4 Income Statement and

Related Information
LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1 Understand the uses and limitations of 5 Understand the reporting of accounting

an income statement. changes and errors.
2 Describe the content of the income 6 Prepare a retained earnings statement.
statement.
7 Explain how to report other
3 Prepare an income statement. comprehensive income.
4 Explain how to report various income
items.

FINANCIAL STATEMENTS ARE CHANGING

The 2014 annual report of Groupon presents the following additional information in its financial statements:

The following is a reconciliation of Adjusted EBITDA to the most comparable U.S. GAAP financial mea-
sure, “Net loss,” for the years ended December 31, 2014 and 2013 (in thousands):
Year Ended December 31,
2014 2013
Net loss $ (63,919) $ (88,946)
Adjustments:
Stock-based compensation 122,019 121,462
Acquisition-related expense (benefit), net 1,269 (11)
Depreciation and amortization 144,921 89,449
Other expense, net 33,353 94,663
Provision for income taxes 15,724 70,037
Total adjustments 317,286 375,600
Adjusted EBITDA $253,367 $286,654

Groupon management indicates that adjusted EBITDA is a non-GAAP financial measure that comprises net
loss excluding income taxes, interest and other nonoperating items, depreciation and amortization, stock-based
compensation, and acquisition-related expense (benefit), net. Management also indicates that the definition of
adjusted EBITDA may differ from similar measures used by other companies, even when similar terms are used to
identify such measures: “Adjusted EBITDA is a key measure used by our management and Board of Directors to
evaluate operating performance, generate future operating plans and make strategic decisions for the allocation of
capital. Accordingly, we believe that adjusted EBITDA provides useful information to investors and others in under-
standing and evaluating our operating results in the same manner as our management and Board of Directors.”
Why do companies report these adjusted income numbers (sometimes referred to as pro forma measures)?
One major reason is that companies believe some items on the income statement are not representative of
operating results. These pro forma advocates defend pro forma reporting, saying it gives better insight into the
fundamental operations of the business. However, while management asserts pro forma is useful to investors,
others raise concerns.
 Skeptics of pro forma reporting often note that these adjustments generally lead to higher adjusted net
income and, as a result, often report earnings before bad stuff (EBS). In Groupon’s case, the add-backs took a
GAAP net loss of $63.9 million and adjusted it to a non-GAAP profit of $253.4 million in 2014. Groupon is not
alone, as 40 (18%) of the 222 companies that had initial public offerings in 2014 reported losses under standard
accounting rules but showed profits using their own tailor-made measures. According to consulting firm Audit
Analytics, this represents the highest level of such companies in the past several years.
Another concern with pro forma reporting is that it is difficult to compare these adjusted numbers because
companies have different views as to what is fundamental to their business. In many ways, the pro forma reporting
practices by companies like Groupon represent implied criticisms of certain financial reporting standards, includ-
ing how the information is presented on the income statement. In response, the SEC issued Regulation G, which
requires companies to reconcile non-GAAP financial measures to GAAP. This regulation provides investors with
a roadmap to analyze adjustments that companies make to their GAAP numbers to arrive at pro forma results.
Regulation G helps investors compare one company’s pro forma measures with results reported by another
company.
The FASB is working on a project on financial statement presentation to address users’ concerns about these
practices. Users believe too many alternatives exist for classifying and reporting income statement information. As a
result, it is difficult to assess the financial performance of the company and compare its results with other companies.
The FASB’s focus on more transparent income reporting is encouraging, but managers still like pro forma reporting,
as indicated by a recent survey. Over 55 percent polled indicated they would continue to practice pro forma reporting,
even with a revised income statement format.
Sources: A. Stuart, “A New Vision for Accounting: Robert Herz and FASB Are Preparing a Radical New Format for Financial
Statements,” CFO Magazine (February 2008), pp. 49–53; SEC Regulation G, “Conditions for Use of Non-GAAP Financial
Measures,” Release No. 33-8176 (March 28, 2003) and Compliance & Disclosure Interpretations: Non-GAAP Financial Mea-
sures (January 15, 2010), available at www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm; and M. Rapoport, “What
Companies Strip Out of ‘Non-GAAP’ Earnings: Fines, Exec Bonuses, Severance, Rebranding Costs…” Wall Street Journal
(January 8, 2015).

PREVIEW OF CHAPTER 4 As indicated in the opening story, companies are at- This chapter also includes
tempting to provide income statement information they believe is useful for decision-making. numerous conceptual and
Investors need complete and comparable information on income and its components to assess international discussions
company profitability correctly. In this chapter, we examine the many different types of revenues, that are integral to the topics
expenses, gains, and losses that affect the income statement and related information, as follows. presented here.

INCOME STATEMENT AND RELATED INFORMATION

INCOME STATEMENT FORMAT OF THE REPORTING VARIOUS OTHER REPORTING ISSUES

INCOME STATEMENT INCOME ITEMS
• Usefulness • Accounting changes and
• Elements • Unusual and infrequent errors
• Limitations
• Intermediate gains and losses • Retained earnings
• Quality of earnings
components • Discontinued operations statement
• Condensed income • Noncontrolling interest • Comprehensive income
statements • Earnings per share
• Single-step income • Summary
statements

REVIEW AND PRACTICE

Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary review
and practice problem with solution. Multiple-choice questions with annotated solutions as well as
additional exercises and practice problem with solutions are also available online.

153
154 Chapter 4 Income Statement and Related Information

LEARNING OBJECTIVE 1 INCOME STATEMENT

Understand the uses and The income statement is the report that measures the success of company operations for
limitations of an income a given period of time. (It is also often called the statement of income or statement of
statement. earnings.1) 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 uncer-
tainty of future cash flows.

Usefulness of the Income Statement

Ford Toyota The income statement helps users of financial statements predict future cash flows in a
number of ways. For example, investors and creditors use the income statement infor-
mation to:
Revenues
– Expenses
$ Profits
< Revenues
– Expenses
$ Profits 1. Evaluate the past performance of the company. Examining revenues and expenses
indicates how the company performed and allows comparison of its performance to its
Which company did better competitors. For example, analysts use the income data provided by Ford to compare its
last year?
performance to that of Toyota.
2. Provide a basis for predicting future performance. Information about past perfor-
mance helps to determine important trends that, if continued, provide information
about future performance. For example, General Electric at one time reported con-
GE Profits
sistent increases in revenues. Obviously, past success does not necessarily translate
into future success. However, analysts can better predict future revenues, and hence
earnings and cash flows, if a reasonable correlation exists between past and future
Where am I headed?
performance.
3. Help assess the risk or uncertainty of achieving future cash flows. Information on
IBM Recurring? the various components of income—revenues, expenses, gains, and losses—
Income for Year Ended
12/31/17 highlights the relationships among them. It also helps to assess the risk of not
Revenues
– Operating expenses
achieving a particular level of cash flows in the future. For example, investors and
Yes
Operating income creditors often segregate IBM’s operating performance from other non-recurring
± Unusual items No
$ Net Income ?
sources of income because IBM primarily generates revenues and cash through its
Recurring items are more
operations. Thus, results from continuing operations usually have greater
certain in the future. significance for predicting future performance than do results from non-recurring
activities and events.

In summary, information in the income statement—revenues, expenses, gains, and

losses—helps users evaluate past performance. It also provides insights into the likeli-
hood of achieving a particular level of cash flows in the future.

Limitations of the Income Statement

Because net income is an estimate and reflects a number of assumptions, income state-
ment users need to be aware of certain limitations associated with its information. Some
of these limitations include:
Exp Exp
Rev Rev Rev
Profits
1. Companies omit items from the income statement that they cannot measure reli-
Unrealized
earnings Brand value ably. Current practice prohibits recognition of certain items from the determina-
You left something out!
tion of income even though the effects of these items can arguably affect the com-
pany’s performance. For example, a company may not record unrealized gains and
losses on certain investment securities in income when there is uncertainty that it

1
We will use the term income statement except in situations where a company reports other comprehensive
income (discussed later in the chapter). In that case, we will use the terms statement of comprehensive
income or comprehensive income statement.
 Income Statement 155

will ever realize the changes in value. In addition, more and more companies, like Income Using:

Cisco Systems and Microsoft, experience increases in value due to brand recogni-
Straight-Line
tion, customer service, and product quality. A common framework for identifying Depreciation

and reporting these types of values is still lacking.

2. Income numbers are affected by the accounting methods employed. One company Accelerated
Depreciation
may depreciate its plant assets on an accelerated basis; another chooses straight-line
depreciation. Assuming all other factors are equal, the first company will report Hmm... Is the income the same?
lower income. In effect, we are comparing apples to oranges.
3. Income measurement involves judgment. For example, one company in good faith Estimates
• High useful lives
may estimate the useful life of an asset to be 20 years, while another company uses • Low warranty costs
• Low bad debts
a 15-year estimate for the same type of asset. Similarly, some companies may make
optimistic estimates of future warranty costs and bad debt write-offs, which result
in lower expense and higher income. $ High Income

Hey...you might be too

In summary, several limitations of the income statement reduce the usefulness of optimistic!
its information for predicting the amounts, timing, and uncertainty of future cash
flows.

Quality of Earnings
So far, our discussion has highlighted the importance of information in the income state-
ment for investment and credit decisions, including the evaluation of the company and
its managers.2 Companies try to meet or beat Wall Street expectations so that the market
price of their stock and the value of management’s stock compensation packages
increase. As a result, companies have incentives to manage income to meet earnings
targets or to make earnings look less risky.
The SEC has expressed concern that the motivations to meet earnings targets may
override good business practices. This erodes the quality of earnings and the quality of
financial reporting. As indicated by one SEC chairperson, “Managing may be giving
way to manipulation; integrity may be losing out to illusion.”3 As a result, the SEC has
taken decisive action to prevent the practice of earnings management.
What is earnings management? It is often defined as the planned timing of reve-
nues, expenses, gains, and losses to smooth out bumps in earnings. In most cases, com-
panies use earnings management to increase income in the current year at the expense
of income in future years. For example, they prematurely recognize sales in order to
boost earnings. As one commentator noted, “it’s like popping a cork in [opening] a
bottle of wine before it is ready.”
Companies also use earnings management to decrease current earnings in order
to increase income in the future. The classic case is the use of “cookie jar” reserves. UNDERLYING
Companies establish these reserves by using unrealistic assumptions to estimate CONCEPTS
liabilities for such items as loan losses, restructuring charges, and warranty returns. The income statement
The companies then reduce these reserves in the future to increase reported income provides important infor-
in the future. mation to help assess
Such earnings management negatively affects the quality of earnings if it distorts the amounts, timing,
the information in a way that is less useful for predicting future earnings and cash flows. and uncertainty of future
Markets rely on trust. The bond between shareholders and the company must remain cash flows—the central
strong. Investors or others losing faith in the numbers reported in the financial state- element of the objective
ments will damage U.S. capital markets. As we mentioned in the opening story, we need of financial reporting.

2
In support of the usefulness of income information, accounting researchers have documented an association
between companies’ market prices and reported incomes. See W. H. Beaver, “Perspectives on Recent Capital
Markets Research,” The Accounting Review (April 2002), pp. 453–474.
3
A. Levitt, “The Numbers Game,” Remarks to NYU Center for Law and Business, September 28, 1998
(Securities and Exchange Commission, 1998).
156 Chapter 4 Income Statement and Related Information

heightened scrutiny of income measurement and reporting to ensure the quality of

earnings and investors’ confidence in the income statement.

WHAT DO THE NUMBERS MEAN? FOUR: THE LONELIEST NUMBER

Managing earnings up or down adversely affects the quality of significantly less often than would be expected by chance.
earnings. Why do companies engage in such practices? Some This effect is called “quadrophobia.” For the typical company
recent research concludes that many companies tweak quar- in the study, an increase of $31,000 in quarterly net income
terly earnings to meet investor expectations. How do they do would boost earnings per share by a 10th of a cent. A more
it? Research findings indicate that companies tend to nudge recent analysis of quarterly results for more than 2,600 com-
their earnings numbers up by a 10th of a cent or two. That lets panies found that rounding up remains more common than
them round results up to the highest cent, as illustrated in the rounding down.
following chart. Another recent study reinforces the concerns about earn-
ings management. Based on a survey of 169 public-company
Hitting the Target Digit Frequency of the Digit
chief financial officers (and with in-depth interviews of 12), the
Companies are more study concludes that high-quality earnings are sustainable
likely to round up 0
when backed by actual cash flows and “avoiding unreliable
earnings per share 1
figures to the next- long-term estimates.” However, about 20 percent of firms
highest cent than to Round
2 manage earnings to misrepresent their economic performance.
round down, a new down
study found. The chart 3 And when they do manage earnings, it could move EPS by an
shows the frequency Least
of the digits in the 4 average of 10 percent.
common
10th-of-a-cent place Is such earnings management a problem for investors?
5
for nearly 489,000
quarterly reports from
It is if they cannot determine the impact on earnings quality.
6
1980 to 2006. Indeed, the surveyed CFOs “believe that it is difficult for
Round
7 outside observers to unravel earnings management, espe-
up
8 cially when such earnings are managed using subtle unob-
9 servable choices or real actions.” What’s an investor to do?
Source: Joseph Grundfest and Nadya The survey authors say the CFOs “advocate paying close
Malenko, Stanford University. 2 4 6 8 10 12%
attention to the key managers running the firm, the lack of
correlation between earnings and cash flows, significant
What the research shows is that the number “4” appeared deviations between firm and peer experience, and unusual
less often in the 10th’s place than any other digit and behavior in accruals.”
Sources: S. Thurm, “For Some Firms, a Case of ‘Quadrophobia’,” Wall Street Journal (February 14, 2010); and H. Greenberg, “CFOs Concede
Earnings Are ‘Managed’,” www.cnbc.com (July 19, 2012). (The study referred to is by I. Dichev, J. Graham, C. Harvey, and S. Rajgopal, “Earnings
Quality: Evidence from the Field,” Emory University Working Paper (July 2012).)

LEARNING OBJECTIVE 2 FORMAT OF THE INCOME STATEMENT

Describe the content of
the income statement.
Elements of the Income Statement
Net income results from revenue, expense, gain, and loss transactions. The income
statement summarizes these transactions. This method of income measurement, the
transaction approach, focuses on the income-related activities that have occurred
during the period.4 The statement can further classify income by customer, product

4
The most common alternative to the transaction approach is the capital maintenance approach to
income measurement. Under this approach, a company determines income for the period based on the
change in equity, after adjusting for capital contributions (e.g., investments by owners) or distributions
(e.g., dividends). The main drawback associated with the capital maintenance approach is that the
components of income are not evident in its measurement. The Internal Revenue Service uses the
capital maintenance approach to identify unreported income and refers to this approach as the “net
worth check.”
 Format of the Income Statement 157

line, or function, or by operating and nonoperating, continuing and discontinued,

and regular and non-recurring categories.5 The following lists more formal defini-
tions of income-related items, referred to as the major elements of the income
statement.

ELEMENTS OF FINANCIAL STATEMENTS

REVENUES. Inflows or other enhancements of assets of an entity or settlements of its li-
abilities during a period from delivering or producing goods, rendering services, or other
activities that constitute the entity’s ongoing major or central operations.

EXPENSES. 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.

GAINS. Increases in equity (net assets) from peripheral or incidental transactions of an

entity except those that result from revenues or investments by owners.

LOSSES. Decreases in equity (net assets) from peripheral or incidental transactions of an

entity except those that result from expenses or distributions to owners.6

Revenues take many forms, such as sales, fees, interest, dividends, and rents.
Expenses also take many forms, such as cost of goods sold, depreciation, interest, rent,
salaries and wages, and taxes. Gains and losses also are of many types, resulting from
the sale of investments or plant assets, settlement of liabilities, and write-offs of assets
due to impairments or casualty.
The distinction between revenues and gains, and between expenses and losses,
depend to a great extent on the typical activities of the company. For example, when
McDonald’s sells a hamburger, it records the selling price as revenue. However, when
McDonald’s sells land, it records any excess of the selling price over the book value as a
gain. This difference in treatment results because the sale of the hamburger is part of
McDonald’s regular operations. The sale of land is not.
We cannot overemphasize the importance of reporting these elements. Most deci-
sion-makers find the parts of a financial statement to be more useful than the whole. As
we indicated earlier, investors and creditors are interested in predicting the amounts,
timing, and uncertainty of future income and cash flows. Having income statement ele-
ments shown in some detail and in comparison with prior years’ data allows decision-
makers to better assess future income and cash flows.

Intermediate Components of the Income Statement LEARNING OBJECTIVE 3

It is common for companies to present some or all of the following sections and totals Prepare an income
within the income statement as shown in Illustration 4-1 (on page 158). This format is statement.
often referred to as the multiple-step income statement.

5
The term “non-recurring” encompasses transactions and other events that are derived from developments
outside the normal operations of the business.
6
“Elements of Financial Statements,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB,
1985), paras. 78–89.
158 Chapter 4 Income Statement and Related Information

ILLUSTRATION 4-1
Income Statement Sections 1. OPERATING SECTION. A report of the revenues and expenses of the company’s prin-
cipal operations.
(a) Sales or Revenue. A subsection presenting sales, discounts, allowances, returns, and
other related information. Its purpose is to arrive at the net amount of sales revenue.
(b) Cost of Goods Sold. A subsection that shows the cost of goods that were sold to
produce the sales.
(c) Selling Expenses. A subsection that lists expenses resulting from the company’s ef-
forts to make sales.
(d) Administrative or General Expenses. A subsection reporting expenses of general
administration.7

2. NONOPERATING SECTION. A report of revenues and expenses resulting from sec-

ondary 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.

3. INCOME TAX. A section reporting federal and state taxes levied on income from con-
tinuing operations.

4. DISCONTINUED OPERATIONS. Material gains or losses resulting from the disposi-

tion of a component of the business.

5. NONCONTROLLING INTEREST. Allocation of income to noncontrolling share-

holders.

6. EARNINGS PER SHARE. A measure of performance over the reporting period.

As indicated, companies report all revenues, gains, expenses, and losses on the
income statement. This statement separates operating transactions from nonoperating
transactions, and matches costs and expenses with related revenues. It highlights cer-
tain intermediate components of income that analysts use to compute ratios for assess-
ing the performance of the company. Companies present nonoperating revenues, gains,
expenses, and losses in a separate section, before income taxes and income from opera-
tions. Companies report discontinued operations as a separate element in the income
statement. Segregating income with different characteristics and providing intermedi-
ate income figures helps readers evaluate earnings information in assessing the amounts,
timing, and uncertainty of future cash flows.
Illustration 4-2 presents an income statement for Cabrera Company. Cabrera’s
income statement includes all of the major items shown in Illustration 4-1, except for
discontinued operations and noncontrolling interest. In arriving at net income, the state-
ment presents the following subtotals and totals: gross profit, income from operations,
income before income tax, and net income.8
7
Although the content of the operating section is always the same, the organization of the material can differ.
The breakdown above uses a natural expense classification. Manufacturing concerns and merchandising
companies in the wholesale trade commonly use this. Another classification of operating expenses,
recommended for retail stores, uses a functional expense classification of administrative, occupancy,
publicity, buying, and selling expenses.
8
Companies must include earnings per share or net loss per share on the face of the income statement. In this
chapter, we discuss only earnings per share or net loss per share where a company has only common stock.
Another measure shown on the face of the income statement (when applicable) is fully diluted earnings per
share, which gives effect to all dilutive potential common shares that were outstanding during the reporting
period. This concept is discussed in Chapter 16.
 Format of the Income Statement 159

ILLUSTRATION 4-2
CABRERA COMPANY
INCOME STATEMENT
Multiple-Step Income
FOR THE YEAR ENDED DECEMBER 31, 2017 Statement

Sales
Sales revenue $3,053,081
Less: Sales discounts $ 24,241
Sales returns and allowances 56,427 80,668
Net sales 2,972,413
Cost of goods sold 1,982,541
Gross profit 989,872
Operating expenses
Selling expenses
Sales salaries and commissions $202,644
Sales office salaries 59,200
Travel and entertainment 48,940
Advertising expense 38,315
Delivery expense 41,209
Shipping supplies and expense 24,712
Postage and stationery 16,788
Telephone and Internet expense 12,215
Depreciation of sales equipment 9,005 453,028
Administrative expenses
Officers’ salaries 186,000
Office salaries 61,200
Legal and professional services 23,721
Utilities expense 23,275
Insurance expense 17,029
Depreciation of building 18,059
Depreciation of office equipment 16,000
Stationery, supplies, and postage 2,875
Miscellaneous office expenses 2,612 350,771 803,799
Income from operations 186,073
Other revenues and gains
Dividend revenue 98,500
Rent revenue 72,910 171,410
357,483
Other expenses and losses
Interest on bonds and notes 126,060
Income before income tax 231,423
Income tax 66,934
Net income for the year $ 164,489
Earnings per common share $1.74

The disclosure of net sales is useful because Cabrera reports regular revenues as a
separate item. It discloses non-recurring or incidental revenues elsewhere in the income
statement. As a result, analysts can more easily understand and assess trends in revenue
from continuing operations.
Similarly, the reporting of gross profit provides a useful number for evaluating per-
formance and predicting future earnings. Statement readers may study the trend in
gross profits to determine how successfully a company uses its resources. They also
may use that information to understand how competitive pressure affected profit
margins.
Finally, disclosing income from operations highlights the difference between regu-
lar and non-recurring or incidental activities. This disclosure helps users recognize that
incidental or non-recurring activities are unlikely to continue at the same level. Further-
more, disclosure of operating earnings may assist in comparing different companies
and assessing operating efficiencies.
160 Chapter 4 Income Statement and Related Information

WHAT DO THE NUMBERS MEAN? TOP LINE OR BOTTOM LINE?

The importance of the components of income, as well as the Boston Scientific, which sells medical devices, to glass-
bottom line, is illustrated in the recent case of Chipotle. Its container maker Owens-Illinois.
stock had climbed fourfold in five years and for good reason. The recent focus on the top line, revenue, arises because
The company had been reporting surprisingly high bottom-line market expectations for revenues do not seem to jive with the
income and investors were clamoring to buy. However, in a companies’ optimistic profit picture. And while companies might
recent month, that pattern was broken—that is, Chipotle report a surprise in earnings, analysts will be focusing on reve-
posted solid earnings, but investors sold. The reason? Analysts nues. Companies have been able to cut costs to compensate—
attribute the sell-off to Chipotle missing its target for revenues. laying off workers, squeezing remaining staff, and using technol-
The stock fell 21 percent, from $404 to $317, in a day. And ogy to run more efficiently—but there’s a limit to how much you
Chipotle was not alone. Six in 10 large companies reported can squeeze your workers and use technology to produce more.
results in that same quarter that missed revenue targets. In U.S. companies are just about as lean as any time in history.
response to the bad revenue news, Priceline.com fell $117 to As one analyst noted (in this economic environment), “you
$562 after reporting revenue that was lower than analysts had won’t be able to grow earnings much faster than revenue. . . .
expected. The story has been the same for dozens of compa- Analysts will have to revise down their earnings.” So watch the
nies across industries, from Coach, a luxury goods retailer, to top line, as well as the bottom line.

Source: Associated Press, “Why Some Stocks Are Sinking Despite Big Profits,” The New York Times (August 12, 2012).

Condensed Income Statements

In some cases, a single income statement cannot possibly present all the desired
expense detail. To solve this problem, a company includes only the totals of expense
groups in the statement of income. It then also prepares supplementary schedules to
support the totals. This format may thus reduce the income statement itself to a few
lines on a single sheet. For this reason, readers who wish to study all the reported data
on operations must give their attention to the supporting schedules. For example,
consider the income statement shown in Illustration 4-3 for Cabrera Company. This
statement is a condensed version of the more detailed multiple-step statement pre-
sented in Illustration 4-2 (page 159). It is more representative of the type found in
practice. Illustration 4-4 then shows an example of a supporting schedule, cross-refer-
enced as Note D and detailing the selling expenses.

ILLUSTRATION 4-3
CABRERA COMPANY
Condensed Income INCOME STATEMENT
Statement FOR THE YEAR ENDED DECEMBER 31, 2017

Net sales $2,972,413

Cost of goods sold 1,982,541
Gross profit 989,872
Selling expenses (see Note D) $453,028
Administrative expenses 350,771 803,799
Income from operations 186,073
Other revenues and gains 171,410
357,483
Other expenses and losses 126,060
Income before income tax 231,423
Income tax 66,934
Net income for the year $ 164,489

Earnings per common share $1.74

 Format of the Income Statement 161

ILLUSTRATION 4-4
Note D: Selling expenses
Sales salaries and commissions $202,644
Sample Supporting
Sales office salaries 59,200 Schedule
Travel and entertainment 48,940
Advertising expense 38,315
Delivery expense 41,209
Shipping supplies and expense 24,712
Postage and stationery 16,788
Telephone and Internet expense 12,215
Depreciation of sales equipment 9,005
Total selling expenses $453,028

How much detail should a company include in the income statement? On the one
hand, a company wants to present a simple, summarized statement so that readers can
readily discover important factors. On the other hand, it wants to disclose the results of
all activities and to provide more than just a skeleton report. As we show in Illustrations
4-3 and 4-4, the income statement always includes certain basic elements, but compa-
nies can present them in various formats.

Single-Step Income Statements

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 state-
ment. 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 expres-
sion “single-step.” Frequently, companies report income tax separately as the last item
before net income to indicate its relationship to income before income tax. Illustration
4-5 shows the single-step income statement of Cabrera Company.

ILLUSTRATION 4-5
CABRERA COMPANY
INCOME STATEMENT
Single-Step Income
FOR THE YEAR ENDED DECEMBER 31, 2017 Statement

Revenues
Net sales $2,972,413
Dividend revenue 98,500
Rent revenue 72,910
Total revenues 3,143,823
Expenses
Cost of goods sold 1,982,541
Selling expenses 453,028
Administrative expenses 350,771
Interest expense 126,060
Income tax expense 66,934
Total expenses 2,979,334

Net income $ 164,489

Earnings per common share $1.74

Companies that use the single-step income statement in financial reporting typi-
cally do so because of its simplicity. That is, the primary advantage of the single-step
format lies in its simple presentation and the absence of any implication that one
type of revenue or expense item has priority over another. This format thus eliminates
potential classification problems.9
9
Accounting Trends and Techniques (New York: AICPA) recently reported that of the 500 companies surveyed,
411 employed the multiple-step form, and 89 employed the single-step income statement format.
162 Chapter 4 Income Statement and Related Information

LEARNING OBJECTIVE 4 REPORTING VARIOUS INCOME ITEMS

Explain how to report Companies are generally allowed flexibility in the presentation of the components of
various income items. income. However, the FASB developed specific guidelines in two important areas: what
to include in income and how to report certain unusual or infrequent items.
What should be reported in net income and where it should be reported is contro-
versial. For example, should companies report a gain or loss on sale of an investment
as part of net income or report it directly in retained earnings? Should a company
report a loss on discontinued operations differently than interest expense? What
we therefore need is consistent and comparable income reporting practices. Develop-
ing a framework for reporting income components is important to ensure useful
information.
Furthermore, as our opening story discusses, we need consistent and comparable
income reporting practices to avoid “promotional” information reported by compa-
nies.10 Some users advocate a current operating performance approach to income
reporting. These analysts argue that the most useful income measure reflects only regu-
lar and recurring revenue and expense elements. Some unusual or infrequent (non-
recurring) items do not reflect a company’s future earning power.
In contrast, others warn that a focus on operating income potentially misses
important information about a company’s performance. Any gain or loss experienced
by the company, whether directly or indirectly related to operations, contributes to its
long-run profitability. As one analyst notes, “write-offs matter. . . . They speak to the
volatility of (past) earnings.”11 As a result, analysts can use some nonoperating items
INTERNATIONAL to assess the riskiness of future earnings. Furthermore, determining which items are
PERSPECTIVE operating and which are infrequent or unusual requires judgment. This might lead to
In many countries, the differences in the treatment of these items and to possible manipulation of income
“modified all-inclusive” measures.
income statement So, what to do? The accounting profession has adopted a modified all-inclusive
approach does not concept. In this approach, companies record most items, including unusual or infre-
parallel that of the quent ones, as part of net income.12 In addition, companies are required to highlight
United States. For these items in the financial statements so that users can better determine the long-run
example, companies earning power of the company. These income items fall into four general categories,
in these countries which we discuss in the following sections:
take some gains and
losses directly to own-
ers’ equity accounts
1. Unusual and infrequent gains and losses
instead of reporting 2. Discontinued operations
them on the income 3. Noncontrolling interest
statement.
4. Earnings per share

Unusual and Infrequent Gains and Losses

Companies that have unusual or infrequent gains and losses or both are required to
disclose this information in the income statement or in the notes to the financial

10
The FASB and the IASB are working on a joint project on financial statement presentation, which is
studying how to best report income as well as information presented in the balance sheet and the statement
of cash flows. See http://www.fasb.org/project/financial_statement_presentation.shtml.
11
A survey of 500 large public companies (Accounting Trends and Techniques (New York: AICPA)) documented
that 106 of the 500 survey companies reported a write-down of assets (see also Illustration 4-6 on page 163).
This highlights the importance of good reporting for these unusual or infrequent items.
12
The FASB issued a statement of concepts that offers some guidance on this topic: “Recognition and
Measurement in Financial Statements of Business Enterprises,” Statement of Financial Accounting Concepts No.
5 (Stamford, Conn.: FASB, 1984).
 Reporting Various Income Items 163

statements. In addition, additional disclosure is often needed in the notes to the finan-
cial statements so that the users of the income statement understand the effect of these
gains or losses on net income and future cash flows. These gains or losses are defined
as follows:

(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.

Common types of unusual or infrequent gains and losses or both are as follows:

• Losses on write-down (impairment) of receivables; inventories; property, plant, and

equipment; goodwill or other intangible assets.
• Restructuring charges.
• Other gains and losses from sale or abandonment of property, plant and equipment.
• Effects of a strike, including those against competitors and major suppliers.
• 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. [1] See the FASB
Codification
Illustration 4-6 identifies the most common types of unusual gains and losses References (page 194).
reported in a survey of 500 large companies. Note that more than 40 percent of the sur-
veyed firms reported restructuring charges, and nearly 60 percent of the companies
reported write-downs or gains or losses on asset sales.

500 ILLUSTRATION 4-6

Number of Unusual Items
289 Reported in a Recent Year
Number of Companies

250
by 500 Large Companies
200
202
150

100

50

0
Restructuring Write-Downs, Gains/Losses
Charges on Asset Sales

As indicated earlier, revenues and expenses, other revenues and gains, and
other expenses and losses should be reported as part of income before income taxes.
Therefore, gains and losses from unusual or infrequent gains or losses or both are
not reported net of tax. In practice, companies will generally itemize each gain or
loss on the income statement or show one amount for all these items and then item-
ize these items in the notes to the financial statements. For homework purposes, these
unusual or infrequent gains or losses or both should be itemized and reported in the Other
revenues and gains section or the Other expenses and losses section of the income statement.
Gains and losses shown in the homework should be considered material and unusual or
infrequent in nature or both.
164 Chapter 4 Income Statement and Related Information

Discontinued Operations
A discontinued operation occurs when two things happen:

1. A company eliminates the results of operations of a component of the business. A

component comprises operations and cash flows that can be clearly distinguished,
operationally and for financial reporting purposes.
2. The elimination of a component that represents a strategic shift, having a major
effect on the company’s operations and financial results. A strategic shift generally
includes the disposal of (1) a major line of business, (2) a major geographical area,
or (3) a major equity method investment. [2]

To illustrate, Softso has the following product lines that it manufactures and sells—
beauty care, health care, and baby care. Within these product lines, it has a total of 18
brands. Each brand is considered a separate component because each brand comprises
operations and cash flows that can be clearly distinguished, operationally and for finan-
cial reporting purposes. Each product line represents a major line of business. Softso
decides to eliminate the baby-care product line because it is suffering substantial losses.
Softso should report the elimination of the baby-care product line as a discontinued
operation because the baby-care line represents a major line of business and its disposal
represents a major part of Softso’s operations (a strategic shift).
On the other hand, assume that Softso decides to remain in the baby-care business
but will discontinue one brand in this product line because it is very unprofitable. Softso
should not report the elimination of this brand as a discontinued operation because it
does not represent a major part of Softso’s operations (disposing of it is not considered
a strategic shift).
As indicated, the reporting of a discontinued operation involves strategic shifts that
are substantial in nature. Here are some additional examples:

1. The sale of a product line that represents 15 percent of a company’s total

revenues.
2. The sale of a geographical area that represents 20 percent of a company’s total assets.
3. The sale of a component that is an equity investment that represents 20 percent of a
company’s total assets.

Companies report as discontinued operations (in a separate income statement cate-

gory) the gain or loss from disposal of a component of a business. In addition,
companies report the results of operations of a component that has been or will be
disposed of separately from continuing operations. Companies show the effects of
discontinued operations net of tax as a separate category, after continuing opera-
tions. [3]
To illustrate, Multiplex Products, Inc., a highly diversified company, decides to dis-
continue its electronics division. During the current year, the electronics division lost
$300,000 (net of tax). Multiplex sold the division at the end of the year at a loss of $500,000
(net of tax). Multiplex determines that the electronics division discontinuation meets the
strategic shift criteria because the division is a major line of business (its assets exceed
20 percent of Multiplex’s total assets). Illustration 4-7 shows the reporting of discontin-
ued operations for Multiplex.

ILLUSTRATION 4-7
Income from continuing operations $20,000,000
Income Statement
Discontinued operations
Presentation of Loss from operation of discontinued electronics
Discontinued division (net of tax) $300,000
Operations Loss from disposal of electronics division (net of tax) 500,000 (800,000)
Net income $19,200,000
 Reporting Various Income Items 165

Companies use the phrase “Income from continuing operations” only when gains or
losses on discontinued operations occur.
A company that reports a discontinued operation must report on the face of the
income statement the per share effect of income from continuing operations and net
income. In addition, it must report per share amounts for discontinued items either on
the face of the income statement or in the notes to the financial statements.13 To illus-
trate, consider the income statement for Poquito Industries Inc., shown in Illustration
4-8. Poquito had 100,000 shares outstanding for the entire year. Notice the order in
which Poquito shows the data, with per share information at the bottom. The Poquito
income statement, as Illustration 4-8 shows, is highly condensed. Poquito would need
to describe items such as “Other expenses and losses” and “Discontinued operations”
fully and appropriately in the statement or related notes.

ILLUSTRATION 4-8
POQUITO INDUSTRIES INC.
Income Statement
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2017

Sales revenue $1,420,000

Cost of goods sold 600,000
Gross profit 820,000
Selling and administrative expenses 320,000
Income from operations 500,000
Other revenues and gains
Interest revenue 10,000
Other expenses and losses
Loss on disposal of part of Textile Division $ 5,000
Loss on sale of investments 30,000
Interest expense 15,000 50,000
Income before income tax 460,000
Income tax 184,000
Income from continuing operations 276,000
Discontinued operations
Income from operations of Pizza Division, less
applicable income tax of $24,800 54,000
Loss on disposal of Pizza Division, less
applicable income tax of $41,000 90,000 36,000
Net income $ 240,000
Per share
Income from continuing operations $2.76
Income from operations of discontinued division, net of tax 0.54
Loss on disposal of discontinued operation, net of tax 0.90
Net income $2.40

Intraperiod Tax Allocation

As indicated in Illustrations 4-7 and 4-8, companies report discontinued operations on
the income statement net of tax. The allocation of tax to this item is called intraperiod
tax allocation, that is, allocation within the income statement of a period. It relates the
income tax expense (sometimes referred to as the income tax provision) of the fiscal
period to the specific items that give rise to the amount of the income tax provision.
Intraperiod tax allocation helps financial statement users better understand the
impact of income taxes on the various components of net income. For example, readers
of financial statements will understand how much income tax expense relates to “Income

13
In practice, a company will generally report only one line on the income statement, such as “Loss on
discontinued operations, net of tax,” and then in the notes explain the two components of the loss that
total $800,000. For homework purposes, report both amounts on the face of the income statement, net of tax, if both
amounts are provided.
166 Chapter 4 Income Statement and Related Information

from continuing operations” and how much to discontinued operations. This approach
helps users to better predict the amount, timing, and uncertainty of future cash flows. In
addition, intraperiod tax allocation discourages statement readers from using pretax
measures of performance when evaluating financial results, and thereby recognizes that
income tax expense is a real cost.
Companies use intraperiod tax allocation on the income statement for (1) income
from continuing operations and (2) discontinued operations. The general concept is “let
the tax follow the income.”
To compute the income tax expense attributable to “Income from continuing opera-
tions,” a company computes the income tax expense related to both the revenue and
expense transactions as well as other income and expense used in determining this
income subtotal. (In this computation, the company does not consider the tax conse-
quences of items excluded from the determination of “Income from continuing opera-
tions.”) Companies then associate a separate tax effect for discontinued operations.
Here, we look in more detail at the calculation of intraperiod tax allocation for a discon-
tinued gain or discontinued loss.

Discontinued Operations (Gain)

In applying the concept of intraperiod tax allocation, assume that Schindler Co. has
income before income tax of $250,000. It has a gain of $100,000 from a discontinued
operation. Assuming a 30 percent income tax rate, Schindler presents the following
information on the income statement.

ILLUSTRATION 4-9
Intraperiod Tax Allocation, Income before income tax $250,000
Income tax 75,000
Discontinued Operations
Gain Income from continuing operations 175,000
Gain on discontinued operations $100,000
Less: Applicable income tax 30,000 70,000
Net income $245,000

Schindler determines the income tax of $75,000 ($250,000 × 30%) attributable to

“Income before income tax” from revenue and expense transactions related to this
income. Schindler omits the tax consequences of items excluded from the determination
of “Income before income tax.” The company shows a separate tax effect of $30,000
related to the “Gain on discontinued operations.”

Discontinued Operations (Loss)

To illustrate the reporting of a loss from discontinued operations, assume that
Schindler Co. has income before income tax of $250,000. It also has a loss from discon-
tinued operations of $100,000. Assuming a 30 percent tax rate, Schindler presents the
income tax on the income statement as shown in Illustration 4-10. In this case, the loss
provides a positive tax benefit of $30,000. Schindler, therefore, subtracts it from the
$100,000 loss.

ILLUSTRATION 4-10
Intraperiod Tax Allocation, Income before income tax $250,000
Income tax 75,000
Discontinued Operations
Loss Income from continuing operations 175,000
Loss from discontinued operations $100,000
Less: Applicable income tax reduction 30,000 70,000
Net income $105,000
 Reporting Various Income Items 167

Companies may also report the tax effect of a discontinued item by means of a note
disclosure, as illustrated below.

ILLUSTRATION 4-11
Income before income tax $250,000 Note Disclosure of
Income tax 75,000
Intraperiod Tax Allocation
Income from continuing operations 175,000
Loss on discontinued operations, less applicable
income tax reduction (Note 1) 70,000
Net income $105,000

Note 1: During the year, the Company suffered a loss on discontinuing operations of $70,000, net of
applicable income tax reduction of $30,000.

Noncontrolling Interest
A company like The Coca-Cola Company owns substantial interests in other companies.
Coca-Cola generally consolidates the financial results of these companies into its own
financial statements. In these cases, Coca-Cola is referred to as the parent, and the other
companies are referred to as subsidiaries. Noncontrolling interest is then the portion of
equity (net assets) interest in a subsidiary not attributable to the parent company.
To illustrate, assume that Coca-Cola acquires 70 percent of the outstanding stock of
Koch Company. Because Coca-Cola owns more than 50 percent of Koch, it consolidates
Koch’s financial results with its own. Consolidated net income is then allocated to the
controlling (Coca-Cola) and noncontrolling stockholders’ percentage of ownership in
Koch. In other words, under this arrangement, the ownership of Koch is divided into
two classes: (1) the majority interest represented by stockholders who own the control-
ling interest, and (2) the noncontrolling interest (sometimes referred to as the minority
interest) represented by stockholders who are not part of the controlling group. When
Coca-Cola prepares a consolidated income statement, GAAP requires that net income
be allocated to the controlling and noncontrolling interest. This allocation is reported at
the bottom of the income statement, after net income.
An example of how Coca-Cola reports its noncontrolling interest is shown in Illus-
tration 4-12.

ILLUSTRATION 4-12
The Coca-Cola Company Presentation of
(in millions)
Noncontrolling Interest
Consolidated net income $7,124
Less: Net income attributable to noncontrolling interests 26
Net income attributable to stockholders of The Coca-Cola Company $7,098

The noncontrolling interest amounts are not an expense or dividend, but are allocations
of net income (loss) to the noncontrolling interest. [4]

Earnings per Share

A company customarily sums up the results of its operations in one important figure: net
income. However, the financial world has widely accepted an even more distilled and
compact figure as the most significant business indicator—earnings per share (EPS).
The computation of earnings per share is usually straightforward. Earnings per
share is net income minus preferred dividends (income available to common stock-
holders), divided by the weighted average of common shares outstanding.14
14
In calculating earnings per share, companies deduct preferred dividends from net income if the dividends
are declared or if they are cumulative though not declared. Only the net income attributable to the
controlling interest should be used in computing earnings per share.
168 Chapter 4 Income Statement and Related Information

To illustrate, assume that Lancer, Inc. reports net income of $350,000. It declares and
pays preferred dividends of $50,000 for the year. The weighted-average number of com-
mon shares outstanding during the year is 100,000 shares. Lancer computes earnings
per share of $3, as shown in Illustration 4-13.

ILLUSTRATION 4-13
Equation Illustrating Net Income − Preferred Dividends
= Earnings per Share
Computation of Earnings Weighted-Average Common Shares Outstanding
per Share
$350,000 − $50,000
= $3
100,000

Note that EPS measures the number of dollars earned by each share of common
stock. It does not represent the dollar amount paid to stockholders in the form of
dividends.
Prospectuses, proxy material, and annual reports to stockholders commonly use the
“net income per share” or “earnings per share” ratio. The financial press, statistical ser-
vices like Standard & Poor’s, and Wall Street securities analysts also highlight EPS.
Because of its importance, companies must disclose earnings per share on the face of
the income statement. A company that reports a discontinued operation must report
per share amounts for this line item either on the face of the income statement or in the
notes to the financial statements. [5]
To illustrate, an excerpt from the income statement for Poquito Industries Inc. is
presented in Illustration 4-14 (taken from Illustration 4-8 on page 165). Notice the per
share information presented at the bottom. Assume that the company had 100,000
shares outstanding for the entire year. The Poquito income statement, as Illustration
4-14 shows, is highly condensed. As discussed, Poquito would need to describe items
such as “Discontinued operations” fully and appropriately in the statement or related
notes.

ILLUSTRATION 4-14
POQUITO INDUSTRIES INC.
Income Statement
INCOME STATEMENT (partial)
FOR THE YEAR ENDED DECEMBER 31, 2017

Income from continuing operations $276,000

Discontinued operations
Income from operations of Pizza Division, less
applicable income tax of $24,800 $54,000
Loss on disposal of Pizza Division, less
applicable income tax of $41,000 90,000 36,000
Net income $240,000

Per share of common stock

Income from continuing operations $2.76
Income from operations of discontinued division, net of tax 0.54
Loss on disposal of discontinued operation, net of tax 0.90
Net income $2.40

As indicated earlier, many corporations have simple capital structures that include
only common stock. For these companies, a presentation such as “Earnings per common
share” is appropriate on the income statement. In many instances, however, companies’
 Reporting Various Income Items 169

earnings per share are subject to dilution (reduction) in the future because existing con-
tingencies permit the issuance of additional common shares. [6]15

Summary of Various Income Items

Because of the numerous intermediate income figures created by the reporting of non-
recurring items, readers must carefully evaluate earnings information reported by the
financial press. Illustration 4-15 summarizes the basic concepts that we previously dis-
cussed. Although simplified, the chart provides a useful framework for determining the
treatment of special items affecting the income statement. ILLUSTRATION 4-15
Summary of Various Items
in the Income Statement

Type of Situation Criteria Examples Placement on Income Statement

Unusual or Material unusual, infrequent, Write-downs of receivables, Reported in “Other revenues and
infrequent gains or both. inventories, property, and gains” or “Other expenses and
or losses intangibles; restructurings; losses” section. (Not shown
gains or losses from sales of net of tax.)
assets used in business.
Discontinued Elimination of the results of Sale by diversified company of Show in separate section after
operations operations of a component of major division that represents continuing operations. (Shown
the business with cash flows only activities in electronics in- net of tax.)
that can be clearly distinguished dustry. Food distributor that
and for which the elimination sells wholesale to supermarket
represents a strategic shift. chains and through fast-food
restaurants decides to discontinue
the division that sells to one of two
classes of customers.
Noncontrolling Allocation of net income or loss Net income (loss) attributable to Report as a separate item
interest divided between two classes: noncontrolling shareholders. below net income or loss as an
(1) the majority interest allocation of the net income or
represented by the shareholders loss (not as an item of
who own the controlling interest, income or expense).
and (2) the noncontrolling interest
(often referred to as the
minority interest).
Earnings per share Must be reported on the face of the Net income minus preferred dividends Report separate EPS for
income statement. divided by weighted-average income from continuing
shares outstanding operations (if applicable) and
net income.

WHAT DO THE NUMBERS MEAN? DIFFERENT INCOME CONCEPTS

As mentioned in the opening story, the FASB has a project examined the recast statements and commented on their
related to presentation of financial statements. In 2008, it usefulness.
issued an exposure draft that presented examples of what One part of the field test asked analysts to indicate which
these new financial statements might look like. The Board primary performance metric they use or create from a com-
also conducted field tests on two groups: preparers and pany’s income statement. They were provided with the foll-
users. Preparers were asked to recast their financial owing options: (a) Net income; (b) Pretax income; (c) Income
statements and then comment on the results. Users before interest and taxes (EBIT); (d) Income before interest,

15
The earnings per share effects of noncontrolling interest should also be presented. In addition, the amounts
of income from continuing operations and discontinued operations (if present) attributable to the controlling
interest should be disclosed. We discuss the computational problems involved in these situations for
earnings per share computations in Chapter 16.
170 Chapter 4 Income Statement and Related Information

taxes, depreciation, and amortization (EBITDA); (e) Operating

What Metrics Do Analysts Create from the Income
Statement? income; (f) Comprehensive income; and (g) Other. The adja-
Net income
cent chart highlights their responses.
As indicated, Operating income (31%) and EBITDA (27%)
6% 10% 7% EBITDA
6% were identified as the two primary performance metrics that
Comprehensive income respondents use or create from a company’s income state-
13%
Operating income ment. A majority of the respondents identified a primary perfor-
31%
EBIT mance metric that uses net income as its foundation (pretax
27% income would be in this group). Clearly, users and preparers
Pretax income
look at more than just the bottom-line income number, which
Other
supports the common practice of providing subtotals within
the income statement.

Source: “FASB-IASB Report on Analyst Field Test Results,” Financial Statement Presentation Informational Board Meeting
(September 21, 2009).

LEARNING OBJECTIVE 5 OTHER REPORTING ISSUES

Understand the reporting In this section, we discuss reporting issues related to (1) accounting changes and errors,
of accounting changes (2) retained earnings statement, and (3) comprehensive income.
and errors.

Accounting Changes and Errors

Changes in accounting principle, change in estimates, and corrections of errors require
unique reporting provisions.

Changes in Accounting Principle

Changes in accounting occur frequently in practice because important events or condi-
UNDERLYING
CONCEPTS
tions may be in dispute or uncertain at the statement date. One type of accounting
change results when a company adopts a different accounting principle. Changes in
Companies can change accounting principle include a change in the method of inventory pricing from FIFO to
principles, but they
average-cost, or a change in accounting for construction contracts from the percentage-
must demonstrate that
the newly adopted
of-completion to the completed-contract method. [7]16
principle is preferable A company recognizes a change in accounting principle by making a retrospective
to the old one. Such adjustment to the financial statements. Such an adjustment recasts the prior years’
changes result in lost statements on a basis consistent with the newly adopted principle. The company records
consistency from period the cumulative effect of the change for prior periods as an adjustment to beginning
to period. retained earnings of the earliest year presented.
To illustrate, Gaubert Inc. decided in March 2017 to change from FIFO to weighted-
average inventory pricing. Gaubert’s income before income tax, using the new weighted-
average method in 2017, is $30,000. Illustration 4-16 presents the pretax income data for
2015 and 2016 for this example.

ILLUSTRATION 4-16
Excess of
Calculation of a Change in Weighted- FIFO
Accounting Principle Average over Weighted-
Year FIFO Method Average Method
2015 $40,000 $35,000 $5,000
2016 30,000 27,000 3,000
Total $8,000

16
In Chapter 22, we examine in greater detail the problems related to accounting changes, and changes in
estimates and errors.
 Other Reporting Issues 171

Illustration 4-17 shows the information Gaubert presented in its comparative

income statements, based on a 30 percent tax rate.

ILLUSTRATION 4-17
2017 2016 2015
Income Statement
Income before income tax $30,000 $27,000 $35,000 Presentation of a Change in
Income tax 9,000 8,100 10,500
Accounting Principle
Net income $21,000 $18,900 $24,500

Thus, under the retrospective approach, the company recasts the prior years’ income
numbers under the newly adopted method. This approach therefore preserves compa-
rability across years.

Changes in Accounting Estimates

Changes in accounting estimates are inherent in the accounting process. For exam-
ple, companies estimate useful lives and salvage values of depreciable assets, uncol-
lectible receivables, inventory obsolescence, and the number of periods expected to
benefit from a particular expenditure. Not infrequently, due to time, circumstances,
or new information, even estimates originally made in good faith must be changed.
A company accounts for such changes in estimates in the period of change if they
affect only that period, or in the period of change and future periods if the change
affects both.
To illustrate a change in estimate that affects only the period of change, assume that
DuPage Materials Corp. consistently estimated its bad debt expense at 1 percent of
accounts receivable. In 2017, however, DuPage determines that it must revise upward
the estimate of bad debts for accounts receivable outstanding to 2 percent, or double the
prior years’ percentage. The 2 percent rate is necessary to reduce accounts receivable to
net realizable value. Using 2 percent results in a bad debt charge of $240,000, or double
the amount using the 1 percent estimate for prior years. DuPage records the bad debt
expense and related allowance at December 31, 2017 (assuming a zero balance in the
allowance), as follows.

Bad Debt Expense 240,000

Allowance for Doubtful Accounts 240,000

DuPage includes the entire change in estimate in 2017 income because the change
does not affect future periods. Companies do not handle changes in estimate retro-
spectively. That is, such changes are not carried back to adjust prior years. Changes in
estimate are not considered errors.

Corrections of Errors
Errors occur as a result of mathematical mistakes, mistakes in the application of
accounting principles, or oversight or misuse of facts that existed at the time finan-
cial statements were prepared. In recent years, many companies have corrected for
errors in their financial statements. The errors involved such items as improper
reporting of revenue, accounting for stock compensation, allowances for receivables,
inventories, and other provisions.
Companies correct errors by making proper entries in the accounts and reporting
the corrections in the financial statements. 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. If a
172 Chapter 4 Income Statement and Related Information

company prepares comparative financial statements, it should restate the prior state-
ments for the effects of the error.
To illustrate, in 2018, Hillsboro Co. determined that it incorrectly overstated its
accounts receivable and sales revenue by $100,000 in 2017. In 2018, Hillsboro makes the
following entry to correct for this error (ignore income taxes).

Retained Earnings 100,000

Accounts Receivable 100,000

Beginning retained earnings is debited in 2018 because sales revenue, and there-
fore net income, was overstated in 2017 (hence, Retained Earnings was overstated).
Accounts Receivable is credited to reduce this overstated balance to the correct
amount.

Summary
The impact of changes in accounting principle and error corrections are debited or cred-
ited directly to retained earnings for the amounts related to prior periods. Illustration
4-18 summarizes the basic concepts related to these two items, as well as the accounting
and reporting for changes in estimates. Although simplified, the chart provides a useful
framework for determining the treatment of special items affecting the income
statement.
ILLUSTRATION 4-18
Summary of Accounting
Changes and Errors

Type of Situation Criteria Examples Placement on Income Statement

Changes in Change from one generally Change in the basis of inventory Recast prior years’ income
accounting accepted accounting principle pricing from FIFO to average- statement on the same basis as
principle to another. cost. the newly adopted principle.
(Shown net of tax.)
Changes in Normal, recurring corrections and Changes in the realizability of Show change only in the affected
estimates adjustments. receivables and inventories; accounts in current and future
changes in estimated lives of periods. (Not shown net of tax.)
equipment, intangible assets;
changes in estimated liability for
warranty costs, income taxes,
and salary payments.
Corrections of Mistake, misuse of facts. Error in reporting income and Treat as prior period adjustment;
errors expenses. restate prior years’ income
statements to correct for error.
(Shown net of tax.)

LEARNING OBJECTIVE 6 Retained Earnings Statement

Prepare a retained Net income increases retained earnings. A net loss decreases retained earnings. Both
earnings statement. cash and stock dividends decrease retained earnings. Changes in accounting principles
(generally) and prior period adjustments may increase or decrease retained earnings.
Companies charge or credit these adjustments (net of tax) to the opening balance of
retained earnings. This excludes the adjustments from the determination of net income
for the current period.
Companies may show retained earnings information in different ways. For exam-
ple, some companies prepare a separate retained earnings statement, as Illustration 4-19
shows.