The Complete Income Statement

CHAPTER 13

The Complete Income Statement

EXERCISES

E13–1

a. Statementb. Classificationc. Explanation

1.ISOtherThis is an example of a bookkeeping entry without an underlying economic event. Some are voluntary, some are involuntary.

2.NN/A

3.NN/A

4.ISUsual and frequentWages are normal, recurring part of operations.

5.ISUsual and frequentBad debts are a normal, recurring part of operations.

6.ISUnusual or infrequentSales of equipment are secondary to normal operations.

7.ISUnusual and infrequentExpropriation against a company occurs rarely in the U.S.

8.S EN/A

9.S EN/A

10.ISUnusual or infrequentDividend Revenue is secondary to normal buying and selling activities of most businesses.

11.ISUsual and frequentCost of goods sold is part of normal daily operations.

12.ISUsual and frequentRent expense is part of normal operations.

PROBLEMS

P13–2

a.Bonus=25%  (Income from Operations Before Interest Expense – Interest Expense)

=25%  [$1,200,000 – ($1,000,000  8% Interest Rate)]

=$280,000

b.Bonus=25%  (Income from Operations Before Interest Expense – Interest Expense)

=25%  ($1,200,000 – $0)

=$300,000

c.The decision whether to finance the plant expansion through an equity issue or through a debt issue is worth $20,000 to the managers because the managers will receive an additional $20,000 in bonuses if the company issues equity instead of debt. Although issuing equity is in the best interest of the managers, this option may not be in the best interest of the existing stockholders. It is possible that issuing additional stock would dilute the ownership interests of the existing stockholders. Further, the interest payments on debt are tax deductible. Hence, issuing debt would reduce cash outflows for taxes.

d.If interest expense was not considered to be an operating expense, the managers' bonus would be the same whether the company issued debt or equity. In either case the bonus would be 25% of $1,200,000, or $300,000. In this situation, the managers would, hopefully, base their decision on factors that are more relevant to the stockholders.

P13–5

a.

1.Hurricanes are unusual in that they are not part of a company's normal operations; however, they occur relatively frequently in Florida. Thus, this loss probably should not be classified as an extraordinary item. Instead, it should be disclosed gross of taxes as part of other revenues and expenses.

2.A loss on the disposal of a business segment is not considered an extraordinary item. This item should be disclosed net of taxes as a separate item on the income statement after income from continuing operations, but before extraordinary items. The classification of this item is the disposal of a business segment.

1. This loss appears to be both unusual and infrequent; consequently, it should be classified as an extraordinary item on the income statement. Extraordinary items should be disclosed net of any tax effect.

4.Writing off an open account receivable as uncollectible should not be disclosed on the income statement. Under GAAP, a company should use the allowance method to account for bad debts. With the allowance method, write-offs of uncollectible accounts affect only balance sheet accounts.

5.Floods are unusual in that they are not part of a company's normal operations. Although Arizona does get flooding, particularly flash floods, the flooding would probably be considered to be infrequent. Consequently, this loss should be classified as an extraordinary item on the income statement. Extraordinary items should be disclosed net of any tax effect.

b.Extraordinary items:

Loss to employee destruction (net of tax benefit of $78,750)...... 146,250

Loss due to flood (net of tax benefit of $31,500)...... 58,500

Total Loss on Extraordinary Items $204,750

ISSUES FOR DISCUSSION

ID13–1

a.The gain on the sale of Hughes would appear net of tax below Net Income from Continuing Operations on the Income Statement of General Motors, as it is not a recurring item. The expenses for labor, pension plans and marketing incentives, however, are a normal part of GM’s business and therefore would appear under Operating Expenses on the Income Statement. If an analyst were to review GM’s performance and draw conclusions about future financial results, the analyst would be more concerned with the recurring events, such as labor and marketing. Hughes is no longer part of GM and will not contribute to earnings and cash flow in the future and, therefore, would not be part of an analysis to determine GM’s potential results.

b.Investors would be concerned in both situations as the issues involved in the earnings announcements will continue to affect both companies. General Motors will have to deal with its labor costs (wages and the legacy of pension obligations) in the future; Ford will continue its relationship and obligation to the former subsidiary Visteon and will continue to be affected by Visteon’s cost structure. The $450 million charge to restructure Ford’s European operations would be considered a non-recurring event, but the overseas operations of Ford will continue to be an issue with investors as Ford tries to improve operations.

ID13–3

a.For an event to be classified as extraordinary, the event must have been both unusual in nature and infrequent in occurrence.

b.If the eruptions continue periodically, then such eruptions would probably not be viewed as being infrequent in occurrence. Thus, any losses resulting from future eruptions probably would not be considered to be extraordinary.

c.The entire loss would have been $69.231 million. That is, the after-tax loss of $36 million divided by (1 – tax rate of 48%). The journal entries would be:

Extraordinary Loss from Volcano Eruption (Lo, –SE)...... 69,231,000

Timberland (–A)...... 69,231,000

Recognized extraordinary loss from volcano eruption.

Income Tax Liability (–L)...... 33,231,000

Extraordinary Loss from Volcano Eruption (–Lo, +SE).... 33,231,000

Recognized tax benefit from volcano eruption.

ID13–5

a.Analysts are many times looking for companies that will be the dominant company in different business categories. The internet has provided an alternative method for selling goods and services to the public. Since this is a new industry many analysts were not sure how much market share this channel would take away from the traditional retailing industry. As a result analysts were trying to pick the future winners in this new industry channel. Since few of these companies are profitable analysts had to develop alternative measures to try and evaluate the relative and absolute performance of these companies.

b.The specific effect that this FASB rule had on the income statements on companies like Amazon.com was to increase the cost of good sold and decrease the gross profit percentage. These companies lobbied against this change because these companies were promoting the idea that their gross profit percentages were much higher than traditional retailers. After this change it became very apparent that their cost structure was not a competitive advantage against traditional retailers. At that point their stock prices started to decline.

c.There is no impact on the reported cash flows of these companies as a result of this accounting change. This change moves where these costs are reported on the income statement but has no impact on the physical operations of the company.

d.Theoretically, the price of a company's stock equals the present value of the cash flows the stock market expects a stockholder in that company to realize from holding that stock. Thus, the stock price of these companies should not be impacted by this accounting change. While the cash flow of a company will not change as a result of this accounting change it does impact the expectations of investors as to the future cash flows of these companies. This change highlighted information in a way that reduced investors future estimates of the profitability or cash flow of these companies.

ID13–6

a.Although it could be argued that lawsuits are a normal part of conducting business in the United States and that lawsuits may not be that infrequent, the settlement was probably disclosed as an extraordinary loss. The determining factor in each case would be if the event was infrequent and unusual, if the event is both of these then it should be reported as an extraordinary. Extraordinary items should be disclosed net of the associated tax effect. With a tax rate of 34% and a loss of $909.5 million, Kodak would receive a tax benefit of $309.23 million. Thus, Kodak should have reported a net loss of $600.27 million on its 1990 income statement for the settlement.

b.The patent infringement case is an example of a contingency. SFAS No. 5, "Accounting for Contingencies" states that a contingency is "an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur." In this particular case, Polaroid had a gain contingency and Kodak had a loss contingency. Under the guidelines set forth in SFAS No. 5, the most that Polaroid could have done in its 1989 annual report was to disclose the lawsuit in a footnote. Alternatively, Kodak could have either disclosed nothing about the lawsuit, disclosed the lawsuit in a footnote, or recorded a loss and associated liability. The appropriate course of action depended upon (1) whether it was remote, reasonably possible, or probable, given the information available in 1989, that Kodak would eventually lose the lawsuit and (2) whether the amount of the loss could be reasonably estimated in 1989. If the probability that Kodak would eventually lose the lawsuit was remote, then Kodak could ignore the lawsuit for financial reporting purposes. If the probability of the loss was reasonably possibly or if the amount of the loss could not be reasonably estimated, Kodak should have disclosed the lawsuit in a footnote only. Finally, if both the probability of the loss was probable and the amount of the loss could be reasonably estimated, Kodak should have recorded a loss and associated liability.

Due to the magnitude of the case and the associated publicity, it is doubtful that Kodak ignored the lawsuit for financial reporting purposes. In addition, if Kodak knew that it was probable that it would lose the lawsuit, it probably would have settled the case out of court. Thus, Kodak most likely did not think it was probable that it would lose the lawsuit, and therefore only disclosed the lawsuit in a footnote.

c.There are at least two reasons why Kodak's stock increased in value. First, the settlement provided unexpected "good" news about Kodak. The stock market may have expected Kodak to lose the lawsuit and have to pay out close to the amount being asked for by Polaroid. The fact that Kodak had to pay considerably less than expected caused the stock market to positively reevaluate the prospects of investing in Kodak.

Second, Kodak reported a large increase in operating earnings. Stockholders are interested in a company's earning power. That is, stockholders are interested in a company's ability to generate net assets from operations on an ongoing basis. The large increase in Kodak's operating earnings provided information to the stock market that Kodak has strong earning power. Alternatively, the lawsuit settlement is a one-time payout that should not adversely affect Kodak's ongoing operations, although it may have some short-term effects on Kodak's earning power.

ID13–9

1. Rising raw material costs would be reflected in Cost of Goods Sold on the income statement, as well as in Inventory (Raw Materials) on the balance sheet. Currency fluctuations would be reflected in comprehensive income under currencey translation adjustments. A gain would be reflected on the income statement under “other gains/expenses”. Increased costs to introduce new models would be reflected on the income statement under operating expenses (engineering, marketing, etc.).

1. Rising material costs and costs to introduce new models might be expenses that will permanently affect BMW’s business model.

1. Comprehensive income measures all changes in a company’s equity due to nowowner transactions. Foreign currency adjustments (as seen by global operations such as BMW) and certain holding gains/losses are not thought to affect a company’s profits but do indeed affect the amount of equity shown on the financial statements. Comprehensive income captures all nonowner changes to equity.

1. Analysts will review a number of factors in addition to a company’s earnings, including: macroeconomic events, overall stock market pricing, a company’s guidance about future earnings, management changes, and a company’s market share.