Chapter 3 The Income Statement and Statement of Cash Flows
QUESTIONS FOR REVIEW OF KEY TOPICS
Question 3-1
The income statement is a change statement that reports
transactions — revenues, expenses, gains and losses — that cause owners’
equity to change during a specified reporting period.
Question 3-2
Income from continuing operations includes the revenue,
expense, gain and loss transactions that will probably continue in future
periods. It is important to segregate the income effects of these
items because they are the most important transactions in terms of predicting
future cash flows.
Question 3-3
Operating activities include revenues and expenses that
are directly related to the principal revenue generating activities of
the company. Nonoperating activities are not directly related to
these activities.
Question 3-4
The single-step format first lists all revenues and gains
included in income from continuing operations to arrive at total revenues
and gains. All expenses and losses are then grouped and subtotaled,
subtracted from revenues and gains to arrive at income from continuing
operations. The multiple-step format reports a series (multiple)
of intermediate totals such as gross profit, operating income, and income
before taxes. Very often income statements adopt variations of these
formats, falling somewhere in between the two extremes.
Question 3-5
The process of intraperiod tax allocation matches tax
expense or tax benefit with each major component of income, specifically
continuing operations and any item reported below continuing operations.
The process is necessary to achieve the desired result of separating the
total income effects of continuing operations from the three separately
reported items - discontinued operations, extraordinary items, and cumulative
effect of a change in accounting principle and also to show the after-tax
effect of each of those three components.
Question 3-6
A segment of the business is a component of an entity
whose activities represent a separate line of business or class of customer.
A segment may be any organizational unit whose assets, results of operations
and activities can be clearly distinguished physically and operationally
and for financial reporting purposes, from the other assets, results of
operations, and activities of the entity.
The net-of-tax income effects of a discontinued operation
must be disclosed separately on the income statement, below income from
continuing operations. The income effects must be separated into
income (loss) from operations and gain (loss) on disposal. The gain
(loss) on disposal itself is comprised of two components: (1) revenues,
expenses, gains and losses, net of income taxes, from the measurement date
to the actual disposal date (closing date), and (2) the actual gain or
loss, net of income taxes, on the sale of assets, or the estimated gain
or loss if disposal takes place subsequent to the end of the fiscal year.
The income (loss) from operations is reported separately on prior income
statements for comparative purposes.
Question 3-7
The measurement date is the date the company adopts a
formal plan to dispose of the business segment. The disposal date
is the closing date of the sale of the assets of the discontinued segment.
Income (loss) from operations includes the net-of-tax effects of the revenues,
expenses, gains and losses from the beginning of the fiscal year through
the measurement date. Gain (loss) on disposal includes revenues,
expenses, gains and losses, net of income taxes, from the measurement date
to the disposal date, the phaseout period.
Question 3-8
Extraordinary items are material gains and losses that
are both unusual in nature and infrequent in occurrence, taking into account
the environment in which the entity operates. The transaction, related
to debt that always must be reported as an extraordinary item, is a material
gain or loss from the early extinguishment of debt.
Question 3-9
Extraordinary gains and losses are presented, net-of-tax,
on the income statement below discontinued operations, if any, and above
the cumulative effect of accounting changes, if any.
Question 3-10
If a material gain or loss does not qualify as an extraordinary
item, but is either unusual or infrequent, it should be reported as a separate
line item included in continuing operations.
Question 3-11
GAAP permit alternative treatments for similar transactions.
Common examples are the choice among FIFO, LIFO, and average cost for the
measurement of inventory and the choice among different depreciation methods.
A change in accounting principle occurs when a company changes from one
generally accepted treatment to another.
The general accounting treatment for a change in accounting
principle is to show the cumulative effect of the change on the income
statement below extraordinary items. The cumulative effect of the
change is the difference between retained earnings at the beginning of
the year of the change as reported, and the beginning of year retained
earnings that would have resulted using the new accounting method.
Question 3-12
Earnings per share (EPS) is the amount of income achieved
during a period for each share of common stock outstanding. If there
are different components of income reported below continuing operations,
their effects on earnings per share must be disclosed. If a period
contains discontinued operations, extraordinary items and cumulative effects
of a change in accounting principle, EPS data must be reported separately
for income from continuing operations and net income. Per share amounts
for discontinued operations, extraordinary items, and the cumulative effect
of a change in accounting principle would be disclosed on the face of the
income statement.
Question 3-13
A change in accounting estimate is accounted for in the
year of the change and in subsequent periods; prior years’ financial statements
are not restated nor is the cumulative effect disclosed.
Question 3-14
Prior period adjustments are accounted for by restating
prior years’ financial statements when those statements are presented again
for comparison purposes. The beginning of period retained earnings
is increased or decreased on the statement of shareholders’ equity (or
the statement of retained earnings) in the year the error is discovered.
Question 3-15
The purpose of the statement of cash flows is to provide
information about the cash receipts and cash disbursements of an enterprise
during a period. Similar to the income statement, it is a change
statement, summarizing the transactions that caused cash to change during
a particular period of time.
Question 3-16
The three categories of cash flows reported on the statement
of cash flows are:
1. Operating activities — Inflows and outflows
of cash related to the transactions entering into the determination of
net income from operations.
2. Investing activities — Involve the acquisition
and sale of (1) long-term assets used in the business and (2) nonoperating
investment assets.
3. Financing activities — Involve cash inflows
and outflows from transactions with creditors and owners.
Question 3-17
Noncash investing and financing activities are transactions
that do not increase or decrease cash but are important investing and financing
activities. An example would be the acquisition of property, plant
and equipment (an investing activity) by issuing either long-term debt
or equity securities (a financing activity). These activities are
reported either in a separate schedule or in a note.
Question 3-18
The direct method of reporting cash flows from operating
activities presents the cash effect of each operating activity directly
on the statement of cash flows. The indirect method of reporting
cash flows from operating activities is derived indirectly, by starting
with reported net income and adding and subtracting items to convert that
amount to a cash basis.
EXERCISES
Exercise 3-1
Requirement 1
GREEN STAR CORPORATION
Income Statement
For the Year Ended December 31, 2000
Revenues and gains:
Sales $1,200,000
Interest and dividends
30,000
Gain on sale of equipment
50,000
Total revenues and gains
1,280,000
Expenses and losses:
Cost of goods sold $720,000
Salaries expense 110,000
Depreciation expense 50,000
Interest expense 40,000
Rent expense 25,000
Income tax expense 100,000
Total expenses and losses
1,045,000
Net income $ 235,000
Earnings per share $2.35
Requirement 2
GREEN STAR CORPORATION
Income Statement
For the Year Ended December 31, 2000
Sales revenue $1,200,000
Cost of goods sold
720,000
Gross profit 480,000
Operating expenses:
Salaries expense $110,000
Depreciation expense 50,000
Rent expense 25,000
Total operating expenses
185,000
Operating income 295,000
Other income (expense):
Interest revenue 30,000
Gain on sale of equipment 50,000
Interest expense (40,000)
Total other income, net
40,000
Income before income taxes
335,000
Income tax expense
100,000
Net income $ 235,000
Earnings per share $2.35
Exercise 3-2
Requirement 1
GENERAL LIGHTING CORPORATION
Income Statement
For the Year Ended December 31, 2000
Revenues and gains:
Sales $2,350,000
Rental revenue
80,000
Total revenues and gains
2,430,000
Expenses and losses:
Cost of goods sold $1,200,300
Salaries expense 300,000
Depreciation expense 100,000
Interest expense 90,000
Rent expense 50,000
Loss on sale of equipment
22,500
Loss from inventory write-down 200,000
Income tax expense * 186,880
Total expenses and losses
2,149,680
Income before extraordinary item Extraordinary
item:Loss from flood damage (net of $48,000 tax benefit) Net income
280,320 (72,000)$ 208,320
Earnings per share:Income before extraordinary item
Extraordinary item Net income
$ .93 (.24)
$ .69
* 40% x $467,200
Requirement 2
GENERAL LIGHTING CORPORATION
Income Statement
For the Year Ended December 31, 2000
Sales revenue $2,350,000
Cost of goods sold 1,200,300
Gross profit 1,149,700
Operating expenses:
Salaries expense $300,000
Depreciation expense 100,000
Rent expense 50,000
Loss from inventory write-down 200,000
Total operating expenses
650,000
Operating income 499,700
Other income (expense):
Rental revenue 80,000
Loss on sale of equipment (22,500)
Interest expense (90,000)
Total other income (expense),
net (32,500)
Income from continuing operations before
income taxes 467,200
Income tax expense * 186,880
Income before extraordinary item Extraordinary
item:Loss from flood damage (net of $48,000 tax benefit) Net income
280,320 (72,000)$ 208,320
Earnings per share:Income before extraordinary item
Extraordinary item Net income
$ .93 (.24)
$ .69
* 40% x $467,200
Exercise 3-3
COFFEY CORPORATION
Income Statement
For the Year Ended December 31, 2000
Sales revenue $1,600,000
Cost of goods sold
960,000
Gross profit 640,000
Operating expenses:
Selling expenses $235,000
Administrative expenses 150,000
Total operating expenses
385,000
Operating income 255,000
Other income (expense):
Interest expense
(25,000)
Income from continuing operations before
income taxes 230,000
Income tax expense *
69,000
Income before extraordinary item and cumulative
effect 161,000
Extraordinary item:Gain on early debt extinguishment
(net of $30,000 tax expense) 70,000
Income before cumulative effect of a change in
accounting principle 231,000
Cumulative effect of a change in accounting
principle (net of $24,000 tax benefit) (56,000)
Net income
$ 175,000
Earnings per share:Income before extraordinary item and
cumulative effect $1.61
Extraordinary item
.70
Cumulative effect of a change in accounting principle
(.56)
Net income
1.75
* 30% x $230,000
Exercise 3-4
AXEL CORPORATION
Income Statement
For the Year Ended December 31, 2000
Sales revenue $ 592,000
Cost of goods sold 295,000
Gross profit 297,000
Operating expenses:
Selling expenses $67,000
Administrative expenses
87,000
Restructuring costs 55,000
Total operating expenses
209,000
Operating income
88,000
Other income (expense):Interest and dividends
32,000
Interest expense
(26,000)
Total other income, net
6,000
Income from continuing operations before income
taxes 94,000
Income tax expense*
37,600
Income before extraordinary item
56,400
Extraordinary item:Gain on early debt extinguishment
(net of $34,400 tax expense) 51,600
Net income
$108,000
Earnings per share:
.56
Income before extraordinary item
Extraordinary item
.52
Net income
$1.08
* 40% x $94,000
Exercise 3-5
CHANCE COMPANY
Income Statement
For the Year Ended December 31, 2000
Income from continuing operations
$ 350,000
Discontinued operations:
Loss from operations (net of $40,000 tax benefit)
(60,000)
Loss on disposal (net of $172,000 tax benefit) *
(258,000)
Loss from discontinued operations
(318,000)
Net income $ 32,000
Earnings per share:
Income from continuing operations $ 3.50
Loss from discontinued operations (3.18)
Net income $ .32
* Loss on disposal:
Loss on sale of assets $400,000
Operating loss, 9/1 - 12/15 30,000
Total before-tax loss 430,000
Less: Income tax benefit (40%) (172,000)
Net of tax loss $258,000
Exercise 3-6
ESQUIRE COMIC BOOK COMPANY
Income Statement
For the Year Ended December 31, 2000
Income from continuing operations * $ 588,000
Discontinued operations:
Loss from operations (net of $40,000 tax benefit)
(60,000)
Loss on disposal (net of $140,000 tax benefit)
(210,000)
Loss from discontinued operations
(270,000)
Income before cumulative effect of accounting change
318,000
Cumulative effect of a change in depreciation method
(net of a $48,000 tax expense)
72,000
Net income $
390,000
* Income from continuing operations:
Income before considering additional items $1,000,000
Increase in income due to change in depreciation
method 50,000
Decrease in income due to restructuring costs
(70,000)
Before-tax income from continuing
operations 980,000
Income tax expense (40%) (392,000)
Income from continuing operations
$ 588,000
Exercise 3-7
Requirement 1
KANDON ENTERPRISES, INC.
Income Statement
For the Year Ended December 31, 2000
Income from continuing operations $ 400,000
Discontinued operations:
Loss from operations (net of $40,000 tax benefit)
(60,000)
Loss on disposal (net of $60,000 tax benefit) *
(90,000)
Loss from discontinued operations
(150,000)
Net income $
250,000
* Estimated loss on disposal:
Operating loss from 11-15-00 through 12-31-00 $
(40,000)
Estimated operating loss from 1-1-01 through estimated
disposal date
(60,000)
Estimated loss on sale of assets ($250,000 - 200,000)
(50,000)
Net before-tax estimated loss
on disposal (150,000)
Income tax benefit (40%) 60,000
Net after-tax estimated loss
on disposal $ (90,000)
Requirement 2
KANDON ENTERPRISES, INC.
Income Statement
For the Year Ended December 31, 2000
Income from continuing operations $ 400,000
Discontinued operations:
Loss from operations (net of $40,000 tax benefit)
(60,000)
Gain (loss) on disposal *
- 0 -
Loss from discontinued operations
(60,000)
Net income $ 340,000
* Estimated Gain (Loss) on disposal:
Operating loss from 11-15-00 through 12-31-00 $
(40,000)
Estimated operating loss from 1-1-01 through estimated
disposal date
(60,000)
Estimated gain on sale of assets ($400,000 - 250,000)
150,000
Net before-tax estimated gain
on disposal $ 50,000
Since a gain is estimated and there is a realized operating loss from the measurement date to the end of the fiscal year, no gain or loss on disposal is reported in 2000. A disclosure note is required.
Exercise 3-8
Requirement 1
This is a change in accounting estimate.
Requirement 2
When an estimate is revised as new information comes
to light, accounting for the change in estimate is quite straightforward.
We do not restate prior years' financial statements to reflect the new
estimate; nor do we report the cumulative effect of the change in current
income. Instead, we merely incorporate the new estimate in any related
accounting determinations from there on. If the after-tax income
effect of the change in estimate is material, the effect on net income
and earnings per share must be disclosed in a note, along with the justification
for the change.
Requirement 3
$800,000 Cost
$160,000 Old annual depreciation ($800,000
÷ 5 years)
x 2 years 320,000 Depreciation to date
(1998-1999)
480,000 Book value
÷ 6
Estimated remaining life (8 years - 2 years)
$ 80,000 New annual depreciation
Exercise 3-9
Requirement 1
This is a change in accounting principle.
Requirement 2
The cumulative income effect is reported — net of the
tax effect of the change — on the income statement as a separate item of
income, between extraordinary items and net income. The before-tax
effect is $(192,000), calculated as follows:
Cumulative effect of the change: ($ in thousands)
Straight-line
DDB
1998 depreciation $160
$320
1999 depreciation 160
192
Accumulated depreciation
and 1998-99 reduction in income $320 æ
å $512
difference
$(192)
The after-tax effect is $(115,200) = [$(192,000) x (1-.40)].
Exercise 3-10
Earnings per share:
Income from continuing operations $5.00
Loss from discontinued operations (1.60)
Extraordinary gain 2.20
Cumulative effect of accounting change
.70
Net income $6.30
Exercise 3-11
1. d
2. d
3. a
4. d
5. b
6. a
Exercise 3-12
1. b Purchase of
equipment for cash.
2. a Payment of employee
salaries.
3. a Collection of
cash from customers.
4. c Cash proceeds
from a note payable.
5. b Purchase of
common stock of another corporation for cash.
6. c Issuance of
common stock for cash.
7. b Sale of machinery
for cash.
8. a Payment of interest
on note payable.
9. d Issuance of
bonds payable in exchange for land and building.
10. c Payment of
cash dividends to shareholders.
11. c Payment of
principal on note payable.
Exercise 3-13
Bluebonnet Bakers
Statement of Cash Flows
For the Year Ended December 31, 2000
Cash flows from operating activities:
Collections from customers $ 380,000
Interest on note receivable
6,000
Purchase of inventory (160,000)
Interest on note payable (5,000)
Payment of salaries (90,000)
Net cash inflows from operating activities
$131,000
Cash flows from investing activities:
Collection of note receivable
50,000
Sale of investments
30,000
Purchase of equipment (85,000)
Net cash outflows from investing activities
(5,000)
Cash flows from financing activities:
Proceeds from note payable 100,000
Payment of note payable (25,000)
Payment of dividends (20,000)
Net cash inflows from financing activities
55,000
Net increase in cash 181,000
Cash and cash equivalents, January 1 17,000
Cash and cash equivalents, December 31 $ 198,000
Exercise 3-14
Requirement 1
Financing Investing Operating
1. $200,000
2. 4 $(10,000)
3. 4
4. 4
5. $ (5,000)
6. (6,000)
7. (60,000)
8. 55,000
9. 4
__________ __________ __________
$200,000 $(10,000) $(16,000) = $174,000
Requirement 2
Wainwright Corporation
Statement of Cash Flows
For the Month Ended March 31, 2000
Cash flows from operating activities:
Collections from customers $ 55,000
Payment of rent (5,000)
Payment of one-year insurance premium (6,000)
Payment to suppliers of merchandise for sale
(60,000)
Net cash outflows from operating activities
$ (16,000)
Cash flows from investing activities:
Purchase of equipment (10,000)
Net cash outflows from investing activities
(10,000)
Cash flows from financing activities:
Issuance of common stock
200,000
Net cash inflows from financing activities
200,000
Net increase in cash 174,000
Cash and cash equivalents, March 1
40,000
Cash and cash equivalents, March 31 $ 214,000
Noncash investing and financing activities:
Acquired $40,000 of equipment by paying cash and issuing
a note as follows:
Cost of equipment $40,000
Cash paid
10,000
Note issued $30,000
Exercise 3-15
1. c
2. d
3. b
Exercise 3-16
List A List B
f 1. Intraperiod
tax allocation a. Unusual, infrequent, and material gains and
losses.
g 2.
Measurement date b. Starts with net income and works backwards to
convert to cash.
n 3. Disposal date
c. Reports the cash effects of each operating
activity directly on the statement.
l 4. Operating
activities (income d. Correction of a material error of a prior period.
statement)
a 5. Extraordinary
items e. Related to the external financing of the company.
m 6. Segment (according
to APBO 30) f. Associates tax with income statement item.
k 7. Gain/loss from
early g. Plan to dispose of segment adopted.
extinguishment of debt
j 8. Earnings per
share h. Related to the transactions entering into the
determination of net income.
d 9. Prior period
adjustment i. Related to the acquisition and disposition of
long-term assets.
e 10. Financing
activities j. Required disclosure for publicly traded
corporation.
h 11. Operating
activities (SCF) k. Always reported as extraordinary item, if
material.
i 12. Investing
activities l. Directly related to principal revenue-generating
activities.
c 13. Direct
method m. Separate line of business or class of customer.
b 14. Indirect method
n. Closing date of sale of segment.
Problem 3-3
Requirement 1
The term segment of the business refers to a component
of an entity whose activities represent a separate line of business or
class of customer. A segment may be any organizational unit whose
assets, results of operations and activities can be clearly distinguished
physically and operationally and for financial reporting purposes, from
the other assets, results of operations, and activities of the entity.
Requirement 2
MABEL CORPORATION
Comparative Income Statements
For the Years Ended December 31
2000 1999
Income from continuing operations before
income taxes [1]......................................
$2,240,000 $1,700,000
Income tax expense 1,120,000
850,000
Income from continuing operations 1,120,000
850,000
Discontinued operations:
Loss from operations (net of $80,000 tax
benefit in 2000 and $250,000 in 1999) [2]...........
(80,000) (250,000)
Gain on disposal (net of $210,000 tax expense) [3]
210,000
_________
Income (loss) from discontinued operations
130,000 (250,000)
Net Income $1,250,000 $
600,000
[1] Income from continuing operations before income
taxes:
2000 1999
Unadjusted $1,600,000 $1,200,000
Add: Loss from discontinued operation
640,000 500,000
Adjusted $2,240,000 $1,700,000
Problem 3-3 (concluded)
[2] Loss from discontinued operations, 2000:
Loss for period January 1 - April 1:
(14 x $640,000) $(160,000)
Tax benefit (50% x $160,000)
80,000
Net of tax loss $ (80,000)
[3] Gain on disposal:
Operating loss from April 1 - December 31:
(34 x $640,000) $(480,000)
Add: Gain on sale 900,000
Net gain before tax 420,000
Tax expense (50% x $420,000) (210,000)
Net of tax gain $ 210,000