BUS103: Introduction to Financial Accounting

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 2010, for example, include an item that can be clearly associated with a prior year, such as additional federal income taxes for 2009? 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.

In Exhibit 28 and Exhibit 30, we show the reporting of discontinued operations, extraordinary items, and prior period adjustments. For Exhibit 28 and Exhibit 30, assume that the Anson Company has 1,000,000 shares of common stock outstanding and the company's earnings are taxed at 40 percent. Also, assume the following:

• Anson sold its Cosmetics Division on 2010 August 1, at a loss of USD 500,000. The net operating loss of that division through 2010 July 31, was USD 2,000,000.
• Anson had a taxable gain in 2010 of USD 40,000 from a sale of a subsidiary at an amount greater than what was on the company's balance sheet (extraordinary item).
• In 2010, Anson discovered that the USD 200,000 cost of land acquired in 2009 had been expensed for both financial accounting and tax purposes. A prior period adjustment was made in 2010.

Next, we explain the effects of these assumptions in greater detail.

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 USD 500,000. The after-tax loss was USD 500,000 X 60 percent = USD 300,000. The operating loss before taxes through July 31 was USD 2,000,000. The after-tax operating loss for that period was USD 2,000,000 X 60 percent = USD 1,200,000. Note this information on the income statement in Exhibit 28.

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 in Exhibit 28, 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.

Exhibit 29: Extraordinary items

In Exhibit 29, note that in a sample of 600 companies for the years 2000-2003, most companies do not report extraordinary items.

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).

According to FASB Statement No. 16, prior period adjustments consist almost entirely of corrections of errors in previously published financial statements. Corrections of abnormal, nonrecurring errors that may have been caused by the improper use of an accounting principle or by mathematical mistakes are prior period adjustments. Normal, recurring corrections and adjustments, which follow inevitably from the use of estimates in accounting practice, are not treated as prior period adjustments. Also, mistakes corrected in the same year they occur are not prior period adjustments. To illustrate a prior period adjustment, suppose that Anson purchased land in 2009 at a total cost of USD 200,000 and recorded this amount in an expense account instead of in the Land account. Discovery of the error on 2010 May 1, after publication of the 2009 financial statements, would require a prior period adjustment. The adjustment would be recorded directly in the Retained Earnings account. Assuming the error had resulted in an USD 80,000 underpayment of taxes in 2009, the entry to correct the error would be:

An ethical perspective:
Ace chemical company

Ace Chemical Company is a small, privately held manufacturer that has been operating at a profit for years. The current balance in the Cash account is USD 8 million, and the balance in Retained Earnings is USD 4 million. The company's plant assets consist of special purpose equipment that can produce only certain chemicals. The company has long-term debt with a principal balance of USD 10 million. Its officers (all of whom are stockholders) are concerned about the future prospects of the company. Many similar firms have been sued by customers and employees claiming that toxic chemicals produced by the company caused their health problems. No such suits have yet been filed against Ace, but the officers fully expect them to be filed within the next two years.

The company's stock is not listed on a stock exchange, nor has it recently been traded. The officers hold 70 percent of the stock and estimate that their total stockholdings have a current market value of about USD 8 million (although its value would be much lower if all the facts were known). They are worried that if suits are filed and the company loses, there will not even be enough remaining assets to satisfy creditors' claims, and the officers' stock would be worthless. Private legal counsel has informed the officers that the company is likely to lose any suits that are filed.

One of the officers suggested that they could at least receive something for their stock by having the company buy half of the shares held by the officers at a total price of USD 4 million. Another officer asked if such a treasury stock transaction would be legal. The response was that the transaction would be legal because it did not dip into the present legal capital of the company. Retained earnings would be reduced to a zero balance, but would not develop a debit balance as a result of the transaction.

Prior period adjustments do not appear on the income statements but in the current-year financial statements as adjustments to the opening balance of retained earnings on the statement of retained earnings (Exhibit 30).

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, as shown in Exhibit 28 and Exhibit 30. 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 in Exhibit 28. Or the company may mention it parenthetically with only the net amount shown (see loss from discontinued operations and change in accounting principle in Exhibit 28 and correction of error in Exhibit 30).

Anson Company
Statement of Retained Earnings For the Year Ended
2010 December 31

Exhibit 30: Statement of retained earnings

• Income from continuing operations of USD 5,550,000 (Exhibit 28) is more representative of the continuing earning power of the company than is the net income figure of USD 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 (USD 5.550) and after (USD 4.078) the discontinued operations, extraordinary item, and the cumulative effect of a change in accounting principle (Exhibit 28).
• The correction of the USD 200,000 error adds only USD 120,000 to retained earnings (Exhibit 30). This result occurs because the mistake was included in the 2009 tax return and taxes were underpaid by USD 80,000. In the 2010 return, the USD 80,000 of taxes would have to be paid.