Topic 2: Income Statement

Sections:

I. Overview
II. Individual Items
III. Quality of Earnings

I. Overview

The income statement reports on the

performance of the firm and the results of its
operating activities during an accounting period.
- flow

In contrast, balance sheet - stock

The matching principle is used for the

preparation of the income statement. That is,
revenues and related costs should be accounted
for during the same accounting period.

Example: The cost of the machine is recognized

as an expense (depreciation) over the whole
range of its estimated useful lifetime rather than
as an expense in the period it is purchased.

Because net income = revenues – expenses, the

income statement has three major elements:

1. Revenues: inflows … of an entity … from

delivering or producing goods, rendering
services, or other activities that constitute the
entity’s ongoing major or central operations
(SFAC (Statement of Financial Accounting
Concepts) 6).

2. Expenses: outflows …from delivering or

producing goods, rendering services, or carrying
out other activities that constitute the entity’s
ongoing major or central operations (SFAC 6).

3. Net income: accounting earnings (not cash).

Non-operating (non-central) inflows and

outflows do not enter the above equation. They
may include gains and losses from asset sales,
lawsuits, and foreign exchange holdings. But, as
usual, the classification of events into operating
(into the income statement) and non-operating
(outside the income statement) can be
problematic.

For example, a sale of a used car can be non-

operating to Little America Hotel & Resort but
central to a car rental company.

As mentioned in Topic 1, even more important is

the decision on when to recognize (spent)
revenues and expenses. This is particularly so
for the so-called new economy companies.

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Individual Homework:

There are two prevailing methods for

recognizing revenues in the software industry:
perpetual licensing and subscription licensing.
When perpetual licensing is used, the software
firm records all of the revenue related to the
product license upfront, providing that 4 criteria
are met: (1) persuasive evidence of an
arrangement exists, (2) delivery has occurred,
(3) the price is fixed or determinable, and (4)
collectability is reasonably assured. In contrast,
subscription licensing arrangements recognize
revenues over a specified subscription period.

Required Tasks:

Submit a short (50-150 words), typed report

answering the following questions: Holding
other factors constant, which method provides
more predictable sales? Why?

In addition, please do an internet search and find

information about how Microsoft recognizes its
revenues. For this task, just copy and paste as a
1-page attachment to the report and you do not
need to write anything.

The report is due in one week (January 31).

Then we will discuss it, and you may be asked to
talk about it. So be prepared.
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II. Individual Items

 The following income statement is retrieved
from Intel’s 2005 10-K:

Intel Corporation
Consolidated Incomes of Statement

Three Years Ended

December 25, 2004
(In Millions—Except 2004 2003 2002
Per Share Amounts)

Net revenue 34,20 30,14 26,76

$ 9 $ 1 $ 4
Cost of sales 14,46 13,04 13,44
3 7 6

Gross margin 19,74 17,09 13,31

 6 4 8

Research and
development 4,778 4,360 4,034
Marketing, general and
administrative 4,659 4,278 4,334
Impairment of
goodwill — 617 —
Amortization and
impairment of
acquisition-related
intangibles and costs 179 301 548
Purchased in-process
research and
development — 5 20

Operating expenses 9,616 9,561 8,936

Operating income 10,13
0 7,533 4,382
Losses on equity
securities, net (2) (283) (372)
Interest and other, net 289 192 194

Income before taxes 10,41

7 7,442 4,204
Provision for taxes 2,901 1,801 1,087

Net income $ 7,516 $ 5,641 $ 3,117

Basic earnings per

common share $ 1.17 $ 0.86 $ 0.47
Diluted earnings per
common share $ 1.16 $ 0.85 $ 0.46

Weighted average
common shares
outstanding 6,400 6,527 6,651

Weighted average
common shares
outstanding,
assuming dilution 6,494 6,621 6,759
 Source: Intel’s 2005 10-K

This is a multiple-step income statement which

usually presents gross profit, operating income,
earnings before income and taxes (EBIT), and
net income separately. This format is by far the
most popular one.

Some firms use a single-step income statement

which totals revenues and gains (other income)
and then deducts total expenses and losses. See
Finance 340 textbook, p. 2 for an example of a
simplified single-step income statement.

Note that many large firms’ statements are

“consolidated” for them and their subsidiaries.
When the parent and its subsidiaries are in
substance one company, given the proportion of
control by the parent, the parent reports
consolidated accounting numbers.

Analysts usually normalize financial statements.

A common-size income statement (balance
sheet) expresses each item on income statement
(balance sheet) as a percentage of net sales (total
assets). The following is a partial common-size
income statement retrieved from Intel’s 2005 10-
K:

2 2 2
0 0 0
0 0 0
4 3 2

Net revenue 1 1 1
0 0 0
0. 0. 0.
0% 0% 0%
Cost of sales 4 4 5
2. 3. 0.
3% 3% 2%
Gross margin 5 5 4
7. 6. 9.
7% 7% 8%
Research and development 1 1 1
4. 4. 5.
0% 5% 1%
Marketing, general and 1 1 1
administrative 3. 4. 6.
6% 2% 2%
Impairment of goodwill 2.
— 0% —
Amortization and
impairment of acquisition-
related intangibles and 0. 1. 2.
costs 5% 0% 0%
Purchased in-process 0.
research and development — — 1%

Operating income 2 2 1
9. 5. 6.
6% 0% 4%
Source: Intel’s 2005 10-K
Net Sales (Revenues)

Sales represent revenue from goods or services

sold to customers. Sales are usually shown net
of any discounts, returns, and allowances.

Sales drive the other accounts in income

statement. The trend of this figure is THE key
element in performance measurement. You
would want to know whether the variation in
sales is a result of variations in price, volume, or
both, and whether the underlying driving forces
are increasing or decreasing. These driving
forces are usually discussed in the Management
Discussion and Analysis section of the 10-K.

Cost of Goods Sold, COGS (or Cost of Sales)

For a retailing firm, COGS = beginning

inventory + purchases – ending inventory.
For a manufacturing firm, COGS = beginning
inventory + the cost of goods manufactured –
ending inventory.

For a service firm, this component is called cost

of services.

COGS is affected by the cost flow assumption.

In general, there are three inventory accounting
methods: FIFO (first in, first out), LIFO (last in,
first out), and average cost. The FIFO (LIFO)
assumes that the first (last) units purchased or
manufactured are the first units sold during an
accounting period.

Example:

Suppose that a new start-up retailing firm

purchases 4 products for sale in its first year of
operation. The purchasing costs are increasing
over time due to inflation.

Item Cost
#1 $5
#2 $6
#3 $7
#4 $8
The firm sells three products during this
accounting period:

COGS (Income Inventory

Statement) (Balance Sheet)
FIFO $18 (#1 + #2 + $8 (#4)
#3)
LIFO $21 (#4 + #3 + $5 (#1)
#2)
Average $19.5 (Total $6.5 (Total
Cost Cost*3/4) Cost*1/4)

When purchasing or manufacturing costs are

increasing, the LIFO method produces the
highest COGS and the lowest inventory.

Note that a firm is usually allowed to use one

accounting method for tax purposes and another
method for reporting purposes. But this is not
the case for treating inventory.
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Questions:
1. According to a survey, slightly more than half
of publicly traded corporations used the LIFO
method during 1990s. Why was this method so
popular?

2. Casual observations show a recent trend for

increasing use of the FIFO method. Why?
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The account of COGS needs to be carefully

examined because this is usually the single
largest outflow. As a result, analysts usually pay
attention to the following ratio.

Gross Profit Margin

Gross Profit margin = (net sales – COGS)/net

sales = gross profit/net sales = gross margin/net
sales
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Questions:

Is there a trend in Intel’s gross profit margins

during 2002-2004? What might cause this?
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Operating Expenses

Operating expenses consist of two types: selling

and administrative. They include salaries, rent,
insurance, utilities, advertising expense, and
sometimes depreciation.

Depreciation and/or Amortization and/or

Depletion

Depreciation is used to allocate the cost of

tangible fixed assets such as buildings,
machinery, equipment, furniture, and vehicles,
etc.
Amortization is the cost write-off process for
capital leases (leasing arrangements that is, in
substance, a purchase by the lessees), leasehold
improvements, and the cost expiration of
intangible assets such as patents, copyrights and
trademarks, etc.

Depletion is used to allocate the cost of

acquiring and developing natural resources such
as oil and gas, timber, and minerals.

Operating Income (Operating Profit, EBIT)

This provides a basis for assessing the success of

a firm apart from its financing and investing
activities and separate from tax considerations.

The operating profit margin = operating

income/net sales

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Question:
Is there a trend in Intel’s operating profit
margins during 2002-2004? What might drive
this?
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Other Income (Expense)

This includes revenues and costs other than

those from operations, such as dividend and
interest income, interest expense, gains and
losses from sale of assets, and equity earnings or
losses.

Equity Earnings (Losses)

Equity earnings (losses) are the investor’s

proportionate share of the investee’s earnings
(losses).

There are two accounting methods, cost or

equity, that can be used to account for
investments in the voting stock of other
companies. The equity method is used when the
investor can exercise “significant” influence
over the investee’s operating and financing
decisions. Under this method, the account of
equity earnings (losses) is used by the investor
to recognize the investor’s proportionate share
of the investee’s earnings (losses).

On the other hand, if the cost method is used, the

investor recognizes dividends received and
records the amount under the account of other
income.

Example:

Suppose that firm A acquires 20% of the

common shares of firm B for $500,000. Firm B
reports $200,000 earnings for the year and pay
$100,000 in dividends. This impacts firm A’s
income statement and balance sheet as follows:

Cost Method Equity Method

Income
Statement
Invest $20,000 $40,000
ment (.2*$100,000) (.2*$200,000)
Income
(Other
Income
or Equity
Earnings)
Balance
Sheet
Invest $500,000 $520,000
ment ($500,000+$40,000-
Account .2*$100,000)^
^Under the equity method, investment account =
investment at cost + investment income –
dividends received

Special Items

This includes equity earnings, unusual or

infrequent items disclosed separately,
discontinued operations, extraordinary gains
(losses), cumulative effect of change in
accounting principle, and minority share of
earnings (losses). Please see FIN 340 textbook,
pp. 4-13.

Net Income (Net Earnings)

Net income is the profit after consideration of all
revenues and expenses.

Earnings per Common Share (EPS)

EPS = net income/number of shares outstanding

There could be 2 calculations of EPS: basic and

diluted. Diluted EPS uses all potentially dilutive
securities (convertible bonds, options, warrants,
etc.) in the number of shares outstanding. As a
result, diluted EPS <=basic EPS.

Comprehensive Income

The prevailing accounting concept is that

income should include all revenues, expenses,
gains and losses, regardless of whether they are
results of operations. As a result, other
comprehensive income includes foreign
currency translation adjustments, unrealized
holding gains and losses on available-for-sale
marketable securities, additional pension
liabilities, and cash flow hedges. See FIN 340
textbook, pp. 15-16.
III. Quality of Earnings

Earnings are the bottom line.

One needs to carefully examine the quality of

earnings in at least three dimensions: (1) Are
reported earnings repeatable? (2) Are reported
earnings subject to accounting manipulation?
(The “when” question.) (3) Are reported
earnings temporarily boosted by a decrease in
necessary expenditures, such as R&D.