The income statement answers some of the most important questions that users of the financial statements have: What were the financial results of the entity's operations for the fiscal period? How much profit (or loss) did the firm have? Are sales increasing relative to cost of goods sold and other operating expenses? Many income statement accounts were introduced in Chapters 5-8 when transactions also affecting asset and liability accounts were explained. However, because of the significance of the net income figure to managers, stockholders, potential investors, and others, it is appropriate to focus on the form and content of this financial statement.
The income statement of Armstrong World Industries, Inc., is on page 25 of the annual report in the Appendix. This page of the annual report has been reproduced as Exhibit 9-1. Note that comparative statements for the years ended December 31, 1994, 1993, and 1992, are presented. This permits the reader of the statement to assess quickly the recent trend of these important data. Note also that Armstrong has used an alternative name for the income statement— the statement of operations.
Armstrong's income statement includes several subtotals between "net sales" (revenues), and what in popular jargon is referred to as the bottom line, which on this statement is labeled "net earnings." The earnings per share data disclosures at the bottom part of the statement will be explained in detail in Chapter 11. The principal objective of the first part of this chapter is to permit you to make sense of the components of any income statement.
The second part of this chapter explores the statement of cash flows in more detail than presented in Chapter 2. Remember that this statement explains the change in the entity's cash from the beginning to the end of the fiscal period by summarizing the cash effects of the firm's operating, investing, and financing activities during the period.
EXHIBIT 9-1 Income Statement
ARMSTRONG WORLD INDUSTRIES, INC., AND SUBSIDIARIES Consolidated Statements of Operations
(million*, event for near share data)
Year Ended December 3
1994 1993 l-
Net sales............................................................................ $2,752.7 $2,525.4 SI I
Cost of goods sold............................................................ 1,904.7 1,819.2
Gross profit......................................................................... $ 848.0 $ 706.2 S -
Selling, general, and administrative expenses................... 514.8 493.6
Restructuring charges........................................................ — 89.9
Operating income (loss)..................................................... $ 333.2 $ 122.7 S I
Interest expense................................................................. 28.3 38.0
Other expense (income), net...................................................... _ A (6.0) _
Earnings (loss) before income taxes.................................... $ 304.5 $ 90.7 $ і
Income taxes..................................................................... 94.1 27.2 ____
Earnings (loss) before cumulative effect of accounting changes . . . $ 210.4 63.5 $ і
Cumulative effect of changes in accounting for:
Postretirement benefits, net of income tax benefit of $84.9. ... — —
Postemployment benefits, net of income tax benefit of $20.9 . . . —
Net earnings (loss)............................................................... $ 210.4 $ 63.5 $ <2У
Dividends paid on Series A convertible preferred stock.. 19.0 19.2
Tax benefit on dividends paid on unallocated preferred shares . . .___________ 4.9 5.3
Net earnings (loss) applicable to common stock................. $ 196.3 $ 49.6 $ (24
Per share of common stock: Primary:
Earnings (loss) before cumulative effect of accounting changes $ 5.22 $ 1.32 $
Cumulative effect of changes in accounting for:
Postretirement benefits...................................................... — —
Postemployment benefits.................................................. — ' '~
Net earnings (loss)............................................................... $ 5.22 $ 1.32 $
Fully diluted:
Earnings (loss) before cumulative effect of accounting changes $ 4.64 $ 1.26 $
Cumulative effect of changes in accounting for:
Postretirement benefits...................................................... — —
Postemployment benefits.................................................. — —
Net earnings (loss)............................................................... $ 4.64 $ 1.26 $ (в..
Armstrong's comparative statements of cash flows are presented on page 27 of the Appendix for each of the past three years. Notice that the subtotal captions describe the activities—operating, investing, and financing—that caused cash to be provided and used during these years. Pay more attention to these three "big-picture" items than to the detailed captions and amounts within each category. Notice, however, that Armstrong uses a substantial amount of cash each year to purchase property, plant, and equipment (an investing activity), and to pay cash dividends (a financing activity). As explained later, these are both signs of a financially healthy firm— especially if the firm can cover these payments from its cash flows provided by operating activities. Did Armstrong do this for each year presented?
The income statement and statement of cash flows report what has happened for a period of time (usually, but not necessarily, for the fiscal year ended on the balance sheet date). The balance sheet, remember, is focused on a single point in time—usually the end of the fiscal year—but one can be prepared as of any date.
LEARNING OBJECTIVES
After studying this chapter you should understand:
• What revenue is, and what the two criteria are that permit revenue recognition.
• How cost of goods sold is determined under both perpetual and periodic inventory accounting systems.
• The significance of gross profit (or gross margin), and how the gross profit (or gross margin) ratio is calculated and used.
• The principal categories of "other operating expenses," and how these items are reported on the income statement.
• What "income from operations" includes, and why this income statement subtotal is significant to managers and financial analysts.
• The nature of the items that make up "other income and expenses."
• The components of the earnings per share calculation, and the reasons for some of the refinements made in that calculation.
• The unusual items that may appear on the income statement, including:
Discontinued operations.
Extraordinary items.
Minority interest in earnings of subsidiaries.
• The alternative income statement presentation models.
The purpose and general format of the statement of cash flows.
• Why the statement of cash flows is significant to financial analysts і investors who rely on the financial statements for much of their evaluative data.
INCOME STATEMENT
Revenues
The FASB defines revenues as "inflows or other enhancements assets of an entity or settlements of its liabilities (or a combination: of both) from delivering or producing goods, rendering services, other activities that constitute the entity's ongoing major or central operations."1 In its simplest and most straightforward application this definition means that when a firm sells a product or provide services to a client or customer, and receives cash, creates an account receivable, or satisfies an obligation, the firm has revenue. M revenue transactions fit this simple and straightforward situation Revenues are generally measured by the amount of cash receive or expected to be received from the transaction. If the cash is l expected to be received within a year, then the revenue is usual! measured by the present value of the amount expected to be received
In Concepts Statement No. 5 the FASB expands upon the about definition of revenues to provide guidance in applying the fundamental criteria involved in recognizing revenue. To be recognized, revenues must be realized or realizable, and earned. Sometimes one о these criteria is more important than the other.
Realization means that the product or service has been exchange for cash, claims to cash, or an asset that is readily convertible to і known amount of cash or claims to cash. Thus the expectation that the product or service provided by the firm will result in a cash receipt has been fulfilled.
Earned means that the entity has completed, or substantially completed, the activities it must perform to be entitled to the revenue benefits (i.e., the increase in cash or some other asset, or the satisfaction of a liability).
The realization and earned criteria for recognizing revenue usually satisfied when the product or merchandise being sold delivered to the customer, or when the service is provided.
revenue from selling and servicing activities is commonly recognized when the sale is made, which means when the product is delivered, or when the service is provided to the customer.
An example of a situation in which the earned criterion is more significant than the realization criterion is the magazine publishing company that receives cash at the beginning of a subscription period. In this case, revenue is recognized as earned by delivery of the magazine. On the other hand, if a product is delivered or a service is provided without any expectation of receiving cash or satisfying a liability (i.e., when a donation is made), there is no revenue to be recognized because the realization criterion has not been fulfilled.
When revenues are related to the use of assets over a period of time—such as the renting of property or the lending of money—they are earned as time passes, and recognized based on the contractual prices that had been established in advance.
Some agricultural products, precious metals, and marketable securities have readily determinable prices and can be sold without significant effort. Where this is the case, revenues (and some gains or losses) may be recognized when production is completed or when prices of the assets change.
Due to the increasing complexity of many business activities and other newly developed transactions, a number of revenue recognition problems have arisen over the years. Therefore, the FASB and its predecessors within the American Institute of Certified Public Accountants have issued numerous pronouncements about revenue recognition issues for various industries and transactions. As a result, revenue recognition is straightforward an overwhelming proportion of the time. However, since they are the key to the entire income statement, revenues that are misstated (usually on the high side) can lead to significantly misleading financial statements. Accordingly, management and internal auditors often design internal control procedures to help promote the accuracy of the revenue recognition process of the firm.
Sales is the term used to describe the revenues of firms that sell purchased or manufactured products. In the normal course of business some sales transactions will be subsequently voided because the customer returns the merchandise for credit, or for a refund. In some cases, rather than have a shipment returned (especially if it is only slightly damaged or defective, and is still usable by the customer), the seller will make an allowance on the amount billed, and reduce the account receivable from the customer for the allowance amount. If the customer has already paid, a refund is made. These sales returns and allowances are accounted for separately for internal control and analysis purposes, but are subtracted from the gross sales amount to arrive atnet sales. In addition, if the firm allows cash discounts for prompt payment, total cash discounts are subtracted from gross sales for reporting purposes. A fully det income statement prepared for use within the company might the following revenue section captions:
Sales $
Less: Sales returns and allowances ( )
Less: Cash discounts _(___ )
Net sales $____
Net sales is the first caption usually seen in the income starter of a merchandising or manufacturing company (as illustrates Exhibit 9-1). Many companies provide the detailed calculation the net sales amount in the accompanying notes or financial review section of the annual report.
Firms that generate significant amounts of revenue from provide; services in addition to, (or instead of) selling a product will lay the revenue source appropriately in the income statement. Thus leasing company might report Rental and service revenues as t lead item on its income statement, or a consulting service firm might show Fee revenues, or simply Fees. If a firm has several types revenue, the amount of each could be shown if each amount significant and is judged by the accountant to increase the usefulness of the income statement.
From a legal perspective, the sale of a product involves the passed: of title (i.e., ownership rights) to the product from the seller to th purchaser. The point at which title passes is usually specified Ь the shipment terms (see Business Procedure Capsule 18—Shipping Terms). This issue becomes especially significant in two situation-The first involves shipments made near the end of a fiscal period The shipping terms will determine whether revenue is recognize: in the period in which the shipment was made, or in the subsequent: period if that is when the shipment was received by the customer Achieving an accurate "sales cutoff" may be important to the accuracy of the financial statements if the period-end shipments material in amount. The second situation relates to any loss or damage of the merchandise while it is in transit from the seller to the buyer. The legal owner of the merchandise, as determined by shipping terms, is the one who suffers the loss. Of course, this party may then seek to recover the amount of the loss from the party responsible for the damage (usually a third-party shipping compain
For certain sales transactions, a firm may take more than a year to construct the item being sold (for example, a shipbuilder or a manufacturer of complex custom machinery). In these circumstance-delaying revenue recognition until the product has been delivered may result in the reporting of misleading income statement information.