CHAPTER 6 – Part 2

THEINCOME

STATEMENT

SFAS No 130 - Reporting Comprehensive Income

Original issues:1. Should comprehensive income be reported?

2. Should cumulative accounting adjustments be included in comprehensive income?

3. How should the components of comprehensive income be classified for disclosure?

4. How should comprehensive income be disclosed in the financial statements?

5. Should the components of other comprehensive income be disclosed before or after their related tax effects?

Should Comprehensive Income Be Reported?

SFAS No 130 Requires the disclosure of comprehensive income and

Discusses how to report and disclose comprehensive income and its components, including net income.

Does not specify when to recognize or how to measure components

Should Cumulative Accounting Adjustments Be Included?

Cumulative Accounting Adjustments

Comprehensive Income

Include As Part Of

Cumulative Accounting

Adjustments

How Should the Components of Comprehensive Income Be Classified for Disclosure?

Requirement:

Companies must disclose an amount for net income

That amount must be accorded equal prominence with the amount disclosed for comprehensive income

Items of other comprehensive income are classified based on their nature

How Should Comprehensive Income be Disclosed in the Financial Statements?

Requires a gross disclosure technique for items of other comprehensive income

Allows for the disclosure of comprehensive income

On income statement

On a separate statement

On the statement of stockholders’ equity

Allows the components of other comprehensive income to be disclosed either

Net of related tax effects orBefore related tax effects with one amount shown for the aggregate income tax expense or benefit related to the total amount of other comprehensive income

Other comprehensive income is transferred to a separate component of stockholders’ equityBest Buy discloses changes in other comprehensive income in its consolidated statement of shareholder's equity.Circuit City does not disclose any items of other comprehensive income in its financial statements.

Should Components of Other Comprehensive Income Be Displayed Before or After Their Related Tax Effects.

Prior Period Adjustments

An adjustment to beginning retained earnings balance

Original criteria in APB No. 9Examples were income tax disputes and litigation

SEC Staff Bulletin No. 8 and APB Opinion No. 16

Correction of an error

Adjustments from realization of operating loss carryforward of purchased subsidiary

Financial Performance Reporting by Business Enterprises

In 2001 FASB initiated a project to redesign the income statement. This project termed Financial Performance Reporting by Business Enterprises has two main objectives:

1. To improve the quality of information disclosed in financial statements to that investors, creditors and other interested parties are able to better evaluate an enterprise’s financial performance

2. To ascertain that the financial statements provide sufficient information to permit the calculation of key financial performance measures.

Financial Performance Reporting by Business Enterprises

While no final conclusions had been drawn when this book was published, some tentative decisions have been offered:1. A single statement of comprehensive income should be prepared that reports all

items of revenue, expense, gains and losses.

2. The statement of comprehensive income should report three major categories

a. Business activities

b. Financing

c. Other

3. Income tax expense should be reported separately after the categories.

4. Income from continuing operations should be disclosed as a subtotal

5. Discontinued operations are to be presented as a separate classification net of their tax effects after income tax expense.

6. Other comprehensive income is also presented

7. The cumulative effect of a change in accounting principle is included in other comprehensive income.

8. Extraordinary items will be reported in the appropriate major category before tax and will not be labels as extraordinary.

The Value of Corporate Earnings

The financial analysis of a company’s income statement focuses on a company’s operating performance by focusing on such questions as:

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?

Sources of Revenue

The financial analysis of a diversified company requires a review of the impact of various business segments on the company as a whole. Best Buy reports segmental information for two segments in its financial statements

domestic international

Circuit City does not disclose any segmental information. Neither company discloses any information about major customers.

Persistence of Revenues

100%100%

208.1%

92.10%

0%

50%

100%

150%

200%

250%

1999 2000 2001 2002 2003

5-Year Revenue Tr end Anal ysis

Best Buy Cir cuit City

Management’s Discussion and Analysis

The MD&A section of a company’s annual report can provide valuable information on the persistence of a company’s earnings and its related costs.

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 eventsexpected future changes in revenues and expensesthe factors that caused current revenues and expenses to increase or decreasetrends not otherwise apparent from a review of the company’s financial statements

An expanded discussion of the MD&A section of the annual report is contained in Chapter 17.

Gross Profit Analysis

0%

5%

10%

15%

20%

25%

1999 2000 2001 2002 2003

5-Year Gross Profi t Trend Anal ysis

Best Buy Cir cuit City

18%

22.7%25%

23.6%

Gross Profit Percentage = Gross profit ÷ net sales

Net Profit Analysis

0%1%1%2%2%3%3%4%

1999 2000 2001 2002 2003

5-Year Net Profi t Trend Anal ysis

Best Buy Cir cuit City

2.1%

1.3%

.5%

1.0%

The Value of Corporate Earnings

The relationship between corporate earnings and stock prices

Measured by price earnings ratio

Current market price per share Earnings per share

Best Buy = 13.54Circuit City = 22.25

International Accounting Standards

International Accounting Standards Committee has:1 Defined the concepts of performance and income in “Framework for

the Preparation and Presentation of Financial Statements”

2 Discussed the content and format of the 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 the 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”

IASC Definitions of Performance and Income

Profit is used

to measure performance

or as the basis for other measures

Measurement of income is dependent on

the concept of capital maintenance used by the enterprise

Physical capital maintenance

Financial capital maintenance

IASC Definitions of Performance and Income

The IASC definition of income encompasses both revenue and expensesThe IASC has not made the distinction between ordinary and nonordinary operations contained in SFAC No. 6A proposed standard would require a “Statement of Non-owner Movements in Equity”Encourages an analysis of income and expenses based on their nature or function in the enterprise

IAS No. 1: Presentation of Financial Statements

Requires an operating/non operating separation and disclosure of the following components of income:

Revenue

Results of operating activities

Finance costs

Income from associates and joint ventures

Taxes

Profit or loss from ordinary activities

Extraordinary items

Minority interest

Net profit or loss

FASB Staff Reaction

IAS No. 8: Accounting Policies, Changes in Accounting Estimates and Errors

Originally, IAS No. 8defined the concepts of

net profit or loss from ordinary activitiesextraordinary itemsaccounting changesfundamental errors

Each of these income statement items was defined and reported in a manner similar to U.S. GAAP

with the exception of fundamental errors

The revised IAS No. 8 does not distinguish between ordinary and extraordinary items

eliminates the concept of fundamental errors

IAS No. 8: Accounting Policies, Changes in Accounting Estimates and Errors

A GAAP hierarchy indicates that the following sources must be applied in descending order of authoritativeness:

International Financial Reporting Standard, including any appendices that form part of the Standard

Interpretations

Appendices to an IFRS that do not form part of the Standard

Implementation guidance issued by IASB in respect of the Standard

Errors Now defined as newly discovered omissions or misstatements of prior period financial statements based on information that was available when the prior financial statements were preparedAll material errors will be accounted for retrospectively

by restating all prior periods presented and adjusting the opening balance of retained earnings of the earliest prior period presentedCumulative effect recognition in income is prohibited

FASB Staff Reaction

IAS No. 8: Accounting Policies, Changes in Accounting Estimates and Errors

IAS No. 18 - Revenue

Revenue should be recognized when:1 The enterprise has transferred to the buyer

the significant risks and rewards of ownership of goods

2 The enterprise doesn’t retain managerial involvement or control over the goods sold

3 The amount can be measured reliably4 It is probable that economic benefits associated

with the transaction will flow to the enterprise5 The costs associated with the transaction can

be measured reliably

IAS No. 18 - Revenue

U. S. GAAP does not specifically address the issue of revenue

If it did, there would probably be a difference because of the IASC use of the term probable future economic benefit

FASB Staff Reaction

IAS No. 35Discontinued Operations

The amended IAS No. 33 incorporated the following additional disclosures and guidelines:

1. Basic and diluted EPS must be presented for

(a) profit or loss from continuing operations and

(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

(IAS 33 previously used net income as the benchmark).

IAS No. 35Discontinued Operations

3. For contracts that may be settled in cash or shares, now 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 associates: participating securities; written put options; and purchased put and call options.

IFRS No. 5: Non-Current Assets Held for Sale and Discontinued Operations

SFRS No. 5 replaces IAS No. 35. Discontinued operations

Post-tax profit or loss of the discontinued

operation

Post-tax gain or loss recognized

on the measurement to

fair value

Cost to sell or fair value

adjustments on the disposal of the assets (or

disposal group)

+ -

Should be presented as a single amount on the face of the income statement

IFRS No. 5: Non-Current Assets Held for Sale and Discontinued Operations

Detailed disclosure of revenue, expenses, pre-tax profit or loss, and related income taxes is required

either in the notes or on the face of the income statement 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.

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Prepared by Richard Schroeder, PhDKathryn Yarbrough, MBA