UNDERSTANDING FINANCIAL STATEMENTS THE INCOME STATEMENT and THE STATEMENT OF STOCKHOLDERS’ EQUITY Chapter 3 Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

The Income Statement Revenues Expenses Net Income Earnings Per Share Also called the Statement of Earnings Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Statement of Shareholders’ Equity Documents changes in balance sheet equity accounts from one accounting period to the next Provides an important link between the balance sheet and the income statement Company may report info in note or supplementary schedule rather than formal statement if desired….(many do!) Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Income Statement Earnings reported on income statement DO NOT EQUAL cash generated during accounting period (no, we are not ignoring cash…stay tuned for Chapter 4 in due time) Income Statement may take multi-step or single step form, but regardless of form, “outline” is as follows……………... Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

“Outline” of Income Statement Income from Continuing Operations “Below the line” Items (reported net of tax): Income from Discontinued Operations Extraordinary Gains and Losses Cumulative Effect of a Change in Accounting Principle Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

“Comprehensive” Income Beginning in 1998, companies required to report COMPREHENSIVE INCOME Comprehensive income includes ALL changes in equity during a period except those resulting from investments by owners and distributions to owners Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Where do I find it? Comprehensive Income may be reported in one of three ways: on the face of the income statement in a separate statement of comprehensive income in a statement of stockholders’ equity We’ll look at this a bit later, but first let’s take a look at the MAJOR CATEGORIES of an income statement Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Major Categories Focus on MULTIPLE-STEP Statement (it has more detail and is more useful…) NET SALES: A firm’s sales are usually reported as Sales less Sales Returns less Sales Allowances the major source of revenue for most companies trends are important Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Major Categories (continued) Cost of Goods Sold (CGS) cost to seller of products sold to customers relationship between CGS and sales is an important one Gross Profit (first step of profit determination) difference between net sales and CGS key analytical tool in analyzing firm’s operating performance Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Major Categories (continued) Operating Expenses Include such things as selling expenses, administrative expenses, advertising, lease payments, depreciation, amortization, repairs and maintenance Important to track carefully -- trends, absolute amounts, relationship to sales, relationship to industry competitors Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Major Categories (continued) Operating Profit (second step of profit determination) -- also called EBIT measures overall performance of company’s operations: sales revenue less expenses associated with generating sales Other Income/Expense includes revenues/expenses other than from operations, e.g. interest Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Major Categories (continued) Earnings before income taxes profit recognized before deduction of income tax expense remember, income taxes paid may differ from income tax expense (deferred taxes) Net Earnings “bottom line” -- firm’s profit after consideration of ALL revenues & expenses Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Major Categories (continued) Earnings per Common Share Determined by dividing earnings available to common shareholders (earnings less any preferred dividend requirements) by average number of common shares outstanding during the period If firm has “complex” capital structure, it will report basic and diluted EPS Extensively used by analysts in evaluating a firm Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Last but not least…. SOMEWHERE, the firm must report Comprehensive Income May be on the face of the income statement, may be in the statement of stockholders’ equity, may be in a separate financial statement Wherever it is -- let’s take a look at what it includes Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Comprehensive Income Includes Net Earnings computed as illustrated Also includes foreign currency translation adjustments, unrealized gains/losses on available-for-sale securities, additional pension liabilities and changes in fair market value of cash flow hedges (beyond the scope of this text…count your blessings!) Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Statement of S/E Details transactions that affected the balance sheet equity accounts during an accounting period In a nutshell, it simply explains how each account got from the balance at the beginning of the period to the balance at the end of the period and describes “events” that caused the balances to change Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Retained Earnings Changes in R/E account are primarily result of net income/loss and dividends Balance can also be affected by prior period adjustments and some changes in accounting principles Changes in R/E are watched by analysts and the details on what caused the changes are documented in the Statement of Stockholders’ Equity Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Complications: Cost vs Equity Two methods may be used to account for investments in other companies -- can make evaluation of a company’s financial condition more complicated If “significant influence” exists, the EQUITY METHOD is used If equity method is used, the income of the investee is recognized when earned instead of when received as dividends Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

SUMMARY Income Statement is important, but it is not the “be all and end all” statement Statement of Stockholders’ Equity can provide useful information for analysis Income Statement provides “fertile ground” for the savvy analyst to till! All in all, earnings are important!!! Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

STATEMENT OF CASH FLOWS “Coming Attractions” NEXT ON THE AGENDA STATEMENT OF CASH FLOWS Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing