السبت، 25 أبريل 2015

Self Study CMAP1A-The Income Statement

The Income Statement

The income statement reports on the success of a company’s operations during a given period of time. The
income statement provides users with information to help them predict the amounts, timing, and uncertainty
of (prospects for) future cash flows.
The income statement is created using the accrual method of accounting as applied to historical transactions.
The income statement gives the results of operations for a period of time and is like a movie recording the
events of the business for that period of time. This attribute of the income statement is in contrast to the
balance sheet, which provides information as of one moment in time.
The accounts that are used to record revenues, expenses, gains and losses are temporary accounts. They
are closed to a permanent account (retained earnings on the balance sheet) at the end of each period
(fiscal year). Thus at the beginning of each fiscal year, the balances in the income statement accounts are
Certain types of events are classified and reported separately on the income statement. The standard
multiple-step income statement format includes the following sections:
Sales or service revenues
− Cost of goods sold (COGS)
= Gross profit
− Selling, general, and administrative expenses
= Operating income
+ Interest and dividend income
− Interest expense
+/− Non-operating gains/(losses)
= Income from continuing operations before income tax
− Provision for income taxes on continuing operations
= Income from continuing operations
+/− Gains/(losses) on operations of discontinued component (net of applicable taxes)
+/− Gains/(losses) on disposal of discontinued component (net of applicable taxes)
Income before extraordinary item
+/− Extraordinary gain/(loss)
Less: Applicable income tax
= Net Income
Note: “Income from continuing operations” on a multi-step income statement is not the same thing as
“operating income.”
Operating income includes revenues and expenses generated by the company’s core business. Operating
income does not include financial income (interest and dividend income) or financial expense (interest
expense), nor does it include non-operating gains and losses or gains and losses on discontinued
operations or extraordinary events.
Income from continuing operations, on the other hand, does include financial income and financial
expense and non-operating gains and losses in addition to revenues and expenses generated by the
company’s core business.
Income from continuing operations refers to income (loss) other than gains (losses) from discontinued
operations and extraordinary events. It is called income from continuing operations to distinguish it from
gains and losses on discontinued operations and extraordinary events.
The line “Income from continuing operations” appears on an income statement only if the firm
is reporting results of discontinued operations.
Similarly, the line “Income before extraordinary item” would appear on an income statement only if the
firm is reporting extraordinary items.
A single-step income statement may also be used. A single-step income statement has only two groupings:
revenues and expenses. Total expenses are subtracted from total revenues to determine the net income or
loss. The single-step form of income statement is simpler and eliminates potential classification problems.
Note: In addition to all of this information regarding income, information regarding Earnings per Share
(EPS) must also be disclosed on the face of the income statement.
Elements of the Income Statement
Revenues represent inflows or other enhancements to assets or settlements of liabilities8 as a result of
delivering goods or providing services that are the entity’s main or central operations. Revenues are usually
recognized when the earnings process (the provision of goods or services to the customer) is complete and an
exchange has taken place. The exchange does not need to include cash but may include a promise to pay in
the future (a receivable).
Note: The revenue recognition principle requires revenues to be recognized in the accounting period in
which the performance obligation is satisfied.
However, revenue may also be recognized under the following methods in the right circumstances:
Percentage-of-completion for long-term contracts,
Production basis for agricultural products and precious metals if they have (1) interchangeable
(fungible) units and (2) quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price, 9
Installment basis, used when we are not certain of the collectability of the account, and
Cost-recovery basis, a method of accounting for an installment basis sale where recognition of the
gross profit is deferred until all cost of the sales has been recovered. Used when the seller is unable
to measure the certainty of collectability.
Expenses are outflows or other using-up of assets or the incurrence of liabilities as a result of delivering
goods or providing services that are the entity’s main or central operations. Expenses are recognized
based upon one of the following three methods:
Cause and effect: the cost of a item sold is recognized as cost of goods sold when the item is sold,
Systematic and rational allocation such as depreciation, and
Immediate recognition: if an expense will not provide future benefit, it is immediately recognized.
Note: The expense recognition principle, commonly called the matching principle, states that
recognition of expenses is related to net changes in assets and the earning of revenues. Expenses should
be recognized during a period as a result of delivering or producing goods and/or performing services and
recognizing the associated revenue during that period. Thus, expenses should be recognized when the
work or product contributes to revenue. The expense recognition principle is implemented by matching
efforts (or expenses) with accomplishments (revenues).
Gains are increases in equity as a result of transactions that are not part of the company’s main or central
operations and that do not result from revenues or investments by the owners of the entity.
Losses are decreases in equity as a result of transactions that are not part of the company’s main or central
operations and that do not result from expenses or distributions made to owners of the entity.
The difference between revenues and gains and between expenses and losses depends on what the
company’s typical activities are. For example, the sale of a product as part of a company’s normal operations
constitutes revenue. However, the sale of a fixed asset is not part of the company’s regular operations, so the
excess of the amount received for the asset over its net book value is a gain, not revenue.
8 Settlement of a liability creates revenue, for example, when the company has received a deposit from a customer for an
order to be delivered in the future. The deposit is a current liability when received. When the order is fulfilled, the liability is
debited to reduce it by the amount of the deposit, and the amount of the deposit is credited to revenue.
9 Per FASB Statement of Concepts No. 5, paragraphs 84(e) and 83(a). Per paragraph 84(e): “If products or other assets
are readily realizable because they are salable at reliably determinable prices without significant effort (for example, certain
agricultural products, precious metals, and marketable securities), revenues and some gains or losses may be recognized at
completion of production or when prices of the assets change. Paragraph 83(a) describes readily realizable (convertible)
assets.” Per Paragraph 83(a): “Readily convertible assets have (i) interchangeable (fungible) units and (ii) quoted prices
available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the
Unusual Gains and Losses
Some items may need separate disclosure on the income statement in order to help users to predict amounts,
timing and uncertainty of future cash flows. Some examples of unusual gains and losses are losses on writedowns of inventory or other assets or restructuring charges.
Companies generally report unusual items in a separate section on the income statement just above Income
from Operations Before Income Taxes.
Unusual gains and losses are different from extraordinary gains and losses, covered below. Although unusual
gains and losses do not qualify to be reported as extraordinary gains and losses, the firm may want to show
them separately.
Discontinued Operations
A discontinued operation is any component of an entity that has been or will be eliminated from the
operations of the company and the company has no further significant involvement in that component after
the disposal transaction.
A discontinued operation exists whenever a company makes a decision to dispose of an identifiable part of its
business. The discontinuation can take the form of the sale of a part of the business or spinning-off part of the
company to form a new company. The discontinuation can also occur through the abandonment of the assets.
All gains or losses that are incurred by the discontinued segment are reported in the period in which the
gain or loss occurred; and this disclosure on the income statement is done net of taxes.
As soon as the company makes the decision to dispose of a component of the business, the operations
(incomes and expenses) of the component to be disposed of should be reported on one line net of tax below
income from continuing operations. When the actual disposal takes place, the gain or loss from the disposal is
also reported net of tax below income from continuing operations. The gain or loss from the actual disposal of
the component should be reported on a separate line from the gain or loss from the operations of the
discontinued component, as follows:
Income from continuing operations
Discontinued operations:
+/− Gain/(loss) on operations of discontinued component (net of applicable taxes)
+/− Gain/(loss) on disposal of discontinued component (net of applicable taxes)
Net Income
In other words, all gains and losses from the component to be discontinued should be removed from income
from continuing operations so users of the financial statements can see what income from continuing
operations is without the operations of the component to be disposed of.
Companies use the line “Income from continuing operations” on the income statement only when gains or
losses on discontinued operations occur.
Extraordinary Items
The criteria for an item to be classified as extraordinary are:
1) Unusual nature. The event or transaction should be highly abnormal and be clearly unrelated to the
ordinary and typical activities of the company.
2) Infrequency of occurrence. The event or transaction should be something the company does not
reasonably expect to recur in the foreseeable future.
Classification of an event or transaction as extraordinary should occur only rarely, for example damage from a
major casualty such as an earthquake if the company is not located in an area where earthquakes occur
When a company has a gain or loss from an extraordinary item, its income statement has a line “Income
before extraordinary item” and the extraordinary gain or loss is reported below the line, net of applicable
income tax, as follows:
Income before income tax and extraordinary item
Income Tax
Income before extraordinary item
+/− Extraordinary gain (loss) [describe]
Less: Applicable income tax
Net Income
Intraperiod Tax Allocation
Discontinued operations and extraordinary items need to be reported on the income statement net of their
applicable taxes. That means taxes must be allocated among the various components of the income
statement. This allocation of tax is called intraperiod tax allocation (allocation within one period). The
income tax due should be allocated first to income from continuing operations. Then the remaining tax due
should be pro-rated among gains/losses from discontinued operations, extraordinary items and any other
items according to each one’s proportion of the total other income.
Noncontrolling Interest
A company may own less than 100% of the stock of another company, but it may own a large enough portion
of the other company’s stock that it has control over the other company and must consolidate the other
company’s financial results with its own financial results. In these cases, the other company is a subsidiary of
the parent company but not a wholly-owned subsidiary. The noncontrolling interest in the other company
is the portion of the equity in the subsidiary that is not owned by the parent.
Since the financial results of the parent and the subsidiary are consolidated, the net income of the
consolidated entity includes some net income that does not belong to the parent because it belongs to the
minority shareholder(s). When the parent prepares a consolidated income statement, the net income must be
allocated between the controlling interest (the parent) and the noncontrolling interest (the minority
shareholder[s]). The allocation is reported after net income on the income statement, as follows:
Consolidated net income
− Less: Net income attributable to noncontrolling interest(s)
= Net income attributable to shareowners of the parent
Use of the Income Statement
The income statement helps users of the financial statements to predict future cash flows, as follows:
It helps users to evaluate the company’s past performance and to compare it to the performance of
its competitors.
It provides a basis for predicting future performance.
It helps users to assess the risk or uncertainty of achieving future cash flows
Limitations of the Income Statement
Most of the limitations of the income statement are caused by its periodic nature. At any particular financial
statement date, buying and selling will be in process, and some transactions will be incomplete. Therefore,
net income for a period necessarily involves estimates, and these estimates affect the company’s performance
for the period.
Limitations that reduce the usefulness of the income statement for predicting amounts, timing and uncertainty
of cash flows include:
Net income is an estimate that reflects a number of assumptions.
Income numbers are affected by the accounting methods used. For example, differences in methods
of depreciation cause differences in amount of depreciation expense during each year of an asset’s
life. A lack of comparability between and among companies results from these differences in accounting methods.
Income measurement involves judgment. For example, the amount of depreciation expense recorded
during a period is dependent upon estimates regarding the useful lives of the assets being depreciated.
Items that cannot be measured reliably are not reported in the income statement. For instance,
increases in value due to brand recognition, customer service, and product quality are not reflected
in net income.
The income statement is limited to reporting events that produce reportable revenues and expenses.
Generally, revenues and gains are not recognized until they can be reliably measured and are realizable. “Reliably measured” means they can be converted into a known amount of cash or claims to
cash. “Realizable” generally means that the company has completed all of its obligations relating to
the sale of the product, and the collection of the receivable is assured beyond reasonable doubt. Delaying the recognition of revenue until it is realizable is a means of dealing with the periodic nature of
the income statement. However, some gains such as holding gains on available-for-sale securities
are realizable but are not reported on the income statement. The available-for-sale securities could
be sold immediately at the market price, but holding gains and losses on them are excluded from net
income, though they are reported in accumulated other comprehensive income in the equity section
of the balance sheet.
Comprehensive income is the total change in equity that results from all sources other than distributions to
owners and investments by owners. It is a little closer to being an economic measure of income than net
income is.
Question 3: The financial statement that provides a summary of the firm’s operations for a period of time
is the
a) income statement.
b) statement of financial position.
c) statement of shareholders’ equity.
d) statement of retained earnings.
 NEXT The Statement of Cash Flows (SCF)

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