Introduction to Income Statements. Chapter 2

Transcription

1 Chapter 2: Introduction to Income Statements 1 Chapter 2 Introduction to Income Statements TABLE OF CONTENTS Introduction 3 Comprehensive Income 4 What Do I See? 5 Revenues 7 Expenses 8 Gains, Losses, and Other Income 10 Common Income Statement Formats 11 What s Behind the Numbers? 13 Revenue Recognition 13 Expense Recognition 16 Expense Recognition Motivated by Matching 17 Expense Recognition Motivated by Conservatism 19 Expense Recognition Motivated By Lower of Cost or Market 20 Exercise Exercise ABC Company Example 25 The Accounting Cycle 52 Exercise How Do I Use the Numbers? 61 Exercise Exercise Key Take-Aways 69

2 2 Navigating Accounting Figure 2.01 Intel s Income Statement 71 Figure 2.02 Cisco s Income Statement 72 Figure 2.03 Gap s Income Statement 73 Figure 2.04 Starbucks Income Statement 74 Figure 2.05 Nike s Income Statement 75 Figure 2.06 Coca Cola s Income Statement 76 Figure 2.07 Federal Express Income Statement 77 Figure 2.08 Dupont Model Computations 78 Figure 2.09 Intel s and AMD s Common Size Income Statements 80 Figure 2.10 Gap s and Limited s Common Size Income Statements 81 Figure 2.11 Starbucks Excerpt from Accounting Policies Footnote 82 Chapter Solutions 83 Solution to Exercise Solution to Exercise Solution to Exercise Solution to Exercise

3 Chapter 2: Introduction to Income Statements 3 INTRODUCTION This chapter is all about measuring performance and, in particular, about income-statement measures. Income measures, which along with measures from other sources, are used to assess companies overall financial performance. You and others have likely been measuring your performance since you were a child in various dimensions of your life including school, sports, work, and social interactions. So you already know performance is measured relative to goals such as mastering techniques, winning contests, setting records, meeting learning objectives, or graduating. You also know performance generally is measured over intervals of varying lengths: during games by keeping score; during the regular season by win-loss records; at the end of the season by final standings; and over a team s history by its life-time achievements. For the for-profit companies we will be studying, management s over arching goal is to maximize the returns owners earn during the periods they hold ownership claims. Comprehensive income, albeit imperfectly measured, reflects the company s performance and sets expectations about future performance. To interpret income numbers when assessing past performance and predicting future performance, investors and other outsiders need to know as much as possible about the measures that produced them. The depth of these analyses will be limited by their conceptual understanding of the business and accounting issues behind the numbers (including related entries), the availability of related information, and their ability to locate and analyze this information. We will first introduce the concept of comprehensive income. It is widely reported and discussed in annual reports so we want to be sure you know what it represents.

4 4 Navigating Accounting COMPREHENSIVE INCOME Comprehensive income is the broadest type of income. As illustrated below, it is net income plus other comprehensive income: Comprehensive Income Equation Comprehensive Income = Net Income Other Comprehensive Income Net income is the famous bottom line on income statements discussed frequently in the press. If you hear someone mention income without specifying the type of income they are referring to, you can be pretty confident that they are referring to net income. Other comprehensive income is comprehensive income standard setters decided not to include in net income. Standard setters have not specified formal criteria for when items should be included in other comprehensive income, but thus far they have restricted inclusion to period changes in the values of assets and liabilities satisfying three conditions: (1) the changes are due to economic factors not controlled or influenced by the company, such as interest rates and stock prices; (2) the company can inadvertently profit from these valuation changes when carrying out its primary business activities, but it can not be in the business of intentionally profiting from them; and (3) the assets and liabilities are still on the balance sheet at the end of the period. For example, suppose ABC Company, a retail car dealer, purchased $100,000 of IBM stock at the beginning of 2007, intending to sell the stock at a future date if it needed cash. Additionally, suppose ABC had not sold the stock by the end of 2007 and its fair value the amount it could be sold for had increased to $110,000. Because the stock had not been sold, the $10,000 gain is unrealized and it is recognized in 2007 other comprehensive income. By contrast, if ABC had sold the stock in 2007, a $10,000 realized gain would have been recognized in net income. As fair values increasingly gain acceptance, there is a good chance items currently included in other comprehensive income will move to net income. In fact, the U.S. standard setters are considering new income statement formats that include all comprehensive income on the income statement.

5 Chapter 2: Introduction to Income Statements 5 WHAT DO I SEE? What you see on the income statement aligns with its purpose. The purpose of an income statement is to help financial statement users assess a company s financial performance during a reporting period by providing details about the net income recognized during the period. In contrast to balance sheets, which measure a company s assets and equities at a point in time, income statements measure performance over an interval of time. In this regard, we say that balance sheets report stocks at a point in time and income statements report interval flows. Users of income statements often make decisions that require them to evaluate a company s past performance or predict its future performance. For example, when estimating the value of a company, financial analysts and investors often use valuation models that are based on predictions of future income or future cash flows. To measure performance requires a performance objective. Navigating Accounting focuses exclusively on for-profit corporations: Management seeks first and foremost to maximize shareholder value and they perform for owners to the extent they meet this challenge. From the balancesheet equation, we see that to maximize the value of the owners claims, management must maximize the value of the company s net assets: Management's Goal Maximize the value of owners' equity A Assets - L Liabilities = OE Owners' Equity NA Net Assets By maximizing the value of the net assets The balance-sheet equation expresses the performance goal at each point in time. Income is related to changes in owners equity during a reporting period, and thus changes in net assets (as illustrated on the next page):

6 6 Navigating Accounting Period Changes in Balance Sheet A L OE Change in Assets - Change in Liabilities = Change in Owners' Equity NA Change in Net Assets The (delta) symbol indicates a change in a variable. Thus, NA represents the change in net assets during the reporting period. While income relates to changes in owners equity, not all changes in owners equity pertain to income. Two broad categories of events and circumstances that occur during the reporting period change owners equity: (1) transactions with owners that change net assets and thus owners equity but do not affect income; and (2) other events and circumstances that change net assets, which constitutes comprehensive income (net income plus other comprehensive income): Measuring Period Performance A Change in Assets - L Change in Liabilities = OE Change in Owners' Equity NA Change in Net Assets Transactions with owners during the period that changed the value of the net assets Other events or cirumstances during the period that changed the value of net assets Dividends Stock Issues Stock Repurchases Comprehensive Income Net Income Other Comprehensive Income

7 Chapter 2: Introduction to Income Statements 7 Net income can be further broken down into its primary elements: revenues, expenses, gains, losses, and other income. Since net income measures performance during a reporting period, income statements report this performance and are largely structured by the following income-statement equation: Income-Statement Equation Net income = Revenues - Expenses Gains - Losses Other income Combining the above equation with the earlier one demonstrates how the primary elements in net income relate to changes in net assets. Indeed, the definitions of these elements are expressed in terms of changes in net assets: Measuring Period Performance A Change in Assets - L Change in Liabilities = OE Change in Owners' Equity NA Change in Net Assets Transactions with owners during the period that changed the value of the net assets Dividends Stock Issues Stock Repurchases Other events or cirumstances during the period that changed the value of net assets Comprehensive Income Net Income Other Comprehensive Income Revenues - Expenses Gains - Losses Other Income Revenues Revenues are changes in owners equity that arise from increases in net assets during a reporting period associated with delivering or producing goods, rendering services, or other activities that constitute the entity s ongoing or central operations. Generally revenues pertain to inflows from customer sales. Notice from the above figure that increasing revenues, increases net income, which increases owners equity and thus net assets.

8 8 Navigating Accounting But, not all increases in net assets give rise to revenues, only those associated with activities that constitute the entity s ongoing or central operations. Revenues are usually recognized when goods or services are exchanged for cash or claims to cash (accounts receivable). For example, when Gap sells clothes to a customer for $60 cash, it recognizes $60 of revenue and $60 of cash. The balance sheet balances: (1) net assets increase by $60 because cash increases by $60; and (2) owners equity increases by $60 because revenues increase by $60. The example illustrates the definition of revenues: The increase in cash gave rise to an increase in net assets associated with customers, that gave rise to revenues. Companies do not always recognize revenues when they receive cash from customers or bill customers. We have seen that when Intel delivers products to distributors and is concerned that the products will be returned or that the price will eventually be discounted, Intel defers recognizing revenues until the distributor sells the goods to its customers. For example, if Intel sells microprocessors to distributors in these situations for $10 on account, it recognizes a $10 increase in both accounts receivable (an asset) and deferred income to distributors (a liability). Net assets do not increase because the $10 increase in the asset is offset by the $10 increase in the liability. The example illustrates that events can be associated with customers and affect assets and/or liabilities without affecting net assets and thus not affecting revenues. Intel recognizes revenues in these situations when distributors sell the products to their customers. At that time, Intel decreases deferred income to distributors by $10 and increases revenues by $10. To summarize, the Gap and Intel examples illustrates two ways that increases in net assets associated with customers can give rise to revenues: (1) In the Gap example, an increase in cash (an asset) gave rise to an increase in net assets, that gave rise to revenues; (2) In the Intel example, a decrease in deferred income to distributors (a liability) gave rise to an increase in net assets, that gave rise to revenues. Revenues are increases in net assets that arise from events and circumstances related to customer sales. They are recognized when either an asset is increased without an offsetting increase in a liability or a liability is decreased without an offsetting decrease in an asset. Expenses

9 Chapter 2: Introduction to Income Statements 9 Expenses are changes in owners equity that arise from decreases in net assets during a reporting period associated with inventing, developing, producing, and delivering goods and services, or performing other activities central to the company s operations. As indicated in the earlier performance measurement illustration (reproduced below for convenience), increasing expenses, decreases net income, which decreases owners equity and thus decreases net assets. But, not all decreases in net assets give rise to expenses, only those associated with performing activities central to the company s operations. For example, when Gap pays its sales person $2, it recognizes a $2 Measuring Period Performance A Change in Assets - L Change in Liabilities = OE Change in Owners' Equity NA Change in Net Assets Transactions with owners during the period that changed the value of the net assets Dividends Stock Issues Stock Repurchases Other events or cirumstances during the period that changed the value of net assets Comprehensive Income Net Income Other Comprehensive Income Revenues - Expenses Gains - Losses Other Income expense and decreases cash by $2. The balance sheet balances: (1) net assets decrease by $2 because cash decreases by $2; and (2) owners equity decreases by $2 because expenses increase by $2. The example illustrates the definition of expenses: The decrease in cash gave rise to a decrease in net assets associated with activities central to the company s operations, that gave rise to an expense. Notice from the above figure that by increasing revenues and/or decreasing expenses, management increases owners equity and thus improves performance. This is accomplished by increasing net assets through transactions with customers and/or by controlling costs that

10 10 Navigating Accounting otherwise would decrease net assets associated with inventing, developing, producing, and delivering good and services, or performing other activities central to the company s operations. Gains, Losses, and Other Income Gains, losses, and other income are not as prominent on income statements as revenues and expenses. Companies often recognize these items without disclosing them by aggregating them with other line items. Gains are changes in owners equity that arise from increases in net assets during a reporting period associated with events and circumstances peripheral to a company s primary business activities, are outside the company s control, and largely unpredictable when the assets or liabilities are originally recognized. For example, selling the corporate headquarters for more than its book value gives rise to a gain. The sale is peripheral to the company s business and the company had very little control over the market value of the building and could not predict the gain when the building was acquired. An example will demonstrate how gains are computed. If GHI purchased a building for $10 (million) in 1995 and sold it in 2008 for $5 cash when its book value was $2 (net of depreciation), GHI would recognize a $3 gain in 2008 ($5 cash proceeds less the $2 book value). Recognizing the gain increased net assets by $3. Assets increased by $3 because $2 of property, plant, and equipment (the building) was replaced with $5 of cash. Owners equity increased by $3 because a $3 gain was recognized in net income. Gains are similar to revenues in that they arise from increases in net assets, but revenues arise from events and circumstances related to customer sales and gains arise from events and circumstances peripheral to companies primary business activities and are largely unpredictable and outside the company s control. Losses are changes in owners equity that arise from decreases in net assets during a reporting period associated with events and circumstances peripheral to a company s primary business activities, are outside the company s control, and largely unpredictable when the assets or liabilities are originally recognized. For the above example, if the proceeds from the sale were less than the book value of the building prior to the sale, the difference would be a loss. Losses are similar to expenses in that they arise from decreases in net assets, but expenses arise from performing activities central to the companies operations

11 Chapter 2: Introduction to Income Statements 11 and losses arise from events and circumstances peripheral to companies primary business activities and are largely unpredictable and outside the company s control. Other income is changes in owners equity that arises from increases in net assets during a reporting period that are not associated with revenues or gains, but rather from such activities as dividends received from investments in other companies stocks or interest received from investments in government bonds. In contrast to gains and losses, other income is somewhat predictable. Common Income Statement Formats From the income-statement equation, you might incorrectly assume that income-statement line items are grouped into five categories corresponding to the elements in the equation and presented in the order they appear in the equation (revenues, expenses, gains, losses, and other income). This is not true. Instead, income statements are divided into sections such as operating and non-operating income, and the primary elements in the equation can belong to more than one section. For example, there are expenses in both the operating and non-operating sections of Intel s income statements. Income statements are arranged hierarchically and, although the actual structures and line items differ, they are generally formatted as follows: Common Income Statement Format Net revenues Period 1 Period 2 Period 3 Cost of sales Gross margin Operating expenses Operating income Interest expense Gains & Losses Other income Income before income taxes Provision for income taxes Net Income

12 12 Navigating Accounting Drill Deeper To learn more see the reference document: Line-by-Line Tour: Intel s Financial Statements on the Navigating Accounting CD. As indicated in the figure at the bottom of the previous page, companies generally report three income statements at once. One presents income line items for the current period and the others for the two prior periods. These statements show how income has changed during the three years. The highlighted items are subtotals that are frequently analyzed by financial analysts and other users of income statements. An example will help you understand these items and, more generally, income statement structures. ABC Company s income statement at the bottom of the page illustrates three levels of organization that are shared by many income statements: 1 At the big-picture level, we see that ABC s income statement reports $60 of net income that is determined by subtracting $20 of tax expense from $80 of income before taxes. Note: numbers in parenthesis are interpreted as negative numbers in financial statements. The statement has a large section that explains how income before taxes is determined (as indicated at the far left). 2 At the second level of organization, income before taxes is split into two sections that explain how operating and non-operating income are derived. Operating income, also called operating profit, is income from ongoing operations. ABC recognizes $70 of operating income. Non-operating income includes expenses, gains, losses and other income that do not pertain to operations. ABC recognizes $10 of nonoperating income. Like most companies, ABC reports a subtotal for operating income but does not report one for non-operating income. The $10 of non-operating income can be derived by summing the line items in this section or subtracting the $70 of operating income from the $80 of income before taxes. 3 The third level of organization is the individual line items within the operating and non-operating sections. Line items in the ABC example such as cost of sales, gross margin, and interest expense will be explained when we do the tour of Intel s income statement. ABC s Income Statement, 2007 Income before taxes Net revenues $150 Cost of sales ($60) Gross margin $90 Operating expenses ($20) Operating income $70 Interest expense ($5) Gains and losses, net $10 Other income $5 Income before income taxes $80 Income tax expense ($20) Net income $60 Operating Income Non-operating Income

13 Chapter 2: Introduction to Income Statements 13 WHAT S BEHIND THE NUMBERS? Revenue Recognition Revenue recognition decisions determine whether and when revenues are recognized on income statements. Similar to asset and liability recognition decisions for balance sheets, revenue recognition must meet definitional and measurability criteria. We have already defined revenues and thus established the definitional criteria: revenues are changes in owners equity that arise from increases in net assets during a reporting period associated with customer sales. Most of the controversial issues related to revenue recognition center on determining when during the life of a sales agreement revenues can be measured reliably enough to be recognized. Equivalently, when do events and circumstances occur that indicate an increase in net assets associated with customer sales can be measured reliably? Depending on the complexity of a company s interactions with its customers, the duration of sales agreements can extend from a few minutes to several years. Generally, they are defined by the following events that can occur in various sequences: Customer orders Production periods Deliveries Billings Collections Service and warranty periods Product returns periods Price-protection discount periods At a fast-food restaurant such as McDonalds, most of these events occur within 30 minutes and thus the timing of revenue recognition is straightforward. By contrast, it can take Boeing several years to produce an airplane from the time it is ordered and determining how much revenue should be recognized at various times during these sales agreements can take considerable judgment. Events or circumstances in the life of a sales agreement can meet the definitional criteria for revenue recognition but not be recognized because they fail to meet measurability criteria: even when there is broad agreement that events and circumstances increase the fair value of a company s net assets, GAAP often presumes that this increase can not be measured reliably enough to merit revenue recognition.

14 14 Navigating Accounting For example, the fair value of owners equity and thus net assets can increase significantly when a start-up company gets an order from a significant customer before it has fully developed its products. Indeed, venture capitalists are generally more willing to contribute cash at favorable terms when start-ups have received orders. Importantly, the fair value of the owners equity (and thus the fair value of the net assets) can increase when orders are received even if there is still significant concern that the start-up might not be capable of fulfilling the orders. The more risk there is about fulfillment, the smaller the increase in owners equity. Intuitively, everything else equal, venture capitalists will value a stock higher as it becomes less risky. The fair value of owners equity will continue to increase as the start up reduces uncertainty by reaching milestones to fulfill the order. Some key lessons have emerged: Regardless of when revenues are recognized on income statements, in an economic sense they can be earned or lost throughout the lives of sales agreements, depending on how well the company performs. Revenue recognition increases the book value of owners equity. These increases can and generally do differ from increases in the fair value of owners equity associated with sales agreements When assessing changes in the fair value of owners equity, among other sources of information, venture capitalists and others use revenues recognized in recent income statements and other sales-agreement information that has not yet been recognized in revenues, such as unfulfilled orders. Because revenues are defined as increases in net assets related to customer sales agreements, revenue recognition is inextricably tied to asset and liability recognition. This means that many problems associated with recognizing and measuring assets and liabilities also affect revenue recognition. GAAP provides four revenue recognition criteria to help companies determine the appropriate time to recognize revenues. Revenue can be recognized when: (1) there is persuasive evidence of a sales arrangement, (2) delivery has occurred or service has been rendered (which also means the buyer has accepted delivery), (3) the seller s price to the buyer is fixed or determinable, and (4) collectibility is reasonably assured. Deciding when these criteria are met is equivalent to deciding when the corresponding increase in net assets can be measured reliably.

15 Chapter 2: Introduction to Income Statements 15 When the first three criteria have been met, we say revenue has been earned, meaning a company has substantially accomplished what it must do under the sales agreement to be entitled to the benefits associated with the revenues (the company has met its obligations). When the fourth criteria reasonable assurance of collectibility has been met, we say revenue has been realized or is realizable. Revenues have been realized when cash is collected from customers. Revenues are realizable when other assets received from customers can readily be converted to cash or when the company can reliably estimate future realizations (e.g. collections on accounts receivable.) Importantly, a company can collect cash from a customer meet the collectibility criteria but still not have earned the revenue because it failed to meet one or more of the first three criteria. In this situation, the company recognizes a liability that represents its remaining obligation to earn the revenues. The asset and liability offset each other and thus there is no increase in net assets. This happens when Intel defers revenue recognition on shipments to select distributors. Intel recognizes an asset (accounts receivable) and a liability (deferred revenues) when the goods are shipped. The liability signifies that Intel has not yet earned the benefits associated with accounts receivable. Revenue recognition can be very problematic when there is significant risk that customers will return products for refunds, receive price-protection discounts, file warranty claims, or default on promised payments. It can also be problematic when products, product updates, and services are bundled together for one price and deliveries of these goods and services are spread over several reporting periods. Many financial reporting scandals have centered on revenue recognition and it has been a hot issue at the Securities and Exchange Commission (SEC) for several years. For example, in 2002, the SEC pressured Xerox to reverse over $6 billion of previously recognized revenues. In doing so, the SEC accused Xerox of dramatically overstating its net income and thus owners equity and net assets during prior years. Similarly, following an SEC investigation in 2001, Lucent reversed $700 million of previously recognized revenues. Restatements such as these have caused large declines in stock prices and thus in the fair value of owners equity. For example, Lucent s share price declined 10% on the day it announced the $700 million revenue restatement. Companies usually pay a hefty penalty when they lose credibility with debt and equity markets.

16 16 Navigating Accounting More generally, the financial reporting scandals in 2002 centered on extremely aggressive accounting. Accounting decisions and policies are considered aggressive to the extent they accelerate income recognition beyond what is warranted by the facts and circumstances by postponing expense recognition or accelerating revenue recognition. By contrast, they are considered conservative to the extent they postpone income recognition beyond what is warranted by accelerating expense recognition or postponing revenue recognition. The conservative principle significantly affects GAAP. It states that when in doubt as to whether income should be recognized sooner or later, recognize it later, and when in doubt as to whether a smaller or larger amount of income should be recognized, recognize the smaller amount. While the SEC has primarily been concerned with extremely aggressive accounting, it has also taken actions to curb overly conservative accounting. For example, in 2002, the SEC announced that Microsoft agreed to stop using an accounting practice that allegedly understated revenue and misled investors. Expense Recognition Expense recognition decisions determine when costs are recognized as expenses on income statements. An expensed cost is one that has been recognized on the income statement as an expense. Like revenue recognition, expense recognition is inextricably tied to asset and liability recognition because expenses are defined as decreases in net assets associated with activities that are central to companies operations. Expense recognition is also tied to revenue recognition: the costs of resources that help generate revenues are often recognized as expenses. Expense recognition is motivated by three principles: 1. The matching principle is the dominant principal for recognizing expenses. It states that the costs of resources that were used to generate revenues and other costs associated with revenues should be recognized as expenses in the same period the revenues are recognized. The matching principle implies that expense recognition is often subordinate to revenue recognition. That is, companies first decide when to recognize revenues and then match expenses. This sequence is important to keep in mind when analyzing financial statements: studying revenue recognition policies first will help you interpret and assess companies expense recognition policies.

17 Chapter 2: Introduction to Income Statements The conservative principle governs expense recognition when matching is problematic. In this regard, it maintains that when the future benefits (including revenues) associated with a cost can not be measured reliably because of uncertainty regarding the amounts or timing of the future benefits, and thus concerns about how reliably the cost can be matched to the benefits, the cost should be recognized as a an expense when incurred. Expenses that are recognized when incurred are called period expenses. 3. The lower of cost or market principle states that expenses should be recognized at the end of reporting periods when necessary to ensure a company s net assets are stated at the lower of cost or market value. When market values are not available, other reliable fair value estimates can be used. These expenses are called impairments or valuation adjustments. With regard to assets, the lower of cost or market principle maintains that when the fair values of assets are reliably less than their book values, expenses should be recognized to write them down to their fair values. With regard to liabilities, it maintains that when the fair values of liabilities reliably exceed their book values, expenses should be recognized to write them up to their fair values. A special case is when no liability has previously been recognized, but new information suggests that one has been incurred and its fair value can be estimated reliably. Like revenue recognition, expense recognition can be very problematic and controversial. The remainder of this section provides additional concepts and examples that will help you begin to understand when expenses are recognized and how they affect net assets. Expense Recognition Motivated by Matching Expenses are recognized when incurred costs or expected future costs can be matched reliably to current-period revenues. Matched reliably means that those who determine GAAP are reasonably confident that the events or circumstances that gave rise to the costs helped generate revenues or were otherwise related to them, or that GAAP permits company s to make this judgment. For example, if ABC Company purchases inventories for $7 cash in 2007 and sells it to customers for $15 in 2008, ABC recognizes $15 of revenues in 2008 and $7 of matched expense in The $7 expense is the cost of the sold inventories. Here we can be very confident of the matching: the event that gave rise to the $7 cost purchasing the inventories in 2007 definitely helped generate the 2008 revenues. Without the inventories, there would not have been a sale.

18 18 Navigating Accounting To extend the example and further demonstrate the matching principle, suppose that a sales person at ABC earned a $1 commission on the 2008 sale but that ABC did not pay her the commission until Because she earned the commission when the sale was made, ABC would match the cost of her services directly to the $15 of revenues it recognized in Again, here we can be very confident that the event that gave rise to the $1 cost the employee earned unpaid compensation definitely helped generate the $15 of revenues. Accordingly, in 2008 ABC increases expenses by $1 and decreases net assets by $1. The $1 decrease in net assets is accomplished by recognizing a $1 accrued compensation liability (or wages payable). Thus, owners equity decreases by $1 because an expense is recognized and this is balanced by a $1 increase in liabilities. To extend the example again, assume that: (i) ABC made several sales on account during 2008 that were recognized as revenues and it has $300 of gross accounts receivable at the end of (ii) Prior to 2008, all sales were for cash and thus the receivables at the end of 2008 all pertain to 2008 revenues. (iii) Based on very reliable information, ABC expects that $25 of the gross receivables at the end of 2008 will likely be written off as bad debts in Under GAAP, ABC would recognize a $25 expense in 2008 that matches the 2008 revenues that are associated with the $25 of expected future costs (bad debts). This $25 expense is balanced on the balance sheet by a $25 increase in the allowance for bad debts, a contra asset to accounts receivable. Increasing a contra asset decreases assets and thus decreases net assets. To summarize, the ABC example illustrates recognition of three expenses that are costs that can be matched reliably to current-period revenues. One recognized expense was associated with a cost that was incurred and paid for in an earlier reporting period: the $7 inventories cost expensed in 2008 was incurred in 2007 when the inventories were purchased and this cost was also paid in A second recognized expense is associated with a cost that was incurred in the current period and will be paid in a future period: the $1 commission expensed in 2008 was incurred in 2008 and will be paid in A third recognized expense was associated with an expected future cost: some of the cash associated with 2008 revenues was not expected to be collected in 2009 or thereafter.

19 Chapter 2: Introduction to Income Statements 19 Four fundamental lessons emerge from the example: Costs are not necessarily expensed when they are incurred (the inventory costs incurred in 2007 were not expensed until 2008). Costs can be paid in periods before, during, or after the period when they are expensed. Costs can be incurred before, during, or after the revenues they are matched with are recognized. Net assets decrease when expenses are recognized either because assets decrease, contra assets increase, or liabilities increase. When costs are incurred in a period before they are expensed, they are capitalized as assets. For the ABC example, when the inventories were purchased in 2007, cash decreased by $7 and inventories increased by $7. We say that the $7 cost is capitalized as inventories. Generally, costs are only capitalized if they can be reliably matched to future benefits (including revenues). When the revenues are recognized, the matched capitalized costs are expensed. Expense Recognition Motivated by Conservatism GAAP generally specifies whether costs can be capitalized as incurred and subsequently expensed when the revenues they helped generate are recognized. When there is considerable uncertainty about future revenues (or other benefits) and costs can not be matched reliably to them, the conservative principal dictates that the costs be expensed immediately as incurred. For example, if DEF company spends $100 (million) cash on research and development in 2008, hoping to develop drugs to sell to customers in future years, under GAAP, the $100 is a current-period expense in In this situation note that recognizing an expense decreases net assets: cash decreases by $100 and this is balanced by a $100 expense (that decreases owners equity). The $100 cost is associated with future benefits (including revenues) but GAAP presumes that companies can not match such costs reliably to future benefits. In fact, research and development is often so risky that it is not possible to reliably conclude that there will be future benefits, let alone match research and development costs to benefits in specific years. For this reason, under GAAP, most research and development costs are expensed as they are incurred. The exceptions are certain costs associated with developing software and films.

20 20 Navigating Accounting Expense recognition can be very contentious. In particular, there is frequently controversy as to whether companies should capitalize or expense the costs they incur to acquire resources that help generate future revenues. Capitalize versus expense controversies generally center on timing: sooner or later the costs of most resources that are acquired to help generate future revenues are expensed. For example, eventually the costs capitalized when a building is acquired are completely expensed through depreciation. Those who favor capitalizing a cost as an asset typically invoke the matching principle to defend their position and those who favor expensing the cost invoke the conservative principle. Deciding whether costs that relate to future revenues should be expensed as incurred, or capitalized as assets and expensed in the future, can require considerable judgment. Sometimes these judgments are determined by GAAP and other times they are made by companies with GAAP guidance. The Worldcom reporting scandal in 2002 centered on this judgement: the SEC accused Worldcom of capitalizing billions of dollars of costs in past years that should have been expensed as incurred, and thus of having overstated net income in prior years. Expense Recognition Motivated By Lower of Cost or Market The lower of cost or market principle maintains that when the fair values of assets are reliably less than their book values, expenses should be recognized to write them down to their fair values. Write downs are also called impairments. For example, if XYZ purchases inventories for $200 and their fair value subsequently decreases to $150, XYZ would recognize a $50 impairment expense. The inventories would decrease by $50 and this decrease in assets would be balanced by a $50 expense (and thus decrease in owners equity). Companies are frequently criticized for delaying the recognition of major asset impairments in order to report higher current-period income. A tell tale sign that this is occurring is when the book value of a company s owners equity is significantly higher than the market value of its stock. Assuming the book and market values of its debt are similar, when the book value of the owners equity is significantly higher than its market value, implicitly the book value of the company s assets is overstated relative to its fair value, and thus some assets are significantly impaired and should be written down to fair value. When this occurs, financial analysts and others sometimes pressure companies to either recognize impairments or explain why they should

21 Chapter 2: Introduction to Income Statements 21 not be recognized. Analysts are seeking more precise information about the magnitude of impairments: the consensus belief of the market is that assets are impaired but this does not mean that these market assessments are as accurate as the ones companies could provide by recognizing impairments. In response to this type of pressure, or on their own volition, companies frequently recognize impairments and some of these are extremely large. For example, in 2002, AOL Time Warner took a $54 billion impairment related to the goodwill and intangibles that were recognized when Time Warner and AOL merged in Similarly, in 2001, Cisco recognized a $2.25 billion inventories impairment that was associated with a severe downturn in the telecom industry. The lower of cost or market principle also implies that expenses should be recognized when the fair values of liabilities reliably exceed their book values. This occurs when a company learns that it has a new liability or that an existing liability is greater than previously anticipated. Restructuring expenses are motivated by the lower of cost or market principle. They pertain to costs associated with major changes in the business such as plant closings and lay offs. GAAP requires companies to estimate and expense restructuring costs in the year they anticipate and plan them, which is often one or more years before the restructuring is completed. For example, if ABC announces a restructuring plan in 2008 wherein it estimates that it will incur $25 of severance costs and $10 of inventories losses in 2009, ABC recognizes a $35 expense in 2008: inventories are written down $10, a $25 liability related to the severance obligation is recognized, and a $35 restructuring expense is recognized. If the actual costs turn out to be less than anticipated in 2009, ABC will recognize a negative expense to correct for the overestimate. For example, if the actual severance costs are $24 in 2009, rather than the estimated $25, ABC will recognize a negative $1 restructuring charge in 2009.

22 22 Navigating Accounting Exercise 2.01 The solutions to the following exercises are on page 83. (a) True or false: Income statements measure performance at reporting dates. (b) True or false: Revenues are increases in net assets. (c) True or false: Decreases in net assets are expenses. (d) True or false: If ABC company recognizes $10 of revenues when it delivers goods to a customer in exchange for a $10 future payment, ignoring the cost of the goods sold, accounts receivable and owners equity both increase by $10. (e) True or false: If ABC delivers goods to customers in exchange for $10 cash, GAAP requires ABC to recognize $10 of revenues. (f) True or False: If ABC delivers goods to customers in exchange for $10 cash, ABC realizes $10 of revenue. (g) True or False: If ABC delivers goods to customers in exchange for a $10 promised future payment and ABC is reasonably confident that the customer will not return the product, seek a price discount, need warranty work, or otherwise require ABC to bear future costs, ABC has earned $10 of revenue and is required under GAAP to recognize $10 in accounts receivable and revenues. (h) True or false: If DEF company sells merchandise for $15 that cost $8, the matching principal implies that DEF should recognize an $8 expense when it recognizes $15 of revenues associated with the sale. (i) True or false: When Intel defers paying employees compensation they earned during the year, it recognizes an expense and increases its accrued compensation and benefits liability. (j) True or false: Global Crossing was accused of overly conservative accounting because it accelerated income recognition beyond what was warranted by the facts and circumstances.

23 Chapter 2: Introduction to Income Statements 23 Search Icon This exercise requires you to search for information. Exercise 2.02 This exercise pertains to the income statements in Figures for Intel, Cisco, Gap, Starbucks, Nike, Coca Cola, and Federal Express (pages 71-77). Hint: As needed, reference Line-by-Line Tour: Intel Financial Statements. This can be found on the Navigating Accounting CD or a back section of your course packet. The solutions are on page 84. (a) Net revenues is the first item on Intel s income statement. What line items on the other six companies income statements likely represent a similar concept? (b) Which two of the seven companies disclose more information about net revenues on their income statements than the other five? (c) The net in net revenues means gross revenues net of returns, early payment discounts, and price-protection discounts. Nike and Federal Express report Revenues rather than Net revenues. What are possible reasons why they did not include the net modifier? (d) Cost of sales is the second item on Intel s income statement. Which of the other six companies recognize this concept on their income statements (perhaps using a synonym)? (e) Two of the seven companies recognize cost of sales in net income but do not disclose it on their income statements. What do these companies have in common? (f) Which of the seven companies explicitly disclose gross margins or a synonym for gross margins on their income statements? (g) Two of the seven companies disclose Research and development expenses on their income statements? How do these companies differ from the other five companies? (h) Presumably Nike and Coca Cola have some research and development activities. Which line items on their income statements likely include research and development expenses? (i) Which company s income statement discloses the most precise information about sales and marketing expenses? (j) Which two companies income statements disclose the fewest line items associated with operating expenses? (k) In terms of what you know about the companies, which of the seven seems to disclose the most detailed information about its operating expenses on its income statement?

24 24 Navigating Accounting (l) Based only on information disclosed on their income statements, which of the seven companies have acquired other companies? (m) Based on information in the income statement only, in which year did Cisco plan a restructuring? (n) Which two of the seven companies do not disclose a separate line item for operating income? Estimate their operating incomes for fiscal To what extent are you confident that your estimates reflect operating activities (rather than non-operating activities)? (o) Which of the seven companies disclose investment gains or losses on their income statements? (p) Starbucks recognized $2,940 of Internet-related investment losses for Why is this $2,940 signed positively on Starbucks income statement if it is a loss? (q) Which of the seven companies disclose interest income and interest expense on their income statements? (r) Which of the companies identified above in (q) signs interest income negatively on its income statement? Interest income would seem to be good for owners, why is it signed negatively? (s) Which of the companies identified above in (q) signs interest income and interest expense positively on its income statement? Why do they have the same sign? (t) What can you conclude about income statement signing conventions from (p), (r) and (s)? (u) Which of the seven companies income statements has another section besides operating and non-operating income?

25 Chapter 2: Introduction to Income Statements 25 In this section we extend the ABC Company example and generalize the balance-sheet-equation template to incorporate income concepts. Figure Colors Use the PDF version of this chapter on your Navigating Accounting CD to zoom in on the color-coded figures in this section. ABC Company Example ABC Company has the following events for its first year of operations (E1-E3 are carried forward from the earlier chapter). All amounts are in thousands of dollars. E1: ABC s shareholders contribute $1,000 of cash to ABC in exchange for 1 million shares of ABC s non-par common stock. E2: ABC purchases a building from Kaplan Properties for $200 cash. The building will be used as a store. E3: ABC purchases $100 of merchandise from Healy Inc. on account and it plans to sell to customers for a profit. E4: ABC sells merchandise that cost $20 for $60. The customers who purchase the merchandise promise to pay the $60 in the future. ABC recognizes revenue when goods are sold to customers. E5: ABC collects $40 of the $60 that customers promised to pay (in event E4). E6: ABC pays $60 of its outstanding obligation to Healy Inc. E7: ABC receives $10 of cash from customers who owe this much in interest because they did not pay their bills on time. E8: ABC declares and pays a $20 dividend on the last day of the year. E9: ABC records depreciation of $10 related to the building purchased from Kaplan Properties. We assume that ABC Company pays no taxes and expects that there will be no bad debts. The next few pages illustrate how these entries are recorded using the modified version of the balance-sheet-equation template. We will work our way through the entries one by one, illustrating how each entry affects the balance sheet and income statement.

26 26 Navigating Accounting Structure of Modified Balance-Sheet-Equation Template The balance-sheet-equation (BSE) template below adds more specificity to illustrate income related concepts. Owners equity is divided into Permanent and Comprehensive income (temporary) Comprehensive income is divided into Net income and Other comprehensive income (OCI) Net income is further divided into Revenues minus Expenses plus Gains minus Losses plus Other income. The template also illustrates closing entries that ensure the temporary accounts associated with comprehensive income start each period with $0 balances: Net income for the period is transferred to retained earnings (in permanent owners equity), and other comprehensive income is transferred to accumulated other comprehensive income (also in permanent owners equity). We will discuss closing entries near the end of the ABC example. Assets = Liabilities Owners' Equities Permanent Comprehensive Income (Temporary) Beginning balances Cash Other Assets = Net income $0 - Revenue Expenses Gains Losses $0 $0 $0 Other $0 Other Comp. Income (OCI) $0 Events during the period = - - Closing entries at end of period Ending balances - - Close net income to retained earnings Close OCI to accumulated other comprehensive income = $0 - $0 $0 $0 - $0 $0