Los 3 Income Statement and Statement of Stockholders' Equity

LOS 3
Income Statement and

Statement of Stockholders’ Equity
Learning about earnings, the bottom line,

Is very important most of the time.
A phony number
Just may encumber
Those folks trying to make more than a dime.
--A. Ormiston
(C) 2007 Prentice Hall, Inc. 3-1

The Income Statement
Also called the Statement of Earnings
Presents:
Revenues
Expenses
Net Income
Earnings Per Share (EPS)

The Income Statement (cont.)
Multiple-step
 Provides several intermediate profit measures prior to

the amount of net earnings for the period:
Gross profit
Operating profit
Earnings before income taxes
Single-step
 Groups all items of revenue together, then deducts all

categories of expense to arrive at a figure for net
income
The Income Statement (cont.)
 Regardless of format, certain special items, if they

occur during an accounting period, must be disclosed
separately on an income statement
These include. . .
 Discontinued operations
 Extraordinary transactions
 Cumulative effect of changes in accounting
principles

Common-Size Income Statement
 Useful analytical tool
 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

Common-Size income statement (cont.)
Comparison of two major retail companies*
Comparison using $ ($ are in millions):
Retailer A Retailer B
Net Sales $ 287,989 $ 46,839
Cost of Sales 219,793 31,445
Operating Expenses 51,105 11,793
Net Income 10,267 3,198
*Data from SEC website, www.sec.gov

Common-Size income statement (cont.)
Comparison of two major retail companies*
Comparison using common size income statement %:
Retailer A Retailer B
Net Sales 100.00 100.00
Cost of Sales 76.32 67.13
Operating Expenses 17.75 25.18
Net Income 3.57 6.83

Net Sales
 Sales are generally reported net of sales returns and

sales allowances
 A sales return is a cancellation of a sale
 A sales allowance is a deduction from the original

sales invoice price

Net Sales - Related Issue
 Are sales growing in “real” (inflation-adjusted) as well
as “nominal” (as reported) terms?
 An adjustment of the reported sales figure with the

Consumer Price Index (or some other measure of
general inflation) will enable the analyst to make a
comparison of the changes in real and nominal terms

Cost of Goods Sold (COGS)
 Also called “Cost of Sales”

 Cost to seller of products or services sold to
customers
 Important for profit determination
 Largest expense item for many firms
 Impacted by cost flow assumption used to value
inventory
 Cost of goods sold percentage is:

Cost of goods sold
Net sales
Gross Profit
 First step of profit measurement

 Difference between net sales and COGS
 Key analytical tool in assessing a firm’s operating
performance
 Gross Profit Margin is:

Gross profit
Net sales

Understand the Math!
 If COGS percentage increases or decreases, this does
not necessarily mean that costs have increased or
decreased
 The change in the percentage may be caused by

decreases or increases in the selling price
 For example. . .

Understand the Math! (cont.)
Year 1 Year 2
Sales $10 100% $8 100%
COGS 4 40% 4 50%
Gross Profit $6 60% $4 50%
Always pay attention to the numbers - know the

difference between raw dollars and percentages!

Operating Expense
 Have considerable impact on the firm’s current and
future profitability
 Important to track carefully-trends, absolute amounts,

relationship to sales, relationship to industry competitors
Example:
Selling and administrative
Advertising
Operating lease payments
Depreciation and amortization
Repairs and maintenance

Depreciation and Amortization
Depreciation
 Used to allocate the cost of tangible fixed assets, other

than land, that will benefit a business for more than a
year, such as:
Buildings
Machinery
Equipment
Furniture and Fixtures
Motor Vehicles

Depreciation and Amortization (cont.).
Amortization is the allocation process applied to:
Capital leases
Leasehold improvements
Cost expiration of intangible assets
Patents
Copyrights
Trademarks
Licenses
Franchises
Goodwill

Depreciation and Amortization (cont.)
 The amount of expense recognized in any
accounting period will depend on
the level of investment in the relevant asset

estimates with regard to the asset’s service
life and residual value
and for depreciation, the method used

Operating Profit
 Second step of profit measurement

 Also called EBIT (Earnings Before Interest and Taxes)
 Measures overall performance of company’s operations:
sales revenue less expenses associated with generating
sales
 Provides a basis for assessing the success of a company
apart from its financing and investing activities and
separate from tax considerations
 Operating Profit Margin is:

Operating profit
(C) 2007 Prentice Hall, Inc.
Net sales 3-18
Other Income (Expense)
Includes
Revenues/expenses other than from operations

Dividend and interest income
Interest expense
Investment gains/losses
Equity earnings/losses
Sales of fixed assets gains/losses

Equity Earnings
 Two methods (equity and cost) may be used to

account for investments in voting stock of other
companies of less than 50%
 Equity Method - Allows the investor proportionate

recognition of the investee’s net income, irrespective
of the payment or nonpayment of cash dividends
 Cost Method - Investor recognizes investment

income only to the extent of any cash dividends
received
Cost vs. Equity
 Analysts should be aware of whether a company

uses the cost or the equity method
 Equity method distorts earnings in the sense that

income is recognized even though no cash may ever
be received

Earnings Before Income Taxes/
Effective Tax Rate
 Earnings before income taxes is the profit recognized
before deduction of income tax expense
 Remember, income taxes paid may differ from
income tax expense (deferred taxes)
 Effective tax rate is:
Income taxes
Earnings before income taxes

Special Items
 Special items are often one-time items that will not
recur in the future
 If companies are affected by the following three items,

they must be disclosed separately on the income
statement, net of income tax effects or retrospectively
applied to prior periods’ financial statements:
Discontinued operations - Occur when a firms

sells or discontinues a clearly distinguishable
portion of its business
Extraordinary items
Accounting changes
Extraordinary Items
Gains and losses that meet two criteria:
1. Unusual in nature
2. Not expected to recur in the foreseeable future,
considering the firm’s operating environment

Accounting Changes
 Prior to 2006, the cumulative effect of a change in
accounting principle was disclosed when a firm
changed an accounting policy
 Retrospective application to prior periods’ financial

statements is required for changes in accounting
principles for fiscal years beginning after 12/15/2005
per SFAS #154, “Accounting Changes and Error
Corrections”

Net Earnings
 Also called the “bottom line”
 Represents the firm’s profit after consideration of ALL

revenue and expense
 Net profit margin is:
Net earnings
Net sales

Earnings Per Common Share
 The net earnings available to common stockholders
for the period divided by the average number of
common stock shares outstanding
 If firm has “complex” capital structure, it will report

basic and diluted EPS
 Extensively used by analysts in evaluating a firm

Earnings Per Common Share (cont.)
Examples of basic and diluted EPS data
reported by a variety of companies*
Basic EPS Diluted EPS
Airline $ 0.70 $ 0.67

Grain Mill 3.34 3.08
Recreation 1.56 1.50
Retailer 2.45 2.43
Semicond. Mfg. 1.03 1.01

Comprehensive Income
 The change in equity of a company during a period
from transactions, other events, and circumstances
relating to nonowner sources
 Companies are required to report total comprehensive

income in one of three ways:
1. On the face of the income statement

2. In the statement of stockholders’ equity
3. In a separate statement of comprehensive
income

Comprehensive Income (cont.)
 Currently, there are four items that may comprise a

company’s other comprehensive income:
1. Foreign currency translation effects

2. Unrealized gains and losses
3. Additional pension liabilities
4. Cash flow hedges

The Statement of Stockholders’
Equity
 Details transactions that affected the balance sheet
equity accounts during an accounting period
 Basically, it simply explains how each account got

from the balance at the beginning of the period to
the balance at the end of the period and describes
“events” that caused the balances to change

Earnings Quality, Cash Flow,
Segmental Accounting
Other topics directly related to the income statement:
 Earnings quality – assessment of the quality of reported

earnings is an essential element of income statement
analysis
 Cash flow – cash flow from operations is a key ingredient

in analyzing operating performance
 Segmental accounting – reviewing the contribution by

each segment of a diversified company facilitates the
analysis of operating performance

Los 3 Income Statement and Statement of Stockholders' Equity

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Los 3 Income Statement and Statement of Stockholders' Equity

Uploaded by

Copyright:

Available Formats

LOS 3

Income Statement and

Learning about earnings, the bottom line,

(C) 2007 Prentice Hall, Inc. 3-1

Also called the Statement of Earnings

(C) 2007 Prentice Hall, Inc. 3-2

 Provides several intermediate profit measures prior to

 Groups all items of revenue together, then deducts all

 Regardless of format, certain special items, if they

(C) 2007 Prentice Hall, Inc. 3-4

 Useful analytical tool

 Expresses each income statement item as a

 Shows the relative magnitude of various expenses

(C) 2007 Prentice Hall, Inc. 3-5

Comparison using $ ($ are in millions):

*Data from SEC website, www.sec.gov

Comparison using common size income statement %:

*Data from SEC website, www.sec.gov

(C) 2007 Prentice Hall, Inc. 3-7

 Sales are generally reported net of sales returns and

 A sales return is a cancellation of a sale

 A sales allowance is a deduction from the original

(C) 2007 Prentice Hall, Inc. 3-8

 An adjustment of the reported sales figure with the

(C) 2007 Prentice Hall, Inc. 3-9

 Also called “Cost of Sales”

 Cost of goods sold percentage is:

 First step of profit measurement

 Gross Profit Margin is:

(C) 2007 Prentice Hall, Inc. 3-11

 The change in the percentage may be caused by

(C) 2007 Prentice Hall, Inc. 3-12

Sales $10 100% $8 100%

COGS 4 40% 4 50%

Gross Profit $6 60% $4 50%

Always pay attention to the numbers - know the

(C) 2007 Prentice Hall, Inc. 3-13

 Important to track carefully-trends, absolute amounts,

(C) 2007 Prentice Hall, Inc. 3-14

 Used to allocate the cost of tangible fixed assets, other

(C) 2007 Prentice Hall, Inc. 3-15

(C) 2007 Prentice Hall, Inc. 3-16

the level of investment in the relevant asset

(C) 2007 Prentice Hall, Inc. 3-17

 Second step of profit measurement

 Operating Profit Margin is:

Revenues/expenses other than from operations

(C) 2007 Prentice Hall, Inc. 3-19

 Two methods (equity and cost) may be used to

 Equity Method - Allows the investor proportionate

 Cost Method - Investor recognizes investment

 Analysts should be aware of whether a company

 Equity method distorts earnings in the sense that

(C) 2007 Prentice Hall, Inc. 3-21

 Effective tax rate is:

Earnings before income taxes

(C) 2007 Prentice Hall, Inc. 3-22

 If companies are affected by the following three items,

Discontinued operations - Occur when a firms

Gains and losses that meet two criteria:

(C) 2007 Prentice Hall, Inc. 3-24

 Retrospective application to prior periods’ financial