3.
Chapter 3: The Income Statement and Related
Information
Lecture Notes
● Purpose of the Income Statement (Statement of Comprehensive
Income):
○ To measure the economic performance of a company over a period
of time.
○ It helps users:
■ Evaluate past performance.
■ Predict future performance.
■ Assess the potential for achieving future cash flows.
● Limitations of the Income Statement:
○ Companies omit items that cannot be measured reliably (e.g., brand
recognition, customer service quality).
○ Income numbers are affected by the accounting methods used
(e.g., LIFO vs. FIFO, different depreciation methods).
○ The use of judgment (e.g., estimates for bad debt, useful life) can
impact the final figure.
● Quality of Earnings:
○ Refers to the extent to which reported income truly reflects the
company's sustainable economic performance. Earnings
Management (the intentional timing of revenues and expenses to
meet targets) reduces quality.
● Format of the Income Statement:
○ The standard format involves several sections to highlight key
financial relationships:
■ Operating Section: Relates to the firm's central operations.
■ Sales/Revenue
■ Cost of Goods Sold (COGS)
■ Selling Expenses
■ General and Administrative Expenses
■ → Income from Operations
■ Non-operating Section: Revenues and expenses from
peripheral or incidental activities.
■ Other Revenues and Gains (e.g., Interest Revenue, Gain
on Sale of Equipment)
■ Other Expenses and Losses (e.g., Interest Expense, Loss
on Sale of Equipment)
■ Income Before Income Tax
■ Income Tax Expense
■ Net Income
● Irregular and Important Items (Reported After Income from
Continuing Operations):
○ These items are reported net of tax (meaning the income tax effect
is already accounted for in the reported number).
○ Discontinued Operations: Occurs when (1) a company eliminates
the results of operations and cash flows of a component (part of an
entity) and (2) there is no significant continuing involvement in that
component after disposal.
■ Reported in two parts: (a) Loss/Gain from operations of the
component until the disposal date, and (b) Loss/Gain on
disposal of the component's assets.
○ Noncontrolling Interest: The portion of equity (Net Income and
Equity) in a subsidiary not attributable to the parent company.
Reported as a separate allocation of Net Income.
● Earnings Per Share (EPS):
○ The most significant ratio reported on the face of the income
statement.
○ Formula:
EPS=Weighted-Average Common Shares OutstandingNet
Income−Preferred Dividends
○ EPS must be disclosed for Income from Continuing Operations,
Discontinued Operations, and Net Income.
● Retained Earnings Statement:
○ Reconciles the beginning and ending balances of Retained Earnings
(a key equity account).
○ Beg. RE+Net Income (or −Net Loss)−Dividends Declared±Prior
Period Adjustments=End. RE
○ Prior Period Adjustments (PPA): Corrections of errors in the prior
year's financial statements are reported net of tax as an
adjustment to the beginning balance of Retained Earnings.
● Comprehensive Income:
○ A broader measure than Net Income; includes all changes in equity
during a period except those resulting from investments by owners
and distributions to owners.
○ Comprehensive Income=Net Income+Other Comprehensive Income
(OCI)
○ Other Comprehensive Income (OCI) includes items like:
■ Unrealized gains/losses on available-for-sale securities.
■ Certain pension adjustments.
■ Gains/losses on derivative instruments.
○ It can be presented either in a Single Continuous Statement
(Statement of Comprehensive Income) or in Two Separate
Statements (Income Statement followed by a Statement of
Comprehensive Income).
Summary (Chapter 3)
Chapter 3 focuses on the Income Statement, which reports a company's
performance over a specific period and aids in predicting future cash flows. It's
constructed with a multi-step format, leading to Income from Operations and
ultimately Net Income. Key items, such as Discontinued Operations, are
reported net of tax below Income from Continuing Operations to help users
assess the sustainable aspects of the business. The crucial metric Earnings Per
Share (EPS) must be disclosed for the major income elements. The chapter also
covers the Retained Earnings Statement, which tracks changes in RE, including
any Prior Period Adjustments. Finally, the chapter introduces Comprehensive
Income, a measure broader than Net Income, which includes Other
Comprehensive Income (OCI) to capture all non-owner equity changes.