Jean Y.
Elia
ACT312 – Advanced Accounting
Chapter 4 - Income Statement and Related Information
Preview
Chapter 4 examines how companies provide income statement information for decision-making,
highlighting the use of non-IFRS measures like "underlying profit" for internal analysis. It
discusses the challenges of comparability and pro forma reporting, as well as the International
Accounting Standards Board’s (IASB's) project to develop consistent principles for financial
statement presentation to improve clarity.
Income Statement
Definition
The income statement measures a company’s operational success, helping investors and creditors
assess profitability, investment value, and future cash flows.
Usefulness of the Income Statement
The income statement helps predict future cash flows and performance.
Evaluating past performance helps compare company results to competitors by
examining revenues and expenses for insights.
Predicting future performance involves identifying trends from past results, allowing
for better forecasts of future revenues and cash flows.
Assessing risk highlights income components and their relationships, helping investors
predict future cash flow uncertainties based on operations.
Limitations of the Income Statement
Net income involves estimates and assumptions, leading to inherent limitations.
Companies omit items from the income statement that can't be reliably measured,
such as unrealized gains and brand recognition value.
Income is affected by different accounting methods, like accelerated versus straight-
line depreciation, leading to non-comparable results.
Income measurement involves judgment, such as varying estimates of asset useful life
or future expenses, affecting reported earnings.
Quality of Earnings
Companies have incentives to manage income
to meet earnings targets - Companies adjust income to hit financial goals. or
to make earnings look less risky - Companies smooth income to reduce perceived
volatility.
Earnings management is the planned timing of revenues, expenses, gains, and losses to smooth
out earnings. It's the strategic timing of financial transactions to stabilize earnings, smoothing out
fluctuations over time to present a more consistent financial performance.
Quality of earnings is reduced if earnings management results in information that is less useful
for predicting future earnings and cash flows. Earnings quality decreases if management's timing
manipulates results, making financial statements less reliable for predicting future performance
and cash flows.
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Jean Y. Elia
ACT312 – Advanced Accounting
Content and Format of the Income Statement
Elements of the Income Statement
Net income is derived from revenue, expenses, gains, and losses, summarized in the income
statement using the transaction approach.
Income. Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to contributions from shareholders.
Income includes both revenues and gains.
Revenues - ordinary activities of a company
Gains - may or may not arise from ordinary activities.
Revenue Accounts Gain Accounts
Sales Gains on the sale of long-term assets
Fee Unrealized gains on trading securities
Interest
Dividend
Rent
Expenses. Decreases in economic benefits during the accounting period in the form of outflows
or depletions of assets or incurrences of liabilities that result in decreases in equity, other than
those relating to distributions to shareholders.
Expenses include both expenses and losses.
Expenses - ordinary activities of a company
Losses - may or may not arise from ordinary activities.
Expense Accounts Loss Accounts
Cost of goods sold Losses on restructuring charges
Depreciation Losses on sale of long-term assets
Interest Unrealized losses on trading securities
Rent
Salary and wages
Taxes
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Jean Y. Elia
ACT312 – Advanced Accounting
Intermediate Components
Companies generally present some or all of these sections and totals within the income
statement.
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Jean Y. Elia
ACT312 – Advanced Accounting
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Jean Y. Elia
ACT312 – Advanced Accounting
Condensed Income Statement
Company prepares supplementary schedules to support the totals.
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Jean Y. Elia
ACT312 – Advanced Accounting
Reporting Various Income Items
Gross Profit
Gross profit is calculated by subtracting the cost of goods sold from net sales. It aids in
performance evaluation and future earnings prediction, while unusual revenues are reported
separately in other income.
Income from Operations
Operating income is calculated by subtracting selling, administrative expenses, and other income
and expenses from gross profit. It reflects regular business activities, helping predict future cash
flows' amount, timing, and uncertainty.
Application 1:
The firm of Telaris Co. performs audit, tax, and consulting services. It has the following
revenues and expenses.
Prepare an income statement based on:
a. the nature-of-expense approach
b. the function-of-expense approach
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Jean Y. Elia
ACT312 – Advanced Accounting
Write-downs of Inventories: Reducing inventory value to its market worth due to
obsolescence or price declines.
Restructuring Charges: Costs from reorganizing operations, including layoffs and facility
closures, to improve efficiency.
Gains and Losses
IASB takes the position that both
revenues and expenses and
other income and expense
should be reported as part of income from operations.
Additional items that may need disclosure:
Losses on write-downs of inventories to net realizable value or of property, plant, and
equipment to recoverable amount, as well as reversals of such write-downs.
Losses on restructurings of the activities and reversals of any provisions for the costs of
restructuring.
Gains or losses on the disposal of items of property, plant, and, equipment or
investments.
Litigation settlements.
Other reversals of liabilities.
Net Income
Represents the income after all revenues and expenses for the period are considered.
Viewed by many as the most important measure of a company’s success or failure for a given
period of time.
Earnings per Share
A significant business indicator.
Measures the dollars earned by each ordinary share.
Must be disclosed on the face of the income statement.
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Jean Y. Elia
ACT312 – Advanced Accounting
Application 2:
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 ordinary shares outstanding during the
year is 100,000 shares.
Calculate Lancer Inc.’s earnings per share. Interpret the value.
Reporting Various Income Items
Discontinued Operations - A component classified as held-for-sale or disposed of, representing
a major business line, geographical area, or part of a coordinated disposal plan, or a subsidiary
intended solely for resale.
Companies report discontinued operations in a separate income statement category, showing
gains or losses from disposing of a business component. This includes results from the disposed
component, separated from ongoing operations. Effects of discontinued operations are presented
net of tax, distinct from the continuing operations' results.
Application 3:
KC Products, a highly diversified company, decides to discontinue its electronics division. KC
generated the amount of £20,000,000 as income from continuing operation. Moreover, during the
current year, the electronics division lost £300,000 (net of tax). KC sold the division at the end of
the year at a loss of £500,000 (net of tax). Report the discontinued operation in a partial income
statement.
A company that reports a discontinued operation must report per share amounts for the line item
either on the face of the income statement or in the notes to the financial statements.
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Jean Y. Elia
ACT312 – Advanced Accounting
Reporting Various Income Items
Intraperiod Tax Allocation - The income tax expense is linked to specific items that create the
tax provision. On the income statement, this tax is allocated to two main areas: (1) income from
continuing operations and (2) discontinued operations.
This distinction allows for a clearer view of how taxes affect both ongoing and divested business
activities, helping users better understand the financial impact of taxes on different parts of the
company’s performance.
“Let the tax follow the income”, meaning the tax allocation should correspond directly to the
income generated by these different activities, ensuring accurate reflection of their respective tax
burdens.
Intraperiod tax allocation refers to the process of assigning income tax expense to different
sections of the financial statement. This ensures that taxes are accurately allocated to specific
items like income from continuing operations, discontinued operations, or other components
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Jean Y. Elia
ACT312 – Advanced Accounting
(e.g., gains or losses). The goal is to match the tax expense with the income that generated it,
providing a clearer picture of the tax impact on various parts of a company’s financial activities.
Application 4:
Case 1: Discontinued Operations (Gain)
Schindler AG 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, how would Schindler present the
the information on the income statement?
Case 2: Discontinued Operations (Loss)
Schindler AG has income before income tax of €250,000. It has a loss of €100,000 from a
discontinued operation. Assuming a 30 percent income tax rate, how would Schindler present the
the information on the income statement?
Allocation to Non-Controlling Interest
When a company prepares a consolidated income statement, IFRS requires that net income be
allocated to the controlling and non-controlling interest. This allocation is reported at the bottom
of the income statement, after net income.
Non-Controlling Interest - This means that when a parent company owns most, but not all, of a
subsidiary, the shareholders who own the remaining portion (the "non-controlling interest") are
entitled to their share of the subsidiary's profits and assets. Even though the parent company
controls the subsidiary, these minority shareholders still have a financial stake. `
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Jean Y. Elia
ACT312 – Advanced Accounting
Summary
Accounting Changes and Errors
Changes in Accounting Principle
A retrospective adjustment (i.e. applying changes to past financial periods consistently) refers to
revising past financial statements to reflect a change in accounting methods. The cumulative
effect is applied to beginning retained earnings, ensuring comparability across periods. For
example, switching from FIFO to average-cost or from percentage-of-completion to the
completed-contract method (in accounting for long-term projects) requires adjusting prior years'
results for consistency.
Therefore, Applying changes to past financial periods consistently means that when a company
changes its accounting method, it revises prior years' financial statements to reflect the new
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Jean Y. Elia
ACT312 – Advanced Accounting
method. This ensures that financial results are comparable across different periods, allowing
users to see what past financial data would have looked like under the updated approach.
Application 5:
Gaubert Inc. decided in March 2019 to change from FIFO to weighted-average inventory
pricing. Gaubert’s income before taxes, using the new weighted-average method in 2019, is
$30,000.
The pretax income data for 2017 and 2018 are stated below.
Show the information Gaubert should present in its comparative income statements, based on a
30 percent tax rate for the years 2017, 2018, and 2019.
Change in Accounting Estimates
This refers to changes in accounting estimates. These are accounted for in the period the
change occurs, and in future periods if both are affected. They are not applied retrospectively and
are not considered errors. Common examples include revising asset useful lives, adjusting for
uncollectible receivables, and inventory obsolescence estimates.
Application 6:
Arcadia HS, purchased equipment for $510,000 which was estimated to have a useful life of 10
years with a residual value of $10,000 at the end of that time. Depreciation has been recorded
for 7 years on a straight-line basis. In 2019 (year 8), it is determined that the total estimated life
should be 15 years with a residual value of $5,000 at the end of that time.
Questions:
1. Does prior years’ depreciation need to be restated?
2. Calculate the depreciation expense for 2019.
Corrections of Errors
Errors in financial statements arise from mathematical mistakes, incorrect application of
accounting principles, or oversight of facts. Such errors are classified as prior period
adjustments, necessitating corrections that affect the beginning balance of retained earnings to
ensure accurate representation of the company's financial position.
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Jean Y. Elia
ACT312 – Advanced Accounting
Application 7:
In 2019, Tsang Ltd. determined that it incorrectly overstated its accounts receivable and sales
revenue by NT$100,000 in 2018. In 2019, what entry should Tsang make to correct for this error
(ignore income taxes)?
Summary of Summary of Accounting Changes and Errors
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Jean Y. Elia
ACT312 – Advanced Accounting
Related Equity Statements
Application 8:
Before issuing the report for the year ended December 31, 2019, you discover a ₩50,000 error
(net of tax) that caused 2018 inventory to be overstated (overstated inventory caused COGS to be
lower and thus net income to be higher in 2018). Would this discovery have any impact on the
reporting of the Statement of Retained Earnings for 2019?
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ACT312 – Advanced Accounting
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