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Chapter 4 The Income Statement and Statement of Cash

Flows

QUESTIONS FOR REVIEW OF KEY TOPICS

Question 4-1

The income statement is a change statement that reports transactions — revenues, expenses, gains and losses — that cause owners’ equity to change during a specified reporting period.

Question 4-2

Income from continuing operations includes the revenue, expense, gain, and loss transactions that will probably continue in future periods. It is important to segregate the income effects of these items because they are the most important transactions in terms of predicting future cash flows.

Question 4-3

Operating income includes revenues and expenses and gains and losses that are directly related to the principal revenue generating activities of the company. Nonoperating income includes items that are not directly related to these activities.

Question 4-4

The single-step format first lists all revenues and gains included in income from continuing operations to arrive at total revenues and gains. All expenses and losses are then grouped and subtotaled, subtracted from revenues and gains to arrive at income from continuing operations. The multiple-step format reports a series (multiple) of intermediate totals such as gross profit, operating income, and income before taxes. Very often income statements adopt variations of these formats, falling somewhere in between the two extremes.

Question 4-5

The term earnings quality refers to the ability of reported earnings (income) to predict a company’s future earnings. After all, an income statement simply reports on events that already have occurred. The relevance of any historical-based financial statement hinges on its predictive value.

Question 4-6

Restructuring costs include costs associated with shutdown or relocation of facilities or downsizing of operations. They are reported as an operating expense in the income statement.

Question 4-7

The process of intraperiod tax allocation matches tax expense or tax benefit with each major component of income, specifically continuing operations and any item reported below continuing operations. The process is necessary to achieve the desired result of separating the total income effects of continuing operations from the two separately reported items - discontinued operations and extraordinary items, and also to show the after-tax effect of each of those two components.

Answers to Questions (continued) Question 4-8

The net-of-tax income effects of a discontinued operation must be disclosed separately in the income statement, below income from continuing operations. The income effects include income (loss) from operations and gain (loss) on disposal. The gain or loss on disposal must be disclosed either on the face of the statement or in a disclosure note. If the component is held for sale but not sold by the end of the reporting period, the income effects will include income (loss) from operations and an impairment loss if the fair value less costs to sell is less than the book value of the component’s assets. The income (loss) from operations of the component is reported separately in discontinued operations on prior income statements presented for comparative purposes.

Question 4-9

Extraordinary items are material gains and losses that are both unusual in nature and infrequent in occurrence, taking into account the environment in which the entity operates.

Question 4-10

Extraordinary gains and losses are presented, net of tax, in the income statement below discontinued operations, if any.

Answers to Questions (continued) Question 4-11

GAAP permit alternative treatments for similar transactions. Common examples are the choice among FIFO, LIFO, and average cost for the measurement of inventory and the choice among alternative revenue recognition methods. A change in accounting principle occurs when a company changes from one generally accepted treatment to another.

In general, we report voluntary changes in accounting principles retrospectively. This means revising all previous periods’ financial statements as if the new method were used in those periods. In other words, for each year in the comparative statements reported, we revise the balance of each account affected. Specifically, we make those statements appear as if the newly adopted accounting method had been applied all along. Also, if retained earnings is one of the accounts whose balance requires adjustment (and it usually is), we revise the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders’ equity (or statements of retained earnings if they’re presented instead). Then we create a journal entry to adjust all account balances affected as of the date of the change. In the first set of financial statements after the change, a disclosure note would describe the change and justify the new method as preferable. It also would describe the effects of the change on all items affected, including the fact that the retained earnings balance was revised in the statement of shareholders’ equity along with the cumulative effect of the change in retained earnings.

An exception is a change in depreciation, amortization, or depletion method. These changes are accounted for as a change in estimate, rather than as a change in accounting principle. Changes in estimates are accounted for prospectively. The remaining book value is depreciated, amortized, or depleted, using the new method, over the remaining useful life.

Question 4-12

A change in accounting estimate is accounted for in the year of the change and in subsequent periods; prior years’ financial statements are not restated. A disclosure note should justify that the change is preferable and should describe the effect of a change on any financial statement line items and per share amounts affected for all periods reported.

Question 4-13

Prior period adjustments are accounted for by restating prior years’ financial statements when those statements are presented again for comparison purposes. The beginning of period retained earnings is increased or decreased on the statement of shareholders’ equity (or the statement of retained earnings) as of the beginning of the earliest period presented.

Answers to Questions (concluded) Question 4-14

Earnings per share (EPS) is the amount of income achieved during a period for each share of common stock outstanding. If there are different components of income reported below continuing operations, their effects on earnings per share must be disclosed. If a period contains discontinued operations and extraordinary items, EPS data must be reported separately for income from continuing operations and net income. Per share amounts for discontinued operations and extraordinary items would be disclosed on the face of the income statement.

Question 4-15

Comprehensive income is the total change in equity for a reporting period other than from transactions with owners. Reporting comprehensive income can be accomplished with a separate statement or by including the information in either the income statement or the statement of changes in shareholders’ equity.

Question 4-16

The purpose of the statement of cash flows is to provide information about the cash receipts and cash disbursements of an enterprise during a period. Similar to the income statement, it is a change statement, summarizing the transactions that caused cash to change during a particular period of time.

Question 4-17

The three categories of cash flows reported on the statement of cash flows are:

1. Operating activities — Inflows and outflows of cash related to the transactions entering

into the determination of net income from operations.

2. Investing activities — Involve the acquisition and sale of (1) long-term assets used in the

business and (2) nonoperating investment assets.

3. Financing activities — Involve cash inflows and outflows from transactions with creditors

and owners.

Question 4-18

Noncash investing and financing activities are transactions that do not increase or decrease cash but are important investing and financing activities. An example would be the acquisition of property, plant and equipment (an investing activity) by issuing either long-term debt or equity securities (a financing activity). These activities are reported either on the face of the statement of cash flows or in a disclosure note.

Question 4-19

The direct method of reporting cash flows from operating activities presents the cash effect of each operating activity directly on the statement of cash flows. The indirect method of reporting cash flows from operating activities is derived indirectly, by starting with reported net income and adding and subtracting items to convert that amount to a cash basis.