Chapter 3

Income Statement and Statement of Stockholders’ Equity

THE INCOME STATEMENT:

Investors, creditors and analysts keenly wait the earning’s report of the company. Why? to see
the profitability of it. This earning report is called the income statement, also called the statement
of earnings that presents a firm’s revenues and expenses.

Statement of Stockholder’s Equity is the link btw balance sheet and income statement. Why?

The income statement comes in two basic formats:

1) Multiple-step format: it is used for analysis purposes that provides several intermediate profit
measures such as (Gross profit, Operating profit and Earnings before income tax) (ex;105)

2) Single-step format: groups all items of revenue together, and then deducts all categories of
expense. (ex;105)

Common-Size Income Statement:

it is useful analytical tool to compare firms with different levels of sales within the industry and
evaluate trends. It expresses each income statement item as a percentage of net sales. Ex: if sales =
215,600 and COGS = 129,364 then the common size of COGS is 60%.
Net Sales:

Sales are the major revenue source for most companies.

If a company’s sales are increasing (or decreasing), it is important to determine whether the
change is a result of price, volume, or a combination of both. Thus it is important to adjust the
sales growth to the real or nominal sales in regards to Consumer price index (CPI) for ex.

Cost of Goods Sold:

It is the largest expense for many firms, called cost of sales and affected by cost flow assumption
used to value inventory (LIFO, FIFO methods)

Gross Profit:

Also called gross margin, it is the difference between net sales and cost of goods sold. It is key analytical
tool in assessing operating performance. Usually, firms want to maintain or increase gross profit margin.
The ratio for sage Co. is:
Operating expense:
Has considerable impact on current and future profitability, and important to track trends. It is categorized:
• Selling and administrative expenses: Relate to the sale, salaries, rent, insurance, utilities…..
• Advertising costs: major expense related to marketing…
• Lease payment: costs that associated with operating rentals of leased facilities…
• Depreciation and amortization: depreciation is used to allocate the cost of tangible fixed
assets. While amortization is an allocation process applied to capital leases, leasehold
improvements, and cost expiration of intangible assets.
• Repairs and maintenance: annual costs of repairing (property, Plant, equipment PP&E)
• Impairment charges: recognized to record a decline below the book value of a long-term asset
(PP&E).

Operating Profit
• Also called earnings before interest and taxes (EBIT)
• Second step of profit determination on the multi-step income statement
• Measures overall performance of operations apart from financing and investing activities
and separate from tax considerations
• Sales revenue less the expenses associated with generating sales

What is the Operating Profit Margin ratio? It is operating profit / net sales
The ratio of Operating Profit Margin for Sage Inc. is:

• The ration Indicates that Sage Inc. strengthened its return on operations in 2016 after a
dip in 2015 despite the percentage increase in cost of goods sold, Sage Inc.’s percentage
of selling and administrative and advertising expenses decreased enough to increase
operating profit.

Other Income (Expense)

It is the revenues and costs other than from operations such as: Dividend and interest income,
Interest expense, Investment gains (losses), Equity earnings (loss), Gains (losses) from sale
of fixed assets.

Earnings before Income Taxes / Effective Tax Rate

It is the profit recognized before the deduction of income tax expense. However, Income
taxes paid may differ from income tax expense.
The effective tax rate is the ratio of income taxes to earnings before income taxes.

Special Items
It’s the discontinued operations that occur when the firm sells or discontinues a portion of its
business and the extraordinary gain or loss items (unusual in nature to happen)
 Net Earnings

Also called the “bottom line” which represents profit after consideration of all revenue and
expense. Net Profit Margin shows the percentage of profit earned on every sales dollar
For Sage Inc. the Net Profit Margin is:

Earnings per Common Share

Net earnings available to common stockholders for the period divided by the average number
of common stock shares outstanding

Statement of shareholders' equity: Is a financial document a company issues as part of its

balance sheet. It highlights the changes in value to stockholders' from the beginning of a
given accounting period to the end of that period.

Equity Earnings – Equity Method

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

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

• Fits accrual accounting requirements

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

Equity Earnings – Cost Method

• Investor recognizes investment income only to the extent of any cash dividends received.
 • Allows recognition of investment income only to the extent of any cash dividends
actually received

• Carries an investment account at cost

• Example – Assume that company A acquires exactly 20% of the voting common stock of
Company B for $400,000. Company B reports $100,000 earnings for the year and pays
$25,000 in cash dividends.

• For company A, income recognition in the earnings statement and the noncurrent
investment account on the balance sheet are different depending on the accounting
method.

Cost Method

• Allows recognition of investment income only to the extent of any cash dividends
actually received:

•
$25,000 x 0.20 = $5,000

• Investment account is carried at cost.

Equity Method

• Permits the investor to count as income the percentage interest in the investee’s earnings.

Equity Method

• Investment account is increased by the amount of investment income recognized and is

reduced by the amount of cash dividends received.