Chapter 3: Income Statement

Goodwill

Goodwill is the excess of cost over the net tangible assets and identifiable intangible assets of acquired businesses. It represents the purchase of an acquired firm's good name and reputation, which have value. Goodwill is the amount of the purchase price that exceeds the fair market values of the target's asset and liabilities. It is recognized on the balance sheet of the acquirer because it is considered a purchased asset, very much like a purchased building.

Government's claim

Government's claim in a taxable business is in the middle between the creditor (first to be paid) and the equityholder (last to be paid).

Gross profit

Gross profit is revenue minus cost of goods sold (COGS).

Net Profit Available to Common Stock Holders

If there are preferred shareholders, they are typically entitled to a fixed dividend. They have priority over common stockholders on the net income with respect to dividend payments. After the dividends are paid to preferred stockholders from net profit, the profit remaining is called net profit available to common stockholders.

Income statement equation

Income statement equation is stated as: Revenue - Expenses = Net Income

Debt Common Line Items

Interest Expense Pretax profit

Interest Tax Shield

Interest Tax Shield is the tax benefit provided when interest expense is deductible from taxable income.

Interest expense

Interest expense is the expense from the payment of interest to creditors (lenders). Interest expense affects tax expense because it reduces taxable profit, thus reducing tax liability.

Matching principle

Matching principle is the accounting principle that matches the recognition of revenue to expense recognition such that revenue and cost are recognized at the same time irrespective of cash receipt or payment. Aka revenue and expenses are matched and recognized at the time of the transaction, and not when cash is received or disbursed.

Net income (or net profit)

Net income (or net profit) is the residual income after deduction of all expenses from revenue (pretax profit - tax expense). It is the profit that remains after all other constituents have been paid (residual income claimed by equity holders after all other expenses are paid). It is synonymous with net profit, profit, and earnings.

Equity Common Line Items

Net profit (or loss)

Accelerated depreciation

Accelerated depreciation refers to several accounting methods provided by GAAP that permit a firm to recognize more depreciation expense for an asset in the earlier period of the asset's life. Accelerated depreciation has several implications. It deduces profit in the early periods, and thus may reduce tax liability as well. However, cash flow is unaffected because depreciation is a non cash expense. Aka the asset is depreciated more in the earlier years than the later years.

Accrual Accounting

Accrual Accounting is the accounting principle that recognizes revenue and expenses at the time of the transaction irrespective of the receipt or payment of cash. As a result, cash flow may not exactly match revenue and expenses, which is the reason why the cash flow statement is important. For example, a company contracts to sell a machine to a buyer for $100,000; the cost of manufacturing is $80,000; the machine is delivered on December 31, 2xx0; there is a 60-day term and so the buyers can pay as late as March 1, 2xx1. The company would recognize revenue and expense as of December 31. Accrual accounting is the opposite of cash accounting. Accrual accounting is not perfect because it requires assumptions about future payments, which can turn out to be wrong. Also, accrual accounting may allow certain discretion in terms of recognizing transactions, and such discretion can lead to uncertainty or abuse. Accrual accounting also recognizes depreciation as a non-cash expense.

Amortization

Amortization is the expense recognizing the decline in the value of an intangible asset, such as intellectual property. The counterpart to tangible assets is depreciation. In a more generic sense, amortization connotes the concept of writing off the cost of an asset.

Income Statement

An income statement provides crucial information on the company's profit and loss. It tells us the total amount of sales of the company's goods or services, and the payment to all of the company's claimants in the form of expenses. When these figures are computed, and total expenses are deducted from revenue, they tell us whether the company made a net profit or a net loss.

Cost of Goods Sold (COGS)

COGS is the direct cost of the production of goods or services, including supplies and payroll attributable to the direct production of goods or services. COGS may include non-cash expenses, such as depreciation of property, plant, and equipment directly associated with the production of goods and services. Examples include depreciation of factories for auto manufacturers, kitchen equipment for restaurants, and airplanes for airlines.

Capitalized cost

Capitalized cost is expenditures associated with improvements in property, plant and equipment (PP&E) such that the expenditure is not recognized immediately as an expense flowing into the income statement, but instead is recognized as an increase in assets in the balance sheet. Basically cash --> capitalized asset (transformation of an asset instead of an expense).

Cash accounting

Cash accounting is the accounting system based on recognition of revenue and expense upon the receipt or payment cash through a firm. It is not a broadly applicable principle of GAAP accounting, but may have use for certain limited purposes such as regulatory oversight of businesses where cash balance and solvency are important. Cash accounting produces misleading results that do not reflect the actual economic reality.

Depreciation & Amortization (D&A)

D&A is the sum of depreciation and amortization expenses, which constitute a firm's non cash expenses. D&A is added to EBIT to calculate EBITDA. Depreciation & Amortization (D&A) connote a common idea of a gradual loss of value in an asset. D&A are costs that are recognized as expenses in the income statement. D&A need not be calculated on a straight line basis. There are other methods under GAAP, which allows discretion in these matters.

Declining Balance Method

Declining Balance Method is a method for calculating depreciation in which the asset is depreciated by a constant percentage of the purchase cost of the asset adjusted each subsequent year for depreciation. It is an accelerated depreciation method as compared to the straight line method.

Delayed tax liability

Delayed tax liability is liability incurred but not obligated to be paid at the moment.

Depreciation

Depreciation is the expense recognizing the decline in the value of a tangible asset, such as property, plant, and equipment.

Dividend

Dividend is a payment, usually in cash, to shareholders made from net income.

Earnings Before Interest & Tax (EBIT)

EBIT is the profit before interest and tax items are deducted.

Earnings before interest, tax, depreciation, and amortization (EBITDA)

EBITDA is EBIT plus depreciation and amortization expenses, which are non-cash expenses and are found in the cash flow from operations statement. EBITDA is a figure that is commonly used because it approximates a firm's operating cash flow.

EPS (basic and diluted)

EPS (basic and diluted) is the net income attributable to common stock divided by the shares outstanding. Shares outstanding can be calculated as basic which includes only shares of common stock, or diluted which includes the share equivalent of securities that can be converted into common stock. For example, if net income attributable to common stock is 100, and basic shares outstanding are 100, then EPS (basic) = $1.00/share.

Earnings

Earnings is synonymous with net income, profit, and net profit. Unmodified, it refers to the net profit.

Expense

Expense is a decrease in equity caused by using up assets in producing revenue or carrying out the activities of a firm.

Income Statement Components

Four major components: -Operations -Debt service -Tax service -Residual profit

Operating profit (income)

Operating profit is the profit from operations only, which is revenue (gross profit) minus operating expenses/sales (COGS + SG&A). In most cases, it is synonymous with earnings before interest and tax, but there is a difference in that EBIT may contain special or one-off gains or losses whereas operating profit refers to the profit from continuing operations.

Overhead expense

Overhead expense is any expense not directly associated with the cost of producing goods or services, and is synonymous with sales, general and administrative expense (SG&A).

Pretax profit

Pretax profit is the profit before deduction of tax expense. Pretax profit is EBIT minus interest expense.

Profit

Profit is synonymous with net profit, net income, and earnings. However, when "profit" is modified, it does not mean net income. For example, pretax profit refers to income before tax expense, and operating profit refers to income from operations before interest and tax expenses are deducted.

Retained Earnings

Retained Earnings are net income that are retained by the company instead of distributed to the shareholders. An increase in retained earnings must balance with an increase in assets (cash or account receivables increases)

Determining Net Profit/Loss

Revenue - COGS & SG&A - Interest expense - Tax expense =Net profit/loss

Operation Common Line Items

Revenue (cost of goods sold) Gross profit (sales, general, & administrative) Operating profit (income)

Revenue

Revenue is the increase in equity caused by the sale of services or goods, which is money gained from the sale of services or goods, and synonymous with sale.

Sales, general and administrative expense - SG&A (or G&A)

SG&A (or G&A) is operating expenses not connected to the direct production of specific goods and services, including overhead and administrative expenses. SG&A expenses may include non-cash expenses such as depreciation. Examples include marketing costs, salaries of employees in finance and human resources departments, and the depreciation on corporate headquarters.

Sales

Sales - see "revenue" ?? lol

Shares outstanding (basic and diluted)

Shares outstanding (basic and diluted) or "outstanding shares," are the number of shares issued by a company and held by shareholders. Basic shares outstanding count the common shares only. Diluted shares outstanding count the share equivalent of securities that are convertible to common stock.

Straight line method of depreciation

Straight line method of depreciation calculates annual depreciation expense as the cost of the tangible asset divided by the useful life of the asset. For example, if an asset costs 100 and has a useful life of 10 years, the depreciation expense under a straight line method is 10 per year. Aka the asset is depreciated by a fixed amount over its life.

Claimants in Priority Order

Suppliers/Vendors/Employees Creditors Government _________________________ Equityholder (gets residual)

Tax Common Line Items

Tax expense

Tax expense

Tax expense is the money paid to the government in tax

Unit-of-activity method

Unit-of-activity method is a method for calculating depreciation in which the depreciation is calculated on a per unit of production basis. As production of units varies, the depreciation expense varies as well.