Income statement and statement of stockholders'equity detailed explanation and analysis

1. Chapter 3
Income Statement and Statement
of Stockholders’ Equity
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2. Income Statement and Statement
of Stockholder’s Equity
• Income Statement
 Also called the statement of earnings
 Presents a firm’s revenues, expenses, net income, and
earnings per share
• Statement of Stockholder’s Equity
 Link between balance sheet and income statement
• Annual reports include three years of income
statements and stockholder’s equity information.
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3. The Income Statement
• Comes in two basic formats
 Multiple-step format
 Single-step format
• Multiple-step format should be used
for analysis purposes.
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4. The Income Statement
Multiple-step format:
• Provides several intermediate profit
measures prior to the amount of net
earnings for the period
 Gross profit
 Operating profit
 Earnings before income tax
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5. The Income Statement
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6. The Income Statement
Single-step format
• Groups all items of revenue together,
then deducts all categories of
expense
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7. The Income Statement
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8. The Income Statement
• Regardless of format, certain items
must be disclosed separately on an
income statement:
 Discontinued operations
 Extraordinary transactions
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9. The Income Statement
Comprehensive Income
• Change in equity during a period from transactions,
other events, and circumstances related to nonowner
sources.
• Companies are required to report comprehensive
income in one of three ways:
 on the face of its income statement
 in a separate statement of comprehensive income, or
 in its statement of stockholders’ equity.
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10. The Income Statement
Common-Size Income Statement
• Useful analytical tool
 Compare firms with different levels of
sales or total assets
 Facilitate internal or structural analysis
 Evaluate trends
 Make industry comparisons
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11. The Income Statement
Common-Size Income Statement
• 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
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12. The Income Statement
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13. The Income Statement
Net Sales
• Total sales revenue is shown net of
returns and allowances.
• A sales return is a cancellation of a sale.
• A sales allowance is a deduction from
the original sales invoice price.
• Sales are the major revenue source for
most companies.
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14. The Income Statement
Net Sales
• If a company’s sales are increasing (or
decreasing), it is important to determine
whether the change is a result of price,
volume, or a combination of both.
• The reasons for sales growth (or decline)
are covered in the Management Discussion
and Analysis.
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15. The Income Statement
Net Sales
• “Real” (inflation adjusted) sales growth
• “Nominal” (as reported) sales growth
• An adjustment of the reported sales figure
with the Consumer Price Index (or some
other measure of general inflation) will
enable the analyst to compare changes in
real and nominal terms.
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16. The Income Statement
Cost of Goods Sold
• Also called cost of sales
• Cost to seller of products or services sold
to customers
• Affected by cost flow assumption used to
value inventory
• Largest expense for many firms
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17. The Income Statement
Cost of Goods Sold Percentage
• Ratio of cost of goods sold and net sales
• Important for profit determination
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18. The Income Statement
Cost of Goods Sold Percentage – Sage Inc.
• Increased between 2014 and 2015. This is the
result of lowering prices or increasing costs.
• MD&A explains that lower prices on footwear
have resulted in lower margins.
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19. The Income Statement
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20. The Income Statement
Gross Profit
• Also called gross margin
• Difference between net sales and cost of
goods sold
• First step of profit measurement on the
multi-step income statement
• Key analytical tool in assessing operating
performance
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21. The Income Statement
Gross Profit Margin
• Ratio of gross profit to net sales (expressed as a
percentage)
• Complement of the cost of goods sold percentage
• Firms want to maintain or increase gross profit
margin.
• Remains relatively constant in stable industries
• May change significantly in volatile industries
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22. The Income Statement
Gross Profit Margin – Sage Inc.
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23. The Income Statement
Gross Profit Margin – Multiple
Revenue Sources
• Each revenue is shown separately.
• Each revenue line will show the
corresponding cost of goods sold for each
revenue source.
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24. The Income Statement
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25. The Income Statement
Operating Expense
• Includes areas in which management
discretion is exercised
• Has considerable impact on current and
future profitability
• Important to track trends, absolute
amounts, relationship to sales, and
relationship to industry competitors
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26. The Income Statement
Operating Expenses include
• Selling and administrative expenses
• Advertising costs
• Depreciation and amortization
• Repairs and maintenance
• Impairment charges
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27. The Income Statement
Operating Expenses – Selling and
Administrative Expenses
• Relate to the sale of products or services
• Salaries, rent, insurance, utilities,
supplies, and sometimes depreciation and
advertising expense.
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28. The Income Statement
Operating Expenses – Advertising
Costs
• Are or should be a major expense when
marketing is an important element of success
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29. The Income Statement
Advertising Costs for Sage Inc.
Sage Inc. spends 6 to 7 cents of every
sales dollar for advertising.
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30. The Income Statement
Operating Expenses – Lease Payments
• Costs associated with operating rentals
of leased facilities for retail outlets
• Note 3 to the financial statements
explains the agreements that apply to
the rental arrangements and presents a
schedule of minimum annual rental
commitments.
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31. The Income Statement
Operating Expenses – Depreciation and
Amortization
• Cost of assets other than land that will
benefit a business enterprise for more than
a year is allocated over the asset’s service
life.
• Cost allocation procedure is determined by
the nature of the long-lived asset.
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32. The Income Statement
Operating Expenses – Depreciation and
Amortization
• Depreciation is used to allocate the cost of
tangible fixed assets.
• Amortization is an allocation process applied
to capital leases, leasehold improvements, and
cost expiration of intangible assets.
• Depletion is an allocation process applied to
acquisition and development of natural
resources.
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33. The Income Statement
Percentage of Depreciation and Amortization Expense
for Sage Inc.
• Decreased somewhat from 2015 to 2016
• New assets were placed in service during 2016 for
only a part of the year (rendering less than full year’s
depreciation and amortization).
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34. The Income Statement
Operating Expenses – Repairs and Maintenance
• Annual costs of repairing and maintaining PP&E
• Should correspond to the level of investment in
capital equipment and to the age and condition of
fixed assets
• Inadequate allowance can impair success.
• Should be evaluated in relation to the firm’s
investments in fixed assets
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35. The Income Statement
Percentage of Repairs and Maintenance Expense
for Sage Inc.
• Decreased from 2015 to 2016
• Could be a result of having newer fixed assets
needing fewer repairs
• Could be a choice to delay repairs in order to
increase operating profit in the short term
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36. The Income Statement
Operating Expenses – Impairment Charges
• Recognized to record a decline in value of a
long-term asset
• May occur in connection with goodwill
• Can also be recognized when asset values of
PP&E decrease below book value
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37. The Income Statement
Operating Profit
• Also called earnings before interest and taxes (EBIT)
• Second step of profit determination on the multi-step
income statement
• Measures overall performance of operations
• Provides a basis for assessing success of a firm apart
from financing and investing activities and separate
from tax considerations
• Sales revenue less the expenses associated with
generating sales
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38. The Income Statement
Operating Profit Margin
• Ratio of operating profit to net sales
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39. The Income Statement
Operating Profit Margin for Sage Inc.
• Indicates that Sage Inc. strengthened its return
on operations in 2016 after a dip in 2015
• Despite the percentage increase in cost of
goods sold, Sage Inc.’s percentage of selling
and administrative and advertising expenses
decreased enough to increase operating profit.
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40. The Income Statement
Other Income (Expense)
• Revenues and costs other than from operations
 Dividend and interest income
 Interest expense
 Investment gains (losses)
 Equity earnings (loss)
 Gains (losses) from sale of fixed assets
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41. The Income Statement
Other Income (Expense)
• Firms that carry debt and equity securities
classified as “trading securities” report
these investments on the balance sheet at
market value with any unrealized gains
and losses included in earnings.
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42. The Income Statement
Other Income (Expense)
• In assessment of earning quality, the analyst should
consider the materiality and the variability of the
nonoperating items of income.
 Gains and losses on the sale of major capital assets
 Accounting changes
 Extraordinary items
 Investment income from temporary investments in cash
equivalents
 Investment income recognized under the equity method
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43. The Income Statement
Equity Earnings
• Two accounting methods for investments
in voting stock of other companies
 Equity method
 Cost method
• Analysts should be aware of whether a
company uses the equity or cost method.
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44. The Income Statement
Equity Earnings – Equity Method
• Allows the investor proportionate recognition of the
investee’s net income, irrespective of the payment or
nonpayment of cash dividends
• Should be used when the investor can exercise
significant influence over the investee’s operating and
financing policies
• Fits accrual accounting requirements
• Distorts earnings when income is recognized and no
cash may ever be received
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45. The Income Statement
Equity Earnings – Cost Method
• Investor recognizes investment income only
to the extent of any cash dividends received.
• Allows recognition of investment income
only to the extent of any cash dividends
actually received
• Carries an investment account at cost
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46. The Income Statement
Example – Assume that company A acquires
exactly 20% of the voting common stock of
Company B for $400,000. Company B
reports $100,000 earnings for the year and
pays $25,000 in cash dividends.
For company A, income recognition in the
earnings statement and the noncurrent
investment account on the balance sheet are
different depending on the accounting
method.
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47. The Income Statement
Cost Method
• Allows recognition of investment
income only to the extent of any cash
dividends actually received:
$25,000 x 0.20 = $5,000
• Investment account is carried at cost.
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48. The Income Statement
Equity Method
• Permits the investor to count as income
the percentage interest in the investee’s
earnings.
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49. The Income Statement
Equity Method
• Investment account is increased by the amount of
investment income recognized and is reduced by the
amount of cash dividends received.
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50. The Income Statement
Equity Method
• Distorts earnings
• Income is recognized even though no
cash may ever be received.
• Assumes that the investor could cause
the investee to pay dividends (which
may not be true)
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51. The Income Statement
Earnings Before Income Taxes /
Effective Tax Rate
• Earnings before income taxes is the profit
recognized before the deduction of income
tax expense.
• Income taxes paid may differ from income
tax expense.
• Effective tax rate is the ratio of income taxes
to earnings before income taxes.
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52. The Income Statement
Sage Inc.’s Effective Tax Rate
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53. The Income Statement
Earnings Before Income Taxes /
Effective Tax Rate
• Noteworthy items that may affect the
effective tax rate are net operating losses
(NOLs) and foreign taxes.
• Users of financial statements need to
distinguish between earnings increasing
due to core operations versus items such as
tax rate deductions.
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54. The Income Statement
Special Items
• Often one-time items that will not
recur in the future
 Discontinued operations
 Extraordinary gains and losses
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55. The Income Statement
Net Earnings
• Also called the “bottom line”
• Represents profit after
consideration of all revenue and
expense
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56. The Income Statement
Net Profit Margin
• Ratio of net earnings to net sales
(expressed as a percentage)
• Shows the percentage of profit
earned on every sales dollar
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57. The Income Statement
Net Profit Margin for Sage Inc.
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58. The Income Statement
Earnings per Common Share
• Net earnings available to common
stockholders for the period divided by the
average number of common stock shares
outstanding
• Firms with complex capital structure report
basic and diluted earnings per common
share.
• Analysts should consider material changes in
the number of common stock shares
outstanding.
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59. The Income Statement
Comprehensive Income
• Reported in one of three ways
 On the face of the income
statement
 In a separate statement of
comprehensive income
 In the statement of stockholders’
equity
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60. The Income Statement
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61. The Income Statement
Comprehensive Income
• Foreign currency translation
effects
• Unrealized gains and losses
• Additional pension liabilities
• Cash flow hedges
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62. The Income Statement
Comprehensive Income – Foreign
Currency Translation Effects
• Arise from changes in equity of
foreign subsidiaries
• Occur as a result of changes in
foreign currency exchange rates
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63. The Income Statement
Comprehensive Income –
Unrealized Gains and Losses
• Cumulative net unrealized
gains and losses
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64. The Income Statement
Comprehensive Income –
Additional Pension Liabilities
• Reported when accumulated
benefit obligation is greater than
the fair market value of plan
assets less the balance of the
accrued pension liability account
or plus the balance in the
deferred pension asset account
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65. The Income Statement
Comprehensive Income – Cash Flow
Hedges
• Derivatives designated as hedging the
exposure to variable cash flows of a
forecasted transaction
• Companies using cash flow hedges
must initially report any gain or loss in
other comprehensive income and
subsequently reclassify the amount into
earnings when the forecasted
transaction affects earnings.
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66. Statement of
Stockholders’ Equity
• Important link between the
balance sheet and the income
statement
• Documents changes in the
balance sheet equity accounts
• Annual reports include three
years of stockholders’ equity
information
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67. Statement of
Stockholders’ Equity
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68. Statement of
Stockholders’ Equity
• Stock dividends
 Issuance of additional shares of stock in
proportion to current ownership
 Reduce retained earnings account
• Stock splits
 Used to lower the market price of shares to
make common stock more affordable
• Reverse stock splits
 Occurs when outstanding shares are
decreased
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69. Earnings Quality, Cash Flow,
and Segmental Accounting
• Assessment of the quality of
reported earnings is an
essential element of income
statement analysis.
• Cash flow from operations is a
key ingredient in analyzing
operating performance.
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70. Earnings Quality, Cash Flow,
and Segmental Accounting
• Segmental data include revenue,
operating profit or loss, assets,
depreciation and amortization,
and capital expenditures by
industry components.
• These disclosures facilitate
analysis of operating
performance and contribution by
each segment.
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