1. Financial Accounting:
Copyright 2004 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
PowerPoint Presentation Materials
For
Financial Accounting:
A New Perspective by
Paul Solomon

2. Using the Income Statement to Make Decisions
CHAPTER 7
Using the Income Statement to Make Decisions

3. PERFORMANCE OBJECTIVES
PO10: Prepare single or multiple step income statements
PO13b: Analyze accounting transactions to determine their effect
PO18e: Distinguish between accrual and cash basis of income measurement
PO19a: Prepare adjustments

4. PERFORMANCE OBJECTIVES
PO19b: Determine amount of balance sheet & income statement accounts after adjustments
PO20: Categorize income statement accounts into:
Primary continuing operating activities
Peripheral continuing activities
Primary discontinued operating activities
Peripheral discontinued activities

5. PERFORMANCE OBJECTIVES
PO21: discuss criteria for revenue recognition

6. USER FOCUS Real world application
How transactions affect financial statements

7. INSIGHTS What is true nature of peripheral activities
How income can be manipulated
Relationship between net income & cash flows

8. CMU: COMPLETING INCOME STATEMENT WITH ADJUSTMENTS
Distinguishing between explicit, implicit transactions
Explicit: identifiable because derived from document
Check
Invoice
Implicit: not derived from document

9. DEFINITION OF ADJUSTMENTS
Implicit transaction recorded at end of accounting period
To ensure revenues & expenses reported in proper period
Underlying concepts
Accruals
Deferrals

10. ACCRUALS Transactions in which
Revenues, expenses recognized in current period
Cash collected, paid in future period

11. ACCRUAL CONCEPT Accounting Period 1 Income effect Implicit transaction
No document
Accounting Period 2
Cash effect
Explicit transaction
Document

12. DEFERRALS Transactions in which Cash collected, paid in current period
Revenues, expenses recognized in future period

13. DEFERRAL CONCEPT Accounting Period 1 Cash effect Explicit transaction
Documentation
Accounting Period 2
Income effect
Implicit transaction
No documentation

14. ADJUSTMENT OF CMU’S EXPLICIT REVENUE TRANSACTIONS
Accrued revenue
Revenue earned in current period
Cash collected future period
Transaction O2
$25 interest earned but not collected on savings
Nature of revenue, expense
Interest Revenue

15. TRANSACTION ANALYSIS: Accrued Revenue
Transaction O2
$25 interest earned but not collected on savings
Assets = 25
Liabilities +
Equity
25 Interest Revenue

16. ADJUSTMENT OF CMU’S EXPLICIT EXPENSE TRANSACTIONS
Accrued expense
Expense incurred in current period
Cash paid in future period
Transaction X
$750 salaries expense incurred but unpaid
Nature of Revenue, Expense
Salaries expense

17. TRANSACTION ANALYSIS: Accrued Expense 1
Transaction X
$750 salaries expense incurred but unpaid
Assets =
Liabilities +
750
Equity
<750> Salaries Expense

18. TRANSACTION ANALYSIS: Accrued Expense 2
Transaction Y
$350 miscellaneous expense incurred but unpaid
Assets =
Liabilities +
350
Equity
<350>
Misc. Expense

19. ADJUSTMENT OF CMU’S EXPENSE TRANSACTIONS
Deferred expense is asset expiration
Cash paid now
Expense incurred in future period
Transaction Q2
$2300 depreciation recorded on equipment
Nature of Revenue or Expense
Depreciation Expense

20. ANALYSIS OF DEPRECIATION: Transaction Q2
Q1 (sold) H L
Holding
8000 (12)
2000 (9/12)
7000 (5/12)
4000 (0/12)
Calculation
(8000/5)
(2000/5)*3/4
(7000/5)*1/2 NA
Amount
$1,600
300
700
$2,600

21. TRANSACTION ANALYSIS: Deferred Expense
Transaction Q2
$2300 depreciation recorded on unsold equipment
Assets =
<2,300>
Liabilities +
Equity
<2,300> Depreciation Expense

22. ADJUSTMENT OF CMU’S REVENUE TRANSACTIONS
Deferred revenue
Cash collected in current period
Revenue earned in future period
Transaction Z
$4,000 inventory delivered to customers who paid in advance
Nature of Revenue, Expense
Sales Revenue

23. TRANSACTION ANALYSIS: Deferred Revenue
Transaction Z
$4,000 inventory delivered to customers who paid in advance
Assets =
Liabilities +
<4000>
Equity
4000
Sales Revenue

24. ACCRUAL & DEFERRAL CONCEPTS: Transaction O2
Accrued revenue
Period 1
+25 Receivable
+25 Revenue
Period 2
-25 Receivable
+25 Cash

25. ACCRUAL & DEFERRAL CONCEPTS: Transaction X
Accrued expense
Period 1
+750 Expense
+759 Liability
Period 2
-750 Cash
-750 Liability

26. ACCRUAL & DEFERRAL CONCEPTS: Transaction Y
Accrued expense
Period 1
+350 Expense
+350 Liability
Period 2
-350 Cash
-350 Liability

27. ACCRUAL & DEFERRAL CONCEPTS: Transaction Q2
Deferred expense & asset expiration
Period 1
+19,000 Assets
19,000 offsets
(C1,H,L,&R)
Period 2
+2,300 Expense
-2,300 Assets

28. ACCRUAL & DEFERRAL CONCEPTS: Transaction Z
Deferred revenue & liability reduction
Period 1
+6,000 Cash
+6,000 Liability
Period 2
+4,000 Revenue
-4,000 Liability

29. FINANCIAL STATEMENT RELATIONSHIPS: Credit Sale
Total Revenue
Increase
Total Expense
No Effect
Net Income
Total Assets
Total Liabilities
No effect
Total Owner’s Equity

30. FINANCIAL STATEMENT RELATIONSHIPS: Credit Sale Error
Total Revenue
Understated
Total Expense
No effect
Net Income
Total Assets
Total Liabilities
Total Owner’s Equity

31. FINANCIAL STATEMENT RELATIONSHIPS: Credit Sale Omitted
Total Revenue
Understated
Total Expense
No effect
Net Income
Total Assets
Total Liabilities
Total Owner’s Equity

32. USER FOCUS: Hitachi Real World Application
Transaction: purchase of E-business
Total Revenue
No effect
Total Expense
Net Income
Total Assets
No effect; + & - by $175m
Total Liabilities
Total Owner’s Equity

33. USER FOCUS: Xerox Real World Application
Xerox slashes $1billion expenses
Xerox sells some assets
Total Revenue
No effect
Potential gain
Total Expense
Decrease
Potential loss
Net Income
Increase
Unclear
Total Assets
Cash increase
Total liabilities
Total Equity

34. CORPORATE INCOME STATEMENTS: Primary & Peripheral
Primary operating activities
More important in evaluating operations
Understand essential nature of business
Peripheral activities
Less important in evaluating operations
Not essential nature of business

35. CORPORATE INCOME STATEMENTS: Continuing & NonContinuing
Continuing activities
Transactions reported regularly on income statement
NonContinuing activities
Do not occur on regular basis

36. INSIGHT 7-1 True Nature of Peripheral Activities
Investing, financing activities
Not operating activities
Examples
Interest revenue, expense
Dividend revenue
Gains, losses on depreciable assets
Income tax expense

37. PRIMARY CONTINUING OPERATING ACTIVITIES
Net sales
Cost of Goods Sold
Gross margin (profit);
Subtotal
Selling, general, administrative expenses
Research, development, engineering
Primary operating income

38. PERIPHERAL CONTINUING ACTIVITIES
Interest revenue, expense
Dividend revenue
Gains, losses on depreciable assets
Income tax expense

39. PRIMARY DISCONTINUED OPERATING ACTIVITIES
Business segment sold or about to be sold
Major line of business or class of customer
Gain/Loss from operations
Gain/loss on disposal of business division

40. PERIPHERAL DISCONTINUED ACTIVITIES
Significant in amount (material)
Unusual in nature and infrequent in occurrence
Extraordinary item
Change in accounting principle

41. INCOME STATEMENT CATEGORIES
Continuing Activities
NonContinuing Activities
Primary operating
Creation/sale products, services
Income/loss from discontinued operations, sales
Peripheral activities
Interest revenue, expense, dividend revenue
Extraordinary items, changes in accounting principles

42. INCOME STATEMENT FORMAT
Multiple-step income statement
Deducts expenses from revenue in series of income subtotals (steps)
Example: Idealistic
Single-step income statement
All operating expenses subtracted from total revenue
Examples: General Motors, Wendy’s

43. DECIDING WHEN TO RECOGNIZE REVENUE
Criteria
Measurement: exchange process
Performance
All critical revenue producing services completed (earnings process complete)
Matching
Expenses associated with revenue have been incurred

44. INSIGHT 7-2 Manipulating Income with Unethical Practices
Recording revenue too early
Shipping goods before sales agreement exists
Recording revenue before known if buyer will keep, pay for goods
Recording revenue when cash received but before services performed

45. ANALYZING INCOME STATEMENT WITH RATIOS
Activity ratios evaluate turnover
Asset turnover ratio
Accounts receivable turnover ratio
Inventory turnover ratio
Financial risk
Profitability ratios
Gross margin ratio
Profit margin ratio
Earnings per share

46. ACTIVITY RATIOS: Asset Turnover Ratio
Measures how efficiently assets used to produce sales during period
Net Sales Revenue
Average Total Assets

47. ACTIVITY RATIOS: Accounts Receivable Turnover Ratio
Measures relative frequency accounts receivable collected in cash
Net Credit Sales
Average Net Accounts Receivable
Sales Revenue

48. ACTIVITY RATIOS: Collection Period
Average period in days for collecting accounts receivable
365
Account Receivable Turnover Ratio

49. ACTIVITY RATIOS: Inventory Turnover
Measures how frequently business sells inventory
Efficiency of sales and production or purchasing
Cost of Goods Sold
Average Inventory

50. ACTIVITY RATIOS: Holding Period
Days of inventories on hand
365
Inventory Turnover Ratio

51. FINANCIAL RISK: Times Interest Earned Ratio
Indicates ability to meet required interest payments
Net Income + Interest Expense + Income Tax Expense
Interest Expense

52. PROFITABILITY RATIOS: Gross Margin Ratio
Evaluates management’s effectiveness
Range: 30% - 50%
For every dollar of sales, the profit left after paying for inventory
Measured in cents
Gross Margin
Sales

53. PROFITABILITY RATIOS: Profit Margin Ratio
Return on Sales
Measure control of expenses in relation to revenues
For every dollar of sales, the profit left after paying all expenses
Net Income
Sales

54. PROFITABILITY RATIOS: Earnings Per Share
Indicates relative profitability per share of common stock for the period
Net Income – Preferred Stock Dividends
Weighted Ave. Common Shares Outstanding

55. ANALYZING INCOME STATEMENT: Vertical Analysis
Expresses each item as a percentage of single designated item with financial statement
Balance Sheet: Total Assets
Income Statement: Net sales

56. ANALYZING INCOME STATEMENT: Horizontal Analysis
Compares how financial statement items change from year to year
Year 2 – Year 1
Year 1

57. USING INFORMATION NOT IN INCOME STATEMENT
Management’s Discussion & Analysis (MD&A)
Discusses results of operations
Notes
Summary of significant accounting policies
Revenue recognition
Detail for income statement accounts

58. INSIGHT 7-3: Relationship Net Income, Cash Flows
Operating activities not only source, use of cash
Accrual basis net income differs from cash flow operating activities