Module 3--The Income Statement

Question 1

What is the INCOME STATEMENT?

Answer 1

The Income Statement
■ The income statement also is called the profit / loss (P&L) statement or the earnings statement.

■ The income statement contains valuable data not only for shareholders, investors and management, but also for HR professionals designing commissions, bonus and profitsharing plans.

■ Two major groups of accounts are included on the income statement.
* Revenue/sales
* Expenses
At the end of the year, the income statement is closed out and the net income (loss) is transferred to retained earnings in the equity section of the balance sheet.

Question 2

What is REVENUE/SALES?

Answer 2

■ Revenue/Sales
* The inflow of revenue received or to be received from:
* Sale of goods (retail)
* Sale of goods manufactured
* Rent from property
* Fee for services

■ Net of returns allowances and net of discounts
* Customers sometimes return goods.
* Companies offer discounts for volume purchases or for quick payment.

■ Calculation of net sales – subtract sales returns and discounts from gross sales

Question 3

What is COST of GOODS SOLD (COST of SALES)?

Answer 3

Cost of goods sold includes raw materials, factory direct labor and factory overhead.

Factory overhead includes utilities, rent, depreciation and indirect labor.
■ Two sources
* Goods manufactured
* Goods purchased for resale (retailer)

Question 4

Formula for COST of GOODs SOLD

Answer 4

Beginning Inventory + Purchases = GOODS AVAILABLE FOR SALE

Goods available for Sale - Ending Inventory = COST of GOODS SOLD

Question 5

What is GROSS MARGIN?

Answer 5

■ Gross margin is the gross profit remaining after subtracting the cost of the products sold from the net sales amount. This gross profit is needed to cover the other expenses of the organization, to pay taxes and to provide income for the owners.

■ Gross margin is one of several profitability measures used to assess both profitability and productivity.

Question 6

What is GROSS MARGIN Ratio?

Answer 6

Gross Margin Ratio
■ Gross margin can be used to compare different companies’ efficiencies.

■ A product with a high gross margin usually is better for the company’s bottom line than one with a low gross margin.

■ Gross margin is commonly used in sales compensation plans.
Example: Use gross margin to determine the number of gross margin dollars generated
Sales generated: $175,000
Gross margin on sales = 15%
$175,000 x 15% = $26,250 gross margin dollars generated

Question 7

What is OPERATING EXPENSES?

Answer 7

Operating Expenses

■ Selling expenses (S)
* Salaries and benefits of sales people
* Commissions
* Travel and entertainment

■ General and administrative expenses (G&A)

Operating Expenses
Selling expenses
General and administrative expenses
* Administrative/office salaries
and benefits
* Rent
* Utilities
* Advertising
* Repairs and maintenance
* Supplies
* Travel and entertainment
* Insurance
* R & D
* Depreciation expense
* Amortization/impairment
* Others

Question 8

What is Depreciation?

Answer 8

Depreciation
■ Depreciation is the systematic and rational allocation of the cost of a fixed asset as an expense over its useful life. It recognizes the gradual wearing out and obsolescence of equipment and records the cost over the years.

■ Depreciation is calculated over expected useful life
* Takes into account the expected salvage value
* Salvage value and useful life must be estimated. Company experience and outside valuation resources may be utilized.

■ Depreciable value
* Factory depreciation in manufacturing companies is included in the cost of goods sold as factory overhead.
* Installation costs and incoming freight costs of equipment are included in the value to be depreciated.

Question 9

What are some DEPRECIATION METHODS?

Answer 9

Depreciation Methods
An organization may choose which method of depreciation to use. Many companies use different
methods for different types of equipment.
■ The depreciation methods allowed by GAAP are:
* Straight-line – cost is spread equally over estimated useful life

rate = ___1_________
est. useful life

• Double-declining balance – accelerated rate of depreciation

rate = ___2_________
est. useful life

• Units of production – allocates cost of the asset based on usage
• Sum-of-the-year’s-digits – not quite as accelerated as the double-declining method; uses
  estimated useful life to calculate rate of depreciation
  ■ The depreciation method allowed by the IRC is:
• MACRS – For tax purposes the Internal Revenue Code (IRC) has mandated the use of the
  Modified Accelerated Cost Recovery System (MACRS). It is about half way between the
  straight-line and the double-declining balance methods. A company may use straight-line
  depreciation for shareholders’ books but MACRS for the IRS.

Question 10

What is STRAIGHT LINE Depreciation?

Answer 10

Straight-Line Depreciation
Straight-line depreciation is one of the most commonly used methods.
■ Equal annual amounts
■ Straight-line calculation,
1

rate =
______1______
est. useful life
Example:
* Asset cost = $10,000
* Estimated salvage value = $500
* Estimated useful life = 5 years

Question 11

What is the DOUBLE-DECLINING Balance method?

Answer 11

Double-Declining Balance Method

Double-declining balance is the MOST accelerated depreciation method. It causes more expense in
the early years and less in the later years. The total depreciation is the same as straight-line, but more
accelerated. The same amount is depreciated in total over useful life.
This method commonly is used for depreciating automobiles, high-tech manufacturing equipment
and other assets that depreciate more in the first year or two of use, or whose useful life is hard
to estimate.
■ A modification of the straight-line method,
2
rate = ____________
est. useful life
■ Salvage value is ignored in the computation until the final year of useful life

Question 12

What is IMPAIRMENT/AMORTIZATION?

Answer 12

Impairment/Amortization
■ Impairment
* Goodwill is written off based on a review of the impairment of the asset.
* Impairment losses will vary from year to year and could be zero.

■ Amortization
* Allocating the cost of other intangible assets (patent, covenant not to compete, franchises)
* Method used: straight-line method
* Based on the useful life
– Legal or stated life
– Estimated remaining useful life

Question 13

What is TREATMENT of GOODWILL?

Answer 13

Treatment of Goodwill
Goodwill occurs when one company acquires another and pays an amount in excess of the appraised value of the net assets (assets – liabilities) acquired. Impairment losses are irregular and vary in amounts from year to year.

■ Shareholders’ books: impairment losses based on GAAP (ASC 360)

■ Tax books: goodwill is amortized over 15 years (IRS rules)

Question 14

What is a PATENT CALCULATION?

Answer 14

Amortization of patents applies only to those that a company purchases.
An internally developed patent is recorded as an expense when being developed and is not shown as an asset on the company books. Therefore, it is not amortized.
The patent cost divided by the legal/useful life equals the amortization expense per year on a
straight-line basis.

Question 15

What is on the OTHER INCOME and EXPENSES?

Answer 15

Investment Income + Interest Income+ Dividend Income+Gaines on Asset Dispositions + Share of Affilates’ earnings - Losses on asset Dispositions - Interest Expense.

Question 16

Investments in Subsidiaries and Affiliates

Answer 16

For tax purposes, consolidation occurs at 80% ownership or more. (This is another example of differences in shareholder and tax books.)
Subsidiary

■ More than 50% ownership: The financial statements are consolidated. Example: ABC company
owns 70% of XYZ company. ABC, in effect, includes 70% of XYZ’s assets and 70% of XYZ’s
liabilities, etc., in its own balance sheet and 70% of XYZ’s revenues and expenses in its income
statement.
Affiliate

■ 20% to 50% ownership (inclusive): The investment is an asset on the balance sheet. When
the affiliate earns money, the value of the asset is increased by the share of ownership. When
dividends are paid, the value of the asset is reduced by the amount of the dividends received and
the income statement reports the share of the affiliate’s earnings.

■ Less than 20% ownership: Investment is an asset and income is shown on the income statement
upon receipt of a dividend.

Question 17

PROVISION FOR TAXES

Answer 17

Provision for Taxes
Provision for taxes is one of the most complex aspects of GAAP. The provision includes federal,
state and local income tax. Taxes applicable to the time period for the shareholders’ book’s income
statement are recorded as provision for tax.
The amount shown on the shareholders’ books is the estimated amount that would be payable for the
year if the tax return reported the same expenses and sales as the shareholders’ books. This usually
is not the case because of different methods of accounting for depreciation, deferred compensation
and many other items in shareholder and tax books.
Include taxes that are
■ Current
■ Deferred
Deferred taxes result when income or expenses are recorded on the company’s income statement in a
different time period than when they are reported on the company’s tax return.

Question 18

NET INCOME

Answer 18

Net Income:
Operating
Gross Sales NET SALES GROSS Margin Income +
_____________ = _______________ = ________________ = ____________ =
Returns COST of Goods Operating other income
Discounts Sold Expenses
Allowances

Income
Before Tax
________________ = NET Income

Provision for Tax

Question 20

What IS Earninings Per Share (EPS)

Answer 20

Net Income
________________
Average # of Shares Outstanding

■ Basic (primary) – reports net income per share of common stock

■ Diluted – Earnings per share is the net income applicable to common stock divided by the sum
of the weighted average of common shares and common share equivalents such as warrants, unexercised stock options, etc., in the divisor.
A company must report both basic and diluted EPS regardless of whether they are the same.

Question 22

What is RETURN on Sales (NET Profit Margin)

Answer 22

Net Income
_____________
Net Sales

• Net income as a percent of sales
• Proportion of sales left as net income
• Indicator of operating efficiency

Question 23

What ar the Similarities between “For Profit” and “Not for Profit”

Answer 23

For Profit Not for Profit

Must Prepare
Financial Statements Yes Yes*

Subjext to Federal Yes No**
Income Tax

Owners Shareholders None

Primary Objective Earn $$ Advance a
Cause

Term for Net Income Profit Surplus

Where does net
income go? Shareholders Reinvested

Question 24

1. Which of the following best describes net sales?
   A. Sale of services plus cost of goods
   B. Revenue from property rentals
   C. Gross sales minus returns and discounts
   D. Sale of goods and services

Answer 24

C. Gross sales minus returns and discounts

Question 25

2. Which of the following must be known in order to calculate straight-line depreciation?
   A. Estimated salvage value
   B. Units of production
   C. Gross market value
   D. Net market value

Answer 25

A. Estimated salvage value

Question 26

3. What is the method used to calculate the amortization of patents?
   A. Straight-line
   B. Units of production
   C. Double-declining balance
   D. Double the straight-line

Answer 26

A. Straight-line

Question 27

4. What are deferred taxes?
   A. Taxes that are not due in the current year because of projected depreciation/amortization
   B. Taxes resulting from expenses recorded in a different time period on the income statement and tax return
   C. Taxes that are refunded after accounting for returns and discounts
   D. Taxes paid by subsidiaries that have 50% or more ownership of an investment

Answer 27

B. Taxes resulting from expenses recorded in a different time period on the income statement and tax return

Question 28

5. The equity method is the accounting approach used when a company owns what percentage of an affiliate?
   A. Less than 20%
   B. 20% to 50%
   C. 50% to 70%
   D. More than 70%

Answer 28

B. 20% to 50%

Question 29

6. Which income statement items are used in the calculation of operating expenses?
   A. Dividend and interest income, and interest expense
   B. Net sales, cost of goods sold and gross margin
   C. Depreciation, amortization and SG&A

Answer 29

C. Depreciation, amortization and SG&A