Income Statement

Single-Step Income Statement  Revenue  All types are listed and totaled  Expenses  All types are listed and totaled  Difference is Net Income (Loss)

Multiple-Step Income Statement  Separate sections  Various subtotals reflect different levels of profitability.

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Components of the Income Statement 1. Revenue 2. Cost of goods sold 3. Operating expenses 4. Other revenues and gains 5. Other expenses and losses 6. Income taxes on continuing operations

Revenue Revenue reports the total sales to customers for the period less any sales returns and allowances or discounts. Components of the Income Statement

Cost of Goods Sold Components of the Income Statement Beginning inventory +Net purchases +Freight-in +Other inventory acquisition costs =Cost of goods available for sale –Ending inventory =Cost of goods sold

Net sales – Cost of goods sold =Gross profit Gross profit ÷ Net sales = Gross profit percentage Gross Profit Components of the Income Statement

Operating expenses may be reported in two parts: 1. 1.Selling expenses Operating Expenses 2. 2.General and administrative expenses Components of the Income Statement

Operating income measures the performance of the fundamental business operations conducted by a company. Operating Income Components of the Income Statement Gross profit –Operating expenses =Operating income

This section usually includes items identified with the peripheral activities of the company. Rent revenue Interest revenue Dividend revenue Gains from the sale of assets Other Revenues and Gains Components of the Income Statement

This section parallels “Other Revenues and Gains” except the items result in deductions from operating income. Interest expense Losses from the sale of assets Other Expenses and Losses Components of the Income Statement

 Gain or loss from the sale or termination of operations  Gain or loss from the operations themselves  Disclose financial details in financial statement notes Discontinued Operations

Extraordinary Items  Events and transactions  Unusual in nature  Infrequent in occurrence.

Not Extraordinary The write-down or write-off of receivables, inventories, equipment leased to others, etc. The gains or losses from exchange or remeasurement of foreign currencies The gains or losses on disposal of business segment Other gains or losses from sale or abandonment of productive assets The effects of a strike Adjustment of accruals on long-term contracts

Changes in Accounting Principles Criteria for change: 1.Change in economic conditions suggests that an accounting change will provide better information. 2.The FASB issues a new pronouncement requiring a change in principle.

Changes in Accounting Principles  A company is required to determine how the income statement would have been different in past years if the new accounting method had been used all along.  Income statements for all years presented must be restated using the new accounting method. (continues)

Changes in Accounting Principles  The beginning balance of Retained Earnings for the oldest period presented should reflect an adjustment for the cumulative income effect of the accounting change on the net income of all preceding years for which a detailed income statement is not presented.  Include information as if the change were retroactive—direct and indirect effects.

Disclosure requirements include: Employ current and prospective approach. Report current and future financial statements on new basis. Present prior periods as previously reported. Make no adjustments to current period opening balances. Change in Estimate

If there is both a change in principle and a change in estimate for an item, the event is treated as a change in estimate. Change in Estimate

Earnings Per Share  Earnings-per-share figures:  Computed for income from continuing operations.  Calculated for each irregular or extraordinary item.

Earnings per share = Income from continuing operations Weighted average number of shares of common stock outstanding Earnings Per Share

Comprehensive Income The number used to reflect an overall measure of the change in a company’s wealth during the period Includes items that arise from changes in market conditions unrelated to the business operations of a company Include a report of comprehensive income as part of the statement of stockholders’ equity.

Comprehensive Income The more common adjustments made in arriving at comprehensive income are: Foreign currency translation adjustments Unrealized gains and losses on available-for-sale securities Deferred gains and losses on derivative financial instruments

Balance Sheet

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Current Assets Cash and resources expected to be converted to cash during the entity’s normal operating cycle or one year, whichever is longer, are current assets.  Cash  Receivables  Inventories

 Listed before noncurrent assets  Listed in the order of their liquidity, with the most liquid items first. Assets Current Assets

Noncurrent Assets  Investments  Property, plant, and equipment  Intangible assets  Deferred income taxes

Investments  Assets held for long-term purposes  Regular income  Appreciation  Ownership control

 Properties of a tangible and relatively permanent nature that are used in the normal business operations. Plant, Property, and Equipment  Land  Buildings  Machinery  Tools

Long-term rights and privileges of a nonphysical nature acquired for use in business operations. Intangible Assets  Goodwill  Patents  Trademarks  Franchises

Obligations expected to be paid using current assets or by creating other current liabilities. Accounts and notes payable Accrued expenses Current portion of long-term obligations Unearned revenues Liabilities Current Liabilities

Short-Term Obligations  Expected to be refinanced or paid back with the proceeds of a replacement loan  Will not require the use of current assets even though it is scheduled to mature within a year Liabilities Current Liabilities

The existing loan is not classified as current as long as: 1.The intent of the company is to refinance the loan on a long-term basis. 2.The company’s intent is evidenced by an actual refinancing after the balance sheet date but before the financial statements are finalized or by the existence of an explicit refinancing agreement. Current Liabilities

Noncurrent Liabilities Current liabilities do not usually include:  Debts to be liquidated from a noncurrent sinking fund.  Short-term obligations to be refinanced.

Long-term debt Long-term lease obligations Deferred income tax liability Pension obligations Obligations not reasonably expected to be paid or otherwise satisfied within 12 months. Noncurrent Liabilities

 Reported at its discounted present value  When a note, bond issue, or a mortgage becomes payable within a year, it should be reclassified as a current liability.  For a capital lease, the present value of the future minimum payments is recorded as a long-term liability.  Most large companies include deferred income tax liabilities on the balance sheet. Noncurrent Liabilities

Contingent Liabilities  Potential claims that involve uncertainty as to possible losses  Definite obligation with only the amount in question and subject to estimation on the balance sheet date.

Owners’ Equity  Also called stockholders’ or shareholders’ equity  Generally divided into two parts:  Contributed capital (also known as paid-in- capital)  Retained earnings

Contributed Capital Two parts of contributed capital: 1. Capital stock — the number of shares  the par value a. Preferred stock — usually pays a fixed annual cash dividend and provides rights to recover investment in case of bankruptcy b. Common stock — provides real ownership of the corporation and grants voting power, but holders are last in line for assets in case of bankruptcy 2. Additional paid-in capital — investment by shareholders in excess of par value of capital stock

Retained Earnings Retained earnings (RE) — the amount of undistributed earnings of past periods RE deficit — an excess of dividends and losses over earnings results in a negative retained earnings balance Sometimes, retained earnings is restricted and unavailable for cash dividends.

Treasury Stock  Stock issued and subsequently bought back by a company  Treasury shares can be retired, or they can be retained and reissued later.

Format of the Balance Sheet Generally:  Assets and liabilities presented in order of liquidity  Presented in comparative form, including data from both the current year and the previous year  Foreign balance sheets frequently list the current assets and current liabilities together.

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Statement of Cash Flows

53 Statement of Cash Flows How did a company acquire cash and how did it spend it? Why did cash increase/decrease during the period?

54 Purposes of the Statement of Cash Flows Predict future cash flows Evaluate management decisions Predict ability to pay debts and to pay dividends

Reporting Cash Flows 1.Cash flows from operating activities are cash flows from transactions that affect net income. 2.Cash flows from investing activities are cash flows from transactions that affect the investments in noncurrent assets. 3.Cash flows from financing activities are cash flows from transactions that affect the equity and debt of the business.

Cash Flows from Operating Activities The direct method reports the sources of operating cash and the uses of operating cash.

The indirect method reports the operating cash flows by beginning with net income and adjusting it for revenues and expenses that do not involve the receipt or payment of cash. Cash Flows from Operating Activities

Noncash Investing and Financing Activities Noncash investing and financing activities are transactions that do not involve cash. The effect of such transactions is recorded in a separate schedule that appears at the bottom of the statement of cash flows.

59 Operating Activities Inflows – cash receipts from earning revenues Sale of goods or services Interest revenue Dividend revenue Other revenues Outflows – cash paid from incurring expenses Salaries and wages Payments to suppliers for inventory Taxes and fines Interest paid to lenders Other expenses Focus your attention on: income statement, and changes in current assets, current liabilities

60 Investing Activities Transactions that increase and decrease long-term assets

61 Investing Activities Inflows Selling long-term productive assets Selling equity investments Collecting of principal on loans Other Outflows Purchase long-term productive assets Purchase equity investments Purchase debt investments Make loans Focus your attention on changes in: plant assets, long-term investments, other long-term assets

62 Financing Activities Increases and decreases in long-term liabilities and owner’s equity

63 Financing Activities Inflows Issuing stock Issuing bonds and notes Outflows Cash dividends or withdrawals by owner Purchase treasury stock Repay cash loans Focus your attention on changes in: long-term debt and stockholder’s equity

64 Format of the Statement of Cash Flows Two acceptable methods for reporting cash flows from operating activities 1. Indirect method 2. Direct method The Investing and Financing sections of the statement will not differ

65 Indirect Method Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: + Depreciation / amortization / depletion expense + Loss on sale of long-term assets - Gain on sale of long-term assets - Increases in current assets other than cash + Decreases in current assets other than cash + Increases in current liabilities - Decreases in current liabilities Net cash provided by operating activities

66 Indirect and Direct Method Cash flows from investing activities: +Sales of long-term assets - Purchases of long-term assets Net cash provided by (used for) investing activities

67 Indirect and Direct Method Cash flows from financing activities: + Issuance of stock + Sale of treasury stock - Purchase of treasury stock + Issuance of notes or bonds payable - Payment of notes or bonds payable - Payment of dividends Net cash provided by (used for) financing activities

Orchard Blossom Company

Direct Method Sales and Cash Collected from Customers Beginning accounts receivable$ 40 +Sales 150 =Cash available for collection$190  Ending accounts receivable 60 =Cash collected from customers$130

Direct Method Cost of Goods Sold and Cash Paid for Inventory Ending inventory$ 75 +Cost of goods sold 80 =Required inventory$155  Beginning inventory 100 =Inventory purchased this year$ 55

Direct Method Wages Expense and Cash Paid for Wages Beginning wages payable$ 7 +Wages expense 25 =Total obligation to employees$32 –Ending wages payable 10 =Cash paid for wages$22

Operating Activities Section of the Statement of Cash Flows—Direct Method Direct Method

Indirect Method Sales The $20 increase in accounts receivable means that cash collected is $20 less than the $150 the sales number indicates. So, the necessary adjustment is to subtract the $20 to show that $130 was collected on account.

Cost of Goods Sold The $25 decrease in inventory means that although cost of good sold of $80 is included in the income statement, less cash was used to purchase inventory than suggested—add $25 to net income. Indirect Method

Wages Expense The $3 increase in wages payable indicates that only $22 of the $25 expense was paid in cash. The $3 increase in wages payable is added to net income. Indirect Method

Depreciation Expense The $30 depreciation expense is a noncash expense. It must be added back to net income because it was deducted from net income to determine the accrual net income. Indirect Method

Note the same net cash from operating activities as calculated using the direct method. Indirect Method

Comparison of Direct and Indirect Methods Direct Method Focus on this column

Indirect Method Comparison of Direct and Indirect Methods Focus on this column

Step 1 Compute how much the cash balance changed during the year. (continues)

Cash increased $10 during the year. (continues)

Step 2 Convert the income statement from an accrual-basis to a cash-basis summary of operations. Start with depreciation. (continues)

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Step 3 Analyze the long-term assets to identify the cash flow effects of investing activities. (continues)

Investing Activities Cash Inflow Sale of plant assets Sale of securities, other than trading securities Collection of principal on loans Cash Outflow Purchase of plant assets Purchase of securities, other than trading securities Making of loans with other entities

Land. Because there is no indication of a land sale, we conclude that land increased by $15 during the year. (continues)

The building account increased $40. We are told that a building was sold for $32 during the year. (continues) Building

Cash proceeds (given)$32 Book value ($36  $14) 22 Gain on sale of building$10 (continues)

Known (continues) Building

Building(s) costing $76 must have been purchased during the year. Building

Step 4 Analyze the long-term debt and stockholders’ equity accounts to determine the cash flow effects of any financing transactions.

Financing Activities Cash Inflow Issuance of own stock Borrowings Cash Outflow Dividend payments Repaying principal on borrowing Treasury stock purchase

Long-Term Debt We can infer that Orchard Blossom repaid $21 in long-term loans during the year.

Retained Earnings Retained earnings decreased by $9. We know there was a $15 net income, so we can use a T- account to determine the amount of the dividend.

Long-Term Debt The $6 debit, or “squeeze” figure, has to be the dividends declared (and we will assume paid) during the year.

Step 5 Prepare a formal statement of cash flows.

Step 6 Prepare supplemental disclosures. Cash paid for interest and income taxes Noncash investing and financing activities