CHAPTER 6 – Part 1

THEINCOME

STATEMENT

Introduction

Various groups are affected by, and have a stake in, the financial reporting requirements of the FASB and the SEC

Introduction

Investors in equity securities are the central focus of the financial reporting environment

Introduction

Investing involves giving up current resources

for future uncertain resources.

Therefore, investors require information assessing future cash flows.

The Economic Consequences of Financial Reporting

Financial reporting has economic consequences including:

1 Financial information can affect the distribution of wealth among investors. More informed investors, or investors employing security analysts, may

be able to increase their wealth at the expense of less informed investors.

The Economic Consequences of Financial Reporting

2 Financial information can affect the level of risk accepted by a firm. Focusing on short-term, less risky, projects may have

long-term detrimental effects.

3 Financial information can affect the rate of capital formation in the economy and result in a reallocation of wealth between consumption and

investment within the economy.

The Economic Consequences of Financial Reporting

4 Financial information can affect how investment is allocated among firms.

These economic consequences may have a differential impact on different user groups and future deliberations of standards must consider these economic consequences

Elements of the Income Statement

SFAC No. 1 indicates that the primary focus of financial reporting is to provide information about a company’s performance

The income statement reports on performance and the elements of the income statement were defined in SFAC No. 6 as:

Revenues

GainsExpenses

Losses

Each Term Is Defined As Changes in Assets and Liabilities

Differences between changes in assets approach and inflow and outflow definition are:

Change in net economic resources

1. VSMeasure of effectiveness

Earnings

2.

VS Revenue & Expenses

Definition of Assets and Liabilities

Creation of deferred charges when measuring

income

3. VSRecognition when they are economic resources

or obligations

Each Term Is Defined As Changes in Assets and Liabilities

4. Both agree on importance of income statement

The change in asset approach limits the

population from which elements can be selected

to net economic resources.

5. VSThe flows method

includes items necessary to match

Statement Format

The preparation of the income statement has been impacted by differences of opinion on the definition of ongoing operations.

Two views:

1 All inclusive

2 Current operating performance

= Net income

= Income from continuing operations Discontinued operations

Extraordinary items Change in accounting principle

= Gross profit Less: Administrative and selling expenses Plus: Other gains Less: Other losses

Current Income Statement Format

Proscribed in APB Opinion No. 9 as:Revenues

Less: Cost of goods sold

Income From Continuing Operations

Normal and recurring revenues and expenses

Sustainable income

Income tax

Nonrecurring itemsDiscontinued operations

Extraordinary items

Change in accounting principle

Best Buy and Circuit City

Best Buy Co., Inc. is a specialty retailer of consumer electronics, home office equipment, entertainment software and appliances.

Circuit City Stores, Inc. is a national retailer of brand name consumer electronics, personal computers and entertainment software.

We will use information from the two companies’ fiscal 2003 annual reports to illustrate the disclosure of information in this and subsequent chapters.

Discontinued Operations

Why special treatment?

Arise from a disposal of a segment of a business

Comprised of two elements

Gain or loss on disposed assets

Gain or loss on operations during the disposal periods

When to report

Measurement date

Disposal date

Circuit City previously owned the CarMax auto superstore, but it was spun off from on October 1, 2002

Extraordinary Items

Original definitionProblems APB No. Opinion No. 301 Unusual nature2 Infrequency of occurrence

Problem: Requirements do not always separate recurring and non-recurring itemsAs a result, there is a tendency to increase the variability of operating income and decrease the predictive ability of earnings

The events of 9/11Neither company discloses any extraordinary items for the years presented

Accounting Changes

The accounting standard of consistency requires that similar transactions should be reported similarly each year

Occasionally an entity may find that reporting needs are better served by changing a method of accounting

If so, the comparability of financial statements is impaired

Basic question: Should previously issued financial statements be amended?

Types of Accounting Changes

Change in accounting principleHow reported

Best Buy changed its method of accounting for goodwill (discussed in Chapter 10) and vendor allowances in fiscal 2003

Change in accounting estimate

How reported

Change in accounting entityHow reported

ErrorHow reported

Earnings Per Share

Basic calculation

APB No. 15Simple vs. complex capital structureRequired calculation of primary and fully diluted earnings per shareCriticism of APB No. 15The FASB and IASC project

Net income - Preferred dividends Average # of common shares outstanding

SFAS No. 128

Reasons for the change

1 Basic EPS and diluted EPS data would give users the most factually range of possibilities

2 Use of a common international method is important due to the data based oriented financial analysis and internationalization of business

3 The notion of common stock equivalents does not operate efficiently in practice

4 The computation of primary EPS is complex and not well understood or consistently applied

5 Presenting basic EPS eliminates criticism about the arbitrary nature of the determination of common stock equivalents

SFAS No. 128

Requires presentation of EPS by all publicly traded companies issuing common stock

Companies with a simple capital structure will only report basic earnings per share. All others will report basic and diluted

Calculation of basic EPS

Net income - Preferred dividends Average # of common shares outstanding

Diluted Earnings Per Share

Objective Historical - basic Pro forma - diluted

Calculation: Includes all potential dilutive securities

1 Options and warrants - treasury stock method2 Convertible securities3 Continently issuable securities

Usefulness of EPS

Objectives of EPS reporting are to provide investors an indication of :

1 Value of the firm

2 Expected future dividends

Question: Historical or forecasted?

Summary indicator

Both Best Buy and Circuit City have complex capital structure

disclose basic as well as diluted earnings per share on their their fiscal 2003 income statements

SFAC No. 5 - Recognition and Measurement

Comprehensive income definition:

The change in net assets of an entity from non-owner transactions

Attempts to combine Hicksian capital maintenance approach with traditional accounting transactions approach

SFAC No. 5 - Recognition and Measurement

A full set of financial statements shall show:

Financial

positionComprehensive

income

Earnings

Investments by and

distributions to ownersCash

flows

SFAS No. 5 - Recognition and Measurement

Comprehensive incomeRevenues EarningsLess: Expenses Plus or minus cumulative accounting

adjustmentsPlus: Gains Plus or minus other nonowner

changes in equityLess: Losses= Earnings = Comprehensive income

Measurement Issues

Definitions. The item meets the definition of an element contained in SFAC No. 6.

Measurability. It has a relevant attribute, measurable with sufficient reliability.

Relevance. The information about the item is capable of making a difference in user decisions.

Reliability. The information is representationally faithful, verifiable, and neutral.

SFAS No 130 - Reporting Comprehensive Income

Reasons for the initial project

1 Off-balance sheet financing

2 The practice of reporting some items of comprehensive income in stockholders’ equity

3 Acknowledged need for harmonization of accounting standards

Definitions

Comprehensive incomethe change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from nonowner sources.

Other comprehensive incomerevenues, expenses, gains, and losses included in comprehensive income but excluded from net income.

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Prepared by Richard Schroeder, PhDKathryn Yarbrough, MBA