1 Tools of the Trade, Part II: Income Statement and Statement of Owners’ Equity CHAPTER F5 © 2007 Pearson Custom Publishing

2 Describe how the income statement provides information about the past performance of a business. Learning Objective 1: © 2007 Pearson Custom Publishing

3 Income Statement This financial statement is intended to provide information related to the results of an entity's operations for a specific time period; typically a year, quarter, or month. This financial statement is intended to provide information related to the results of an entity's operations for a specific time period; typically a year, quarter, or month. It is more formally known as the Statement of Earnings or the Statement of Results of Operations. It is more formally known as the Statement of Earnings or the Statement of Results of Operations. © 2007 Pearson Custom Publishing

4 Revenues Inflows of assets to an entity from delivering or producing goods, rendering services, or carrying out other activities. (FASB definition) Inflows of assets to an entity from delivering or producing goods, rendering services, or carrying out other activities. (FASB definition) Basically, revenues represent the things of value that our customers have agreed to pay us in exchange for the business that we have conducted with them. Basically, revenues represent the things of value that our customers have agreed to pay us in exchange for the business that we have conducted with them. © 2007 Pearson Custom Publishing

5 Expenses Outflows or other using up of assets from delivering or producing goods, rendering services, or carrying out other activities. (FASB definition) Outflows or other using up of assets from delivering or producing goods, rendering services, or carrying out other activities. (FASB definition) Basically, expenses represent the things of value that we have used in order to generate revenues for our business. Basically, expenses represent the things of value that we have used in order to generate revenues for our business. © 2007 Pearson Custom Publishing

6 Net Income Revenues - Expenses = Net Income Revenues - Expenses = Net Income Therefore, as revenues increase, net income also increases. As expenses increase, net income decreases. Therefore, as revenues increase, net income also increases. As expenses increase, net income decreases. Similar to cost-benefit analysis, we usually choose to incur expenses only if we believe that they will generate revenues greater than the cost of the expenses. Similar to cost-benefit analysis, we usually choose to incur expenses only if we believe that they will generate revenues greater than the cost of the expenses. © 2007 Pearson Custom Publishing

7 Distinguish between single-step and multistep income statements. Learning Objective 2: © 2007 Pearson Custom Publishing

8 Basic Format This basic format is also known as the Single-step format of the income statement.

9 Cost of Goods Sold Both merchandising and manufacturing companies sell products as their major source of revenue. The costs associated with the purchase or production of these products is known as Cost of Goods Sold. Both merchandising and manufacturing companies sell products as their major source of revenue. The costs associated with the purchase or production of these products is known as Cost of Goods Sold. Cost of goods sold is also sometimes called “cost of sales.” Cost of goods sold is also sometimes called “cost of sales.” © 2007 Pearson Custom Publishing

10 Discussion Question Think of a fast-food restaurant, such as your favorite burger joint. Make a list of the costs you think the restaurant incurs in its day-to-day operations. Which of these costs do you think should be included in the cost of goods sold and which ones are other expenses? Explain. Think of a fast-food restaurant, such as your favorite burger joint. Make a list of the costs you think the restaurant incurs in its day-to-day operations. Which of these costs do you think should be included in the cost of goods sold and which ones are other expenses? Explain. © 2007 Pearson Custom Publishing

Single-Step Format The different revenues are added together on top The different expenses are added together on bottom Expenses are subtracted in a “single step.” © 2007 Pearson Custom Publishing

12 Multistep Format The multistep format of the income statement provides some subtotals that are not apparent on the single-step statement. The multistep format of the income statement provides some subtotals that are not apparent on the single-step statement. Gross margin (or gross profit) is shown as the difference between sales revenue and the cost of goods sold. Gross margin (or gross profit) is shown as the difference between sales revenue and the cost of goods sold. Operating income is shown as the amount of profit earned from the company’s primary business activity. Operating income is shown as the amount of profit earned from the company’s primary business activity. © 2007 Pearson Custom Publishing

13 Multistep Format 1st subtotal 2nd subtotal Bottom Line © 2007 Pearson Custom Publishing

14 Discussion Questions Try to identify two or three companies that you think would have a large gross margin on sales. In other words, which companies do you think have a high markup for their products? Try to identify two or three companies that you think would have a large gross margin on sales. In other words, which companies do you think have a high markup for their products? Try to identify two or three companies that you think would have a low gross margin on sales. Why would this be the case? Try to identify two or three companies that you think would have a low gross margin on sales. Why would this be the case? © 2007 Pearson Custom Publishing

15 Gross Margin Examples Intel Corp Intel Corp Sales38,826 COGS15,777 Gross23,049 Gross margin % 59% 4 Eli Lilly Co Sales14,645 COGS 3,474 Gross11,171 Gross margin % 76% 4 Pepsico 2005 Sales32,562 COGS 14,176 Gross18,386 Gross Margin % 56% 4 Kimberly-Clark 2005 Sales15,902 COGS10,828 Gross 5,075 Gross Margin % 32% © 2007 Pearson Custom Publishing

16 Discussion Questions Consider the following simplified multistep income statement for Terrell and Co.: Consider the following simplified multistep income statement for Terrell and Co.: Sales (1,000 units) $500,000 Sales (1,000 units) $500,000 LESS: Cost of goods sold (550,000) LESS: Cost of goods sold (550,000) Gross margin ($50,000) Gross margin ($50,000) LESS: Other expenses ($45,000) LESS: Other expenses ($45,000) Net income (loss) ($95,000) Net income (loss) ($95,000) What can you learn from Terrell’s gross margin? What can you learn from Terrell’s gross margin? How many units must be sold to earn a profit? How many units must be sold to earn a profit? © 2007 Pearson Custom Publishing

17 Relationship Between Net Income and Owners’ Equity Any net income earned by a business during an accounting period is considered to be an increase in the owners’ equity in the business. Any net income earned by a business during an accounting period is considered to be an increase in the owners’ equity in the business. If the company suffers a net loss for the period, the amount of the loss is reflected as a reduction in the owners’ equity in the business. If the company suffers a net loss for the period, the amount of the loss is reflected as a reduction in the owners’ equity in the business. © 2007 Pearson Custom Publishing

18 Explain the impact of net income or net loss on owners’ equity. Learning Objective 3: © 2007 Pearson Custom Publishing

19 Relationship Between Net Income and Owners’ Equity Remember from Chapter 3 that there are two sources of equity: owner investments and company earnings. Remember from Chapter 3 that there are two sources of equity: owner investments and company earnings. Therefore, income (or losses) “become” a part of owners’ equity. Therefore, income (or losses) “become” a part of owners’ equity. © 2007 Pearson Custom Publishing

20 Statement of Owners’ Equity The Statement of Owners’ Equity “connects” the Balance Sheet to the Income Statement. The Statement of Owners’ Equity “connects” the Balance Sheet to the Income Statement. It shows the beginning balance and ending balance of the owners’ equity accounts (from the balance sheet), and the increases or decreases in each of the accounts. It shows the beginning balance and ending balance of the owners’ equity accounts (from the balance sheet), and the increases or decreases in each of the accounts. © 2007 Pearson Custom Publishing

21 Construct statements of capital for proprietorships and partnerships. Learning Objective 4: © 2007 Pearson Custom Publishing

22 Statement of Owners’ Equity The exact format of the statement depends on the form of business organization: corporation, partnership, or proprietorship. The exact format of the statement depends on the form of business organization: corporation, partnership, or proprietorship. A proprietorship or partnership will have a Statement of Capital. A proprietorship or partnership will have a Statement of Capital. A corporation will have a Statement of Stockholders’ Equity. A corporation will have a Statement of Stockholders’ Equity. © 2007 Pearson Custom Publishing

23 Statement of Capital - Proprietorships © 2007 Pearson Custom Publishing

24 Statement of Capital - Partnerships 2nd partner 1st partner © 2007 Pearson Custom Publishing

25 Identify the differences between statements of stockholders’ equity and statements of retained earnings for corporations and construct the statement of stockholders’ equity. Learning Objective 5: © 2007 Pearson Custom Publishing

26 Statement of Stockholders’ Equity - Corporations © 2007 Pearson Custom Publishing

27 Statement of Retained Earnings If there has been no change in the amount of contributed capital, a corporation can choose not to issue a Statement of Stockholders’ Equity. If there has been no change in the amount of contributed capital, a corporation can choose not to issue a Statement of Stockholders’ Equity. Instead, a Statement of Retained Earnings can be issued. This statement shows the beginning R.E. balance, net income or loss, dividends, and ending R.E. balance. Instead, a Statement of Retained Earnings can be issued. This statement shows the beginning R.E. balance, net income or loss, dividends, and ending R.E. balance. © 2007 Pearson Custom Publishing

28 Statement of Retained Earnings - Corporations © 2007 Pearson Custom Publishing

29 Compare and contrast the impact of drawings on statements of capital and the impact of dividends on the statements of stockholders’ equity and statements of retained earnings. Learning Objective 6: © 2007 Pearson Custom Publishing

30 Distributions to Owners At some point, business owners usually either desire or require a distribution of cash from the business. These distributions reduce the amount of owners’ equity. At some point, business owners usually either desire or require a distribution of cash from the business. These distributions reduce the amount of owners’ equity. In most cases, these distributions represent a return on investment for the owners, but it is possible that they are a return of investment. In most cases, these distributions represent a return on investment for the owners, but it is possible that they are a return of investment. © 2007 Pearson Custom Publishing

31 Drawings - Proprietorships and Partnerships When a proprietor or a partner receives a distribution from the business it is called a drawing or withdrawal. When a proprietor or a partner receives a distribution from the business it is called a drawing or withdrawal. A proprietor can determine when and how much of a drawing to take. A proprietor can determine when and how much of a drawing to take. Partners are somewhat restricted and usually are allowed withdrawals that have been previously agreed to by all partners. Partners are somewhat restricted and usually are allowed withdrawals that have been previously agreed to by all partners. © 2007 Pearson Custom Publishing

32 Explain why dividends are paid and under what circumstances they can be paid. Learning Objective 7: © 2007 Pearson Custom Publishing

33 Corporate Distributions Distributions to stockholders of a corporation are called dividends. Distributions to stockholders of a corporation are called dividends. Many corporations pay fairly predictable dividends on a regular basis, usually every quarter. Other corporations choose not to pay dividends in order to help the company grow by reinvesting earnings. Many corporations pay fairly predictable dividends on a regular basis, usually every quarter. Other corporations choose not to pay dividends in order to help the company grow by reinvesting earnings. © 2007 Pearson Custom Publishing

34 Cash Dividends To pay cash dividends to stockholders, a corporation must have the following: To pay cash dividends to stockholders, a corporation must have the following: 1) Sufficient retained earnings: after paying the dividend, there must be a positive balance in retained earnings. 2) Sufficient cash: just like paying a bill to a supplier, the corporation must have enough cash on hand in order to pay the dividend. © 2007 Pearson Custom Publishing

35 Dividend Dates There are three important dividend dates: 1) Date of Declaration: when the board of directors decides to pay a dividend. 2) Date of Record: stockholders who own the stock on this date will receive the dividend. 3) Date of Payment: the corporation settles the dividend liability by making payment to the stockholders. © 2007 Pearson Custom Publishing

36 Discussion Questions If Company A has paid a steadily increasing dividend every year for thirty years, and Company B has never paid a dividend, would that influence you if you were deciding in which of these two companies to buy stock? If Company A has paid a steadily increasing dividend every year for thirty years, and Company B has never paid a dividend, would that influence you if you were deciding in which of these two companies to buy stock? Can you think of reasons why you still might prefer Company B over A? Can you think of reasons why you still might prefer Company B over A? © 2007 Pearson Custom Publishing

37 Describe in your own words the articulation of income statements, balance sheets, and statements of owners’ equity. Learning Objective 8: © 2007 Pearson Custom Publishing

38 Articulation There is a linkage between the three financial statements known as articulation. There is a linkage between the three financial statements known as articulation. Income Statement Balance Sheet Statement of Capital © 2007 Pearson Custom Publishing

39 Articulation Income Statement: the revenues and expenses are listed to determine net income (or loss). Income Statement: the revenues and expenses are listed to determine net income (or loss). Statement of Capital: the net income is added to help determine the ending capital balance. Statement of Capital: the net income is added to help determine the ending capital balance. © 2007 Pearson Custom Publishing

40 Articulation Balance Sheet: the ending capital balance is reported in the owners’ equity section of the balance sheet. Therefore, net income flows forward into the balance sheet. Balance Sheet: the ending capital balance is reported in the owners’ equity section of the balance sheet. Therefore, net income flows forward into the balance sheet. © 2007 Pearson Custom Publishing

41 Discussion Questions The balance sheet for the corporate form of business is a bit more detailed than that for the proprietorship. Comparing the two, what can you learn from the corporate balance sheet that you would not know from looking at the proprietorship’s balance sheet? The balance sheet for the corporate form of business is a bit more detailed than that for the proprietorship. Comparing the two, what can you learn from the corporate balance sheet that you would not know from looking at the proprietorship’s balance sheet? In particular, what can you learn about past earnings of the company? In particular, what can you learn about past earnings of the company? © 2007 Pearson Custom Publishing

42 End of Chapter 5 © 2007 Pearson Custom Publishing