Chapter 4 The Income Statement Comprehensive Income and Statement of Cash Flows PART A The purpose of the income statement sometimes called the Statement of operations or statement of earnings is to summarize the profit generating activities that occurred during a particular reporting period o Many investors and creditors perceive it as the statement most useful for predicting future profitability future cash generating ability The purpose of the statement of cash flows is to provide information about the cash receipts and cash disbursements of an enterprise that occurred during a period Unlike the balance sheet which is a position statement the income statement and the statement of cash flows are change statements THE INCOME STATEMENT AND COMPREHENSIVE INCOME The need to provide information to help analysts predict future cash flows emphasizes the importance of properly reporting the amount of income from the entity s continuing operations Clearly it s the operating transactions that probably will continue into the future that are the best predictors of future cash flows The components of income from continuing operations are revenues expenses including income taxes gains and losses excluding those related to discontinued operations and extraordinary items Revenues Expenses Gains and Losses Revenues are inflows of resources resulting from providing goods services to customers Expenses are outflows of resources incurred while generating revenue o The costs of providing the services The matching principle is a key player in the way we measure expense Gains and losses are increases or decreases in equity from peripheral or incidental transactions of an entity o Result from changes in equity that don t result directly from operations but nonetheless are related to those activities Income Tax Expense Income taxes represent a major expense to a corporation and accordingly income tax expense is given special treatment in the income statement Because of the importance of the size of income tax expense it always is reported as a separate expense in corporate income statements Federal state and sometimes local taxes are assessed annually and usually are determined by first applying a designated percentage or percentages the tax rate or rates to taxable income Taxable income comprises revenues expenses gains and losses as measured according to the regulations of the appropriate taxing authority o Many of the components of taxable income and income reported in the income statement coincide o But sometimes tax rules and GAAP differ with respect to when and even whether a particular revenue or expense is included in income When tax rules and GAAP differ regarding the timing of revenue or expense recognition the actual payment of taxes may occur in a period different from when income tax expense is reported in the income statements At this point consider income tax expense to be simply a percentage of income before taxes Operating versus Nonoperating Income Many corporate income statements distinguish between operating income and nonoperating income Operating income includes revenues and expenses directly related to the primary revenue generating activities of the company Nonoperating income relates to peripheral or incidental activities of the company o Other income expense Income Statement Formats No specific standards dictate how income from continuing operations must be displayed so companies have considerable latitude in how they present the components of income from continuing operations The flexibility has resulted in a variety of income statement presentations o o Single step and multi step The single step format first lists all the revenues and gains included in income from continuing operations Then expense and losses are grouped subtotaled and subtracted to get income from continuing operations The multi step format reports a series of intermediate subtotals such as gross profit operating income and income before taxes o Can be useful in analyzing trends Net income is the same regardless of the format used Multi step format is used more than 5 times as often as the single step format Earnings Quality Earnings quality is used as a framework for more in depth discussion of operating and nonoperating income The term earnings quality refers to the ability of reported earnings income to predict a company s future earnings o An income statement reports on events that already have occurred o The relevance of any historical based financial statement hinges on its predicative value To enhance predicative values analysts try to separate a company s transitory earnings effects from its permanent earnings Transitory earnings effects results from transactions or events that aren t likely to occur again in the foreseeable future or that are likely to have a different impact on earnings in the future Manipulating Income and Income Smoothing Two major methods are used for manipulating income 1 Income shifting i Accelerating or delaying the recognition of revenue or expenses 1 For example a practice called channel stuffing accelerate revenue recognition by persuading distributors to purchase more of your product than necessary near the end of the reporting period 2 Income statement classification i The most common income statement classification manipulation involves the inclusion of recurring operating expenses in special charge categories such as restructuring costs 1 This practice is sometimes referred to as big bath accounting a reference to cleaning up company balance sheets To improve transparency of financial statements Operating Income and Earnings Quality Not all items of revenue and expense in included in operating income should be considered indicative of a company s permanent earnings o Sometimes operating income includes unusual items that may or may not continue in the future RESTRUCTURING COSTS Its not usual for a company to reorganize its operations to attain greater efficiency o When this happens the company often incurs significant associated restructuring costs Facility closings and related employee layoffs translate into costs incurred for severance pay and relocation costs Restructuring costs are incurred in connection with o A program that s planned and controlled by management and materially changes either the scope of a business undertaken by an entity or the manner in which the business is conducted Restructuring costs are recognized in the period the exit or disposal cost