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									The Income Statement


       Chapter 4
Introduction
• Four major types of items appear on
  income statements.
  –   Revenues
  –   Expenses
  –   Gains
  –   Losses
Revenues
• Revenues are inflows of assets (or
  reductions in liabilities) from
  providing goods and services to
  customers.
• Revenues arise from the firm's
  ongoing, central operations.
Expenses
• Expenses arise from consuming
  resources in order to generate
  revenue.
• As is true for revenues, expenses arise
  from the firm's ongoing, central
  operations.
Gains
• Gains increase assets or decrease
  liabilities.
  – A gain differs from a revenue in that
    gains arise from peripheral transactions
    of the business.
Gains
• Gains increase assets or decrease
  liabilities.
  – A paper company earns revenues by
    selling paper.
Gains
• Gains increase assets or decrease
  liabilities.
  – If it sells extra equipment from the
    employee lounge for more than the
    equipment's carrying value, then it will
    have a gain, not revenue.
Losses
• Losses decrease assets or increase
  liabilities.
  – A loss differs from an expense, however,
    in that losses arise from peripheral
    transactions of the business.
Losses
• Losses decrease assets or increase
  liabilities.
  – Returning to the above example—if the
    paper company sells that extra
    equipment for less than its carrying
    value, then it will have a loss, not an
    expense.
The Materiality Principle
• The materiality principle states that
  separate disclosure on a financial
  statement is not required if an item is
  so small that knowledge of it would
  not affect the decision of a reasonable
  financial statement reader.
Net Sales
• Net sales is the difference between
  gross sales and certain items, such as
  sales returns.
Gross Margin
• Gross margin is the difference
  between net sales and cost of goods
  sold.
Selling Expenses
• Selling expenses include any expenses
  necessary for the sale of goods, such as
  advertising and commissions.
Administrative Expenses
• Administrative expenses include
  expenses related to the administration
  of the business, such as management
  salaries and legal and accounting fees.
Operating Income
• Operating income is the difference
  between gross margin and selling and
  administrative expenses.
Operating Income
• When interest and income tax expense
  are deducted from operating income,
  the result is net income.
Remember the following
important difference:
• Revenue refers to the total inflow of
  assets or reduction in liabilities.
• Profit is the net increase in a firm's
  recorded wealth after deducting
  expenses.
Presenting the Income
Statement
• Income statements may be presented
  in several different formats.
  – The multiple-step income statement
    shows various relationships.
  – The single-step format adds up all
    revenues and all expenses and does a
    single step, a subtraction, with the totals.
          Multi-Step Income Statement
Net Sales                                  $ 172,428
Cost of sales                                134,373
Gross profit                                  38,055
Selling, general and administrative
    expenses                                 14,844
Income from operations                       23,211
Other income                                  1,503
Interest expense                                 31
Income before provision for income taxes     24,683
Provision for income taxes                   10,016
Net income                                 $ 14,667
          Single Step Income Statement
Revenues
 Net sales                                    $172,428
 Other income                                     1,503
Expenses
 Cost of goods sold                  $134,373
 Selling, general and administrative
 expenses                              14,844
 Interest expense                          31
 Provision for income taxes            10,016
Total expenses                                 159,264
Net income                                    $ 14,667
Uses of the Income
Statement
• A major purpose of the income
  statement is to show a firm's
  profitability.
• Investors, lenders, and company
  management all use income statement
  information for their assorted
  purposes.
Revenue Recognition
• A firm’s earning process often takes
  place over an extended period of time.
Revenue Recognition
Principle
• One of the generally accepted
  accounting principles is the revenue
  recognition principle.
Revenue Recognition
Principle
• The revenue recognition principle
  states that revenue should be
  recognized in the accounting records
  when the earnings process is
  substantially complete and the
  amount to be collected is reasonably
  determinable.
Revenue Recognition
Principle
• In most cases, revenue is recognized at
  the point of sale.
Revenue Recognition
Principle
• Revenue is earned, and thus recorded,
  whether or not cash is received.
Revenue Recognition
Principle
• Payment for a good or service may be
  in the form of cash or an account
  receivable.
Exceptions to the Revenue
Recognition Principle
• There are several exceptions to the
  revenue recognition principle.
Exceptions to the Revenue
Recognition Principle
• If a seller is highly uncertain about the
  collectibility of receivables, then he
  should not recognize revenue until he
  receives cash.
Exceptions to the Revenue
Recognition Principle
• With respect to long-term construction
  contracts, a contractor may use the
  percentage-of-completion method to
  record revenues and profits
  periodically.
Exceptions to the Revenue
Recognition Principle
• Another exception is certain service
  contracts.
Revenue Recognition
• A company ought to disclose its
  revenue recognition policies in the
  notes to the financial statements.
Expense Recognition
• The matching principle drives expense
  recognition.
Matching Principle
• It states that costs incurred to generate
  revenue appearing on the income
  statement in a given period should
  appear on the income statement in
  that same period.
Matching Principle
• The matching principle is
  implemented in one of three ways.
Matching Principle
• First is associating cause and effect,
  which implies that there is a clear and
  direct relationship between an
  expense and a revenue.
Matching Principle
• Second is systematic and rational
  allocation, which is used when a cost
  cannot be directly linked to specific
  revenue transactions—the cost is
  simply allocated over time.
Matching Principle
• Third is immediate recognition, used
  when costs have no discernible future
  benefit and thus are expensed
  immediately.
A Closer Look at the Income
Statement
• Income statements summarize past
  transactions and events.
• But many financial statement users are
  concerned about the future, about
  earnings sustainability.
A Closer Look at the Income
Statement
• GAAP requires that income
  statements report certain items
  separately from ongoing operations.
  – Examples include discontinued
    operations and extraordinary items.
Discontinued Operations
• Discontinued operations occur when a
  firm ceases, or plans to cease,
  operating, a major segment of its
  business.
Discontinued Operations
• There are two line items.
  – The results of operating the segment.
  – The loss realized on the disposal.
  – These items are shown net of income tax.
Discontinued Operations
• Since there is presumably a loss on
  discontinued operations, the tax effect
  is a tax benefit because losses lower
  the taxes a firm must pay.
Discontinued Operations
• To make predictions about future
  earnings, most analysts will add back
  the losses to reported net earnings to
  obtain adjusted net earnings because
  the discontinued operations results
  will not recur in the future.
Extraordinary Items
• Extraordinary items are events and
  transactions that are unusual in nature
  and infrequent in occurrence.
  – Evaluating both of those characteristics
    requires great judgment on the part of the
    accountant who decides whether or not
    an item is extraordinary.
Extraordinary Items
• These items, such as natural disasters
  and a foreign government's
  expropriation of a firm's assets, are
  also shown net of income tax.
Extraordinary Items
• An extraordinary item may be either a
  gain or a loss.
Earnings Per Share
• Earnings per share must be disclosed
  on the face of the income statement.
Earnings Per Share
• Earnings per share is computed by
  dividing net income by the average
  number of shares of stock
  outstanding.
                  Net income
         EPS =
               Shares outstanding
Earnings Per Share
• Earnings per share is computed by
  dividing net income by the average
  number of shares of stock
  outstanding.
  – If net income is $100,000, and there are
    200,000 shares of stock outstanding, then
    earnings per share is $ .50
    ($100,000/200,000).
Analyzing the Income
Statement
• The income statement contains a
  number of measures related to a firm’s
  ability to generate earnings.
• This helps analysts assess a firm’s
  expected return.
Vertical Analysis
• Vertical analysis examines
  relationships within a given year.
  – This is accomplished by dividing each
    line of the income statement by the first
    item, which is net sales.
  – This yields common-size income
    statements in percentage terms.
Common-Size Income
Statements
• The top line will always be 100%
  because net sales divided by itself
  yields 100%.
Common-Size Income
Statements
• The second line—cost of products sold
  divided by net sales—is referred to as
  the cost of goods sold percentage.
Common-Size Income
Statements
• The third line—gross profit (or gross
  margin) percentage—is calculated by
  dividing gross profit by net sales or by
  subtracting the cost of goods sold
  percentage from 100%.
Common-Size Income
Statements
• The fourth line reflects the
  relationship between selling, general,
  and administrative expences.
Common-Size Income
Statements
• The operating income percentage is a
  measure of management's success in
  operating the firm.
Common-Size Income
Statements
• The net income percentage is a
  measure of the firm's overall
  profitability.
Common-Size Income
Statements
• A lower cost of goods sold percentage
  and a higher gross profit percentage
  are desirable.
                     Income Statements
                                              Year Ended December 31,
                                                1997         1996
Net Sales                                     $395,196  $444,766
Cost of products sold                          250,815   300,495
Gross profit                                   144,381   144,271
Selling, general, & administrative expenses    115,439   122,055
Special charges and plant closings                        32,900
Royalty income, net                             (7,945)   (6,100)
Operating income (loss)                         36,887    (4,584)
Interest expense                                  (305)   (1,088)
Other income                                     1,605     1,575
Income (loss) before taxes                      38,187    (4,097)
Income taxes (benefit)                          15,629    (5,216)
Net income                                    $ 22,558 $ 1,119
         Common-Size Income Statements
                                              Year Ended December 31,
                                                1997         1996
Net Sales                                        100.0%      100.0%
Cost of products sold                             63.5        67.6
Gross profit                                      36.5        32.4
Selling, general, & administrative expenses       29.2        27.4
Special charges and plant closings                             7.4
Royalty income, net                                (2.0)      (1.4)
Operating income (loss)                             9.3       (1.0)
Interest expense                                   (0.1)      (0.2)
Other income                                        0.5        0.3
Income (loss) before taxes                          9.7       (0.9)
Income taxes (benefit)                              4.0       (1.2)
Net income                                          5.7%       0.3%
Trend Analysis
• Trend analysis involves comparing
  financial statement numbers over a
  period of time.
• One way to accomplish this is to
  compare the common-size income
  statement items over a period of time.
Horizontal Analysis
• Another form of trend analysis is
  horizontal analysis.
Horizontal Analysis
• Horizontal analysis uses the figures
  from a prior year's income statement
  as the base year for calculating
  percentage increases over a period of
  time.
Horizontal Analysis
• Assume that net income for 1996 is
  $100,000 and for 1997 is $110,000.
• Net income has thus increased by
  $10,000.
  – Dividing the $10,000 increase by the 1996
    base year net income number of $100,000
    shows that net income has increased by
    10% from one year to the next.
The Return on
Shareholders' Equity Ratio
• The return on shareholders' equity
  (ROE) ratio is computed by dividing
  net income by average shareholders'
  equity.
                Net income
  ROE =
        Average shareholders' equity
The Return on
Shareholders' Equity Ratio
• Average shareholders' equity is
  computed by adding the beginning-of-
  the-year and the end-of-the-year
  shareholders' equity balances and then
  dividing the total by 2.
Return on Assets Ratio
• The return on assets (ROA) ratio
  relates a firm's earnings to all assets
  the firm has available to generate
  those earnings.
Return on Assets Ratio
 • It is computed by dividing average
   total assets into the sum of net income
   and interest expense (net of income
   tax).

     ROA =
Net income + Interest expense  (1 - tax rate)
           Average total assets
Times Interest Earned
• The times interest earned ratio shows
  how many times interest expense is
  covered by resources generated from
  operations and is very important to
  creditors of a business.
Times Interest Earned
• It is computed by dividing earnings
  before interest and taxes by interest
  expense.

    Times interest expense =
  Earnings before interest and taxes
          Interest expense
Times Interest Earned
• A creditor would certainly prefer a
  high number instead of a low number
  for this ratio.
Limitations of Accounting
Income
• For some assets, an increase in value is
  recognized only at the disposal of the
  asset.
• Financial statements often do not
  reflect accomplishments of a firm, as
  in the case of an executory contract.
Limitations of Accounting
Income
• The conservatism principle, one of the
  generally accepted accounting
  principles, also may limit the extent to
  which accounting income reflects
  changes in wealth.
Limitations of Accounting
Income
• The conservatism principle states that
  when given a choice between or
  among acceptable alternatives for
  treatment for a transaction, the
  accountant should choose the
  alternative which least overstates
  assets and income.
Accounting Income and
Economic Consequences
• Reported earnings have an affect on
  managers' wealth and consequently,
  on their accounting policy decisions.
  – Bonuses can motivate a company's
    managers to make accounting-related
    decisions that do not affect the
    underlying profitability of the company
    but that do affect reported accounting
    income.
Accounting Income and
Economic Consequences
• Reported earnings have an affect on
  managers' wealth and consequently,
  on their accounting policy decisions.
  – Because managers' self-interests influence
    their accounting policy judgments,
    financial statements may not be an
    unbiased reflection of the underlying
    economic activities of a firm.
The Income Statement


   End of Chapter 4

								
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