Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1 Understanding Financial Statements NINTH EDITION Lyn M. Fraser Aileen Ormiston

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice HallCopyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 11

Understanding Understanding Financial Financial

StatementsStatementsNINTHNINTH EDITION EDITION

Lyn M. Fraser Lyn M. Fraser

Aileen OrmistonAileen Ormiston

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice HallCopyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3-3-22

CopyCopyright Noticeright Notice

All rights reserved. No part of this publication All rights reserved. No part of this publication may be reproduced, stored in a retrieval may be reproduced, stored in a retrieval system, or transmitted, in any form or by any system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, means, electronic, mechanical, photocopying, recording, or otherwise, without the prior recording, or otherwise, without the prior written permission of the publisher. Printed in written permission of the publisher. Printed in the United States of America.the United States of America.


Chapter 3: Income Statement Chapter 3: Income Statement and and Statement of Stockholders’ Statement of Stockholders’ EquityEquity

Learning about earnings, the bottom line,Is very important most of the time.

A phony number Just may encumber

Those folks trying to make more than a dime.

--A. Ormiston


Income Statement andIncome Statement andStatement of Stockholders’ Statement of Stockholders’ EquityEquity

Operating performance of a firm has Operating performance of a firm has traditionally been measured by its traditionally been measured by its success generating earnings – the success generating earnings – the “bottom line.”“bottom line.”

Annual reports include three years of Annual reports include three years of income statements and income statements and stockholder’s equity.stockholder’s equity.


The Income StatementThe Income StatementAlso called the statement of earningsAlso called the statement of earningsPresents a business firm’sPresents a business firm’s

• revenuesrevenues• expensesexpenses• net incomenet income• earnings per shareearnings per share

Reveals management’s ability to Reveals management’s ability to translate sales dollars into profitstranslate sales dollars into profits


The Income StatementThe Income StatementComes in two basic formatsComes in two basic formats• Multiple-stepMultiple-step

− Provides several intermediate profit Provides several intermediate profit measures prior to the amount of measures prior to the amount of net earnings for the periodnet earnings for the period

• Single-stepSingle-step− Groups all items of revenue Groups all items of revenue

together, then deducts all together, then deducts all categories of expensecategories of expense


The Income StatementThe Income StatementMultiple-step formatMultiple-step formatIntermediate profit measures includeIntermediate profit measures include

• Gross profitGross profit• Operating profitOperating profit• Earnings before income taxesEarnings before income taxes

This format should be used for analysis This format should be used for analysis purposes.purposes.

The analyst should redo an income The analyst should redo an income statement that is not already in the statement that is not already in the multiple-step format before analyzing.multiple-step format before analyzing.


The Income StatementThe Income Statement

Regardless of format, certain Regardless of format, certain special items must be disclosed special items must be disclosed separately on an income separately on an income statement:statement:

• Discontinued operationsDiscontinued operations• Extraordinary transactionsExtraordinary transactions


Common-Size Income Common-Size Income StatementStatement

Useful analytical tool toUseful analytical tool to• compare firms with different compare firms with different

levels of sales or total assetslevels of sales or total assets• facilitate internal or structural facilitate internal or structural

analysisanalysis• evaluate trendsevaluate trends• make industry comparisonsmake industry comparisons


Common-Size Income Common-Size Income StatementStatement

Expresses each income statement Expresses each income statement item as a percentage of net item as a percentage of net salessales

Shows the relative magnitude of Shows the relative magnitude of various expenses relative to various expenses relative to sales, the profit percentages, sales, the profit percentages, and the relative importance of and the relative importance of “other” revenues and expenses“other” revenues and expenses


Net SalesNet Sales

Total sales revenue is shown net of Total sales revenue is shown net of returns and allowances.returns and allowances.

A sales return is a cancellation of a A sales return is a cancellation of a sale.sale.

A sales allowance is a deduction from A sales allowance is a deduction from the original sales invoice price.the original sales invoice price.

Sales are the major revenue source Sales are the major revenue source for most companies.for most companies.


R.E.C. Inc. Consolidated R.E.C. Inc. Consolidated Statements of Earnings (in Statements of Earnings (in Thousands)Thousands)

20102010 20092009 20082008

Net SalesNet Sales $215,600$215,600 $153,000$153,000 $140,70$140,7000

Sales increased 40.9% between 2009 and Sales increased 40.9% between 2009 and 2010.2010.

Sales increased 8.7% between 2008 and 2009.Sales increased 8.7% between 2008 and 2009.

It is important to determine whether the It is important to determine whether the change is the result of price, volume, or the change is the result of price, volume, or the combination of both.combination of both.


Net SalesNet Sales

Are sales growing in “real” (inflation-Are sales growing in “real” (inflation-adjusted) as well as “nominal” (as adjusted) as well as “nominal” (as reported) terms?reported) terms?

An adjustment of the reported sales An adjustment of the reported sales figure with the Consumer Price Index figure with the Consumer Price Index (or some other measure of general (or some other measure of general inflation) will enable the analyst to inflation) will enable the analyst to compare changes in real and nominal compare changes in real and nominal terms.terms.


Cost of Goods Sold Cost of Goods Sold (COGS)(COGS)

Also called cost of salesAlso called cost of sales

Cost to seller of products or Cost to seller of products or services sold to customersservices sold to customers

Affected by cost flow assumption Affected by cost flow assumption used to value inventoryused to value inventory

Largest expense item for many Largest expense item for many firmsfirms


Cost of Goods Sold Cost of Goods Sold PercentagePercentageRelationship between COGS and net Relationship between COGS and net

salessalesImportant for profit determinationImportant for profit determination

Given byGiven by

Change in the COGS percentage may Change in the COGS percentage may be caused by changes in cost or be caused by changes in cost or changes in selling price.changes in selling price.

Cost of goods soldCost of goods sold

Net salesNet sales


Cost of Goods Sold Cost of Goods Sold PercentagePercentageR.E.C. Inc.R.E.C. Inc.

COGS percentage increased between 2008 COGS percentage increased between 2008 and 2009.and 2009.

This is a result of lowering prices or This is a result of lowering prices or increasing costs.increasing costs.

20102010 20092009 20082008


Cost of Goods Cost of Goods SoldSold

129,364129,364 91,87991,879 81,60681,606

Cost of Goods Cost of Goods SoldSold

Net SalesNet Sales 60.0%60.0% 60.1%60.1% 58.0%58.0%


Gross Profit (or Gross Gross Profit (or Gross Margin)Margin)• First step of profit measurementFirst step of profit measurement• Difference between net sales and Difference between net sales and

COGSCOGS• Key analytical tool in assessing Key analytical tool in assessing

operating performanceoperating performance

• Given byGiven byGross profitGross profit

Net salesNet sales


Gross Profit MarginGross Profit MarginGross profit margin and cost of goods Gross profit margin and cost of goods

sold percentage are complements (the sold percentage are complements (the two percentages add to 100%).two percentages add to 100%).

Firms want to maintain or increase gross Firms want to maintain or increase gross profit margin.profit margin.

Gross profit margin remains relatively Gross profit margin remains relatively constant in stable industries and may constant in stable industries and may change significantly in volatile change significantly in volatile industries.industries.


Gross Profit MarginGross Profit MarginCompanies with more than one Companies with more than one

revenue source will show each revenue source will show each revenue line separately.revenue line separately.

Each revenue line will show the Each revenue line will show the corresponding cost of goods sold corresponding cost of goods sold for each revenue source.for each revenue source.


Operating ExpenseOperating Expense

Exercise of management discretion Exercise of management discretion in these areasin these areas

Has considerable impact on the Has considerable impact on the firm’s current and future firm’s current and future profitabilityprofitability

Important to carefully track trends, Important to carefully track trends, absolute amounts, relationship absolute amounts, relationship to sales, and relationship to to sales, and relationship to industry competitorsindustry competitors


Operating ExpensesOperating ExpensesExamplesExamples

• Selling and administrativeSelling and administrative−relate to the sale of products or servicesrelate to the sale of products or services−salaries, rent, insurance, utilities, salaries, rent, insurance, utilities,

supplies, depreciation (sometimes), etc.supplies, depreciation (sometimes), etc.• AdvertisingAdvertising

−major expense when marketing is an major expense when marketing is an important element of successimportant element of success

• Lease paymentsLease payments


Depreciation and Depreciation and AmortizationAmortization

Cost of assets other than land Cost of assets other than land that will benefit a business that will benefit a business enterprise for more than a enterprise for more than a year is allocated over the year is allocated over the asset’s service life.asset’s service life.

Cost allocation procedure is Cost allocation procedure is determined by the nature of determined by the nature of the long-lived asset.the long-lived asset.


Depreciation and Depreciation and AmortizationAmortizationDepreciationDepreciation

Used to allocate the cost of tangible Used to allocate the cost of tangible fixed assets such asfixed assets such as

• buildingsbuildings• machinerymachinery• equipmentequipment• furniture and fixturesfurniture and fixtures• motor vehiclesmotor vehicles


Depreciation and Depreciation and AmortizationAmortizationAmortizationAmortization

Allocation process applied toAllocation process applied to• capital leasescapital leases• leasehold improvementsleasehold improvements• patentspatents• copyrightscopyrights• trademarkstrademarks• franchisesfranchises


Depreciation and Depreciation and AmortizationAmortizationDepletionDepletion

Allocation applied to acquisition Allocation applied to acquisition and development of natural and development of natural resourcesresources

• oil and gasoil and gas• other mineralsother minerals• standing timberstanding timber


Depreciation and Depreciation and AmortizationAmortizationRepairs and maintenanceRepairs and maintenance

Annual costs of repairing and Annual costs of repairing and maintaining property, plant, and maintaining property, plant, and equipmentequipment

Should correspond to the level of Should correspond to the level of investment in capital equipment and investment in capital equipment and to the age and condition of fixed to the age and condition of fixed assetsassets

Inadequate allowance can impair Inadequate allowance can impair successsuccess


Depreciation and Depreciation and AmortizationAmortization

The amount of expense recognized in The amount of expense recognized in

any accounting period will depend onany accounting period will depend on• the level of investment in the relevant the level of investment in the relevant

assetasset• estimates with regard to the asset’s estimates with regard to the asset’s

service life and residual valueservice life and residual value• for depreciation, the method usedfor depreciation, the method used


Operating ProfitOperating ProfitSecond step of profit determinationSecond step of profit determinationAlso called earnings before interest Also called earnings before interest

and taxes (EBIT)and taxes (EBIT)Measures overall performance of Measures overall performance of

company’s operations: sales company’s operations: sales revenue less expenses associated revenue less expenses associated with generating saleswith generating sales

Provides a basis for assessing success Provides a basis for assessing success of a firm apart from financing and of a firm apart from financing and investing activities and separate investing activities and separate from tax considerationsfrom tax considerations


Operating Profit MarginOperating Profit Margin

Relationship between operating Relationship between operating profit and net salesprofit and net sales

Given byGiven byOperating profitOperating profit

Net salesNet sales


Operating Profit MarginOperating Profit MarginR.E.C. Inc.R.E.C. Inc.

The ratio indicates R.E.C. Inc. The ratio indicates R.E.C. Inc. strengthened its return on operations strengthened its return on operations in 2010 after a dip in 2009.in 2010 after a dip in 2009.

20102010 20092009 20082008


Operating ProfitOperating Profit 19,24319,243 11,80611,806 11,25611,256

Operating ProfitOperating Profit

Net SalesNet Sales8.9%8.9% 7.7%7.7% 8.0%8.0%


Other Income (Expense)Other Income (Expense)

Revenues and costs other than from Revenues and costs other than from operations such asoperations such as

• dividend and interest incomedividend and interest income• interest expenseinterest expense• investment gains (losses)investment gains (losses)• equity earnings (losses)equity earnings (losses)• gains (losses) from sale of fixed gains (losses) from sale of fixed

assetsassets


Other Income (Expense)Other Income (Expense)

Firms that carry debt and equity Firms that carry debt and equity securities classified as “trading securities classified as “trading securities” report these securities” report these investments on the balance sheet investments on the balance sheet at market value with any at market value with any unrealized gains and losses unrealized gains and losses included in earnings.included in earnings.


Other Income (Expense)Other Income (Expense)In assessment of earnings quality, the analyst In assessment of earnings quality, the analyst should consider the materiality and variability should consider the materiality and variability of nonoperating items of income such asof nonoperating items of income such as

• gains (losses) on the sale of major capital gains (losses) on the sale of major capital assetsassets

• accounting changesaccounting changes• extraordinary itemsextraordinary items• investment income from temporary investment income from temporary

investments in cash equivalentsinvestments in cash equivalents• investment income recognized under the investment income recognized under the

equity methodequity method


Equity EarningsEquity Earnings

Two methods may be used to Two methods may be used to account for investments in voting account for investments in voting stock of other companies.stock of other companies.

• EquityEquity• CostCost

Questions regarding use of cost or Questions regarding use of cost or equity come into play for stock equity come into play for stock investments of less than 50%.investments of less than 50%.


Equity EarningsEquity Earnings

Equity MethodEquity Method

Allows the investor proportionate Allows the investor proportionate recognition of the investee’s net income, recognition of the investee’s net income, irrespective of the payment or irrespective of the payment or nonpayment of cash dividendsnonpayment of cash dividends

Cost MethodCost Method

Investor recognizes investment income Investor recognizes investment income only to the extent of any cash dividends only to the extent of any cash dividends received.received.


Equity EarningsEquity EarningsEquity MethodEquity Method

Should be used when investor can Should be used when investor can exercise significant influence over exercise significant influence over investee’s operating and financing investee’s operating and financing policiespolicies

Fits accrual accounting requirementsFits accrual accounting requirements

Distorts earnings when income is Distorts earnings when income is recognized and no cash may ever recognized and no cash may ever be receivedbe received


Equity EarningsEquity EarningsCost MethodCost Method Allows recognition of investment Allows recognition of investment

income only to the extent of any income only to the extent of any cash dividends actually receivedcash dividends actually received

Carries an investment account at Carries an investment account at costcost

Analysts should be aware of Analysts should be aware of whether a company uses the cost whether a company uses the cost or equity method.or equity method.


Earnings Before Income Earnings Before Income Taxes/Taxes/Effective Tax RateEffective Tax RateEarnings before income taxes is the Earnings before income taxes is the

profit recognized before deduction profit recognized before deduction of income tax expense.of income tax expense.

Income taxes paid may differ from Income taxes paid may differ from income tax expense (deferred income tax expense (deferred taxes)taxes)

Effective tax rate is given byEffective tax rate is given byIncome taxesIncome taxes

Earnings before income taxesEarnings before income taxes


Effective Tax RateEffective Tax Rate

User of financial statements need to User of financial statements need to distinguish between earnings distinguish between earnings increasing due to core operations increasing due to core operations versus items such as tax rate versus items such as tax rate deductions.deductions.

Noteworthy items that may affect the Noteworthy items that may affect the effective tax rate are net operating effective tax rate are net operating losses (NOLs) and foreign taxes.losses (NOLs) and foreign taxes.


Special ItemsSpecial ItemsOften one-time items that will not Often one-time items that will not recur in the futurerecur in the future

• Discontinued operationsDiscontinued operations• Occur when a firm sells or Occur when a firm sells or

discontinues a clearly distinguishable discontinues a clearly distinguishable portion of its businessportion of its business

• Extraordinary gains and lossesExtraordinary gains and losses• Unusual in natureUnusual in nature• Not expected to recur in the Not expected to recur in the

foreseeable futureforeseeable future


Accounting ChangesAccounting Changes

Prior to 2006, the cumulative effect of a Prior to 2006, the cumulative effect of a change in accounting principle was change in accounting principle was disclosed when a firm changed an disclosed when a firm changed an accounting policy.accounting policy.

Retrospective application to prior Retrospective application to prior periods’ financial statements is periods’ financial statements is required for changes in accounting required for changes in accounting principles for fiscal years beginning principles for fiscal years beginning after 12/15/2005.after 12/15/2005.


Net EarningsNet Earnings• Also called the “bottom line”Also called the “bottom line”• Represents profit after Represents profit after

consideration of all revenue and consideration of all revenue and expenseexpense

• Net profit margin shows the Net profit margin shows the percentage of profit earned on percentage of profit earned on every sales dollar.every sales dollar.

• Net profit margin is given byNet profit margin is given byNet Net

earningsearningsNet salesNet sales


Earnings Per Common Earnings Per Common Share Share (EPS)(EPS)

EPS is the net earnings available to EPS is the net earnings available to common stockholders for the period common stockholders for the period divided by the average number of divided by the average number of common stock shares outstanding.common stock shares outstanding.

If a firm has “complex” capital If a firm has “complex” capital structure, it will report basic and structure, it will report basic and diluted earnings per common share.diluted earnings per common share.


Earnings Per Common Earnings Per Common ShareShare

Analysts should consider material Analysts should consider material changes in the number of changes in the number of common stock shares common stock shares outstanding that will cause a outstanding that will cause a change in the computation of change in the computation of earnings per share.earnings per share.


Comprehensive incomeComprehensive income

According to FASB “Elements of According to FASB “Elements of Financial Statements,” Financial Statements,” comprehensive income is the comprehensive income is the change in equity of a company change in equity of a company during a period from transactions, during a period from transactions, other events, and circumstances other events, and circumstances relating to nonowner sources.relating to nonowner sources.


Comprehensive incomeComprehensive incomeFASB requires companies to report FASB requires companies to report comprehensive income in one of comprehensive income in one of three ways.three ways.

• On the face of its income On the face of its income statementstatement

• In a separate statement of In a separate statement of comprehensive incomecomprehensive income

• In its statement of stockholder’s In its statement of stockholder’s equityequity


Comprehensive IncomeComprehensive Income

Currently, there are four items Currently, there are four items that may comprise a company’s that may comprise a company’s other comprehensive income:other comprehensive income:

• Foreign currency translation Foreign currency translation effectseffects

• Unrealized gains and lossesUnrealized gains and losses• Additional pension liabilitiesAdditional pension liabilities• Cash flow hedgesCash flow hedges


TThe Statement of he Statement of Stockholders’ EquityStockholders’ Equity

Important link between the balance Important link between the balance sheet and the income statementsheet and the income statement

Documents changes in the balance Documents changes in the balance sheet equity accounts from one sheet equity accounts from one accounting period to the nextaccounting period to the next

Can also be presented in a Can also be presented in a supplementary schedule or in a supplementary schedule or in a notenote


The Statement of The Statement of Stockholders’ EquityStockholders’ EquityIncludes transactions such asIncludes transactions such as• stock dividendsstock dividends

− issuance of additional shares of stock in issuance of additional shares of stock in proportion to current ownershipproportion to current ownership

− reduce retained earnings accountreduce retained earnings account• stock splitsstock splits

− used to lower the market price of shares used to lower the market price of shares to make common stock more affordableto make common stock more affordable

• reverse stock splitsreverse stock splits− occurs when outstanding shares are occurs when outstanding shares are

decreaseddecreased


Earnings Quality and Cash Earnings Quality and Cash FlowFlow

Other topics directly related to Other topics directly related to the income statementthe income statement

• Assessment of the quality of reported Assessment of the quality of reported earnings is an essential element of earnings is an essential element of income statement analysis.income statement analysis.

• Cash flow from operations is a key Cash flow from operations is a key ingredient in analyzing operating ingredient in analyzing operating performance.performance.