4.

2 INCOME STATEMENT

The income statement is usually considered to be more important to investors and creditors than the
balance sheet. The FASB-in its Statement of Financial Accounting Concepts No. 1, "Objectives of Financial
Reporting by Business Enterprises"-explains the importance of the income statement as follows:

The primary focus of financial reporting is information about an enterprise's performance

provided by measures of earnings and its components. Investors, creditors, and others who are
concerned with assessing the prospects for enterprise net cash inflows are especially interested
in that information.5

As this passage suggests, we often forecast future performance when doing financial statement
analysis. The income statement, far more than the balance sheet, helps do this.

The income statement is closely related to the balance sheet. Why? We have seen that share-
holders' equity is equal to net assets. This is true at any balance sheet date. So, it is also true that the
change in shareholders' equity during a year is equal to the change in net assets in that year.

Change in shareholders' equity = Change in net assets

This equation is important because GAAP define net income implicitly, based on the change in
shareholders' equity. Net income is the change in shareholders' equity that is not due to contributions of
capital or distributions of capital. To see the intuition behind this definition of income, consider your
savings account. It increases when you make a deposit or earn interest. It decreases when you make a
withdrawal or incur service fees. The net income from the savings account is the interest earned less the
service fees. This is the total of all changes in the account balance that are not due to contributions of
capital (deposits) or distributions of capital (withdrawals).

Similarly, GAAP define a firm's net income to be the change in its net assets, excluding stock
issuances (contributions of capital) and dividends (distributions of capital). That means the balance sheet
recognition and valuation rules directly affect net income. If the rules call for the net asset balance to
increase, there is net income for the amount of the increase. If the rules call for net assets to decrease,
there is a net loss for the amount of the decrease. For example, Simple Company's shareholders' equity
and net assets increased by $130 million during 2001, from $835 million to $965 million. Suppose it sold
stock for $40 million during the year and paid dividends of $20 million. Its net income for the year must
be $110 million. Exhibit 4.5 explains the change in Simple Company's equity.

Although reconciling the shareholders' equity account determines the amount of net income, it
does not provide much information about how that income was earned. This is where the income
statement comes in.

Income Statement Content

The income statement summarizes the transactions that led to the firm's net income. Broadly
speak- ing, the income statement contains five categories of items: revenues, expenses, gains, losses,
and spe- cial items. These categories contain clues that are helpful in forecasting, because they relate to
whether the item is likely to recur. The income statement in Exhibit 4.6 explains Simple Company's 2001
income of $110 million.
 Simple Company's income statement includes revenues (sales), expenses (cost of sales, deprecia
tion expense, interest expense, income tax expense), a gain, and a loss. We explain each of these cat-
egories next

1. Revenues include increases in net assets that result from selling goods and services in the
normal course of business, Revenues also include other income that is not the result of selling a
security or other asset. For example, royalties and interest income are considered revenues.
2. Expenses are decreases in net assets that result from activities related to preparing product for
sale or delivering services in the normal course of business, or financing costs. Cost of goods
sold, depreciation, advertising, salaries, rent, travel, interest, and taxes are examples of expenses
3. Gains, like revenues, represent increases in net assets. However, they differ from revenues in an
important respect. Gains do not arise in the ordinary course of business. For example, if a toy
manufacturer sells one of its manufacturing plants for more than the amount shown on the bal-
ance sheet (its "hook value") as of the date of sale, the firm would recognize a gain for the dif
ference. Selling a plant is not part of the company's normal business of selling toys, so this inflow
is not classified as revenue.
4. Losses are decreases in net assets resulting from transactions that are not part of the normal
course of business operations. If the toy company sold the plant for less than its book value, the
company would recognize a loss.

Simple Company does not have any special items, but we describe special items here for completeness.

5. Special items include extraordinary items, changes in accounting principles, and discontinued
operations. These items are generally nonrecurring,
a. Extraordinary items are gains and losses that are deemed to be both unusual and nonre-
curring. Examples include losses from natural disasters, such as an earthquake or a tor-
nado, assuming the location of the affected facility is not such that the disaster would be
likely to recur.
b. Changes in accounting principles arise when the firm switches from one accounting method
to another. As of the first day of the year of the change, the firm revalues all its assets and
liabilities to what they would have been had the firm always used the new accounting
method. The resulting gain or loss is classified as a change in accounting prin- ciple. For
example, if a firm switches from accelerated depreciation to straight-line, it revalues its net
fixed assers to a higher amount, to reflect the amount at which its fixed assets would have
been valued had the firm been using straight-line all along. This increase in fixed assets
results in income recognition, which is classified as a change in accounting principle.
c. Discontinued operations include all the items of income, expense, gain, and loss related to
the operations of the firm's businesses that it intends to sell or otherwise dispose of. After
Quaker Oats made the decision to dispose of its Fisher-Price toys unit, but before the
transac- tion was complete, Fisher-Price was classified as a discontinued operation. All
income state- ment items related to Fisher-Price were shown as profit or loss from
discontinued operations.

The presentation of the various income statement components highlights whether each line
item is likely to recur. Revenues and expenses relate to the normal course of business and generally recur
every year. Gains and losses are not in the normal course of business, so we do not necessarily expect
them to recur at the same level every year. However, they are not so unusual that we would not expect
them ever to recur. Special items are much less likely to recur. The analyst can use these categorizations
to develop better assessments of future profitability

Accounting Analysis of the Income Statement

Accounting analysis of the income statement often focuses on earnings quality. What is earnings quality?
Different analysts use the term differently. Earnings quality can mean conservative account- ing methods,
earnings that are free of manipulation, and the exclusion of nonrecurring items.

Conservatism

Conservative accounting methods are those that tend to delay recognition of assets and accelerate
recognition of liabilities or that tend to provide lower asset valuations and higher liability valuations.
Although conservative accounting methods generally lead to lower values for reported net assets, they
do not necessarily result in lower reported earnings. Choosing a conservative accounting method usually
lowers income in early years and increases it in later years. For example, using accel- erated depreciation
increases depreciation charges in the early years of an asset's life, but lowers them in later years.
Similarly, choosing a higher level for the allowance for uncollectibles reduces income in one period, but
increases it in the next.

Firms sometimes take a "big bath." In a year in which the firm is going to report lower earnings,
the firm writes off additional assets, taking a charge to income. This is very conservative in that it
provides a significantly lower asset valuation. However, this leads to higher income in future periods as
depreciation charges are smaller.

Free of Manipulation

Some analysts say a firm has good-quality earnings if earnings are free of manipulation. This suggests
that estimates, such as for the allowance for uncollectibles, be unbiased estimates of the underlying
amounts. This is difficult to verify for a particular firm. Further, how can an analyst classify one
depreciation method or inventory method as more free of manipulation than another? However, to the
extent possible, the analyst should try to undo any management manipulation before using his- torical
data.

The earnings manipulation issue has been in the news even more since the collapse of Enron in
late 2001. In a story on the topic, the Wall Street Journal stated,

Alan R. Ackerman, a veteran market strategist at Fahnestock & Co., says the multiplying
accounting scandals are creating "a crisis of confidence among investors. Many people are mov-
ing money to the sidelines because of a high degree of concern about the quality of corporate
carnings and how much accounting engineering is involved in producing those earnings."?

Excludes Nonrecurring Items

Sometimes earnings quality means earnings include only items expected to recur. Such a definition
implies higher-quality earnings are those that are more useful for forecasting. For example, because
extraordinary items are defined as unusual and nonrecurring, the analyst can usually ignore these items.
A loss from an earthquake will not be forecasted to recur in the future. Similarly, analysts often exclude
earnings from discontinued operations from their financial analysis.

Treatment of gains and losses in a forecast is more complex because there are many types of
gains and losses. Should gains or losses be expected to recur in the future? Because gains and losses do
not arise from the normal course of business, they are candidates for exclusion. However, gains and
losses are not so unusual and nonrecurring to be considered extraordinary items. They can sometimes
recur period after period. For example, McDonald's Corporation regularly acquires its franchised restau-
rants and later resells them to new franchisees. This creates gains and losses (usually gains) that appear
regularly. The analyst must carefully consider each gain or loss in his or her analysis.

No one can determine a "true" historical earnings amount. In using historical income statement
information to help us understand a business or develop a forecast, we need to assess the effect of
choice in accounting methods, estimates, and nonrecurring items. These judgments will affect our own
estimates of the firm's future performance.

4.3 CASH FLOW STATEMENT.

The cash flow statement describes the reasons for the change in the firm's cash balance from the
beginning to the end of the period. Virtually all cash flow statements use the indirect method. Under this
method, the cash flow statement begins with net income and then reconciles that amount to the change
in cash. Simple Company's net income was $110 million, whereas its balance sheet shows that its cash
increased by only $60 million, from $150 million to $210 million. Its cash flow statement begins with net
income of $110 million and then has $50 million of net downward-reconciling items, to arrive at the $60
million increase in cash.

Cash Flow Statement Content

Exhibit 4.7 is Simple Company's cash flow statement for 2001. The GAAP cash flow statement divides
cash flow into three categories: cash flow from operations, cash flow from investing, and cash flow from
financing. Cash flow from operations includes the items that relate to the determination of net income.
For example, producing or selling the firm's products or services is an operating activ- ity. Cash flow from
investing is the cash flow from activities in which the firm acquires or divests long-term assets or
investment securities. Purchases of property, plant, and equipment; lending money or collecting
principal on loans; and making investments in equity securities are investing activities. Cash flow from
financing includes borrowing money from creditors and repaying debt, as well as obtaining funds from
stockholders, paying dividends to stockholders, and repurchasing shares from stockholders.

The Simple Company cash flow statement starts with net income of $110 million. The bottom
line of the cash flow statement ($60 million) is equal to the change in the cash balance on the bal- ance
sheet ($210 million minus $150 million). Each reconciling item represents a reversal of a non- cash
component of income, a cash flow that has no income statement effect, or a difference between the
amount of income statement recognition and cash flow on a particular group of transactions

The first reconciling item is depreciation. Being a noncash expense, depreciation has no effect on
cash flow, but it is subtracted in calculating net income. As a result, depreciation must be added back in
the cash flow statement to reverse its effect in the income statement. The positive $5 million in the cash
flow statement for the decrease in inventory indicates that cash flow from sales of products exceeded
gross profit on the income statement by $5 million, because Simple Company did not replenish all the
inventory that it sold. Capital expenditures are payments for new fixed assets. These payments are not
expensed in the income statement, but they are cash outflows, so they appear on the cash flow state-
ment. Issuance of stock is a cash inflow, whereas dividends and debt repayments are cash outflows.

As we will see in Chapter 9, the GAAP definitions of cash flow are not consistent with the typ-
ical definition of cash flow used in financial analysis. For example, cash flow from operations under GAAP
includes interest income and interest expense, whereas one of the first lessons we learn in corporate
finance is to segregate these items from operating cash flows. As a result, when we use the cash flow
statement to do financial analysis, we often reclassify certain components of the GAAP cash flow
statement to make the statement consistent with a financial analysis framework.

Accounting Analysis of the Cash Flow Statement

Quality issues are less problematic for the cash flow statement than for the income statement or bal-
ance sheet. Cash flow is simply the change in cash and this amount is not affected by accounting method
choices or estimates. However, individual line items in the cash flow statement are affected. For
example, a large write-off of a fixed asset does not affect cash flow but does reduce income, resulting in
a positive reconciling item in the cash flow statement. The reconciling items on the cash flow statement
may be a useful tool for identifying potential earnings quality issues. Large reconcil- ing items are
potential red flags and should be evaluated. For example, large negative reconciling amounts for changes
in working capital could indicate that earnings are being propped up through accruals management,
resulting in increases in the reported values of noncash assets or liabilities. If income is increased by
extending depreciable lives of fixed assets, this fact will be highlighted in the cash flow statement, even if
depreciation is not a separate line item in the income statement.

The Combined Income Statement and Cash Flow Statement

Although it is not the format prescribed by GAAP, it is possible to combine the income statement and
cash flow statement into a single statement, simply by substituting the entire income statement for the
first line of the cash flow statement, which is net income. Although this format contains no new
information, it puts all the elements of cash flow in a single statement, rather than splitting them
between the income statement and the cash flow statement. Thus, it is a convenient format in financial
statement analysis and in valuation. Exhibit 4.8 is Simple Company's combined income statement and
cash flow statement.

This format allows us to view all the elements of cash flow, whether included in income or not. It
is a convenient format because as we adjust the financial statements to remove nonrecur- ring items, to
deal with other quality issues, or to produce any particular analysis, it provides a natural check on our
work. Our analysis cannot involve a change in the bottom line of this state- ment-the net change in cash.