Chapter 4

Question 1

Income Statement - Usefulness

Answer 1

• Evaluate past performance of the company
• Provide a basis for predicting future performance
• Help assess the risk or uncertainty of achieving future cash flows

Question 2

Income Statement - Limitations

Answer 2

• Companies omit items they cannot measure reliably
• Income is affected by the accounting methods employed
• Income measurement involves judgment

Question 3

Income Statement - Quality of Earnings

Answer 3

Companies have incentives to manage income to meet or beat Wall Street expectations, so that

• market price of stock increases and
• value of stock options increase.

Quality of earnings is reduced if earnings management results in information that is less useful for predicting future earnings and cash flows.

Question 4

Revenues

Answer 4

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.

Examples include sales, fees, interest, dividends, and rents.

Question 5

Expenses

Answer 5

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.

Examples include cost of goods sold, depreciation, interest, rent, salaries and wages, and taxes.

Question 6

Gains

Answer 6

Increases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from revenues or investments by owners.

Question 7

Losses

Answer 7

Decreases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from expenses or distributions to owners.

Question 8

Multiple-Step Income Statement

Answer 8

• Separates operating transactions from non-operating transactions
• Matches costs and expenses with related revenues
• Highlights certain components of income that analysts use assessing financial performance

Question 9

Intermediate Components

Operating Section

Answer 9

1. Operating Section. A report of the revenues and expenses of the company’s principal operations.
   a. Sales or Revenue.
   b. Cost of Goods Sold.
   c. Selling Expenses.
   d. Administrative or General Expenses

Question 10

Companies are required to report unusual and infrequent items as part of net income so users can better determine the long-run earning power of the company.

Answer 10

These income items fall into four general categories:

• Unusual gains and losses
• Discontinued operations
• Noncontrolling interest
• Earnings per share

Question 11

Unusual and Infrequent Gains and Losses

Answer 11

a. Unusual. High degree of abnormality and 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. Type of transaction that is not reasonably expected to recur in the foreseeable future, taking into account the environment in which the company operates.

Reported in “Other revenues and gains” or “Other expenses and losses” section. (Not shown net of tax.)

Question 12

Common types of unusual or infrequent gains and losses:

Answer 12

• Losses on write-down (impairment) of receivables; inventories; property, plant, and equipment; goodwill or other intangible assets
• Restructuring charges
• Gains and losses from sale or abandonment of property, plant and equipment
• Effects of a strike
• Gains and losses on extinguishment (redemption) of debt obligations.
• Gains and losses related to casualties such as fires, floods, and earthquakes.
• Gains or losses on sale of investment securities.

Question 13

Intraperiod Tax Allocation

Answer 13

• Allocation of tax within a period
• Helps users understand impact of income taxes on various components of net income

Intraperiod tax allocation is used for:

• Income from continuing operations
• discontinued operations

Question 14

Accounting Changes and Errors

Changes in Accounting Principle

Answer 14

• Retrospective adjustment
• Cumulative effect adjustment to beginning retained earnings
• Approach preserves comparability across years
• Examples include:
  
  • change from F I F O to average cost
  • change from percentage-of-completion to completed–contract method

Question 15

Accounting Changes and Errors

Change in Accounting Estimates

Answer 15

• Corrections of errors are treated as prior period adjustments, similar to changes in accounting principles.
• Companies record a correction of an error in the year in which it is discovered.
• They report the error in the financial statements as an adjustment to the beginning balance of retained earnings.
• Examples include:
  
  • Useful lives and salvage values of depreciable assets
  • Allowance for uncollectible receivables
  • Inventory obsolescence

Question 16

Accounting Errors

Corrections of Errors

Answer 16

Result from:

• mathematical mistakes
• mistakes in application of accounting principles
• oversight or misuse of facts
• Corrections treated as prior period adjustments
• Adjustment to the beginning balance of retained earnings

Question 17

Retained Earnings Statement

Answer 17

The retained earnings statement should disclose net income (loss), dividends, adjustments due to changes in accounting principles, error corrections, and restrictions of retained earnings.
Increase
-Net income
-Change in accounting principle
-Prior period adjustments

Decrease

• Net loss
• Dividends
• Change in accounting principles
• Prior period adjustments

Question 18

Comprehensive Income

Answer 18

All changes in equity during a period except those resulting from investments by owners and distributions to owners.
Includes:
-all revenues and gains, expenses and losses reported in net income, and
-all gains and losses that bypass net income but affect stockholders’ equity

Question 19

Other Comprehensive Income

Answer 19

Gains and losses that bypass net income but affect stockholders’ equity

Question 20

Statement of Stockholders’ Equity

Answer 20

This statement reports the change in each stockholders’ equity account (including Accumulated Other Comprehensive Income) and in total stockholders’ equity for the period.

• Following items are disclosed in the statement:
  
  • Contributions (issuances of shares) and distributions (dividends) to owners
  • Reconciliation of carrying amount of each component of stockholders’ equity from beginning to end of period

Question 21

Income Statement

Answer 21

Report that measures the success of company operations for a given period of time.

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.

Question 22

Earnings Management

Answer 22

Defined as the planned timing of revenues, expenses, gains, and losses to smooth out bumps in earnings.

In most cases, companies use earnings management to increase income in the current year at the expense of income in future years.

Question 23

Intermediate Components of the Income Statement

Nonoperating Section

Answer 23

A report of revenues and expenses resulting from secondary or auxiliary activities of the company. In addition, special gains and losses that are infrequent or unusual, or both, are normally reported in this section. Generally these items break down into two main subsections:

a. Other Revenues and Gains. A list of the revenues recognized or gains incurred, generally net of related expenses, from nonoperating transactions.
b. Other Expenses and Losses. A list of the expenses or losses incurred, generally net of any related incomes, from nonoperating transactions.

Question 24

Intermediate Components of the Income Statement

Income Tax

Answer 24

A section reporting federal and state taxes levied on income from continuing operations.

Question 25

Intermediate Components of the Income Statement

Discontinued Operations

Answer 25

Material gains or losses resulting from the disposition of a component of the business.
1 A company eliminates the results of operations of a component of the business.

2 The elimination of a component that represents a strategic shift, having a major effect on the company’s operations and financial results.

Show in separate section after continuing operations. Amounts are reported “net of tax.”

Question 26

Intermediate Components of the Income Statement

Noncontrolling interest

Answer 26

Allocation of income to noncontrolling shareholders.

When a company owns substantial interests (generally greater than 50%) in another company, G A A P generally require that the financial statements of both companies be consolidated together into one set of financials.

Noncontrolling interest is the portion of equity (net assets) interest in a subsidiary not attributable to the parent company.

Report as a separate item below net income or loss as an allocation of the net income or loss (not as an item of income or expense).

Question 27

Intermediate Components of the Income Statement

Earnings Per Share

Answer 27

A measure of performance over the reporting period.

(Net Income - Preferred Dividends) / Weighted Avg. of Common Shares outstanding

• A significant business indicator
• Measures the dollars earned by each share of common stock
• Must be disclosed on the income statement

Report separate EPS for income from continuing operations (if applicable) and net income.

Question 28

Single-Step Income Statements

Answer 28

In reporting revenues, gains, expenses, and losses, some companies often use a format known as the single-step income statement instead of a multiple-step income statement.

The single-step statement consists of just two groupings: revenues and expenses. Expenses are deducted from revenues to arrive at net income or loss, hence the expression “single-step.”

Question 29

modified all-inclusive concept

Answer 29

In this approach, companies record most items, including unusual or infrequent ones, as part of net income.
In addition, companies are required to highlight these items in the financial statements so that users can better determine the long-run earning power of the company. These income items fall into four general categories:

1. Unusual and infrequent gains and losses.
2. Discontinued operations.
3. Noncontrolling interest.
4. Earnings per share.