1 tools of the trade, part ii: income statement and statement of owners’ equity chapter f5 © 2007...

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Tools of the Trade, Tools of the Trade, Part II: Income Part II: Income Statement and Statement and Statement of Statement of

Owners’ EquityOwners’ Equity

CHAPTER F5

© 2007 Pearson Custom © 2007 Pearson Custom PublishingPublishing

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Describe how the Describe how the income statement income statement

provides information provides information about the past about the past

performance of a performance of a business.business.

Learning Objective 1:


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Income StatementIncome Statement

This financial statement is intended to This financial statement is intended to provide information related to the results provide information related to the results of an entity's operations for a specific time of an entity's operations for a specific time period; typically a year, quarter, or month.period; typically a year, quarter, or month.

It is more formally known as the It is more formally known as the Statement of EarningsStatement of Earnings or the or the Statement Statement of Results of Operations.of Results of Operations.

© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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RevenuesRevenues

Inflows of assets to an entity from Inflows of assets to an entity from delivering or producing goods, delivering or producing goods, rendering services, or carrying out rendering services, or carrying out other activities.other activities. (FASB definition) (FASB definition)

Basically, revenues represent the things Basically, revenues represent the things of value that our customers have agreed of value that our customers have agreed to pay us in exchange for the business to pay us in exchange for the business that we have conducted with them.that we have conducted with them.© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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ExpensesExpenses

Outflows or other using up of assets Outflows or other using up of assets from delivering or producing goods, from delivering or producing goods, rendering services, or carrying out rendering services, or carrying out other activities.other activities. (FASB definition) (FASB definition)

Basically, expenses represent the things Basically, expenses represent the things of value that we have used in order to of value that we have used in order to generate revenues for our business.generate revenues for our business.


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Net IncomeNet Income Revenues - Expenses = Net IncomeRevenues - Expenses = Net Income Therefore, as revenues increase, net income Therefore, as revenues increase, net income

also increases. As expenses increase, net also increases. As expenses increase, net income decreases.income decreases.

Similar to cost-benefit analysis, we usually Similar to cost-benefit analysis, we usually choose to incur expenses only if we believe choose to incur expenses only if we believe that they will generate revenues greater than that they will generate revenues greater than the cost of the expenses.the cost of the expenses.


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Distinguish between Distinguish between single-step and single-step and

multistep income multistep income statements.statements.



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Basic FormatBasic Format Company A

Income StatementFor the Year Ending December 31, 2000

Revenues:Revenue type #1 $4,000Revenue type #2 3,000Revenue type #3 2,000

Total revenues: $9,000

Expenses:Expense type #1 $2,500Expense type #2 2,000Expense type #3 1,500Expense type #4 1,000Expense type #5 500

Total expenses: 7,500

Net income: $1,500

This basicformat is

also known as the

Single-stepformat of

the incomestatement.

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Cost of Goods SoldCost of Goods Sold

Both merchandising and manufacturing Both merchandising and manufacturing companies sell products as their major companies sell products as their major source of revenue. The costs associated source of revenue. The costs associated with the purchase or production of these with the purchase or production of these products is known as products is known as Cost of Goods Cost of Goods Sold.Sold.

Cost of goods sold is also sometimes Cost of goods sold is also sometimes called “cost of sales.”called “cost of sales.”


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Discussion QuestionDiscussion Question

Think of a fast-food restaurant, such as Think of a fast-food restaurant, such as your favorite burger joint. Make a list your favorite burger joint. Make a list of the costs you think the restaurant of the costs you think the restaurant incurs in its day-to-day operations. incurs in its day-to-day operations. Which of these costs do you think Which of these costs do you think should be included in the cost of goods should be included in the cost of goods sold and which ones are other sold and which ones are other expenses? Explain.expenses? Explain.


Single-Step FormatSingle-Step FormatCompany A


Revenues:Sales $4,000Rent revenue 3,000Interest revenue 2,000Total revenues: $9,000

Expenses:Cost of goods sold $2,500Wages expense 2,000Utilities expense 1,500Insurance expense 1,000Interest expense 500Total expenses: 7,500

Net income: $1,500

The differentrevenues are added

together on top

The differentexpenses are addedtogether on bottom

Expenses are subtracted in a“single step.”


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Multistep FormatMultistep Format The The multistep formatmultistep format of the income statement of the income statement

provides some subtotals that are not apparent provides some subtotals that are not apparent on the single-step statement.on the single-step statement.

Gross marginGross margin (or gross profit) is shown as the (or gross profit) is shown as the difference between sales revenue and the cost difference between sales revenue and the cost of goods sold.of goods sold.

Operating incomeOperating income is shown as the amount of is shown as the amount of profit earned from the company’s primary profit earned from the company’s primary business activity.business activity.


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Multistep FormatMultistep FormatCompany A


Sales 4,000$ - Cost of goods sold 2,500 Gross margin 1,500$

Wages expense 2,000$ Utilities expense 1,500 Insurance expense 1,000

Total operating expenses 4,500 Operating income (3,000)$ Other revenues:Rent revenue 3,000$ Interest revenue 2,000 5,000

Other expenses:Interest expense (500)

Net income: 1,500$

1st subtotal

2nd subtotal

Bottom Line


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Discussion QuestionsDiscussion Questions Try to identify two or three companies that Try to identify two or three companies that

you think would have a large gross margin you think would have a large gross margin on sales. In other words, which companies on sales. In other words, which companies do you think have a high markup for their do you think have a high markup for their products?products?

Try to identify two or three companies that Try to identify two or three companies that you think would have a low gross margin on you think would have a low gross margin on sales. Why would this be the case?sales. Why would this be the case?


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Gross Margin ExamplesGross Margin Examples Intel Corp. 2005Intel Corp. 2005

SalesSales 38,82638,826

COGSCOGS 15,77715,777

GrossGross 23,04923,049

Gross margin % 59%Gross margin % 59%

Eli Lilly Co. 2005

Sales 14,645

COGS 3,474

Gross 11,171

Gross margin % 76%

Pepsico 2005

Sales 32,562

COGS 14,176

Gross 18,386

Gross Margin % 56%

Kimberly-Clark 2005

Sales 15,902

COGS 10,828

Gross 5,075

Gross Margin % 32%


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Discussion QuestionsDiscussion Questions Consider the following simplified multistep Consider the following simplified multistep

income statement for Terrell and Co.:income statement for Terrell and Co.: Sales (1,000 units)Sales (1,000 units) $500,000 $500,000 LESS: Cost of goods soldLESS: Cost of goods sold (550,000)(550,000) Gross marginGross margin ($50,000) ($50,000) LESS: Other expensesLESS: Other expenses ($45,000)($45,000) Net income (loss)Net income (loss) ($95,000) ($95,000)

What can you learn from Terrell’s gross margin?What can you learn from Terrell’s gross margin? How many units must be sold to earn a profit?How many units must be sold to earn a profit?


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Relationship Between Relationship Between Net Income and Owners’ Net Income and Owners’

EquityEquity Any Any net incomenet income earned by a business earned by a business

during an accounting period is considered to during an accounting period is considered to be an increase in the owners’ equity in the be an increase in the owners’ equity in the business.business.

If the company suffers a net loss for the If the company suffers a net loss for the period, the amount of the loss is reflected as period, the amount of the loss is reflected as a reduction in the owners’ equity in the a reduction in the owners’ equity in the business.business.


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Explain the impact of Explain the impact of net income or net loss net income or net loss

on owners’ equity.on owners’ equity.



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Relationship Between Relationship Between Net Income and Owners’ Net Income and Owners’

EquityEquity Remember from Chapter 3 that there Remember from Chapter 3 that there

are two sources of equity: owner are two sources of equity: owner investments and company earnings.investments and company earnings.

Therefore, income (or losses) Therefore, income (or losses) “become” a part of owners’ equity.“become” a part of owners’ equity.


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Statement of Owners’ Statement of Owners’ EquityEquity

The The Statement of Owners’ EquityStatement of Owners’ Equity “connects” the Balance Sheet to the “connects” the Balance Sheet to the Income Statement. Income Statement.

It shows the beginning balance and ending It shows the beginning balance and ending balance of the owners’ equity accounts balance of the owners’ equity accounts (from the balance sheet), and the (from the balance sheet), and the increases or decreases in each of the increases or decreases in each of the accounts.accounts.© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Construct statements Construct statements of capital for of capital for

proprietorships and proprietorships and partnerships.partnerships.



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Statement of Owners’ Statement of Owners’ EquityEquity

The exact format of the statement The exact format of the statement depends on the form of business depends on the form of business organization: corporation, partnership, or organization: corporation, partnership, or proprietorship.proprietorship.

A proprietorship or partnership will have A proprietorship or partnership will have a a Statement of CapitalStatement of Capital..

A corporation will have a A corporation will have a Statement of Statement of Stockholders’ EquityStockholders’ Equity..


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Statement of Capital Statement of Capital - Proprietorships- Proprietorships


Company AStatement of Capital

For the Year Ending December 31, 2007

Owner, Capital, 1/1/2007 $9,750

ADD: Net Income 1,50011,250

LESS: Drawings -2,000Owner, Capital, 12/31/2007 $9,250

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Company BStatement of Capital


Partner #1, Capital, 1/1/2007 $15,000ADD: Net Income 2,500

17,500LESS: Drawings -1,000

Partner #1, Capital, 12/31/2007 $16,500

Partner #2, Capital, 1/1/2007 $12,000ADD: Net Income 1,500

13,500LESS: Drawings -2,000

Partner #2, Capital, 12/31/2007 $11,500

Statement of Capital - Statement of Capital - PartnershipsPartnerships

2nd partner

1st partner


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Identify the differences Identify the differences between statements of between statements of

stockholders’ equity and stockholders’ equity and statements of retained statements of retained

earnings for corporations and earnings for corporations and construct the statement of construct the statement of

stockholders’ equity.stockholders’ equity.



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Corporation CStatement of Stockholders' Equity

For the Year Ending December 31, 2007Common

StockAdd'l Paid

RetainedEarnings

TotalEquity

Balance, 1/1/07 $2,000 $40,000 $8,000 $50,000Net income 10,000 10,000Dividends -7,500 -7,500Balance 12/31/07 $2,000 $40,000 $10,500 $52,500

Statement of Statement of Stockholders’ Equity - Stockholders’ Equity -

CorporationsCorporations


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Statement of Statement of Retained EarningsRetained Earnings

If there has been no change in the If there has been no change in the amount of contributed capital, a amount of contributed capital, a corporation can choose not to issue a corporation can choose not to issue a Statement of Stockholders’ Equity. Statement of Stockholders’ Equity.

Instead, a Instead, a Statement of Retained Statement of Retained EarningsEarnings can be issued. This statement can be issued. This statement shows the beginning R.E. balance, net shows the beginning R.E. balance, net income or loss, dividends, and ending income or loss, dividends, and ending R.E. balance.R.E. balance.


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Corporation CStatement of Retained Earnings


Retained earnings, 1/1/2007 $8,000ADD: Net Income 10,000

18,000LESS: Dividends -7,500

Retained earnings, 12/31/2007 $10,500

Statement of Retained Statement of Retained Earnings - CorporationsEarnings - Corporations


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Compare and contrast the Compare and contrast the impact of drawings on impact of drawings on

statements of capital and the statements of capital and the impact of dividends on the impact of dividends on the

statements of stockholders’ statements of stockholders’ equity and statements of equity and statements of

retained earnings. retained earnings.



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Distributions to Distributions to OwnersOwners

At some point, business owners usually At some point, business owners usually either desire or require a distribution of cash either desire or require a distribution of cash from the business. These distributions from the business. These distributions reduce the amount of owners’ equity.reduce the amount of owners’ equity.

In most cases, these distributions represent In most cases, these distributions represent a return a return onon investment for the owners, but it investment for the owners, but it is possible that they are a return is possible that they are a return ofof investment.investment.


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Drawings - Drawings - ProprietorshipsProprietorships

and Partnershipsand Partnerships When a proprietor or a partner receives a When a proprietor or a partner receives a

distribution from the business it is called a distribution from the business it is called a drawingdrawing or or withdrawalwithdrawal..

A proprietor can determine when and how A proprietor can determine when and how much of a drawing to take.much of a drawing to take.

Partners are somewhat restricted and Partners are somewhat restricted and usually are allowed withdrawals that have usually are allowed withdrawals that have been previously agreed to by all partners.been previously agreed to by all partners.


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Explain why dividends Explain why dividends are paid and under are paid and under what circumstances what circumstances they can be paid. they can be paid.



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Corporate Corporate DistributionsDistributions

Distributions to stockholders of a Distributions to stockholders of a corporation are called corporation are called dividendsdividends..

Many corporations pay fairly predictable Many corporations pay fairly predictable dividends on a regular basis, usually every dividends on a regular basis, usually every quarter. Other corporations choose not to quarter. Other corporations choose not to pay dividends in order to help the pay dividends in order to help the company grow by reinvesting earnings.company grow by reinvesting earnings.


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Cash DividendsCash Dividends To pay cash dividends to stockholders, a To pay cash dividends to stockholders, a

corporation must have the following:corporation must have the following:

1) 1) Sufficient retained earningsSufficient retained earnings: after paying : after paying the dividend, there must be a positive the dividend, there must be a positive balance in retained earnings.balance in retained earnings.

2) 2) Sufficient cashSufficient cash: just like paying a bill to a : just like paying a bill to a supplier, the corporation must have enough supplier, the corporation must have enough cash on hand in order to pay the dividend.cash on hand in order to pay the dividend.


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Dividend DatesDividend Dates

There are three important dividend dates:There are three important dividend dates:1) 1) Date of DeclarationDate of Declaration: when the board of : when the board of

directors decides to pay a dividend.directors decides to pay a dividend.2) 2) Date of RecordDate of Record: stockholders who own : stockholders who own

the stock on this date will receive the the stock on this date will receive the dividend.dividend.

3) 3) Date of PaymentDate of Payment: the corporation settles : the corporation settles the dividend liability by making payment to the dividend liability by making payment to the stockholders.the stockholders.


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Discussion QuestionsDiscussion Questions If Company A has paid a steadily If Company A has paid a steadily

increasing dividend every year for thirty increasing dividend every year for thirty years, and Company B has never paid a years, and Company B has never paid a dividend, would that influence you if you dividend, would that influence you if you were deciding in which of these two were deciding in which of these two companies to buy stock?companies to buy stock?

Can you think of reasons why you still Can you think of reasons why you still might prefer Company B over A?might prefer Company B over A?


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Describe in your own Describe in your own words the articulation words the articulation of income statements, of income statements, balance sheets, and balance sheets, and

statements of owners’ statements of owners’ equity. equity.



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ArticulationArticulation There is a linkage between the three There is a linkage between the three

financial statements known as financial statements known as articulationarticulation..

IncomeStatement

BalanceSheet

Statementof

Capital


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ArticulationArticulation

Income Statement: the revenues and Income Statement: the revenues and expenses are listed to determine net expenses are listed to determine net income (or loss).income (or loss).

Statement of Capital: the net income Statement of Capital: the net income is added to help determine the ending is added to help determine the ending capital balance.capital balance.


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ArticulationArticulation

Balance Sheet: the ending capital Balance Sheet: the ending capital balance is reported in the owners’ balance is reported in the owners’ equity section of the balance sheet. equity section of the balance sheet. Therefore, net income flows forward Therefore, net income flows forward into the balance sheet.into the balance sheet.


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Discussion QuestionsDiscussion Questions

The balance sheet for the corporate form of The balance sheet for the corporate form of business is a bit more detailed than that for business is a bit more detailed than that for the proprietorship. Comparing the two, what the proprietorship. Comparing the two, what can you learn from the corporate balance can you learn from the corporate balance sheet that you would not know from looking at sheet that you would not know from looking at the proprietorship’s balance sheet?the proprietorship’s balance sheet?

In particular, what can you learn about past In particular, what can you learn about past earnings of the company?earnings of the company?


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End of Chapter 5


1 tools of the trade, part ii: income statement and statement of owners’ equity chapter f5 © 2007...

Documents

net income revenues

statement of results

net income decreases

financial statement

statement of earnings

revenues greater

expenses outflows

cost of goods