L2 - Chapter 4 Income Statement COPYRIGHT ©2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

The Income Statement Dated for a period of time Multiple-step format For the Year Ended... Multiple-step format Gross profit Operating income Income before taxes Net income Single-step format Total of all revenues and gains Less the total of all expenses and losses Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Multiple-Step Single Step Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Basic Elements of the Income Statement Net Sales (Revenues) Cost of Goods Sold Other Operating Revenue Operating Expenses Other Income or Expense Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Net Sales Revenue from the sale of principal goods or services sold to customers Shown net of Discounts Returns Allowances Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Cost of Goods Sold The cost of goods that were sold to produce revenue Retailer Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold Manufacturer Beginning Inventory + Cost of Goods Manufactured – Ending Inventory = Cost of Goods Sold Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Other Operating Revenue Reflects the nature of the business Examples Lease revenue Royalty revenue Finance charges Commission revenue Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Operating Expenses Selling expenses Administrative expenses Result from the company’s effort to create sales Examples Advertising Sales commissions Sales supplies used Administrative expenses Relate to the general administration of the company’s operation Salaries Insurance Bad debt expense Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Other Income or Expense Secondary activities not directly related to operations Dividend income Interest income Gains (losses) from sale of assets Interest expense Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Special Income Statement Items Unusual or Infrequent Items Disclosed Separately Included with normal recurring revenues and expenses If material, disclosed separately, before income taxes Relate to operations Treatment for analysis Primary analysis: include Supplementary analysis: exclude Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Special Income Statement Items (cont’d) Equity in Earnings of Nonconsolidated Subsidiaries The investor’s proportional share of the investee’s net income Does not represent cash flow to the investor Cash dividends received represent cash flow Analysis issues: Investor’s net income includes revenue of other entity May distort ratios Presented before tax; tax consequences typically immaterial Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Special Income Statement Items (cont’d) Income Taxes Related to Operations Federal, state, and local Includes both paid and deferred taxes Discontinued Operations Reported net of income tax Analysis issues: Inadequate disclosure of associated assets Lack of historical profit and loss information on the discontinued operations Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Special Income Statement Items (cont’d) Extraordinary Items Unusual and infrequent Reported net of income tax Analysis issues: Exclude from primary analysis Include for supplementary analysis Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Special Income Statement Items (cont’d) Cumulative Effect of a Change in Accounting Principle For fiscal years beginning before 12/15/05 Cumulative effect of the change shown net of tax on the income statement of the period in which change was made Earlier statements not restated to reflect application of the new principle Effective for fiscal years beginning after 12/15/05 All comparative statements are retrospectively restated to reflect application of the new accounting principle The cumulative effect on income of earlier years is shown as a net-of-tax adjustment to the beginning Retained Earnings balance of the earliest period presented Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Special Income Statement Items (cont’d) Minority Share of Earnings Earnings of a partially-owned consolidated subsidiary that would accrue to the minority owners Presentation may be either pre-tax or net-of-tax Earnings per Share Net income ÷ Number of shares outstanding Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Reconciliation of Retained Earnings Reported as part of the Statement of Stockholders’ Equity or combined with the Income Statement Beginning of year balance of retained earnings + Prior period adjustments ± Cumulative effect of a change in accounting principle = Beginning balance as adjusted + Net income – Dividends = End-of-year balance of retained earnings Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Retained Earnings The accumulated undistributed earnings of the corporation reported on the balance sheet Appropriated Restricted by law, contract, or management decision Not available for dividends Unappropriated Available for dividends Does not represent cash or any other asset Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Stock Dividends Cash dividends Stock dividends Date of declaration: create liability and reduce retained earnings Date of payment: reduce liability and cash Stock dividends Small (less then 25%): capitalize the market value of the stock Material: capitalize the par value of the stock Total equity is unaffected by a stock dividend Analysis issues: Restate share quantities to reflect stock dividend activity Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Stock Dividend Example 100,000 shares outstanding; $1 par; $5 market 5% stock dividend on 100,000 shares: issue 5,000 additional shares recorded at $5 per share 30% stock dividend on 100,000 shares: issue 30,000 additional shares recorded at $1 per share Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Stock Splits 2-for-1 split Doubles the quantity of stock Par or stated value is halved No effect on retained earnings, additional paid-in capital, or capital stock accounts Analysis issues: Restate share quantities to reflect split activity Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Legality of Distributions to Shareholders Per various state laws Distributions are acceptable as long as the firm has the ability to pay debts as they come due in the normal course of business Distributions to stockholders are acceptable as long as the firm is solvent and the distributions do not exceed the fair value of the assets Distributions consist of solvency and balance sheet test of liquidity and risk Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Comprehensive Income Net income + The period’s change in accumulated other comprehensive income = Comprehensive income Foreign currency translation adjustments Unrealized holding gains and losses on available-for-sale marketable securities Changes to stockholders’ equity resulting from additional minimum pension liability adjustments Unrealized gains and losses from derivative instruments Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Comprehensive Income (cont’d) Required disclosures Comprehensive income Other comprehensive income from each category Reclassification adjustments for each category of other comprehensive income Tax effects for each category of other comprehensive income Balances for each category of other comprehensive income Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Comprehensive Income (cont’d) Presentation In a separate financial statement Combined with the income statement As part of the schedule of changes in stockholders’ equity Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Comprehensive Income – Separate Statement Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Comprehensive Income – Combined with Income Statement Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Comprehensive Income – As Part of the Statement of Stockholders’ Equity Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Comprehensive Income (cont’d) Analysis issues: Typically more volatile than net income A better indication of long-run profitability Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.