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!