1. This week its Accounting and Beyond Morning Session Afternoon Session Monday Tuesday Wednesday Intro & Income Statement Thursday Balance Sheet Cash Flow Statement Friday Financial Analysis & Exam Group Assessment 1-1

2. The Income Statement  Also called the statement of earnings  Presents a firm’s:  revenues  expenses  net income  earnings per share  Annual reports include three years of income statements. 3-2

3. The Income Statement  Comes in two basic formats  Single-step format  Multiple-step format  Multiple-step format should be used for analysis purposes. 3-3

4. The Income Statement Single-step format  Groups all items of revenue together, then deducts all categories of expense 3-4

5. The Income Statement 3-5

6. 6 Single-Step Income Statement Relevant Information Advertising = 2,000 Commissions = 5,000 Cost Of Goods Sold = 75,000 Gain on Sale of Investment = 3,000 Interest Expense = 500 Interest Revenues = 5,000 Loss from Lawsuit = 1,500 Office Equipment = 2,500 Office Supplies = 3,500

7. The Income Statement Multiple-step format  Provides several intermediate profit measures prior to the amount of net earnings for the period  Gross profit  Operating profit  Earnings before income tax 3-7

8. The Income Statement 3-8

9. 9 Multi-Step Income Statement Relevant Information Advertising = 2,000 Commissions = 5,000 Cost Of Goods Sold = 75,000 Gain on Sale of Investment = 3,000 Interest Expense = 500 Interest Revenues = 5,000 Loss from Lawsuit = 1,500 Office Equipment = 2,500 Office Supplies = 3,500

10. The Income Statement  Regardless of format, certain items must be disclosed separately on an income statement:  Discontinued operations  Extraordinary transactions 3-10

11. The Income Statement Comprehensive Income  Change in equity of a company during a period from transactions, other events, and circumstances related to nonowner sources.  Companies are required to report comprehensive income in one of three ways:  on the face of its income statement  in a separate statement of comprehensive income, or  in its statement of stockholders’ equity. 3-11

12. The Income Statement Common-Size Income Statement  Useful analytical tool to:  compare firms with different levels of sales or total assets,  facilitate internal or structural analysis,  evaluate trends, and  make industry comparisons. 3-12

13. The Income Statement Common-Size Income Statement  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 3-13

14. The Income Statement 3-14

15. The Income Statement Net Sales  Total sales revenue is shown net of returns and allowances.  A sales return is a cancellation of a sale.  A sales allowance is a deduction from the original sales invoice price.  Sales are the major revenue source for most companies. 3-15

16. The Income Statement Net Sales  If a company’s sales are increasing (or decreasing), it is important to determine whether the change is a result of price, volume, or a combination of both.  The reasons for sales growth (or decline) are covered in the Management Discussion and Analysis section of the annual or 10-K report. 3-16

17. The Income Statement Net Sales  “Real” (inflation adjusted) sales growth  “Nominal” (as reported) sales growth  An adjustment of the reported sales figure with the Consumer Price Index (or some other measure of general inflation) will enable the analyst to compare changes in real and nominal terms. 3-17

18. The Income Statement Cost of Goods Sold  Also called cost of sales  Cost to seller of products or services sold to customers  Affected by cost flow assumption used to value inventory  Largest expense for many firms 3-18

19. The Income Statement Cost of Goods Sold Percentage  Ratio of cost of goods sold and net sales  Important for profit determination 3-19

20. The Income Statement Cost of Goods Sold Percentage – Sage Inc.  Increased between 2011 and 2012  MD&A explains that lower prices on footwear have resulted in lower margins. 3-20

21. The Income Statement 3-21

22. The Income Statement Gross Profit  Also called gross margin  Difference between net sales and cost of goods sold  First step of profit measurement on the multi-step income statement  Key analytical tool in assessing operating performance 3-22

23. The Income Statement Gross Profit Margin  Ratio of gross profit to net sales (expressed as a percentage)  Complement of the cost of goods sold percentage  Firms want to maintain or increase gross profit margin.  Remains relatively constant in stable industries  May change significantly in volatile industries 3-23

24. The Income Statement Gross Profit Margin – Sage Inc. 3-24

25. The Income Statement Gross Profit Margin – Multiple Revenue Sources  Each revenue is shown separately.  Each revenue line will show the corresponding cost of goods sold for each revenue source. 3-25

26. The Income Statement 3-26

27. The Income Statement Operating Expense  Includes areas in which management discretion is exercised  Has considerable impact on current and future profitability  Important to track trends, absolute amounts, relationship to sales, and relationship to industry competitors 3-27

28. The Income Statement Operating Expenses  Selling and administrative expenses  Advertising costs  Depreciation and amortization  Repairs and maintenance  Impairment charges 3-28

29. The Income Statement Operating Expenses – Selling and Administrative Expenses  Relate to the sale of products or services  Salaries, rent, insurance, utilities, supplies, etc. 3-29

30. The Income Statement Operating Expenses – Advertising Costs  Are or should be a major expense when marketing is an important element of success 3-30

31. The Income Statement Advertising Costs for Sage Inc.  Sage Inc. spends 6 to 7 cents of every sales dollar for advertising. 3-31

32. The Income Statement Operating Expenses – Lease Payments  Costs associated with operating rentals of leased facilities for retail outlets  Note 3 to the financial statements explains the agreements that apply to the rental arrangements and presents a schedule of minimum annual rental commitments. 3-32

33. The Income Statement Operating Expenses – Depreciation and Amortization  Cost of assets other than land that will benefit a business enterprise for more than a year is allocated over the asset’s service life.  Cost allocation procedure is determined by the nature of the long-lived asset. 3-33

34. The Income Statement Operating Expenses – Depreciation and Amortization  Depreciation is used to allocate the cost of tangible fixed assets, such as:  buildings  machinery  equipment  furniture and fixtures  motor vehicles 3-34

35. The Income Statement Operating Expenses – Depreciation and Amortization  Amortization is an allocation process applied to:  capital leases  leasehold improvements  cost expiration of intangible assets, such as patents, copyrights, trademarks, and franchises 3-35

36. The Income Statement Operating Expenses – Depreciation and Amortization  Depletion is an allocation process applied to acquisition and development of natural resources, such as:  oil and gas  other minerals  standing timber 3-36

37. The Income Statement Percentage of Depreciation and Amortization Expense for Sage Inc.  Decreased somewhat from 2012 to 2013  New assets were placed in service during 2013 for only a part of the year (rendering less than full year’s depreciation and amortization) 3-37

38. The Income Statement Operating Expenses – Repairs and Maintenance  Annual costs of repairing and maintaining PP&E  Should correspond to the level of investment in capital equipment and to the age and condition of fixed assets  Inadequate allowance can impair success.  Should be evaluated in relation to the firm’s investments in fixed assets 3-38

39. The Income Statement Percentage of Repairs and Maintenance Expense for Sage Inc.  Decreased from 2012 to 2013  Could be a result of having newer fixed assets needing fewer repairs  Could be a choice to delay repairs in order to increase operating profit in the short term 3-39

40. The Income Statement Operating Expenses – Impairment Charges  Recognized to record a decline in value of a long-term asset  May occur in connection with goodwill  Can also be recognized when asset values of PP&E decrease below book value 3-40

41. The Income Statement Operating Profit  Also called earnings before interest and taxes (EBIT)  Second step of profit determination on the multi- step income statement  Measures overall performance of operations  Provides a basis for assessing success of a firm apart from financing and investing activities and separate from tax considerations  Sales revenue less the expenses associated with generating sales 3-41

42. The Income Statement Operating Profit Margin  Ratio of operating profit to net sales 3-42

43. The Income Statement Operating Profit Margin for Sage Inc.  Indicates that Sage Inc. strengthened its return on operations in 2013 after a dip in 2012  Despite the percentage increase in cost of goods sold, Sage Inc.’s percentage of selling and administrative and advertising expenses decreased enough to increase operating profit. 3-43

44. The Income Statement Other Income (Expense)  Revenues and costs other than from operations, such as:  dividend and interest income  interest expense  investment gains (losses)  equity earnings (loss)  gains (losses) from sale of fixed assets 3-44

45. The Income Statement Other Income (Expense)  Firms that carry debt and equity securities classified as “trading securities” report these investments on the balance sheet at market value with any unrealized gains and losses included in earnings. 3-45

46. The Income Statement Other Income (Expense)  In assessment of earning quality, the analyst should consider the materiality and the variability of the nonoperating items of income:  Gains and losses on the sale of major capital assets  Accounting changes  Extraordinary items  Investment income from temporary investments in cash equivalents  Investment income recognized under the equity method 3-46

47. The Income Statement Earnings Before Income Taxes / Effective Tax Rate  Earnings before income taxes is the profit recognized before the deduction of income tax expense.  Income taxes paid may differ from income tax expense.  Effective tax rate is the ratio of income taxes to earnings before income taxes. 3-47

48. The Income Statement Sage Inc.’s Effective Tax Rate 3-48

49. The Income Statement Earnings Before Income Taxes / Effective Tax Rate  Noteworthy items that may affect the effective tax rate are net operating losses (NOLs) and foreign taxes.  Users of financial statements need to distinguish between earnings increasing due to core operations versus items such as tax rate deductions. 3-49

50. The Income Statement Special Items  Often one-time items that will not recur in the future  Discontinued operations  Occur when a firm sells or discontinues a clearly distinguishable portion of its business  Extraordinary gains and losses  Unusual in nature  Not expected to recur in the future 3-50

51. The Income Statement Net Earnings  Also called the “bottom line”  Represents profit after consideration of all revenue and expense 3-51

52. The Income Statement Net Profit Margin  Ratio of net earnings to net sales (expressed as a percentage)  Shows the percentage of profit earned on every sales dollar 3-52

53. The Income Statement Net Profit Margin for Sage Inc. 3-53

54. The Income Statement Earnings per Common Share  Net earnings available to common stockholders for the period divided by the average number of common stock shares outstanding  Firms with complex capital structure report basic and diluted earnings per common share. 3-54

55. The Income Statement Earnings per Common Share  Analysts should consider material changes in the number of common stock shares outstanding, such as:  treasury stock purchases  purchase and retirement of a firm’s own common stock  stock splits  reverse stock splits 3-55

56. The Income Statement 3-56

57. The Income Statement Comprehensive Income  Reported in one of three ways  On the face of the income statement  In a separate statement of comprehensive income  In the statement of stockholders’ equity 3-57

58. The Income Statement Comprehensive Income  Foreign currency translation effects  Unrealized gains and losses  Additional pension liabilities  Cash flow hedges 3-58

59. The Income Statement Comprehensive Income – Foreign Currency Translation Effects  Arise from changes in equity of foreign subsidiaries  Occur as a result of changes in foreign currency exchange rates 3-59

60. The Income Statement Comprehensive Income – Unrealized Gains and Losses  Cumulative net unrealized gains and losses 3-60

61. The Income Statement Comprehensive Income – Additional Pension Liabilities  Reported when accumulated benefit obligation is greater than the fair market value of plan assets less the balance of the accrued pension liability account or plus the balance in the deferred pension asset account 3-61

62. The Income Statement Comprehensive Income – Cash Flow Hedges  Derivatives designated as hedging the exposure to variable cash flows of a forecasted transaction  Companies using cash flow hedges must initially report any gain or loss in other comprehensive income and subsequently reclassify the amount into earnings when the forecasted transaction affects earnings. 3-62

63. Statement of Stockholders’ Equity  Important link between the balance sheet and the income statement  Documents changes in the balance sheet equity accounts  Annual reports include three years of stockholders’ equity information 3-63

64. Statement of Stockholders’ Equity 3-64

65. Statement of Stockholders’ Equity  Stock dividends  Issuance of additional shares of stock in proportion to current ownership  Reduce retained earnings account  Stock splits  Used to lower the market price of shares to make common stock more affordable  Reverse stock splits  Occurs when outstanding shares are decreased 3-65

66. Earnings Quality, Cash Flow, and Segmental Accounting  Assessment of the quality of reported earnings is an essential element of income statement analysis.  Cash flow from operations is a key ingredient in analyzing operating performance. 3-66

67. Earnings Quality, Cash Flow, and Segmental Accounting  Segmental data include revenue, operating profit or loss, assets, depreciation and amortization, and capital expenditures by industry components.  These disclosures facilitate analysis of operating performance and contribution by each segment. 3-67

68.  Prepared to reconcile the beginning and ending retained earnings balances  Beginning RE + Net Income – Dividends = Ending RE  Statement has standard heading as shown below 68 Statement of Retained Earnings