3 Days of Accounting :D.. Wednesday AM Introduction Wednesday PM Income Statement Thursday AM Balance Sheet Thursday PM Cash Flow Statement Friday AM Practical Exam & Conclusion

The Income Statement Also called the statement of earnings Presents a firm’s: revenues expenses net income earnings per share Annual reports include three years of income statements.

The Income Statement Comes in two basic formats Single-step format Multiple-step format Multiple-step format should be used for analysis purposes.

The Income Statement Single-step format Groups all items of revenue together, then deducts all categories of expense

The Income Statement

Single-Step Income Statement Relevant Information Advertising = 2,000 Commissions = 5,000 Cost Of Goods Sold = 75,000 Gain on Sale of Investment = 3,000 Interest Expense = 500 Interest Revenues = 5,000 Loss from Lawsuit = 1,500 Office Equipment = 2,500 Office Supplies = 3,500

The Income Statement Multiple-step format Provides several intermediate profit measures prior to the amount of net earnings for the period Gross profit Operating profit Earnings before income tax

The Income Statement

The Income Statement Regardless of format, certain items must be disclosed separately on an income statement: Discontinued operations Extraordinary transactions

The Income Statement Comprehensive Income Change in equity of a company during a period from transactions, other events, and circumstances related to nonowner sources. Companies are required to report comprehensive income in one of three ways: on the face of its income statement in a separate statement of comprehensive income, or in its statement of stockholders’ equity.

The Income Statement Common-Size Income Statement Useful analytical tool to: compare firms with different levels of sales or total assets, facilitate internal or structural analysis, evaluate trends, and make industry comparisons.

The Income Statement Common-Size Income Statement Expresses each income statement item as a percentage of net sales Shows the relative magnitude of various expenses relative to sales, the profit percentages, and the relative importance of “other” revenues and expenses

The Income Statement

The Income Statement Net Sales Total sales revenue is shown net of returns and allowances. A sales return is a cancellation of a sale. A sales allowance is a deduction from the original sales invoice price. Sales are the major revenue source for most companies.

The Income Statement Net Sales If a company’s sales are increasing (or decreasing), it is important to determine whether the change is a result of price, volume, or a combination of both. The reasons for sales growth (or decline) are covered in the Management Discussion and Analysis section of the annual or 10-K report.

The Income Statement Net Sales “Real” (inflation adjusted) sales growth “Nominal” (as reported) sales growth An adjustment of the reported sales figure with the Consumer Price Index (or some other measure of general inflation) will enable the analyst to compare changes in real and nominal terms.

The Income Statement Cost of Goods Sold Also called cost of sales Cost to seller of products or services sold to customers Affected by cost flow assumption used to value inventory Largest expense for many firms

The Income Statement Cost of Goods Sold Percentage Ratio of cost of goods sold and net sales Important for profit determination

The Income Statement

The Income Statement Gross Profit Also called gross margin Difference between net sales and cost of goods sold First step of profit measurement on the multi-step income statement Key analytical tool in assessing operating performance

The Income Statement Gross Profit Margin Ratio of gross profit to net sales (expressed as a percentage) Complement of the cost of goods sold percentage Firms want to maintain or increase gross profit margin. Remains relatively constant in stable industries May change significantly in volatile industries

The Income Statement Gross Profit Margin – Multiple Revenue Sources Each revenue is shown separately. Each revenue line will show the corresponding cost of goods sold for each revenue source.

The Income Statement

The Income Statement Operating Expense Includes areas in which management discretion is exercised Has considerable impact on current and future profitability Important to track trends, absolute amounts, relationship to sales, and relationship to industry competitors

The Income Statement Operating Expenses Selling and administrative expenses Advertising costs Depreciation and amortization Repairs and maintenance Impairment charges

The Income Statement Operating Expenses – Selling and Administrative Expenses Relate to the sale of products or services Salaries, rent, insurance, utilities, supplies, etc.

The Income Statement Operating Expenses – Advertising Costs Are or should be a major expense when marketing is an important element of success

The Income Statement Operating Expenses – Lease Payments Costs associated with operating rentals of leased facilities for retail outlets Note 3 to the financial statements explains the agreements that apply to the rental arrangements and presents a schedule of minimum annual rental commitments.

The Income Statement Operating Expenses – Depreciation and Amortization Cost of assets other than land that will benefit a business enterprise for more than a year is allocated over the asset’s service life. Cost allocation procedure is determined by the nature of the long-lived asset.

The Income Statement Operating Expenses – Depreciation and Amortization Depreciation is used to allocate the cost of tangible fixed assets, such as: buildings machinery equipment furniture and fixtures motor vehicles

The Income Statement Operating Expenses – Depreciation and Amortization Amortization is an allocation process applied to: capital leases leasehold improvements cost expiration of intangible assets, such as patents, copyrights, trademarks, and franchises

The Income Statement Operating Expenses – Depreciation and Amortization Depletion is an allocation process applied to acquisition and development of natural resources, such as: oil and gas other minerals standing timber

The Income Statement Operating Expenses – Repairs and Maintenance Annual costs of repairing and maintaining PP&E Should correspond to the level of investment in capital equipment and to the age and condition of fixed assets Inadequate allowance can impair success. Should be evaluated in relation to the firm’s investments in fixed assets

The Income Statement Operating Expenses – Impairment Charges Recognized to record a decline in value of a long-term asset May occur in connection with goodwill Can also be recognized when asset values of PP&E decrease below book value

The Income Statement Operating Profit Also called earnings before interest and taxes (EBIT) Second step of profit determination on the multi-step income statement Measures overall performance of operations Provides a basis for assessing success of a firm apart from financing and investing activities and separate from tax considerations Sales revenue less the expenses associated with generating sales

The Income Statement Operating Profit Margin Ratio of operating profit to net sales

The Income Statement Other Income (Expense) Revenues and costs other than from operations, such as: dividend and interest income interest expense investment gains (losses) equity earnings (loss) gains (losses) from sale of fixed assets

The Income Statement Other Income (Expense) Firms that carry debt and equity securities classified as “trading securities” report these investments on the balance sheet at market value with any unrealized gains and losses included in earnings.

The Income Statement Other Income (Expense) In assessment of earning quality, the analyst should consider the materiality and the variability of the nonoperating items of income: Gains and losses on the sale of major capital assets Accounting changes Extraordinary items Investment income from temporary investments in cash equivalents Investment income recognized under the equity method

The Income Statement Earnings Before Income Taxes / Effective Tax Rate Earnings before income taxes is the profit recognized before the deduction of income tax expense. Income taxes paid may differ from income tax expense. Effective tax rate is the ratio of income taxes to earnings before income taxes.

The Income Statement Earnings Before Income Taxes / Effective Tax Rate Noteworthy items that may affect the effective tax rate are net operating losses (NOLs) and foreign taxes. Users of financial statements need to distinguish between earnings increasing due to core operations versus items such as tax rate deductions.

The Income Statement Special Items Often one-time items that will not recur in the future Discontinued operations Occur when a firm sells or discontinues a clearly distinguishable portion of its business Extraordinary gains and losses Unusual in nature Not expected to recur in the future

The Income Statement Net Earnings Also called the “bottom line” Represents profit after consideration of all revenue and expense

The Income Statement Net Profit Margin Ratio of net earnings to net sales (expressed as a percentage) Shows the percentage of profit earned on every sales dollar

Multi-Step Income Statement Relevant Information Advertising = 2,000 Commissions = 5,000 Cost Of Goods Sold = 75,000 Gain on Sale of Investment = 3,000 Interest Expense = 500 Interest Revenues = 5,000 Loss from Lawsuit = 1,500 Office Equipment = 2,500 Office Supplies = 3,500

The Income Statement Earnings per Common Share Net earnings available to common stockholders for the period divided by the average number of common stock shares outstanding Firms with complex capital structure report basic and diluted earnings per common share.

The Income Statement Earnings per Common Share Analysts should consider material changes in the number of common stock shares outstanding, such as: treasury stock purchases purchase and retirement of a firm’s own common stock stock splits reverse stock splits

Statement of Stockholders’ Equity Important link between the balance sheet and the income statement Documents changes in the balance sheet equity accounts Annual reports include three years of stockholders’ equity information

Statement of Stockholders’ Equity

Statement of Stockholders’ Equity Stock dividends Issuance of additional shares of stock in proportion to current ownership Reduce retained earnings account Stock splits Used to lower the market price of shares to make common stock more affordable Reverse stock splits Occurs when outstanding shares are decreased

Earnings Quality, Cash Flow, and Segmental Accounting Assessment of the quality of reported earnings is an essential element of income statement analysis. Cash flow from operations is a key ingredient in analyzing operating performance.

Earnings Quality, Cash Flow, and Segmental Accounting Segmental data include revenue, operating profit or loss, assets, depreciation and amortization, and capital expenditures by industry components. These disclosures facilitate analysis of operating performance and contribution by each segment.

Statement of Retained Earnings Prepared to reconcile the beginning and ending retained earnings balances Beginning RE + Net Income – Dividends = Ending RE Statement has standard heading as shown below