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Using the Income Statement to Make Decisions CHAPTER 7 Using the Income Statement to Make Decisions

PERFORMANCE OBJECTIVES PO10: Prepare single or multiple step income statements PO13b: Analyze accounting transactions to determine their effect PO18e: Distinguish between accrual and cash basis of income measurement PO19a: Prepare adjustments

PERFORMANCE OBJECTIVES PO19b: Determine amount of balance sheet & income statement accounts after adjustments PO20: Categorize income statement accounts into: Primary continuing operating activities Peripheral continuing activities Primary discontinued operating activities Peripheral discontinued activities

PERFORMANCE OBJECTIVES PO21: discuss criteria for revenue recognition

USER FOCUS Real world application How transactions affect financial statements

INSIGHTS What is true nature of peripheral activities How income can be manipulated Relationship between net income & cash flows

CMU: COMPLETING INCOME STATEMENT WITH ADJUSTMENTS Distinguishing between explicit, implicit transactions Explicit: identifiable because derived from document Check Invoice Implicit: not derived from document

DEFINITION OF ADJUSTMENTS Implicit transaction recorded at end of accounting period To ensure revenues & expenses reported in proper period Underlying concepts Accruals Deferrals

ACCRUALS Transactions in which Revenues, expenses recognized in current period Cash collected, paid in future period

ACCRUAL CONCEPT Accounting Period 1 Income effect Implicit transaction No document Accounting Period 2 Cash effect Explicit transaction Document

DEFERRALS Transactions in which Cash collected, paid in current period Revenues, expenses recognized in future period

DEFERRAL CONCEPT Accounting Period 1 Cash effect Explicit transaction Documentation Accounting Period 2 Income effect Implicit transaction No documentation

ADJUSTMENT OF CMU’S EXPLICIT REVENUE TRANSACTIONS Accrued revenue Revenue earned in current period Cash collected future period Transaction O2 $25 interest earned but not collected on savings Nature of revenue, expense Interest Revenue

TRANSACTION ANALYSIS: Accrued Revenue Transaction O2 $25 interest earned but not collected on savings Assets = 25 Liabilities + Equity 25 Interest Revenue

ADJUSTMENT OF CMU’S EXPLICIT EXPENSE TRANSACTIONS Accrued expense Expense incurred in current period Cash paid in future period Transaction X $750 salaries expense incurred but unpaid Nature of Revenue, Expense Salaries expense

TRANSACTION ANALYSIS: Accrued Expense 1 Transaction X $750 salaries expense incurred but unpaid Assets = Liabilities + 750 Equity <750> Salaries Expense

TRANSACTION ANALYSIS: Accrued Expense 2 Transaction Y $350 miscellaneous expense incurred but unpaid Assets = Liabilities + 350 Equity <350> Misc. Expense

ADJUSTMENT OF CMU’S EXPENSE TRANSACTIONS Deferred expense is asset expiration Cash paid now Expense incurred in future period Transaction Q2 $2300 depreciation recorded on equipment Nature of Revenue or Expense Depreciation Expense

ANALYSIS OF DEPRECIATION: Transaction Q2 Q1 (sold) H L Holding 8000 (12) 2000 (9/12) 7000 (5/12) 4000 (0/12) Calculation (8000/5) (2000/5)*3/4 (7000/5)*1/2 NA Amount $1,600 300 700 $2,600

TRANSACTION ANALYSIS: Deferred Expense Transaction Q2 $2300 depreciation recorded on unsold equipment Assets = <2,300> Liabilities + Equity <2,300> Depreciation Expense

ADJUSTMENT OF CMU’S REVENUE TRANSACTIONS Deferred revenue Cash collected in current period Revenue earned in future period Transaction Z $4,000 inventory delivered to customers who paid in advance Nature of Revenue, Expense Sales Revenue

TRANSACTION ANALYSIS: Deferred Revenue Transaction Z $4,000 inventory delivered to customers who paid in advance Assets = Liabilities + <4000> Equity 4000 Sales Revenue

ACCRUAL & DEFERRAL CONCEPTS: Transaction O2 Accrued revenue Period 1 +25 Receivable +25 Revenue Period 2 -25 Receivable +25 Cash

ACCRUAL & DEFERRAL CONCEPTS: Transaction X Accrued expense Period 1 +750 Expense +759 Liability Period 2 -750 Cash -750 Liability

ACCRUAL & DEFERRAL CONCEPTS: Transaction Y Accrued expense Period 1 +350 Expense +350 Liability Period 2 -350 Cash -350 Liability

ACCRUAL & DEFERRAL CONCEPTS: Transaction Q2 Deferred expense & asset expiration Period 1 +19,000 Assets 19,000 offsets (C1,H,L,&R) Period 2 +2,300 Expense -2,300 Assets

ACCRUAL & DEFERRAL CONCEPTS: Transaction Z Deferred revenue & liability reduction Period 1 +6,000 Cash +6,000 Liability Period 2 +4,000 Revenue -4,000 Liability

FINANCIAL STATEMENT RELATIONSHIPS: Credit Sale Total Revenue Increase Total Expense No Effect Net Income Total Assets Total Liabilities No effect Total Owner’s Equity

FINANCIAL STATEMENT RELATIONSHIPS: Credit Sale Error Total Revenue Understated Total Expense No effect Net Income Total Assets Total Liabilities Total Owner’s Equity

FINANCIAL STATEMENT RELATIONSHIPS: Credit Sale Omitted Total Revenue Understated Total Expense No effect Net Income Total Assets Total Liabilities Total Owner’s Equity

USER FOCUS: Hitachi Real World Application Transaction: purchase of E-business Total Revenue No effect Total Expense Net Income Total Assets No effect; + & - by $175m Total Liabilities Total Owner’s Equity

USER FOCUS: Xerox Real World Application Xerox slashes $1billion expenses Xerox sells some assets Total Revenue No effect Potential gain Total Expense Decrease Potential loss Net Income Increase Unclear Total Assets Cash increase Total liabilities Total Equity

CORPORATE INCOME STATEMENTS: Primary & Peripheral Primary operating activities More important in evaluating operations Understand essential nature of business Peripheral activities Less important in evaluating operations Not essential nature of business

CORPORATE INCOME STATEMENTS: Continuing & NonContinuing Continuing activities Transactions reported regularly on income statement NonContinuing activities Do not occur on regular basis

INSIGHT 7-1 True Nature of Peripheral Activities Investing, financing activities Not operating activities Examples Interest revenue, expense Dividend revenue Gains, losses on depreciable assets Income tax expense

PRIMARY CONTINUING OPERATING ACTIVITIES Net sales Cost of Goods Sold Gross margin (profit); Subtotal Selling, general, administrative expenses Research, development, engineering Primary operating income

PERIPHERAL CONTINUING ACTIVITIES Interest revenue, expense Dividend revenue Gains, losses on depreciable assets Income tax expense

PRIMARY DISCONTINUED OPERATING ACTIVITIES Business segment sold or about to be sold Major line of business or class of customer Gain/Loss from operations Gain/loss on disposal of business division

PERIPHERAL DISCONTINUED ACTIVITIES Significant in amount (material) Unusual in nature and infrequent in occurrence Extraordinary item Change in accounting principle

INCOME STATEMENT CATEGORIES Continuing Activities NonContinuing Activities Primary operating Creation/sale products, services Income/loss from discontinued operations, sales Peripheral activities Interest revenue, expense, dividend revenue Extraordinary items, changes in accounting principles

INCOME STATEMENT FORMAT Multiple-step income statement Deducts expenses from revenue in series of income subtotals (steps) Example: Idealistic Single-step income statement All operating expenses subtracted from total revenue Examples: General Motors, Wendy’s

DECIDING WHEN TO RECOGNIZE REVENUE Criteria Measurement: exchange process Performance All critical revenue producing services completed (earnings process complete) Matching Expenses associated with revenue have been incurred

INSIGHT 7-2 Manipulating Income with Unethical Practices Recording revenue too early Shipping goods before sales agreement exists Recording revenue before known if buyer will keep, pay for goods Recording revenue when cash received but before services performed

ANALYZING INCOME STATEMENT WITH RATIOS Activity ratios evaluate turnover Asset turnover ratio Accounts receivable turnover ratio Inventory turnover ratio Financial risk Profitability ratios Gross margin ratio Profit margin ratio Earnings per share

ACTIVITY RATIOS: Asset Turnover Ratio Measures how efficiently assets used to produce sales during period Net Sales Revenue Average Total Assets

ACTIVITY RATIOS: Accounts Receivable Turnover Ratio Measures relative frequency accounts receivable collected in cash Net Credit Sales Average Net Accounts Receivable Sales Revenue

ACTIVITY RATIOS: Collection Period Average period in days for collecting accounts receivable 365 Account Receivable Turnover Ratio

ACTIVITY RATIOS: Inventory Turnover Measures how frequently business sells inventory Efficiency of sales and production or purchasing Cost of Goods Sold Average Inventory

ACTIVITY RATIOS: Holding Period Days of inventories on hand 365 Inventory Turnover Ratio

FINANCIAL RISK: Times Interest Earned Ratio Indicates ability to meet required interest payments Net Income + Interest Expense + Income Tax Expense Interest Expense

PROFITABILITY RATIOS: Gross Margin Ratio Evaluates management’s effectiveness Range: 30% - 50% For every dollar of sales, the profit left after paying for inventory Measured in cents Gross Margin Sales

PROFITABILITY RATIOS: Profit Margin Ratio Return on Sales Measure control of expenses in relation to revenues For every dollar of sales, the profit left after paying all expenses Net Income Sales

PROFITABILITY RATIOS: Earnings Per Share Indicates relative profitability per share of common stock for the period Net Income – Preferred Stock Dividends Weighted Ave. Common Shares Outstanding

ANALYZING INCOME STATEMENT: Vertical Analysis Expresses each item as a percentage of single designated item with financial statement Balance Sheet: Total Assets Income Statement: Net sales

ANALYZING INCOME STATEMENT: Horizontal Analysis Compares how financial statement items change from year to year Year 2 – Year 1 Year 1

USING INFORMATION NOT IN INCOME STATEMENT Management’s Discussion & Analysis (MD&A) Discusses results of operations Notes Summary of significant accounting policies Revenue recognition Detail for income statement accounts

INSIGHT 7-3: Relationship Net Income, Cash Flows Operating activities not only source, use of cash Accrual basis net income differs from cash flow operating activities