Income Statement

1. Income Statement Two most common formats: Single-Step Format Multiple-Step Format

2. classify all revenues then subtract all expenses to arrive at net income. Net Sales $1,000,000 Rental Revenue $525,000 Total Revs $1,525,000 Cost of Goods Sold $725,000 Selling Exps $115,000 Admin Exps $45,000 Income Tax Expense $35,000 Total Exps $920,000 Net Income $605,000 Income Statement Single-step format: Earnings Per Share (Common) $0.605* *assume 1,000,000 shares of common outstanding

3. Income Statement Multiple-step format • Compute Operating Income • Operating Revenue – Operating Expenses • Add other income and gains. • Subtract other expenses and losses to arrive at net income. Allows a better picture of whether operations provided sufficient net income, since income from operations is directly computed.

4. Sales (Operating Revenue) $2,000,000 Less COGS $1,150,000 Gross Margin $850,000 Less Operating Expenses $350,000 Less Administration Expenses $175,000 Operating Income $325,000 Operating Revenues – Operating Expenses Other Revenues – Other Expenses Other Revenues and Gains $55,000 Less Other Expenses $48,000 Net Income (before tax) $332,000 Multi-step Income Statement Less Income Tax (30%) $99,600 Net Income $232,400

5. Note: from this point forward, all additions and subtractions need to be made in after-tax dollars (i.e. net of tax). Income Statement Most common general format Sales minus COGS equals Gross Margin minus Selling Expenses minus Administrative and General Expenses equals Operating Income plus Other Revenues and Gains plus Unusual Gains minus Unusual Losses equals Net Income Before Taxes, Disc. Operations, & Extraord. Items minus Income Taxes equals Net Income Before Disc. Operations & Extraord. Items (net of tax) minus Discontinued Operations (net of tax) minus Extraordinary Items (net of tax) plus/min Cumulative Effect of Change in Accounting Principle (net of tax) equals Net Income Earnings Per Share

6. Income Statement Major income statement “highlights” • Called “highlighting” because each of the following • categories must be represented in its own line on the • income statement. • Discontinued Operations • Extraordinary Items • Unusual Gains and Losses • Changes in Accounting Principle • Changes in Estimates

7. These are considered normal operating disposals and are reported as operating gains and losses. Income Statement Discontinued Operations Gains or losses from disposalof a segment of a business are reported separately from the normal operating income of the parent. This is reported net of tax since it comes after taxes have been subtracted. Normal disposal of assets, partial segment disposal, phasing out a product line do not qualify for this treatment.

8. Income Statement Extraordinary Items Material, non-normal, non-recurring gains or losses. • Must meet two criteria: • Unusual in nature • Infrequent occurrence The following cannot be considered extraordinary: • Write down of receivables, inventory, intangible assets • Foreign currency exchange gains or losses • Effects of a labor strike • Adjustments of accruals on long-term contracts

9. Income Statement Extraordinary Items Material, non-normal, non-recurring gains or losses. • Must meet two criteria: • Unusual in nature • Infrequent occurrence The following might be considered extraordinary: • Major, unusual natural disasters • Terrorism (assuming it’s not frequent, like Israel) Report net of tax

10. Note that these are not discontinued operations, because they do not pertain to an entire business segment. Income Statement Unusual Gains and Losses Items that are considered unusual but generally occur frequently and therefore cannot be called extraordinary. The following might be considered unusual: • Restructuring charges • Layoffs • Plant Closings • Asset write-offs Report in before-tax dollars (since this is highlighted before taxes are deducted).

11. Income Statement Changes in Accounting Principle • If there is a change in GAAP • If the company changes its reporting choice for a particular • item (LIFO for FIFO, for example) the retroactive cumulative (all prior years) effect of the change is reported as a separate item. Reported net of tax.

12. Income Statement Changes in Accounting Principle Example: Inventory was purchased in 2000: 1/10 100 units @ $4.00 1/25 400 units @ $5.00 2/10 200 units @ $6.00 Inventory sold (and method chosen): Year 2000: 300 units (LIFO) Year 2001: 350 units (switch to FIFO) The switch to FIFO requires us to report 2001 income under FIFO and fix 2000 income as if it were reported under FIFO. This is done using a cumulative adjustment on the new year’s income statement (2001).

13. Income Statement Changes in Accounting Principle Purchases Sales 1/10/00 100 units @ $4.00 1/25/00 400 units @ $5.00 2/10/00 200 units @ $6.00 2000: 300 units (LIFO) 2001: 350 units (switch to FIFO) First, compute the 2000 adjustment for change in principle: COGS under old system (LIFO): COGS under new system (FIFO): 200 x $6.00 $1200 100 x $5.00 $500 Total $1700 100 x $4.00 $400 200 x $5.00 $1000 Total $1400 The difference is a $300 reduction in 2000 COGS If the tax rate is 30%, this results in a $210, net of tax, cumulative increase to income to be reported on the 2001 income statement.

14. now 200 are left here Income Statement Changes in Accounting Principle Purchases Sales 1/10/00 100 units @ $4.00 1/25/00 400 units @ $5.00 2/10/00 200 units @ $6.00 2000: 300 units (LIFO) (now FIFO) 2001: 350 units (switch to FIFO) Next, compute the 2001 COGS: 200 x $5.00 $1000 150 x $6.00 $900 Total $1900

15. Income Statement Changes in Accounting Principle This will be reflected in the 2001 (current year’s) income statement as follows: Sales $3,875 COGS $1,900 Gross Margin $1,975 Selling Exps $350 Admin Exps $200 Operating Income $1,425 Taxes Paid (30%) $427.50 Net Income bef. Cumulative effect of acctg change $997.50 Cumulative effect of accounting change (net of tax) $210 Net Income $1207.50

16. Income Statement Changes in Estimates • Covered in Chapter 23. • Not retroactively applied. • Examples: • Changes in bad debt allowance estimate • Changes in expected useful life for an asset

17. Net Income – Preferred Dividends Weighted Average # of Shares Outstanding Income Statement Earnings Per Share • Required to be reported in Income Statement • Must be reported for discontinued operations, • extraordinary items, and cumulative effect of • accounting changes (see example, bottom of • illustration 4-17 on pg. 148)

18. Revenues Expenses Dividends Income Statement Retained Earnings Retained Earnings

19. Income Statement Retained Earnings Alternatively, Revenues – Expenses = Net Income Retained Earnings Expenses Dividends

20. Income Statement Statement of Retained Earnings Reconciles activities in the Retained Earnings account

21. Income Statement Statement of Retained Earnings Reconciles activities in the Retained Earnings account Beginning Balance $1,000,000

22. Income Statement Statement of Retained Earnings Reconciles activities in the Retained Earnings account Beginning Balance $1,000,000 Correction for understatement of income error, prior year $100,000 Any prior year net income errors are adjusted directly to the Retained Earnings account.

23. Income Statement Statement of Retained Earnings Reconciles activities in the Retained Earnings account Beginning Balance $1,000,000 Correction for understatement of income error, prior year $100,000 Adjusted Beginning Balance $1,100,000 Add: Net Income $450,000 Less: Dividends Paid $350,000 Ending Balance $1,200,000