UNDERSTANDING FINANCIAL

STATEMENTS

• INCOME STATEMENT
(Chapter 4)
 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.
 Income Statement

• 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.
 Income Statement

• Single-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
Gross Profit subtotals are reported.
Operating Income • Involves separate sections for gross profit,

Other Income/losses operating income, other income/losses, income

before income taxes, and net income.
 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
 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
 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
 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
 Income Statement (continued)

Operating Income
+/- Other Income/Expense
Interest income
Gain from sale of equipment FOR SALE
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)
 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
 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.
 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

Less: Income tax

Net Income from Discontinued
Operations
 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).
 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.
 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)
 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
 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
 Earnings per share

• Basic Earnings per share =

Net Income
number of average shares of common
stock outstanding

• Diluted Earnings per share =

Net Income
number of average shares of common stock outstanding plus
number of dilutable shares

(dilutable shares are shares from future conversion

of convertible bonds and shares from future
exercise of stock options)
 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
 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
 Comprehensive Income

• 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
 Retained Earnings
Retained earnings, an account on the balance
sheet, represents the undistributed earnings of
the corporation. A reconciliation of retained
earnings summarizes the changes in retained
earnings. It shows the retained earnings at the
beginning of the year, the net income for the year
as an addition, the dividends as a subtraction,
and concludes with end-of-year retained
earnings. It also includes, if appropriate, prior
period adjustments (net of tax) and some
adjustments for changes in accounting principles
(net of tax).
 Legality of Distributions
to Stockholders
1. Distributions to stockholders are acceptable as
long as the firm has the ability to pay debts as
they come due in the normal course of business.

2. Distributions to stockholders are acceptable as

long as the firm is solvent and the distributions
do not exceed the fair value of net assets.

3. Distributions consist of solvency and balance

sheet tests of liquidity and risk.