Chapter 2: Introduction to Income Statements Chapter 2 · Chapter 2: Introduction to Income Statements ... statement formats that include all ... While income relates to changes in

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© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson

Chapter 2: Introduction to Income Statements

Chapter 2IntroduCtIon to InCome StatementS

TABLE OF CONTENTS

Introduction 3

Comprehensive Income 4

What Do I See? 5

Revenues 7

Expenses 8

Gains, Losses, and Other Income 10

Common Income Statement Formats 11

What’s Behind the Numbers? 13

Revenue Recognition 13

Expense Recognition 16

Expense Recognition Motivated by Matching 17

Expense Recognition Motivated by Conservatism 19

Expense Recognition Motivated By Lower of Cost or Market 20

Exercise 2.01 22

Exercise 2.02 23

ABC Company Example 25

The Accounting Cycle 52

Exercise 2.03 55

How Do I Use the Numbers? 61

Exercise 2.04 65

Exercise 2.05 68

Key Take-Aways 69

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Navigating Accounting®

Figure 2.01 Intel’s Income Statement 71

Figure 2.02 Cisco’s Income Statement 72

Figure 2.03 Gap’s Income Statement 73

Figure 2.04 Starbucks’ Income Statement 74

Figure 2.05 Nike’s Income Statement 75

Figure 2.06 Coca Cola’s Income Statement 76

Figure 2.07 Federal Express’ Income Statement 77

Figure 2.08 Dupont Model Computations 78

Figure 2.09 Intel’s and AMD’s Common Size Income Statements 80

Figure 2.10 Gap’s and Limited’s Common Size Income Statements 81

Figure 2.11 Starbucks’ Excerpt from Accounting Policies Footnote 82

Chapter Solutions 83

Solution to Exercise 2.01 83




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INTRODUCTIONThis chapter is all about measuring performance and, in particular, about income-statement measures. Income measures, which along with measures from other sources, are used to assess companies’ overall financial performance.

You and others have likely been measuring your performance since you were a child in various dimensions of your life including school, sports, work, and social interactions. So you already know performance is measured relative to goals such as mastering techniques, winning contests, setting records, meeting learning objectives, or graduating. You also know performance generally is measured over intervals of varying lengths: during games by keeping score; during the regular season by win-loss records; at the end of the season by final standings; and over a team’s history by its life-time achievements.

For the for-profit companies we will be studying, management’s over arching goal is to maximize the returns owners earn during the periods they hold ownership claims. Comprehensive income, albeit imperfectly measured, reflects the company’s performance and sets expectations about future performance.

To interpret income numbers when assessing past performance and predicting future performance, investors and other outsiders need to know as much as possible about the measures that produced them. The depth of these analyses will be limited by their conceptual understanding of the business and accounting issues behind the numbers (including related entries), the availability of related information, and their ability to locate and analyze this information.

We will first introduce the concept of comprehensive income. It is widely reported and discussed in annual reports so we want to be sure you know what it represents.

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Net income is the famous “bottom line” on income statements discussed frequently in the press. If you hear someone mention income without specifying the type of income they are referring to, you can be pretty confident that they are referring to net income.

Other comprehensive income is comprehensive income standard setters decided not to include in net income. Standard setters have not specified formal criteria for when items should be included in other comprehensive income, but thus far they have restricted inclusion to period changes in the values of assets and liabilities satisfying three conditions: (1) the changes are due to economic factors not controlled or influenced by the company, such as interest rates and stock prices; (2) the company can inadvertently profit from these valuation changes when carrying out its primary business activities, but it can not be in the business of intentionally profiting from them; and (3) the assets and liabilities are still on the balance sheet at the end of the period.

For example, suppose ABC Company, a retail car dealer, purchased $100,000 of IBM stock at the beginning of 2007, intending to sell the stock at a future date if it needed cash. Additionally, suppose ABC had not sold the stock by the end of 2007 and its fair value — the amount it could be sold for — had increased to $110,000. Because the stock had not been sold, the $10,000 gain is unrealized and it is recognized in 2007 other comprehensive income. By contrast, if ABC had sold the stock in 2007, a $10,000 realized gain would have been recognized in net income.

As fair values increasingly gain acceptance, there is a good chance items currently included in other comprehensive income will move to net income. In fact, the U.S. standard setters are considering new income statement formats that include all comprehensive income on the income statement.

COMPREHENSIVE INCOMEComprehensive income is the broadest type of income. As illustrated below, it is net income plus other comprehensive income:

Comprehensive Income Equation

= +Net Income Other Comprehensive Income

ComprehensiveIncome

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WHAT DO I SEE?What you see on the income statement aligns with its purpose. The purpose of an income statement is to help financial statement users assess a company’s financial performance during a reporting period by providing details about the net income recognized during the period.

In contrast to balance sheets, which measure a company’s assets and equities at a point in time, income statements measure performance over an interval of time. In this regard, we say that balance sheets report stocks at a point in time and income statements report interval flows.

Users of income statements often make decisions that require them to evaluate a company’s past performance or predict its future performance. For example, when estimating the value of a company, financial analysts and investors often use valuation models that are based on predictions of future income or future cash flows.

To measure performance requires a performance objective. Navigating Accounting focuses exclusively on for-profit corporations: Management seeks first and foremost to maximize shareholder value and they perform for owners to the extent they meet this challenge. From the balance-sheet equation, we see that to maximize the value of the owners’ claims, management must maximize the value of the company’s net assets:

=OE

Owners' Equity

Maximizethe value of

owners'equity

Management's Goal

-A

Assets

LLiabilities

By maximizing the value of

thenet assets

NANet Assets

The balance-sheet equation expresses the performance goal at each point in time. Income is related to changes in owners’ equity during a reporting period, and thus changes in net assets (as illustrated on the next page):

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=

∆OEChange in Owners' Equity

Period Changes in Balance Sheet

-

∆AChange

in Assets

∆LChange

in Liabilities

∆NAChange in Net Assets

The ∆ (delta) symbol indicates a change in a variable. Thus, ∆NA represents the change in net assets during the reporting period.

While income relates to changes in owners’ equity, not all changes in owners’ equity pertain to income. Two broad categories of events and circumstances that occur during the reporting period change owners’ equity: (1) transactions with owners that change net assets and thus owners’ equity but do not affect income; and (2) other events and circumstances that change net assets, which constitutes comprehensive income (net income plus other comprehensive income):

Measuring Period Performance

=-

∆AChange

in Assets

∆LChange

in Liabilities



Other events or cirumstances during the period that changed

the value of net assets

Comprehensive Income

Transactions with owners during the period that changed

the value of the net assets

DividendsStock

RepurchasesStockIssues

OtherComprehensive

Income

NetIncome

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Net income can be further broken down into its primary elements: revenues, expenses, gains, losses, and other income. Since net income measures performance during a reporting period, income statements report this performance and are largely structured by the following income-statement equation:

Income-Statement Equation= + Other incomeLosses-Gains+Expenses-RevenuesNet income

Combining the above equation with the earlier one demonstrates how the primary elements in net income relate to changes in net assets. Indeed, the definitions of these elements are expressed in terms of changes in net assets:


=-

∆AChange

in Assets

∆LChange

in Liabilities








DividendsStock


OtherComprehensive

Income

NetIncome

Revenues - Expenses + Gains - Losses + Other Income

revenueSRevenues are changes in owners’ equity that arise from increases in net assets during a reporting period associated with delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing or central operations. Generally revenues pertain to inflows from customer sales. Notice from the above figure that increasing revenues, increases net income, which increases owners’ equity and thus net assets.

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But, not all increases in net assets give rise to revenues, only those associated with activities that constitute the entity’s ongoing or central operations.

Revenues are usually recognized when goods or services are exchanged for cash or claims to cash (accounts receivable). For example, when Gap sells clothes to a customer for $60 cash, it recognizes $60 of revenue and $60 of cash. The balance sheet balances: (1) net assets increase by $60 because cash increases by $60; and (2) owners’ equity increases by $60 because revenues increase by $60.

The example illustrates the definition of revenues: The increase in cash gave rise to an increase in net assets associated with customers, that gave rise to revenues.

Companies do not always recognize revenues when they receive cash from customers or bill customers. We have seen that when Intel delivers products to distributors and is concerned that the products will be returned or that the price will eventually be discounted, Intel defers recognizing revenues until the distributor sells the goods to its customers.

For example, if Intel sells microprocessors to distributors in these situations for $10 on account, it recognizes a $10 increase in both accounts receivable (an asset) and deferred income to distributors (a liability). Net assets do not increase because the $10 increase in the asset is offset by the $10 increase in the liability.

The example illustrates that events can be associated with customers and affect assets and/or liabilities without affecting net assets and thus not affecting revenues.

Intel recognizes revenues in these situations when distributors sell the products to their customers. At that time, Intel decreases deferred income to distributors by $10 and increases revenues by $10.

To summarize, the Gap and Intel examples illustrates two ways that increases in net assets associated with customers can give rise to revenues: (1) In the Gap example, an increase in cash (an asset) gave rise to an increase in net assets, that gave rise to revenues; (2) In the Intel example, a decrease in deferred income to distributors (a liability) gave rise to an increase in net assets, that gave rise to revenues.

Revenues are increases in net assets that arise from events and circumstances related to customer sales. They are recognized when either an asset is increased without an offsetting increase in a liability or a liability is decreased without an offsetting decrease in an asset.

expenSeS

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Expenses are changes in owners’ equity that arise from decreases in net assets during a reporting period associated with inventing, developing, producing, and delivering goods and services, or performing other activities central to the company’s operations.

As indicated in the earlier performance measurement illustration (reproduced below for convenience), increasing expenses, decreases net income, which decreases owners’ equity and thus decreases net assets. But, not all decreases in net assets give rise to expenses, only those associated with performing activities central to the company’s operations.

For example, when Gap pays its sales person $2, it recognizes a $2


=-

∆AChange

in Assets

∆LChange

in Liabilities








DividendsStock


OtherComprehensive

Income

NetIncome

Revenues - Expenses + Gains - Losses + Other Income

expense and decreases cash by $2. The balance sheet balances: (1) net assets decrease by $2 because cash decreases by $2; and (2) owners’ equity decreases by $2 because expenses increase by $2.

The example illustrates the definition of expenses: The decrease in cash gave rise to a decrease in net assets associated with activities central to the company’s operations, that gave rise to an expense.

Notice from the above figure that by increasing revenues and/or decreasing expenses, management increases owners’ equity and thus improves performance. This is accomplished by increasing net assets through transactions with customers and/or by controlling costs that

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otherwise would decrease net assets associated with inventing, developing, producing, and delivering good and services, or performing other activities central to the company’s operations.

GaInS, LoSSeS, and other InComeGains, losses, and other income are not as prominent on income statements as revenues and expenses. Companies often recognize these items without disclosing them by aggregating them with other line items.

Gains are changes in owners’ equity that arise from increases in net assets during a reporting period associated with events and circumstances peripheral to a company’s primary business activities, are outside the company’s control, and largely unpredictable when the assets or liabilities are originally recognized. For example, selling the corporate headquarters for more than its book value gives rise to a gain. The sale is peripheral to the company’s business and the company had very little control over the market value of the building and could not predict the gain when the building was acquired.

An example will demonstrate how gains are computed. If GHI purchased a building for $10 (million) in 1995 and sold it in 2008 for $5 cash when its book value was $2 (net of depreciation), GHI would recognize a $3 gain in 2008 ($5 cash proceeds less the $2 book value). Recognizing the gain increased net assets by $3. Assets increased by $3 because $2 of property, plant, and equipment (the building) was replaced with $5 of cash. Owners’ equity increased by $3 because a $3 gain was recognized in net income.

Gains are similar to revenues in that they arise from increases in net assets, but revenues arise from events and circumstances related to customer sales and gains arise from events and circumstances peripheral to companies’ primary business activities and are largely unpredictable and outside the company’s control.

Losses are changes in owners’ equity that arise from decreases in net assets during a reporting period associated with events and circumstances peripheral to a company’s primary business activities, are outside the company’s control, and largely unpredictable when the assets or liabilities are originally recognized. For the above example, if the proceeds from the sale were less than the book value of the building prior to the sale, the difference would be a loss.

Losses are similar to expenses in that they arise from decreases in net assets, but expenses arise from performing activities central to the companies’ operations

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Common Income Statement FormatPeriod 1 Period 2

Net revenues

Period 3

Cost of sales

Operating expenses

Gross margin

Operating income

Interest expense

Gains & Losses

Other income

Income before income taxes

Provision for income taxes

Net Income

and losses arise from events and circumstances peripheral to companies’ primary business activities and are largely unpredictable and outside the company’s control.

Other income is changes in owners’ equity that arises from increases in net assets during a reporting period that are not associated with revenues or gains, but rather from such activities as dividends received from investments in other companies’ stocks or interest received from investments in government bonds. In contrast to gains and losses, other income is somewhat predictable.

Common InCome Statement FormatSFrom the income-statement equation, you might incorrectly assume that income-statement line items are grouped into five categories corresponding to the elements in the equation and presented in the order they appear in the equation (revenues, expenses, gains, losses, and other income). This is not true.

Instead, income statements are divided into sections such as operating and non-operating income, and the primary elements in the equation can belong to more than one section. For example, there are expenses in both the operating and non-operating sections of Intel’s income statements.

Income statements are arranged hierarchically and, although the actual structures and line items differ, they are generally formatted as follows:

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As indicated in the figure at the bottom of the previous page, companies generally report three income statements at once. One presents income line items for the current period and the others for the two prior periods. These statements show how income has changed during the three years.

The highlighted items are subtotals that are frequently analyzed by financial analysts and other users of income statements. An example will help you understand these items and, more generally, income statement structures. ABC Company’s income statement at the bottom of the page illustrates three levels of organization that are shared by many income statements:

1 At the big-picture level, we see that ABC’s income statement reports $60 of net income that is determined by subtracting $20 of tax expense from $80 of income before taxes. Note: numbers in parenthesis are interpreted as negative numbers in financial statements. The statement has a large section that explains how income before taxes is determined (as indicated at the far left).

2 At the second level of organization, income before taxes is split into two sections that explain how operating and non-operating income are derived. Operating income, also called operating profit, is income from ongoing operations. ABC recognizes $70 of operating income. Non-operating income includes expenses, gains, losses and other income that do not pertain to operations. ABC recognizes $10 of non-operating income. Like most companies, ABC reports a subtotal for operating income but does not report one for non-operating income. The $10 of non-operating income can be derived by summing the line items in this section or subtracting the $70 of operating income from the $80 of income before taxes.

3 The third level of organization is the individual line items within the operating and non-operating sections. Line items in the ABC example such as cost of sales, gross margin, and interest expense will be explained when we do the tour of Intel’s income statement.

Income before taxes

Operating Income

Non-operating Income

ABC’s Income Statement, 2007Net revenues $150Cost of sales ($60)Gross margin $90Operating expenses ($20)Operating income $70Interest expense ($5)Gains and losses, net $10Other income $5Income before income taxes $80Income tax expense ($20)Net income $60

Drill DeeperTo learn more see the reference document: Line-by-Line Tour: Intel’s Financial Statements on the Navigating Accounting CD.

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WHAT’S BEHIND THE NUMBERS?revenue reCoGnItIonRevenue recognition decisions determine whether and when revenues are recognized on income statements. Similar to asset and liability recognition decisions for balance sheets, revenue recognition must meet definitional and measurability criteria.

We have already defined revenues and thus established the definitional criteria: revenues are changes in owners’ equity that arise from increases in net assets during a reporting period associated with customer sales.

Most of the controversial issues related to revenue recognition center on determining when during the life of a sales agreement revenues can be measured reliably enough to be recognized. Equivalently, when do events and circumstances occur that indicate an increase in net assets associated with customer sales can be measured reliably?

Depending on the complexity of a company’s interactions with its customers, the duration of sales agreements can extend from a few minutes to several years. Generally, they are defined by the following events that can occur in various sequences:

• Customer orders• Production periods• Deliveries• Billings• Collections• Service and warranty periods• Product returns periods• Price-protection discount periods

At a fast-food restaurant such as McDonalds, most of these events occur within 30 minutes and thus the timing of revenue recognition is straightforward. By contrast, it can take Boeing several years to produce an airplane from the time it is ordered and determining how much revenue should be recognized at various times during these sales agreements can take considerable judgment.

Events or circumstances in the life of a sales agreement can meet the definitional criteria for revenue recognition but not be recognized because they fail to meet measurability criteria: even when there is broad agreement that events and circumstances increase the fair value of a company’s net assets, GAAP often presumes that this increase can not be measured reliably enough to merit revenue recognition.

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For example, the fair value of owners’ equity and thus net assets can increase significantly when a start-up company gets an order from a significant customer before it has fully developed its products. Indeed, venture capitalists are generally more willing to contribute cash at favorable terms when start-ups have received orders.

Importantly, the fair value of the owners’ equity (and thus the fair value of the net assets) can increase when orders are received even if there is still significant concern that the start-up might not be capable of fulfilling the orders. The more risk there is about fulfillment, the smaller the increase in owners’ equity. Intuitively, everything else equal, venture capitalists will value a stock higher as it becomes less risky. The fair value of owners’ equity will continue to increase as the start up reduces uncertainty by reaching milestones to fulfill the order.

Some key lessons have emerged:

• Regardless of when revenues are recognized on income statements, in an economic sense they can be earned or lost throughout the lives of sales agreements, depending on how well the company performs.

• Revenue recognition increases the book value of owners’ equity. These increases can and generally do differ from increases in the fair value of owners’ equity associated with sales agreements

• When assessing changes in the fair value of owners’ equity, among other sources of information, venture capitalists and others use revenues recognized in recent income statements and other sales-agreement information that has not yet been recognized in revenues, such as unfulfilled orders.

• Because revenues are defined as increases in net assets related to customer sales agreements, revenue recognition is inextricably tied to asset and liability recognition. This means that many problems associated with recognizing and measuring assets and liabilities also affect revenue recognition.

GAAP provides four revenue recognition criteria to help companies determine the appropriate time to recognize revenues. Revenue can be recognized when: (1) there is persuasive evidence of a sales arrangement, (2) delivery has occurred or service has been rendered (which also means the buyer has accepted delivery), (3) the seller’s price to the buyer is fixed or determinable, and (4) collectibility is reasonably assured. Deciding when these criteria are met is equivalent to deciding when the corresponding increase in net assets can be measured reliably.

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When the first three criteria have been met, we say revenue has been earned, meaning a company has substantially accomplished what it must do under the sales agreement to be entitled to the benefits associated with the revenues (the company has met its obligations). When the fourth criteria — reasonable assurance of collectibility — has been met, we say revenue has been realized or is realizable. Revenues have been realized when cash is collected from customers. Revenues are realizable when other assets received from customers can readily be converted to cash or when the company can reliably estimate future realizations (e.g. collections on accounts receivable.)

Importantly, a company can collect cash from a customer — meet the collectibility criteria — but still not have earned the revenue because it failed to meet one or more of the first three criteria. In this situation, the company recognizes a liability that represents its remaining obligation to earn the revenues. The asset and liability offset each other and thus there is no increase in net assets. This happens when Intel defers revenue recognition on shipments to select distributors. Intel recognizes an asset (accounts receivable) and a liability (deferred revenues) when the goods are shipped. The liability signifies that Intel has not yet earned the benefits associated with accounts receivable.

Revenue recognition can be very problematic when there is significant risk that customers will return products for refunds, receive price-protection discounts, file warranty claims, or default on promised payments. It can also be problematic when products, product updates, and services are bundled together for one price and deliveries of these goods and services are spread over several reporting periods.

Many financial reporting scandals have centered on revenue recognition and it has been a hot issue at the Securities and Exchange Commission (SEC) for several years. For example, in 2002, the SEC pressured Xerox to reverse over $6 billion of previously recognized revenues. In doing so, the SEC accused Xerox of dramatically overstating its net income and thus owners’ equity and net assets during prior years. Similarly, following an SEC investigation in 2001, Lucent reversed $700 million of previously recognized revenues.

Restatements such as these have caused large declines in stock prices and thus in the fair value of owners’ equity. For example, Lucent’s share price declined 10% on the day it announced the $700 million revenue restatement. Companies usually pay a hefty penalty when they lose credibility with debt and equity markets.

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More generally, the financial reporting scandals in 2002 centered on extremely aggressive accounting. Accounting decisions and policies are considered aggressive to the extent they accelerate income recognition beyond what is warranted by the facts and circumstances by postponing expense recognition or accelerating revenue recognition. By contrast, they are considered conservative to the extent they postpone income recognition beyond what is warranted by accelerating expense recognition or postponing revenue recognition.

The conservative principle significantly affects GAAP. It states that when in doubt as to whether income should be recognized sooner or later, recognize it later, and when in doubt as to whether a smaller or larger amount of income should be recognized, recognize the smaller amount.

While the SEC has primarily been concerned with extremely aggressive accounting, it has also taken actions to curb overly conservative accounting. For example, in 2002, the SEC announced that Microsoft agreed to stop using an accounting practice that allegedly understated revenue and misled investors.

expenSe reCoGnItIonExpense recognition decisions determine when costs are recognized as expenses on income statements. An expensed cost is one that has been recognized on the income statement as an expense.

Like revenue recognition, expense recognition is inextricably tied to asset and liability recognition because expenses are defined as decreases in net assets associated with activities that are central to companies’ operations. Expense recognition is also tied to revenue recognition: the costs of resources that help generate revenues are often recognized as expenses.

Expense recognition is motivated by three principles:

1. The matching principle is the dominant principal for recognizing expenses. It states that the costs of resources that were used to generate revenues and other costs associated with revenues should be recognized as expenses in the same period the revenues are recognized.

The matching principle implies that expense recognition is often subordinate to revenue recognition. That is, companies first decide when to recognize revenues and then match expenses. This sequence is important to keep in mind when analyzing financial statements: studying revenue recognition policies first will help you interpret and assess companies’ expense recognition policies.

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2. The conservative principle governs expense recognition when matching is problematic. In this regard, it maintains that when the future benefits (including revenues) associated with a cost can not be measured reliably because of uncertainty regarding the amounts or timing of the future benefits, and thus concerns about how reliably the cost can be matched to the benefits, the cost should be recognized as a an expense when incurred. Expenses that are recognized when incurred are called period expenses.

3. The lower of cost or market principle states that expenses should be recognized at the end of reporting periods when necessary to ensure a company’s net assets are stated at the lower of cost or market value. When market values are not available, other reliable fair value estimates can be used. These expenses are called impairments or valuation adjustments.

With regard to assets, the lower of cost or market principle maintains that when the fair values of assets are reliably less than their book values, expenses should be recognized to write them down to their fair values. With regard to liabilities, it maintains that when the fair values of liabilities reliably exceed their book values, expenses should be recognized to write them up to their fair values. A special case is when no liability has previously been recognized, but new information suggests that one has been incurred and its fair value can be estimated reliably.

Like revenue recognition, expense recognition can be very problematic and controversial. The remainder of this section provides additional concepts and examples that will help you begin to understand when expenses are recognized and how they affect net assets.

Expense Recognition Motivated by MatchingExpenses are recognized when incurred costs or expected future costs can be matched reliably to current-period revenues. Matched reliably means that those who determine GAAP are reasonably confident that the events or circumstances that gave rise to the costs helped generate revenues or were otherwise related to them, or that GAAP permits company’s to make this judgment.

For example, if ABC Company purchases inventories for $7 cash in 2007 and sells it to customers for $15 in 2008, ABC recognizes $15 of revenues in 2008 and $7 of matched expense in 2008. The $7 expense is the cost of the sold inventories. Here we can be very confident of the matching: the event that gave rise to the $7 cost — purchasing the inventories in 2007— definitely helped generate the 2008 revenues. Without the inventories, there would not have been a sale.

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To extend the example and further demonstrate the matching principle, suppose that a sales person at ABC earned a $1 commission on the 2008 sale but that ABC did not pay her the commission until 2009. Because she earned the commission when the sale was made, ABC would match the cost of her services directly to the $15 of revenues it recognized in 2008.

Again, here we can be very confident that the event that gave rise to the $1 cost— the employee earned unpaid compensation— definitely helped generate the $15 of revenues. Accordingly, in 2008 ABC increases expenses by $1 and decreases net assets by $1. The $1 decrease in net assets is accomplished by recognizing a $1 accrued compensation liability (or wages payable). Thus, owners’ equity decreases by $1 because an expense is recognized and this is balanced by a $1 increase in liabilities.

To extend the example again, assume that: (i) ABC made several sales on account during 2008 that were recognized as revenues and it has $300 of gross accounts receivable at the end of 2008. (ii) Prior to 2008, all sales were for cash and thus the receivables at the end of 2008 all pertain to 2008 revenues. (iii) Based on very reliable information, ABC expects that $25 of the gross receivables at the end of 2008 will likely be written off as bad debts in 2009.

Under GAAP, ABC would recognize a $25 expense in 2008 that matches the 2008 revenues that are associated with the $25 of expected future costs (bad debts). This $25 expense is balanced on the balance sheet by a $25 increase in the allowance for bad debts, a contra asset to accounts receivable. Increasing a contra asset decreases assets and thus decreases net assets.

To summarize, the ABC example illustrates recognition of three expenses that are costs that can be matched reliably to current-period revenues. One recognized expense was associated with a cost that was incurred and paid for in an earlier reporting period: the $7 inventories cost expensed in 2008 was incurred in 2007 when the inventories were purchased and this cost was also paid in 2007. A second recognized expense is associated with a cost that was incurred in the current period and will be paid in a future period: the $1 commission expensed in 2008 was incurred in 2008 and will be paid in 2009. A third recognized expense was associated with an expected future cost: some of the cash associated with 2008 revenues was not expected to be collected in 2009 or thereafter.

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Four fundamental lessons emerge from the example:

• Costs are not necessarily expensed when they are incurred (the inventory costs incurred in 2007 were not expensed until 2008).

• Costs can be paid in periods before, during, or after the period when they are expensed.

• Costs can be incurred before, during, or after the revenues they are matched with are recognized.

• Net assets decrease when expenses are recognized either because assets decrease, contra assets increase, or liabilities increase.

When costs are incurred in a period before they are expensed, they are capitalized as assets. For the ABC example, when the inventories were purchased in 2007, cash decreased by $7 and inventories increased by $7. We say that the $7 cost is capitalized as inventories. Generally, costs are only capitalized if they can be reliably matched to future benefits (including revenues). When the revenues are recognized, the matched capitalized costs are expensed.

Expense Recognition Motivated by ConservatismGAAP generally specifies whether costs can be capitalized as incurred and subsequently expensed when the revenues they helped generate are recognized. When there is considerable uncertainty about future revenues (or other benefits) and costs can not be matched reliably to them, the conservative principal dictates that the costs be expensed immediately as incurred.

For example, if DEF company spends $100 (million) cash on research and development in 2008, hoping to develop drugs to sell to customers in future years, under GAAP, the $100 is a current-period expense in 2008. In this situation note that recognizing an expense decreases net assets: cash decreases by $100 and this is balanced by a $100 expense (that decreases owners’ equity).

The $100 cost is associated with future benefits (including revenues) but GAAP presumes that companies can not match such costs reliably to future benefits. In fact, research and development is often so risky that it is not possible to reliably conclude that there will be future benefits, let alone match research and development costs to benefits in specific years. For this reason, under GAAP, most research and development costs are expensed as they are incurred. The exceptions are certain costs associated with developing software and films.

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Expense recognition can be very contentious. In particular, there is frequently controversy as to whether companies should capitalize or expense the costs they incur to acquire resources that help generate future revenues. Capitalize versus expense controversies generally center on timing: sooner or later the costs of most resources that are acquired to help generate future revenues are expensed. For example, eventually the costs capitalized when a building is acquired are completely expensed through depreciation. Those who favor capitalizing a cost as an asset typically invoke the matching principle to defend their position and those who favor expensing the cost invoke the conservative principle.

Deciding whether costs that relate to future revenues should be expensed as incurred, or capitalized as assets and expensed in the future, can require considerable judgment. Sometimes these judgments are determined by GAAP and other times they are made by companies with GAAP guidance. The Worldcom reporting scandal in 2002 centered on this judgement: the SEC accused Worldcom of capitalizing billions of dollars of costs in past years that should have been expensed as incurred, and thus of having overstated net income in prior years.

Expense Recognition Motivated By Lower of Cost or MarketThe lower of cost or market principle maintains that when the fair values of assets are reliably less than their book values, expenses should be recognized to write them down to their fair values. Write downs are also called impairments.

For example, if XYZ purchases inventories for $200 and their fair value subsequently decreases to $150, XYZ would recognize a $50 impairment expense. The inventories would decrease by $50 and this decrease in assets would be balanced by a $50 expense (and thus decrease in owners’ equity).

Companies are frequently criticized for delaying the recognition of major asset impairments in order to report higher current-period income. A tell tale sign that this is occurring is when the book value of a company’s owners’ equity is significantly higher than the market value of its stock. Assuming the book and market values of its debt are similar, when the book value of the owners’ equity is significantly higher than its market value, implicitly the book value of the company’s assets is overstated relative to its fair value, and thus some assets are significantly impaired and should be written down to fair value.

When this occurs, financial analysts and others sometimes pressure companies to either recognize impairments or explain why they should

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not be recognized. Analysts are seeking more precise information about the magnitude of impairments: the consensus belief of the market is that assets are impaired but this does not mean that these market assessments are as accurate as the ones companies could provide by recognizing impairments. In response to this type of pressure, or on their own volition, companies frequently recognize impairments and some of these are extremely large.

For example, in 2002, AOL Time Warner took a $54 billion impairment related to the goodwill and intangibles that were recognized when Time Warner and AOL merged in 2000. Similarly, in 2001, Cisco recognized a $2.25 billion inventories impairment that was associated with a severe downturn in the telecom industry.

The lower of cost or market principle also implies that expenses should be recognized when the fair values of liabilities reliably exceed their book values. This occurs when a company learns that it has a new liability or that an existing liability is greater than previously anticipated.

Restructuring expenses are motivated by the lower of cost or market principle. They pertain to costs associated with major changes in the business such as plant closings and lay offs. GAAP requires companies to estimate and expense restructuring costs in the year they anticipate and plan them, which is often one or more years before the restructuring is completed.

For example, if ABC announces a restructuring plan in 2008 wherein it estimates that it will incur $25 of severance costs and $10 of inventories losses in 2009, ABC recognizes a $35 expense in 2008: inventories are written down $10, a $25 liability related to the severance obligation is recognized, and a $35 restructuring expense is recognized. If the actual costs turn out to be less than anticipated in 2009, ABC will recognize a negative expense to correct for the overestimate. For example, if the actual severance costs are $24 in 2009, rather than the estimated $25, ABC will recognize a negative $1 restructuring charge in 2009.

22



Exercise 2.01The solutions to the following exercises are on page 83.

(a) True or false: Income statements measure performance at reporting dates.

(b) True or false: Revenues are increases in net assets.

(c) True or false: Decreases in net assets are expenses.

(d) True or false: If ABC company recognizes $10 of revenues when it delivers goods to a customer in exchange for a $10 future payment, ignoring the cost of the goods sold, accounts receivable and owners’ equity both increase by $10.

(e) True or false: If ABC delivers goods to customers in exchange for $10 cash, GAAP requires ABC to recognize $10 of revenues.

(f ) True or False: If ABC delivers goods to customers in exchange for $10 cash, ABC realizes $10 of revenue.

(g) True or False: If ABC delivers goods to customers in exchange for a $10 promised future payment and ABC is reasonably confident that the customer will not return the product, seek a price discount, need warranty work, or otherwise require ABC to bear future costs, ABC has earned $10 of revenue and is required under GAAP to recognize $10 in accounts receivable and revenues.

(h) True or false: If DEF company sells merchandise for $15 that cost $8, the matching principal implies that DEF should recognize an $8 expense when it recognizes $15 of revenues associated with the sale.

(i) True or false: When Intel defers paying employees compensation they earned during the year, it recognizes an expense and increases its accrued compensation and benefits liability.

(j) True or false: Global Crossing was accused of overly conservative accounting because it accelerated income recognition beyond what was warranted by the facts and circumstances.

23



Exercise 2.02This exercise pertains to the income statements in Figures 2.01-.07 for Intel, Cisco, Gap, Starbucks, Nike, Coca Cola, and Federal Express (pages 71-77).

Hint: As needed, reference Line-by-Line Tour: Intel Financial Statements. This can be found on the Navigating Accounting CD or a back section of your course packet.

The solutions are on page 84.

(a) Net revenues is the first item on Intel’s income statement. What line items on the other six companies’ income statements likely represent a similar concept?

(b) Which two of the seven companies disclose more information about net revenues on their income statements than the other five?

(c) The net in net revenues means gross revenues net of returns, early payment discounts, and price-protection discounts. Nike and Federal Express report “Revenues” rather than “Net revenues.” What are possible reasons why they did not include the net modifier?

(d) Cost of sales is the second item on Intel’s income statement. Which of the other six companies recognize this concept on their income statements (perhaps using a synonym)?

(e) Two of the seven companies recognize cost of sales in net income but do not disclose it on their income statements. What do these companies have in common?

(f ) Which of the seven companies explicitly disclose gross margins or a synonym for gross margins on their income statements?

(g) Two of the seven companies disclose Research and development expenses on their income statements? How do these companies differ from the other five companies?

(h) Presumably Nike and Coca Cola have some research and development activities. Which line items on their income statements likely include research and development expenses?

(i) Which company’s income statement discloses the most precise information about sales and marketing expenses?

(j) Which two companies’ income statements disclose the fewest line items associated with operating expenses?

(k) In terms of what you know about the companies, which of the seven seems to disclose the most detailed information about its operating expenses on its income statement?

Search IconThis exercise requires you to search for information.

24



(l) Based only on information disclosed on their income statements, which of the seven companies have acquired other companies?

(m) Based on information in the income statement only, in which year did Cisco plan a restructuring?

(n) Which two of the seven companies do not disclose a separate line item for operating income? Estimate their operating incomes for fiscal 2002. To what extent are you confident that your estimates reflect operating activities (rather than non-operating activities)?

(o) Which of the seven companies disclose investment gains or losses on their income statements?

(p) Starbucks recognized $2,940 of Internet-related investment losses for 2001. Why is this $2,940 signed positively on Starbucks’ income statement if it is a loss?

(q) Which of the seven companies disclose interest income and interest expense on their income statements?

(r) Which of the companies identified above in (q) signs interest income negatively on its income statement? Interest income would seem to be good for owners, why is it signed negatively?

(s) Which of the companies identified above in (q) signs interest income and interest expense positively on its income statement? Why do they have the same sign?

(t) What can you conclude about income statement signing conventions from (p), (r) and (s)?

(u) Which of the seven companies’ income statements has another section besides operating and non-operating income?

25



In this section we extend the ABC Company example and generalize the balance-sheet-equation template to incorporate income concepts.

aBC Company exampLe ABC Company has the following events for its first year of operations (E1-E3 are carried forward from the earlier chapter). All amounts are in thousands of dollars.

E1: ABC’s shareholders contribute $1,000 of cash to ABC in exchange for 1 million shares of ABC’s non-par common stock.

E2: ABC purchases a building from Kaplan Properties for $200 cash. The building will be used as a store.

E3: ABC purchases $100 of merchandise from Healy Inc. on account and it plans to sell to customers for a profit.

E4: ABC sells merchandise that cost $20 for $60. The customers who purchase the merchandise promise to pay the $60 in the future. ABC recognizes revenue when goods are sold to customers.

E5: ABC collects $40 of the $60 that customers promised to pay (in event E4).

E6: ABC pays $60 of its outstanding obligation to Healy Inc.

E7: ABC receives $10 of cash from customers who owe this much in interest because they did not pay their bills on time.

E8: ABC declares and pays a $20 dividend on the last day of the year.

E9: ABC records depreciation of $10 related to the building purchased from Kaplan Properties.

We assume that ABC Company pays no taxes and expects that there will be no bad debts.

The next few pages illustrate how these entries are recorded using the modified version of the balance-sheet-equation template. We will work our way through the entries one by one, illustrating how each entry affects the balance sheet and income statement.

Figure ColorsUse the PDF version of this chapter on your Navigating Accounting CD to zoom in on the color-coded figures in this section.

26



Structure of Modified Balance-Sheet-Equation TemplateThe balance-sheet-equation (BSE) template below adds more specificity to illustrate income related concepts.

• Owners’ equity is divided into Permanent and Comprehensive income (temporary)

• Comprehensive income is divided into Net income and Other comprehensive income (OCI)

• Net income is further divided into Revenues minus Expenses plus Gains minus Losses plus Other income.

The template also illustrates closing entries that ensure the temporary accounts associated with comprehensive income start each period with $0 balances: Net income for the period is transferred to retained earnings (in permanent owners’ equity), and other comprehensive income is transferred to accumulated other comprehensive income (also in permanent owners’ equity). We will discuss closing entries near the end of the ABC example.

© 2006, G. Peter & Carolyn R. Wilson

Beginning balances

Assets +Liabilities=

CashOtherAssets

Events during the period +

+

=

=

+

+

+

+

Net income

-

-

Owners' Equities

Permanent + Comprehensive Income (Temporary)

+

+

+

-

-

+

+Revenue Expenses Gains Losses- + -

Closing entriesat end of period

- + -Close net income to retained earnings

Close OCI to accumulated other comprehensive income

$0

Endingbalances

$0 $0 $0

+ = + + - + - +$0$0 $0 $0

OtherComp.Income(OCI)

$0

+

+

+$0

$0

Other+

+

$0

27



= +

+ = + +

+ C + AR + Inven + GPPE - AcDep = + AP + CS + RE + Rev - Cgs - DepEx + Intinc + IncS

+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0

E1 Issue stock for cash + + 1,000 + + + - = + + + 1,000 + + - - + +

E2 Purchase building with cash + - 200 + + + + 200 - = + + + + - - + +

E3 Purchase inventory on account + + + + 100 + - = + + 100 + + + - - + +

E4a Recognize revenue + + + + - = + + + + - - + +

E4b Recognize cost of sales + + + + - = + + + + - - + +

E5 Customer collections + + + + - = + + + + - - + +

E6 Supplier payments + + + + - = + + + + - - + +

E7 Interest income and collection + + + + - = + + + + - - + +

E8 Dividend declared and paid + + + + - = + + + + - - + +

E9 Depreciation expense + + + + - = + + + + - - + +

+ + + + - = + + + + - - + +

+ + + + - = + + + + - - + +

+ + + + - = + + + + - - + +

+ + + + - = + + + + - - + +

Beginning balances

Peri

od

En

trie

s

Trial balance

Closing to and from income summary

Ending balances

Assets Liabilities Owners' Equity

Current Noncurrent Current Permanent Net income

Recording Events E4 - E9Record entries E4-E9 in the BSE matrix below, using ABC Company’s chart of accounts. After doing so, derive trial balances for all of the accounts. You can check your answer on pages 28-48.

ASSETSCurrent

AR Accounts receivableC CashInven Inventory

NoncurrentPPE Property, plant, and equipment, net

GPPE PP&E historical costAcDep PP&E accumulated depreciation

LIABILITIES

CurrentAP Accounts payable

OWNERS' EQUITY

PermanentCS Common stock (non-par)RE Retained earnings

Net incomeCgs Cost of goods soldDepEx Depreciation expenseIncS Income summaryIntinc Interest incomeRev Revenues, net

ABC CompanyChart of Accounts

Interpreting the two signs in front of the measures in the cells.

• Account signs: These signs indicate how an account’s balance affects its primary class (assets, liabilities, or owners’ equity). An account’s sign is the same for all entries. For example, cash is a positively signed account because its balance increases its primary class (assets) and expenses are negatively signed accounts because their balances decrease their primary class (owners’ equity). Of the two signs associated with the measures in the BSE cells, the account signs are first on the left or furthest from the numbers [measures].

• Entry signs: These signs indicate how the entry affected the account: they are positive when an entry increases the account and negative when it decreases the account. Of the two signs associated with the measures in the BSE cells, the entry signs are closest to the measures.

28



E1 — Issue Common Stock for CashHow does the event affect the balance sheet?

ABC records the following entry:

• Cash increase by $1,000, reflecting the future benefit associated with the cash collected from shareholders.

• Common stock increases $1,000 reflecting the increase in the value of the owners’ claim on the assets.

These accounts correspond to balance-sheet line items with the same captions as the account names. Thus, cash and common stock both increased by $1,000.

How does the event affect the income statement?

No effect: we didn’t record revenues, expenses, gains, losses, or other income.

How does it affect the statement of changes in owners’ equity?

Common stock increases by $1,000.

What would an outsider see?

An outsider would see the $1,000 recorded on the statement of changes in owners’ equity, as indicated on the next page, and on the statement of cash flows, which we will study in the next chapter.

Take-aways

The statement of owners’ equity is typically the best place to search for information related to entries associated with transactions with owners.

An outsider would likely not see the $1,000 if the company had other issuances of common stock for cash during the year. Instead, the outsider would see the total cash inflow from these stock issuances on the statement of cash flows. This total would also likely be seen on the statement of owners’ equity, providing it was not aggregated with non-cash stock transactions.

29



= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0




E4a Recognize revenue + + + 60 + + - = + + + + + 60 - - + +

E4b Recognize cost of sales + + + - 20 + - = + + + + - + 20 - + +

E5 Customer collections + + 40 + - 40 + + - = + + + + - - + +

E6 Supplier payments + - 60 + + + - = + - 60 + + + - - + +

E7 Interest income and collection + + 10 + + + - = + + + + - - + + 10 +

E8 Dividend declared and paid + - 20 + + + - = + + + - 20 + - - + +

E9 Depreciation expense + + + + - + 10 = + + + + - - + 10 + +

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

Per

iod

En

trie

s

Trial balance


Ending balances

Net incomeCurrent

LiabilitiesAssets Owners' Equity

Current Noncurrent Permanent

ABC Company Statement of Changes in EquityFirst year of operations

CommonStock

RetainedEarnings Reserves Total

Beginning balances $0 $0 $0 $0Comprehensive income

Net profit 40 40Other comprehensive income 0 0

Total 40 0 40Common stock issued 1,000 1,000Dividend declared (20) 0 (20)Ending balances $1,000 $60 $0 $1,060

ABC Company Balance SheetFirst year of operationsAssets End Bal Beg Bal

CurrentCash $770 $0Accounts receivable 20 0Inventories 80 0Total current assets 870 0

Non-current assetsProperty, plant, and equipment, net

Historical cost of PP&E 200 0Less accumulated depreciation (10) 0

Property, plant and equipment, net 190 0Total non-current assets 190 0

Total assets $1,060 $0

Liabilities and Stockholders' EquityLiabilities

CurrentAccounts payable 40 0Total current liabilities 40 0

Non-current 0 0Total liabilities 40 0Stockholders' equity

Common stock 1,000 0Retained earnings 20 0Total stockholders' equity 1,020 0

Total liabilities and stockholders' equity $1,060 $0

ABC Statement of Comprehensive IncomeFirst year of operationsOperating profit

Revenues $60Cost of sales (20)Depreciation (10)Operating profit 30

Non-operating profitInterest income 10

Net profit 40Other comprehensive income 0Comprehensive income $40

+ + 1,000 + + 1,000

Cash $770

+ + $770Common stock 1,000

+ + $1,000

Common stock issued 1,000

Event E1 — Issuing common stock for $1,000 cash

30



E2 — Purchase a Building for CashHow does the event affect the balance sheet?


• Cash decreases by $200 reflecting the cash outflow to purchase the building.

• Gross property, plant, and equipment increases by $200, reflecting the historical cost of the future benefit associated with the building.

Thus, on the balance sheet, cash decreases by $200 and the historical cost of PP&E increases by $200. Other balance sheet subtotals that depend on these line items, such as property, plant, and equipment net, would also change. However, unless instructed otherwise, you can ignore subtotal effects when you are asked to determine how financial statements are affected by entries.




No effect: no owners’ equity accounts were affected by the entry.


An outsider would see $200 reported on the cash flows statement, which we will study in the next chapter.

Take-aways

An outsider would likely not see the $200 on the statement of cash flows if the company had other cash purchases of PP&E during the year. Instead, the outsider would see the total cash outflow for these purchases.

31



= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0











+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

Per

iod

En

trie

s

Trial balance


Ending balances

Net incomeCurrent




CommonStock




















+ + 200+ - 200

+ + $770 + + $200

Cash $770

Historical cost of PP&E 200

Event E2 — Purchasing a building for $200 cash

32



E3 — Purchase Inventory on AccountHow does the event affect the balance sheet?


• Inventories increases by $100, reflecting the future benefits of having inventory available to sell to customers.

• Accounts payable increases $100, reflecting the company’s obligation to pay the supplier this amount in the future.

Thus, on the balance sheet, inventories and accounts payable both increase by $100.






An outsider would not see this $100 because it would be aggregated with too many other significant increases and decreases that affect these balance sheet line items.

33



= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0











+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

Per

iod

En

trie

s

Trial balance


Ending balances

Net incomeCurrent




CommonStock




















+ + 100 + + 100

+ + $80 + + $40

Invevv ntories 80

Accounts payable 40

Event E3 — Purchasing inventory on account for $100 cash

34



E4a — Recognizing Sale on AccountAt the time ABC sales merchandise to customers, it recognizes revenues and cost of sales. We could record a single entry to record revenues and costs of sales. However, its is easier to break this entry into two parts: a revenue entry (E4a) and a cost of sales entry (E4b).

How does the event affect the balance sheet?

ABC records the following for the revenue portion of E4a:

• Accounts receivable increases by $60, reflecting the future benefit associated with the expected future cash collection from customers.

• Revenues increase by $60, reflecting the increase in net assets associated with the sale.

Two balance-sheet effects of E4a keep the balance sheet balanced:

• Accounts receivable increases by the $60 we recorded to this account.

• Retained earnings increases: Revenue recognized in E4a increases net income and net income is transferred to retained earnings at the end of the accounting period by the closing entry we will examine later.

Thus, accounts receivable and retained earnings both increase by $60.


The income statement effect is straightforward: revenues increase associated with the sale, which increases net income.


The increase in retained earnings associated with income (which is affected by the $60 of revenues) is reported in the statement of changes in owners’ equity.


An outsider would see the $60 of revenues on the income statement if this was the only entry that affected revenues, as it does for ABC. The effects of this entry are aggregated with others on the balance sheet.

Take-aways

We are assuming ABC has no remaining obligations to customers after the sale and is reasonably assured it will collect the $60. To the extent this is true, the revenues, and thus income, reflect performance accurately.

35



Event E4a — Recognizing $60 revenue for sale on account

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0











+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

Per

iod

En

trie

s

Trial balance


Ending balances

Net incomeCurrent




CommonStock




















+ + 60 + + 60

+ + $20 + + $20

Accounts rerr ceivavv ble 20

Retained earnings 20

+ + $60

Revevv nues $60

Net profit 40

+ + 40

Net prorr fiff t 40

36



E4b — Recognizing Cost of SalesEntry E4b recognizes the costs associated with the revenue in entry in E4a. The $20 of cost of sales is highlighted in the figure.


• Inventories decrease by $20, indicating ABC has relinquished the benefits associated with the merchandise it gives to the customer.

• Expenses increase by $20, reflecting the decrease in net assets associated with the sale.

Two balance-sheet effects of E4b keep the balance sheet balanced:

• Inventories decreases, as indicated above.

• Retained earnings decreases: Expenses recognized as cost of sales decreased net income. Net income is transferred to retained earnings at the end of the accounting period.

Thus, inventories and retained earnings both decrease by $20.


Cost of sales increase by the $20 expense and income decreases $20.


The increase in retained earnings associated with income (which is affected negatively by the $20 of cost of sales) is reported in the statement of changes in owners’ equity.


An outsider would see the $20 of cost of sales on the income statement if this was the only entry that affected cost of sales, as it does for ABC.

The effects of this entry are aggregated with other information on the balance sheet. Importantly, the $20 retained earnings balance is the sum of two entries. Also, expenses have a negative effect on income so retained earnings would be negative $20 if E4b was the only entry that affected retained earnings.

• An general lesson has emerged from E4a and E4b: Any entry recorded into income (revenues, expenses, gains, losses, or other income), will affect retained earnings on the balance sheet via the end-of-period closing entry discussed later.

37



Event E4b — Recognizing $20 of cost of sales

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0











+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

Per

iod

En

trie

s

Trial balance


Ending balances

Net incomeCurrent




CommonStock




















+ - 20 - + 20

+ + $80 + + $20

Invevv ntories 80


- + $20

Cost of sales (20)

Net profit 40

+ + 40

Net prorr fiff t 40

38



E5 — Customer CollectionsThe entry to recognize $40 of customer collections is highlighted in the figure on the next page.


• Cash and thus assets increase by $40, indicating the future benefits associated with the cash received from customers.

• Accounts receivable decreases by $40, indicating ABC is no longer expecting a future collection: $40 of the receivable is no longer outstanding.

Thus, cash increases by $40 and accounts receivable decreases by $40. This entry simply replaces one asset (receivables) with another (cash) and thus has no effect on liabilities or owners’ equity.






Nothing. The entry’s effects are “behind the numbers” reported on the balance sheet. However, outsiders can often get a reasonable estimate of customer collections following an approach introduced in a later chapter.

Take-aways

• Collecting cash from customers enhances ABC’s liquidity and confirms the quality of previously recognized revenues.

39



Event E5 — Collecting $40 from customers

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0











+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

Per

iod

En

trie

s

Trial balance


Ending balances

Net incomeCurrent




CommonStock




















+ + 40 + - 40

+ + $770 + + $20

Cash $770Accounts rerr ceivavv ble 20

40



E6 — Supplier PaymentsThe entry to recognize $60 of supplier payments associated with the earlier purchase of inventory on account is highlighted in the figure on the next page.


• Cash and thus assets decrease by $60, indicating the benefits relinquished by paying the supplier.

• Accounts payable decreases by $60, indicating ABC is no longer obligated to the supplier for the $60 portion of its outstanding obligation recognized in accounts payable.

Thus, cash and accounts payable decrease $60.






Nothing. The entry’s effects are “behind the numbers” reported on the balance sheet. However, outsiders can sometimes get an estimate of supplier payments following an approach introduced in a later chapter.

41



Event E6 — Paying suppliers $60

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0











+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

Per

iod

En

trie

s

Trial balance


Ending balances

Net incomeCurrent




CommonStock




















+ - 60 + - 60

+ + $770 + + $40

Cash $770

Accounts payable 40

42



E7 — Recognizing interest income receivedThis entry recognizes $10 of interest income from customers associated with late payments.


• Cash and thus assets increase by $10, indicating the benefits received from the cash from customers.

• Other income increases by $10, indicating the increase in net assets associated with the cash received.

Two balance-sheet effects of E7 keep the balance sheet balanced:

• Cash increases, as indicated above

• Retained earnings increases: Entry E7 increases other income, which increases net income. This effect is transferred to retained earnings at the end of the accounting period.

Thus, cash and retained earning both increase $10.


When interest income associated with outstanding receivables (or investment securities) is not classified as revenue, it is generally included in the non-operating income section of the income statement, as indicated on the next page for ABC.

Thus, interest income and net income increase by $10.


The increase in retained earnings associated with income (which is affected positively by the $10 of cost of interest income) is reported in the statement of changes in owners’ equity.


ABC reports the interest income on its income statement. Most companies do not disclose interest income as a separate line item on their income statements. However, when interest income is significant, it is sometimes disclosed on the income statement or in a footnote.

Key Take Aways

• Some companies classify interest income received from customers as revenues, arguing the revenues definition is met: increases in net assets associated with delivering or producing goods, services, or other activities that constitute the entity’s central operations. The judgment associated with this classification centers on whether the company believes collecting interest income is central to its operations.

43



Event E7 — Recognizing $10 of interest income received

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0











+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

Per

iod

En

trie

s

Trial balance


Ending balances

Net incomeCurrent




CommonStock




















+ + 10+ + 10

+ + $770 + + $20

Cash $770


+ + 40

Net prorr fiff t 40

+ + $10

Interer st income 10Net profit 40

44



E8 — Declare and Pay DividendsThis entry recognizes $20 of dividends declared and paid to ABC’s shareholders.


• Cash and thus assets decrease by $20, indicating the benefits relinquished by paying a cash dividend to shareholders.

• Retained earnings decreases by $20, indicating owners received a distribution of part of their ownership claim.


• Cash decreases, as indicated above.

• Retained earnings decreases, as indicated above.

Thus, cash and retained earning both decrease $20.




The decrease in retained earnings associated with the dividend is reported in the statement of changes in owners’ equity.


Declared dividends are reported on the statement of owners’ equity. Thus, if this was the only declaration of dividends, an outsider would see the $20 on this statement. Otherwise, it might be aggregated with other dividends declared during the year. Dividends paid are reported on the statement of cash flows, which we will examine in the next chapter.

Key Take Aways

• Dividends do not affect income (in the United States and most other countries). Rather they directly reduce retained earnings.

• In this example, we assume dividends are paid at the same time they are declared. Typically, they are declared by the board of directors before they are paid. At the declaration date, a liability for the amount of the declared dividend is recorded (recognizing the company’s legal obligation to pay the dividend) and retained earnings is decreased. Later, when the dividend is paid, cash and the liability are decreased.

45



Event E8 — Declare and pay dividend of $20

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0











+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

Per

iod

En

trie

s

Trial balance


Ending balances

Net incomeCurrent




CommonStock




















+ - 20+ - 20

+ + $770 + + $20

Cash $770


Divivvdend declarerr d (20)

46



E9 — Recognizing DepreciationABC records the following entry to recognize depreciation expense associated with the building purchased in E2.


• Increase in accumulated depreciation by $10, indicating the benefits associated with the building purchased in E2 were partially used up during the first year of operations. This leaves $190 of remaining future benefits recognized as an asset, or 95% of the building’s useful life.

• Increase depreciation expenses by $10, reflecting the decrease in assets associated with using up part of the building.


• Accumulated depreciation (a subtraction on the balance sheet)increases, which decreases net PP&E.

• Retained earnings decreases: Depreciation expense decreases net income. This effect is transferred to retained earnings at the end of the accounting period.


This entry increases ABC’s depreciation expense, which decreases net income.


The increase in retained earnings associated with income (which is affected negatively by the $10 of depreciation expense) would be reported in the statement of changes in owners’ equity.


For ABC company, an outsider would find the $10 of depreciation reported as an expense on the income statement and as the ending balance in accumulated depreciation on the balance sheet (because this is the first year of operations).

Most companies do not report a separate line item for depreciation on their income statements. Rather, they include it in a line item such as sales and general administrative expenses.

47



Event E9 — Recognize $10 of depreciation

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0











+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

Per

iod

En

trie

s

Trial balance


Ending balances

Net incomeCurrent




CommonStock




















- + 10- + 10

- + $10 + + $20

Less accumulated deprerr ciation (10)


- + $10

Deprer ciation (10)

Net profit 40

+ + 40

Net prorr fiff t 40

48



Closing Income to Retained Earnings The two closing entries serve two purposes: First, they ensure the income accounts all have zero ending balances. Second, they ensure net income is transferred to retained earnings. As indicated below, this a 2-step process:

Step 1: Close income accounts to income summary

• The closing entry decreases the accounts by the net amounts in the trial balance for revenues, cost of sales, expenses, and interest income. This will create a $0 balance for these temporary accounts. The net effect is - $40: - $40 = - (+$60) - (-$20) - (-$10) - (+$10)

• Income summary (last account on right) increases by $40, which keeps the equation in balance. This is the first year’s net income.

Step 2: Close income summary into retained earnings.

• Decrease income summary by $40, leaving a $0 balance.

• Increase retained earnings by $40, reflecting the transfer of income to permanent owners’ equity.

These two steps can be combined by directly closing the income accounts into retained earnings (and thus not using the income summary account.)This is what a third closing entry would do for other comprehensive income: it directly closes other comprehensive income into accumulated other comprehensive income (a permanent owners’ equity account).

Creating financial statements from the BSEThe diagram on the next page illustrates how the statements can be created from the BSE matrix. This is the second phase of the R&R map (Record Keeping and Reporting Map). In the next chapter, we will add the final phase.

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0











+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

Per

iod

En

trie

s

Trial balance


Ending balances

Net incomeCurrent



+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40CClloossiinngg ttoo aanndd ffrroomm iinnccoommee ssuummmmaarryyrrr

49



Creating Financial Statements from the BSE matrix (R&R Map: Phase 2)

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0











+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

Per

iod

En

trie

s

Trial balance


Ending balances

Net incomeCurrent




CommonStock




















+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0

$00

0

00

00

$0

0

00

00

0

Beg Bal

$000

Ending balances $1,000 $60 $0 $1,060

+ + $60 - + $20 - + $10 + + $10

40

$60(20)(10)30

10

0$40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20

End Bal

$7702080

870

200(10)190190

$1,060

40400

40

1,00020

1,020$1,060

$0$00 $0Beginning balances $0

+ + 1,000 +

+ +

+ +

+ +

+ +

+ +

+ +

+ +

+ + - 20

+ +

+ + $1,000 + - $20

+ +

+ + + 40

Comprehensive incomeNet prorr fiff t 40Other comprer hensivevv income 0

ToTT tal 40 0Common stock issued 1,000 1,000Divivvdend declarerr d (20) 0 (20)

400

40

50



Intel Consolidated Statements of IncomeThree Years Ended December 29, 2007(In Millions--Except Per Share Amounts) 2006 1 2005Net Revenue $ 35,382$ 38,826$Cost of sales 17,164 15,777Gross Margin 18,218 23,049Research and development 5,873 5,145Marketing, general and administrative 6,096 5,688Restructuring and asset impairment charges 555Amortizaton of acquisition-related intangibles and costs 42 126Operating expenses 12,566 10,959Operating income 5,652 12,090Gains (losses) on equity investments, net 214 (45)Interest and other, net 1,202 565Income before taxes 7,068 12,610Provision for taxes 2,024 3,946Net income ,$ 5,044$ 8,664$Basic earnings per common share $1.20 $0.87 $1.42Diluted earnings per common share $1.18 $0.86 $1.40Weighted average shares outstanding

Basic 5,816 5,797 6,106Diluted 5,936 5,880 6,178

1Cost of sales and operarr titt nii g expxx enses foff r thtt e yeyy arsrr ended December 29, 2007 and December 30, 2006 inii clude sharerr -

based compensatitt on. See "N" ote 2" Accountitt nii g Polill cies" and "N" ote 3: EmEE ployeyy e Equityt Incentitt ve Plans."

See notes to Consolill dated FiFF nii anciai l Statements.

© NavAcc LLC, G. Peter & Carolyn R. Wilson

Beginning balances


CashOtherAssets


+

=

=

+

+

+

+

Net income

-

-

Owners' Equities

Permanent +Comprehensive Income

+

+

+

-

-

+





$0

Endingbalances

$0 $0 $0

+ = + + - + - +$0$0 $0 $0


$0

+

+

+$0

$0

Other-

+

$0

2007 1

38,33418,43019,9045,7555,401

51616

11,6888,216

157793

9,1662,1906,976

- + - +

Connecting Intel’s Statement of Shareholders’ Equity to the BSE TemplateThe graphic on the next page shows how income flows from the BSE template into Intel’s statement of owners’ equity.

Connecting Intel’s Income Statement to the BSE TemplateThis graphic illustrates how the revised version of the BSE template generalizes to Intel. In particular, it illustrates how income statements are created from numbers recorded into the revenues, expenses, gains, losses, and other income on the right side of the balance-sheet-equation.

51



Intel Consolidated Statements of Stockholders' EquityAcquisition-

Related AccumulatedUnearned Other

Stock Compre-Three Years Ended December 29, 2007 Number of Compen- hensive Retained(In Millions--Except Per Share Amounts) Shares Amount sation Income (loss) Earnings TotalBalance at December 25, 2004 6,253 6,143$ (4)$ 152$ 32,288$ 38,579$ Components of comprehensive income, net of tax:

Net income 8,664 8,664Other comprehensive income (25) (25)

Total comprehensive income 8,639Proceeds from sales of shares through employee equity

incentive plans, tax benefit of $351 million, and other 84 1,553 1,553Assumption of acquisition related stock options and

amortization of acquisition-related unearned stockcompensation, net of adjustments 2 4 6

Repurchase and retirement of common stock (418) (1,453) (9,184) (10,637)Cash dividends declared ($0.32 per share) (1,958) (1,958)Balance at December 31, 2005 5,919 6,245 0 127 29,810 36,182Components of comprehensive income, net of tax:

Net income 5,044 5,044Other comprehensive income 26 26

Total comprehensive income 5,070Adjustment for initially applying SFAS 158, net of tax (210) (210)Proceeds from sales of shares through employ

incentive plans, tax benefit and other 73 1,248 1,248Share-based compensation 1,375 1,375Repurchase and retirement of common stock (226) (1,043) (3,550) (4,593)Cash dividends declared ($0.40 per share) (2,320) (2,320)Balance at December 31, 2006 5,766 7,825 0 (57) 28,984 36,752Cumulative-effect adjustments, net of tax 1

Adoption of EITF 06-02 (181) (181)Adoption of FIN 48 181 181

Components of comprehensive income, net of tax:Net income 6,976 6,976Other comprehensive income 318 318

Total comprehensive income 7,294Proceeds from sales of shares through employ

incentive plans, tax benefit and other 165 3,170 3,170Share-based compensation 952 952Repurchase and retirement of common stock (113) (294) (2,494) (2,788)Cash dividends declared ($0.45 per share) (2,618) (2,618)Balance at December 31, 2007 5,818 $11,653 $0 $261 $30,848 $42,762

in Excess of Par Valueand Capital

Common Stock

© NavAcc LLC, G. Peter & Carolyn R. Wilson

Beginning balances


CashOtherAssets


+

=

=

+

+

+

+

Net income

-

-

Owners' Equities

Permanent +Comprehensive Income

+

+

+

-

-

+





$0

Endingbalances

$0 $0 $0

+ = + + - + - +$0$0 $0 $0


$0

+

+

+$0

$0

Other-

+

$0

+- + - + +

+

+

+

+

+ +

5,766 7,825 0 (57) 28,984 36,752

(181) (181)181 181

7,294

165 3,170 3,170952 952

(113) (294) (2,494) (2,788)(2,618) (2,618)

5,818 $11,653 $0 $261 $30,848 $42,762

6,976 6,976318 318

52



the aCCountInG CyCLeThis section explains how entries fit into the accounting cycle. We will develop an icon and summarize and extend points covered earlier in this chapter. Since it reflects the accounting cycle, you will also learn about the cycle as you progress.

The figure below illustrates features of the record keeping icon:

• Balance-sheet equation: The topmost item in the icon. Each account defines a column in the balance-sheet-equation data matrix.

• Beginning of period balances: This is the top row in the balance-sheet-equation data (BSE matrix), which is designated by the shaded regions in the record keeping box. The beginning balances are zero for the temporary owners’ equity accounts.

• Entries: The next two items from the top illustrate entries recorded during the accounting period. These include entries recorded as events occur during the period and adjusting entries that are recorded at the end of the period.

Recording entries during the period is the first step in the accounting cycle.

Recording adjusting entries at the end of the period is the second step. Adjusting entries never affect cash, but generally affect income.

Entries

Beg Bal Zero

cash +other assets = liabilities + permanent OE+ temporary OE

Assets = Liabilities + Owners' Equities

Noncash, nonincome Temporary owners' equityCash

THREE KEY ACCOUNT CATEGORIES

Entries recorded during the period as events occur.

Adjusting entries recorded at the end of the period.

TWO

ENTRY

TYPES

53



• Classifying accounts to better understand entries’ financial statement consequences: Accounts are classified into three categories that have different financial statement consequences.

The figure on the next page builds on the one on the previous page. It extends the accounting cycle.

Creating trial balances is the third step in the accounting cycle.

Recording closing entries is the fourth step, followed by determining the ending balances.

Actually, the picture distorts the accounting cycle somewhat since trial balances are often computed during the period to check for errors (make sure everything balances) and just before adjusting entries to obtain information needed to determine the adjustments.

• Trial balances at period end: After recording entries during the period (including the end-of-period adjustments), a trial balance is prepared to determine the amounts that must be closed to income summary. This is accomplished by adding the entries in each account that occurred during the period to the beginning balance.

• Close to income summary: Revenues, expenses, gains, and losses are closed to the income summary account to ensure they have zero balances at the start of the next period. This entry also summarizes all of the information needed to produce the reporting period’s income statement. Thus, this is where you will find the numbers that are needed to create income statements.

This closing entry is accomplished by decreasing revenues, expenses, gains, and losses by their trial balances (period totals) and increasing income summary by net income.

• Close income summary to retained earnings: The income summary account is then closed into retained earnings. This entry is accomplished by decreasing income summary by net income and increasing retained earnings by net income. Again the row balances because the increase in one owners’ equity account is offset by the decrease in another owners’ equity account.

• End of period balances: The icon’s last item is the ending balances, which are needed to prepare balance sheets. The ending balances are determined by adding the closing entry numbers to the trial balances.

54



Balance-sheet equation.

Beginning of period balances.

Record entries during period as events occur and make adjusting entries at the end of the period.

Trial balance at end of period.

Close to income summary and then to retained earnings.

End of period balances.

Entries

Beg Bal

Tr Bal

Cls IS

Cls RE

End Bal

Zero

Zero

cash +other assets = liabilities + permanent OE+ temporary OE

Assets = Liabilities + Owners' Equities

Accounting Cycle

55



Exercise 2.03The following events occurred at CreativeABCs during December 2010:

E1 Nick Carlstedt starts a retail toy company, CreativeABCs Inc., on December 1, 2010. On December 2, he contributes $10,000 and a business plan to CreativeABCs in exchange for 100 shares of common stock that has $1 par value. 500 shares are authorized. Nick’s accountant tells him that the business plan can not be recognized on CreativeABCs’ balance sheet.

E2 CreativeABCs purchases debt securities for $5,500 on December 2. The company expects to hold the securities for 3-6 months and it classifies them as available-for-sale.

E3 CreativeABCs buys inventories on account from TrustySupplier for $4,000 on December 2.

E4 Between December 3 and December 31st, CreativeABCs sells inventories for $3,000 on account that cost $1,000. The company’s policy is to recognize revenues when sells occur.

E5 CreativeABCs pays Nick, its only employee, $500 on December 16th for services rendered through December 15th.

E6 CreativeABCs pays TrustySupplier $1,500 on December 30th.

E7 CreativeABCs pays its landlord $800 for store space rented during December on December 31st.

E8 CreativeABCs collects $700 from customers between December 4th and December 31st.

E9 On December 31st, CreativeABCs receives $30 cash for interest earned during December on the debt securities purchased on December 2.

E10 At the end of the month, Nick determines that CreativeABCs owes him $500 for services rendered from December 16th through December 31st.

E11 At the end of the month, CreativeABC determines that the securities purchased on December 2 still have a fair value of $5,500. Also it expects that all outstanding receivables will be collected.

E12 At the end of the month, CreativeABC owes the government income taxes for December, which will be determined by multiplying its income before taxes for December by 40%. No other taxes are owed.

Answer the questions on the next page. The solution is on page 88.

56



Use the following process to create a balance sheet, income statement, and statement of changes in owners’ equity for CreativeABCs. Templates are on the next four pages.

(1) Complete the BSE matrix as we did for ABC Company:

• Record the entries using the BSE matrix on the next page and the chart of accounts below.

• Derive trial balances for each account.

• Close the income accounts into retained earnings.

(2) Create beginning and ending balance sheets for December, an income statement for December, and a statement of owners’ equity for December:

• Complete the templates for these statements on the next pages using the BSE matrix you created in part (1).

• Use the R&R Map for ABC on page 49 as a model for how to map BSE information into the financials.

ASSETSCurrent

AR Accounts receivableC CashInven InventoryStInv Short-term investments

LIABILITIES

CurrentAP Accounts payableAcCB Accrued compensation & benefitsTaxP Taxes payable

OWNERS' EQUITY

PermanentCS Common stock (non-par)RE Retained earnings

Net incomeCgs Cost of goods soldMG&A Marketing, general & administrative expenseIncS Income summaryIntinc Interest incomeRev Revenues, netTxExp Tax expense

CreativeABC CompanyChart of Accounts

57



Crea

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31, 2

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+

+

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=+

AP+

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++

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E2Pu

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During month Month-end

Asse

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++

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58



CreativeABC Company Balance Sheets

Assets 31-Dec-10 01-Dec-10Current

CashAccounts receivableShort-term investmentsInventoriesTotal current assets

Non-currentTotal assets


CurrentAccounts payableAccrued compensation and benefitsIncome taxes payableTotal current liabilities

Non-currentTotal liabilitiesStockholders' equity

Common stockRetained earningsTotal stockholders' equity

Total liabilities and stockholders' equity

59



CreativeABC Company Income StatementDecember 1 - December 31, 2010Operating profit

RevenuesCost of salesMarketing general and administrativeProfit from operations

Non-operating profitInterest income

Profit before taxesTax expense

Net profitOther comprehensive income 0Comprehensive income

60



Crea

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61



HOW DO I USE THE NUMBERS?How do revenues, expenses, gains, and losses relate to the purpose of income statements? That is, how do they help users assess a company’s financial performance during a reporting period? Let’s see with Intel. So, how well did Intel perform in 2007? How was its performance relative to its stated goals going into 2007 and compared to its biggest competitor’s performance (AMD)? What does Intel’s past performance tell us about predicting its future performance?

Starting with the “top line,” Intel’s revenues were $38.3 billion, up 8% compared to 2006. The “bottom line”, net income, was up 38% to nearly $7 billion. With net income growing faster than revenues, it appears that Intel was successful in cutting costs and increasing operational efficiencies by executing its restructuring plans as described in its 2006 annual report:

“Our restructuring efforts, coupled with our strong product lineup, position us to compete aggressively [in 2007] ...”

Paul S. Otellini, CEO Letter, Intel’s 2006 Annual Report

So, how was Intel’s performance relative to its biggest competitor? When making these assessments, users create ratios to adjust for size differences. For example, larger companies will generally report more income than smaller ones, even if they do not perform as well for shareholders.

Return on equity (ROE) is the most commonly used performance ratio. It is defined as net income divided by the book value of owners’ equity. Everything else equal, the higher the ROE, the more net income the company is generating per dollar of owners’ equity, that is per dollar of net assets.

Return on Equity Ratio

= AverageOwners’ EquityROE /Net

Income

Average Owners’ EquityGenerally, analysts use average owners’ equity for the reporting period over which net income is measured. The idea being this measures the average net assets available during the period to generate income.

Intel’s ROE was particularly strong at 17.6% versus AMD at – 77.0% for 2007. AMD’s negative ROE is a reflection of its net loss of $3.4 billion for 2007. In fact, Intel’s ROE improved in 2007 (up from 13.8% in 2006) while AMD’s declined (from – 3.6% in 2006).

So, what did Intel do to improve its ROE? At the big picture level the answer is easy: increase net income and/or decrease owners’ equity, since ROE is net income divided by owners’ equity. However, this is not very actionable.

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The Dupont Model decomposes ROE into four factors that suggest more specific actions managers can take to increase ROE. These factors also offer insights for analysts and others evaluating a company’s performance:

Dupont Model

= AssetTurnover

ROE XProfitMargin

FinancialLeverage

IncomeTax FactorX X

Profit margin (pretax profit divided by sales) measures pretax profit per sales dollar. Everything else equal, the more profit a company can earn on each dollar of sales, the higher its ROE. To get a better understanding of the factors that determine profit margins, managers and other users often split profit margin into: gross-margin percent, other operating expenses as a percent of sales, and non-operating income as a percent of sales. These, in turn, can be further split into individual income-statement line items as a percent of sales. Common size income statements, which are created by dividing each income statement item by net revenues, facilitate this analysis.

Asset turnover (sales divided by average assets) measures how efficiently a company uses assets to generate sales — how well the entity uses its inputs (assets) to generate outputs (revenues). Managers and other users can combine income statement and balance sheet information to further analyze efficiency. For example, they can measure receivables turnover (sales divided by average receivables), inventory turnover (cost of sales divided by average inventories) and PP&E turnover (sales divided by average PP&E).

Financial leverage (assets divided by owners’ equity) measures the extent to which owners are using creditors’ money to generate ROE. Everything else equal, increasing financial leverage increases ROE. However, increasing financial leverage increases the owners’ risk because creditors must be paid regardless of whether the company has operating income or losses. When profit margins are negative, increasing financial leverage makes ROE more negative.

Income tax factor (1 minus the tax rate, where the tax rate is the tax expense divided by pretax income) isolates the extent to which income taxes affect ROE.

The Dupont model suggests that performance can be improved by increasing profit margin, asset turnover rate, or financial leverage or by decreasing the tax rate. To various degrees, depending on the circumstances, management’s actions can influence these factors and thus ROE.

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Decomposing Intel’s ROE into the four Dupont model factors revealed Intel’s profit margin drives its ROE. As illustrated in this graph, Intel’s ROE and profit margins have been highly correlated for the past decade.

30%

35%

40%

45%

50%

Intel's ROEs & Profit Margins 1996-2007

0%

5%

10%

15%

20%

25%

30%

1996 1998 2000 2002 2004 2006 2008

ROE

Profit Margin

First, we see Intel’s ROE (the bottom line in the graph) varied significantly over the years, from a 38.4% high in 1997 to a 3.5% low in 2001, after the high-tech bubble burst. Then, ROE and profit margin steadily increased until 2006. So, what caused the drop in 2006?

Analyzing common-size income statements for Intel shows a 12.5 percentage point decrease in profit margin in 2006 due to a 15.2 point decrease in operating income, offset by a 2.6 point increase in gains and interest income. Changes in operating income are generally more persistent than changes in gains and losses and thus more predictive of future performance. By analyzing the changes in the line items above operating income, we find that cost of sales increased by 7.9 points in 2006. This likely raised a red flag for investors, especially because cost of sales increased while net revenues decreased in 2006.

How did Intel turn around its performance? According to its 2007 annual report, Intel responded by launching new products, controlling spending and increasing efforts to gain operational efficiencies: all actions that improve profit margin and thus ROE. Indeed, the common-size statement shows a 5 point improvement in operating income from reduced spending in 2007.

Thus far, we have seen how business factors affect profit margin. However, it can also be impacted by accounting policy changes. In 2006, Intel’s profit margin decreased because GAAP mandated companies start expensing stock-based compensation, such as stock options granted to employees. As a result, Intel recognized nearly $1.4 billion of expenses on its income statement associated with stock-based compensation.

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Importantly, Intel, like most companies, has been using stock-based compensation for years and reporting related information in its footnotes, but it has not been recognizing these expenses on its income statement. This means that while the 2006 income statement reflects compensation costs more accurately, comparability to earlier years is sacrificed. For the comparison to be valid, analysts should either remove the stock-based compensation from the affected 2006 income-statement line items or include the footnote information from earlier years in the earlier income statement line items. For example, using the disclosed information, we can remove the stock-based compensation from Intel’s 2006 income-statement and recompute the ratios. In fact, this improved Intel’s profit margin by 4 points. So, this one accounting policy change helps explain the drop in profit margin and ROE in 2006.

Another observation from the graph of Intel’s ROE is that it varies significantly and is impacted by actions management can take, accounting policy changes, and by industry and economic trends. This suggests predictions of Intel’s future ROEs based solely on past ROEs would likely not be very accurate. Clearly, analysts must dig deeper in the financial statements, understand what’s behind the numbers, and integrate this into the broader business context.

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Exercise 2.04This question compares the financial performance of Intel, Advanced Micro Devices (AMD), Federal Express, Gap, Limited, and Nike. AMD competes with Intel in developing, manufacturing, and selling cutting-edge microprocessors and Gap and Limited compete in retailing fashionable clothing.

The solutions start on page 89.

(a) Complete the following tables for Intel. Start with the bottom table since you will need it to complete the top table. You will need to refer to Intel’s Balance sheet (Figure 1.01, Chapter 1) and Intel’s Income Statement in Figure 2.01 (page 71). Use the Dupont model to complete the top table.

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2006 2005 2004 2003

Profit margin 32.48% 30.45% 24.69%

Turnover 0.81 0.72 0.66

Financial Leverage 1.29 1.25 1.25

(1-tax rate) 68.71% 72.15% 75.80%

ROE 23.18% 19.67% 15.39%

Net revenues $38,826 $34,209 $30,141

Income before taxes $12,610 $10,417 $7,442

Tax expense $3,946 $2,901 $1,801

Net Income $8,664 $7,516 $5,641

Beginning owners' equity $38,579 $37,846 $35,468

Ending owners' equity $36,182 $38,579 $37,846

Average owners' equity $37,381 $38,213 $36,657

Beginning total assets $48,143 $47,143 $44,224

Ending total assets $48,314 $48,143 $47,143

Average total assets $48,229 $47,643 $45,684

Intel

(b) Figure 2.08 on pages 78 and 79 presents Dupont-Model numbers for Intel, AMD, Federal Express, Gap, Limited, and Nike for 1998-2002. The 1998 ROE for Limited has been adjusted by removing a $1,740 million pretax gain that Limited recognized when it exited a business. Removing this unusual gain reduced ROE from 86.55% to 16.29%.

Determine each company’s average ROE for 1998-2000 (exclude 2001 and 2002) and rank the companies by these averages.

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(c) Which companies’ ROEs declined precipitously in 2001 relative to their averages for 1998-2000? What happened to them in 2002?

(d) A company’s performance can decline because of industry-wide or economy-wide factors that harm all companies in the industries where it competes and/or because it loses ground to competitors. Based on the information in Figure 2.08, to what extent does it appear that economy-wide or industry-wide problems rather than competitors caused the performance of the companies you identified in (c) to decline so precipitously in 2001.

(e) Figure 2.08 indicates that all four of the Dupont model factors decreased from 2000 to 2001 for Intel and AMD: profit margin, turnover, financial leverage, and income tax factor. Which of these factors caused the biggest decline in ROE for each company? To answer this question, perform a sensitivity analysis by completing the following table: substitute the 2001 values for the four factors one at a time for the corresponding factors in the 2000 Dupont Model derivation.

ROE can be derived by multiplying the four factors; however, the results are slightly different due to rounding versus computing ROE by dividing net income by average owners’ equity. For instance Intel’s 2000 ROE would be 29.87% using the multiplication method versus 30.16%. For this analysis, use the multiplication method.

2000 computation using 2000

factors


profit margin


turnover


financial leverage

2000 computation using 2001 tax factor

Profit margin 44.89% 8.23% 44.89% 44.89% 44.89%

Turnover 0.73 0.73 0.57 0.73 0.73Financial Leverage 1.31 1.31 1.31 1.26 1.31(1-tax rate) 69.58% 69.58% 69.58% 69.58% 59.14%ROE 30.16%


factors


profit margin


turnover


financial leverage


Profit margin 26.96% -2.41% 26.96% 26.96% 26.96%

Turnover 0.92 0.92 0.68 0.92 0.92

Financial Leverage 1.97 1.97 1.97 1.70 1.97

(1-tax rate) 79.48% 79.48% 79.48% 79.48% 84.60%ROE 39.06%

Intel

Advanced Micro Devices

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(f ) Figure 2.09 provides common size income statements for Intel and AMD for 2000-2002, which are derived by dividing each income statement item by net revenues. These are useful for learning more about profit margins. What were the two major reasons that Intel’s and AMD’s profit margins declined sharply in 2001?

(g) What would AMD’s profit margin have been if it had not taken a restructuring charge in 2002?

(h) Figure 2.08 indicates that three of the four Dupont model factors for Gap decreased from 2000 to 2001: profit margin, turnover, and taxes. The highly unusual 2001 tax rate (more than 100%) was largely due to a tax charge explained in the income tax footnote:

The tax charge of $131 million primarily reflected changes in the estimates of probable settlements of foreign and domestic tax audits. In addition, the level and mix of earnings caused our tax rate to increase well above earlier expectations.

Page 26, Gap’s 2002 Annual Report

To the extent that analysts believe this charge is non-recurring, when using current ROE to predict future ROE, they will adjust ROE so that it does not reflect the charge. What would Gap’s ROE have been in 2001 without the tax charge?

(i) Figure 2.08 indicates that Limited’s profit margin increased in 2001 and that Gap’s profit margin decreased. What do the common size income statements in Figure 2.10 tell you about the reasons why Limited’s profit margin was higher than Gap’s in 2001? Why did Gap’s profit margin increase in 2002?

(j) To what extent is the 1.51 percentage point decrease in Federal Express’ profit margin from 2000 to 2001 attributable to operating income?

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Exercise 2.05Answer these questions using Figure 2.11, Excerpt from Starbucks’ 2002 Annual Report disclosing some of the company’s accounting policies.

There are no solutions provided for this exercise.

(a) First, assume Starbucks recognizes revenues at the point-of-sale when they sell $10 of coffee. Ignoring the cost of the coffee, how is the revenue from the sale reflected in the balance-sheet equation? Do net assets increase? If so, why?

(b) Suppose coffee beans cost Starbucks $2 to purchase, $1 to roast, and $0.50 to brew. How is net assets affected when Starbucks purchases coffee beans? How is net assets affected when the coffee beans are roasted? How are net assets affected when the processed coffee beans are brewed and sold? Which principle supports recognizing inventoried costs when coffee is sold and revenues are recognized?

(c) Why report $10 of revenue and $3.50 of expenses rather than simply $6.50 of net income?

(d) Now, suppose that the gross margin decreases from $6.5 to $6. Why do we care whether this decrease is due to a decrease in revenues, an increase in expenses, or some combination of changes to revenues and expenses?

(e) Next, assume a customer pays $10 for a Starbucks value card up front and then uses the card over time until the balance is depleted to zero. In this case, the value card is swiped through a machine each time coffee or another Starbucks product is sold, rather than collecting cash from the customer. Should Starbucks recognize revenue when the value card is sold? If not, why not? Which revenue recognition criteria are satisfied and which, if any, have not been satisfied? When should the revenue be recognized?

(f ) What risky events or circumstances could occur between the time Starbucks sells a value card and the customer uses it that could prevent Starbucks from earning related income?

(g) What are the revenue-recognition policies associated with value cards?

(h) Assume Starbucks incurs $15 of cost to advertise in a paper this year. When will Starbucks recognize related advertising expense?

(i) Now assume that Starbucks incurs $25 of cost this year to produce an advertisement that will run for the first time next year. The advertisement will likely benefit sales for a few years. When will Starbucks recognize the related advertising expense?

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KEY TAKE-AWAYS• The purpose of an income statement is to help users assess a

company’s financial performance during a reporting period by providing details about the net income recognized during the period.

• In contrast to balance sheets, income statements measure performance over an interval of time. In this regard, we say that balance sheets report stocks at a point in time and income statements report interval flows .

• Revenues are changes in owners’ equity that arise from increases in net assets during a reporting period associated with delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing or central operations.

• Expenses are changes in owners’ equity that arise from decreases in net assets during a reporting period associated with inventing, developing, producing, and delivering goods and services, or performing other activities central to the company’s operations. Net assets decrease when expenses are recognized either because assets decrease, contra assets increase, or liabilities increase.

• Gains are changes in owners’ equity that arise from increases in net assets during a reporting period associated with events and circumstances peripheral to a company’s primary business activities, are outside the company’s control, and largely unpredictable when the assets or liabilities were originally recognized. For example, selling the corporate headquarters for more than its book value gives rise to a gain.

• Losses are changes in owners’ equity that arise from decreases in net assets during a reporting period associated with events and circumstances peripheral to a company’s primary business activities, are outside the company’s control, and largely unpredictable when the assets or liabilities are originally recognized. For example, if the proceeds from the sale were less than the book value of the building prior to the sale, the difference would be a loss.

• Other income is changes in owners’ equity that arise from increases in net assets during a reporting period that are not associated with revenues or gains, but rather from such activities as dividends received from investments in other companies’ stocks or interest received from investments in government bonds. In contrast to gains and losses, other income is somewhat predictable.

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• Revenue recognition decisions determine whether and when revenues are recognized on income statements.

• Revenue recognition can be very problematic, for example, when there is significant risk that customers will return products for refunds, receive price-protection discounts, file warranty claims, or default on promised payments. Many financial reporting scandals have centered on revenue recognition and it has been a hot issue at the Securities and Exchange Commission (SEC) for several years.

• Expense recognition decisions determine when costs are recognized as expenses on income statements. Costs are not necessarily expensed when they are paid: Costs can be paid in periods before, during, or after the period when they are expensed.

• Expense recognition can be very contentious. In particular, there is frequently controversy as to whether companies should capitalize or expense the costs they incur. Capitalize versus expense controversies generally center on timing: sooner or later the costs of most resources that are acquired to help generate future revenues are expensed. For example, eventually the costs capitalized when a building is acquired are completely expensed through depreciation.

• Deciding whether costs that relate to future revenues should be expensed as incurred, or capitalized as assets and expensed in the future, can require considerable judgment. Sometimes these judgments are determined by GAAP and other times they are made by companies with GAAP guidance. The Worldcom reporting scandal in 2002 centered on this judgement: the SEC accused Worldcom of capitalizing billions of dollars of costs in past years that should have been expensed as incurred, and thus of having overstated net income in prior years.

• Return on equity (ROE) is the most commonly used performance ratio when analyzing income statements. It is defined as net income divided by the book value of owners’ equity. Everything else equal, the higher the ROE, the more net income the company is generating per dollar of owners’ equity, that is per dollar of net assets. The Dupont Model provides additional guidance to actions managers can take to increase ROE. It decomposes ROE into four factors that suggest more specific ways to improve performance: profit margin, turnover, financial leverage and an income tax factor.

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Figure 2.01 Intel’s Income StatementThis figure illustrates Intel’s income statements.

Intel Consolidated Statements of IncomeThree Years Ended December 29, 2007(In Millions--Except Per Share Amounts) 2007 1 2006 1 2005Net Revenue 38,334$ 35,382$ 38,826$Cost of sales 18,430 17,164 15,777Gross Margin 19,904 18,218 23,049Research and development 5,755 5,873 5,145Marketing, general and administrative 5,401 6,096 5,688Restructuring and asset impairment charges 516 555 ─Amortizaton of acquisition-related intangibles and costs 16 42 126Operating expenses 11,688 12,566 10,959Operating income 8,216 5,652 12,090Gains (losses) on equity investments, net 157 214 (45)Interest and other, net 793 1,202 565Income before taxes 9,166 7,068 12,610Provision for taxes 2,190 2,024 3,946Net income 6,976$ 5,044$ 8,664$Basic earnings per common share $1.20 $0.87 $1.42Diluted earnings per common share $1.18 $0.86 $1.40Weighted average shares outstanding

Basic 5,816 5,797 6,106Diluted 5,936 5,880 6,178

1 Cost of sales and operating expenses for the years ended December 29, 2007 and December 30, 2006 include share-based compensation. See "Note 2" Accounting Policies" and "Note 3: Employee Equity Incentive Plans."

See notes to Consolidated Financial Statements.

The company’s notes found in its annual report are an integral part of this statement.

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Figure 2.02 Cisco’s Income StatementThis figure illustrates Cisco’s income statements.


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CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands except share 52 Weeks Ended Percentage 52 Weeks Ended Percentage 53 Weeks Ended Percentageand per share amounts) Feb. 1, 2003 to Sales Feb. 2, 2002 to Sales Feb. 3, 2001 to Sales

Net sales $ 14,454,709 100.0% $13,847,873 100.0% $13,673,460 100.0%

Costs and expenses

Cost of goods sold andoccupancy expenses 9,541,558 66.0 9,704,389 70.1 8,599,442 62.9

Operating expenses 3,900,522 27.0 3,805,968 27.5 3,629,257 26.5

Interest expense 248,599 1.7 109,190 0.8 74,891 0.5

Interest income (36,845) (0.2) (13,315) (0.1) (12,015) 0.0

Earnings before income taxes 800,875 5.5 241,641 1.7 1,381,885 10.1

Income taxes 323,418 2.2 249,405 1.8 504,388 3.7

Net earnings (loss) $ 477,457 3.3% $ (7,764) (0.1%) $ 877,497 6.4%

Weighted-average number of shares — basic 875,545,551 860,255,419 849,810,658

Weighted-average numberof shares — diluted 881,477,888 860,255,419 879,137,194

Earnings (loss) per share — basic $ 0.55 $ (0.01) $ 1.03

Earnings (loss) per share — diluted (a) 0.54 (0.01) 1.00

See Notes to Consolidated Financial Statements.

(a) Diluted losses per share for the 52 weeks ended February 2, 2002, are computed using the basic weighted-average number of shares outstanding and exclude13,395,045 dilutive shares, as their effects are antidilutive when applied to losses.

33

Figure 2.03 Gap’s Income StatementThis figure illustrates Gap’s income statements.


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24

CONSOLIDATED STATEMENTS OF EARNINGSIn thousands, except earnings per share

Fiscal year ended Sept 29, 2002 Sept 30, 2001 Oct 1, 2000 Net revenues:

Retail $ 2,792,904 $ 2,229,594 $ 1,823,607 Specialty 496,004 419,386 354,007

Total net revenues 3,288,908 2,648,980 2,177,614 Cost of sales and related occupancy costs 1,350,011 1,112,785 961,885 Store operating expenses 1,121,108 875,473 704,898 Other operating expenses 127,178 93,326 78,445 Depreciation and amortization expenses 205,557 163,501 130,232 General and administrative expenses 202,161 151,416 110,202

Income from equity investees 35,832 28,615 20,300 Operating income 318,725 281,094 212,252

Interest and other income, net 9,300 10,768 7,110 Internet-related investment losses - 2,940 58,792Gain on sale of investment 13,361 - - Earnings before income taxes 341,386 288,922 160,570

Income taxes 126,313 107,712 66,006 Net earnings $ 215,073 $ 181,210 $ 94,564

Net earnings per common share – basic $ 0.56 $ 0.48 $ 0.25 Net earnings per common share – diluted $ 0.54 $ 0.46 $ 0.24

Weighted average shares outstanding:Basic 385,575 380,566 371,191 Diluted 397,526 394,349 385,999


CONSOLIDATED BALANCE SHEETSIn thousands, except share data

Sept 29, 2002 Sept 30, 2001 ASSETS Current assets:

Cash and cash equivalents $ 174,572 $ 113,237 Short-term investments – Available-for-sale securities 217,302 101,399 Short-term investments – Trading securities 10,360 5,913 Accounts receivable, net of allowances of $3,680 and $4,590, respectively 97,573 90,425 Inventories 263,174 221,253 Prepaid expenses and other current assets 42,351 29,829 Deferred income taxes, net 42,206 31,869 Total current assets 847,538 593,925

Equity and other investments 105,986 63,097 Property, plant and equipment, net 1,265,756 1,135,784 Other assets 53,554 31,868 Goodwill, net 19,902 21,845

TOTAL ASSETS $ 2,292,736 $ 1,846,519 LIABILITIES AND SHAREHOLDERS’ EQUITY Current liabilities:

Accounts payable $ 135,994 $ 127,905 Checks drawn in excess of bank balances 74,895 61,987 Accrued compensation and related costs 105,899 81,458 Accrued occupancy costs 51,195 35,835 Accrued taxes 54,244 70,346 Other accrued expenses 72,289 40,117 Deferred revenue 42,264 26,919 Current portion of long-term debt 710 697 Total current liabilities 537,490 445,264

Deferred income taxes, net 22,496 19,133 Long-term debt 5,076 5,786 Other long-term liabilities 1,036 409

Shareholders’ equity:Common stock and additional paid-in capital – Authorized, 600,000,000 shares;

issued and outstanding, 388,228,592 and 380,044,042 shares, respectively (includes 1,697,100 common stock units in both years) 891,040 791,622

Other additional paid-in capital 39,393 - Retained earnings 804,786 589,713Accumulated other comprehensive loss (8,581) (5,408) Total shareholders’ equity 1,726,638 1,375,927 TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY $ 2,292,736 $ 1,846,519


Figure 2.04 Starbucks’ Income StatementThis figure illustrates Starbucks’ income statements.


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Figure 2.05 Nike’s Income StatementThis figure illustrates Nike’s income statements.


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Figure 2.06 Coca Cola’s Income StatementThis figure illustrates Coca Cola’s income statements.


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28––

Consolidated Statements of Income

Years ended May 31In millions, except per share amounts 2002 2001 2000

REVENUES $20,607 $19,629 $18,257Operating ExpensesSalaries and employee benefits 9,099 8,263 7,598Purchased transportation 1,825 1,713 1,675Rentals and landing fees 1,780 1,650 1,538Depreciation and amortization 1,364 1,276 1,155Fuel 1,100 1,143 919Maintenance and repairs 1,240 1,170 1,101Airline stabilization compensation (119) – –Other 2,997 3,343 3,050

19,286 18,558 17,036OPERATING INCOME 1,321 1,071 1,221Other Income (Expense)Interest, net (139) (144) (106)Other, net (22) – 23

(161) (144) (83)Income Before Income Taxes 1,160 927 1,138Provision for Income Taxes 435 343 450Income Before Cumulative Effect of Change in Accounting Principle 725 584 688Cumulative Effect of Change in Accounting for Goodwill, Net of Tax Benefit of $10 (15) – –NET INCOME $ 710 $ 584 $ 688

BASIC EARNINGS PER COMMON SHARE:Income before cumulative effect of change in accounting principle $ 2.43 $ 2.02 $ 2.36Cumulative effect of change in accounting for goodwill (.05) – –Basic Earnings Per Common Share $ 2.38 $ 2.02 $ 2.36

DILUTED EARNINGS PER COMMON SHARE:Income before cumulative effect of change in accounting principle $ 2.39 $ 1.99 $ 2.32Cumulative effect of change in accounting for goodwill (.05) – –Diluted Earnings Per Common Share $ 2.34 $ 1.99 $ 2.32

The accompanying notes are an integral part of these consolidated financial statements.

Figure 2.07 Federal Express’ Income StatementThis figure illustrates Federal Express’ income statements.


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Figure 2.08 Dupont Model Computations This figure reports 1998-2002 Dupont Model Computations for Intel, Advance Micro Devices, Federal Express, Gap, Limited and Nike. The computations are based on average balance-sheet numbers (e.g., average total assets).Note: The ROE numbers are computed as net income divided by average owners’ equity. Multiplying the four Dupont-Model factors in the table results in a small round-off error.

Figure 2.08 is Continued on Page 79.

2002 2001 2000 1999 1998

Profit margin 15.71% 8.23% 44.89% 38.20% 34.78%Turnover 0.60 0.57 0.73 0.78 0.87Financial Leverage 1.24 1.26 1.31 1.35 1.41(1-tax rate) 74.14% 59.14% 69.58% 65.14% 66.41%ROE 8.74% 3.53% 30.16% 26.16% 28.44%

2002 2001 2000 1999 1998Profit margin -46.89% -2.41% 26.96% 2.58% -8.16%

Turnover 0.48 0.68 0.92 0.66 0.65


(1-tax rate) 103.53% 84.60% 79.48% -120.80% 50.12%

ROE -43.27% -1.80% 39.06% -4.46% -5.15%

2002 2001 2000 1999 1998


Intel

Federal Express

Advanced Micro Devices (AMD)

79



Figure 2.08 Continued.

2002 2001 2000 1999 1998Profit margin 5.54% 1.74% 10.11% 15.34% 14.57%

Turnover 1.64 1.88 2.24 2.54 2.48


(1-tax rate) 59.62% -3.21% 63.50% 63.14% 62.50%

ROE 14.32% -0.26% 34.00% 59.21% 52.22%

2002 2001 2000 1999 1998Profit margin 9.91% 10.47% 7.98% 8.87% 7.40%

Turnover 1.37 1.76 2.01 1.83 1.73


(1-tax rate) 59.26% 57.37% 56.14% 55.41% 54.20%

ROE 13.05% 20.00% 18.24% 19.98% 16.29%

2002 2001 2000 1999 1998


Gap

Nike

Limited

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Figure 2.09 Intel’s and AMD’s Common Size Income StatementsThis figure reports Intel’s and AMD’s common size income statements for 2000-2002. These are derived by dividing each income statement entry by net revenues.

Intel Common Size Income Statements

2002 2001 2000Net revenue 100.0% 100.0% 100.0%Cost of sales 50.2% 50.8% 37.5%Gross margin 49.8% 49.2% 62.5%Research and development 15.1% 14.3% 11.6%Marketing, general and administrative 16.2% 16.8% 15.1%Amortization of goodwill 6.4% 3.9%Amortization and impairment of acquisition-related intangibles and costs 2.0% 2.4% 0.8%Purchased in-process research and development 0.1% 0.7% 0.3%Operating expenses 33.4% 40.7% 31.7%Operating income 16.4% 8.5% 30.8%Gains (losses) on equity securities, net -1.4% -1.8% 11.1%Interest and other, net 0.7% 1.5% 2.9%Income before taxes 15.7% 8.2% 44.9%Provision for taxes 4.1% 3.4% 13.7%Net income 11.6% 4.9% 31.2%

AMD Common Size Income Statements

2002 2001 2000Net sales 100.0% 100.0% 100.0%Expenses

Cost of sales 78.1% 66.5% 54.1%Research and development 30.3% 16.7% 13.8%Marketing, general and administrative 24.8% 15.9% 12.9%Restructuring and other special charges 12.3% 2.3% 0.0%

145.4% 101.5% 80.9%Operating income (loss) -45.4% -1.5% 19.1%Gain on sale of Legerity 7.3%Interest and other income, net 1.2% 0.7% 1.9%Interest expense -2.6% -1.6% -1.3%Income (loss) before income taxes, equity in net income of joint

ventures and extraordinary item -46.9% -2.4% 27.0%Provision (bebefit) for income taxes 1.7% -0.4% 5.5%Income (loss) before equity in net income of joint

ventures and extraordinary item -48.5% -2.0% 21.4%Equity in net income of joint ventures 0.2% 0.5% 0.2%Net income (loss) before extraordinary item -48.3% -1.6% 21.7%Extraordinary item - debt retirement -0.5%Net income (loss) -48.3% -1.6% 21.2%


81



Figure 2.10 Gap’s and Limited’s Common Size Income StatementsThis figure reports Gap’s and Limited’s common size income statements for 2000-2002. These are derived by dividing each income statement entry by net revenues.

GAP Common Size Income Statements52 Weeks Ended

Feb 1, 200352 Weeks Ended

Feb 2, 200253 Weeks Ended

Feb 3, 2001

Net sales 100.0% 100.0% 100.0%Costs and Expenses

Cost of good sold and occupancy costs 66.0% 70.1% 62.9%Operating expenses 27.0% 27.5% 26.5%Interest expense 1.7% 0.8% 0.5%Interest income -0.3% -0.1% -0.1%

Earnings before income taxes 5.5% 1.7% 10.1%Income taxes 2.2% 1.8% 3.7%Net earnings 3.3% -0.1% 6.4%

Limited Common Size Income Statements2002 2001 2000

Net sales 100.0% 100.0% 100.0%Cost of good sold, buying, and occupancy -63.4% -64.2% -64.9%Gross income 36.6% 35.8% 35.1%General, administrative and store operating expenses -26.3% -27.2% -25.8%Special and non-recurring items, net -0.4% 2.0% -0.1%Operating income 9.9% 10.6% 9.2%Interest expense -0.4% -0.4% -0.6%Interest income 0.3% 0.3% 0.5%Other income, net 0.0% 0.0% -0.2%Minority interest -0.1% -0.8% -0.8%Gains on stock by investees 0.1% 0.7% 0.0%Income before income taxes 9.9% 10.5% 8.0%Income tax expense 4.0% 4.5% 3.5%Net income 5.9% 6.2% 4.7%


82



28

years for buildings. Leasehold improvements are amortized overthe shorter of their estimated useful lives or the related lease life,generally ten years.The portion of depreciation expense relatedto production and distribution facilities is included in “Cost ofsales and related occupancy costs” on the accompanyingconsolidated statements of earnings. The costs of repairs andmaintenance are expensed when incurred, while expendituresfor refurbishments and improvements that significantly add tothe productive capacity or extend the useful life of an asset arecapitalized. When assets are retired or sold, the asset cost andrelated accumulated depreciation are eliminated with anyremaining gain or loss reflected in net earnings.

Goodwill and Other Intangible AssetsThe Company’s intangible assets mainly consist of goodwill,trademarks, patents and copyrights.These assets are amortized ona straight-line basis over the period of expected benefit, whichranges from ten to twenty years. Starbucks will adopt SFAS No.142, “Goodwill and Other Intangible Assets” in fiscal 2003.Accordingly, goodwill and certain intangibles with indefinitelives will not be amortized but instead will be reviewed forimpairment at least annually. Remaining intangibles with finiteuseful lives will continue to be amortized.As of September 29,2002, Starbucks had goodwill and other intangible assets, net ofaccumulated amortization, of $19.9 million and $9.9 million,respectively, which are subject to the transitional assessmentprovisions of SFAS No. 142.The Company’s management hasdetermined that the adoption of SFAS No. 142 will not have amaterial impact on results of operations or the Company’sconsolidated financial position.

Long-lived AssetsWhen facts and circumstances indicate that the carrying valuesof long-lived assets, including intangibles, may be impaired, anevaluation of recoverability is performed by comparing thecarrying value of the assets to projected future cash flows inaddition to other quantitative and qualitative analyses. Uponindication that the carrying value of such assets may not berecoverable, the Company recognizes an impairment loss by acharge against current operations. Property, plant andequipment assets are grouped at the lowest level for which thereare identifiable cash flows when assessing impairment. Cashflows for retail assets are identified at the individual store level.

Revenue RecognitionIn most instances, retail store revenues are recognized whenpayment is tendered at the point of sale. Revenues from storedvalue cards are recognized upon redemption. Until theredemption of stored value cards,outstanding customer balanceson such cards are included in “Deferred revenue” on theaccompanying consolidated balance sheets. Specialty revenues,consisting mainly of product sales, are generally recognizedupon receipt by customers. Initial non-refundable fees requiredunder licensing agreements are earned upon substantialperformance of services. Royalty revenues based upon apercentage of sales and other continuing fees are recognizedwhen earned.All revenues are recognized net of any discounts.

AdvertisingThe Company expenses costs of advertising the first time theadvertising campaign takes place, except for direct-to-consumer advertising, which is capitalized and amortized overits expected period of future benefit, generally six to twelvemonths. Net capitalized direct-to-consumer advertising costswere $0.8 million and $0.9 million as of September 29, 2002,and September 30, 2001, respectively, and are included in“Prepaid expenses and other current assets” on theaccompanying consolidated balance sheets. Total advertisingexpenses, recorded in “Store operating expenses” and “Otheroperating expenses,” on the accompanying consolidatedstatements of earnings were $25.6 million, $28.8 million and$32.6 million in 2002, 2001 and 2000, respectively.

Store Preopening ExpensesCosts incurred in connection with the start-up and promotionof new store openings are expensed as incurred.

Rent ExpenseCertain of the Company’s lease agreements provide forscheduled rent increases during the lease terms or for rental

payments commencing at a date other than the date of initialoccupancy. Minimum rental expenses are recognized on astraight-line basis over the terms of the leases.

Stock-based CompensationThe Company accounts for stock-based compensation usingthe intrinsic value method prescribed in Accounting PrinciplesBoard Opinion (“APB”) No. 25,“Accounting for Stock Issuedto Employees.” Compensation cost for stock options, if any, ismeasured by the excess of the quoted market price of theCompany’s stock at the date of grant over the amount anemployee must pay to acquire the stock. SFAS No. 123,“Accounting for Stock-Based Compensation,” establishedaccounting and disclosure requirements using a fair-value basedmethod of accounting for stock-based employee compensationplans. The Company follows the disclosure requirements ofSFAS No. 123, see Note 12, and intends to disclose stock-basedcompensation information quarterly in fiscal 2003.

Foreign Currency TranslationThe Company’s international operations use their localcurrency as their functional currency. Assets and liabilities aretranslated at exchange rates in effect at the balance sheet date.Income and expense accounts are translated at the averagemonthly exchange rates during the year. Resulting translationadjustments are recorded as a separate component ofaccumulated other comprehensive income.

Income TaxesThe Company computes income taxes using the asset andliability method, under which deferred income taxes areprovided for the temporary differences between the financialreporting basis and the tax basis of the Company’s assetsand liabilities.

Stock SplitOn April 27, 2001, the Company effected a two-for-one stocksplit of its $0.001 par value common stock for holders ofrecord on March 30, 2001. All applicable share and per-sharedata in these consolidated financial statements have beenrestated to give effect to this stock split.

Earnings Per ShareThe computation of basic earnings per share is based onthe weighted average number of shares and commonstock units outstanding during the period. The computa-tion of diluted earnings per share includes the dilutive effectof common stock equivalents consisting of certain sharessubject to stock options.

Recent Accounting PronouncementsIn August 2001, the Financial Accounting Standards Board(“FASB”) issued SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” whichsupercedes SFAS No. 121,“Accounting for the Impairment ofLong-Lived Assets and for Long-Lived Assets to Be DisposedOf.” SFAS No.144 retains the fundamental provisions of SFASNo. 121, but sets forth new criteria for asset classification andbroadens the scope of qualifying discontinued operations. TheCompany’s adoption of SFAS No.144 on September 30, 2002,will not have a material impact on the Company’s consolidatedfinancial position and results of operations.

In November 2001, FASB issued Emerging Issues Task Force(“EITF”) No. 01-14, “Income Statement Characterization ofReimbursements Received for ‘Out-of-Pocket’ ExpensesIncurred.” This Issue clarifies the FASB staff ’s position that allreimbursements received for incidental expenses incurred inconjunction with providing services as part of a company’scentral ongoing operations should be characterized as revenue inthe income statement.The Company adopted EITF No. 01-14on December 31, 2001, and it did not have a material impact onthe Company’s consolidated results of operations.

In November 2002, the FASB issued Interpretation No. 45,“Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness ofOthers,” which elaborates on existing disclosure of mostguarantees, and clarifies when a company must recognize aninitial liability for the fair value of obligations it assumes underguarantee agreements.The initial recognition and measurement

Figure 2.11 Starbucks’ Excerpt from Accounting Policies FootnoteThis figure illustrates Starbucks’ accounting policies footnote.


83



CHAPTER SOLUTIONSSolution to Exercise 2.01(a) False: Income statements measure performance during a reporting

period, not at the reporting date.

(b) True: Revenues are increases in net assets that are associated with customer sales. However, this does not mean that all increases in net assets are revenues.

(c) False: Expenses are decreases in net assets, but not all decreases in net assets are expenses. For example, declaring cash dividends reduces net assets because dividends payable (a liability) increases and retained earnings (an owners’ equity) decreases.

(d) True: Owners’ equity increases because ABC recognizes revenues at this time and accounts receivable increases, indicating the future benefit associated with the anticipated collection from the customer.

(e) False: ABC has realized $10 of revenues but it might not have earned them yet and revenue recognition only occurs when revenues are deemed realizable and earned.

(f ) True: Revenue is realized when cash is collected.

(g) False: ABC has earned revenue but it might not be realizable. If there is considerable uncertainty about collecting the $10 and ABC does not believe it can reliably estimate an allowance for bad debts, ABC should recognize a $10 increase to accounts receivable and a deferred income liability.

(h) True: This is an application of the matching principal.

(i) True: Intel’s balance sheet recognizes an accrued compensation and benefits liability. This liability increases when Intel recognizes earned deferred compensation and decreases when Intel pays employees previously deferred compensation.

(j) False: Global Crossing was accused of overly aggressive accounting. Overly conservative accounting postpones income recognition beyond what is warranted by the facts and circumstances.

84



Solution to Exercise 2.02(a) Here are the line items on the other six companies’ income statements

that likely represent a similar concept to net revenues: Net Revenues: Starbucks’ Net sales: Cisco and Gap Revenues: Nike and Federal Express Net operating revenues: Coca Cola

(b) Cisco and Starbucks. Cisco splits total net sales into net sales from products and net sales from services. Starbucks splits total net revenues into retail and specialty. Starbucks defines specialty in its footnotes:

In addition, Starbucks sells coffee and tea products through other channels of distribution, and, through certain of its equity investees, Starbucks also produces and sells bottled Frappuccino® and Starbucks DoubleShot™ coffee drinks and a line of premium ice creams. These non-retail channels are collectively known as “Specialty Operations.”

Page 15, Starbucks’ 2002 Annual Report

(c) For Federal Express, it is possible that the company has very few returns and discounts, if any. Thus, there is likely no need to include net as a modifier. By contrast, Nike states that it has returns and discounts in the Recognition of revenues section of its Summary of Significant Accounting Policies footnote:

Provisions for sales discounts and returns are made at the time of sale.

Page 35, Nike’s 2002 Annual Report

Thus, presumably Nike assumes that readers will infer that “Revenues” means net of returns and discounts. There seems to be no harm from this assumption because companies that report net revenues generally do not disclose details about gross revenues, returns, and discounts. Thus, in effect, Nike is recognizing comparable information to the other companies. Alternatively, Nike might be implying that its returns and discounts are so negligible that there is no need to include the net modifier.

(d) All of the other six companies except Federal Express recognize the cost of sales concept, although some report synonyms (“cost of goods: sold” and “total cost of sales”) and two companies aggregate cost of sales with occupancy costs. Federal Express likely has negligible cost of sales, if any. Recall that cost of sales are costs that can be traced directly to a specific sale. Federal Express could possibly estimate the packaging and delivery costs for specific sales, providing it tracks

85



the types of packages that are sent by customers. However, these are likely inconsequential relative to the operating expenses listed on Federal Express’s income statement. Federal Express is also the only service company in the group of seven. It is likely that many other service companies do not recognize cost of sales.

(e) Gap and Starbucks recognize cost of sales but do not disclose it separately in their income statements. Rather, they disclose cost of sales plus occupancy expenses. Presumably occupancy expenses include costs associated with renting or owning stores, fixtures, and equipment. Both of these companies sell products directly to end-users in retail stores. Aggregating cost of sales and occupancy costs on income statements is common practice for retailers.

(f ) Intel and Cisco report gross margins and Coca Cola reports gross profits, which is synonymous with gross margins.

(g) Cisco and Intel disclose research and development expenses. These are high-tech companies that expend large amounts on research and development to stay competitive.

(h) Nike likely recognizes minor research and development expenses in Selling and administrative expenses. Based on the line item descriptions, the only other viable candidate is Other income/expense, net. However, this item is below interest expense, suggesting that other income/expense does not include operating expenses. Also, the footnotes referenced on Nike’s income statement for this item do not discuss research and development. Coca Cola likely includes minor research and development expenses in Selling, general, and administrative expenses. Again, this conclusion is based on a process of elimination: The descriptions of the other line items seem to preclude including research and development.

(i) Cisco is the only company that discloses sales and marketing costs separate from general and administrative costs.

(j) Gap and Nike disclose the fewest items associated with operating expenses. Gap discloses two items: Cost of good sold and occupancy expenses and Operating expenses. Nike also discloses two items: Cost of sales and Selling and administrative.

(k) Federal Express seems to disclose the most detailed information about its operating expenses. It discloses more items separately and these can easily be interpreted in terms of Federal Express’ business. Thus they provide very useful information to investors and other users for assessing performance.

86



$ in millions 2002Revenues $9,893.0Cost of sales $6,004.7Selling and administrative $2,820.4Operating income $1,067.9

$ in thousands 2002Net sales $14,454,709Cost goods sold and occupancy expenses $9,541,558Operating expenses $3,900,522Operating income $1,012,629

Nike

Gap

(l) Based only on information disclosed on their income statements, we can conclude that Intel and Cisco have acquired other companies. Both recognize amortization of goodwill and intangibles acquired through acquisitions and both recognize in process research and development expenses. These expenses only arise from acquiring other companies.

(m) Cisco took a restructuring charge in 2001.

(n) Gap and Nike do not disclose separate line items for operating income. Estimated 2002 operating incomes for Gap and Nike are provided below. You should be pretty confident that these estimates reflect operating activities.

(o) Intel and Starbucks disclose investment gains or losses on their income statements.

(p) The $2,940 of Internet-related investment losses for 2001 is signed positively because it is subtracted from the $281,094 of Operating income and $10,768 of Interest and other income, net to get the $288,922 of Earnings before income taxes. If Starbucks had signed the number negatively as ($2,940), it: (1) would have added ($2,940) to $281,094 and $10,768, and (2) should have changed the line item’s description to “Internet-related investment (losses).”

(q) Gap and Coca Cola disclose interest income and interest expense on their income statements. The other companies aggregate this information.

(r) Gap signs interest income negatively on its income statement. It is signed negatively because it is included in a list of expenses that are subtracted from Net sales to get Earnings before income taxes.

87



(s) Coca Cola signs interest income and interest expense positively on its income statement. It appears that Coca Cola presumes that users should know that the $199 of Interest expense for 2002 is subtracted from $5,458 of Operating income plus $209 Interest income plus $384 of Equity income (loss) less $353 of Other income (loss), net to get the $5,499 of Income before Income taxes and cumulative effect of accounting change.

(t) From (p), (r), and (s), you can conclude that there is not a uniform signing convention for income statements and that you must interpret numbers by (1) their descriptions and (2) the way they are combined to derive subtotals and net income.

(u) Nike, Federal Express and Coca Cola report separate sections to recognize Cumulative effects of accounting changes, net of income taxes. Companies mostly recognize cumulative effects of accounting changes when they adopt new accounting standards. New standards often mandate new ways to measure assets and liabilities or the inclusion of assets or liabilities that were previously not recognized on the balance sheet. For example, Coca Cola’s footnotes indicate that it adopted new standards in 2001 and 2002. When this occurs there are two consequences, one of which is disclosed on Coca Cola’s income statement:

(1) Coca Cola restated its assets and liabilities at the start of 2001 and 2002 to reflect the accounting changes. The after-tax change in net assets caused by the new standard is assigned to net income and/or accumulated other comprehensive income. For Coca Cola, ($926) in 2002 and ($10) in 2001 was assigned to net income as Cumulative effect of accounting change, net of income taxes.

(2) Typically, new standards also affect the way pretax income is measured during the year it is adopted. This effect is disclosed in a footnote if it is significant.

88



Solution to Exercise 2.03(a) Here is CreativeABCs BSE matrix and financial statements:

+

+

+ C + AR + StInv + Inven = + AP + AcCB + TaxP + CS + RE + Rev - Cgs - MG&A + Intinc - TxExp + IncS

December 1, 2010 + + $0 + + $0 + + $0 + + $0 = + + $0 + + $0 + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 - + $0 + + $0

E1 Issue stock + + 10,000 + + + = + + + + + 10,000 + + - - + - +

E2 Purchase debt securities + - 5,500 + + + 5,500 + = + + + + + + - - + - +

E3 Purchase inventory on account + + + + + 4,000 = + + 4,000 + + + + + - - + - +

E4a Recognize revenue + + + 3,000 + + = + + + + + + + 3,000 - - + - +

E4b Recognize cost of sales + + + + - 1,000 = + + + + + + - + 1,000 - + - +

E5 Pay wages for Dec 1- Dec15 + - 500 + + + = + + + + + + - - + 500 + - +

E6 Supplier payments + - 1,500 + + + = + - 1,500 + + + + + - - + - +

E7 Pay landlord for December rent + - 800 + + + = + + + + + + - - + 800 + - +

E8 Customer collections + + 700 + - 700 + + = + + + + + + - - + - +

E9 Interest earned + + 30 + + + = + + + + + + - - + + 30 - +

E10 Unpaid wages for Dec 15- Dec 31 + + + + = + + + 500 + + + + - - + 500 + - +

E12 Recognize tax expense + + + + = + + + + 92 + + + - - + - + 92 +

+ + $2,430 + + $2,300 + + $5,500 + + $3,000 = + + $2,500 + + $500 + + $92 + + $10,000 + + $0 + + $3,000 - + $1,000 - + $1,800 + + $30 - + $92 + + $0

+ + + + = + + + + + + - 3,000 - - 1,000 - - 1,800 + - 30 - - 92 + + 138

+ + + + = + + + + + + 138 + - - + - + - 138

December 31, 2010 + + $2,430 + + $2,300 + + $5,500 + + $3,000 = + + $2,500 + + $500 + + $92 + + $10,000 + + $138 + + $0 - + $0 - + $0 + + $0 - + $0 + + $0

LiabilitiesOwners' Equity

Permanent Net income

Trial balance


Assets =

Du

rin

g m

on

thM

on

th-

end

CreativeABC Company Balance Sheets

Assets 31-Dec-10 01-Dec-10Current

Cash $2,430 $0Accounts receivable 2,300 0Short-term investments 5,500 0Inventories 3,000 0Total current assets 13,230 0

Non-current 0 0Total assets $13,230 $0


CurrentAccounts payable $2,500 $0Accrued compensation and benefits 500 0Income taxes payable 92 0Total current liabilities 3,092 0

Non-current 0 0Total liabilities 3,092 0Stockholders' equity



CreativeABC Company Income StatementDecember 1 - December 31, 2010Operating profit

Revenues $3,000Cost of sales (1,000)Marketing general and administrative (1,800)Profit from operations 200


Profit before taxes 230Tax expense (92)


CreativeABC Company Statement of Owners' Equity

Commonstock

Retainedearnings Reserves Total

December 1, 2010 $0 $0 $0Comprehensive income


Total 138 0 138Common stock issued 10,000 10,000December 31, 2010 $10,000 $138 $0 $10,138

+ C + AR + StInv + Inven = + AP + AcCB + TaxP + CS + RE

01-Dec-10

$000000

$0

$000000

000

$0

December 1, 2010 $0 $0 $0

+ + $2,430 + + $2,300 + + $5,500 + + $3,000 = + + $2,500 + + $500 + + $92 + + $10,000 + + $138

31-Dec-10

$2,4302,3005,5003,000

13,2300

$13,230

$2,50050092

3,0920

3,092

10,000138

10,138$13,230

December 31, 2010 $10,000 $138 $0 $10,138

+ + $0 + + $0

+ + 10,000 +

+ +

+ +

+ +

+ +

+ +

+ +

+ +

+ +

+ +

+ +

+ +

+ + $10,000 + + $0

+ +

+ + + 138

Comprerr hensivevv incomeNet pror fiff t 138Other comprerr hensivevv income 0

ToTT tal 138 0Common stock issued 10,000 10,000

+ + $3,000 - + $1,000 - + $1,800 + + $30 - + $92

$3,000(1,000)(1,800)

200

30230(92)138

138

0$138

0138

89



Solution to Exercise 2.04(a) Here are the completed tables. The information in the second table

was gathered from Intel’s income statement and balance sheet. The computations in the top table were derived using the Dupont model:

2006 2005 2004 2003

Profit margin 19.98% 32.48% 30.45% 24.69%

Turnover 0.73 0.81 0.72 0.66

Financial Leverage 1.33 1.29 1.25 1.25

(1-tax rate) 71.36% 68.71% 72.15% 75.80%

ROE 13.83% 23.18% 19.67% 15.39%

Net revenues $35,382 $38,826 $34,209 $30,141

Income before taxes $7,068 $12,610 $10,417 $7,442

Tax expense $2,024 $3,946 $2,901 $1,801

Net Income $5,044 $8,664 $7,516 $5,641

Beginning owners' equity $36,182 $38,579 $37,846 $35,468

Ending owners' equity $36,752 $36,182 $38,579 $37,846

Average owners' equity $36,467 $37,381 $38,213 $36,657

Beginning total assets $48,314 $48,143 $47,143 $44,224

Ending total assets $48,368 $48,314 $48,143 $47,143

Average total assets $48,341 $48,229 $47,643 $45,684

Intel

(b) Here are the companies ranked according to average ROE for 1998-2000, from highest to lowest:

Average for 1998-2000 2000 1999 1998

GAP 48.48% 34.00% 59.21% 52.22%Intel 28.25% 30.16% 26.16% 28.44%Limited 18.17% 18.24% 19.98% 16.29%Nike 14.68% 17.90% 13.69% 12.45%Federal Express 14.19% 14.57% 14.64% 13.35%AMD 9.82% 39.06% -4.46% -5.15%

ROE

(c) As indicated in the table at the top of the next page, three companies had sharp ROE decreases in 2001:

• Gap’s ROE decreased 48 percentage points from its average,

• Intel’s ROE decreased 24 percentage points from its average, and

• AMD’s ROE decreased 11 percentage points from its average.

AMD’s ROE declined even further in 2002, while Intel’s and Gap’s began to improve.

90



2001 Average for 1998-2000

Percentage points

decreaseGAP -0.26% 48.48% -48.74Intel 3.53% 28.25% -24.73AMD -1.80% 9.82% -11.62Federal Express 10.94% 14.19% -3.25Limited 20.00% 18.17% 1.83Nike 17.79% 14.68% 3.11

ROE

(d) Intel’s and AMD’s ROE decreases in 2001 were probably due more to problems in the high-tech industry than to economy wide factors or competition. The economy was down in 2001 relative to the previous four years, but Intel and AMD performed considerably poorer than Limited, Federal Express, and Nike. Gap’s performance seems to be mostly attributable to competition from Limited and other fashion retailers. In fact, Gaps’ 2001 annual report begins with the following:

Our performance in 2001 made us remember three things about satisfying our customers:

Offer the right products in the right assortments.

Be consistent in everything you do.

Always keep it simple.

That’s the way we built our company. That’s how we created three of retail’s most popular brands.

In 2001, we forgot to stay true to those three basic ideas. But after disappointing our customers and our shareholders in what was a very humbling year, we’ve learned a lot—and we’ve got a lot to do.

Page 1, Gap’s 2001 Annual Report

(e) As indicated in the tables below and at the top of the next page, the biggest factor affecting ROE for both companies was profit margins.


factors


profit margin


turnover


financial leverage



Intel

91




factors


profit margin


turnover


financial leverage


Profit margin 26.96% -2.41% 26.96% 26.96% 26.96%

Turnover 0.92 0.92 0.68 0.92 0.92


(1-tax rate) 79.48% 79.48% 79.48% 79.48% 84.60%ROE 39.06% -3.48% 28.78% 33.45% 41.34%

Advanced Micro Devices

(f ) Here are two major reasons why Intel’s and AMD’s profit margins declined sharply in 2001:

• Both companies’ gross margins deteriorated significantly in 2001: Intel’s cost of sales increased from 38% of net revenues to 51% and AMD’s cost of sales increased from 54% of net revenues to 67%.

• Both companies’ operating margins were boosted considerably in 2000 by investment gains that did not recur in 2001.

(g) If AMD had not taken a restructuring charge in 2002, its profit margin would have been 12.3 percentage points higher or -35% instead of -47% profit margin.

(h) In 2001, Gap’s reported tax expense would be $131 million less or $118,405 (thousand). Its tax rate would decrease from 103% to 49% and the tax factor in the Dupont model would change from -3.2% to 51%. As a result, the ROE would change to 4.15%.

(i) The common size statements suggest at least two reasons why Limited’s profit margin was higher than Gap’s in 2001:

• Gap’s gross margin decreased by about 7 percentage points (cost of sales increased from 63% of net revenues to 70%) and Limited’s gross margin improved by 0.7 percentage points.

• Limited’s operating margin increased 1.9 percentage points because of a Special and non-recurring item, net.

Gap’s profit margin increased in 2002 because cost of sales improved from 70% of net revenues to 66%.

(j) From Federal Express’ income statement (Figure 2.07 on page 77S), we see that operating income decreased from 6.69% of revenues to 5.46%, explaining 1.23 percentage points of the 1.51 percentage points decrease in profit margin.

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Chapter 2: Introduction to Income Statements Chapter 2 · Chapter 2: Introduction to Income Statements ... statement formats that include all ... While income relates to changes in