Understanding the Income Statement: Revenues, Expenses, Gains, and Limitations

1. Chapter 5 Income Statement & Related Information

2. Income Statement • Revenues: inflows from major operations • Expenses: outflows from major operations • Gains & Losses: changes in equity from peripheral activities • Non-recurring items • Net income: bottom line all operating activities recorded on the income statement • Comprehensive income: Changes in equity from all non-owner sources (note: usually not reported on the income statement

3. Income Statement Usefulness • Evaluate past performance. • Predicting future performance. • Help assess the risk or uncertainty of achieving future cash flows.

4. Income Statement Limitations • Companies omit items that cannot be measured reliably. • Income is affected by the accounting methods employed. • Income measurement involves judgment.

5. Earnings Quality • Companies have incentives to manage income to meet or beat Wall Street expectations, so that • the market price of stock increases and • the value of stock options increase. • Quality of earnings is reduced if earnings management results in information that is less useful for predicting future earnings and cash flows.

6. Revenue • Revenues – Inflows or other enhancements of assets or settlements of its liabilities that constitute the entity’s ongoing major or central operations. • Sales • Fee Revenue (services, etc.) • Interest Revenue • Dividend Revenue • Rent Revenue

7. Expenses • Outflows or other using-up of assets or incurrences of liabilities that constitute the entity’s ongoing major or central operations.

8. Expenses by Category • Cost of goods sold (manufacturing, retail) • Cost of sales (services or services included) • Operating expenses (selling, general & administrative, research & development, other) • Interest income & expenses • Provision for tax

9. Gains & Losses • Gains – Increases in equity (net assets) from peripheral or incidental transactions. • Losses - Decreases in equity (net assets) from peripheral or incidental transactions. • Gains and losses can result from • sale of investments or plant assets, • settlement of liabilities, • write-offs of assets.

10. Non-recurring Items • Extraordinary items • Discontinued operations • Accounting changes Change in accounting principle Change in accounting estimate Correction of an error

11. Single Step Income Statement

12. Multiple Step Income Statement • Separates operating transactions from non-operating transactions. • Matches costs and expenses with related revenues. • Highlights certain intermediate components of income that analysts use.

13. Multiple Step Income Statement

14. Non-recurring & Other Irregular Items • Companies are required to report irregular items in the financial statements so users can determine the long-run earning power of the company. (Irregular items for 600 companies, 1 Year.)

15. Discontinued Operations • Discontinued Operations occur when, • (a) company eliminates the • results of operations and • cash flows of a component. • there is no significant continuing involvement in that component. • Amount reported “net of tax” (intra-period tax allocation).

16. Extraordinary Items • Extraordinary items are nonrecurring material items that differ significantly from a company’s typical business activities. With SFAS #145-relatively rare. • Extraordinary Item must be both of an • Unusual nature and • Occur infrequently • Company must consider the environmentin which it operates. • Amount reported “net of tax.”

17. Unusual Gains & Losses • Material items that are unusual or infrequent, but not both, should be reported in a separate section just above “Income from continuing operations before income taxes.” These are not non-recurring items. • Examples can include: • Write-downs of inventories • Foreign exchange transaction gains and losses • The Board prohibits net-of-tax treatment for these items.

18. Changes in Accounting Principle • Retrospective adjustment • Cumulative effect adjustment to beginning retained earnings • Approach preserves comparability • Examples include: • change from FIFO to average cost • change from the percentage-of-completion to the completed-contract method

19. Changes in Estimate • Accounted for in the period of change and future periods • Not handled retrospectively • Not considered errors or extraordinary items • Examples include: • Useful lives and salvage values of depreciable assets • Allowance for uncollectible receivables • Inventory obsolescence

20. Correction of an Error • Result from: • mathematical mistakes • mistakes in application of accounting principles • oversight or misuse of facts • Corrections treated as prior period adjustments • Adjustment to the beginning balance of retained earnings

21. Tax Allocation • Tax Allocation Result from: • mathematical mistakes • mistakes in application of accounting principles • oversight or misuse of facts • Corrections treated as prior period adjustments • Adjustment to the beginning balance of retained earnings • Tax affect is reported within the line item. • Inter-period Tax Allocation is the timing difference between GAAP and tax accounting; for example, most companies use straight-line depreciation for financial reporting and accelerated for tax purposes

22. Earnings Per Share (EPS) • Calculation: • Net income - Preferred dividends Weighted average number of shares outstanding • An important business indicator. • Measures the dollars earned by each share of common stock. • Must be disclosed on the income statement.

23. Changes in Retained Earnings • Increases: Net income Change in accounting principle Error corrections • Decreases: Net loss Dividends Change in accounting principles Error corrections

24. All-Inclusive Income • Net income is considered “modified” all-inclusive income • All-inclusive is Comprehensive Income • Some companies report comprehensive income as part of the income statement • For most companies, comprehensive income has to be calculated.

25. Other Comprehensive Income • Gains & losses not reported on the income statement (also called “dirty surplus): • Unrealized gains and losses on available-for-sale securities. • Translation gains and losses on foreign currency. • Pension & derivatives gains & losses • Other

26. Comprehensive Income • Usually reported at part of the statement of stockholders’ equity.

27. Comprehensive Income • Balance Sheet presentation (part of stockholders’ equity):

28. Earnings Measures • Gross profit • Operating income • Income before tax • Earnings before income & taxes (EBIT) • Income from continuing operations • Net income • Comprehensive income