Chapter 5 The Income Statement

2 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Business Deals Beginning of YearEnd of Year Income Measurement

3 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Accrual Accounting Raw transaction data is refined from –When paid/collected to –When incurred/earned Resulting from transactions of the current period Measures economic performance

Different Measures of Income

5 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Different Measures Of Income Increase in wealth –a simple definition Physical capital maintenance –income is earned only when there is an increase in actual physical resources

6 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Different Measures Of Income Financial capital maintenance –income exists when the dollar amount of a company’s net assets increases during the year, excluding the effects of owner investments and dividends –this is the approach that accountants use to measure income

Different Measures Of Income Sales –Cost of goods sold =Gross profit – Other operating expenses, gains, and losses =Operating income – Interest expense ±Miscellaneous revenues, expenses, gains, and losses =Income before taxes – Income tax expense = Income from continuing operations ±Income from discontinued operations ±Extraordinary items ±Cumulative effect of accounting changes =Net income ±Unrealized gains and losses not included in net income = Comprehensive income the difference between sales of the product and the cost of sales of the product

Different Measures Of Income Sales –Cost of goods sold =Gross profit – Other operating expenses, gains, and losses =Operating income – Interest expense ±Miscellaneous revenues, expenses, gains, and losses =Income before taxes – Income tax expense = Income from continuing operations ±Income from discontinued operations ±Extraordinary items ±Cumulative effect of accounting changes =Net income ±Unrealized gains and losses not included in net income = Comprehensive income gross profit minus operating expenses; measures the performance of the central operations of the company

Different Measures Of Income Sales –Cost of goods sold =Gross profit – Other operating expenses, gains, and losses =Operating income – Interest expense ±Miscellaneous revenues, expenses, gains, and losses =Income before taxes – Income tax expense = Income from continuing operations ±Income from discontinued operations ±Extraordinary items ±Cumulative effect of accounting changes =Net income ±Unrealized gains and losses not included in net income = Comprehensive income operating income minus interest expense, income tax expense, and other miscellaneous items

Different Measures Of Income Sales –Cost of goods sold =Gross profit – Other operating expenses, gains, and losses =Operating income – Interest expense ±Miscellaneous revenues, expenses, gains, and losses =Income before taxes – Income tax expense = Income from continuing operations ±Income from discontinued operations ±Extraordinary items ±Cumulative effect of accounting changes =Net income ±Unrealized gains and losses not included in net income = Comprehensive income income from continuing operations adjusted for “below the line” items

11 Financial Accounting, 7e Stice/Stice, 2006 © Thomson “Below the Line” Items Income or loss from discontinued operations –results from the disposal of a major business segment Extraordinary gains and losses –unusual in nature and infrequent in occurrence Cumulative effect of accounting changes –a “catch-up” adjustment for a change to a new accounting method`

Different Measures Of Income Sales –Cost of goods sold =Gross profit – Other operating expenses, gains, and losses =Operating income – Interest expense ±Miscellaneous revenues, expenses, gains, and losses =Income before taxes – Income tax expense = Income from continuing operations ±Income from discontinued operations ±Extraordinary items ±Cumulative effect of accounting changes =Net income ±Unrealized gains and losses not included in net income = Comprehensive income net income plus (minus) changes in market condition unrelated to business operations

13 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Unrealized Gains & Losses Changes in the dollar value of foreign subsidiaries caused by movement of foreign currency exchange rates Changes in the value of investment securities that are not actively traded Changes in the value of certain derivative financial instruments

Individual Income Statement Items

15 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Revenues The value of the goods and services provided by a company in its business operations – Sales revenue : the aggregate selling price of goods sold during the period – Service revenue : fees charged for services

16 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Non-Operating Revenues Interest revenue : earned from extending credit or loaning money Other revenue : comprised of revenues that come from different sources

17 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Expenses The value of resources used in generating reported revenue Cost of goods sold : the expense directly associated with the sales revenue for the period

18 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Expenses (con’t) Selling General, & Administrative Expense –Research and development Expensing required –Wages and salaries –Bad debt The cost of selling merchandise on credit

19 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Expenses (con’t) Depreciation –Allocation of the cost of long-lived assets Interest expense –The cost of borrowing money Income tax expense –The sum of all income tax consequences of all transactions during a year

20 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Gains and Losses Created by activities peripheral to a company’s primary operations –Sale of long-term assets –Restructuring charges

21 Financial Accounting, 7e Stice/Stice, 2006 © Thomson “Below the Line” Items All reported net of applicable income taxes –Income (or loss) from discontinued operations –Extraordinary (unusual and infrequent) gains and losses –Cumulative effect from change in accounting principle

22 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Comprehensive Income Reflects the overall change in a company’s wealth during a period. Includes three items not reported in net income: –Foreign currency translation adjustment –Unrealized gains and losses on available-for-sale securities –Deferred gains and losses on derivative financial instruments

23 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Earnings Per Share (EPS) The amount of net income associated with each share of stock Two earnings per share numbers: – Basic EPS reports earnings based solely on shares actually outstanding during the year – Diluted EPS reflects the existence of stock options and other potentially dilutive securities

Income Statement Format

25 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Single-Step Income Statement All revenues are grouped together, all expenses are grouped together, and the difference is reported as net income Income tax expense is shown separately

Single-Step Income Statement

27 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Multiple-Step Income Statement Revenue and expense items are arranged to highlight important profit relationships and income numbers such as gross profit and operating income

Multiple-Step Income Statement

Revenue Recognition and Matching

30 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Revenue Recognition Revenue is recognized when –The promised work is done, and –Cash collectibility is reasonably assured

31 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Expense Recognition Is based on the matching principle –An expense should be recognized in the same period in which the revenue it generates is recognized Three bases of expense recognition: –Direct matching (or cause and effect) –Systematic allocation –Immediate recognition

32 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Expense Recognition: Direct Matching The expense is directly traceable to the revenue it generates (cause and effect) Cost of goods sold matched with sales Sales commissions matched with sales

33 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Expense Recognition: Systematic Allocation The expense is associated more with the passage of time than a specific revenue- generating activity Depreciation expense Insurance expense

34 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Expense Recognition: Immediate Recognition An expenditure is expensed currently because there is no future benefit or the future benefit is uncertain Advertising expense Research and development expense

Transaction Analysis

36 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Transaction Analysis Transactions are analyzed using the expanded accounting equation... ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY

37 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Expanded Accounting Equation Assets = Liabilities + Stockholders’ Equity Paid-In Capital + Retained Earnings Beginning RE + Net Income - Dividends Revenues + Gains – Expenses - Losses

38 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Transaction Analysis Assets = Liabilities + Paid-In Capital + Beginning RE + (Revenues + Gains – Expenses – Losses) – Dividends

39 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Veda Landscape Solutions January 1 transactions (from chapter 4)

41 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Transaction Analysis Key points to remember –Revenues increase retained earnings –Expenses decrease retained earnings –Dividends decrease retained earnings The income statement can be prepared from the revenue and expense columns of the spreadsheet

42 Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Forecasting The Future

44 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Past income statements can be used to predict income in future periods Good forecasting requires an understanding of what factors determine the amount of a future revenue or expense Forecasting the Future

45 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Forecasting begins with a forecast of sales The sales forecast forms the basis of predicting the future balance sheet, income statement, and statement of cash flows Forecasting Sales - Mon

46 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Natural Increase –Cash, accounts receivable, inventory, and accounts payable Long-term Planning –Property, plant, and equipment Financing Choices –Long-term debt and paid-in capital Forecasting the Balance Sheet

47 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Forecasting the Income Statement Income Statement ElementRelated To Cost of Goods SoldSales Wage ExpenseSales Depreciation Expense Property, Plant and Equipment Interest ExpenseDebt Income Tax ExpensePre-tax income

48 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Forecasting the Income Statement Income Statement ElementRelated To Cost of Goods SoldSales Wage ExpenseSales Depreciation Expense Property, Plant and Equipment Interest ExpenseDebt Income Tax ExpensePre-tax income

49 Financial Accounting, 7e Stice/Stice, 2006 © Thomson In Summary... A variety of income measurements Income statement reports revenues, expenses, gains, and losses Comprehensive income includes additional unrealized gains and losses Expanded accounting equation Forecasting the future from historical statements