Financial Statement Analysis

Income Statement
The Income Statement

• Summarizes revenues and expenses, and gains

and losses
• Ends with the net income for a specific period
• Multiple-step format—presents separately
– Gross profit
– Operating income
– Income before taxes
– Net income

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The Income Statement - Continued

• Single-step format
– Totals all revenues and gains
– Deducts total expenses and losses

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 Multiple-Step Single-Step
Multiple-step Income Statement Single-step Income Statement
For the Year Ended December 31, 2013 For the Year Ended December 31, 2013

Net revenue $37,586 Net revenue $ 37,586

Cost of sales 16,742 Interest income 488
Gross margin 20,844 Other income -
Operating Expenses: 38,074
General & administrative $ 5,458 Costs and Expenses:
Research & development 5,722 Cost of sales $ 16,742
Restructuring charges 710 11,890 General & administrative 5,458
Operating income 8,954 Research & development 5,722
Interest income (expense) 488 Other losses 1,756
Other gains (losses) (net) (1,756) (1,268)
Restructuring charges 710 30,388
Income before taxes 7,686
Income before taxes 7,686
Provision for taxes 2,394
Provision for taxes 2,394
Net Income $ 5,292
Net income $ 5,292
Basic Elements of the Income
Statement
• Net Sales (Revenues)
• Cost of Goods Sold (Cost of Sales)
• Other Operating Revenue
• Operating Expenses
• Other Income or Expense

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Net Sales (Revenues)
• Represents revenue from the sale of principal
goods or services sold to customers
• Shown net of
– Discounts
– Returns
– Allowances

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Cost of Goods Sold (Cost of Sales)
• The cost of goods that were sold to produce
revenue
Retailer Manufacturer
Beginning Inventory Beginning Inventory
+ Purchases + Cost of Goods Manufactured
− Ending Inventory − Ending Inventory
Cost of Goods Sold Cost of Goods Sold

• A service firm will not have cost of goods sold,

but it will often have cost of services

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Other Operating Revenue
• Depends on the operations of the business
• Examples
– Lease revenue
– Royalties

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Operating Expenses
• Consist of two types
– Selling expenses
• Result from a company’s effort to create sales
• Advertising. Sales commissions, and Sales supplies used
– Administrative expenses
• Relate to the general administration of a company’s
operation
• Salaries, Insurance, and Bad debt expense

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Other Income or Expense
• Secondary activities not directly related to
operations
• Dividend income. Interest income, Gains
(losses) from sale of assets, and Interest
expense

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Special Income Statement Items
• Unusual or Infrequent Item Disclosed Separately
– Shown with normal recurring revenues and expenses
– If material, disclosed separately, before tax
– Treatment for analysis
• Included in primary analysis as they relate to operations
• In supplementary analysis, it should be removed net after tax

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Special Income Statement Items -
Continued
• Equity Earnings of Nonconsolidated Subsidiaries
– The investor’s proportionate share of the investee’s
net income
– Does not represent cash flow to the investor
• Cash dividends received represent cash flow
– Analysis issues
• Investor’s net income includes revenue of other entity
• May distort ratios
• Presented before tax; tax consequences typically immaterial

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Special Income Statement Items -
Continued
• Income Taxes Related to Operations
– Federal, state, and local taxes
– Includes both paid and deferred taxes
• Discontinued Operations
– Reported net of income tax
– Profitability analysis issues
• Inadequate disclosure of associated assets
• Lack of historical profit and loss information on the
discontinued operations

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Special Income Statement Items -
Continued
• Extraordinary Items
– Unusual and infrequent
– Reported net of income tax
– Analysis issues
• Exclude from primary analysis; it is not expected to recur
• Include for supplementary analysis; this approach avoids
disregarding extraordinary items

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Special Income Statement Items -
Continued
• Change in Accounting Principles
– Current GAAP requires retrospective approach,
unless it is impracticable
• Cumulative effect on prior years reported is reflected in
beginning retained earnings in the year of change
– If impracticable
• Determine the difference to the opening balances in the
accounts
– Prior to current GAAP, changes were presented using
the prospective method

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Special Income Statement Items -
Continued
• Net Income: Non-controlling Interest (prior to
Dec. 31, 2009 it was called minority share of
earnings)
– Earnings of a partially-owned consolidated subsidiary
that would accrue to the minority owners
– Presented net-of-tax

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Earnings per Share
• Earnings divided by the number of shares of
outstanding common stock

Net income
EPS =
Outstanding shares of common stock

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Retained Earnings
• The accumulated undistributed earnings of the
corporation reported on the balance sheet
• Appropriated
– Restricted by law, contract, or management decision
– Not available for dividends
– Does not represent cash or any other asset
• Unappropriated
– Available for dividends

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Reconciliation of Retained Earnings
• Reported as part of the statement of
stockholders’ equity or combined with the
income statement
Beginning balance of retained earnings
+ Prior period adjustments (net of tax)
Cumulative effect of a change in accounting principle
±
(net of tax)
= Beginning balance as adjusted
+ Net income
– Dividends
= End-of-year balance of retained earnings
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Dividends
• Dividends return profits to the owners of a
corporation
• Date of declaration
– Creates liability and reduces retained earnings
• Date of payment
– Eliminates liability and reduces cash

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Stock Dividends
• Issuing a percentage of outstanding stock as
new shares to existing shareholders
– Assuming a small distribution (less then 25%)
• Removing the fair market value of the stock from retained
earnings and transferring it to paid-in capital
– If the stock dividend is material
• The amount transferred to paid-in capital is determined by
multiplying the par value by the number of additional shares
• Total equity is unaffected by a stock dividend
– Restate share quantities to reflect stock dividend
activity
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Stock Dividend - Example
• 100,000 shares outstanding; $1 par; $5 market
• 10% stock dividend on 100,000 shares, issue
10,000 additional shares recorded at $5 per
share
10% stock dividend
Before Effect of dividend After
Common stock par value $1.00 $1.00
Shares outstanding 100,000 issue 10,000 shares 110,000
Total par value $100,000 10,000 $110,000
Additional paid-in capital 750,000 40,000 790,000
Total paid-in capital 850,000 900,000
Retained earnings 1,000,000 (50,000) 950,000
Total stockholders' equity $1,850,000 $1,850,000

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Stock Dividend Example
• 100,000 shares outstanding; $1 par; $5 market
• 40% stock dividend on 100,000 shares, issue
40,000 additional shares recorded at $1 per
share
40% stock dividend
Before Effect of dividend After
Common stock par value $1.00 $1.00
Shares outstanding 100,000 issue 40,000 shares 140,000
Total par value $100,000 40,000 $140,000
Additional paid-in capital 750,000 750,000
Total paid-in capital 850,000 890,000
Retained earnings 1,000,000 (40,000) 960,000
Total stockholders' equity $1,850,000 $1,850,000

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Stock Splits
• 2-for-1 split
– Doubles the quantity of stock
– Par or stated value is halved
• No effect on retained earnings, additional paid-in
capital, or capital stock accounts
• Analysis issues
– Restate share quantities to reflect split activity

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Legality of Distributions to
Shareholders
• As per various state laws
– Distributions to stockholders are acceptable as long
as the firm has the ability to pay debts as they come
due in the normal course of business
– Distributions to stockholders are acceptable as long
as the firm is solvent and the distributions do not
exceed the fair value of the assets
– Distributions consist of solvency and balance sheet
test of liquidity and risk

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Comprehensive Income
• Foreign currency translation adjustments
• Unrealized holding gains and losses on
available-for-sale marketable securities
• Changes to stockholders’ equity resulting from
additional minimum pension liability adjustments
• Unrealized gains and losses from derivative
instruments
Net income
+ The period’s change in accumulated other comprehensive income
= Comprehensive income
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Comprehensive Income - Continued
• Required disclosures
– Comprehensive income
– Each category of other comprehensive income
– Reclassification adjustments for each category of
other comprehensive income
– Tax effects for each category of other comprehensive
income
– Balances for each category of accumulated other
comprehensive income

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Comprehensive Income - Continued
• Presentation
– A single income statement reporting net income and
comprehensive income, or
– Report comprehensive income in a separate
statement immediately following the statement of
income
• Analysis issues
– Typically more volatile than net income
• A better indication of long-run profitability

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Comprehensive Income -
Combined with Income Statement
XYZ Corporation
Statement of Income and Comprehensive Income
For the Year Ended December 31, 2013

Sales $ 230,000
Cost of goods sold 140,000
Gross profit 90,000
Operating expenses 40,000
Operating income 50,000
Other income 4,000
Income before income taxes 54,000
Income taxes 20,000
Net income 34,000
Other comprehensive income
Available-for-sale security adjustment, net of tax 5,500
Minimum pension liability adjustment, net of tax 3,500
Foreign currency transaction adjustment, net of tax (5,000)
Other comprehensive income 4,000
Comprehensive income $ 38,000

Earnings per share (for net income only) $ 2.80

Comprehensive Income - Separate
Statement
XYZ Corporation
Statement of Comprehensive Income
For the Year Ended December 31, 2013

Net income $ 34,000

Other comprehensive income
Available-for-sale security adjustment, net of tax 5,500
Minimum pension liability adjustment, net of tax 3,500
Foreign currency transaction adjustment, net of tax (5,000)
Total other comprehensive income 4,000
Comprehensive income $ 38,000
Income Statement IFRS vs. GAAP
• IFRS and U.S. GAAP for income statements are
similar, with some presentation differences
– IFRS has no required format of the income statement
– IFRS classifies expenses based on their nature or
function
– IFRS equipment may be revalued which result in the
adjustment of depreciation expenses
– IFRS allows for alternative performance measures to
be presented in income statement

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