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 information to:

In summary, information in the income statement—revenues, expenses, gains, and losses—helps users evaluate past performance. It also provides insights into the likelihood of achieving a particular level of cash flows in the future.

Because net income is an estimate and reflects a number of assumptions, income statement users need to be aware of certain limitations associated with its information. Some of these limitations include:

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

So far, our discussion has highlighted the importance of information in the income statement for investment and credit decisions, including the evaluation of the company and its managers.^[37] Companies try to meet or beat Wall Street expectations so that the market price of their stock and the value of management's stock options 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 chairman, "Managing may be giving way to manipulation; integrity may be losing out to illusion."^[38] 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 revenues, expenses, gains, and losses to smooth out bumps in earnings. In most cases, companies use earnings management to increase income in the current year at the expense of income in future years. For example, they prematurely recognize sales (i.e., before earned) 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. Companies establish these reserves by using unrealistic assumptions to estimate liabilities for such items as loan losses, restructuring charges, and warranty returns. The companies then reduce these reserves in the future to increase reported income in the future.

Such earnings management negatively affects the quality of earnings if it distorts the information in a way that is less useful for predicting future earnings and cash flows. Markets rely on trust. The bond between shareholders and the company must remain strong. Investors or others losing faith in the numbers reported in the financial statements will damage U.S. capital markets. As we mentioned in the opening story, we need heightened scrutiny of income measurement and reporting to ensure the quality of earnings and investors' confidence in the income statement.

Managing earnings up or down adversely affects the quality of earnings. For example, in one of the earliest and most notable cases, W. R. Grace managed earnings down by taking excess "cookie jar" reserves in good earnings years. During the early 1990s, Grace was growing fast, with profits increasing 30 percent annually. Analysts' targets had Grace growing 24 percent each year. Worried about meeting these growth expectations, Grace began stashing away excess profits in an all-purpose reserve (a "cookie jar"). In 1995, when profits fell below expectations, Grace wanted to reduce this reserve and so increase income. The SEC objected, noting this violated generally accepted accounting principles.

As another example, MicroStrategy managed earnings up by booking revenue for future software upgrades, even though it had not yet delivered them. And Rent-Way, Inc. managed its earnings up by understating some $65 million in expenses relating to such items as automobile maintenance and insurance payments.

Does the market value accounting quality? Apparently so: The stock of each of these companies took a beating in the marketplace when the earnings management practices came to light. For example, Rent-Way's stock price plummeted from above $25 per share to below $10 per share when it announced restatements for its improper expense accounting. So, whether managing earnings up or down, companies had better be prepared to pay the price for poor accounting quality.

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.^[39] The statement can further classify income by customer, product line, or function or by operating and nonoperating, continuing and discontinued, and regular and irregular categories.^[40] The following lists more formal definitions of income-related items, referred to as the major elements of the income statement.

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, 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 decision 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 elements shown in some detail and in comparison with prior years' data allows decision makers to better assess future income and cash flows.

In reporting revenues, gains, expenses, and losses, companies often use a format known as the single-step income statement. 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 expression "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 4-1 shows the single-step income statement of Dan Deines Company.

Figure 4-1. Single-Step Income Statement

Companies that use the single-step income statement in financial reporting typically do so because of its simplicity. In recent years, though, the multiple-step form has gained popularity.^[42]

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.

Some contend that including other important revenue and expense classifications makes the income statement more useful. These further classifications include:

Companies use a multiple-step income statement to recognize these additional relationships. This statement separates operating transactions from nonoperating transactions, and matches costs and expenses with related revenues. It highlights certain intermediate components of income that analysts use to compute ratios for assessing the performance of the company.

Intermediate Components of the Income Statement

When a company uses a multiple-step income statement, it may prepare some or all of the following sections or subsections.

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.

Usually, financial statements provided to external users have less detail than internal management reports. Internal reports include more expense categories—usually grouped along lines of responsibility. This detail allows top management to judge staff performance. Irregular transactions such as discontinued operations and extraordinary items are reported separately, following income from continuing operations.

Dan Deines Company's statement of income illustrates the multiple-step income statement. This statement, shown in Illustration 4-2 (on page 138), includes items 1, 2, 3, and 6 from the list above.^[43] Note that in arriving at net income, the statement presents three subtotals of note:

The disclosure of net sales revenue is useful because Deines reports regular revenues as a separate item. It discloses irregular 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 performance 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 regular and irregular or incidental activities. This disclosure helps users recognize that incidental or irregular activities are unlikely to continue at the same level. Furthermore, disclosure of operating earnings may assist in comparing different companies and assessing operating efficiencies.

Figure 4-2. Multiple-Step Income Statement

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 Dan Deines Company. This statement is a condensed version of the more detailed multiple-step statement presented earlier. It is more representative of the type found in practice.

Figure 4-3. Condensed Income Statements

Illustration 4-4 shows an example of a supporting schedule, cross-referenced as Note D and detailing the selling expenses.

Figure 4-4. Sample Supporting Schedule

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 showed above, the income statement always includes certain basic elements, but companies can present them in various formats.

Which number—net income or income from operations—should an analyst use in evaluating companies that have unusual items? Some argue that operating income better represents what will happen in the future. Others note that special items are often no longer special. For example, one study noted that in 2001, companies in the Standard & Poor's 500 index wrote off items totaling $165 billion—more than in the prior five years combined.

A study by Multex.com and the Wall Street Journal indicated that analysts should not ignore these charges. Based on data for companies taking unusual charges from 1996–2001, the study documented that companies reporting the largest unusual charges had more negative stock price performance following the charge, compared to companies with smaller charges. Thus, rather than signaling the end of bad times, these unusual charges indicated poorer future earnings.

In fact, some analysts use these charges to weed out stocks that may be headed for a fall. Following the "cockroach theory," any charge indicating a problem raises the probability of more problems. Thus, investors should be wary of the increasing use of restructuring and other one-time charges, which may bury expenses that signal future performance declines.

Source: Adapted from J. Weil and S. Liesman, "Stock Gurus Disregard Most Big Write-offs, But They Often Hold Vital Clues to Outlook," Wall Street Journal Online (December 31, 2001).

International Insight

In many countries the "modified all-inclusive" income statement approach does not parallel that of the U.S. For example, companies in these countries take some gains and losses directly to owners' equity accounts instead of reporting them on the income statement.

So, what to do? The accounting profession has adopted a modified all-inclusive concept and requires application of this approach in practice. This approach indicates that companies record most items, including irregular ones, as part of net income.^[47] In addition, companies are required to highlight irregular items in the financial statements so that users can better determine the long-run earning power of the company.

Irregular items fall into six general categories, which we discuss in the following sections:

As Illustration 4-5 shows, one of the most common types of irregular items is discontinued operations. A discontinued operation occurs when two things happen: (a) a company eliminates the results of operations and cash flows of a component from its ongoing operations, and (b) there is no significant continuing involvement in that component after the disposal transaction.

To illustrate a component, S. C. Johnson manufactures and sells consumer products. It has several product groups, each with different product lines and brands. For S. C. Johnson, a product group is the lowest level at which it can clearly distinguish the operations and cash flows from the rest of the company's operations. Therefore each product group is a component of the company. If a component were disposed of, S. C. Johnson would classify it as a discontinued operation.

Here is another example. Assume that Softso Inc. has experienced losses with certain brands in its beauty-care products group. As a result, Softso decides to sell that part of its business. It will discontinue any continuing involvement in the product group after the sale. In this case, Softso eliminates the operations and the cash flows of the product group from its ongoing operations, and reports it as a discontinued operation.

On the other hand, assume Softso decides to remain in the beauty-care business but will discontinue the brands that experienced losses. Because Softso cannot differentiate the cash flows from the brands from the cash flows of the product group as a whole, it cannot consider the brands a component. Softso does not classify any gain or loss on the sale of the brands as a discontinued operation.

Companies report as discontinued operations (in a separate income statement category) 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 operations but before extraordinary items. [1]

To illustrate, Multiplex Products, Inc., a highly diversified company, decides to discontinue 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 shows the information on the current year's income statement as follows.

Figure 4-6. Income Statement Presentation of Discontinued Operations

Companies use the phrase "Income from continuing operations" only when gains or losses on discontinued operations occur.

Extraordinary items are nonrecurring material items that differ significantly from a company's typical business activities. The criteria for extraordinary items are as follows.

Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence. Classifying an event or transaction as an extraordinary item requires meeting both of the following criteria:

For further clarification, the following gains and losses are not extraordinary items.

International Insight

Special reporting for extraordinary items is prohibited under international financial reporting standards (iGAAP).

The above items are not considered extraordinary "because they are usual in nature and may be expected to recur as a consequence of customary and continuing business activities."

Only rarely does an event or transaction clearly meet the criteria for an extraordinary item.^[48] For example, a company classifies gains or losses such as (a) and (d) above as extraordinary if they resulted directly from a major casualty (such as an earthquake), an expropriation, or a prohibition under a newly enacted law or regulation. Such circumstances clearly meet the criteria of unusual and infrequent. For example, Weyerhaeuser Company (forest and lumber) incurred an extraordinary item (an approximate $36 million loss) as a result of volcanic activity at Mount St. Helens. The eruption destroyed standing timber, logs, buildings, equipment, and transportation systems covering 68,000 acres.

In determining whether an item is extraordinary, a company must consider the environment in which it operates. The environment includes such factors as industry characteristics, geographic location, and the nature and extent of governmental regulations. Thus, the FASB accords extraordinary item treatment to the loss from hail damages to a tobacco grower's crops if hailstorm damage in its locality is rare. On the other hand, frost damage to a citrus grower's crop in Florida does not qualify as extraordinary because frost damage normally occurs there every three or four years.

Similarly, when a company sells the only significant security investment it has ever owned, the gain or loss meets the criteria of an extraordinary item. Another company, however, that has a portfolio of securities acquired for investment purposes would not report such a sales as an extraordinary item. Sale of such securities is part of its ordinary and typical activities.

In addition, considerable judgment must be exercised in determining whether to report an item as extraordinary. For example, the government condemned the forestlands of some paper companies to preserve state or national parks or forests. Is such an event extraordinary, or is it part of a paper company's normal operations? Such determination is not easy. Much depends on the frequency of previous condemnations, the expectation of future condemnations, materiality, and the like.^[49]

No event better illustrates the difficulties of determining whether a transaction meets the definition of extraordinary than the financial impacts of the terrorist attack on the World Trade Center on September 11, 2001.

To many, this event, which resulted in the tragic loss of lives, jobs, and in some cases, entire businesses, clearly meets the criteria for unusual and infrequent. For example, in the wake of the terrorist attack that destroyed the World Trade Center and turned much of lower Manhattan including Wall Street into a war zone, airlines, insurance companies, and other businesses recorded major losses due to property damage, business disruption, and suspension of airline travel and of securities trading.

But, to the surprise of many, the FASB did not permit extraordinary item reporting for losses arising from the terrorist attacks. The reason? After much deliberation, the Emerging Issues Task Force (EITF) of the FASB decided that measurement of the possible loss was too difficult. Take the airline industry as an example: What portion of the airlines' losses after September 11 was related to the terrorist attack, and what portion was due to the ongoing recession? Also, the FASB did not want companies to use the attack as a reason for reporting as extraordinary some losses that had little direct relationship to the attack. Indeed, energy company AES and shoe retailer Footstar, who both were experiencing profit pressure before 9/11, put some of the blame for their poor performance on the attack.

Source: Julie Creswell, "Bad News Bearers Shift the Blame," Fortune (October 15, 2001), p. 44.

Companies must show extraordinary items net of taxes in a separate section in the income statement, usually just before net income. After listing the usual revenues, expenses, and income taxes, the remainder of the statement shows the following.

Figure 4-7. Income Statement Placement of Extraordinary Items

For example, Illustration 4-8 shows how Keystone Consolidated Industries reported an extraordinary loss.

Figure 4-8. Income Statement Presentation of Extraordinary Items

Because of the restrictive criteria for extraordinary items, financial statement users must carefully examine the financial statements for items that are unusual or infrequent but not both. Recall that companies cannot consider items such as write-downs of inventories and transaction gains and losses from fluctuation of foreign exchange as extraordinary items. Thus, companies sometimes show these items with their normal recurring revenues and expenses. If not material in amount, companies combine these with other items in the income statement. If material, companies must disclose them separately, and report them above "Income (loss) before extraordinary items."

For example, PepsiCo, Inc. presented an unusual charge in its income statement, as Illustration 4-9 shows.

Figure 4-9. Income Statement Presentation of Unusual Charges

Restructuring charges, like the one PepsiCo reported, have been common in recent years (see also Illustration 4-5). A restructuring charge relates to a major reorganization of company affairs, such as costs associated with employee layoffs, plant closing costs, write-offs of assets, and so on. A company should not report a restructuring charge as an extraordinary item, because these write-offs are part of a company's ordinary and typical activities.

Companies tend to report unusual items in a separate section just above "Income from operations before income taxes" and "Extraordinary items," especially when there are multiple unusual items. For example, when General Electric Company experienced multiple unusual items in one year, it reported them in a separate "Unusual items" section of the income statement below "Income before unusual items and income taxes." When preparing a multiple-step income statement for homework purposes, you should report unusual gains and losses in the "Other revenues and gains" or "Other expenses and losses" section unless you are instructed to prepare a separate unusual items section.^[50]

In dealing with events that are either unusual or nonrecurring but not both, the profession attempted to prevent a practice that many believed was misleading. Companies often reported such transactions on a net-of-tax basis and prominently displayed the earnings per share effect of these items. Although not captioned "Extraordinary items," companies presented them in the same manner. Some had referred to these as "first cousins" to extraordinary items.

As a consequence, the Board specifically prohibited a net-of-tax treatment for such items, to ensure that users of financial statements can easily differentiate extraordinary items—reported net of tax—from material items that are unusual or infrequent, but not both.

Changes in accounting occur frequently in practice, because important events or conditions 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 accounting principle include a change in the method of inventory pricing from FIFO to average cost, or a change in accounting for construction contracts from the percentage-of-completion to the completed-contract method. [5]^[51]

Companies can change principles, but they must demonstrate that the newly adopted principle is preferable to the old one. Such changes result in lost consistency from period to period.

A company recognizes a change in accounting principle by making a retrospective adjustment to the financial statements. Such an adjustment recasts the prior years' statements on a basis consistent with the newly adopted principle. The company records the cumulative effect of the change for prior periods as an adjustment to beginning retained earnings of the earliest year presented.

To illustrate, Gaubert Inc. decided in March 2010 to change from FIFO to weighted-average inventory pricing. Gaubert's income before taxes, using the new weighted-average method in 2010, is $30,000. Illustration 4-10 (on page 146) presents the pretax income data for 2008 and 2009 for this example.

Figure 4-10. Calculation of a Change in Accounting Principle

Illustration 4-11 shows the information Gaubert presented in its comparative income statements, based on a 30 percent tax rate.

Figure 4-11. Income Statement Presentation of a Change in Accounting Principle

Thus, under the retrospective approach, the company recasts the prior years' income numbers under the newly adopted method. This approach thus preserves comparability across years.

Estimates are inherent in the accounting process. For example, companies estimate useful lives and salvage values of depreciable assets, uncollectible 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 credit sales. In 2010 however, DuPage determines that it must revise upward the estimate of bad debts for the current year's credit sales 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 provision at December 31, 2010, as follows.

DuPage includes the entire change in estimate in 2010 income because the change does not affect future periods. Companies do not handle changes in estimate retrospectively. That is, such changes are not carried back to adjust prior years. (We examine changes in estimate that affect both the current and future periods in greater detail in Chapter 22.) Changes in estimate are not considered errors or extraordinary items.

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 financial statements were prepared. In recent years, many companies have corrected for errors in their financial statements. For example, one consulting group noted that over 1,300 companies (10 percent of U.S. public companies) reported error-driven restatements in 2007. The errors involved such items as improper reporting of revenue, accounting for stock options, allowances for receivables, inventories, and loss contingencies.^[52]

Companies must 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 company prepares comparative financial statements, it should restate the prior statements for the effects of the error.

To illustrate, in 2011, Hillsboro Co. determined that it incorrectly overstated its accounts receivable and sales revenue by $100,000 in 2010. In 2011, Hillboro makes the following entry to correct for this error (ignore income taxes).

Retained Earnings is debited because sales revenue, and therefore net income, was overstated in a prior period. Accounts Receivable is credited to reduce this overstated balance to the correct amount.

The AICPA Special Committee on Financial Reporting indicates a company's core activities—usual and recurring events—provide the best historical data from which users determine trends and relationships and make their predictions about the future. Therefore, companies should separately display the effects of core and non-core activities.

The public accounting profession now tends to accept a modified all-inclusive income concept instead of the current operating performance concept. Except for changes in accounting principle and error corrections, which are charged or credited directly to retained earnings, companies close all other irregular gains or losses or nonrecurring items to Income Summary and include them in the income statement.

Of these irregular items, companies classify discontinued operations of a component of a business as a separate item in the income statement, after "Income from continuing operations." Companies show the unusual, material, nonrecurring items that significantly differ from the typical or customary business activities in a separate "Extraordinary items" section below "Discontinued operations." They separately disclose other items of a material amount that are of an unusual or nonrecurring nature and are not considered extraordinary.

Because of the numerous intermediate income figures created by the reporting of these irregular items, readers must carefully evaluate earnings information reported by the financial press. Illustration 4-12 (on page 148) summarizes the basic concepts that we previously discussed. Although simplified, the chart provides a useful framework for determining the treatment of special items affecting the income statement.

Figure 4-12. Summary of Irregular Items in the Income Statement

Companies report irregular items (except for unusual gains and losses) on the income statement or statement of retained earnings net of tax. This procedure is called intraperiod tax allocation, that is, allocation within 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 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 from continuing operations" and how much relates to certain irregular transactions and events. This approach should help 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 the following items: (1) income from continuing operations, (2) discontinued operations, and (3) extraordinary items. The general concept is "let the tax follow the income."

To compute the income tax expense attributable to "Income from continuing operations," a company would find the income tax expense related to both the revenue and expense transactions used in determining this income. (In this computation, the company does not consider the tax consequences of items excluded from the determination of "Income from continuing operations.") Companies then associate a separate tax effect with each irregular item (e.g., discontinued operations and extraordinary items). Here we look in more detail at calculation of intraperiod tax allocation for extraordinary gains and losses.

Extraordinary Gains

In applying the concept of intraperiod tax allocation, assume that Schindler Co. has income before income tax and extraordinary item of $250,000. It has an extraordinary gain of $100,000 from a condemnation settlement received on one its properties. Assuming a 30 percent income tax rate, Schindler presents the following information on the income statement.

Figure 4-13. Intraperiod Tax Allocation, Extraordinary Gain

Schindler determines the income tax of $75,000 ($250,000 × 30%) attributable to "Income before income tax and extraordinary item" 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 and extraordinary item." The company shows a separate tax effect of $30,000 related to the "Extraordinary gain—condemnation settlement."

Extraordinary Losses

To illustrate the reporting of an extraordinary loss, assume that Schindler Co. has income before income tax and extraordinary item of $250,000. It suffers an extraordinary loss from a major casualty of $100,000. Assuming a 30 percent tax rate, Schindler presents the income tax on the income statement as shown in Illustration 4-14. In this case, the loss provides a positive tax benefit of $30,000. Schindler, therefore, subtracts it from the $100,000 loss.

Figure 4-14. Intraperiod Tax Allocation, Extraordinary Loss

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

Figure 4-15. Note Disclosure of Intraperiod Tax Allocation

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 stockholders), divided by the weighted average of common shares outstanding.^[53]

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 common shares outstanding during the year is 100,000 shares. Lancer computes earnings per share of $3, as shown in Illustration 4-16.

Figure 4-16. Equation Illustrating Computation of Earnings per Share

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 services 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 or an extraordinary item must report per share amounts for these line items either on the face of the income statement or in the notes to the financial statements. [6]

To illustrate, consider the income statement for Poquito Industries Inc. shown in Illustration 4-17 (on page 151). Notice the order in which Poquito shows the data, with per share information at the bottom. Assume that the company had 100,000 shares outstanding for the entire year. The Poquito income statement, as Illustration 4-17 shows, is highly condensed. Poquito would need to describe items such as "Unusual charge," "Discontinued operations," and "Extraordinary item" fully and appropriately in the statement or related notes.

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' earnings per share are subject to dilution (reduction) in the future because existing contingencies permit the issuance of additional common shares. [7]^[54]

In summary, the simplicity and availability of EPS figures lead to their widespread use. Because of the importance that the public, even the well-informed public, attaches to earnings per share, companies must make the EPS figure as meaningful as possible.

Figure 4-17. Income Statement

Net income increases retained earnings. A net loss decreases retained earnings. Both 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 example, some companies prepare a separate retained earnings statement, as Illustration 4-18 shows.

Figure 4-18. Retained Earnings Statement

The reconciliation of the beginning to the ending balance in retained earnings provides information about why net assets increased or decreased during the year. The association of dividend distributions with net income for the period indicates what management is doing with earnings: It may be "plowing back" into the business part or all of the earnings, distributing all current income, or distributing current income plus the accumulated earnings of prior years.^[55]

Companies generally include in income all revenues, expenses, and gains and losses recognized during the period. These items are classified within the income statement so that financial statement readers can better understand the significance of various components of net income. Changes in accounting principles and corrections of errors are excluded from the calculation of net income because their effects relate to prior periods.

In recent years, there is increased use of fair values for measuring assets and liabilities. Furthermore, possible reporting of gains and losses related to changes in fair value have placed a strain on income reporting. Because fair values are continually changing, some argue that recognizing these gains and losses in net income is misleading. The FASB agrees and has identified a limited number of transactions that should be recorded directly to stockholders equity. One example is unrealized gains and losses on available-for-sale securities.^[56] These gains and losses are excluded from net income, thereby reducing volatility in net income due to fluctuations in fair value. At the same time disclosure of the potential gain or loss is provided.

Companies include these items that bypass the income statement in a measure called comprehensive income. Comprehensive income includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Comprehensive income, therefore, includes the following: all revenues and gains, expenses and losses reported in net income, and all gains and losses that bypass net income but affect stockholders' equity. These items—non-owner changes in equity that bypass the income statement—are referred to as other comprehensive income.

The FASB decided that companies must display the components of other comprehensive income in one of three ways: (1) a second income statement; (2) a combined statement of comprehensive income; or (3) as a part of the statement of stockholders' equity. [8]^[57] Regardless of the format used, companies must add net income to other comprehensive income to arrive at comprehensive income. Companies are not required to report earnings per share information related to comprehensive income.^[58]

To illustrate, assume that V. Gill Inc. reports the following information for 2010: sales revenue $800,000; cost of goods sold $600,000; operating expenses $90,000; and an unrealized holding gain on available-for-sale securities of $30,000, net of tax.

Second Income Statement

Illustration 4-19 shows the two-income statement format based on the above information for V. Gill. Reporting comprehensive income in a separate statement indicates that the gains and losses identified as other comprehensive income have the same status as traditional gains and losses. Placing net income as the starting point in the comprehensive income statement highlights the relationship of the statement to the traditional income statement.

Figure 4-19. Two-Statement Format: Comprehensive Income

Statement of Stockholders' Equity

A third approach reports other comprehensive income items in a statement of stockholders' equity (often referred to as statement of changes in stockholders' equity). This statement reports the changes in each stockholder's equity account and in total stockholders' equity during the year. Companies often prepare in columnar form the statement of stockholders' equity. In this format, they use columns for each account and for total stockholders' equity.

To illustrate, assume the same information for V. Gill. The company had the following stockholder equity account balances at the beginning of 2010: Common Stock $300,000; Retained Earnings $50,000; and Accumulated Other Comprehensive Income $60,000. No changes in the Common Stock account occurred during the year. Illustration 4-20 shows a statement of stockholders' equity for V. Gill.

Figure 4-20. Presentation of Comprehensive Income Items in Stockholders' Equity Statement

Most companies use the statement of stockholders' equity approach to provide information related to other comprehensive income. Because many companies already provide a statement of stockholders' equity, adding additional columns to display information related to comprehensive income is not costly.

Balance Sheet Presentation

Regardless of the display format used, V. Gill reports the accumulated other comprehensive income of $90,000 in the stockholders' equity section of the balance sheet as follows.

Figure 4-21. Presentation of Accumulated Other Comprehensive Income in the Balance Sheet

By providing information on the components of comprehensive income, as well as accumulated other comprehensive income, the company communicates information about all changes in net assets.^[59] With this information, users will better understand the quality of the company's earnings.

You will want to read the CONVERGENCE CORNER on page 155

for discussion of how international convergence efforts relate to the income statement.

As indicated, under iGAAP companies can prepare a statement of recognized income and expense (SoRIE). A SoRIE reports the net income or loss for the period and all the income and expense items that are included in comprehensive income but not net income until realized. Here is a SoRIE for Hulce Inc.

If a company presents information by means of a SoRIE, it would not prepare a traditional statement of stockholders' equity.

The IASB and FASB are working on a project that would rework the structure of financial statements. In phase 1 of this project, a major focus is on the reporting of revenues and expenses. What appears likely is an amendment to IAS 1 that would bring it largely into line with the equivalent U.S. GAAP, on reporting of comprehensive income, as discussed in this chapter. A proposed amendment to IAS 1 would present all income and expenses separately from changes in equity that arise from transactions with its owners. Companies would have a choice of presenting income and expenses in a single statement or in two statements (the two approaches discussed in this chapter). The option to report this information solely in the statement of stockholders' equity or by use of the SoRIE approach would not be permitted.

The second stage of this project will address the issue of how to classify various items in the income statement. A main goal of this new approach is to provide information that better represents how businesses are run. In addition, this approach draws attention away from just one number—net income.