1. UNDERSTANDING FINANCIAL STATEMENTS
INCOME STATEMENT
(Chapter 3)

2. Income Statement Revenues less Expenses = Net Income
Earnings Per Share is reported on face of IS
Also called the Statement of Earnings
Comparative financial statements enable users to analyze performance over multiple periods and identify significant trends.
Consolidated financial statements combine the financial results of a “parent company” with its subsidiaries.

3. Income reported on income statement
is based on Accrual Accounting, all revenues earned in the year & all expenses incurred in that year (NOT on the cash generated or cash paid during accounting period)
Income Statement may be presented in the multi-step or single step form.

4. Income Statement Single-step Multiple-step
All operating revenues and gains are reported first, followed by all operating expenses and other losses.
No separate section is prepared for COGS and gross profit.
Multiple-step
Divided into separate sections, various subtotals are reported.
Involves separate sections for gross profit, operating income, other income/losses, income before income taxes, and net income.
Gross Profit
Operating Income
Other Income/losses

5. Common size Income Statement
Analytical tool to compare firms with different level of sales.
Used to facilitate structural analysis of a firm, to evaluate trends and make industrial comparisons.
Expresses each income statement category as a percentage of net sales.
See Exhibit 3-3

6. Focus on Multi-step format (it has more detail and is more useful)
Income Statement
Focus on Multi-step format
(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

7. Income Statement (continued)
Net Sales
Less: Cost of Goods Sold (COGS)
Cost to seller of products sold to customers.
If purchased, then price plus freight-in.
If manufactured, then DM, DL, Manf. Ovhd.
The relationship between COGS and sales is an important one.
= Gross Profit
Key analytical tool in analyzing firm’s operating performance.
Gross profit percentage equals
Gross profit/Sales

8. Income Statement (continued)
Gross Profit
Less: Operating Expenses
Selling Expenses:
Advertising expenses
Salesmen’ salaries
General and Administrative Expenses:
Office and officer salaries Payroll taxes
Depreciation expense Repairs & maint.
Insurance expense Rent expense
Lease expense Bad debt expense
Research and Development Supplies
= Operating Income (or Operating Profit or Income from Operations)
Measures overall performance of company’s operations
Operating Income Percentage=Operating Income/Sales

9. Income Statement (continued)
Operating Income
+/- Other Income/Expense
Interest income
Gain from sale of equipment
Gain from sale of investments
Interest expense
Loss from sale of equipment
Loss from sale of investments
Loss from write-down of inventory
Earnings before income taxes
Less: Income taxes
Net Earnings or Net Income
(or Income from Continuing Operations)
FOR SALE

10. Income Statement (continued)
Income from Continuing Operations
+/- Income from Discontinued Operations (net of tax)
+/- Extraordinary Gains and Losses (net of tax)
+/- Cumulative Effect of a Change in Accounting Principle (net of tax)
Net Earnings or Net Income
Net Earnings Percentage =Net Earnings/Sales

11. Income from Discontinued Operations
A significant segment of a business that has been discontinued.
A segment is a unit that is clearly distinguishable physically, operationally, and for financial reporting purposes.
It represents either a separate,
(1) major line of business, or
(2) line of customers.
Income from discontinued operations is segregated from income from continuing operations to assist financial statement users in assessing future cash flows of the company.

12. Income from Discontinued Operations
Income (loss) from operations of discontinued operations (from 1/1 to measurement date)
Less: Income tax
Gain (loss) from sale of discontinued operations
(a)Income (loss) from operations (after measurement date)
(b)Gain (loss) on disposition of segment of assets
Net Income from Discontinued Operations

13. Extraordinary Gains and Losses
gains and losses that are both unusual in nature and infrequent in occurrence.
gains and losses from most natural disasters (unless frequent occurrences, then “other income/losses)
gains and losses on extinguishment of a company’s own debt (even if frequent).
does not include losses from strikes (even if infrequent).

14. Cumulative Effect of a Change in Accounting Principle
Accounting principle changes may be required by FASB or may be made at management’s discretion.
The cumulative effect—the difference between the revenue/expense under the old and the revenue/expense under the new method up to the beginning of the year of the change. It is reported net of the tax effect.
Use the new method for the current year.

15. Cumulative Effect of a Change in Accounting Principle
The cumulative effect may be reflected either of two ways:
(1) Ordinarily, in the income statement as “Cumulative Effect of Change in Accounting Principle”
(2) In special cases, in the opening balance of retained earnings, with restatement of prior-years’ statements presented on a comparative basis (on Stmt. of RE)
(a)changing from LIFO to FIFO
(b)changing from one type of long-term contracting principle to another
(c) changing from an unacceptable accounting principle to a GAAP (correction of an error)

16. No “cumulative effect” of the change
Changes in estimates
Estimates are made using the BEST available information at the statement date.
Changes in estimates should be reflected in the current period (date of the revision) and in future periods, if any, that are affected.
No “cumulative effect” of the change

17. Earnings per share (EPS)
Earnings available to common shareholders divided by average number of common shares outstanding
If firm has “complex” capital structure, it will report basic and diluted EPS
EPS ( both basic EPS and diluted EPS) must be shown for each of the following (see Exhibit 3-4):
Income from continuing operations
Discontinued segment income/loss
Extraordinary income/loss
Cumulative effect of change of accounting principle
Net Income

18. Earnings per share
Basic Earnings per share =
Net Income
number of average shares of common stock outstanding
Diluted Earnings per share =
number of average shares of common stock o/s plus number of dilutable shares
(dilutable shares are shares from future conversion of convertible bonds and shares from future exercise of stock options)

19. Comprehensive Income
Beginning in 1998, companies required to report COMPREHENSIVE INCOME
Comprehensive income includes ALL changes in stockholders’equity during a period except those resulting from investments by owners and distributions to owners
Does not include:
Dividends to stockholders
Issuance of stock
Treasury stock transactions

20. Net Income (from Income Statement)
Comprehensive Income
Net Income (from Income Statement)
+/- Foreign currency translation adjustments
+/- Unrealized gains/losses on available-for-sale securities
+/- Additional pension liabilities
+/- Changes in fair market value of cash flow hedges
= Comprehensive Income/Loss

21. Comprehensive Income may be reported in one of three ways:
on the face of the income statement
in a separate statement of comprehensive income
in a statement of stockholders’ equity