Chapter 3: Income Statement, Statement of Changes in Equity, and Statement of Recognized Gains and Losses

Perspective and Issues

In discussing the concept of performance, the IASC's Framework for the Preparation and Presentation of Financial Statements states that profit is frequently used as a measure of performance. Historically, under all sets of extant accounting standards, the income statement has provided this vital piece of information about what is sometimes referred to as the "bottom-line" for the enterprise, the ultimate measure of entity economic performance. However, under both IAS and various national GAAP standards, over the years a number of sources of changes in owner net worth, excluding investments by or distributions to the owners themselves, have become excluded from this "bottom-line" measure, for various reasons. For example, revaluations of plant assets, which are sanctioned by IAS 16, are not considered to be culminations of the normal earnings process (since commercial enterprises are not typically organized to speculate on the changing values of their productive assets), and thus such items have been relegated to equity accounts such as revaluation surplus. As a consequence, the income statement cannot and does not purport to reveal the totality of economic changes in the enterprise for the period.

To deal with the fact that the income statement has diverged increasingly from being a complete picture of the economic changes affecting the reporting entity over the course of a reporting period, accounting standard setters in the US and the UK, as well as the IASB, have been deliberating the need either for an expanded income statement (which would include the various changes which have, under the respective sets of standards, been consigned to assorted "contra equity" or "additional equity" accounts) or for a new financial statement which would summarize these changes in some other fashion.

IASC had proposed to require such a statement (which was tentatively called the statement of nonowner movements in equity) which would have included all non-income-statement changes in net worth other than owner transactions, as well as net income. That proposal was not enacted, however, and the current standard, IAS 1, requires that one of two possible new financial statements be added to that traditional set of statements presented, with expanded footnote disclosures also needed under certain conditions. These are each presented in detail, later in this chapter.

The traditional income statement has been known by many titles. The international accounting standards, such as IAS 1 and IAS 8, refer to this statement as the income statement, but in the United Kingdom and certain developing countries it is also referred to as the profit and loss account; and in the United States other names, such as the statement of income, statement of earnings, or statement of operations, are sometimes used. By whatever name, this statement is a major component of an entity's periodic financial reporting and captures most of the changes in the entity's economic position over the course of the reporting period, which is most often one year.

Since the late 1960s or early 1970s, the income statement has been widely perceived by investors, creditors, management, and other interested parties as the single most important of an enterprise's basic financial statements. Investors consider the past income of a business as the most useful predictor of future earnings and performance, which in turn is widely deemed to be the best indicator of future dividends and market stock price performance. In fact, the reason that many other changes in net worth, such as that resulting from changes in fair values of plant assets or investments, are excluded from the income statement is that these are not considered to be useful as predictors of future economic performance.

Creditors look principally to the income statement for insight into the borrower's ability to generate the future cash flows needed to repay the obligations. (While the cash flow statement would appear more logically to be the source for these insights, that statement is a relatively late development and not universally understood yet; thus, traditionally, financial statement users have been more comfortable drawing these inferences from the income statement.) Management, then, must be concerned with the income statement by virtue of the importance placed on it by investors and creditors. Additionally, management uses the income statement as a gauge of its effectiveness and efficiency in combining the factors of production into the goods and/or services that it creates and sells.

The information provided by the income statement, relating to individual items of income and expense and to different combinations of these items (such as the amounts reported as gross margin or profit before interest and taxes), facilitates the process of financial analysis, especially that relating to the entity's profitability. Further, the manner of presentation of certain items of income and expense on the face of the income statement can provide relevant information for proper economic decision making.

For one example of this last matter, it is normal practice to distinguish between those items of income and expense that arise from ordinary activities and those that do not. IAS 8 requires that income and expenses (and profit or loss) from ordinary activities be disclosed separately on the face of the income statement, distinguishing them from any extraordinary items, which must be identified clearly and disclosed separately. The standard also requires that if individual items of income and expense within profit or loss from ordinary activities, due to materiality considerations or because of their nature or incidence, need disclosure to assist the user of the financial statements in understanding the performance of the enterprise, these must be given separate disclosure. The paramount concern is that financial statement users be able to assess the ability of the enterprise to replicate the item and thus to generate earnings and ultimately cash and cash equivalents in the future.

The ability to project future performance—whether in terms of earnings or cash flows—is dependent, among other factors, on consistency in financial reporting for a given entity over time as well as within a reporting period. SIC 18 confirms the belief that, when more than one accounting policy is available under an IAS or an SIC, an enterprise should choose and apply consistently one of those policies, unless the standard or interpretation permits categorization of items for which different policies may be appropriate. If a standard or an interpretation permits categorization of items, the most appropriate accounting policy should be selected and applied to each category. Once an appropriate policy has been selected, any change in policy must be in accordance with the requirements of IAS 8.

Much of current accounting theory is concerned with the measurement of income. Even with the renewed interest in the balance sheet, the income statement remains of great importance to the majority of financial statement users. This chapter focuses on key income measurement issues and on matters of income statement presentation and disclosure. It also explains and illustrates the presentation of the new component of financial statements prescribed by IAS 1, statement of changes in equity (or, alternatively, the statement of recognized gains and losses together with the required footnote disclosure).

IAS 1 has added, in a somewhat controversial move, what may be deemed a "fairness exception" to compliance with IAS. If management concludes that application of a particular provision of a standard would cause the financial statements to be misleading, it may choose to depart from that provision in order to achieve a fair presentation. In such circumstances, however, the fact of the departure, the nature of it, the treatment which IAS would have required, and why it was deemed to be misleading, must all be included in the notes to the financial statements.

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Sources of IAS

IAS 1, 8, 14, 16, 18, 21, 25, 30, 35, 36, 37, 38, 39, 40

SIC 8, 18, 29

IASC's Framework for the Preparation and Presentation of Financial Statements

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Wiley Ias 2003(c) Interpretation and Application of International Accounting Standards
WILEY IAS 2003: Interpretation and Application of International Accounting Standards
ISBN: 0471227366
EAN: 2147483647
Year: 2005
Pages: 147 © 2008-2017.
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