Wall Street Prep - Accounting Crash Course - Introduction & The Income Statement
Companies must file periodic financial reports with the SEC - why?
"The laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it. To achieve this, the SEC requires public companies to disclose meaningful financial and other information to the public, which provides a common pool of knowledge for all investors to use to judge for themselves if a company's securities are a good investment. Only through the steady flow of timely, comprehensive and accurate information can people make sound investment decisions." - Securities and Exchange Commission
Reading the 10-K part 1
1. Business Item 1A. Risk Factors Item 1B. Unresolved Staff Comments Item 2. Properties Item 3. Legal Proceedings Item 4. Mine Safety Disclosures
Not all income is revenue
A company may have other income streams, which are not related to its main operations: • Interest income earned from investments (recorded as non-operating income on the income statement) • Income received from a legal settlement (if material, identified as a separate line item on the income statement below revenue) or netted against operating expenses
Research & Development (R&D)
A company's activities that are directed at developing new products or procedures.
Summary of accounting assumptions, principles, constraints: Periodicity
A company's continuous life can be divided into measured periods of time for which financial statements are prepared. U.S. companies are required to file quarterly (10-Q) and annual (10-K) reports.
Interest Income
A company's income from its cash holdings and investments (stocks, bonds, and savings accounts).
Summary of accounting assumptions, principles, constraints: Going Concern
A corporation is assumed to remain in existence for the foreseeable future.
Summary of accounting assumptions, principles, constraints: Accounting Entity
A corporation is considered a "living" enterprise i.e. a "fictional" being.
Summary of accounting assumptions, principles, constraints: Conservatism
A downward measurement bias is used in the preparation of financial statements. Assets and revenues should not be overstated while liabilities and expenses should not be understated.
Earnings per share
A very common way that investors analyze company profits is by dividing net income by shares outstanding, and this metric is called 'earnings per share' (EPS). EPS measures how much of the total current period profits belong to each shareholder. • There are two ways to think about who is a shareholder, which leads to two different ways to reference and calculate EPS:
Other Operating Expenses / Income
Any operating expenses not allocated to COGS, SG&A, R&D, D&A
Useful life of fixed assets
Assets that have physical substance, along with typical depreciable period: • Plants and buildings (15- 40 years) • Machinery & equipment (3-20 years) • Furniture & fixtures (5-10 years) • Computer software & hardware (3-5 years) Land Land is a fixed asset but is NOT depreciated
Form 10-K (annual filing)
At the end of each fiscal year, publicly-traded companies must file a 10-K report which includes a thorough overview of their businesses and finances as well as their financial statements. • 10-K's must be filed within 60-90 days within year end, depending on the filer's status (large accelerated / accelerated /non-accelerated filer)
Summary of accounting assumptions, principles, constraints: Estimates & Judgments
Certain measurements cannot be performed completely accurately, and must therefore utilize conservative estimates and judgments.
Summary of accounting assumptions, principles, constraints: Disclosure
Companies must reveal information determined to make a difference to its users.
The "matching principle" states that: Costs associated with making a product must be recognized at the end of the production process. Costs associated with making a product must be recognized immediately as incurred. Costs associated with making a product must be recognized during the same period as revenue generated from that product. Costs associated with making a product must be recorded during the same period as the sales, general, and administrative expenses that are also associated with the product.
Costs associated with making a product must be recognized during the same period as revenue generated from that product.
Summary of accounting assumptions, principles, constraints: Matching Principle
Costs of a product must be recorded during the same period as revenue from selling it.
Cost of goods sold For a service provider Examples
Direct service costs • Google's payments to its advertising network (traffic acquisition costs) • Compensation of Huron consultants that directly generate consulting fees
Net Income
EBIT - Net Interest Expense - Other Nonoperating Income - Taxes
Operating profit (EBIT)
Earnings before interest & taxes: EBITDA - D&A
EBITDA
Earnings before interest, taxes, depreciation & amortization : Gross Profit - SG&A - R&D. EBITDA is a popular measure of a company's financial performance.
Amortization expense Example
Example: Google buys a patent • Google invests $30m to acquire several patents from a mobile technology firm. • The patents are expected to have a useful life of 10 years • Accordingly, on the income statement, Google will recognize an annual amortization expense of $3 million, every year for the next 10 years.
The regulating body that oversees the development of accounting standards in the U.S. is:
FASB
Summary of accounting assumptions, principles, constraints: Historical Cost
Financial statements report companies' resources and obligations at an initial historical cost. This conservative measure precludes constant appraisal and revaluation.
Summary of accounting assumptions, principles, constraints: Measurement & Units of Measure
Financial statements show only measurable activities of a company. Financial statements must be reported in the national monetary unit (U.S. $ for U.S. companies).
Summary of accounting assumptions, principles, constraints: Consistency
For each company, preparation of financial statements must utilize measurement techniques and assumptions which are consistent from one reporting period to another.
Which of the following statements is TRUE? GAAP requires that firms show recorded values for acquired intangible assets such as patents and trademarks on their financial statements. GAAP requires that firms show recorded values for intangible assets such as employee and customer loyalty. GAAP requires that financial statements accurately reflects the market value of internally-developed trademarks such as the value of the Coca-Cola brand name. All of the above.
GAAP requires that firms show recorded values for acquired intangible assets such as patents and trademarks on their financial statements.
Revenue manipulation Example
In the real world - TSAI • TSAI represents a classic example of a company taking advantage of the ability to change revenue recognition approaches to mask falling revenues • Software maker TSAI sold 5-year license agreements for its software. • Up until 1998, the company employed conservative revenue recognition practices - only recording revenues from agreements when the customers were billed through the course of the 5- year agreement. • The company began experiencing slowing sales in 1998. To hide the problem, it changed its revenue recognition practices to record nearly 5 years' worth of revenues upfront, thereby artificially boosting sales. • 1998 didn't look that bad anymore, but in 1999 when investors compared results to 1998, the chickens came home to roost - and saw a 20% decline in revenues.
Summary of accounting assumptions, principles, constraints: Materiality
Inclusion of certain financial transaction in financial statements hinges on their size and that of a company performing them.
Interest Expense
Interest expense is the amount the company has to pay on debt owed. This could be to bondholders or to banks. Interest expense subtracted from EBIT equals earnings before taxes (EBT).
Cost of goods sold For a manufacturer Examples
Inventory The cost of tires that Michelin sells Direct labor The laborers working on an Exxon Mobil oil well Factory overhead (indirect costs) Rents, heat, administrative salaries, equipment maintenance costs, custodial costs in a GM automotive plant Shipping & delivery costs Lumber delivery costs for Sierra Pacific
Cost of goods sold For a merchandiser Examples
Inventory The cost of TV sets for Walmart Shipping & delivery costs Shipping & delivery costs of Apple's inventory (Apple is both a manufacturer and merchandiser)
Reading the 10-K part 3
Item 10. Directors, Executive Officers and Corporate Governance Item 11. Executive Compensation Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Item 13. Certain Relationships and Related Transactions, and Director Independence Item 14. Principal Accounting Fees and Services
Reading the 10-K part 4
Item 15. Exhibits and Financial Statement Schedules and Signatures
Reading the 10-K part 2
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities Item 6. Selected Financial Data Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Item 7A. Quantitative and Qualitative Disclosures about Market Risk Item 8. Financial Statements and Supplementary Data Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Item 9A. Controls and Procedures Item 9B. Other Information
Non-operating items
Items peripheral to core operations. Includes gains/losses on investments and revaluation of certain financial assets and debt obligations.
Why is accounting important?
Making corporate decisions • Suppose a telecom company is looking to acquire a regional company to boost its presence in that region. There are several potential targets that fit the bill. How does this company determine which of these, if any, companies would make a good acquisition candidate? Making investment decisions • A mutual fund is looking to invest in several diverse technology companies - Microsoft, Oracle, and Intel. How does this mutual fund determine in which of these, if any, companies it should make an investment? • A major part of corporate and investment decisions relies on analyzing each of the companies' financial information in the above-mentioned cases .• Accounting, the standard language by which such financial information can be assessed and compared, is fundamental to making these decisions.
Basic earnings per share (EPS)
Net income / Basic Weighted Average Shares Outstanding
Diluted EPS
Net income / Diluted Weighted Average Shares Outstanding
Common dividends
Net income represents the profits that a company generates during a period. • An important question for CFOs is what to do with those profits. • One option is to make distributions to shareholders via dividends. • Dividends represent a portion of a company's net income that is returned to shareholders, typically on a quarterly basis, in the form of cash. • Dividend policy is set by the Board of Directors, is reviewed regularly, and is disclosed in the company's financial statements.
Selling, General & Administrative (SG&A)
Operating costs not directly associated with the production or procurement of the product or service that the company sells to generate revenue. Payroll, wages, commissions, meal and travel expenses, stationary, advertising, and marketing expenses fall under this line item.
Jones Company has provided the following information: Cash sales totaled $255,000. Credit sales totaled $479,000. Interest income was $7,700. Interest expense was $19,900. Cost of goods sold was $336,000. Rent expense was $36,000. Salaries expense was $49,000. Other operating expenses totaled $79,000. How much was Jones' operating income? $234,000 $221,800 $322,000 $199,800
Operating revenues = $734,000 = $255,000 + $479,000. Operating expenses = $500,000 = $336,000 + $36,000 + $49,000 + $79,000. Operating income = $234,000 = $734,000 - $500,000.
Which of the following statements is TRUE? Publicly traded US companies are required to file four 10-Q's and one 10-K annually. All US companies are required to file three 10-Q's and one 10-K annually. Publicly traded US companies are required to file three 10-Q's and one 10-K annually. Publicly traded US companies are required to file one 10-K annually; 10-Q's are typically filed but are technically voluntary.
Publicly traded US companies are required to file three 10-Q's and one 10-K annually.
Which of the following statements is FALSE? A liability is created when cash is received prior to delivery of the goods or services. Revenue is recognized at the time of delivery of the goods or services regardless of if cash is received. Revenue is not recognized at the time of delivery of goods and services if cash is received after delivery of the goods and services. Collecting cash after delivery of a good or service does not create revenue on the income statement on the date of collection.
Revenue is not recognized at the time of delivery of goods and services if cash is received after delivery of the goods and services. -Revenue is recognized at the time of delivery of goods and services regardless of when the cash is received.
Gross Profit
Revenues - Cost of Goods Sold
Summary of accounting assumptions, principles, constraints: Revenue Recognition
Revenues must be recorded when earned and measurable.
Dilutive securities
Securities that can be converted into common stock include: • Stock options & warrants (the right to buy shares at predetermined price) • Convertible preferred stock • Convertible debt
The income statement is also referred to as:
The Consolidated Statement of Earnings • The Profit and Loss (P&L) Statement • Statement of Revenues and Expenses
Depreciation & Amortization (D&A)
The allocation of cost over a fixed asset's useful life in order to match the timing of the cost of the asset with when it is expected to generate revenue benefits.
The income statement is designed to measure: The liquidity of a firm. How solvent a company has been. The income of a firm at a point in time. Cash inflows/outflows generated over a period of time. The profits of a firm over a period of time.
The profits of a firm over a period of time.
Income Tax Expense
The tax liability a company reports on the income statement.
Net Revenues
Total dollar payment for goods and services that are credited to an income statement over a particular time period.
Amortization expense Types
Types of intangible assets • Customer Lists • Franchise, Memberships, Licenses • Patents and Technology • Trademarks and goodwill are considered to have indefinite useful life so they are not amortized (more on this later)
International Financial Reporting Standards (IFRS)
While this course focuses on the US standards, over 100 countries, including the EU, UK, Canada, Australia, Russia (see map) have adopted a unified set of international accounting standards (IFRS). • Many other countries like China, India, Brazil, are either actively pursuing convergence with IFRS or have incorporated IFRS standards into their national accounting standards. • In 2014, the SEC backed away from the promise of complete convergence with IFRS, but the last decade of cooperation has already led to significant convergence of US GAAP and IFRS, meaning that in practice, global accounting standards are far more standardized than they have ever been.
Cost of Goods Sold
cost of Goods sold represents a company's direct cost of manufacture (for manufacturers) or procurement (for merchandisers) of a good or service that the company sells to generate revenue.
By matching costs with revenues, the accrual concept strives to
more accurately depict a company's operating results.
Annual report of foreign companies
• 20-F is an annual report filed by certain foreign issuers of securities trading in the U.S.
Introduction Summary
• Accounting is a standard language of measuring financial performance by a variety of organizations. • Accounting follows Generally Accepted Accounting Principles (GAAP), which are guidelines for measuring and presenting financial information in a fair, consistent, and straight-forward basis. • U.S. GAAP are developed by FASB on the behalf of the SEC, with input from a variety of interest groups. • Over 100 countries, including the EU, UK, Canada, Australia, Russia (see map) have adopted a unified set of international accounting standards (IFRS). • Although we have seen unprecedented convergence over the last few years between US GAAP and IFRS, some differences remain. • This course focuses on the US standards, but where there are major differences, we will identify them.
What is accounting?
• Accounting is the language of business. It is a standard set of rules for measuring a firm's financial performance. Assessing a company's financial performance is important for many groups, including: • The firm's officers (managers and employees) • Investors (current and potential shareholders) • Lenders (banks) • General public • Standard financial statements serve as a "yardstick" of communicating financial performance to the general public. • For example, monthly sales released by McDonald's Corp. provide both its managers and the general public with an opportunity to assess the company's financial performance across major geographic segments (U.S., Europe, Asia Pacific, Middle East, and Africa).
Who uses accounting?
• Accounting is used by a variety of organizations - from the federal government to non-profit organizations to small businesses to corporations. • We will be discussing accounting rules as they pertain to publicly-traded companies.
Accrual versus cash accounting
• Although the benefits of the accrual method should by now be apparent, it does by definition have the limitation that analysts cannot track objectively the movement of cash. • Public companies are required to use accrual accounting in accordance with GAAP. • The cash flow statement, one of the three principal financial statements, allows analysts to reconcile these differences. • Cash accounting is not allowed under GAAP, but for tax reporting certain businesses are allowed to use cash basis. • Cash accounting objectively recognizes revenues when cash is received and records costs when cash is paid out; accrual accounting involves subjectivity in regards to the allocation of revenues and expenses to different periods. • In the US, for example, the IRS allows cash accounting for businesses with under $1m in revenue or up to $10m under certain circumstances.
Tax expense doesn't equal the actual cash taxes paid!
• Although this topic can get quite esoteric and is firmly outside the scope of this course, we can broadly say that because of the ability of companies to defer certain taxes, the tax expense companies recognize on their income statement does not equal that actual cash taxes they have to pay for the same period.
Amortization is a non-cash expense like depreciation
• Amortization expense does not depict any actual cash outflow (payment) • The only difference between depreciation and amortization is that depreciation refers to fixed (physical) assets, while amortization refers to acquired intangible (not physical) assets
Amortization expense
• Amortization is the allocation of the cost of intangible assets over the number of years that these assets are expected to help generate revenue for the company. • Conceptually similar to depreciation and often lumped in with depreciation as Depreciation & Amortization (D&A) in financial disclosures. • Like with fixed assets, when a company purchases an intangible asset from which it expects to generate benefits over future periods, the cost of that asset is not simply recognized during the year it was acquired. • Instead, it is spread over that particular asset's useful life in the form of amortization expense.
Earnings before interest and taxes, depreciation & amortization (EBITDA)
• An even more popular profit metric is EBITDA, which starts with EBIT but adds back D&A expense. • The rationale for using EBITDA as a way to compare companies is twofold: 1. D&A is a huge noncash expense for fixed asset and intangible asset intensive businesses, and stripping out the biggest noncash expense provides a more accurate picture of "real" profits during the year. 2. Since companies can use different useful life assumptions and even depreciation methods to calculate D&A this can significantly skew the comparison of operating profitability across two otherwise identical firms
Form 10-Q (quarterly)
• At the end of each quarter of their fiscal year (for the first three quarters of a fiscal year), publicly-traded companies also file a report with the SEC which includes financial statements and non-financial data. • 10-Q's must be filed within 40- 45 days of quarter end
Revenue manipulation
• Because of accrual accounting, revenue recognition can be subjective. • This "wiggle room" creates potential for manipulation in the form of shifting revenues from one period to another. • While revenue recognition methods are almost always explained in companies' 10K footnotes, and when there is suspicion of "shenanigans," these should be read carefully.
10-K vs. 10-Q - what's the difference?
• Both 10-K's and 10-Q's include financial statements, important footnotes and management commentary on the state of the business, but 10-Ks are generally more detailed filings than 10-Qs • A 10-K will usually contain more details regarding stock options, fixed and intangible assets, debt, and future expectations and include extensive management, as well as commentary on the state of the business (management discussion & analysis "MD&A"). • 10-K reports are audited by an independent firm, while 10-Q filings are reviewed by a CPA but are unaudited. • This is important because an auditing firm may sometimes highlight certain financial information and valuation methodologies it believes do not conform with GAAP.
Other operating expenses / income
• Companies will sometimes recognize expenses (or income) on the income statement that, while still related to operating activities, are a little less typical. Common examples include • Gains/losses on sale of fixed assets : • Gains/losses from a legal settlement • Restructuring expenses and severance costs • Losses do to inventory spoilage (inventory write-down)
Proxy
• DEF 14A is a notification to shareholders of matters to be brought before shareholders meeting. It solicits proxy. Especially useful when analyzing an acquisition because companies provide shareholders a lot of technical details regarding the deal when soliciting shareholder approval.
Depreciation expense is a non-cash expense
• Depreciation is a non-cash expense and can make up a significant portion of total expenses on a company's income statement. • That makes the income statement a poor tool for tracking a company's cash position: • Income statement profits are reduced every year by depreciation expense, whereas actual Cash profits are affected only when cash payments for purchases of assets are made
Internally-generated intangible assets
• Expenses associated with internally developing intangible assets like patents, customer lists, trademarks are expensed fully as they are incurred (no amortization) • Since companies are not allowed to write up the value of intangible assets (historical cost and conservatism), companies with very valuable trademarks and patents (Coke, GE, Apple) do not recognize or amortize these assets.
Finding financial reports
• Filings made with the SEC are public information and can be found on the SEC's official website - http://www.sec.gov • Company websites - 'investor relations' section • Financial websites and services: Yahoo! Finance, Capital IQ, Thomson, Factset, etc
Stock based compensation expense Example
• For example, a company that pays a sales person a cash salary of $100,000 and stock options valued at $50,000 will recognize: • $150,000 in SG&A compensation (even though only $100,000 was spent). • The extra $50,000 reflects that the employee earned an additional $50,000 in compensation (the actual payment down the road in the form of additional shares may not happen for a while). • Even though its recognized as an expense as an employee earns the SBC, remember that SBC is a non-cash form of compensation
Revenue recognition: Long-term projects
• For long-term projects, companies have some flexibility with respect to revenue recognition: 1. Percentage of Completion method • Revenues are recognized on the basis of the percentage of total work completed during the accounting period. 2. Completed Contract method • Rarely used in the U.S., this method allows revenue recognition only once the entire project has been completed.
Depreciation expense Example: GE buys a sensor
• GE invests $30 million (in an upfront cash payment) in a new flow meter sensor, which it expects will significantly improve productivity. • The equipment is expected to have a useful life of 10 years, at which point it will be disposed of (assume no salvage value). • Accordingly, on the income statement, GE will recognize an annual depreciation expense of $3 million for this sensor, every year for the next 10 years.
Generally Accepted Accounting Principles (GAAP)
• In the Unites States, a governmental agency called the Securities and Exchange Commission (SEC) authorizes the Financial Accounting Standards Board (FASB) to determine U.S. accounting rules. • FASB communicates these rules through the issuance of Statements of Financial Accounting Standards (SFAS). These statements make up the body of accounting rules known as the Generally Accepted Accounting Principles (GAAP). • These rules have been developed to provide guidelines for financial accounting in order to ensure that businesses present their financial information in a fair, consistent, and straightforward basis. Financial statements must be prepared according to GAAP.
Why is the income statement important?
• It facilitates the analysis of a company's growth prospects, cost structure, and profitability. • Analysts can use the income statement to identify the components and sources ("drivers") of net earnings.
Why is the 10-K important?
• It is a required annual filing. • 10-K usually provides the most detailed overview of companies' financial operations and regulations governing them.
Where is SBC expense on the Income Statement?
• Just like depreciation, you wont see a line item on the I/S specifically identifying SBC expense. • SBC is included within the operating expenses in which the employee is classified • However, like depreciation, you will almost always find SBC expense identified separately on the cash flow statement (which we'll address in detail later)
Net income is also called:
• Net earnings • Net profit • "Bottom line"
Revenue recognition: To recognize and when
• Recall that accrual basis of accounting dictates that revenue must be recorded only when it is earned and measurable. • Recall the Amazon.com exercise: Amazon.com received a $20 book order on 12/29/14, but it could only record it as revenue once it was shipped on 1/4/15. • According to the revenue recognition principle, a company cannot record revenue until it is earned - that is, until that order is shipped to a customer and collection from that customer, who used a credit card, is reasonably assured. • Deciding when to recognize revenue can be less straight-forward for some companies than for Amazon.com
Shares outstanding
• Represent the number of shares of common stock outstanding. • One share of common stock represents one unit of ownership of a public company. • For private and public companies alike, shares are held by company founders, investors, management, and other employees of the firm. • Owners of these shares (shareholders) are generally entitled to vote on the selection of directors and other important matters in proportion with the number of shares they own (i.e. 100 shares = 100 votes) as well as to receive dividends on their holdings. • Shares that have been issued, but subsequently repurchased by the company are called treasury stock and they are no longer outstanding (we'll discuss why a company may choose to repurchase its shares at a later point) . • Shares Outstanding = Shares Issued - Treasury Stock
Revenue
• Revenue represents proceeds from the sale of goods and services produced or offered by a company. • You will see revenues represented on the income statement as Revenues, Sales, Turnover, Net Sales or Net Revenues. We'll explain what is being "netted" out of net revenues shortly. • Revenues are referred to colloquially as a company's top-line.
Securities offering IPO, equity offered in merger, etc
• S-1 registration filed by a company when it decides to go public and sell securities and an Initial Public Offering (IPO). This document includes the prospectus - the company document outlining the companies operations to help investors make an informed decision about investing. • S-2 and S-3 are required filings for secondary offerings. • S-4 filed to register a securities offering in certain mergers or reorganizations. • S-11 Filed by real estate companies (limited partnership and investment trusts).
Examples of revenues include
• Sale of crude oil by ExxonMobil • Sale of books by Amazon.com • Sale of hamburgers by McDonald's
Weighted average presentation
• Since the total number of shares outstanding fluctuates as shares from other securities are converted or the company repurchases shares, companies usually show the number of shares outstanding on the income statement as weighted average of the amount of shares outstanding during the period of the income statement (quarter or year).
The Matching Principle
• The Matching Principle states that expenses should be "matched" to revenues. In other words, the costs of manufacturing a product are matched to the revenue generated from that product during the same period. • In our Amazon example, costs associated with the procurement of the book must be recorded in the same period as the revenue from its sale. • In our Boeing example, costs associated with the production of airplanes must be recorded in the same period as the revenue from their sale.
An overview of FASB
• The SEC largely relies on the input of the private sector to establish and maintaining financial accounting and reporting standards • The FASB was established in 1973 as an independent body to carry out the function of codifying these standards on the behalf of the SEC. • FASB is composed of seven full-time members appointed for five years by the Financial Accounting Foundation (FAF), a "parent" organization. • FASB formulates accounting standards through the issuance of Statements of Financial Accounting Standards (SFAS). These statements make up the body of accounting rules known as the Generally Accepted Accounting Principles (GAAP). • The FASB is independent, with close relations with the SEC, its decisions are influenced by a variety of entities: Corporatio
An overview of the SEC
• The Securities and Exchange Commission is a U.S. federal agency, which was established by the U.S. Congress in 1934. • The agency's primary mission is "to protect investors and maintain the integrity of the securities markets," which includes the establishment and maintenance of accounting principles and regulations.
Tax expense Diving a little deeper
• The calculation of cash taxes are made using the relevant country's tax code accounting 'tax rules', while the tax expense on the income statement is calculated using the relevant local 'book rules' (US GAAP, IFRS, etc.) • The different accounting rules, primarily revolving the calculation of deprecation, when revenues are recognized, and how losses are treated create many of the differences between the tax expense and the actual taxes paid.
What Is the Income Statement?
• The income statement is a financial report that depicts the operating performance of a company (i.e. revenues less expenses generated - i.e. profitability) over a specific period of time (typically a quarter or year).
Income statement summary
• The income statement is a summary of a company's profitability over a certain period of time. • Profitability is the difference between revenues and expenses generated by a company's activities. • Revenues are recognized when an economic exchange occurs, and expenses associated with a product are matched during the same period as revenue generated from that product. • Special care must be taken to distinguish operating expenses (stemming from core activities) from non-operating costs (arising from peripheral transactions) in arriving at a company's net income. Net income is an important indicator of a company's operating performance. Analysts focus on EPS, EBIT, and EBITDA as measures of a company's profitability.
Annual report vs 10-K
• The two terms are often used interchangeably, but be careful! • Sometimes companies provide a "polished" Annual Report that summarizes data in the 10-K and adds marketing fluff but is not the complete 10-K • As an analyst, the complete 10-K is the primary document for company data
Shares outstanding - basic vs. diluted
• There are two ways to think about who is a shareholder • Basic shares outstanding includes only the actual shareholders. • Diluted shares outstanding include the impact of potentially dilutive security holders that expand the share base, like stock option holders and preferred shareholders that can convert their preferred shares to common stock.
Tax expense
• Under US GAAP and IFRS, companies report tax expense as a separate line item usually right below a line item called 'Pretax Income' or 'Income before provision for income taxes'
Straight-line depreciation method
• Under US GAAP and IFRS, most companies choose to depreciate assets evenly over their useful lives, and this approach is called the 'straight-line method' • Under the straight-line depreciation method, the depreciable cost of an asset is spread evenly over the asset's estimated useful life. • Accordingly, depreciation expense for each period (quarter or year) is the same, and can be calculated as follows • Annual depreciation expense = Original cost − Salvage value/Useful life • Original Cost = original cost of the asset. • Salvage (residual) value = the asset's estimated salvage (or disposal / residual / trade-in value) at the time of disposal. • Original cost minus salvage value is often referred to as the depreciable cost. • Useful Life = total years the asset is expected to remain in service.
Stock based compensation expense
• We've already discussed how the expense of employee salaries are embedded within the expense categories based on the employee's job function. • A corporate manager or sales person's salary will likely be embedded in SG&A • The salary of a software engineer will likely be embedded in R&D • The salary of a factory supervisor at a tire manufacturer will likely be embedded in COGS • But what happens when a company compensates an employee with stock (like stock options or restricted stock)? hint: accrual accounting • When a company compensates an employee with stock (like stock options or restricted stock), the value of that compensation (called "stock based compensation" or "SBC") is recognized as an expense in the same expense category as the employee's regular cash compensation1.
Earnings before interest and taxes (EBIT)
• When analyzing a businesses, analysts are often comparing to the performance of other businesses • Since non operating items like interest expense, interest income, and taxes can vary widely across even similar types of businesses, analysts focus on operating income, or earnings before interest and taxes (EBIT).
Accelerated depreciation method
• While most companies choose straight-line depreciation, under both US GAAP and IFRS, companies are allowed to use accelerated depreciation methods, which calculate a greater amount of depreciation in earlier years than later years. The most common accelerated depreciation methods are: • Declining balance • Sum of years digits • Units of production
