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Income Statement and Related Information
Terms in this set (30)
The income statement is the report that measures the success of company operations for a given period of time. (It is also often called the statement of income or statement of earnings.1) The business and investment community uses the income statement to determine profitability, investment value, and creditworthiness. It provides investors and creditors with information that helps them predict the amounts, timing, and uncertainty of future cash flows.
Usefulness of the Income Statement
The income statement helps users of financial statements predict future cash flows in a number of ways. For example, investors and creditors use the income statement information to:
1. Evaluate the Past Performance of the Company
2. Provide a Basis for Predicting Future Performance.
3. Help Assess the Risk or Uncertainty of Achieving Future Cash Flows.
Limitations of the Income Statement
Because net income is an estimate and reflects a number of assumptions, income statement users need to be aware of certain limitations associated with its information. Some of these limitations include:
1. Companies Omit Items From the Income Statement That They Cannot Measure Reliably.
2. Income Numbers Are Affected By the Accounting Methods Employed.
3. Income Measurement Involves Judgment.
Earnings management - The planned timing of revenues, expenses, gains, and losses to smooth out bumps in earnings.
Quality of earnings
Quality of earnings - the extent to which earnings is useful to investors and creditors in making resource allocation decisions, generally in terms of predicting future earnings and cash flows. Thus, higher-quality earnings exhibit higher levels of relevance and faithful representation. Earnings of high quality boost investors' confidence in the financial statements. Earnings management negatively affects the quality of earnings when it distorts the information in a way that does not accurately predict future earnings and cash flows.
Transaction approach - Method of income measurement that focuses on the income-related activities—revenue, expense, gain, and loss transactions—that have occurred during the period.
Elements of the financial statements
Elements of the financial statement:
- Revenues. Inflows or other enhancements of assets of an entity or settlements of its liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations.
- Expenses. Outflows or other using-up of assets or incurrences of liabilities 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.
- Gains. Increases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from revenues or investments by owners.
- Losses. Decreases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from expenses or distributions to owners.
Single-step income statement
Single-step income statement - Income statement format that consists of just two groupings: revenues and expenses. Expenses are deducted from revenues to arrive at net income or loss. Companies that use the single-step income statement in financial reporting typically do so because of its simplicity.
- Companies that use the single-step income statement in financial reporting typically do so because of its simplicity. That is, the primary advantage of the single-step format lies in its simple presentation and the absence of any implication that one type of revenue or expense item has priority over another.
Multiple-step income statement
Multiple-step income statement - Income statement format that separates operating transactions from nonoperating transactions, and matches costs and expenses with related revenues. It highlights certain intermediate components of income that analysts use to compute ratios for assessing the performance of the company.
Intermediate Components of the Income Statement
When a company uses a multiple-step income statement, it may prepare some or all of the following sections or subsections.
1. Operating Section.
a. Sales or Revenue section
b. Cost of goods sold section
c. selling expense
d. Administrative or General Expense
2. Nonoperating Section.
a. Other Revenue and Gains
b. Other expenses and losses
3. Income Tax.
4. Discontinued Operations.
5. Extraordinary Items.
6. Earnings Per Share.
Natural expense classification
An organization of the operating section of the income statement commonly used by wholesale trade companies, like manufacturing and merchandising companies.
Functional expense classification
classification of operating expenses used commonly by retail stores that use administrative, occupancy, publicity, buying, and seeling expenses
Condensed Income Statements
format of income statement that might include only totals of expense groups and also prepares supplementary schedules to support the totals
Current operating performance approach
current operating performance approach - Income-reporting approach that advocates reporting only regular and recurring revenue and expense elements, but not irregular items, in income
Modified all-inclusive concept
Modified all-inclusive concept- Approach, adopted by the accounting profession, that dictates that companies record just about all items, including irregular ones, as part of net income, and that companies must highlight irregular items in the financial statements.
irregular items - Income-statement components for which the FASB has established special reporting rules. These items fall into six general categories:
(1) discontinued operations,
(2) extraordinary items,
(3) unusual gains and losses,
(4) changes in accounting principle,
(5) changes in estimates, and
(6) corrections of errors.
Discontinued operation - Occurs for a company when two things happen: (1) a company eliminates the results of operations and cash flows of a component from its ongoing operations, and (2) there is no significant continuing involvement in that component after the disposal transaction. Companies report a discontinued operation (in a separate income statement category), indicating the gain or loss from disposal of a business. In addition, companies report separately from continuing operations the results of operations of a component that has been, or will be, disposed of.
Extraordinary items - Nonrecurring material items that differ significantly from a company's typical business activities. They are distinguished by their unusual nature and by the infrequency of their occurrence.
a. Unusual Nature. The underlying event or transaction should possess 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 company, taking into account the environment in which it operates.
b. Infrequency of Occurrence. The underlying event or transaction should be of a type that the company does not reasonably expect to recur in the foreseeable future, taking into account the environment in which the company operates.
Items that are not extraordinary
the following gains and losses are not extraordinary items.
a. Write-down or write-off of receivables, inventories, equipment leased to others, deferred research and development costs, or other intangible assets.
b. Gains or losses from exchange or translation of foreign currencies, including those relating to major devaluations and revaluations.
c. Gains or losses on disposal of a component of an entity (reported as a discontinued operation).
d. Other gains or losses from sale or abandonment of property, plant, or equipment used in the business.
e. Effects of a strike, including those against competitors and major suppliers.
f. Adjustment of accruals on long-term contracts. 
The above items are not considered extraordinary "because they are usual in nature and may be expected to recur as a consequence of customary and continuing business activities."
Unusual Gains and Losses
Items that are unusual or infrequent but not both.
If not material can combine with other items in income, if material must disclose above Income before extraordinary.
Changes in Accounting Principle
Changes in accounting occur frequently in practice because important events or conditions may be in dispute or uncertain at the statement date. One type of accounting change results when a company adopts a different accounting principle. Changes in accounting principle include a change in the method of inventory pricing from FIFO to average cost, or a change in accounting for construction contracts from the percentage-of-completion to the completed-contract method.
An adjustment that recasts the prior years' statements on a basis consistent with the newly adopted principle.
- The company records the cumulative effect of the change for prior periods as an adjustment to beginning retained earnings of the earliest year presented.
Changes in estimates
Changes in estimates - Adjustments or changes that companies must make because financial circumstances did not turn out as expected. Companies account for changes in estimates in the period of change if they affect only that period, or in the period of change and future periods if the change affects both. They do not carry back such changes to prior years. Changes in estimate are not considered errors or extraordinary items.
Correction of errors
record as an adjustment to beginning retained earnings
called prior period adjustments
should restate prior statements affected to correct the error
Prior period adjustments
Prior period adjustments - Corrections of accounting errors made in previous accounting periods. Companies correct such errors by making proper entries in the accounts and reporting the corrections in the financial statements (as an adjustment to the beginning balance of retained earnings) in the year in which they are discovered. If a company prepares comparative financial statements, it should restate the prior statements for the effects of the error.
Intraperiod tax allocation
Intraperiod tax allocation - Reporting of irregular items within an accounting period on the income statement or statement of retained earnings net of tax. Such allocation relates the income tax expense of the fiscal period to the specific items that give rise to the amount of the tax provision. It helps financial statement users better understand the impact of income taxes on the various components of net income, and it discourages statement readers from using pretax measures of performance when evaluating financial results.
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