Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1 Understanding Financial Statements NINTH EDITION Lyn M. Fraser Aileen Ormiston

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-2 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 © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-3 Chapter 3: Income Statement and Statement of Stockholders’ Equity Learning about earnings, the bottom line, Is very important most of the time. A phony number Just may encumber Those folks trying to make more than a dime. --A. Ormiston

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-4 Income Statement and Statement of Stockholders’ Equity Operating performance of a firm has traditionally been measured by its success generating earnings – the “bottom line.” Annual reports include three years of income statements and stockholder’s equity.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-5 The Income Statement Also called the statement of earnings Presents a business firm’s revenues revenues expenses expenses net income net income earnings per share earnings per share Reveals management’s ability to translate sales dollars into profits

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-6 The Income Statement Comes in two basic formats Multiple-step Multiple-step − Provides several intermediate profit measures prior to the amount of net earnings for the period Single-step Single-step − Groups all items of revenue together, then deducts all categories of expense

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-7 The Income Statement Multiple-step format Intermediate profit measures include Gross profit Gross profit Operating profit Operating profit Earnings before income taxes Earnings before income taxes This format should be used for analysis purposes. The analyst should redo an income statement that is not already in the multiple-step format before analyzing.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-8 The Income Statement Regardless of format, certain special items must be disclosed separately on an income statement: Discontinued operations Discontinued operations Extraordinary transactions Extraordinary transactions

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-9 Common-Size Income Statement Useful analytical tool to compare firms with different levels of sales or total assets compare firms with different levels of sales or total assets facilitate internal or structural analysis facilitate internal or structural analysis evaluate trends evaluate trends make industry comparisons make industry comparisons

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-10 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 © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-11 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 © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-12 R.E.C. Inc. Consolidated Statements of Earnings (in Thousands) Net Sales $215,600$153,000$140,700 Sales increased 40.9% between 2009 and Sales increased 8.7% between 2008 and It is important to determine whether the change is the result of price, volume, or the combination of both.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-13 Net Sales Are sales growing in “real” (inflation- adjusted) as well as “nominal” (as reported) terms? 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 © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-14 Cost of Goods Sold (COGS) 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 item for many firms

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-15 Cost of Goods Sold Percentage Relationship between COGS and net sales Important for profit determination Given by Change in the COGS percentage may be caused by changes in cost or changes in selling price. Cost of goods sold Net sales

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-16 Cost of Goods Sold Percentage R.E.C. Inc. COGS percentage increased between 2008 and This is a result of lowering prices or increasing costs Net Sales $215,600$153,000$140,700 Cost of Goods Sold 129, ,364 91,879 91,879 81,606 81,606 Cost of Goods Sold Net Sales Net Sales 60.0% 60.0%60.1%58.0%

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-17 Gross Profit (or Gross Margin) First step of profit measurement First step of profit measurement Difference between net sales and COGS Difference between net sales and COGS Key analytical tool in assessing operating performance Key analytical tool in assessing operating performance Given by Given by Gross profit Net sales

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-18 Gross Profit Margin Gross profit margin and cost of goods sold percentage are complements (the two percentages add to 100%). Firms want to maintain or increase gross profit margin. Gross profit margin remains relatively constant in stable industries and may change significantly in volatile industries.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-19 Gross Profit Margin Companies with more than one revenue source will show each revenue line separately. Each revenue line will show the corresponding cost of goods sold for each revenue source.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-20 Operating Expense Exercise of management discretion in these areas Has considerable impact on the firm’s current and future profitability Important to carefully track trends, absolute amounts, relationship to sales, and relationship to industry competitors

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-21 Operating Expenses Examples Selling and administrative Selling and administrative − relate to the sale of products or services − salaries, rent, insurance, utilities, supplies, depreciation (sometimes), etc. Advertising Advertising − major expense when marketing is an important element of success Lease payments Lease payments

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-22 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 © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-23 Depreciation and Amortization Depreciation Used to allocate the cost of tangible fixed assets such as buildings buildings machinery machinery equipment equipment furniture and fixtures furniture and fixtures motor vehicles motor vehicles

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-24 Depreciation and Amortization Amortization Allocation process applied to capital leases capital leases leasehold improvements leasehold improvements patents patents copyrights copyrights trademarks trademarks franchises franchises

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-25 Depreciation and Amortization Depletion Allocation applied to acquisition and development of natural resources oil and gas oil and gas other minerals other minerals standing timber standing timber

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-26 Depreciation and Amortization Repairs and maintenance Annual costs of repairing and maintaining property, plant, and equipment Should correspond to the level of investment in capital equipment and to the age and condition of fixed assets Inadequate allowance can impair success

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-27 Depreciation and Amortization The amount of expense recognized in any accounting period will depend on the level of investment in the relevant asset the level of investment in the relevant asset estimates with regard to the asset’s service life and residual value estimates with regard to the asset’s service life and residual value for depreciation, the method used for depreciation, the method used

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-28 Operating Profit Second step of profit determination Also called earnings before interest and taxes (EBIT) Measures overall performance of company’s operations: sales revenue less expenses associated with generating sales Provides a basis for assessing success of a firm apart from financing and investing activities and separate from tax considerations

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-29 Operating Profit Margin Relationship between operating profit and net sales Given by Operating profit Net sales

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-30 Operating Profit Margin R.E.C. Inc. The ratio indicates R.E.C. Inc. strengthened its return on operations in 2010 after a dip in Net Sales $215,600$153,000$140,700 Operating Profit 19,243 19,24311,80611,256 Operating Profit Net Sales Net Sales 8.9%7.7%8.0%

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-31 Other Income (Expense) Revenues and costs other than from operations such as dividend and interest income dividend and interest income interest expense interest expense investment gains (losses) investment gains (losses) equity earnings (losses) equity earnings (losses) gains (losses) from sale of fixed assets gains (losses) from sale of fixed assets

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-32 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 © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-33 Other Income (Expense) In assessment of earnings quality, the analyst should consider the materiality and variability of nonoperating items of income such as gains (losses) on the sale of major capital assets gains (losses) on the sale of major capital assets accounting changes accounting changes extraordinary items extraordinary items investment income from temporary investments in cash equivalents investment income from temporary investments in cash equivalents investment income recognized under the equity method investment income recognized under the equity method

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-34 Equity Earnings Two methods may be used to account for investments in voting stock of other companies. Equity Equity Cost Cost Questions regarding use of cost or equity come into play for stock investments of less than 50%.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-35 Equity Earnings Equity Method Allows the investor proportionate recognition of the investee’s net income, irrespective of the payment or nonpayment of cash dividends Cost Method Investor recognizes investment income only to the extent of any cash dividends received.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-36 Equity Earnings Equity Method Should be used when investor can exercise significant influence over investee’s operating and financing policies Fits accrual accounting requirements Distorts earnings when income is recognized and no cash may ever be received

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-37 Equity Earnings Cost Method Allows recognition of investment income only to the extent of any cash dividends actually received Carries an investment account at cost Analysts should be aware of whether a company uses the cost or equity method.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-38 Earnings Before Income Taxes/ Effective Tax Rate Earnings before income taxes is the profit recognized before deduction of income tax expense. Income taxes paid may differ from income tax expense (deferred taxes) Effective tax rate is given by Income taxes Earnings before income taxes

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-39 Effective Tax Rate User of financial statements need to distinguish between earnings increasing due to core operations versus items such as tax rate deductions. Noteworthy items that may affect the effective tax rate are net operating losses (NOLs) and foreign taxes.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-40 Special Items Often one-time items that will not recur in the future Discontinued operations Discontinued operations Occur when a firm sells or discontinues a clearly distinguishable portion of its business Occur when a firm sells or discontinues a clearly distinguishable portion of its business Extraordinary gains and losses Extraordinary gains and losses Unusual in nature Unusual in nature Not expected to recur in the foreseeable future Not expected to recur in the foreseeable future

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-41 Accounting Changes Prior to 2006, the cumulative effect of a change in accounting principle was disclosed when a firm changed an accounting policy. Retrospective application to prior periods’ financial statements is required for changes in accounting principles for fiscal years beginning after 12/15/2005.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-42 Net Earnings Also called the “bottom line” Also called the “bottom line” Represents profit after consideration of all revenue and expense Represents profit after consideration of all revenue and expense Net profit margin shows the percentage of profit earned on every sales dollar. Net profit margin shows the percentage of profit earned on every sales dollar. Net profit margin is given by Net profit margin is given by Net earnings Net sales

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-43 Earnings Per Common Share (EPS) EPS is the net earnings available to common stockholders for the period divided by the average number of common stock shares outstanding. If a firm has “complex” capital structure, it will report basic and diluted earnings per common share.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-44 Earnings Per Common Share Analysts should consider material changes in the number of common stock shares outstanding that will cause a change in the computation of earnings per share.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-45 Comprehensive income According to FASB “Elements of Financial Statements,” comprehensive income is the change in equity of a company during a period from transactions, other events, and circumstances relating to nonowner sources.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-46 Comprehensive income FASB requires companies to report comprehensive income in one of three ways. On the face of its income statement On the face of its income statement In a separate statement of comprehensive income In a separate statement of comprehensive income In its statement of stockholder’s equity In its statement of stockholder’s equity

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-47 Comprehensive Income Currently, there are four items that may comprise a company’s other comprehensive income: Foreign currency translation effects Foreign currency translation effects Unrealized gains and losses Unrealized gains and losses Additional pension liabilities Additional pension liabilities Cash flow hedges Cash flow hedges

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-48 T he Statement of Stockholders’ Equity Important link between the balance sheet and the income statement Documents changes in the balance sheet equity accounts from one accounting period to the next Can also be presented in a supplementary schedule or in a note

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-49 The Statement of Stockholders’ Equity Includes transactions such as stock dividends stock dividends − issuance of additional shares of stock in proportion to current ownership − reduce retained earnings account stock splits stock splits − used to lower the market price of shares to make common stock more affordable reverse stock splits reverse stock splits − occurs when outstanding shares are decreased

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall3-50 Earnings Quality and Cash Flow Other topics directly related to the income statement Assessment of the quality of reported earnings is an essential element of income statement analysis. 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. Cash flow from operations is a key ingredient in analyzing operating performance.