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CHAPTER 4
Income Statement and Related Information
ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)
Topics Questions
Brief Exercises Exercises Problems
Concepts for Analysis
- Income measurement concepts.
- Computation of net income from balance sheets and selected accounts.
- Single-step income statements; earnings per share.
- Multiple-step income statements.
- Accounting changes; discontinued operations; prior period adjustments; errors.
- Retained earnings statement.
- Intraperiod tax allocation.
- Comprehensive income.
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)
Learning Objectives Questions Brief Exercises Exercises Problems
Concepts for Analysis
- Understand the uses and limitations of an income statement.
- Describe the content of the income statement.
- Prepare an income statement.
- Explain how to report various income items.
- Understand the reporting of accounting changes, and errors.
- Prepare a retained earnings statement.
- Explain how to report other comprehensive income.
ANSWERS TO QUESTIONS
1. The income statement is important because it provides investors and creditors with information that helps them predict the amount, timing, and uncertainty of future cash flows. It helps investors and creditors predict future cash flows in a number of different ways. First, investors and creditors can use the information on the income statement to evaluate the past performance of the company. Second, the income statement helps users of the financial statements to determine the risk (level of uncertainty) of income—revenues, expenses, gains, and losses—and highlights the relationship among these various components.
It should be emphasized that the income statement is used by parties other than investors and creditors. For example, customers can use the income statement to determine a company’s ability to provide needed goods or services, unions examine earnings closely as a basis for salary dis- cussions, and the government uses the income statements of companies as a basis for formulating tax and economic policy.
LO: 1, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
2. Information on past transactions can be used to identify important trends that, if continued, provide information about future performance. If a reasonable correlation exists between past and future performance, predictions about future earnings and cash flows can be made. For example, a loan analyst can develop a prediction of future performance by estimating the rate of growth of past income over the past several periods and project this into the next period. Additional information about current economic and industry factors can be used to adjust the trend rate based on historical information.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
3. Some situations in which changes in value are not recorded in income are: (a) Unrealized gains or losses on available-for-sale investments, (b) Changes in the fair values of long-term liabilities, such as bonds payable, (c) Changes (increases) in value of property, plant and equipment, such as land, natural resources, or equipment, (d) Changes (increases) in the values of intangible assets such as customer goodwill, brand value, or intellectual capital.
Note that some of these omissions arise because the items (e.g., brand value) are not recognized in financial statements, while others (value of land) are recorded in financial statements but meas- urement is at historical cost.
LO: 7, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
4. Some situations in which application of different accounting methods or estimates lead to comparison problems include: (a) Inventory methods—LIFO vs. FIFO, (b) Depreciation Methods—straight-line vs. accelerated, (c) Accounting for long-term contracts—percentage-of-completion vs. completed-contract, (d) Estimates of useful lives or salvage values for depreciable assets, (e) Estimates of bad debts, (f) Estimates of warranty costs.
LO: 3, 4, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
Questions Chapter 4 (Continued)
5. The transaction approach focuses on the activities that have occurred during a given period and instead of presenting only a net change, a description of the components that comprise the change is included. In the capital maintenance approach, only the net change (income) is reflected whereas the transaction approach not only provides the net change (income) but the components of income (revenues and expenses). The final net income figure should be the same under either approach given the same valuation base.
LO: 2, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
6. Earnings management is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. For example, companies prematurely recognize sales in order to boost earnings. Earnings management can also be used to decrease current earnings in order to increase income in the future. The classic case is the use of “cookie jar” reserves, which are established by using unrealistic assumptions to estimate liabilities for such items as loan losses, restructuring charges and warranty returns.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
7. Earnings management has a negative effect on the quality of earnings if it distorts the information in a way that is less useful for predicting future cash flows. Within the Conceptual Framework, useful information is both relevant and representationally faithful. However, earnings management reduces the reliability of income, because the income measure is biased (up or down) and/or the reported income is not representationally faithful to that which it is supposed to report (e.g., volatile earnings are made to look more smooth).
LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
8. Caution should be exercised because many assumptions and estimates are made in accounting and the net income figure is a reflection of these assumptions. If for any reason the assumptions are not well-founded, distortions will appear in the income reported. The objectives of the application of generally accepted accounting principles to the income statement are to measure and report the results of operations as they occur for a specified period without recognizing any artificial exclusions or modifications.
LO: 2, 3, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
9. The term “quality of earnings” refers to the credibility of the earnings number reported. Companies that use aggressive accounting policies report higher income numbers in the short-run. In such cases, we say that the quality of earnings is low. Similarly, if higher expenses are recorded in the current period, in order to report higher income in the future, then the quality of earnings is also considered low.
LO: 1, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
10. The major distinction between revenues and gains (or expenses and losses) depends on the typical activities of the company. Revenues can occur from a variety of different sources, but these sources constitute the entity’s ongoing major or central operations. Gains also can arise from many different sources, but these sources occur from peripheral or incidental transactions of an entity. The same type of distinction is made between expenses and losses.
LO: 2, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
11. The advantages of the single-step income statement are: (1) simplicity and conciseness, (2) probably better understood by the layperson, (3) emphasis on total costs and expenses, and net income, and (4) does not imply priority of one revenue or expense over another. The disadvantages are that it does not show the relationship between sales revenue and cost of goods sold and it does not show other important relationships and information, such as income from operations, income before income tax, etc.
LO: 3, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 4 (Continued)
16. (a) The remaining book value of the equipment should be depreciated over the remainder of the five-year period. The additional depreciation ($425,000) is not a correction of an error and is not shown as an adjustment to retained earnings. The change is considered a change in estimate. (b) The loss should be shown in the other expenses and losses section of the income statement. (c) The write-off should be shown as other expenses and losses in the income statement. (d) A correction of an error should be considered a prior period adjustment and the beginning balance of Retained Earnings should be restated, if material. (e) The cumulative effect of the change is reported as an adjustment to beginning retained earnings. Prior years’ statements are recast on a basis consistent with the new standard.
LO: 5, Bloom: C, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
17. (a) Other expenses and losses section. (b) Other expenses and losses section. (c) Operating expense section, as a selling expense, but sometimes reflected as an administrative expense. (d) Separate section after income from continuing operations, entitled discontinued operations. (e) Other revenues and gains section or in a separate section, appropriately labeled as an unusual item, if unusual or infrequent. (f) Other revenues and gains section. (g) Operating expense section, normally administrative. If a manufacturing concern, may be included in cost of goods sold. (h) Other expenses and losses section.
LO: 3, 4, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
18. Perlman and Sheehan should not report the sales in a similar manner. This type of transaction appears to be typical of Perlman’s central operations. Therefore, Perlman should report revenues of $160,000 and expenses of $100,000 ($70,000 + $30,000). However, Sheehan’s transaction appears to be a peripheral or incidental activity not related to its central operations. Thus, Sheehan should report a gain of $60,000 ($160,000 – $100,000). Note that although the classification is different, the effect on net income is the same ($60,000 increase).
LO: 3, 4, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
19. You should tell Greg that a company’s reported net income is the same whether the single-step or multiple-step format is used. Either way, the company has the same revenues, gains, expenses, and losses; they are simply organized in a different format.
LO: 3, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
20. Both formats are acceptable. The amount of detail reported in the income statement is left to the judgment of the company, whose goal in making this decision should be to present financial statements which are most useful to decision makers. We want to present a simple, understand- able statement so that a reader can easily discover the facts of importance; therefore, a single amount for selling expenses might be preferable. However, we also want to fully disclose the results of all activities; thus, a separate listing of expenses may be preferred. Note that if the condensed version is used, it should be accompanied by a supporting schedule of the eight components in the notes to the financial statements.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
21. Intraperiod tax allocation should not affect the reporting of an unusual gain. The FASB specifically prohibits a “net-of-tax” treatment for such items to insure that users of financial statements can easily differentiate items that are unusual or infrequent. “Net-of-tax” treatment is reserved for discontinued operations, and prior period adjustments.
LO: 4, Bloom: K, Difficulty: Complex, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 4 (Continued)
22. (a) A loss on discontinued operations is reported net of tax in the income statement between income from continuing operations and net income. (b) Noncontrolling interest allocation is reported in the income statement after the net income. (c) Earnings per share are shown in the income statement after the noncontrolling interest allocation. (d) A gain on sale of equipment in shown under other revenues and gains in the income statement.
LO: 4, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
23. Lebron presents the income information as follows:
Net income $ 124, Less: Net income attributed to the noncontrolling interest 30, Net income attributable to Lebron Company $ 94,
LO: 4, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
24. Intraperiod tax allocation has no effect on reported net income, although it does affect the amounts reported for various components of income. The effects on these components offset each other so net income remains the same. Intraperiod tax allocation merely takes the total income tax expense and allocates it to the various items which affect the tax amount.
LO: 4, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
25. If Neumann has preferred stock outstanding, the numerator in its computation may be incorrect. A better description of “earnings per share” is “earnings per common share.” The numerator should include only the earnings available to common shareholders. Therefore, the numerator should be: net income less preferred dividends.
The denominator is also incorrect if Neumann had any common stock transactions during the year. Since the numerator represents the results for the entire year, the denominator should reflect the weighted-average number of common shares outstanding during the year, not the shares outstanding at one point in time (year-end).
LO: 4, Bloom: C, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
26. The earnings per share trend is not favorable. Discontinued items are often one-time occurrences which are not expected to be reported in the future. Therefore, earnings per share on income from continuing operations is more useful because it represents the results of ordinary business activity. Considering this EPS amount, EPS has decreased from $7.21 to $6.40.
LO: 4, Bloom: AN, Difficulty: Simple, Time: 3-5, Analysis, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
27. Tax allocation within a period is the practice of allocating the income tax for a period to such items as income from continuing operations, discontinued items, and prior period adjustments.
The justification for tax allocation within a period is to produce financial statements which disclose an appropriate relationship, for example, between income tax expense and (a) income before from continuing operations, (b) discontinued operations, and (c) prior period adjustments (or of the opening balance of retained earnings).
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 4 (Continued)
33. Generally accepted accounting principles are ordinarily concerned only with a “fair presentation” of business income. In contrast, taxable income is a statutory concept which defines the base for raising tax revenues by the government, and any method of accounting which meets the statutory definition will “clearly reflect” taxable income as defined by the Internal Revenue Code. It should be noted that the Code prohibits use of the cash receipts and disbursements method as a method which will clearly reflect income in accounting for purchases and sales if inventories are involved.
The cash receipts and disbursements method will not usually fairly present income because: (1) The completed transaction, not receipt or disbursement of cash, increases or diminishes income. Thus, a sale on account produces revenue and increases income, and the incurrence of expense reduces income without regard to the time of payment of cash. (2) The expense recognition principle generally results in costs being matched against related revenues produced. In most situations the cash receipts and disbursements method will violate this principle. (3) Consistency requires that accountable events receive the same accounting treatment from accounting period to accounting period. The cash receipts and disbursements method permits manipulation of the timing of revenues and expenses and may result in treatments which are not consistent, detracting from the usefulness of comparative statements.
LO: 4, Bloom: K, Difficulty: Moderate, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
34. From the revenue side, there are many types of revenue transactions which require estimation. For example, it is difficult to estimate the amount of revenue to recognize for a long-term contract in a given period. Other estimation situations also prevalent such as high rates of return on products sold, net versus gross sales issues, sales with buyback options, estimating revenues in licensing arrangements and so on. During a single fiscal period it often is difficult to determine the expiration of certain costs which may benefit several periods. Business is continuous and estimates have to be made of the future if we are to systematically apportion costs to fiscal periods. Examples of items which present serious obstacles include such items as institutional advertising costs.
Accountants have established certain rules for handling revenues and costs which are applied con- sistently and in a systematic manner. From period to period, application of these rules generally results in a satisfactory matching of costs and revenues unless there are large changes from one period to another. These rules, influenced by conservatism in the face of the uncertainties involved, tend to charge costs to expense earlier than might be ideally desirable if we had more knowledge of the future.
Costs or expenses of the types mentioned above, by their very nature, defy any attempt to relate them to revenues of a specific period or periods. Although it is known that institutional advertising will yield benefits beyond the present, both the amount of such benefits and when they will be enjoyed are shrouded in uncertainty. The degree of certainty with which their time distribution can be forecast is so small and the results, therefore, so unreliable that the accountant writes them off as applicable to the period or periods in which the expense was incurred.
LO: 7, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
Questions Chapter 4 (Continued)
35. Elements are the basic ingredients which comprise the income statement; that is, revenues, gains, expenses, and losses. Items are descriptions of the elements such as rent revenue, rent expense, etc.
In order to predict the future, the amounts of individual items may have to be reported. For example, if “income from continuing operations” is significantly lower this year and is reported as a single amount, users would not know whether to attribute the decrease to a temporary increase in an expense item (for example, an unusually large bad debt), a structural change (for example, a change in the relationship between variable and fixed expenses), or some other factor. Another example is income data that are distorted because of large discretionary expenses.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
36. Other comprehensive income must be displayed (reported) in one of two ways: (1) a single continuous income statement (one statement approach) or (2) two separate but consecutive statements of net income and other comprehensive income (two statement approach).
LO: 7, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
37. The results of continuing operations should be reported separately from discontinued operations, and any gain or loss from disposal of a component of a business should be reported with the related results of discontinued operations. The following format illustrates the proper disclosure:
Income from continuing operations before income tax.............................. $XXX Income tax................................................................................................ XXX Income from continuing operations ........................................................... XXX Discontinued operations Gain (loss) on disposal of Division X less applicable income taxes of $– ..................................................... XXX Net income ............................................................................................... $XXX
LO: 3, 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
BRIEF EXERCISE 4-
BRISKY CORPORATION
Income Statement
For the Year Ended December 31, 2017
Revenues
Net sales ........................................................ $2,400,
Interest revenue ............................................ 31,
Total revenues....................................... 2,431,
Expenses
Cost of goods sold ....................................... $1,450,
Selling expenses........................................... 280,
Administrative expenses .............................. 212,
Interest expense ........................................... 45,
Income tax expense* .................................... 133,
Total expenses ..................................... 2,120,
Net income .............................................................. $ 310,
Earnings per share**............................................... $4.
*($2,431,000 – $1,450,000 – $280,000 – $212,000 – $45,000) X 30% = $133,200.
**$310,800 ÷ 70,000 shares.
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
BRIEF EXERCISE 4-
BRISKY CORPORATION
Income Statement
For the Year Ended December 31, 2017
Net sales ............................................................... $2,400,
Cost of goods sold ............................................... 1,450,
Gross profit ................................................ 950,
Selling expenses .................................................. $280,
Administrative expenses ..................................... 212,000 492,
Income from operations ....................................... 458,
Other revenue and gains
Interest revenue ......................................... 31,
Other expenses and losses
Interest expense......................................... 45,000 14,
Income before income tax ................................... 444,
Income tax expense ............................................. 133,
Net income ............................................................ $ 310,
Earnings per share ............................................... $4.44*
*$310,800 ÷ 70,000 shares.
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
BRIEF EXERCISE 4-
Income from continuing operations .................... $10,600,
Discontinued operations
Loss from operation of discontinued
restaurant division net of tax ................. $315,
Loss from disposal of restaurant
division net of tax .................................... 189,
Net income ............................................................ $10,096,
Earnings per share ...............................................
Income from continuing operations .......... $1.
Discontinued operations, net of tax........... (0.05)*
Net income ................................................... $1.
*Rounded
LO: 2, 3, 4, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
BRIEF EXERCISE 4-
= $3.95 per share
LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
BRIEF EXERCISE 4-
PORTMAN CORPORATION
Retained Earnings Statement
For the Year Ended December 31, 2017
Retained earnings, January 1 .......................................... $ 675,
Add: Net income ............................................................. 1,400,
Less: Cash dividends ...................................................... 75,
Retained earnings, December 31 .................................... $2,000,
LO: 6, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 4-
PORTMAN CORPORATION
Retained Earnings Statement
For the Year Ended December 31, 2017
Retained earnings, January 1, as reported ..................... $ 675,
Correction for overstatement of expenses in
prior period (net of tax).......................................... 80,
Retained earnings, January 1, as adjusted .................... 755,
Add: Net income ............................................................. 1,400,
Less: Cash dividends ...................................................... 75,
Retained earnings, December 31 .................................... $2,080,
LO: 5, 6, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 4-
(a) Net income (Interest revenue) ............................... $3,
(b) Net income.............................................................. $3,
Unrealized holding gain (net of tax) ...................... 4,
Comprehensive income ......................................... $7,
(c) Unrealized holding gain (net of tax)
Other comprehensive income ............................... $4,
(d) Accumulated other comprehensive income,
January 1, 2017 .................................................. $ 0
Unrealized holding gain (net of tax) ...................... 4,
Accumulated other comprehensive income,
December 31, 2017 ............................................. $4,
LO: 7, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 4-2 (10–15 minutes)
Sales revenue .........................................................................
Cost of goods sold ................................................................. 140,
Gross profit............................................................................. 170,
Selling and administrative expenses .................................... 50,
Income from operations 120,000(a)
Other revenues and gains
Gain on sale of plant assets ......................................... 30,
Other expenses and losses
Interest expense ............................................................ 6,
Income from continuing operations ..................................... 144,
Loss on discontinued operations ......................................... (12,000)
Net income .............................................................................. $ 132,000(b)
Net income .............................................................................. $132,
Unrealized gain on available-for-sale investments .............. 10,
Comprehensive income ......................................................... $142,000(c)
Net income .............................................................................. $132,
Dividends ................................................................................ (5,000)
12/31/17 Retained earnings .................................................. $127,000(d)
(a) Income from operations $120,
(b) Net income $132,
(c) Comprehensive income $142,
(d) Retained earnings balance $127,
LO: 2, 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 4-3 (25–35 minutes)
(a) Total net revenue:
Sales revenue ................................................... $390,
Less: Sales discounts .................................... $ 7,
Sales returns and allowances ............. 12,400 20,
Net sales ........................................................... 369,
Dividend revenue ............................................. 71,
Rent revenue .................................................... 6,
Total net revenue ..................................... $447,
(b) Net income:
Total net revenue (from a) ............................... $447,
Expenses:
Cost of goods sold ..................................... 184,
Selling expenses ........................................ 99,
Administrative expenses ........................... 82,
Interest expense ......................................... 12,
Total expenses ..................................... 379,
Income before income tax ............................... 68,
Income tax ........................................................ 31,
Net income .................................................. $ 37,
(c) Dividends declared:
Ending retained earnings ................................ $125,
Beginning retained earnings ........................... 114,
Net increase ............................................................... 10,
Less: Net income (attributed to controlling
shareholders) ............................................................ 20,300*
Dividends declared ................................................... $ 9,
