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Chapter 3

THE INCOME STATEMENT AND STATEMENT OF CASH FLOWS

Lecture Outline
Part A: The Income Statement
I. Income from Continuing Operations
A. Income from continuing operations includes the revenues, expenses, gains, and
losses that will probably continue in future periods.
1. Income tax expense always is shown as a separate expense.
2. A distinction often is made between operating and nonoperating income.
(T3-1)
3. A single-step income statement format groups all revenues and gains
together and all expenses and losses together. (T3-2)
4. A multiple-step income statement format includes a number of intermediate
subtotals before arriving at income from continuing operations. (T3-3)

II. Earnings Quality


A. Earnings quality refers to the ability of reported earnings (income) to predict a
companys future earnings.
1. To enhance predictive value, analysts try to separate a companys
transitory earnings effects from its permanent earnings.
2. Many believe that corporate earnings management practices reduce the
quality of earnings. Two major methods used by managers to manipulate
income are (1) income shifting and (2) income statement classification.
B. Not all items included in operating income should be considered indicative of a
companys permanent earnings. (T3-4)
1. Restructuring costs include costs associated with shutdown or relocation of
facilities or downsizing of operations. Prior to 2003, these costs were
recognized (expensed) in the period the decision to restructure was made,
not in the period or periods in which the actual activities took place. In the
United States, SFAS No. 146 now requires these costs to be expensed in the
period(s) incurred.
2. Asset impairment losses, inventory write-down charges, and in-process
research and development are other operating expenses that call into
question the issue of earnings quality.
3. Earnings quality is affected by revenue issues as well.
C. Some nonoperating items have generated considerable discussion with respect
to earnings quality, notably gains and losses generated either from the sale of
operational assets or from the sale of investments. (T3-5)

III. Separately Reported Items (T3-6)


A. Interperiod tax allocation associates tax expense or tax benefit with continuing
operations and any item reported below continuing operations. (T3-7)
B. Discontinued operations involve the disposal or planned disposal of a
component of an entity whose operations and cash flows can be clearly
distinguished from the rest of the entity. (T3-8)
1. When the component has been sold, the income effects of a discontinued
operation includes (1) the operating income or loss of the component from
the beginning of the reporting period to the disposal date, and (2) the gain
or loss on disposal. (T3-9)
2. When the component is considered held for sale, the income effects of a
discontinued operation includes (1) operating income or loss of the
component from the beginning of the reporting period to the end of the
reporting period, and (2) an impairment loss if the carrying value (book
value) of the assets of the component are more than fair value minus cost to
sell. (T3-10)
C. Extraordinary items are material gains and losses that are both unusual in
nature and infrequent in occurrence. (T3-11)
1. Extraordinary gains and losses are presented, net-of-tax, in the income
statement below discontinued operations.
2. A material gain or loss that is either unusual or infrequent should be
reported as a separate component of continuing operations.
D. A change in accounting estimate is reflected in the financial statements of the
current period and future periods. (T3-12)
E. A change in reporting entity requires that financial statements of prior periods
be retroactively restated.

IV. Correction of Accounting Errors


A. Errors discovered in the same year they are made are simply corrected by
journal entry.
B. Treatment of errors discovered in a year subsequent to the year the error is
made depends on whether the error is material.
1. If the error is not material, it is simply corrected in the year discovered.
2. If the error is material, the correction causes a restatement of the financial
statements of prior years which is summarized in retained erarnings.

V. Earnings per Share Disclosures


A. Earnings per share (EPS) is the amount of income achieved during a period for
each share of common stock outstanding.
B. All corporations whose common stock is publicly traded must disclose EPS.
C. The EPS for income from continuing operations, and for each item below
continuing operations, must be disclosed. (T3-13)

Part B: The Cash Flow Statement


I. Usefulness of the Cash Flow Statement
A. The purpose of the cash flow statement (CFS) is to provide information about
cash receipts and cash disbursements that occurred during a period.
B. A CFS is presented for each period in which results of operations are provided.
II. Classifying Cash Flows
A. The CFS classifies all transactions affecting cash into one of three categories:
(T3-14)
1. Operating activities are inflows and outflows of cash related to the
transactions entering into the determination of net operating income.
a. The Direct Method
b. The Indirect Method
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 (excluding trade creditors) and owners.
B. Significant investing and financing transactions not involving cash also are
reported in the CFS.