Chapter 13: Income Statement What is Income (Profit)?  A measure of a change in value – As compared to equity, which measures the level of value (or wealth)  It is NOT net cash flow  It is a measure of performance  It is a link between two balance sheets Figure 13-1 Figure 13-1 Figure 13-1 Elements of the Income Statement  Comprehensive income - changes in net assets from all non-owner sources; is broken into two categories: – net income: consisting of revenues, expenses, gains and losses (next slide) – other comprehensive income Campbell’s Soup 2009 statement of Shareholders’ Equity The Income Statement Operating Section Non-Operating Section Sales Revenue less: Cost of Goods Sold less: Selling Expenses less: Administrative Expenses Add: Less: Other Revenues and Gains Other Expenses and Losses Income Tax Irregular Items Net Income Earnings per Share Discontinued Operations (net of tax) Extraordinary Items (net of tax) Two Different Concepts of Income: Matching and Fair Market Value The matching process: Revenues - Expenses = Net Income Fair Market Value approach: FMV Net Assets (end) - FMV Net Assets (beginning) = Net Income Financing, Investing, and Operating Transactions: A Framework 10 Format of the Income Statement  First, note the subtotals – Gross profit is presented when a company uses a multi-step income statement; more relevant for companies that are primarily retail or manufacturing (less relevant for service industries) – Income from operations indicates income from primary, on-going activity (usual and frequent) – Income from continuing operations (IFCO) also includes peripheral activity like interest income, as well as potentially nonrecurring activity like restructuring charges (unusual or infrequent) – Net income also includes “special” items that are presented separately because they are significant activities that are usually nonrecurring 13 Format of the Income Statement  Now, more information on the “special” items below Income From Continuing Operations (IFCO): – discontinued operations – extraordinary items  Note that each of these items is presented “net of tax.” This is necessary because income tax expense has already been calculated on IFCO Therefore, each level below IFCO must present the tax effect for that component  This is called “intraperiod” tax allocation allocation of income tax expense to different parts of the income statement 14 Format - Discontinued Operations  Discontinued operations (DO) relate to the disposal of a segment of a company Because the disposal means that the segment activity will be discontinued, separate disclosures are required so that investors could distinguish between ongoing activity and nonrecurring activity  A segment is defined as an entire line of business or a separately identifiable segment For example, General Motors would need to discontinue Chevrolet (not just a manufacturing plant)  Financial statement presentation includes any operating income or loss to the measurement date (the date the board of directors declares intention to dispose of the segment), as well as any gain or loss on the disposal of the assets 15 Format - Extraordinary Items  Extraordinary items (EI) are defined as those activities that are material in amount, unusual in nature, and infrequent in occurrence  To determine, consider the natural, political, and economic environment of the firm  Examples of EI include natural disasters, nationalization or expropriation of assets by a foreign government, and onetime major economic transactions  If unusual or infrequent, but not both, report in “other gains/losses”, as part of IFCO Examples include material write-down of receivables, and losses from an employee strike 16 Income Statement Format - Other Issues  Consistency requires the use of the same accounting method from year to year  However, a company may choose to change to an alternative accounting method (ex: DDB to SL or FIFO to average)  Also, a company may be required to change to a new accounting technique by the issue of a new accounting standard  Accounting standards required companies to show the cumulative effect for prior years’ income on the current income statement in a special category called “change in accounting principle.” 17 Income Statement Format - Other Issues  This special category allowed investors to analyze IFCO for the current year separately from the effect of the cumulative change  Problem: This “cumulative” calculation was reported as part of current net income, even though it relates to prior years’ net income  Solution: In mid 2005, FASB eliminated this category from the income statement Now all changes in principle receive either a retroactive restatement (like errors of a prior period) or a prospective treatment (like changes in estimate) 18 Figure 13-5 19 Earnings Per Share (EPS)  SFAS 128 simplified the presentation of earnings per share to two components: – basic EPS – diluted EPS  Calculation of Basic EPS = Net Income - preferred dividends Weighted average common shares outstanding  Concept: To indicate how much each common shareholder “owns” with respect to earnings  Preferred dividends are deducted - if declared or if cumulative because they are “owed” to preferred shareholders  This is a calculation of “what is” - the numerator and denominator use actual shares outstanding and actual net income for the year 20 Earnings Per Share (EPS) Class problem: Bush Company reported net income of $30,000 in 2007 The company had 60,000 shares of common stock outstanding for all of 2007 Bush also had 5,000 shares of convertible preferred stock outstanding for all of 2007 During 2007, the company declared a $4,000 cash dividend to preferred shareholders Each share of preferred stock is convertible to shares of common stock 1.Calculate basic EPS: $30,000 - 4,000 = $0.43 per share 60,000 (Note that the convertibility component is ignored for basic EPS.) 21 Earnings Per Share (EPS) Calculate diluted EPS: $30,000 - _ = $0.38 per share 60,000 + (5,000 x 4) Note that the convertibility component is assumed to have been exercised for diluted EPS If the PS was converted to CS at the beginning of the year, there would have been NO preferred dividend, and there would have been 20,000 additional shares of common stock outstanding all year The effects for convertible bonds and employee stock options are similar for diluted EPS 22 EPS Disclosure     Separate EPS disclosure for: – Net income from continuing operations (after tax) – Disposals of business segments – Extraordinary items Calculation – Separate dollar amount (from above categories) divided by number of common shares outstanding If diluted EPS exists, the company should also calculate diluted EPS for each level of presentation If diluted EPS is antidilutive (the calculation is actually higher than basic EPS), the company does not have to present diluted EPS 23 Problems with EPS  The numerator can be manipulated by a number of earning management techniques  The denominator can be manipulated by stock buybacks (treasury stock)  The “what-if” presentation of diluted EPS is a fictitious number - it can never actually happen The potentially dilutive securities have not been converted at year end, and they can never have claims to the current year’s income The only benefit of diluted EPS is that it can indicate the magnitude of the maximum potential dilution for the future 24 Economic Consequences of Reporting Net Income  Investors focus heavily on income and related indices like earnings per share and the P/E (price per share to earnings per share) ratio  Recent announcements (noting that the reported EPS was off the estimate by as little as a penny) have caused the market price of reporting companies to drop significantly  Because of investor focus, and because of compensation bonuses, managers continue to focus heavily on the bottom line, sometimes with dire effects  Expanded financial statement disclosure and increased awareness by investors may drive this earnings fixation 25 International Perspective  Under IFRS an entity must present a statement of comprehensive income, often called the statement of recognize income and expenses (SORIE) The SORIE below was taken from the 2008 annual report of Unilever Group 26 Copyright Copyright © 2011 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein [...]... will be discontinued, separate disclosures are required so that investors could distinguish between ongoing activity and nonrecurring activity  A segment is defined as an entire line of business or a separately identifiable segment For example, General Motors would need to discontinue Chevrolet (not just a manufacturing plant)  Financial statement presentation includes any operating income or loss... an alternative accounting method (ex: DDB to SL or FIFO to average)  Also, a company may be required to change to a new accounting technique by the issue of a new accounting standard  Accounting standards required companies to show the cumulative effect for prior years’ income on the current income statement in a special category called “change in accounting principle.” 17 Income Statement Format... presented when a company uses a multi-step income statement; more relevant for companies that are primarily retail or manufacturing (less relevant for service industries) – Income from operations indicates income from primary, on-going activity (usual and frequent) – Income from continuing operations (IFCO) also includes peripheral activity like interest income, as well as potentially nonrecurring activity... reporting companies to drop significantly  Because of investor focus, and because of compensation bonuses, managers continue to focus heavily on the bottom line, sometimes with dire effects  Expanded financial statement disclosure and increased awareness by investors may drive this earnings fixation 25 International Perspective  Under IFRS an entity must present a statement of comprehensive income,... “what is” - the numerator and denominator use actual shares outstanding and actual net income for the year 20 Earnings Per Share (EPS) Class problem: Bush Company reported net income of $30,000 in 2007 The company had 60,000 shares of common stock outstanding for all of 2007 Bush also had 5,000 shares of convertible preferred stock outstanding for all of 2007 During 2007, the company declared a $4,000... end, and they can never have claims to the current year’s income The only benefit of diluted EPS is that it can indicate the magnitude of the maximum potential dilution for the future 24 Economic Consequences of Reporting Net Income  Investors focus heavily on income and related indices like earnings per share and the P/E (price per share to earnings per share) ratio  Recent announcements (noting...Classifying Operating Transactions 11 Format of the Income Statement See Page 606 for sample format: Sales - COGS = Gross profit - Operating expenses = Income from operations + Other revenues and gains - Other expenses and losses = Income from continuing operations (IFCO) +/-Discontinued operations +/-Extraordinary items = Net income Earnings per Share 12 Format of the Income Statement ... government, and onetime major economic transactions  If unusual or infrequent, but not both, report in “other gains/losses”, as part of IFCO Examples include material write-down of receivables, and losses from an employee strike 16 Income Statement Format - Other Issues  Consistency requires the use of the same accounting method from year to year  However, a company may choose to change to an alternative accounting. .. directors declares intention to dispose of the segment), as well as any gain or loss on the disposal of the assets 15 Format - Extraordinary Items  Extraordinary items (EI) are defined as those activities that are material in amount, unusual in nature, and infrequent in occurrence  To determine, consider the natural, political, and economic environment of the firm  Examples of EI include natural disasters,... nonrecurring activity like restructuring charges (unusual or infrequent) – Net income also includes “special” items that are presented separately because they are significant activities that are usually nonrecurring 13 Format of the Income Statement  Now, more information on the “special” items below Income From Continuing Operations (IFCO): – discontinued operations – extraordinary items  Note that each