1 The Income Statement Chapter 5

2 Objectives for the day After reviewing homework… 1. Examine Key Issues relating to Income Statement. 2. Examine the “articulation” of I/S & B/S using transactions.

3 Objectives for the day 3. Compute I/S based ratios 4. Practice comparing different industries’ financial info 5. Look at some creative accounting

4 Terminology and Concepts Resource inflows resulting from completed sales of products or services Revenues

5 Terminology and Concepts Costs incurred to earn revenues Expenses

6 Terminology and Concepts Gains and losses result from sales not in the ordinary course of business.

7 Terminology and Concepts WHEN AN ASSET is SOLD: Proceeds = P Carrying Value = CV P > CV = Gain P < CV = Loss

8 Gain and Loss: Extent of? One estimate is that at least 7 % of manufacturing assets are sold or exchanged each year…...

9 Revenue Recognition 4 When may a company recognize revenue from a transaction? 4 Three questions:

10 Revenue Recognition 4 Has the buyer accepted substantially all of the risk associated with the product or service?

11 Revenue Recognition 4 Have we earned the right to the proceeds from this because we have completed our share of the transaction?

12 Revenue Recognition 4 Can we estimate the collectibility of proceeds from this sale with a reasonable degree of certainty?

13 Expense Recognition 4 When may a company recognize an expense? 4 Three questions:

14 Expense Recognition 4 Have we included all of the costs and expenses associated with the benefits we realized during the year? The Matching Principle

15 Expense Recognition 4 Have our judgments and estimates been appropriately conservative?

16 Expense Recognition 4 Do all of our assets still have the potential to earn future cash flows equal to their current costs? (or have they been Impaired?)

17 Revenue Recognition 4 When a company recognizes revenue what Balance Sheet account(s) is(are) usually affected?

18 4 Assets 4 Expenses & Losses 4 Liabilities 4 Equities 4 Revenues & Gains Journal Entry: DR. CR.

19 Expense Recognition 4 When a company recognizes expense what Balance Sheet account(s) is(are) usually affected?

20 Cost of Goods Sold - Inventory KEY EXPENSE on I/S is COST OF GOODS SOLD A review…. What are LIFO and FIFO and why do they matter?

21 4 Assets 4 Expenses & Losses 4 Liabilities 4 Equities 4 Revenues & Gains Journal Entry: DR. CR.

22 Depreciation Expense Depreciate Tangible Fixed assets over useful life Show Accumulated Depreciation as a valuation (contra asset) account Purpose of doing so???

23 4 Assets 4 Expenses & Losses 4 Liabilities 4 Equities 4 Revenues & Gains Journal Entry: DR. CR.

24 Key Income Statement Issues 1.Expensing versus Capitalizing? 2.Operating vs. Non- operating? 3. Ordinary vs. Unusual vs. Extraordinary? Death of an Ox?

25 Key Income Statement Issues 4. Pro Forma Income 5. Comprehensive Income --- how to recognize changes in value without causing extreme volatility in income?

26 1. Expensing vs. Capitalizing… Impact on I/S? and on Balance Sheet? World.Com became famous for being aggressive in this area.

27 2. Operating Income 4 Income statement format: –Sales or Revenues. –Deduct Cost of Sales = Gross Profit or Margin –various categories of expenses but not INTEREST. = OPERATING INCOME

28 3. Reporting the Results of Ordinary Operations 4 Income statement format: 4 Operating Income Interest Investments Other 4 = Ordinary Income

29 What do we mean by NON Ordinary? 4 Some companies use the term “unusual” to highlight events that are not typical but do not quality for separate disclosure.

30 Must Report these three below Ordinary Income 4 Discontinued Operations –Shows income related to major segments of the business that have been discontinued. 4 Extraordinary Items –Both unusual in nature and infrequent in occurrence.

31 One more NON-ordinary item…... 4 Changes in Accounting Policies –GAAP requires consistent application of principles from one period to the next. –When a change in principle occurs, special accounting and reporting of the effect of the change is required.

32 4. What is the Fuss about Pro- Forma Income?  “Pro forma” is a weasel phrase and can be used to mean too many different things….  E.g. EBITDA  Amazon.com

33 5. Valuation to avoid volatility?  Available for trading portfolio 4 Foreign currency. 4 Some Pension liabilities 4 Some hedge gains (losses)

34 Do F/S of all industries look the same? Why or why not?

35 Ratios -- Now we can look at Income (often called Return) as a measure against ASSETS, EQUITY, Liabilities, Sales, or any combination thereof….. These are the Profitability ratios.

36 Analyzing the Income Statement, using BALANCE SHEET 4 Return on total assets 4 Return on equity = Net income Average total assets = Net income Average owners’ equity

37 Analyzing the Income Statement -Using SALES  Gross Profit Margin = Sales - Cost of goods sold Sales

38 Analyzing the Income Statement - Using SALES 4 Gross Margin % 4 Return on Sales = Sales - Cost of goods sold Sales = Net income Sales

39 Creative Accounting 101 The B/S and I/S are linked, so being “creative” affects both... The two statements FIT together (they articulate)….

40 To do for next time……. 1.Read Puzzle of Cash Flow and chapter 6 2. Do homework 3. Be ready to do a simple Statement of cash flows