After reading this chapter, you should be able to answer the following questions: What is revenue, and what are the two criteria that permit revenue recognition? How is cost of goods sold determined under both perpetual and periodic inventory accounting systems? What is the significance of gross profit, and how is gross profit calculated and used?...
CHAPTER THE INCOME STATEMENT AND THE STATEMENT OF CASH FLOWS McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Learning Objectives What is revenue, and what are the two criteria that permit revenue recognition? How is cost of goods sold determined under both perpetual and periodic inventory accounting systems? What is the significance of gross profit, and how is gross profit calculated and used? What are the principal categories and components of “other operating expenses,” and how are these items reported on the income statement? McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Learning Objectives What is included in “income from operations,” and why is this income statement subtotal significant to managers and financial analysts? What are the components of the earnings per share calculation, and what are the reasons for some of the refinements made in that calculation? What are the alternative income statement presentation models? McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Learning Objectives What are the unusual items that may appear on the income statement? What are the purpose and general format of the statement of cash flows? 10 What is the difference between the direct and the indirect methods of presenting cash flows from operating activities? 11 Why is the statement of cash flows significant to financial analysts and investors who rely on the financial statements? McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Learning Objective ã What is revenue, and what are the two criteria that permit revenue recognition? McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Income Statement ã Answers important questions such as: – What are the financial results of operations of the entity for the fiscal year? – Are sales increasing relative to cost of goods sold and other operating expenses? • Reports what has happened over a period of time McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Revenues ã Inflows or other enhancements of assets from rendering goods or services that constitute the entity’s ongoing, major operations • To be recognized, revenue must be: – Realized or realizable – Earned McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Realization and Earned • Realization – the product or service has been exchanged for cash or claims to cash • Earned – the entity has completed the activities it must perform to be entitled to the revenue benefits • Both criteria are usually satisfied when product being sold is delivered to the customer McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Sales ã Sales describes the revenues of firms that sell purchased or manufactured products • Sales returns and allowances – a refund or reduced price for defective merchandise • Net sales – gross sales less sales returns and allowances • Other terms for revenues include Rental Revenue, Fees, and Other Revenues McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Shipping Terms ã FOB destination – the seller owns the product until accepted by the buyer at the buyer’s designated location Title to the merchandise passes when the merchandise is received by the buyer Seller incurs shipping costs • FOB shipping point – buyer accepts ownership of the product at the seller’s shipping location Buyer incurs shipping costs McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Learning Objective ã What are the unusual items that may appear on the income statement? McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Unusual Items Sometimes Seen on an Income Statement • Income statements are used by investors to predict probable results of future operations, but they only want to consider recurring items • Nonrecurring items are reported separately, net of the income tax effect of the event • These events include: discontinued operations, extraordinary items, minority interest in subsidiaries, and cumulative effect of change in accounting principle McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Discontinued Operations • Disclose the impact of a the disposal of a segment or major portion of a business • Helps investors see the impact on the firm’s operations without the disposed business segment • Shown net of taxes • Report earnings per share effect of disposal McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Extraordinary Items • Must be unusual in nature and infrequent in occurrence to qualify as an extraordinary item (or if prescribed by the FASB) • The event is not likely to recur • Examples include: gains and losses from early repayment of long-term debt, litigation settlements, and pension plan terminations • Shown net of tax • Report earnings per share for extraordinary items McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Minority Interest in Earnings of Subsidiaries • The financial statements of a subsidiary are combined with those of the parent • Only the parent’s equity in the subsidiary’s earnings is reported • The minority interest earnings are deducted from income after taxes • Reported separately only if significant McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Cumulative Effect of a Change in Accounting Principle • A change from one generally accepted accounting principle to another is permitted only if the change is promulgated by a standard-setting body or if the change can be justified • Report the cumulative effect of the change net of tax McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Learning Objective ã What are the purpose and general format of the statement of cash flows? McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Statement of Cash Flows ã Relatively new financial statement • Primary purpose is to provide relevant information about the cash receipts and cash payments of an entity during a period • Key word is “cash” McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Learning Objective 10 ã What is the difference between the direct and the indirect methods of presenting cash flows from operating activities? McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Cash Flows from Operating Activities • Two methods of presenting the operating activities section: – The direct method involves listing each major class of cash receipts and cash disbursements – The indirect method explains cash flow by explaining the change in each of the non-cash operating accounts in the balance sheet McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Direct Method • Lists cash activities such as: – Cash received from customers – Cash paid to merchandise or raw materials suppliers – Cash paid to employees for wages – Cash paid for interest – Cash paid for income taxes McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Indirect Method • Begins with net income and adds back depreciation expense • Adjusts for changes in non-cash operating accounts in the balance sheet such as accounts receivable, inventory, and accounts payable • Also need to include deferred income taxes, gains and losses on assets, and amortization on bonds payable McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Cash Flows from Investing and Financing Activities • Investing activities relate to the purchase and sale of noncurrent assets such as land and buildings and debt and equity securities • Financing activities relate to changes in noncurrent liabilities and owners’ equity accounts such as issuing bonds or stock and paying dividends McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Learning Objective 11 ã Why is the statement of cash flows significant to financial analysts and investors who rely on the financial statements? McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Interpreting the Statement of Cash Flows • Did the firm’s cash balance increase or decrease during the period? • A firm should have a positive cash flow from operating activities • Cash from operating activities should be greater than cash used for investing activities • Can often determine a firm’s growth strategy from the statement of cash flows McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 ... significance of gross profit, and how is gross profit calculated and used? What are the principal categories and components of “other operating expenses,” and how are these items reported on the income statement? ... Objective ã What are the purpose and general format of the statement of cash flows? McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Statement of Cash Flows ã Relatively new financial statement. .. statement of cash flows? 10 What is the difference between the direct and the indirect methods of presenting cash flows from operating activities? 11 Why is the statement of cash flows significant