CHAPTER 5 DIFFERENT MEASURES OF INCOME DIFFERENT MEASURES OF INCOME THE INCOME STATEMENT

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1 1 CHAPTER 5 THE INCOME STATEMENT DIFFERENT MEASURES OF INCOME Sales - Cost of goods sold = Gross profit - Other operating expenses, gains, and losses = Operating income - Interest income +/- Miscellaneous revenues, expenses, gains, and losses - Income tax expense = Income from continuing operations +/- Income from discontinued operations +/- Extraordinary items +/- Cumulative effect of accounting changes = Net income +/- Unrealized gains and losses not included in net income = Comprehensive income 2 DIFFERENT MEASURES OF INCOME Gross profit is the difference between sales of the product and the cost of sales of the product Operating income is gross profit minus operating expenses It measures the performance of the central operations of the company 3

2 4 DIFFERENT MEASURES OF INCOME Income from continuing operations is operating income minus interest expense, income tax expense, and other miscellaneous items Net income is income from continuing operations adjusted for Income from discontinued operations Extraordinary gains and losses Cumulative effect of accounting changes DIFFERENT MEASURES OF INCOME Income or loss from discontinued operations results from a company disposing of a major business segment Extraordinary gains and losses are those that are unusual in nature and infrequent in occurrence Cumulative effect of accounting changes is a catch-up adjustment for a change to a new accounting 5 method Revenues represent the value of goods and services provided by a company Sales revenue reflects the aggregate selling price of goods sold during the period Service revenue represents fees charged for services 6

3 7 Interest revenue is earned from extending credit or loaning money Other revenue is comprised of revenues that come from different sources Expenses represent the value of resources used in generating reported revenue Cost of goods sold is the expense directly associated with the sales revenue for the period 8 Selling, general, and administrative expense represents a wide variety of operating expenses including Research and development expense All R&D is required to be expensed Wages and salaries expense Bad debt expense (the cost of selling merchandise on credit) 9

4 10 Depreciation Allocation of the cost of long-lived assets Interest expense Rent paid to use someone else s money Income tax expense The sum of all income tax consequences of all transactions during a year Gains and losses occur from activities peripheral to a company s primary operations Sales of long-term assets for more or less than their carrying value Restructuring of operations which causes some assets to lose value 11 Below-the-line items (all reported net of applicable income taxes) Income (or loss) from discontinued operations is reported in two parts: Income (or loss) from operations Gain (or loss) from disposal of the assets of the segment Extraordinary gains and losses are Unusual in nature 12 Infrequent in occurrence

5 13 Earnings per share (EPS) The amount of net income associated with each share of stock Two earnings per share numbers: Basic EPS reports earnings based solely on shares actually outstanding during the year Diluted EPS reflects the existence of stock options and other potentially dilutive securities Net Income - Preferred Dividends BASIC EPS = Average Number of Common Shares Outstanding Net Income - Preferred Dividends DILUTED EPS = Average Number of Common Shares Outstanding + Potentially Dilutive Securities 14 FORMAT OF THE INCOME STATEMENT Single-step income statement All revenues are grouped together, all expenses are grouped together, and the difference is reported as net income Income tax expense is shown separately to emphasize that tax expense depends on the amount of income before taxes 15

6 16 Single-Step Step Income Statement QUICK BUCK CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Dollars in Millions) Years Ended December 31, NET SALES AND REVENUES Manufactured products $153,683 $145,341 $143,666 Financial services 12,762 12,674 11,664 Other income 11,729 5,998 4,924 TOTAL NET SALES AND 178, , ,254 REVENUES COSTS AND EXPENSES Cost of sales and other operating charges, exclusive of items listed below 130, , ,300 Selling, general and administrative 16,192 14,580 12,550 expenses Depreciation and amortization expenses 16,616 11,840 11,213 Interest expense 6,113 5,695 5,182 Other deductions 1,511 2,083 1,678 TOTAL COSTS AND EXPENSES 170, , ,923 INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES AND MINORITY INTERESTS 7,714 6,620 8,331 Income taxes 1,069 1,723 2,316 Minority interests INCOME FROM CONTINUING OPERATIONS BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE 6,698 4,953 6,033 Income from discontinued operations Cumulative effect of accounting change (52) NET INCOME $ 6,698 $ 4,963 $ 6,881 Basic earnings per share $8.70 $6.06 $7.28 Diluted earnings per share FORMAT OF THE INCOME STATEMENT Multiple-step income statement Revenue and expense items are arranged to highlight important profit relationships and income numbers such as gross profit and operating income 17 Multiple-Step Income Statement QUICK BUCK CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Dollars in Millions) Years Ended December 31, Net Sales of manufactured products $153,683 $145,341 $143,666 Cost of sales and other operating charges, exclusive of items listed in operating expenses 130, , ,300 Gross profit $ 23,655 $ 22,146 $ 22,366 Operating expenses: Selling, general and administrative expenses 16,192 14,580 12,550 Depreciation and amortization expenses 16,616 11,840 11,213 Operating income (loss) (9,153) (4,274) (1,397) $ $ $ Financial services revenue 12,762 12,674 11,664 Other income 11,729 5,998 4,924 Interest expense (6,113) (5,695) (5,182) Other deductions (1,511) (2,083) (1,678) Total non-operating revenues and expenses 16,867 10,894 9,728 INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES AND MINORITY INTERESTS 7,714 6,620 8,331 Income taxes 1,069 1,723 2,316 Minority interests INCOME FROM CONTINUING OPERATIONS BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE 6,698 4,953 6,033 Income from discontinued operations Cumulative effect of accounting change (52) NET INCOME $ 6,698 $ 4,963 $ 6,881 18

7 19 REVENUE RECOGNITION Revenue is recognized when The promised work is done, and Cash collectibility is reasonably assured EXPENSE RECOGNITION Is based on the matching principle An expense should be recognized in the same period in which the revenue it generates is recognized Three bases of expense recognition: 1 Direct matching (or cause and effect) 2 Systematic allocation 3 Immediate recognition 20 EXPENSE RECOGNITION Direct matching (cause and effect) The expense is directly traceable to the revenue it generates For example, cost of goods sold matched with sales and Sales commissions matched with sales 21

8 22 EXPENSE RECOGNITION Immediate recognition An expenditure is expensed currently because their is no future benefit or the future benefit is uncertain For example, advertising expense and Research and development expense TRANSACTION ANALYSIS Recall the January 1 transactions for Veda Landscape Solutions in Chapter 4 OWNERS ASSETS = LIABILITIES + EQUITY Prepaid Accounts Loan Mortgage Owner's Insurance Payable Payable Payable Equity Cash Inventory Land Buildings Equipment , , Initial investment 2. Bank loan 300, , Purchased (100,000) warehouse 400,000 50, , Purchased equipment (650,000) 650, Hired employees 6. Leased truck 7. Purchased inventory (10,000) 90,000 80, Paid for insurance (15,000) 15, ,000 90,000 15,000 50, ,000 #REF! 80, , , ,000 ======= ======= ======= ======= ======= ======= ======= ======= ======= ======= 23 TRANSACTION ANALYSIS ASSETS = LIABILITIES + STOCKHOLDERS EQUITY The transactions for the remainder of the year are analyzed using the expanded accounting equation... 24

9 25 TRANSACTION ANALYSIS ASSETS = LIABILITIES + STOCKHOLDERS EQUITY PAID-IN IN CAPITAL + RETAINED EARNINGS BEGINNING R.E. + NET INCOME - DIVIDENDS REVENUES + GAINS - EXPENSES - LOSSES Unearned Bank Accounts Prepaid Accounts Wages Franchise Interest Loan Mortgage Receivable Insurance Payable Payable Revenue Payable Payable Payable Cash Inventory Land Buildings Equipment ,000 90,000 15,000 50, , ,000 80, , ,000 Balance, January 1 9. Purchased inventory 1,300,000 1,300, Sold inventory 200,000 (800,000) 900, Consulting services 200, Collected consulting 160,000 (160,000) 13. Landscaping work 500,000 (100,000) 14. Collected retail 820,000 (820,000) 15. Paid suppliers (1,200,000) (1,200,000) 16. Paid employees (460,000) 40, Paid lease (9,600) 18. Paid SG&A (150,000) 19. Franchise 50,000 50, Accrued interest 58, Insurance expired (15,000) 22. Depreciation (20,000) (130,000) 23. Dividends (5,000) , , , , , , ,000 40,000 50,000 58, , ,000 Balance, December 31 ======= ======= ======= ======= ======= ======= ======= ======= ======= ======= ======= ======= ======= Landscaping Paid-in Sales Consulting Landscaping Cost of Supplies Wages SG&A Interest Depreciation Capital Revenue Revenue Revenue Goods Sold Expense Expense Expense Expense Expense Dividends ,000 Balance, January 1 9. Purchased inventory 10. Sold inventory 1,100,000 (800,000) 11. Consulting services 200, Collected consulting 13. Landscaping work 500,000 (100,000) 14. Collected retail 15. Paid suppliers 16. Paid employees (500,000) 17. Paid lease (9,600) 18. Paid SG&A (150,000) 19. Franchise 20. Accrued interest (58,000) 21. Insurance expired (15,000) 22. Depreciation (150,000) 23. Dividends (5,000) ,000 1,100, , ,000 (800,000) (100,000) (500,000) (174,600) (58,000) (150,000) (5,000) Balance, December 31 ======= ======= ======= ======= ======= ======= ======= ======= ======= ======= ======= TRANSACTION ANALYSIS Key points to remember Revenues increase retained earnings Expenses decrease retained earnings Dividends decrease retained earnings The income statement can be prepared from the revenue and expense columns of the spreadsheet 27

10 28 Veda Landscape Solutions Income Statement For the Year Ended December 31, 2003 Sales revenue $1,100,000 Consulting revenue 200,000 Landscaping revenue 500,000 Total revenues $1,800,000 Expenses: Cost of goods sold $800,000 Landscaping supplies expense 100,000 Wages expense 500,000 Selling, general, and administrative expense 174,600 Interest expense 58,000 Depreciation expense 150,000 Total expenses 1,782,600 Net income $ 17,400 FORECASTING THE FUTURE Past income statements can be used to predict income in future periods Good forecasting requires an understanding of what factors determine the amount of a future revenue or expense 29 FORECASTING THE FUTURE Forecasting begins with a forecast of sales The sales forecast forms the basis of predicting the future balance sheet, income statement, and statement of cash flows 30

11 31 FORECASTING THE FUTURE Forecast of balance sheet amounts Some amounts increase naturally as sales increase Cash, accounts receivable, inventory, and accounts payable Other amounts change in response to the long-term strategic plan Property, plant, and equipment Financing items are dependent on financing choices Long-term debt and paid-in capital FORECASTING THE FUTURE Forecast of income statement amounts Some items maintain a fairly constant relationship with sales Cost of goods sold and wages expense Depreciation expense is likely to be related to property, plant, and equipment Interest is related to debt Income tax is related to pre-tax income 32 FORECASTING THE FUTURE Sensitivity analysis Involves repeating the forecasting sequence using a set of pessimistic and a set of optimistic assumptions Forecasting is a useful tool for Loan officers Investors Management 33