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The Income Statement
Chapter 5
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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.
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Objectives for the day
3. Compute I/S based ratios
4. Practice comparing different industries’ financial info
5. Look at some creative accounting
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Terminology and Concepts
Resource inflows
resulting from
completed sales of
products or services
Revenues
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Terminology and Concepts
Costs incurred to earn
revenues
Expenses
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Terminology and Concepts
Gains and losses
result from sales not in the ordinary
course of business.
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Terminology and Concepts
WHEN AN ASSET is SOLD:
Proceeds = P
Carrying Value = CV
P > CV = Gain
P < CV = Loss
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Gain and Loss: Extent of?
One estimate is thatat least 7 % of manufacturingassets are sold or exchangedeach year…...
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Revenue Recognition
When may a company recognize revenue from a transaction?
Three questions:
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Revenue Recognition
Has the buyer accepted substantially all of the risk associated with the product or service?
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Revenue Recognition
Have we earned the right to the proceeds from this because we have completed our share of the transaction?
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Revenue Recognition
Can we estimate the collectibility of proceeds from this sale with a reasonable degree of certainty?
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Expense Recognition
When may a company recognize an expense?
Three questions:
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Expense Recognition
Have we included all of the costs and expenses associated with the benefits we realized during the year?
The The MatchinMatching g PrinciplPrinciplee
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Expense Recognition
Have our judgments and estimates been appropriately conservative?
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Expense Recognition
Do all of our assets still have the potential to earn future cash flows equal to their current costs?
(or have they been
Impaired?)
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Revenue Recognition
When a company recognizes revenue what Balance Sheet account(s) is(are) usually affected?
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Assets
Expenses & Losses
Liabilities
Equities
Revenues & Gains
Journal Entry:DR.
CR.
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Expense Recognition
When a company recognizes expense what Balance Sheet account(s) is(are) usually affected?
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Cost of Goods Sold -Inventory
KEY EXPENSE on I/S is COSTOF GOODS SOLDA review….What are LIFO and FIFO andwhy do they matter?
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Assets
Expenses & Losses
Liabilities
Equities
Revenues & Gains
Journal Entry:DR.
CR.
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Depreciation Expense
Depreciate Tangible Fixedassets over useful life
Show Accumulated Depreciation as a valuation (contra asset) account
Purpose of doing so???
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Assets
Expenses & Losses
Liabilities
Equities
Revenues & Gains
Journal Entry:DR.
CR.
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Key Income Statement Issues
1.Expensing versus Capitalizing?
2.Operating vs. Non-operating?
3. Ordinary vs. Unusual vs. Extraordinary? Death of
an Ox?
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Key Income Statement Issues
4. Pro Forma Income5. Comprehensive Income
--- how to recognize changes in value without causing extreme volatility in income?
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1. Expensing vs. Capitalizing…
Impact on I/S? and on BalanceSheet?World.Com became famousfor being aggressive in this area.
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2. Operating Income
Income statement format:– Sales or Revenues.– Deduct Cost of Sales= Gross Profit or Margin– various categories of
expenses but not INTEREST.
= OPERATING INCOME
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3. Reporting the Results of Ordinary Operations Income statement format: Operating Income + - Interest + - Investments + - Other = Ordinary Income
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What do we mean by NON Ordinary? Some companies use the
term “unusual” to highlight events that are not typical but do not quality for separate disclosure.
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Must Report these three below Ordinary Income Discontinued
Operations– Shows income related
to major segments of the business that have been discontinued.
Extraordinary Items– Both unusual in
nature and infrequent in occurrence.
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One more NON-ordinary item…... 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.
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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
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5. Valuation to avoid volatility? Available for trading
portfolioForeign currency.Some Pension liabilitiesSome hedge gains (losses)
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Do F/S of all industries look the same? Why or why not?
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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.
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Analyzing the Income Statement, using BALANCE SHEET Return on total assets
Return on equity
=Net income
Average total assets
=
Net income
Average owners’ equity
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Analyzing the Income Statement -Using SALES Gross Profit Margin
=Sales - Cost of goods sold
Sales
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Analyzing the Income Statement- Using SALES
Gross Margin %
Return on Sales
=Sales - Cost of goods sold
Sales
=Net income
Sales
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Creative Accounting 101
The B/S and I/S are linked, so being “creative” affects both...
The two statements FIT together (they articulate)….
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To do for next time…….
1.Read Puzzle of CashFlow and chapter 6
2. Do homework3. Be ready to do a simple Statement of cash flows