Income Statement: Results of Operating Performance

15.511 Corporate Accounting Summer 2004

Professor SP Kothari
Sloan School of Management Massachusetts Institute of Technology

June 10, 2004

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Chapter 3: Income Statement Accounting in a one-period world

- Cash Invested 0 + Cash Returned 1

Example: Shipping Expeditions in the 15th Century Ship sold at the end of a voyage: Finite project life No information flow from time ship left port until it returned Performance: Discounted Cash Flow (DCF)

Accounting in a multi-period world

Cash Invested 0 1 2 3 4 5 6

Cash Returned

No pre-determined end to a firm's life - going concern Cash invested and generated at multiple points in time Subsequent actions affected by prior results feedback
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Principles in Preparing Financial Statements: Fiscal Period

Artificially divide the life of an organization into annual periods for the purpose of financial reporting.
SEC requires quarterly reporting. Internationally, trend toward quarterly reporting

Why is there a demand for periodic performance measures?

Valuation Evaluate management performance
Reward management Decide whether to continue to trust the firms assets with the current management

Ideally, all the relevant information with respect to a firms performance should be in the quarterly report on a timely basis. Is that the case?

Financial Accounting Principles: Objectivity and Conservatism

Objectivity: financial accounting information must be verifiable and reliable. Conservatism
Asymmetry in the treatment of gains and losses Greater degree of verification for gains than for losses Required by GAAP, but arose voluntarily. Why?
Managements incentive to report good information, hide bad information Asymmetric payoff to bondholders Credibility of information in valuation

Conservatism does not suggest that financial statements should arbitrarily understate assets and overstate liabilities.
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Income Statement: Results of Operating Performance

Revenues -- Sales or service revenue Gains -- e.g., selling an equipment for cash greater than its net book value Expenses -- Cost of goods sold, operating expenses, etc. Losses Other revenues and expenses
Interest revenue, dividend income, interest expense for a manufacturing or merchandising firm.

Income Statement: Results of Operating Performance

The income statement measures firm performance regardless of when cash is exchanged. Toward this end, two key principles are Revenue Recognition: Earnings process substantially complete Cash collection reasonably assured
Conservatism principle is applicable

The Matching Principle for Expenses: Match efforts to the benefits generated Capitalize expenditures that will benefit future periods, expense as benefits are realized Recognize liabilities when efforts benefiting the current period require cash payment in the future Produces a difference between cash flows and earnings

Matching Example
Blockbuster video buys a copy of the Matrix Reloaded video for $20. Experience indicates that video will be rented: Year1 50x Year2 17x

How much should Blockbuster recognize as an expense each year?

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Matching Example
Year1 50x Year2 17x

Estimate:

How much should Blockbuster recognize as an expense each year? 50 67 17 67 (50+17)

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Matching Example
Estimate: Year1 50x Year2 17x

How much does Blockbuster recognize as an expense each year? 50 ($20) 67 Yearly Expenses $15 17 ($20) 67 $5
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Matching Example
Estimate 2: Year1 50% Year2 25% Year3 25%

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Matching Example
Year1 Estimate 2: 50% Year2 25% Year3 25%

Yearly Expenses

$10

$5

$5

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Recording video expenses

Cash Buy Video Video Asset Retained Earn.

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Recording video expenses

Cash Buy Video (20) Video Asset 20 Retained Earn.

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Recording video expenses

Buy Video Rent 50x @$3each Cash (20) Video Asset 20 Retained Earn.

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Recording video expenses

Buy Video Rent 50x @$3each Cash (20) 150 Video Asset 20 Retained Earn.

150

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Recording video expenses

Buy Video Rent 50x @$3each End of Y1 Cash (20) 150 Video Asset 20 Retained Earn.

150

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Recording video expenses

Buy Video Rent 50x @$3each End of Y1 Cash (20) 150 (15) Video Asset 20 Retained Earn.

150 (15)

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Recording video expenses

Buy Video Rent 50x @$3each End of Y1 Rent 17x @$3each Cash (20) 150 (15) Video Asset 20 Retained Earn.

150 (15)

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Recording video expenses

Buy Video Rent 50x @$3each End of Y1 Rent 17x @$3each Cash (20) 150 (15) 51 Video Asset 20 Retained Earn.

150 (15) 51

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Recording video expenses

Buy Video Rent 50x @$3each End of Y1 Rent 17x @$3each End of Y2 Cash (20) 150 (15) 51 Video Asset 20 Retained Earn.

150 (15) 51

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Recording video expenses

Buy Video Rent 50x @$3each End of Y1 Rent 17x @$3each End of Y2 Cash (20) 150 (15) 51 (5) Video Asset 20 Retained Earn.

150 (15) 51 (5)

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Recording video expenses

Buy Video Rent 50x @$3each End of Y1 Rent 17x @$3each End of Y2 Cash (20) 150 (15) 51 (5) Video Asset 20 Retained Earn.

150 (15) 51 (5)

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Total video expenses = $20

Recording video expenses Estimate 1 and Estimate 2

Buy Video Rent 50x @$3each End of Y1 Rent 17x @$3each End of Y2 End of Y3 Cash (20) 150 (15) (10) 51 (5) (5) (5) Video Asset 20 Retained Earn.

150 (15) (10) 51 (5) (5) (5)

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Total video expenses = $20 $20

What is Cost of Goods Sold?

Freshest Grocer buys $10,000 worth of cereals from Quality Foods for cash. Assets = L + OE Cash Inventory -10,000 +10,000 Exchange of one asset for another asset Operating outflow = $10,000
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What is Cost of Goods Sold?

Freshest Grocer sold one-half of the cereals for $8,000 cash Assets = L + Owners Equity Cash Retained Earnings +8,000 +8,000 What is the most significant matching expense?
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What is Cost of Goods Sold?

The cost to Freshest Grocer of buying the cereal that was sold for $8,000 one-half of $10,000 = $5,000 = Cost of Goods Sold or Cost of Sales Assets = L + Owners Equity Inventory Retained Earnings -5,000 -5,000

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What is Gross Profit or Margin?

Assets = L + Owners Equity Cash Inventory Retained Earnings -10,000 +10,000 +8,000 +8,000 -5,000 -5,000 Increase in retained earnings +3,000 Gross Profit or Margin = Sales Revenue (-) Cost of Goods Sold = $3,000 GM rate = $3,000/$8,000 = 37.5%

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Components of Income
Sales or Service Revenue (-) Cost of Goods Sold (-) Operating Expenses (-) Unusual or Infrequent items (-) Income Tax Expense = Income from Continuing Operations (ICO) All items disclosed below ICO are referred to as below the line items. The below-the-line items are each shown net of income tax.

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Components of Income - Staples

Sales Cost of goods sold& Occupancy costs Gross Profit Operating expenses Operating &selling Pre-opening General & administrative Amortization on intangibles Amortization on goodwill Asset impairment charges Store closure charge Interest & other expenses Total operating & other expenses Income before taxes Income taxes Net income 11,596,075 08,652,593 02,943,482 01,795,428 00,008,746 00,454,501 00,002,135 0 0 0 00,020,609 02,281,419 00,662,063 00,215,963 00,446,100
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Data source: Staples Corporation. "2002 Annual Report." 5 May 2003, p. C-4.

Cash Flow Statement

Operating Activities
Net income Adjustments,
Depreciation and amortization(+) ------

0,446,100
0,267,209

Cash flow from operating

0,468,250 (0,264,692) (1,171,187) (1,436,226) 0,078,895 0,730,897 (0,95,235) 0,714,083

Investing activities
Acquisition of property & equip Acquisitions of businesses ------Net cash from investing

Financing activities
Proceeds from sale of capital stock Proceeds from borrowings Payments on borrowings ------? Net cash from financing

Net increase/(decrease)

0,201,240

Data source: Staples Corporation. "2002 Annual Report." 5 May 2003, p. C-6.

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Components of Income
Income from Continuing Operations Discontinued Operations
Income or Loss from Discontinued Operations Gain or Loss on Disposal of Discontinued Operations

Extraordinary Items (Unusual and Infrequent) Cumulative Effect of Change in Accounting Principles
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Advantages of Income Statement Components

Forecasting future performance Distinguish between core operating performance (recurring items) versus transitory components (unusual and/or infrequent items) Disclosure on Discontinued Operations An example: Firm A has two business segments, i.e., M & N. In 1997, As total income was $100,000 (M earned $70,000 and N earned $ 30,000) All numbers are assumed after tax
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Advantages of Income Statement Components

1997 Net Income (= ICO) = $100,000 In 1998, the total income was $100,000 also. M earned $90,000 income whereas N earned only $10,000. On December 31, 1998, Firm A decides to discontinue the business segment N. It expects to lose $15,000 by disposing off the assets of N. i.e., it will generate $15,000 less cash compared to the net book value of the assets of segment N.
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Advantages of Income Statement Components

What would Firm A disclose in its 1998 financial statements? Usually comparative statements are provided 1998 1997 Income from Cont. Ops. $90,000 $70,000 Income from Disc. Ops. 10,000 30,000 Loss on sale of Disc. Ops. (15,000) Net Income 85,000 100,000
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Summary
Key principles underlying financial statement preparation
Objectivity Conservatism Matching Revenue recognition

Income statement
Preparing an income statement from transaction history Presentation Information in components of income
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