Lecture Accounting: What the numbers mean (5/e) - Chapter 9: The income statement and the statement of cash flows

After reading this chapter, you should be able to answer the following questions: What is revenue, and what are the two criteria that permit revenue recognition? How is cost of goods sold determined under both perpetual and periodic inventory accounting systems? What is the significance of gross profit, and how is gross profit calculated and used?...

CHAPTER 9

THE INCOME STATEMENT

AND THE STATEMENT OF

CASH FLOWS

Learning Objectives

1 What is revenue, and what are the two

criteria that permit revenue recognition?

2 How is cost of goods sold determined

under both perpetual and periodic

inventory accounting systems?

3 What is the significance of gross profit,

and how is gross profit calculated and

used?

4 What are the principal categories and

components of “other operating

expenses,” and how are these items

reported on the income statement?

Learning Objectives

5 What is included in “income from

operations,” and why is this income

statement subtotal significant to

managers and financial analysts?

6 What are the components of the

earnings per share calculation, and

what are the reasons for some of the

refinements made in that calculation?

7 What are the alternative income

statement presentation models?

Learning Objective 1

• What is revenue, and what are

the two criteria that permit revenue recognition?

Income Statement

• Answers important questions such as:

– What are the financial results of operations

of the entity for the fiscal year?

– Are sales increasing relative to cost of

goods sold and other operating expenses?

• Reports what has happened over a period of

time

• Inflows or other enhancements of

assets from rendering goods or

services that constitute the entity’s

ongoing, major operations

• To be recognized, revenue must be:

– Realized or realizable

– Earned

Realization and Earned

• Realization – the product or service has

been exchanged for cash or claims to cash

• Earned – the entity has completed the

activities it must perform to be entitled to

the revenue benefits

• Both criteria are usually satisfied when

product being sold is delivered to the

customer

• Sales – describes the revenues of firms that

sell purchased or manufactured products

• Sales returns and allowances – a refund or

reduced price for defective merchandise

• Net sales – gross sales less sales returns

and allowances

• Other terms for revenues include Rental

Revenue, Fees, and Other Revenues

Shipping Terms

• FOB destination – the seller owns the product until accepted by the buyer at the buyer’s

designated location Title to the merchandise

passes when the merchandise is received by

the buyer Seller incurs shipping costs

• FOB shipping point – buyer accepts ownership

of the product at the seller’s shipping location Buyer incurs shipping costs

• Increases in net assets resulting from

incidental transactions or nonoperating activities

• Not included with revenues at the

beginning of the income statement

• Reported as “other income”

• Outflows or other using up of assets or

incurrence of liabilities from delivering goods

or services that constitute the entity’s

ongoing, major operations

• Based on the matching principle

• Some recognized in the period in which they are incurred (administrative expenses)

• Others are an allocation of cost

(depreciation)

• Decreases in an entity’s net assets

resulting from incidental transactions or

Learning Objective 2

• How is cost of goods sold

determined under both perpetual and periodic inventory accounting

systems?

Cost of Goods Sold

• Most significant expense for many

manufacturing and merchandising firms

• Inventory shrinkage usually included

• Is a function of the inventory cost flow

assumption

• Computed as (under periodic system):

• Cost of beginning inventory + Net purchases – Cost of ending inventory

Net Purchases

• Purchases are the inventory bought

for resale in a merchandising firm

• Freight charges are added

• Purchase discounts are deducted

• Purchase returns and allowances –

refunds or credits for defective

merchandise – are deducted

Expanded Cost of Goods Sold

Cost of beginning inventory XX

= Cost of goods available for sale XX

- Cost of ending inventory XX

= Cost of goods sold XX

Learning Objective 3

• What is the significance of gross profit, and how is gross profit calculated and used?

Gross Profit or Gross Margin

• The difference between sales revenue and cost

of goods sold

• May be expressed as a dollar amount or as a

percentage of sales ( gross profit ratio )

• A measure of the amount of each sales dollar

that is available to cover operating expenses

Gross Profit Ratio

• Gross profit divided by sales

• Can be used to set selling prices

• Differs by class of merchandise sold

• Sales mix is the proportion of sales of

each class of merchandise

• Overall gross profit ratio depends on

the sales mix

Learning Objective 4

• What are the principal categories

and components of “other operating expenses,” and how are these

items reported on the income

statement?

Other Operating Expenses

• Consists of:

– Selling expenses

– General and administrative expenses

– Research and development expenses

• Footnotes to the financial statements

often offer details about these expenses

Learning Objective 5

• What is included in “income from

operations,” and why is this income

statement subtotal significant to

managers and financial analysts?

Income From Operations

• The difference between gross profit and

Other Income and Expenses

• Includes interest expense, interest income, gains, and losses

• Items that are not significant are reported

in “other income” and “other expenses”

• Nonoperating gains and losses include

sale or disposal of assets, losses from

inventory obsolescence, and litigation

gains and losses

Income Before Income Taxes

• Listed on the income statement after

other income and expenses

• Listed before income tax expense

• Usually a footnote to the financial

statements discloses detail of the

income tax calculation

Net Income

• Net income is often referred to as “the

bottom line”

• All revenues and gains less all

expenses and losses

• Since net income impacts dividends,

stockholders and potential investors are

very interested in net income

Learning Objective 6

• What are the components of the

earnings per share calculation, and what are the reasons for some of

the refinements made in that

calculation?

Earnings Per Share

• Used to facilitate interpretation of net

income

• Basic earnings per share is net income

divided by the weighted average number

of shares of common stock outstanding

• Diluted earnings per share also is shown

if a firm has convertible securities

Calculation of Earnings Per Share

• Basic earnings per share =

Net income – preferred stock dividends

Weighted average number of common

shares outstanding

• The weighting of the shares outstanding

is done based on the number of months

each block of shares has been

Other Earnings Per

Share Amounts

• If any securities (bonds or preferred stock)

are convertible to common stock, diluted

earnings per share is reported

• In this calculation, it is assumed that the

securities have been converted and the

dividends or interest have not been paid

• Earnings per share also is shown for any

unusual items on the income statement

Learning Objective 7

• What are the alternative income

statement presentation models?

Income Statement Presentation Alternatives

• Single step format uses no breakdowns

as to gross profit, operating income, etc

• All items are listed in order with no

subtotals in the single step format

• Multiple step format uses subtotals and

categories of income and expenses

Learning Objective 8

• What are the unusual items that

may appear on the income

statement?

Unusual Items Sometimes Seen on an Income Statement

• Income statements are used by investors to

predict probable results of future operations,

but they only want to consider recurring

items

• Nonrecurring items are reported separately,

net of the income tax effect of the event

• These events include: discontinued

operations, extraordinary items, minority

interest in subsidiaries, and cumulative effect

of change in accounting principle

Discontinued Operations

• Disclose the impact of a the disposal of a

segment or major portion of a business

• Helps investors see the impact on the firm’s

operations without the disposed business

segment

• Shown net of taxes

• Report earnings per share effect of disposal

Extraordinary Items

• Must be unusual in nature and infrequent in

occurrence to qualify as an extraordinary

item (or if prescribed by the FASB)

• The event is not likely to recur

• Examples include: gains and losses from

early repayment of long-term debt, litigation

settlements, and pension plan terminations

• Shown net of tax

• Report earnings per share for extraordinary

items

Minority Interest in Earnings of Subsidiaries

• The financial statements of a subsidiary

are combined with those of the parent

• Only the parent’s equity in the subsidiary’s earnings is reported

• The minority interest earnings are

deducted from income after taxes

• Reported separately only if significant

Cumulative Effect of a Change

in Accounting Principle

• A change from one generally accepted

accounting principle to another is

permitted only if the change is

promulgated by a standard-setting body

or if the change can be justified

• Report the cumulative effect of the

change net of tax

Learning Objective 9

• What are the purpose and

general format of the statement

of cash flows?

Statement of Cash Flows

• Relatively new financial statement

• Primary purpose is to provide relevant

information about the cash receipts and cash payments of an entity during a

period

• Key word is “cash”

Cash Flows from Operating Activities

• Two methods of presenting the operating

activities section:

– The direct method involves listing each major class of cash receipts and cash disbursements

– The indirect method explains cash flow by

explaining the change in each of the non-cash operating accounts in the balance sheet

Direct Method

• Lists cash activities such as:

– Cash received from customers

– Cash paid to merchandise or raw

materials suppliers– Cash paid to employees for wages

– Cash paid for interest

– Cash paid for income taxes

Indirect Method

• Begins with net income and adds back

depreciation expense

• Adjusts for changes in non-cash

operating accounts in the balance sheet such as accounts receivable, inventory,

and accounts payable

• Also need to include deferred income

taxes, gains and losses on assets, and

amortization on bonds payable

Cash Flows from Investing

and Financing Activities

• Investing activities relate to the purchase

and sale of noncurrent assets such as land and buildings and debt and equity

securities

• Financing activities relate to changes in

noncurrent liabilities and owners’ equity

accounts such as issuing bonds or stock

and paying dividends

Learning Objective 11

• Why is the statement of cash

flows significant to financial

analysts and investors who rely

on the financial statements?

Interpreting the Statement

• Cash from operating activities should be greater

than cash used for investing activities

• Can often determine a firm’s growth strategy from the statement of cash flows