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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