Net income inclusions and exclusions
Accounting has long faced the problem of what to include in the net income reported for a period. Should net income include only the revenues and expenses related to normal operations? Or should it include the results of discontinued operations and unusual, nonrecurring gains and losses? And further, should the determination of net income for this year, include an item that can be clearly associated with a prior year, such as additional federal income taxes for last year? Or should such items, including corrections of errors, be carried directly to retained earnings? How are the effects of making a change in accounting principle to be reported?
APB Opinion No. 9 (December 1966) sought to provide answers to some of these questions. The Opinion directed that unusual and nonrecurring items having an earnings or loss effect are extraordinary items (reported in the income statement) or prior period adjustments (reported in the statement of retained earnings). Extraordinary items are reported separately after net income from regular continuing activities.
Assume that the Anson Company has 1,000,000 shares of common stock outstanding and the company’s earnings are taxed at 40%. Also, assume the following:
- Anson sold its Cosmetics Division on August 1, at a loss of $500,000. The net operating loss of that division through July 31, was $2,000,000.
- Anson had a taxable gain in of $40,000 from a sale of a subsidiary at an amount greater than what was on the company’s balance sheet (extraordinary item).
- Anson discovered that the $ 200,000 cost of land acquired in last year had been expensed for both financial accounting and tax purposes. A prior period adjustment was made this year.
Next, we explain the effects of these assumptions in greater detail (we learned the prior period adjustment earlier but will review its presentation here).
A discontinued operation occurs when a business sells a segment (usually an unprofitable department or division) to another company or abandons it. When a company discontinues a segment, it shows the relevant information in a special section of the income statement immediately after income from continuing operations and before extraordinary items. Two items of information appear:
- The income or loss (net of tax effect) from the segment’s operations for the portion of the current year before it was discontinued.
- The gain or loss (net of tax effect) on disposal of the segment.
To illustrate, Anson’s sale of its Cosmetics Division on August 1 led to a before-tax loss of $500,000. The after-tax loss was $500,000 x 60% = $300,000. The operating loss before taxes through July 31 was $2,000,000. The after-tax operating loss for that period was $2,000,000 x 60% = $1,200,000.
Prior to 1973, companies reported a gain or loss as an extraordinary item if it was either unusual in nature or occurred infrequently. As a result, companies were inconsistent in the financial reporting of certain gains and losses. This inconsistency led to the issuance of APB Opinion No. 30 (September 1973). Opinion No. 30 redefined extraordinary items as those unusual in nature and occurring infrequently. Note that both conditions must be met—unusual nature and infrequent occurrence. Accountants determine whether an item is unusual and infrequent in light of the environment in which the company operates. Examples of extraordinary items include gains or losses that are the direct result of a major catastrophe (a flood or hurricane where few have occurred before), a confiscation of property by a foreign government, or a prohibition under a newly enacted law.
Extraordinary items are included in the determination of periodic net income, but are disclosed separately (net of their tax effects) in the income statement below “Income from continuing operations”. As shown below, Anson reported the extraordinary items after reporting the loss from discontinued operations.
Gains or losses related to ordinary business activities are not extraordinary items regardless of their size. For example, material write-downs of uncollectible receivables, obsolete inventories, and intangible assets are not extraordinary items. However, such items may be separately disclosed as part of income from continuing operations.
Changes in accounting principle can materially alter a company’s reported net income and financial position. Changes in accounting principle are changes in accounting methods pertaining to such items as inventory. Such a change includes a change in inventory valuation method from FIFO to LIFO.
According to APB Opinion No. 20, a company should consistently apply the same accounting methods from one period to another. However, a company may make a change if the newly adopted method is preferable and if the change is adequately disclosed in the financial statements. In the period in which a company makes a change in accounting principle, it must disclose on the financial statements the nature of the change, its justification, and its effect on net income. Also, the company must show on the income statement for the year of the change and the cumulative effect of the change on prior years’ income (net of tax).
Most discontinued operations, extraordinary items, changes in accounting principle, and prior period adjustments affect the amount of income taxes a corporation must pay. To report the income tax effect, FASB Statement No. 96 requires reporting all of these items net of their tax effects. Net-of-tax effect means that items appear at the dollar amounts remaining after deducting the income tax effects. Thus, the total effect of a discontinued operation, an extraordinary item, a change in accounting principle, or a prior period adjustment appears in one place in the appropriate financial statement. The reference to “Income from continuing operations” on the income statement represents the results of transactions (including income taxes) that are normal for the business and may be expected to recur. Note that the tax effect of an item may appear separately, as it does for the gain on voluntary early retirement of debt below or the company may mention it parenthetically with only the net amount shown.
For the Year Ended December 31
|Cost of goods sold||$22,000,000|
|Administrative, selling, and general expenses||12,000,000||34,000,000|
|Income before federal income taxes||$9,250,000|
|Deduct: Federal income taxes (40%)||(3,700,000)|
|Income from continuing operations||$5,550,000|
|Loss from operations of discontinued Cosmetics Division (net of 40% tax effect of $800,000)||$(1,200,000)|
|Loss on disposal of Cosmetics Division (net of 40% tax effect of $200,000)||(300,000)||(1,500,000)|
|Income before extraordinary item and the cumulative effect of a change in accounting principle||$4,050,000|
|Gain on sale of subsidiary over book value||$40,000|
|Less: Tax effect (40%)||(16,000)||24,000|
|Income after extraordinary item||$4,074,000|
|Earnings per share of common stock:|
|Income from continuing operations||$ 5.550|
- Income from continuing operations of $5,550,000 is more representative of the continuing earning power of the company than is the net income figure of $4,077,600.
- Following income, the special items from continuing operations appear at their actual impact on the company—that is, net of their tax effect.
- EPS is reported both before ($5.550) and after ($ 4.078) the discontinued operations, extraordinary item, and the cumulative effect of a change in accounting principle.
Statement of Retained Earnings
For the Year Ended December 31
|Retained earnings, January 1||$5,000,000|
|Prior period adjustment:|
|Correction of error of expensing land (net of tax effect of $80,000)||-120,000|
|Retained earnings, January 1, as adjusted||$5,120,000|
|Add: Net income||4,077,600|
|Less: Dividends||– 500,000|
|Retained earnings, December 31||$8,687,600|
- The correction of the $200,000 error adds only $120,000 to retained earnings. This result occurs because the mistake was included in the last year’s tax return and taxes were underpaid by $80,000. In the this year’s return, the $80,000 of taxes would have to be paid.