BSAD 221
Introductory Financial
Accounting
Donna Gunn, CA
Income Statement Elements
Revenues
Less: Operating Expenses
Subtotal: Operating Income
Non-operating Items
Subtotal: Earnings before income tax
Less: Income Tax Expenses
Total: Net Income
Income Statement Elements
Revenues
Revenues are transactions that result in an
increase in a company’s assets from the selling
of goods or services
Income Statement Elements
Less: Operating Expenses
Costs of good sold
The direct cost of the products sold to
customers
Other operating expenses
The usual expenses that make up business
operations, other than costs of goods sold
Income Statement Elements
Subtotal: Operating Income
Earnings from ongoing operations
Income Statement Elements
Non-operating items
Gains or losses that result from items outside of
normal operating activities
Income Statement Elements
Earnings before income taxes
Equal to revenues minus ALL expenses except
for income tax expenses
Income Statement Elements
Income tax expense
Income taxes for the year required for the
federal and provincial governments
Difference between revenues and expenses
times the tax rate
Income Statement Elements
Total: Net Income
Total of ALL revenues and expense for the period
Income Statement Elements
Results of continuing operations can be
presented in one of the two formats
Single step format:
Multiple step format:
Revenues
Sales
(All Operating Expenses)
(Cost of Goods Sold)
Operating income
Gross Margin
(Other Operating
Expenses)
Operating income
Single-Step Income
Statement
Presents only two groupings for operating income:
1. Revenues (includes gains)
2. Expenses (includes losses)
Advantages:
• Simplicity
• Eliminates classification problems for revenues/
expenses
Disadvantage:
• Operating and non-operating activities reported together
Multiple-Step Income
Statement
Operating and non-operating activities are separated
Advantages:
• Greater predictive value and feedback value
• Provides better detail to compare companies
• Allows for ratio analysis used to assess performance
Disadvantage:
• More work due to increased complexity
12
Other
Comprehensive Income
Largely other comprehensive income is a
separate section that reports unrealized gains
and losses not included on the income
statement.
13
Comprehensive Income
Statement
Example of a combined income and comprehensive I/S:
Sales
Cost of goods sold
Gross profit
Operating expenses
Net income
Other comprehensive income
Unrealized gain
800,000
600,000
200,000
90,000
110,000
Comprehensive income
140,000
30,000
Uses and Limitations of the
Income Statement
Uses:
• Evaluate past performance and profitability
• Assist in predicting future performance
• Assess potential risk or uncertainty in
achieving future cash flows
Uses and Limitations of the
Income Statement
Limitations:
• Items are excluded if they cannot be
measured reliably
• Amounts reported are affected by accounting
methods used
• Use of estimates in measuring income
Quality of Earnings
Nature of Content
• Free from bias
• Represents economic reality
• Reflects earnings from ongoing operations
• Can be correlated with cash flows from
operations
Presentation
• Does not disguise or mislead (transparent)
• Information presented is understandable
• Information is clear and concise
Evaluating the
Quality of Earnings
Research has shown that about half of all financial statement
fraud over the past two decades has involved improper
revenue recognition – such as:
1. Recognizing revenue before it is earned
2. Providing incentives for customers to buy more
inventory than needed
3. Reporting revenue when significant services/goods are
still to be delivered
4. Reporting sales to fictitious or nonexistent customers
Earnings per Share
Earnings per share (EPS) is considered one
of the most significant business indicators
Indicates dollars earned per common share; it
does not report the dollars paid (or to be paid)
per common share
Earnings per Share
Calculated as:
Net Income – Preferred Dividends
Weighted Average of Common Shares Outstanding
Value of a Company
Income from continuing operations can be
used in estimating the value of common
shares.
To do this we use a capitalization rate.
Earnings Valuation
of a Company
Assume an interest rate of 12%
to value Westmount.
Estimated value of Westmount’s common shares
=
Estimated annual income in the future
÷
Investment capitalization rate
=
$54,000 ÷ 0.12 = $450,000
Market Value
of a Company
Current market
Number of
value of the = common shares ×
company
outstanding
$513,000
=
12,500
×
Current
market price
per share
$41.04
Continuing Operations:
Investment Decision
The investment decision rule may take this form:
Estimated Value > Market Value
……
BUY
Estimated Value = Market Value
…….
HOLD
Estimated Value < Market Value
…….
SELL
Continuing Operations:
Investment Decision
In the case of Westmount…
Estimated Value = $450,000
Market Value = $513,000
Estimated Value < Market Value, therefore sell
Statement of
Shareholders Equity
Common Retained
Shares Earnings
Balance, Jan 1
Net income
$180,000 $136,000 $(4,000)
54,400
Cash dividends
Issuance of shares
Balance, Dec 31
Total
Shareholder's
AOCI
Equity
(21,000)
6,000
$186,000 $169,400 $(4,000)
$312,000
54,400
(21,000)
6,000
$351,400
Accounting for Corporate
Income Taxes
Suppose for 2011, Red Lake
Outfitters Ltd. has pretax
accounting income of $10
million on the income statement.
Taxable income is $9.2 million on
the company’s income tax return.
The tax rate is 30%.
Accounting for Corporate
Income Taxes
Dr. Income Tax Expense (1)
3M
Cr. Income Tax Payable (2)
Cr. Future Income Tax Liability (3)
Recorded income tax for the year
(1) $10M x 30%
(2) $9.2M x 30%
(3) $3M - $2.76M
2.76M
0.24M
Accounting for Corporate
Income Taxes
Income statement
Income before income tax
Income tax expense
Net income
Balance sheet
Current Liabilities:
Income tax payable
Long-term liabilities:
Future income tax liability
$10.00
(3.00)
$ 7.00
$2.76
0.24*
*Assumes beginning tax liability was zero.