Understanding Financial Statements Seventh EDITION Lyn M. Fraser Aileen Ormiston Insert BOOK COVER

(C) 2004 Prentice Hall, Inc.3-2 Income Statement and Statement of Stockholders’ Equity Income Statement and Statement of Stockholders’ Equity Chapter 3 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

(C) 2004 Prentice Hall, Inc.3-3 The Income Statement Also called the Statement of Earnings Presents:RevenuesExpenses Net Income Earnings Per Share

(C) 2004 Prentice Hall, Inc.3-4 The Income Statement Continued Comes in two basic formats Multiple-stepSingle-step

(C) 2004 Prentice Hall, Inc.3-5 The Income Statement Continued Multiple-step Provides several intermediate profit measures prior to the amount of net earnings for the period:  Gross profit  Operating profit  Earnings before income tax

(C) 2004 Prentice Hall, Inc.3-6 The Income Statement Continued Single-step Groups all items of revenue together, then deducts all categories of expense to arrive at a figure for net income

(C) 2004 Prentice Hall, Inc.3-7 The Income Statement Continued The Income Statement Continued Regardless of format, certain special items, if they occur during an accounting period, must be disclosed separately on an income statement These include...

(C) 2004 Prentice Hall, Inc.3-8 The Income Statement Continued The Income Statement Continued  Discontinued operations  Extraordinary transactions  Cumulative effect of changes in accounting principles

(C) 2004 Prentice Hall, Inc.3-9 Common-Size Income Statement Is a useful analytical tool 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

(C) 2004 Prentice Hall, Inc.3-10 Net Sales Sales are generally reported net of sales returns and sales allowances

(C) 2004 Prentice Hall, Inc.3-11 Net Sales Continued A sales return is a cancellation of a sale A sales allowance is a deduction from the original sales invoice price

(C) 2004 Prentice Hall, Inc.3-12 Net Sales—Related Issue Are sales growing in “real” (inflation- adjusted) as well as “nominal” (as reported terms?)

(C) 2004 Prentice Hall, Inc.3-13 Net Sales—Related Issue Continued Net Sales—Related Issue Continued An adjustment of the reported sales figure with the Consumer Price Index (or some other measure of general inflation) will enable the analyst to make a comparison of the changes

(C) 2004 Prentice Hall, Inc.3-14 Cost of Goods Sold (COGS)  Cost to seller of products sold to customers  AKA “Cost of Sales”  Important for profit determination  Is largest expense item for may firms

(C) 2004 Prentice Hall, Inc.3-15 Gross Profit  First step of profit measurement  Difference between net sales and COGS  Key analytical tool in assessing a firm’s operating performance

(C) 2004 Prentice Hall, Inc.3-16 Operating Expense Have considerable impact on the firm’s current and future profitability Important to track carefully--trends, absolute amounts, relationship to sales, relationship to industry competitors

(C) 2004 Prentice Hall, Inc.3-17 Operating Expense Continued Operating Expense Continued Selling and administrative Advertising Depreciation and amortization Repairs and maintenance Operating lease payments Examples:

(C) 2004 Prentice Hall, Inc.3-18 Understand the Math! If COGS percentage increases or decreases, this does not necessarily mean that costs have increased or decreased

(C) 2004 Prentice Hall, Inc.3-19 Understand the Math! Continued Understand the Math! Continued The change in the percentage may be caused by decreases or increases in the selling price For example...

(C) 2004 Prentice Hall, Inc.3-20 Understand the Math! Continued Understand the Math! Continued Year 1 Year 2 Sales$10100%$8100% COGS 4 40% 40% 4 50% 50% Gross Profit $ 6 60% 60%$4 50% 50% Always pay attention to the numbers—know the difference between raw dollars and percentages!

(C) 2004 Prentice Hall, Inc.3-21 Depreciation and Amortization Depreciation Used to allocate the cost of tangible fixed assets such as: BuildingsMachineryEquipmentFurniture Motor Vehicles

(C) 2004 Prentice Hall, Inc.3-22 Depreciation and Amortization Con’t. Depreciation and Amortization Con’t. Amortization is the process applied to: Capital leasesLeasehold improvements Cost of expiration of intangible assets PatentsCopyrightsTrademarks LicensesFranchisesGoodwill

(C) 2004 Prentice Hall, Inc.3-23 Depreciation and Amortization Con’t. Depreciation and Amortization Con’t. The amount of expense recognized in any accounting period will depend on the level of investment in the relevant asset; estimates with regard to the asset’s service life and residual value; and for depreciation, the method used

(C) 2004 Prentice Hall, Inc.3-24 Operating Profit Also called EBIT—Earnings Before Interest and Taxes Measures overall performance of company’s operations: sales revenue less expenses associated with generating sales

(C) 2004 Prentice Hall, Inc.3-25 Operating Profit Margin

(C) 2004 Prentice Hall, Inc.3-26 Other Income (Expense) Revenues/expenses other than from operations Dividend and interest income Interest expense Investment gains/losses Equity earnings/losses Sales of fixed assets gains/losses Includes

(C) 2004 Prentice Hall, Inc.3-27 Equity Earnings Two methods may be used to account for investments in other companies EquityCost

(C) 2004 Prentice Hall, Inc.3-28 Equity Method Allows the investor proportionate recognition of the investee’s net income, irrespective of the payment or nonpayment of cash dividends

(C) 2004 Prentice Hall, Inc.3-29 Cost Method The investor recognizes investment income only to the extent of any cash dividends received

(C) 2004 Prentice Hall, Inc.3-30 Cost vs. Equity Analysts, however, should be aware of whether a company uses the cost or the equity method

(C) 2004 Prentice Hall, Inc.3-31 Cost vs. Equity Continued Cost vs. Equity Continued Equity earnings distorts earnings in the sense that income is recognized even though no cash may ever be received

(C) 2004 Prentice Hall, Inc.3-32 Earnings Before Income Taxes Profit recognized before deduction of income tax expense Remember, income taxes paid may differ from income tax expense (deferred taxes)

(C) 2004 Prentice Hall, Inc.3-33 Special Items Are often one-time items that will not recur in the future

(C) 2004 Prentice Hall, Inc.3-34 Special Items Continued Special Items Continued If companies are affected by the following three items, they must be disclosed separately on the income statement, net of income tax effects: Discontinued operations Extraordinary items Cumulative effect of accounting changes

(C) 2004 Prentice Hall, Inc.3-35 Discontinued Operations Occur when a firms sells a major portion of its business

(C) 2004 Prentice Hall, Inc.3-36 Extraordinary Gains and Losses Are items that meet two criteria: 1. Unusual in nature 2. Not expected to recur in the foreseeable future, considering the firm’s operating environment

(C) 2004 Prentice Hall, Inc.3-37 Cumulative Effect of Accounting Changes Is disclosed when a firm changes an accounting policy

(C) 2004 Prentice Hall, Inc.3-38 Net Earnings Also called the “bottom line” Represents the firm’s profit after consideration of ALL revenue and expenses

(C) 2004 Prentice Hall, Inc.3-39 Earnings Per Common Share Is the net earnings available to common stockholders for the period divided by the average number of common stock shares outstanding

(C) 2004 Prentice Hall, Inc.3-40 Earnings Per Common Share Con’t. Earnings Per Common Share Con’t. If firm has “complex” capital structure, it will report basic and diluted EPS Extensively used by analysts in evaluating a firm

(C) 2004 Prentice Hall, Inc.3-41 Comprehensive Income Is the change in equity of a company during a period from transactions, other events, and circumstances relating to nonowner sources

(C) 2004 Prentice Hall, Inc.3-42 Comprehensive Income Con’t. Comprehensive Income Con’t. Companies are required to report total comprehensive income in one of three ways: 1. On the face of its income statement 2. In a separate statement of comprehensive income 3. In its statement of stockholders’ equity

(C) 2004 Prentice Hall, Inc.3-43 Comprehensive Income Con’t. Comprehensive Income Con’t. Currently, there are four items that may comprise a company’s other comprehensive income: 1. Foreign currency translation effects 2. Unrealized gains 3. Unrealized losses 4. Additional pension liabilities

(C) 2004 Prentice Hall, Inc.3-44 The Statement of Stockholders’ Equity Details transactions that affected the balance sheet equity accounts during an accounting period

(C) 2004 Prentice Hall, Inc.3-45 The Statement of Stockholders’ Equity 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

(C) 2004 Prentice Hall, Inc.3-46 The Journey Through the Maze Continues Ch. 4:Statement of Cash Flows Ch. 5:The Analysis of Financial Statements Statements