Income Statement

&
Statement of Cash Flows

Week 3

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 Relation Between Balance Sheet and Income
Statement
Liab- Shareholders’
Assets = +
ilities Equity

Contri-
Liab- Retained
Assets = + buted +
ilities Earning
Capital

Contri- Retained
Liab- Earning Net Income Dividends
Assets = ilities + buted + Beginning + for period - for period
Capital of Period

Contri- Retained
Liab- Earning Revenues Expenses Dividends
Assets = ilities + buted + Beginning + for period - for period - for period
Capital of Period
 5 Steps to Prepare an IS

• Identify the dual effects of all transactions

• Use journal entries to record the identified dual effects.
Instead of using Retained Earnings for IS transactions, we
use Revenue and Expense accounts temporarily.
• List the IS accounts to present the IS
• Close the Revenue and Expense accounts by transferring
their balances to Retained Earnings (a BS account)
• List the balances of all BS accounts to present the BS.

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 Miller Example – Matched Expense

• Transaction 2:
 Dr. Advance from Customer 3,000

 Dr. Accounts Receivable 47,000

• Cr. Revenue 50,000
• Transaction 3:
 Dr. Cost of Goods Sold 30,000
• Cr. Merchandise Inventory 30,000

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 Adjusting Entries for Incurred Expense

• Transaction 8: Insurance expense

 Dr. Expense-SGA 50=600/12
• Cr. Prepaid Insurance 50

• Transaction 11: Interest expense

 Dr. Expense-Interest Expense 333=4,000/12

• Cr. Interest Payable 333

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 Adjusting Entries for Incurred Expense

• Transaction 10: Depreciation expense

 Dr. Expense-SGA-Depreciation 167=40/240
• Cr. Accumulated Depreciation 167
• AD is an Contra account: It preserves information about
the original cost of the building and the current value of the
building.

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 Closing Entries

• Close the IS accounts after IS is prepared.

• Dr. Revenue $50,000

 Cr. Expense-COGS $30,000
 Expense-SGA $15,550
 Expense-SGA-Depreciation $167
 Expense-Interest $333
 Expense-Tax $1,383
 Retained earnings $2,568

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 Groupon’s Accounting Controversy 1

• What is Groupon’s revenue?

• Groupon sells products on behalf of various merchants

 A customer pays X to Groupon

 Groupon pays the merchant Y and retain X-Y

 Groupon incurs other cost Z

• Groupon’s profit is NI=X-Y-Z

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Pingyang Gao 9
June 2011 Prospectus

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September 2011 Revised Prospectus

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Accrual v.s. Cash Basis Accounting

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 Why is SCF important?

• Net income is the most important measure of performance.

• Net income is not Cash!

• But the ability to generate cash and to manage their timing

is also critical to the survival of business enterprises.

• All cash is not captured by Net Income.

• Cash is King, sometimes!

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 Accrual Accounting
• Both revenue and expense recognitions are independent of cash.
• Revenue recognition criteria
 The firm has performed all, or most of, the services it expects to

provide;
 The firm has received cash or some other assets such as

receivables, whose cash-equivalent value can be measured with

reasonable precision.
• Expense recognition criteria
 related revenues are recognized (matching principle);

 incurred (i.e., when assets are consumed), if difficult to match with

revenues (expensing rule);

 event triggered - downward revaluation of assets (loss recognition

rule).

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 Accrual accounting and adjusting entries

Cash in past (deferral) Cash in future (accrual)

Revenue Fulfilled liability
(e.g. subscription
revenue)
Expense Consumed asset
(e.g. prepaid rent,
depreciation)
Uncollected asset
(e.g. interest
receivable)
Unpaid liability
(e.g. salaries payable)

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 Example 1: deferral-unearned revenue
• A firm may receive prepayment from customers. Since it hasn’t
provided the service yet, it recognizes the prepayment as a liability,
such as magazine subscription and insurance premium.
• As the firm gradually fulfills its obligation, it recognizes the revenue
and writes down the liability at the end of an accounting period in
proportion to the amount of services provided.

• At the beginning of the year, Time magazine receives $12,000 cash for
the subscription of the entire year.
 Dr. Cash 12,000

o Cr. Advance from Readers 12,000

• At the end of each quarter, it recognizes revenue for the quarter.
 Dr. Advance from Readers 3,000

o Cr. Revenue 3,000

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 Example 2.1: deferral-prepaid expense
• The firm prepays for a service. Since a prepaid service has future
benefit, it is an asset until the time for the service expires.
• When the service begins, accrual accounting calls for recognizing the
expense and adjusting the asset down at the end of accounting periods
in proportion to the amount of service used.

• When the firm pays for insurance policy with half a year coverage:
 Dr. Prepaid Insurance 1,000
o Cr. Cash 1,000
• At the end of the first quarter:
 Dr. Expense - Insurance 500
o Cr. Prepaid Insurance 500

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 Example 2.2: depreciation
• Depreciation is a long-term form of a prepaid service. An asset may
last many years. As the asset is used, it is expensed.
• One simple form of depreciation is straight-line. The original cost of
the asset is expensed over the useful life in equal amounts over time.

• When asset is purchased ( The asset will last 10 years ):

 Dr. Property, plant and equipment 800,000
o Cr. Cash 800,000

• By the end of the first quarter:

 Dr. Expense - Depreciation 20,000
o Cr. Accumulated Depreciation 20,000

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 Example 3: accrual-earned revenue
• When a firm has rendered service but hasn’t received cash, it
recognizes a non-cash asset, such as receivables.

• Goldman Sachs holds a bond of 1 billion $ with interest rate of 12%

per year. Interests are received only once a year. At the end of each of
the first three quarters, it recognizes the revenue for the quarter.
 Dr. Interest Receivables 30,000,000
o Cr. Revenue - Interest 30,000,000
• At the end of the fourth quart, it receives the interest for the entire
year.
 Dr. Cash 120,000,000

o Cr. Revenue - Interest 30,000,000

o Cr. Interest Receivables 90,000,000

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 Example 4: accrual-accrued expense
• A firm receives services but may not pay it at the end of the accounting
period.
• Since it incurs an obligation to pay for them, accrual accounting calls
for recognizing the proportion of service received as an expense.

• Goldman Sachs promises bonus to employees but the bonus is not paid
this year. On 12/31/2009, it recognize the expected bonus payout.
 Dr. Expense – Compensation 6,000,000,000
o Cr. Bonus Payable 6,000,000,000

• On 2/1/2010, it pays out the bonus.

 Dr. Bonus Payable 6,000,000,000

o Cr. Cash 6,000,000,000

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Prepare a SCF

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Pingyang Gao 22
Ambiguities in Classifying Cash Flows

U.S. GAAP IFRS permits firms to

select the classification
requires that firms (operating, or
classify cash investing, or financing)
payments for for cash payments of
interest expense as interest expense, again
an operating requiring consistent
classification from
activity. period to period.

23
 Ambiguities in Classifying Cash Flows

U.S. GAAP requires that IFRS permits firms to

firms classify cash classify cash from
receipts from interest and interest and dividend
dividend revenues as an revenue as operating,
operating activity, but investing, or financing
classify cash flows
related to the purchase activities, provided the
and sale of investments in classification is
securities as an investing consistently applied
activity. across periods.

24
 The Key to Prepare a SCF

• Cash change equations

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 Notations

• CA: Current Asset

• LA: Long-term Asset
• CL: Current Liability
• LL: Long-term Liability
• CC: Contributed Capital
• NI: Net Income
• Div: Dividend
• WC: Working Capital
• D&A: Depreciation and Amortization
•  : Change

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 Cash Change Equation #1 – Indirect Method

A = L + SE

Cash + CA+LA=CL+LL + SE

 Cash +  CA+  LA =  CL+  LL +  SE

 Cash =  SE – (  CA -  CL) -  LA +  LL
=  CC+ (NI-Div) -  WC + D&A - ( LA+ D&A) +  LL
=(NI + D&A -  WC) - ( LA+ D&A) + ( CC+  LL-Div)

=CFO+CFI+CFF

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 Reporting components of CFO

CFO=NI - WC+ D&A

• WC is equal to current assets minus current liability, and

classified as operating.
 Investment in Inventory reduces CFO

 Investment in Accounts Receivable reduces CFO

 Financing from Accounts Payable increases CFO

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 Illustration: Indirect Method
1. A firm purchase inventory for $27 cash and sell it for 40 on credit

• Indirect-Method: Undo accrual accounting

Net Income $13
Less increase in AR (40)
Cash Flow from Operating $ (27)

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 Depreciation, CFO and Net Income

CFO=NI - WC+ D&A

• Depreciation is not a direct source of cash flow.

• Due to accrual accounting, Depreciation Expense (DE)is a
non-cash expense and subtracted when calculating NI. To
calculate CFO, we “undo” accrual accounting by adding DE
back to NI.
• Previous example: suppose $5 DE is recognized.

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 Add $5 Depreciation Expense

• Indirect-Method: Undo accrual accounting

Net Income $13 $8
Less increase in AR (40) (40)
Add: Deprecation 5
Cash Flow from Operating $ (27) $ (27)

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Cash Change Equation #2 – Direct Method

 Cash =Cash Received (CR) –Cash Paid (CP)

CR from Customers=  Advance+Revenue –  AR
 Dr. Cash
• Cr. Advance from Customer
 Dr. Cash
• Cr. Revenue
 Dr. Cash
• Cr. AR
 Dr. Advance from Customer
• Cr. Revenue
 Dr. AR
• Cr. Revenue

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 Cash Payment to Supplier

• CP to Supplier (+)=  Prepaid to supplier +( Inventory

+COGS ) -  AP

 Dr. Prepaid to Supplier

• Cr. Cash to Supplier
 Dr. Inventory
• Cr. Cash to Supplier
 Dr. Accounts Payables
• Cr. Cash to Supplier
 Dr. Cost of Goods Sold (COGS)
• Cr. Inventory
 Dr. Inventory
• Cr. Prepaid to Supplier
 Dr. Inventory
• Cr. Accounts Payables
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 Illustration: Indirect and Direct Methods
1. A firm purchase inventory for $27 cash and sell it for 40 on credit

• Indirect-Method: Undo accrual accounting

Net Income $13
Less increase in AR (40)
Cash Flow from Operating $ (27)

• Direct-Method Statement of Cash Flows

Cash receipts from customer $0
Less cash payment to supplier (27)
Cash Flow from Operating $ (27)

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 Add $5 Depreciation Expense

• Indirect-Method: Undo accrual accounting

Net Income $13 $8
Less increase in AR (40) (40)
Add: Deprecation 5
Cash Flow from Operating $ (27) $ (27)

• Direct-Method Statement of Cash Flows

Cash receipts from customer $0
Less cash payment to supplier (27)
Cash Flow from Operating $ (27)

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 Earnings v.s. Pro Forma Earnings
• In general, pro forma earnings refer to net income excluding the effects
of “unusual and nonrecurring transactions.” Although they are often
labeled as cash earnings, they are not.
• Pro forma earnings are supposed to give investors more relevant
information to assess future corporate prospects.
• However, firms have abused the discretion to exclude special charges
from net income. Many firms emphasize on pro forma earnings to
explain away their (often poor) GAAP net income and pro forma
earnings are typically much better than GAAP earnings.
• Remember: Pro forma earnings are non-GAAP earnings.
• EBIT (operation earnings), EBITDA, CFO (cash earnings), Non-cash
charges
• Pro forma financial statement has less stigma than pro forma earnings.

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 Groupon’s Accounting Controversy 2
• June 2011 “We believe Adjusted CSOI is an important
measure of the performance of our business as it excludes
expenses that are non-cash or otherwise not indicative of
future operating expenses. In 2010 and the first quarter of
2011, we generated Adjusted CSOI of $60.6 million and
$81.6 million, respectively. ”
• September 2011 “We believe CSOI is an important
measure for management to evaluate the performance of
our business as it represents the operating results of our
segments and, as reported under U.S. GAAP, does not
include certain non-cash expenses. In 2010 and the first
half of 2011, our CSOI was $(181.0) million and $(160.6)
million, respectively.
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Adjust CSOI in June 2011 Prospectus

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CSOI in September 2011 Revised Propsectus

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