Transcript This week its Accounting and Beyond

This week its Accounting and Beyond
Session 1
Tuesday
Financial Statements/Expenses/Revenues
Wednesday
Thursday
Friday
The Balance Sheet
The Cash Flow Statement
Tax Havens
Session 2
Accounting Cycle & Accounts
The Income Statement
Tools & Techniques
Exam
1-1
The Income Statement
3-2
 Also called the statement of earnings
 Presents a firm’s:
 revenues
 expenses
 net income
 earnings per share
 Annual reports include three years of income
statements.
The Income Statement
3-3
 Comes in two basic formats
 Multiple-step format
 Single-step format
 Multiple-step format should be used for
analysis purposes.
The Income Statement
3-4
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
The Income Statement
3-5
Multi-Step Income Statement
6
Relevant Information
•Advertising = 2,000
•Commissions = 5,000
•Cost Of Goods Sold = 75,000
•Gain on Sale of Investment =
3,000
•Interest Expense = 500
•Interest Revenues = 5,000
•Loss from Lawsuit = 1,500
•Office Equipment = 2,500
•Office Supplies = 3,500
The Income Statement
3-7
Single-step format
 Groups all items of revenue together, then
deducts all categories of expense
The Income Statement
3-8
Single-Step Income Statement
9
Relevant Information
•Advertising = 2,000
•Commissions = 5,000
•Cost Of Goods Sold = 75,000
•Gain on Sale of Investment =
3,000
•Interest Expense = 500
•Interest Revenues = 5,000
•Loss from Lawsuit = 1,500
•Office Equipment = 2,500
•Office Supplies = 3,500
The Income Statement
3-10
 Regardless of format, certain items must be
disclosed separately on an income statement:


Discontinued operations
Extraordinary transactions
The Income Statement
3-11
Comprehensive Income
 Change in equity of a company 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.
The Income Statement
3-12
Common-Size Income Statement
 Useful analytical tool to:

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

compare firms with different levels of sales or total
assets,
facilitate internal or structural analysis,
evaluate trends, and
make industry comparisons.
The Income Statement
3-13
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
The Income Statement
3-14
The Income Statement
3-15
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.
The Income Statement
3-16
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 section of the annual or 10-K report.
The Income Statement
3-17
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.
The Income Statement
3-18
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
The Income Statement
3-19
Cost of Goods Sold Percentage
 Ratio of cost of goods sold and net
sales
 Important for profit determination
The Income Statement
320
Cost of Goods Sold Percentage – Sage Inc.
 Increased between 2011 and 2012
 MD&A explains that lower prices on
footwear have resulted in lower margins.
The Income Statement
3-21
The Income Statement
3-22
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
The Income Statement
3-23
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
The Income Statement
3-24
Gross Profit Margin – Sage Inc.
The Income Statement
3-25
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.
The Income Statement
3-26
The Income Statement
3-27
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
The Income Statement
328
Operating Expenses
 Selling and administrative expenses
 Advertising costs
 Depreciation and amortization
 Repairs and maintenance
 Impairment charges
The Income Statement
3-29
Operating Expenses – Selling and
Administrative Expenses
 Relate to the sale of products or services
 Salaries, rent, insurance, utilities, supplies,
etc.
The Income Statement
330
Operating Expenses – Advertising Costs
 Are or should be a major expense when
marketing is an important element of success
The Income Statement
3-31
Advertising Costs for Sage Inc.
 Sage Inc. spends 6 to 7 cents of every sales
dollar for advertising.
The Income Statement
3-32
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.
The Income Statement
3-33
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.
The Income Statement
3-34
Operating Expenses – Depreciation and
Amortization
 Depreciation is used to allocate the cost of
tangible fixed assets, such as:
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buildings
machinery
equipment
furniture and fixtures
motor vehicles
The Income Statement
3-35
Operating Expenses – Depreciation
and Amortization
 Amortization is an allocation process applied
to:



capital leases
leasehold improvements
cost expiration of intangible assets, such as patents,
copyrights, trademarks, and franchises
The Income Statement
3-36
Operating Expenses – Depreciation
and Amortization
 Depletion is an allocation process applied to
acquisition and development of natural
resources, such as:

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oil and gas
other minerals
standing timber
The Income Statement
3-37
Percentage of Depreciation and Amortization
Expense for Sage Inc.
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
Decreased somewhat from 2012 to 2013
New assets were placed in service during
2013 for only a part of the year (rendering
less than full year’s depreciation and
amortization)
The Income Statement
338
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
The Income Statement
3-39
Percentage of Repairs and Maintenance
Expense for Sage Inc.
Decreased from 2012 to 2013
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


The Income Statement
340
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
The Income Statement
3-41
Operating Profit
 Also called earnings before interest and
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
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
The Income Statement
3-42
Operating Profit Margin
 Ratio of operating profit to net sales
The Income Statement
3-43
Operating Profit Margin for Sage Inc.
 Indicates that Sage Inc. strengthened its return on
operations in 2013 after a dip in 2012
 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.
The Income Statement
3-44
Other Income (Expense)
 Revenues and costs other than from
operations, such as:





dividend and interest income
interest expense
investment gains (losses)
equity earnings (loss)
gains (losses) from sale of fixed assets
The Income Statement
3-45
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.
The Income Statement
3-46
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
The Income Statement
3-47
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.
The Income Statement
348
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
The Income Statement
3-49
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
The Income Statement
350
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.
The Income Statement
3-51
Income recognition in the earnings
statement and the noncurrent
investment account on the balance
sheet are different depending on the
accounting method:
The Income Statement
3-52
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.
The Income Statement
3-53
Equity Method
 Permits the investor to count as
income the percentage interest in the
investee’s earnings.
The Income Statement
3-54
Equity Method
 Investment account is increased by the
amount of investment income recognized
and is reduced by the amount of cash
dividends received.
The Income Statement
3-55
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)
The Income Statement
3-56
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.
The Income Statement
3-57
Sage Inc.’s Effective Tax Rate
The Income Statement
3-58
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.
The Income Statement
3-59
Special Items
 Often one-time items that will not recur in the
future
 Discontinued operations

Occur when a firm sells or discontinues a clearly
distinguishable portion of its business
 Extraordinary gains and losses


Unusual in nature
Not expected to recur in the future
The Income Statement
360
Net Earnings
 Also called the “bottom line”
 Represents profit after consideration of all revenue
and expense
The Income Statement
3-61
Net Profit Margin
 Ratio of net earnings to net sales (expressed as a
percentage)
 Shows the percentage of profit earned on every sales
dollar
The Income Statement
3-62
Net Profit Margin for Sage Inc.
The Income Statement
3-63
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.
The Income Statement
3-64
Earnings per Common Share
 Analysts should consider material changes in the
number of common stock shares outstanding,
such as:
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

treasury stock purchases
purchase and retirement of a firm’s own common stock
stock splits
reverse stock splits
The Income Statement
3-65
The Income Statement
3-66
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
The Income Statement
3-67
Comprehensive Income
 Foreign currency translation effects
 Unrealized gains and losses
 Additional pension liabilities
 Cash flow hedges
The Income Statement
368
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
The Income Statement
3-69
Comprehensive Income – Unrealized Gains and Losses
 Cumulative net unrealized gains and losses
The Income Statement
3-70
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
The Income Statement
3-71
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.
Statement of Stockholders’ Equity
3-72
 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
Statement of Stockholders’ Equity
3-73
Statement of Stockholders’ Equity
3-74
 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
Earnings Quality, Cash Flow, and Segmental
Accounting
3-75
 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.
Earnings Quality, Cash Flow, and Segmental
Accounting
3-76
 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.
Statement of Retained Earnings
77
 Prepared to reconcile the beginning and
ending retained earnings balances
 Beginning RE + Net Income – Dividends =
Ending RE
 Statement has standard heading as shown
below