Understanding
Financial Statements
Seventh EDITION
Lyn M. Fraser
Aileen Ormiston
Insert
BOOK COVER
Income Statement and
Statement of Stockholders’ Equity
Learning about earnings, the bottom line,
Is very important most of the time.
A phony number
Just may encumber
Those folks trying to make more than a dime.
--A. Ormiston
Chapter 3
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The Income Statement
Also called the Statement of Earnings
Presents:
Revenues
Expenses
Net Income
Earnings Per Share
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The Income Statement
Continued
Comes in two basic formats
Multiple-step
Single-step
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The Income Statement
Continued
Multiple-step
Provides several intermediate profit
measures prior to the amount of
net earnings for the period:



Gross profit
Operating profit
Earnings before income tax
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The Income Statement
Continued
Single-step
Groups all items of revenue together,
then deducts all categories of
expense to arrive at a figure for net
income
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The Income Statement
Continued
Regardless of format, certain special
items, if they occur during an
accounting period, must be
disclosed separately on an income
statement
These include. . .
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The Income Statement



Continued
Discontinued operations
Extraordinary transactions
Cumulative effect of changes in
accounting principles
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Common-Size
Income Statement
Is a useful analytical tool
Expresses each income statement item as a
percentage of net sales
Shows the relative magnitude of various
expenses relative to sales, the profit
percentages, and the relative
importance of “other” revenues and
expenses
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Net Sales
Sales are generally reported net of sales
returns and sales allowances
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Net Sales
Continued
A sales return is a cancellation of a sale
A sales allowance is a deduction from
the original sales invoice price
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Net Sales—Related Issue
Are sales growing in “real” (inflationadjusted) as well as “nominal”
(as reported terms?)
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Net Sales—Related Issue
Continued
An adjustment of the reported sales
figure with the Consumer Price
Index (or some other measure of
general inflation) will enable the
analyst to make a comparison of
the changes
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Cost of Goods Sold (COGS)




Cost to seller of products sold to
customers
AKA “Cost of Sales”
Important for profit determination
Is largest expense item for may firms
Cost of goods sold
Net sales
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Gross Profit



First step of profit measurement
Difference between net sales and COGS
Key analytical tool in assessing a firm’s
operating performance
Gross Profit
Net sales
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Operating Expense
Have considerable impact on the firm’s
current and future profitability
Important to track carefully--trends,
absolute amounts, relationship to
sales, relationship to industry
competitors
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Operating Expense
Continued
Examples:
Selling and administrative
Advertising
Depreciation and amortization
Repairs and maintenance
Operating lease payments
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Understand the Math!
If COGS percentage increases or
decreases, this does not necessarily
mean that costs have increased or
decreased
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Understand the Math!
Continued
The change in the percentage may be
caused by decreases or increases in
the selling price
For example. . .
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Understand the Math!
Continued
Year 1
Year 2
Sales
$10
100%
$8
100%
COGS
4
40%
4
50%
Gross Profit $ 6
60%
$4
50%
Always pay attention to the numbers—know the
difference between raw dollars and percentages!
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Depreciation and Amortization
Depreciation
Used to allocate the cost of tangible fixed
assets such as:
Buildings
Machinery
Equipment
Furniture
Motor Vehicles
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Depreciation and Amortization
Con’t.
Amortization is the process applied to:
Capital leases
Leasehold improvements
Cost of expiration of intangible assets
Patents
Copyrights
Trademarks
Licenses
Franchises
Goodwill
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Depreciation and Amortization
Con’t.
The amount of expense recognized in
any accounting period will depend
on the level of investment in the
relevant asset; estimates with
regard to the asset’s service life and
residual value; and for depreciation,
the method used
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Operating Profit
Also called EBIT—Earnings Before
Interest and Taxes
Measures overall performance of
company’s operations: sales
revenue less expenses associated
with generating sales
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Operating Profit Margin
Operating profit
Net sales
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Other Income (Expense)
Includes
Revenues/expenses other than from operations
Dividend and interest income
Interest expense
Investment gains/losses
Equity earnings/losses
Sales of fixed assets gains/losses
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Equity Earnings
Two methods may be used to account
for investments in other companies
Equity
Cost
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Equity Method
Allows the investor proportionate
recognition of the investee’s net
income, irrespective of the payment
or nonpayment of cash dividends
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Cost Method
The investor recognizes investment
income only to the extent of any
cash dividends received
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Cost vs. Equity
Analysts, however, should be aware of
whether a company uses the cost or
the equity method
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Cost vs. Equity
Continued
Equity earnings distorts earnings in the
sense that income is recognized
even though no cash may ever be
received
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Earnings Before Income Taxes
Profit recognized before deduction of
income tax expense
Remember, income taxes paid may differ
from income tax expense (deferred
taxes)
Income taxes
Earnings before income taxes
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Special Items
Are often one-time items that will not
recur in the future
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Special Items
Continued
If companies are affected by the following
three items, they must be disclosed
separately on the income statement, net
of income tax effects:
Discontinued operations
Extraordinary items
Cumulative effect of accounting changes
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Discontinued Operations
Occur when a firms sells a major portion
of its business
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Extraordinary Gains and Losses
Are items that meet two criteria:
1. Unusual in nature
2. Not expected to recur in the
foreseeable future, considering the
firm’s operating environment
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Cumulative Effect
of Accounting Changes
Is disclosed when a firm changes an
accounting policy
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Net Earnings
Also called the “bottom line”
Represents the firm’s profit after
consideration of ALL revenue and
expenses
Net earnings
Net sales
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Earnings Per Common Share
Is the net earnings available to common
stockholders for the period divided
by the average number of common
stock shares outstanding
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Earnings Per Common Share
Con’t.
If firm has “complex” capital structure, it
will report basic and diluted EPS
Extensively used by analysts in
evaluating a firm
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Comprehensive Income
Is the change in equity of a company
during a period from transactions,
other events, and circumstances
relating to nonowner sources
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Comprehensive Income
Con’t.
Companies are required to report total
comprehensive income in one of
three ways:
1. On the face of its income statement
2. In a separate statement of
3.
comprehensive income
In its statement of stockholders’ equity
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Comprehensive Income
Con’t.
Currently, there are four items that may
comprise a company’s other
comprehensive income:
1.
2.
3.
4.
Foreign currency translation effects
Unrealized gains
Unrealized losses
Additional pension liabilities
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The Statement
of Stockholders’ Equity
Details transactions that affected the
balance sheet equity accounts
during an accounting period
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The Statement
of Stockholders’ Equity
In a nutshell, it simply explains how
each account got from the balance
at the beginning of the period to
the balance at the end of the period
and describes “events” that caused
the balances to change
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The Journey
Through the Maze Continues
Ch. 4:
Ch. 5:
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Statement of Cash Flows
The Analysis of Financial
Statements
3-46