Chapter 3 Income Statement and Statement of Stockholders’ Equity Copyright © 2016 Pearson Education, Inc.

Income Statement and Statement of Stockholder’s Equity Also called the statement of earnings Presents a firm’s revenues, expenses, net income, and earnings per share Statement of Stockholder’s Equity Link between balance sheet and income statement Annual reports include three years of income statements and stockholder’s equity information. Copyright © 2016 Pearson Education, Inc.

The Income Statement Comes in two basic formats Multiple-step format Single-step format Multiple-step format should be used for analysis purposes. Copyright © 2016 Pearson Education, Inc.

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 Copyright © 2016 Pearson Education, Inc.

The Income Statement Copyright © 2016 Pearson Education, Inc.

The Income Statement Single-step format Groups all items of revenue together, then deducts all categories of expense Copyright © 2016 Pearson Education, Inc.

The Income Statement Copyright © 2016 Pearson Education, Inc.

The Income Statement Regardless of format, certain items must be disclosed separately on an income statement: Discontinued operations Extraordinary transactions Copyright © 2016 Pearson Education, Inc.

The Income Statement Comprehensive Income Change in equity 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. Copyright © 2016 Pearson Education, Inc.

The Income Statement Common-Size Income Statement Useful analytical tool Compare firms with different levels of sales or total assets Facilitate internal or structural analysis Evaluate trends Make industry comparisons Copyright © 2016 Pearson Education, Inc.

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 Copyright © 2016 Pearson Education, Inc.

The Income Statement Copyright © 2016 Pearson Education, Inc.

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. Copyright © 2016 Pearson Education, Inc.

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. Copyright © 2016 Pearson Education, Inc.

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. Copyright © 2016 Pearson Education, Inc.

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 Copyright © 2016 Pearson Education, Inc.

The Income Statement Cost of Goods Sold Percentage Ratio of cost of goods sold and net sales Important for profit determination Copyright © 2016 Pearson Education, Inc.

The Income Statement Cost of Goods Sold Percentage – Sage Inc. Increased between 2014 and 2015 MD&A explains that lower prices on footwear have resulted in lower margins. Copyright © 2016 Pearson Education, Inc.

The Income Statement Copyright © 2016 Pearson Education, Inc.

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 Copyright © 2016 Pearson Education, Inc.

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 Copyright © 2016 Pearson Education, Inc.

The Income Statement Gross Profit Margin – Sage Inc. Copyright © 2016 Pearson Education, Inc.

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. Copyright © 2016 Pearson Education, Inc.

The Income Statement Copyright © 2016 Pearson Education, Inc.

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 Copyright © 2016 Pearson Education, Inc.

The Income Statement Operating Expenses Selling and administrative expenses Advertising costs Depreciation and amortization Repairs and maintenance Impairment charges Copyright © 2016 Pearson Education, Inc.

The Income Statement Operating Expenses – Selling and Administrative Expenses Relate to the sale of products or services Salaries, rent, insurance, utilities, supplies, etc. Copyright © 2016 Pearson Education, Inc.

The Income Statement Operating Expenses – Advertising Costs Are or should be a major expense when marketing is an important element of success Copyright © 2016 Pearson Education, Inc.

The Income Statement Advertising Costs for Sage Inc. Sage Inc. spends 6 to 7 cents of every sales dollar for advertising. Copyright © 2016 Pearson Education, Inc.

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. Copyright © 2016 Pearson Education, Inc.

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. Copyright © 2016 Pearson Education, Inc.

The Income Statement Operating Expenses – Depreciation and Amortization Depreciation is used to allocate the cost of tangible fixed assets. Amortization is an allocation process applied to capital leases, leasehold improvements, and cost expiration of intangible assets. Depletion is an allocation process applied to acquisition and development of natural resources. Copyright © 2016 Pearson Education, Inc.

The Income Statement Percentage of Depreciation and Amortization Expense for Sage Inc. Decreased somewhat from 2015 to 2016 New assets were placed in service during 2016 for only a part of the year (rendering less than full year’s depreciation and amortization). Copyright © 2016 Pearson Education, Inc.

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 Copyright © 2016 Pearson Education, Inc.

The Income Statement Percentage of Repairs and Maintenance Expense for Sage Inc. Decreased from 2015 to 2016 Could be a result of having newer fixed assets needing fewer repairs Could be a choice to delay repairs in order to increase operating profit in the short term Copyright © 2016 Pearson Education, Inc.

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 Copyright © 2016 Pearson Education, Inc.

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 Copyright © 2016 Pearson Education, Inc.

The Income Statement Operating Profit Margin Ratio of operating profit to net sales Copyright © 2016 Pearson Education, Inc.

The Income Statement Operating Profit Margin for Sage Inc. Indicates that Sage Inc. strengthened its return on operations in 2016 after a dip in 2015 Despite the percentage increase in cost of goods sold, Sage Inc.’s percentage of selling and administrative and advertising expenses decreased enough to increase operating profit. Copyright © 2016 Pearson Education, Inc.

The Income Statement Other Income (Expense) Revenues and costs other than from operations Dividend and interest income Interest expense Investment gains (losses) Equity earnings (loss) Gains (losses) from sale of fixed assets Copyright © 2016 Pearson Education, Inc.

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. Copyright © 2016 Pearson Education, Inc.

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 Copyright © 2016 Pearson Education, Inc.

The Income Statement Equity Earnings Two accounting methods for investments in voting stock of other companies Equity method Cost method Analysts should be aware of whether a company uses the equity or cost method. Copyright © 2016 Pearson Education, Inc.

The Income Statement Equity Earnings – Equity Method Allows the investor proportionate recognition of the investee’s net income, irrespective of the payment or nonpayment of cash dividends Should be used when the investor can exercise significant influence over the investee’s operating and financing policies Fits accrual accounting requirements Distorts earnings when income is recognized and no cash may ever be received Copyright © 2016 Pearson Education, Inc.

The Income Statement Equity Earnings – Cost Method Investor recognizes investment income only to the extent of any cash dividends received. Allows recognition of investment income only to the extent of any cash dividends actually received Carries an investment account at cost Copyright © 2016 Pearson Education, Inc.

The Income Statement Example – Assume that company A acquires exactly 20% of the voting common stock of Company B for $400,000. Company B reports $100,000 earnings for the year and pays $25,000 in cash dividends. For company A, income recognition in the earnings statement and the noncurrent investment account on the balance sheet are different depending on the accounting method. Copyright © 2016 Pearson Education, Inc.

The Income Statement Cost Method Allows recognition of investment income only to the extent of any cash dividends actually received: $25,000 x 0.20 = $5,000 Investment account is carried at cost. Copyright © 2016 Pearson Education, Inc.

The Income Statement Equity Method Permits the investor to count as income the percentage interest in the investee’s earnings. Copyright © 2016 Pearson Education, Inc.

The Income Statement Equity Method Investment account is increased by the amount of investment income recognized and is reduced by the amount of cash dividends received. Copyright © 2016 Pearson Education, Inc.

The Income Statement Equity Method Distorts earnings Income is recognized even though no cash may ever be received. Assumes that the investor could cause the investee to pay dividends (which may not be true) Copyright © 2016 Pearson Education, Inc.

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. Copyright © 2016 Pearson Education, Inc.

The Income Statement Sage Inc.’s Effective Tax Rate Copyright © 2016 Pearson Education, Inc.

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. Copyright © 2016 Pearson Education, Inc.

The Income Statement Special Items Often one-time items that will not recur in the future Discontinued operations Extraordinary gains and losses Copyright © 2016 Pearson Education, Inc.

The Income Statement Net Earnings Also called the “bottom line” Represents profit after consideration of all revenue and expense Copyright © 2016 Pearson Education, Inc.

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 Copyright © 2016 Pearson Education, Inc.

The Income Statement Net Profit Margin for Sage Inc. Copyright © 2016 Pearson Education, Inc.

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. Analysts should consider material changes in the number of common stock shares outstanding. Copyright © 2016 Pearson Education, Inc.

The Income Statement Comprehensive Income Reported in one of three ways On the face of the income statement In a separate statement of comprehensive income In the statement of stockholders’ equity Copyright © 2016 Pearson Education, Inc.

The Income Statement Copyright © 2016 Pearson Education, Inc.

The Income Statement Comprehensive Income Foreign currency translation effects Unrealized gains and losses Additional pension liabilities Cash flow hedges Copyright © 2016 Pearson Education, Inc.

The Income Statement Comprehensive Income – Foreign Currency Translation Effects Arise from changes in equity of foreign subsidiaries Occur as a result of changes in foreign currency exchange rates Copyright © 2016 Pearson Education, Inc.

The Income Statement Comprehensive Income – Unrealized Gains and Losses Cumulative net unrealized gains and losses Copyright © 2016 Pearson Education, Inc.

The Income Statement Comprehensive Income – Additional Pension Liabilities Reported when accumulated benefit obligation is greater than the fair market value of plan assets less the balance of the accrued pension liability account or plus the balance in the deferred pension asset account Copyright © 2016 Pearson Education, Inc.

The Income Statement Comprehensive Income – Cash Flow Hedges Derivatives designated as hedging the exposure to variable cash flows of a forecasted transaction Companies using cash flow hedges must initially report any gain or loss in other comprehensive income and subsequently reclassify the amount into earnings when the forecasted transaction affects earnings. Copyright © 2016 Pearson Education, Inc.

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 Copyright © 2016 Pearson Education, Inc.

Statement of Stockholders’ Equity Copyright © 2016 Pearson Education, Inc.

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 Copyright © 2016 Pearson Education, Inc.

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. Copyright © 2016 Pearson Education, Inc.

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. Copyright © 2016 Pearson Education, Inc.

Copyright Notice All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2016 Pearson Education, Inc.