MAT 201 Module 4 Corporate Income and Financial Statements Example

Continuing, Discontinued and Per Share: Building a Creamery's Corporate Income Statement

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Business Administration Program, Aspen University

MAT 201: Principles of Accounting II

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Month Day, Year

Continuing, Discontinued and Per Share: Building a Creamery's Corporate Income Statement

Cedar Valley Creamery's second year as a corporation included a major decision: in September, it sold its small butter brand to a larger dairy so it could concentrate on milk and yogurt. The corporation also now pays income tax on its profits. Its income statement must show both facts clearly, along with earnings per share, which every stockholder will look at first. This paper builds the statement and explains each section.

Income Tax Expense

A regular corporation pays federal and state income tax on its taxable income. Cedar Valley's combined rate, 21% federal plus Iowa's corporate tax net of the federal benefit, is about 25%. Income tax expense on the income statement is based on accounting income before tax, adjusted for differences between accounting and tax rules. Some differences reverse over time, such as faster depreciation for tax purposes, and create deferred tax amounts on the balance sheet. Others never reverse, such as fines that are not deductible. Cedar Valley's main difference comes from deducting the yogurt line's equipment faster on its tax return than on its books, which lowers this year's tax payment and creates a deferred tax liability that will be paid in later years when tax depreciation runs out.

Separating Discontinued Operations

When a company sells a component of its business that represents a strategic shift, the results of that component are reported separately as discontinued operations, net of tax, below income from continuing operations. The reason is persistence: the butter brand's results will not recur, and users forecasting next year's earnings need to see the continuing business on its own. The butter brand lost $56,000 before tax in its last nine months and was sold for a gain of $42,000 before tax. Its sales, about $1.2 million, are excluded from the $18.4 million of net sales above, so the top line also describes only the business that continues. Net of the 25% tax effect, those become a $42,000 loss and a $31,500 gain.

The Income Statement

Cedar Valley Creamery, Inc., Income Statement, Year Ended December 31

Earnings per Share

Earnings per share uses the weighted average number of common shares outstanding during the year, so that a share outstanding for half a year counts as half a share. Cedar Valley had 574,000 shares outstanding all year before the October stock dividend. A stock dividend is treated as if it had been outstanding for the whole year, because it gives owners more shares without bringing in any money, so the weighted average is 574,000 times 1.05, or 602,700 shares. Earnings per share from continuing operations is $622,500 divided by 602,700, or $1.03. The discontinued operations amount to a loss of about $0.02 per share, and net earnings per share is $612,000 divided by 602,700, or $1.02; the figures differ by a cent because of rounding.

GAAP and Street Earnings

Bradshaw and Sloan (2002) compared earnings under generally accepted accounting principles with Street earnings, the figures analysts forecast and report, which exclude items such as special charges. They found that Street earnings had pulled steadily further above GAAP earnings over the years studied, and that in later years share prices reacted more strongly to surprises in the Street figure than in the GAAP one. The trend raised concern that companies were steering investors toward more favorable numbers.

Bhattacharya et al. (2003) assessed pro forma earnings that companies themselves announced. They found that pro forma earnings were, on average, more informative and more permanent than GAAP operating earnings, suggesting that excluding some items helped investors. But because managers chose what to exclude, they cautioned that pro forma figures could also be used opportunistically.

Taxes and Earnings Quality

Hanlon (2005) studied firms with large differences between book income and taxable income. Firms with large book-tax differences, especially large deferred tax liabilities, had less persistent earnings, and investors appeared to recognize this. Large gaps can arise from legitimate timing differences, but they can also signal aggressive accounting.

Cedar Valley's book-tax difference is small, mainly from faster tax depreciation on the yogurt line, which supports the persistence of its continuing earnings. The board does not report any adjusted earnings figure to stockholders; the GAAP statement, with continuing and discontinued results separated, already shows what will recur.

Other Comprehensive Income

A few kinds of gain and loss skip net income entirely and land in other comprehensive income, for example paper gains on some investments and certain pension remeasurements. Cedar Valley holds no such items, so its comprehensive income equals its net income. If the creamery later invests its warehouse reserve in bonds held for sale, changes in their fair value would appear there, and the statements would add a statement of comprehensive income.

What a Stockholder Should Take From the Statement

An employee who owns 1,000 shares sees net earnings per share of $1.02, so the employee's share of the year's profit was about $1,020, of which $300 was paid as the cash dividend in Module 3 and the rest retained to grow the business. The continuing operations figure, $1.03, is the better guide to next year, because the butter brand is gone. The stockholder should also notice that operating income of $950,000 on sales of $18.4 million is a margin of about 5%, thin enough that a rise in milk prices could erase much of the profit.

Conclusion

The income statement separates the continuing business from the butter brand and reports EPS of $1.03 from continuing operations. Bradshaw and Sloan and Bhattacharya and colleagues show why users look beyond net income, and Hanlon shows how taxes can reveal earnings quality.

References

Bhattacharya, N., Black, E. L., Christensen, T. E., & Larson, C. R. (2003). Assessing the relative informativeness and permanence of pro forma earnings and GAAP operating earnings. Journal of Accounting and Economics, 36(1-3), 285-319. https://doi.org/10.1016/j.jacceco.2003.06.001

Bradshaw, M. T., & Sloan, R. G. (2002). GAAP versus the Street: An empirical assessment of two alternative definitions of earnings. Journal of Accounting Research, 40(1), 41-66. https://doi.org/10.1111/1475-679X.00038

Hanlon, M. (2005). The persistence and pricing of earnings, accruals, and cash flows when firms have large book-tax differences. The Accounting Review, 80(1), 137-166. https://doi.org/10.2308/accr.2005.80.1.137