Other Revenues
Revenues and
and Gains
Gains
This section usually includes items
identified with the peripheral activities
of the company:
• Rent revenue
• Interest revenue
• Dividend revenue
• Gains from the sale of assets
(continued)
 Income from Continuing
Operations
Other
Other Expenses
Expenses and
and Losses
Losses

This section parallels “Other Revenues

and Gains” except the items result in
deductions from operating income:
• Interest expense
• Losses from the sale of assets

(continued)
 Income from Continuing
Operations
Income
Income Taxes
Taxes on
on
Continuing
Continuing Operations
Operations
• Income tax expense is the sum of all the
income tax consequences of all transactions
undertaken by a company during a year.
• The separation of income taxes into different
sections of the income statement is referred
to as intraperiod income tax allocation.

(continued)
 Income from Continuing
Operations
Transitory,
Transitory, Irregular,
Irregular, and
and
Extraordinary
Extraordinary Items
Items
• These items arise from transactions and
events that are not expected to continue
to impact reported results in future years.
• Two types of transactions and events are
reported in this manner: (1) discontinued
operations and (2) extraordinary items.
DISCONTINUED OPERATIONS

To report discontinued operations:

• The operations and cash flows of the component must be clearly distinguishable from
other operations and cash flows of the company, both physically and operationally, as
well as for financial reporting purposes.
• For example, discontinued operations would result if a company closed one of five
product lines in a plant which tracks its cash flows and income separately.

(continued)
 Reporting Requirements for
Discontinued Operations
• Thom Beard Company has two divisions, A
and B. The operations and cash flows of these
two divisions are clearly distinguishable, and
so they both qualify as business components.
• On June 20, 2013, Thom Beard decides to
dispose of the assets and liabilities of Division
B. The revenues and expenses for Thom
Beard for 2013 and for the preceding two
years are shown in Slide 4-58.

(continued)
DISCONTINUED OPERATIONS
• The reporting requirements for discontinued
operations are contained in FASB ASC
Subtopic 205.
• On the balance sheet, assets and liabilities
associated with discontinued components that
have not been completely disposed of as of the
balance sheet date are to be listed separately
in the asset and liability sections of the balance
sheet.

(continued)
 International Accounting for
Discontinued Operations
According to IFRS 5, companies with
discontinued operations must disclose the
following:
• The amount of revenue, expenses, and
pretax profit or loss attributed to the
discontinued operations and related income
tax expense.
• A separate disclosure of the assets, liabilities,
and cash flows of the discontinued
operations.
(continued)
EXTRAORDINARY ITEMS
Extraordinary items are events and
transactions that are both unusual in nature
and infrequent in occurrence. Thus, they
must contain “a high degree of abnormality
and be of a type clearly unrelated to, or only
incidentally related to, the ordinary and
typical activities of the entity . . . [and] be of a
type that would not reasonably be expected
to recur in the foreseeable future. . .”¹
¹Opinions of the Accounting Principles Board No. 30, “Reporting the
Results of Operations (NY: AICPA, 1973), par. 20.

(continued)
 NOT EXTRAORDINARY
• The write-down or write-off of receivables,
inventories, equipment leased to others, etc.
• The gains or losses from exchange or remeasurement
of foreign currencies
• The gains or losses on disposal of business segment
• Other gains or losses from sale or abandonment of
productive assets
• The effects of a strike
• Adjustment of accruals on long-term contracts

(continued)
 Changes in Accounting
Principles
• The conditions of some occasions justify
a change from one accounting principle
to another.
• Occasionally a company will change an
accounting principle because a change
in economic conditions suggests that an
accounting change will provide better
information.

(continued)
 Changes in Accounting
Principles
• More frequently, a change in accounting
principle occurs because the FASB
issues a new pronouncement requiring a
change in principle.
• To improve compatibility, income
statements for all years presented must
be restated using the new accounting
method.

(continued)
 Changes in Estimate
• In reporting periodic revenues and in
attempting to properly match those expenses
incurred to generate current-period revenues,
accountants must continually make judgments.
• Estimates are required for such factors as the
number of years of useful life for depreciable
assets, the amount of uncollectible accounts
expected, and the amount of warrant liability to
be recorded on the books.
• No retroactive adjustments.
(continued)
 Net Income or Loss

Income or loss from continuing

operations combined with the results of
discontinued operations and
extraordinary items provides a
summary measure of the firm’s
performance for a period: net income
or net loss.
EARNINGS PER SHARE

Earnings per share =

Income from continuing operations
Weighted average number of shares of
common stock outstanding

(continued)
EARNINGS PER SHARE

When presenting earnings-per-share

figures:
• Earnings per share amounts are computed for income from continuing
operations and for each unusual or extraordinary item.
• If necessary, companies display basic and diluted earnings per share.
 Price-Earnings (P/E) Ratio

The price-earnings (P/E) ratio

expresses the market value of common
stock as a multiple of earnings and allows
investors to evaluate the attractiveness of
a firm’s common stock.
Market value per share
P/E ratio =
Earnings per share

(continued)
 Price-Earnings (P/E) Ratio

In general, the following types of firms

have higher than average P/E ratios:
• Firms with strong future growth
possibilities
• Firms with earnings for the year lower than
average because of a nonrecurring event
• Firms with substantial unrecorded assets

(continued)
 Price-Earnings (P/E) Ratio

In general, the following types of firms

have lower than average P/E ratios:
• Firms with earnings for the year higher
than average because of a nonrecurring
event
• Firms perceived as being very risky
 COMPREHENSIVE INCOME

• Comprehensive income is the number used to reflect

an overall measure of the change in a company’s
wealth during the period.
• In addition to net income, it includes items that arise
from changes in market conditions unrelated to the
business operations of a company.
• Most companies include a report of comprehensive
income as part of the statement of stockholders’
equity.
(continued)
 FORECASTING FUTURE PERFORMANCE

• Financial statements report the past, but are used to

predict the future.
• Key to a good forecast involves identifying factors
that determine a certain level of revenue or expense.
• Forecasting starts with a forecast for sales.
• It indicates how fast the company is expected to grow
and represents the general volume of activity expected
in the company.

(continued)