Chapter 13: Income Statement

2. Chapter 13:Income Statement

3. A measure of a change in value As compared to equity, which measures the level of value (or wealth) It is NOT net cash flow It is a measure of performance It is a link between two balance sheets What is Income (Profit)?

4. Sales Revenue less: Cost of Goods Sold less: Selling Expenses less: Administrative Expenses Operating Section 1 3 Income Tax 5 6 Net Income Earnings per Share The Multiple Step Income Statement Non-Operating Section 2 Add: Other Revenues and Gains Less: Other Expenses and Losses Discontinued Operations (net of tax) Extraordinary Items (net of tax) Irregular Items 4

5. Comprehensive income - changes in net assets from all non-owner sources; is broken into two categories: net income: consisting of revenues, expenses, gains and losses (next slide) other comprehensive income Campbell’s Soup 2006 statement of Shareholders’ Equity 1. Elements of the Income Statement

6. Revenues - increases in net assets for activities that constitute a company’s ongoing central operations. Expenses - decreases in net assets for activities that constitute a company’s ongoing central operations. Gains - increases in net assets for activities that constitute a company’s peripheral or incidental activities. Losses - decreases in net assets for activities that constitute a company’s peripheral or incidental activities. 1. Elements of the Income Statement

7. See Page 573 for sample format: Sales - COGS = Gross profit - Operating expenses = Income from operations + Other revenues and gains - Other expenses and losses = Income from continuing operations (IFCO) +/-Discontinued operations +/-Extraordinary items = Net income (Note: text also includes “Change in Accounting Principles” but the FASB eliminated this category in mid 2005.) 2. Format of the I/S

8. First, note the subtotals Gross profit is presented when a company uses a multi-step income statement; more relevant for companies that are primarily retail or manufacturing (less relevant for service industries). Income from operations indicates income from primary, on-going activity (usual and frequent). Income from continuing operations (IFCO) also includes peripheral activity like interest income, as well as potentially nonrecurring activity like restructuring charges (unusual or infrequent). Net income also includes “special” items that are presented separately because they are significant activities that are usually nonrecurring. 2. Format of the I/S

9. Now, more information on the “special” items below IFCO: discontinued operations extraordinary items Note that each of these items is presented “net of tax.” This is necessary because income tax expense has already been calculated on IFCO. Therefore, each level below IFCO must present the tax effect for that component. This is called “intraperiod” tax allocation - allocation of income tax expense to different parts of the income statement. 2. Format of the I/S

10. Discontinued operations (DO) relate to the disposal of a segment of a company. Because the disposal means that the segment activity will be discontinued, separate disclosures are required so that investors could distinguish between ongoing activity and nonrecurring activity. A segment is defined as an entire line of business or a separately identifiable segment. For example, General Motors would need to discontinue Chevrolet (not just a manufacturing plant). Financial statement presentation includes any operating income or loss to the measurement date (the date the board of directors declares intention to dispose of the segment), as well as any gain or loss on the disposal of the assets. 2. Format - Discontinued Operations

11. Extraordinary items are defined as those activities that are material in amount, unusual in nature, andinfrequent in occurrence. To determine, consider the natural, political, and economic environment of the firm. Examples of EI include natural disasters, nationalization or expropriation of assets by a foreign government, and one-time major economic transactions. If unusual or infrequent, but not both, report in “other gains/losses”, as part of IFCO. Examples include material write-down of receivables, and losses from an employee strike. 2. Format - Extraordinary Items

12. Consistency requires the use of the same accounting method from year to year. However, a company may choose to change to an alternative accounting method (ex: DDB to SL or FIFO to average). Also, a company may be required to change to a new accounting technique by the issue of a new accounting standard. The APB required companies to show the cumulative effect for prior years’ incomeon the current income statement in a special category called “change in accounting principle.” 2. I/S Format - Other Issues

13. This special category allowed investors to analyze IFCO for the current year separately from the effect of the cumulative change. Problem: This “cumulative” calculation was reported as part of current net income, even though it relates to prior years’ net income. Solution: In mid 2005, FASB eliminated this category from the income statement. Now all changes in principle receive either a retroactive restatement (like errors of a prior period) or a prospective treatment (like changes in estimate). 2. I/S Format - Other Issues

14. SFAS 128 simplified the presentation of earnings per share to two components: basic EPS diluted EPS Calculation of Basic EPS = Net Income - preferred dividends Weighted average common shares outstanding Concept: To indicate how much each common shareholder “owns” with respect to earnings. Preferred dividends are deducted - if declared or if cumulative - because they are “owed” to preferred shareholders. This is a calculation of “what is” - the numerator and denominator use actual shares outstanding and actual net income for the year. 3. Earnings Per Share (EPS)

15. Diluted earnings per share examines all the potentially dilutive securities that a company has issued, like convertible preferred stock, convertible bonds, and employee stock options. Although these securities have not been converted at year end, the calculation shows the effect that the shares could have on EPS. Calculation of Diluted EPS = Net Income + adjustment for dilutive shares Weighted avg. CS outstanding + adj for dilutive shares Concept: To indicate how much each common shareholder would “own” with respect to earnings IF all dilutive securities had been exercised at the beginning of the year. 3. Earnings Per Share (EPS)

16. Diluted EPS is a “what if” calculation - the numerator and denominator are adjusted for potential effects of dilutive securities as if the securities had been converted to common stock at the beginning of the current year: convertible PS: eliminate preferred dividend (would not exist if converted) increase shares outstanding (would be larger if converted) convertible bonds: eliminate interest expense (would not exist if converted) increase shares outstanding (would be larger if converted) stock options: Increase compensation expense increase shares outstanding (note that it is not a 1 for 1 conversion). If any of these potentially dilutive securities exist, the company is said to have a complex capital structure. 3. Earnings Per Share (EPS)

17. Class problem: Bush Company reported net income of $30,000 in 2007. The company had 60,000 shares of common stock outstanding for all of 2007. Bush also had 5,000 shares of convertible preferred stock outstanding for all of 2007. During 2007, the company declared a $4,000 cash dividend to preferred shareholders. Each share of preferred stock is convertible to 4 shares of common stock. 1.Calculate basic EPS: $30,000 - 4,000 = $0.43 per share 60,000 (Note that the convertibility component is ignored for basic EPS.) 3. Earnings Per Share (EPS)

18. 2. Calculate diluted EPS: $30,000 - 0 _ = $0.38 per share 60,000 + (5,000 x 4) Note that the convertibility component is assumed to have been exercised for diluted EPS. If the PS was converted to CS at the beginning of the year, there would have been NO preferred dividend, and there would have been 20,000 additional shares of common stock outstanding all year. The effects for convertible bonds and employee stock options are similar for diluted EPS. 3. Earnings Per Share (EPS)

19. Separate EPS disclosure for: Net income from continuing operations (after tax) Disposals of business segments Extraordinary items Calculation Separate dollar amount (from above categories) divided by number of common shares outstanding If diluted EPS exists, the company should also calculate diluted EPS for each level of presentation. If diluted EPS is antidilutive (the calculation is actually higher than basic EPS), the company does not have to present diluted EPS. 3. EPS Disclosure

20. The numerator can be manipulated by a number of earning management techniques. The denominator can be manipulated by stock buybacks (treasury stock). The “what-if” presentation of diluted EPS is a fictitious number - it can never actually happen. The potentially dilutive securities have not been converted at year end, and they can never have claims to the current year’s income. The only benefit of diluted EPS is that it can indicate the magnitude of the maximum potential dilution for the future. 3. Problems with EPS

21. Investors focus heavily on income and related indices like earnings per share and the P/E (price per share to earnings per share) ratio. Recent announcements (noting that the reported EPS was off the estimate by as little as a penny) have caused the market price of reporting companies to drop significantly. Because of investor focus, and because of compensation bonuses, managers continue to focus heavily on the bottom line, sometimes with dire effects. Expanded financial statement disclosure and increased awareness by investors may drive this earnings fixation. 4. Economic Consequences of Reporting Net Income