II: The (Many) Peculiarities of the Income Statement

Question 1

Explain the meaning behind The Peter Principle.

Answer 1

The Peter Principle states that an employee continues to receive promotions to work in higher ranks up to that point where he reaches a level of incompetence. In simple terms, the higher the hierarchy ladder an individual goes, the more likely he is to fail in his new position.

Question 2

What is another term for revenue, profit and cost?

Answer 2

An income statement measures something quite different from cash in the door, cash out the door, and cash left over. It measures sales or revenues, costs or expenses, and profit or income.

Question 3

Explain the parts of the income statement.

Answer 3

Any income statement begins with sales. When a business delivers a product or a service to a customer, accountants say it has made a sale. Never mind if the customer hasn’t paid for the product or service yet—the business may count the amount of the sale on the top line of its income statement for the period in question.

The costs and expenses on the income statement are those it incurred in generating the sales recorded during that time period.

Question 4

What is the fundamental accounting rule for preparing an income statement?

Answer 4

The matching principle is a fundamental accounting rule for preparing an income statement.

Question 5

What is The Matching Principle?

Answer 5

It simply states, “Match the sale with its associated costs to determine profits in a given period of time—usually a month, quarter, or year.” In other words, one of the accountants’ primary jobs is to figure out and properly record all the costs incurred in generating sales.

Question 6

Explain The Matching Principle on an example.

Answer 6

If an ink-and-toner company buys a truckload of cartridges in June to resell to customers over the next several months, it does not record the cost of all those cartridges in June. Rather, it records the cost of each cartridge when the cartridge is sold. The reason is the matching principle.

Question 7

What is the purpose of the income statement?

Answer 7

The income statement tries to measure whether the products or services that a company provides are profitable when everything is added up.

It’s the accountants’ best effort to show the sales the company generated during a given time period, the costs incurred in making those sales (including the costs of operating the business for that span of time), and the profit, if any, that is left over.

Question 8

What are the phrases that are used at the top of the income statement document?

Answer 8

“Profit and loss statement” or “P&L statement,” “operating statement” or “statement of operations,” “statement of earnings” or “earnings statement.” Often the word consolidated is in front of these phrases.

Question 9

What is the next step after confirming that it is the income statement document?

Answer 9

Is this income statement for an entire company? Is it for a division or business unit? Is it for a region?

Larger companies typically produce income statements for various parts of the business as well as for the whole organization.

Once you have identified the relevant entity, you need to check the time period. An income statement, like a report card in school, is always for a span of time: a month, quarter, or year, or maybe year-to-date. Some companies produce income statements for a time span as short as a week.

Question 10

What is a pro forma income statement?

Answer 10

Sometimes pro forma means that the income statement is a projection. If you are drawing up a plan for a new business, for instance, you might write down a projected income statement for the first year or two—in other words, what you hope and expect will happen in terms of sales and costs. That projection is called a pro forma.

Pro forma can also mean an income statement that excludes any unusual or one-time charges. Say a company has to take a big write-off in a particular year, resulting in a loss on the bottom line. (More on write-offs later in this part.) Along with its actual income statement, it might prepare one that shows what would have happened without the write-off.

Question 11

What are the three main categories of the income statement?

Answer 11

One is sales, which may be called revenue (it’s the same thing). Sales or revenue is always at the top.

Costs and expenses are in the middle, and profit is at the bottom.

Question 12

What are the three columns of figures consolidated income statements usually have?

Answer 12

You may see something like this, for example:

Actual % of salesBudget % of salesVariance %

Or like this:

Actual previous period$ Change (+/-)% Change

Question 13

What is the meaning of “% of sales”?

Answer 13

“% of sales” is simply a way of showing the magnitude of an expense number relative to revenue. The revenue line is taken as a given—a fixed point—and everything else is compared with it.

Question 14

What is the point of the comparative income statements?

Answer 14

The point of these comparative income statements is to highlight what is changing, which numbers are where they are supposed to be, and which ones are not.

Question 15

Why are there footnotes in the income statements?

Answer 15

In cases where there is any question, the rules of accounting require the financial folks to explain how they arrived at their totals. So most of the notes are like windows into how the numbers were determined

Question 16

What is the main rule to take into account before starting to analyze income statements?

Answer 16

Remember that many numbers on the income statement reflect estimates and assumptions. Accountants have decided to include some transactions here and not there. They have decided to estimate one way and not another.

Question 17

What is sales or revenue?

Answer 17

Sales or revenue is the dollar value of all the products or services a company provided to its customers during a given period of time.

Question 18

Give a couple of examples when recording a revenue is not straightforward.

Answer 18

1) Your company does systems integration for large customers. A typical project requires about six months to design and gain approval from the customer, then another twelve months to implement. The customer gets no real value from the project until the whole thing is complete. So when have you earned the revenue that the project generates?

2) Your company sells to retailers. Using a practice known as bill-and-hold, you allow your customers to buy product (say, a popular Christmas item) well in advance of the time they will actually need it. You warehouse it for them and ship it out later. When have you earned the revenue?

3) You work for an architectural firm. The firm provides clients with plans for buildings, deals with the local building authorities, and supervises the construction or reconstruction. All these services are included in the firm’s fee, which is generally figured as a percentage of construction costs. How do you figure out when the firm has earned its revenue?

Question 19

How are those not so straightforward situations dealt with?

Answer 19

Project-based companies typically have rules allowing partial revenue recognition when a project reaches certain milestones.

Question 20

Give an example when change in the way revenue is recorded could be motivated by suspicious causes.

Answer 20

Let’s take a software company, for example. And let’s say that it sells software along with maintenance-and-upgrade contracts extending over a period of five years. So it has to make a judgment about when to recognize revenue from a sale.

Now suppose this software company is actually a division of a large corporation, one that makes earnings predictions to Wall Street. The folks in the corporate office want to keep Wall Street happy. This quarter, alas, it looks as if the parent company is going to miss its earnings per share estimate by one penny. If it does, Wall Street will not be happy. And when Wall Street isn’t happy, the company’s stock gets hammered.

Aha! (You can hear the folks in the corporate office thinking.) Here is this software division. Suppose we change how its revenue is recognized? Suppose we recognize 75 percent up front instead of 50 percent? The logic might be that a sale in this business takes a lot of initial work, so they should recognize the cost and effort of making the sale as well as the cost of providing the product and delivering the service. Make the change—recognize the extra revenue—and suddenly earnings per share are nudged up to where Wall Street expects them to be.

Question 21

What are Earnings per Share (EPS)?

Answer 21

Earnings per share (EPS) is a company’s net profit divided by the number of shares outstanding. It’s one of the numbers that Wall Street watches most closely. Wall Street has “expectations” for many companies’ EPS, and if the expectations aren’t met, the share price is likely to drop.

Question 22

Into which two basic categories expenses on the income statement fall?

Answer 22

The first is cost of goods sold, or COGS. As usual, there are a couple of different names for this category—in a service company, for instance, it may be called cost of services (COS).

That’s the other basic category of costs, namely operating expenses.

Question 23

What is the main idea behind COGS?

Answer 23

The idea behind COGS is to measure all the costs directly associated with making the product or delivering the service. The materials. The labor.

Question 24

What is COGS or COS?

Answer 24

Cost of goods sold or cost of services is one category of expenses. It includes all the costs directly involved in producing a product or delivering a service.

Question 25

Give a couple of examples for COGS/COS.

Answer 25

In a manufacturing company, for instance, the following costs are definitely in:

• The wages of the people on the manufacturing line
• The cost of the materials that are used to make the product

Question 26

Give a couple of example for what should not be in COGS/COS.

Answer 26

And plenty of costs are definitely out, such as:

• The cost of supplies used by the accounting department (paper, etc.)
• The salary of the human resources manager in the corporate office

Question 27

Give a couple of example for a “gray area” which could be in COGS/COS.

Answer 27

For example:

• What about the salary of the person who manages the plant where the product is manufactured?
• What about the wages of the plant supervisors?
• What about sales commissions?

Question 28

What is GAAP?

Answer 28

GAAP— the generally accepted accounting principles that govern how U.S. accountants keep their books—runs for some 4,000 pages and spells out a lot of detailed rules.

GAAP stands for “generally accepted accounting principles.” GAAP defines the standard for creating financial reports in the United States. It helps to ensure the statements’ validity and reliability, and allows for easy comparison between companies and across industries. But GAAP doesn’t spell out everything; it allows for plenty of discretion and judgment calls.

Question 29

What are key principle for solving “gray area”?

Answer 29

The key, as accountants like to say, is reasonableness and consistency. So long as a company’s logic is reasonable, and so long as that logic is applied consistently, whatever it wants to do is OK.

Question 30

What are some implications of being included in COS?

Answer 30

You run the engineering analysis department at an architectural firm, and in the past your staff’s salaries have been included in COS. Now the finance folks are moving all those costs out of COS. It’s perfectly reasonable—even though your department has a lot to do with completing an architectural design, a case can be made that it isn’t directly related to any particular job. So does the change matter? You bet. You and your staff are no longer part of what’s often called “above the line.” That means you’re going to show up differently on the corporate radar screen. If your company focuses on gross profit, for instance, management will be monitoring COS carefully, and making sure that departments that affect COS have everything they need to hit their targets. Once you’re outside of COS—“below the line”—the level of attention may be significantly less.

Question 31

What it means to be Above or Below the line?

Answer 31

The “line” generally refers to gross profit. Above that line on the income statement, typically, are sales and COGS or COS. Below the line are operating expenses, interest, and taxes. What’s the difference? Items listed above the line tend to vary more (in the short term) than many of those below the line, and so tend to get more managerial attention.

Question 32

Where do costs go when they are taken out of COGS?

Answer 32

That’s the other basic category of costs, namely operating expenses

Question 33

What is typically included in operating expenses?

Answer 33

The category includes items such as rent, utilities, telephone, research, and marketing. It also includes management and staff salaries—HR, accounting, IT, and so forth—plus everything else that the accountants have decided does not belong in COGS.

Question 34

What are operating expenses?

Answer 34

Operating expenses are the other major category of expenses. The category includes costs that are not directly related to making the product or delivering a service.

Question 35

Give an example of how can depreciation change the net profit.

Answer 35

Our company bought one of those $36,000 trucks to make the deliveries.

a) They might assume the truck will last only one year, in which case they have to depreciate it at $3,000 a month. That takes $2,000 off the bottom line and moves the company from a net profit of $1,000 to a loss of $1,000.

b) Alternatively, they could assume that it will last six years (seventy-two months). In that case, depreciation is only $500 a month, and net profit jumps to $1,50

Question 36

Explain the term noncash expense.

Answer 36

Depreciation is a prime example of what accountants call a noncash expense. Right here, of course, is where they often lose the rest of us. How can an expense be other than cash? The key to that puzzling term is to remember that the cash has probably already been paid. The company already bought the truck. But the expense wasn’t recorded that month, so it has to be recorded over the truck’s life, a little at a time. No more money is going out the door; rather, it’s just the accountant’s way of figuring that this month’s revenues depend on using that truck, so the income statement better have something in it that reflects the truck’s cost

Question 37

What is amortization?

Answer 37

Take a patent. Your company had to buy the patent, or it had to do the research and development that lies behind it and then apply for it. Now the patent is helping to bring in revenue. So the company must match the expense of the patent with the revenue it helps to bring in, a little bit at a time. When an asset is intangible, though, accountants call that process amortization rather than depreciation. We’re not sure why— but whatever the reason, it’s a source of confusion.

Question 38

When do usually one-time charge happen?

Answer 38

Sometimes write-offs occur, as in Waste Management’s case, when a company has been doing something wrong and wants to correct its books.

More often, onetime charges occur when a new CEO takes over a company and wants to restructure, reorganize, close plants, and maybe lay off people.

Question 39

What is usually included in one-time charge?

Answer 39

Normally, such a restructuring entails a lot of costs—paying off leases, offering severance packages, disposing of facilities, selling off equipment, and so on.

Question 40

Why is one-time charge considered as a yellow flag?

Answer 40

So when a restructuring occurs, accountants need to estimate those charges and record them.

Here is a real yellow flag—a truly terrific place for bias in the numbers to show up. After all, how do you really estimate the cost of restructuring?

Question 41

What are some terms used instead of profit?

Answer 41

It might also equal earnings, net income, or even net margin

Question 42

What is a profit?

Answer 42

Profit is the amount left over after expenses are subtracted from revenue.

Question 43

What are the three basic types of profit?

Answer 43

There are three basic types of profit: gross profit, operating profit, and net profit. Each one is determined by subtracting certain categories of expenses from revenue.

Question 44

How to use profits to analyze your company’s business?

Answer 44

To gauge your company’s gross profit, you can compare it with industry standards, particularly for companies of a similar size in your industry. You can also look at year-to-year trends, examining whether your gross profit is headed up or headed down. If it’s headed down, you can ask why. Are production costs rising? Is your company discounting its sales? Understanding why gross profit is changing, if it is, helps managers figure out where to focus their attention.

Question 45

What is a gross profit?

Answer 45

Gross profit is sales minus cost of goods sold or cost of services. It is what is left over after a company has paid the direct costs incurred in making the product or delivering the service. Gross profit must be sufficient to cover a business’s operating expenses, taxes, financing costs, and net profit

Question 46

What biases can affect the gross profit?

Answer 46

Gross profit can be greatly affected by decisions about when to recognize revenue and by decisions about what to include in COGS.

Question 47

What is an Operating Profit (EBIT)?

Answer 47

EBIT stands for earnings before interest and taxes. (Remember, earnings is just another name for profit). What has not yet been subtracted from revenue is interest and taxes. Why not? Because operating profit is the profit a business earns from the business it is in—from operations. Taxes don’t really have anything to do with how well you are running your company. And interest expenses depend on whether the company is financed with debt or equity.

Operating profit is gross profit minus operating expenses, which include depreciation and amortization. In other words, it shows the profit made from running the business.

Question 48

Why is healthy operating profit important from the employees perspective?

Answer 48

A healthy and growing operating profit suggests that the employees are going to be able to keep their jobs and may have opportunities for advancement.

Question 49

What is a Net Profit?

Answer 49

Net profit is what is left over after everything is subtracted—cost of goods sold or cost of services, operating expenses, taxes, interest, one-time charges, and noncash expenses such as depreciation and amortization. When someone asks, “What’s the bottom line?” he or she is almost always referring to net profit.

Net profit is the bottom line of the income statement: what’s left after all costs and expenses are subtracted from revenue. It’s operating profit minus interest expenses, taxes, one-time charges, and any other costs not included in operating profit.

Question 50

How to improve company’s net profit?

Answer 50

One, the company can increase profitable sales. You have to find new markets or new prospects, work through the sales cycle, and so on.

Two, it can figure out how to lower production costs and run more efficiently—that is, reduce COGS. This, too, takes time: you need to study the production process, find the inefficiencies, and implement changes.

Three, it can cut operating expenses, which almost always means reducing the headcount.