Income Statement

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Income Statement (???)

• Revenues (????)
• Cost of goods sold (COGS) (??????)
• Gross Profit (???)
• Expenses (??)
• Earnings Before Tax (????)
• Tax (???)
• Net Income (???)
• The purpose of firm is to earn income for
  investors through selling goods or providing
  services to customers. Income statement measures
  how much income is earned during a specific
  period, such as a year, a quarter, or a month.

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Definitions
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Ledger (T- Account) treatment of income statement
accounts

• Revenues
• Gains

• Expenses (inc. COGS)
• Loss
• Dividends

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Cash Accounting (?????)

• Revenues recognized at the time that cash is
  received
• Expenses recognized at the time that cash is
  disbursed
• Note Cash received from and disbursed (??) to
  shareholders and creditors(???) is neither
  revenues nor expenses, and does not enter income
  statement under cash accounting
• An example A toy retailer starts business on
  November 1, 19x0, He pays two months rent on his
  store, 2,000, on that day, and also purchases
  and pay for 35,000 toys. However, he sells
  nothing in November. In December, he sells all
  the toys with a sales price of 40,000 and
  collects 5,000 in cash

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Cash Accounting Income Statement
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Problems with Cash Accounting

• Mismatch the cost of efforts (expenses) with the
  output of the efforts (revenues)
• Delay recognition of revenues
• Provide opportunities to manage earnings

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Accrual Accounting (?????????)

• Revenue recognition
• follow realization principle (????)
• 1) A firm has performed all, or most of, the
  services it expects to provide
• 2) The firm has received cash or some other
  assets capable of reasonably precise measurement,
  such as account receivables

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Accrual Accounting

• Expense recognition
• When an asset is used directly to generate
  revenues, the used asset becomes expense. E.g.,
  Amazon.com sold books, the cost to purchase the
  sold books become COGS, a part of expenses. This
  is called matching principle(????) of accounting.
• When an used asset is indirectly related to the
  current, and only the current, period revenues,
  we treat the used asset as expense. E.g., cash to
  pay for advertisement, salary for the CEO.
• When an asset is used to benefit both the current
  and the future period, the benefit, nevertheless,
  not matter current or future, is hard to identify
  and measure, we treat the used asset as expense.
  E.g., cash used to pay research and development
  for pharmaceutical companies. This is
  conservative principle(????) of accounting.

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Accrual Accounting Income Statement
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Adjusting Journal Entries Under Accrual Accounting

• Under accrual accounting, some journal entries
  are not explicitly related to a transaction. We
  make these entries, adjusting journal entries,
  most likely at the end of an accounting period.
• There are four types of adjusting entries
• Unearned revenue (?????)
• Accrued Revenue(????)
• Prepaid expense(????)
• Accrued expense(????)

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Unearned Revenue

• Example Suppose you are the accountant of
  Guanghua and Guanghuas policy is to
  proportionately return student tuitions whenever
  a student chooses to quit school (not a bad act,
  Bill Gates quitted Harvard). So on September 1,
  2002, you paid 80,000 to Guanghua for two-year
  tuitions.
• Receive cash
  recognize revenue

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Unearned Revenue

• On Sep. 1, 2002, although Guanghua received the
  cash, to it, the cash received is unearned
  revenue. That is, Guanghua has not provided you
  educational service yet. Guanghuas journal
  entry
• Dr. Cash 80,000
• Cr. Unearned Revenue (liability) 80,000
• On Dec. 31, 2002, after you have spent half a
  year at Guanghua to enjoy its superb service,
  Guanghua has earned one-fourth of the tuitions.
  Journal entry
• Dr. Unearned Revenue 20,000
• Cr. Revenue 20,000

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Accrued Revenue

• Example If you are a manufacture of cars and I
  bought a car from you on Nov. 12, 2002 for
  3,000, but we agree that I pay you next year.
  You have earned the money because I took the car.
  But you have not received the cash. Still, it is
  your money and your revenue.
• Dr. Account Receivable 3,000
• Cr. Revenue 3,000
• Recognize revenue Receive
  cash

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Prepaid expense

• Example, back to the Guanghua case, from your
  point of view, the 80,000 is prepaid expense.
  That is, if on Sep. 2, 2002, you want to quit
  school, you will get money back (if you want to
  try this, please do so before or after my
  course). That is, you still own the money.
• Pay cash
  recognize expense

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Prepaid expense

• On Sep. 1, 2002, your account
• Dr. Prepaid tuitions 80,000
• Cr. Cash 80,000
•  
• On Dec. 31, 2002, you
• Dr. Tuition expense 20,000
• Cr. Prepaid expense 20,000
• If you quit school on this day, you get 60,000
  back from the school.

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Accrued Expense

• Example, you worked for your company in December
  2002, and your company will pay your salary of
  3,000 of December in January 2003. But to the
  company, expense has incurred in 2002, although
  cash is not paid in December of 2002. So the
  company
• Dr. Expense 3,000
• Cr. Salary payable 3,000
• recognize expense pay cash

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The Final Stages of the Accounting Process (refer
to a premier on accounting handout)

• On Dec. 31 of the year, the accountants finished
  all journal entries, posted to ledger
  (T-accounts), calculated the balance (??)of every
  ledger account, and did a trial balance. Now
  she/he does adjusted journal entries, and then
  posts to ledger again, and does an adjusted trial
  balance.
• What she/he has in hands now is a list of
  accounts. Next
• Prepare income statement
• Close income statement accounts to retained
  earnings account
• Prepare balance sheet
• Q.E.D

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Expensing(???) vs. Capitalization (???) of
Expenditures(??)

• A firm pays employee salaries, we say the firm
  expense employee salary
• Expensed expenditures go to income statement
• Expensed expenditures help generate revenues in
  current period
• If a firm expenses the expenditure, current
  earnings will be lower by that amount

• A firm buy a building, we say the firm capitalize
  the building as asset.
• Capitalized expenditures go to balance sheet
• Capitalized expenditures help generate revenues
  in current and future periods
• If a firm capitalizes the expenditure, current
  earnings will not be lowered by that amount

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Expensing vs. Capitalization of Expenditures

• But life is not so simple and straightforward.
  Sometimes it is difficult to determine whether
  the expenditures benefit future periods, and if
  it benefits future periods, it is difficult to
  determine which future period will benefit.
  Therefore, firms expense some expenditures that
  may otherwise be capitalized. This is a
  conservative treatment of the expenditures by
  GAAP.
• Marketing expenditures
• Research and Development
• Stock options

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The Worldcom scandal

• June 26, 2002, Worldcom reports it overstated
  earnings by 3.8 billion in the past few years.
  It quickly asked for chapter 11 protection
• What did they do? Capitalize expenditures that
  should have been expensed. That is, 3.8 billion
  should not be on balance sheet, but go through
  income statement as expense.
• In 2001, the company reports earnings of 1.4
  billion, which should have been a loss year.

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The relation between balance sheet and income
statement

• Assets Liabilities Equity
• Equity Contributed capital(??) Retained
  Earnings (RE)
• Ending(????) RE Beginning (????)RE Net Income
  Dividends
• Net Income Revenues Expenses
• A L Contributed capital Beginning RE
  (Revenues Expenses) Dividends
• Therefore, revenues increase assets and equity
• expenses decreases assets and equity

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Time Series analysis of common-size income
statement
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Cross section analysis (????)of common-size
income statement
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Growth analysis of income statement
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A few items on I/S explained

• Cost of revenues Cost of goods sold (COGS)
• Sales and Marketing
• Selling, general and administrative
• Product development
• Depreciation and amortization
• Operating income or income from operation
• Extraordinary item unusual and infrequent
• Net Income
• Earnings per share-primary
• Earnings per share-diluted
• Earnings per share-end of year number of shares,
  or average number of shares?
• Pro Forma earnings As if earnings

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AOL 2000
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AOL 2000
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Earnings Management-Why

• For managers earnings-based bonus
• For shareholders earnings-based bond covenant
• For the company
• Better IPO price(???????)
• Avoid government regulation
• Avoid paying employee high salaries

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Earnings Management-How

• Accelerate or delay revenues
• Accelerate or delay expenses
• Take one-time gains or charges big bath

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Earnings management Who gain, who lose?

• Enron case
• Worldcom case

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Who Lose?
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Who lose?
Life Sentence
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How to detect earnings management?
Time-series analysis Cross-Sectional
analysis Growth analysis As long as ratios are
out of step with peers or trends, there is
reason for suspicion.
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Price-to-earnings ratio P/E

• P/E is a ready yardstick for valuation
• Use comparable firms P/E to price IPO stocks
• P/E is a rough indicator of relative
  over-valuation or under-valuation
• Average P/E ratio of all stocks on a market
  indicates the level of valuation of the market

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P/E anomaly

• High P/E stocks (glamour stocks, growth stocks)
  earn lower return in the one-year-ahead period
  low P/E stocks (value stocks) earn higher stock
  returns in the same period. The return
  differential is not explained by risk.
• Fama and French Journal of Finance 1992, the
  numbers are monthly return in percentage

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Caveats(??) in using P/E in valuation

• Negative earnings can not be used in computing
  P/E
• Earnings contain transitory (???) items, or
  one-time items that drive P/E up or down
  temporarily
• P/E ratio is meaningful only when earnings come
  from normal, repetitive operation
• In investing community, people use different
  earnings to compute P/E, lag earnings, lead
  earnings, average earnings

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Investing Motto

• Financial Statement is like bikini, what it
  reveals is interesting, but what it conceals it
  vital.
• Burton G. Malkiel ltA random walk down wall streetgt