The Income Statement BA 617 Module 4 Overview

The Income Statement BA 617 Module 4

Overview Summarizes results of company’s operations for a period of time Many consider it the most important financial statement Prepared on an accrual basis Multiple step vs. single step Relationship to actual performance Opportunity for earnings management

Opportunity? Revenue recognition Depreciation Nonrecurring items Discretionary Costs Quality of reported earnings

Major Categories Focus on MULTIPLE-STEP Statement (it has more detail and is more useful…) NET SALES: A firm’s sales are usually reported as Sales less Sales Returns less Sales Allowances – the major source of revenue for most companies – trends are important

Kodak (in millions 2000 Sales $13, 994 Net earnings $ 1, 407 1999 1998 14, 089 13, 406 1, 392 1, 390 Sales and net income moving in opposite directions

Major Categories (continued) Cost of Goods Sold (CGS) – cost to seller of products sold to customers – relationship between CGS and sales is an important one Beginning inventory Plus: Purchases during the period Less: Ending Inventory = Cost of goods sold expense for the period

Categories (cont’d) Gross Profit (first step of profit determination) – difference between net sales and CGS – key analytical tool in analyzing firm’s operating performance Fulfillment costs

Major Categories (continued) Operating Expenses – Include such things as selling expenses, administrative expenses, advertising, lease payments, depreciation, amortization, repairs and maintenance – Important to track carefully -- trends, absolute amounts, relationship to sales, relationship to industry competitors Research and Development Costs

Major Categories (continued) Operating Profit (second step of profit determination) -- also called Earnings from Operations or EBIT – measures overall performance of company’s operations: sales revenue less expenses associated with generating sales

Major Categories (cont’d) Other Income/Expense – includes revenues/expenses other than from operations, e. g. interest Earnings before income taxes – profit recognized before deduction of income tax expense – remember, income taxes paid may differ from income tax expense (deferred taxes)

Major Categories (continued) Net Earnings – “bottom line” -- firm’s profit after consideration of ALL revenues & expenses

Major Categories (continued) Earnings per Common Share – Determined by dividing earnings available to common shareholders (earnings less any preferred dividend requirements) by average number of common shares outstanding during the period – If firm has “complex” capital structure, it will report basic and diluted EPS – Extensively used by analysts in evaluating a firm

Did the number of shares change? 2000 1999 1998 Basic earnings per share $4. 62 $4. 38 $4. 30 (in millions) 2000 1999 1998 Number of common shares 304. 9 318. 0 323. 3

Unusual Income Statement Items Below the line” Items (reported net of tax): – Income from Discontinued Operations – Extraordinary Gains and Losses – Cumulative Effect of a Change in Accounting Principle

Last but not least…. SOMEWHERE, the firm must report Comprehensive Income May be on the face of the income statement, may be in the statement of stockholders’ equity, may be in a separate financial statement Wherever it is -- let’s take a look at what it includes

Comprehensive Income Includes Net Earnings computed as illustrated Also includes foreign currency translation adjustments, unrealized gains/losses on available-for-sale securities, additional pension liabilities and changes in fair market value of cash flow hedges (beyond the scope of this text…count your blessings!)

Which earnings figure to use? Net income EBITDA Operating Profit Pro Forma earnings and Core Earnings Cash Flow from Operations S&P Redefines Core Earnings

Accounting chef techniques Big bath Channel stuffing Barter Sales Reserve accounts Premature revenue recognition Cheney and Halliburton

Caution Flags Revenue and earnings growing at substantially different rates or moving in opposite directions Accounts receivable and/or inventories growing much faster than sales Large unexplained reductions and discretionay items such as advertising, research and development Profit margins shrinking or growing dramatically or moving in opposite directions Earnings reports featuring “pro forma” and other earnings figures that are not prepared according to GAAP

More flags Showing more than one pro forma earnings amount Taking large, one-time (special) charges against earnings Increasing reserves without justification Reducing the allowance for doubtful accounts when sales and accounts receivable are rising Changing accounting estimates and assumptions

Just for fun put it in perspective Next…the statement of changes in stockholders’ equity!