Chapter 3 Income Statement and Statement of Stockholders' Equity

How is a common-size income statement created?

A common size income statement is created by dividing each of the line items on the income statement for a year by the net sales or net revenues amount for that same year.

Explain how a company could have a decreasing gross profit margin.

A decreasing gross profit margin could occur if the sales prices or volume in a capital intensive company decreased or the cost of goods sold increased. Operating profit margin, while affected by the change in gross profit margin, is also affected by changes in operating expenses other than cost of goods sold. Significant decreases in operating expenses such as general and administrative, marketing and selling or research and development, for example, could cause operating profit margin to increase despite a decrease in gross profit margin

Discuss all reasons that could explain an increase or decrease in gross profit margin.

Gross profit margin can increase or decrease as a result of a change in sales prices, a change in cost of goods sold, or in the case of capital intensive industries, a change in volume. Increases (decreases) in sales prices, decreases (increases) in cost of goods sold and increases (decreases) in volume in capital intensive industries will lead to an increase in gross profit margin.

why is it important to evaluate increases and decreasing in operating expenses?

Increases in operating expenses may indicate inefficiencies, and decreases in operating expenses may be detrimental to long-term sales growth

what accounts can be found on a statement of stockholders equity?

treasury stock, accumulated other comprehensive income, and retained earnings

extraordinary events

unusual events not expected to recur in the foreseeable future

when is a dual presentation of a basic and diluted earnings per share required?

when a company has a simple capital structure

What are the two causes of an increasing and decreasing sales number?

Sales will increase or decrease if the amount of units sold increases or decreases or if the price at which the product or service is sold increases or decreases.

What is an example of an industry that would need to spend a minimum amount on advertising to be competitive? On research and development?

The beverage and athletic shoes industries are examples of industries that must advertise regularly or risk losing market share. The pharmaceutical and high technology industries are examples of industries that must do extensive research and development to create new and innovative products.

Discuss the four items that are included in a company's comprehensive income.

The four items included in comprehensive income include: Foreign currency translation effects which are adjustments to the equity section of the balance sheet resulting from the translation of foreign financial statements. Unrealized gains and losses on investments in debt and equity securities classified as available-for-sale are reported in comprehensive income. Additional pension liabilities are reported as other comprehensive income when the accumulated benefit obligation is greater than the fair market value of plan assets less the balance in the accrued pension liability account or plus the balance in the deferred pension asset account. Cash flow hedges (derivatives designated as hedging the exposure to variable cash flows of a forecasted transaction) are required to initially report any gain or loss from a change in the fair market value of the cash flow hedge in other comprehensive income and subsequently reclassify the amount into earnings when the forecasted transaction affects earnings.

What is the difference between a multiple - step and a single- step format of the earnings statement? Which form is the most useful for analysis?

The multiple-step format provides several intermediate profit measures: gross profit, operating profit, and earnings before income taxes. The single-step format groups revenues together and then deducts all categories to arrive at net earnings. The multiple-step format is the most useful for analysis.

Why is the bottom line figure, net income, not necessarily a good indicator of a firms' financial success?

The net income figure is based on accounting choices and estimates. The inventory valuation and depreciation methods chosen can vary significantly and impact differently on net income. Discretionary items such as advertising and repairs and maintenance can be manipulated to change the net income of a firm. Use of the equity method for investments may also distort net income. Nonrecurring and nonoperating items are included in net income. Net income also incorporates accounting changes and extraordinary items. Finally, net income does not equal cash flow.

What does the income statement measure for a firm?

The results of operations for a period

Explain what can be found on a statement of stockholders' equity.

The statement of stockholders' equity summarizes the changes in all of the equity accounts, including the retained earnings account.

what is a common size income statement?

a statement that expresses each item on an income statement as a percentage of net sales

depletion

allocation of costs of acquiring and developing natural resources

amortization

allocation of costs of intangible assets

depreciation

allocation of costs of tangible fixed assets

how should foreign currency and translation effects be recorded

as other comprehensive income

prior period adjustment, payment of dividends, net profit loss

causes changes in the retained earning account balance

how are costs of assets that benefit a firm for more than one year allocated?

depreciation and depletion and amortization

net profit

difference between all revenues and expenses

gross profit

difference between net sales and costs of goods sold

operating profit

difference between sales and revenue and expenses associated with generating sales

which of the following items needs to be disclosed separately in the income statement?

discontinued operations

diluted earnings per share

earnings per share figure based on the assumption that all potentially dilutive securities have been converted to common stock

basic earnings per share

earnings per share figure calculated by dividing the average number of common stock shares outstanding into the net earnings available to common stockholders

what are three profit measures calculated from the income statement?

gross profit margin, operating profit margin, net profit margin

why should the expenditures for repairs and maintenance correspond to the level of investment in capital equipment and to the age and condition of that equipment?

inadequate repairs of equipment can impair the operating success of a business enterprise

why can the equity method of accounting for investments in the voting stock of other companies cause distortions in net earnings?

income is recognized where no cash may ever be received

what is a statement of owners equity?

it is a statement that summarizes changes in the entire stockholders equity section of the balance sheet

why should the effective tax rate be evaluated when assessing earnings?

it is important to understand whether earnings have increased because of tax techniques rather than from positive changes in core operations

which of the following assets will not be depreciated over its service life?

land

How are companies required to report total comprehensive income?

on the face of the income statement, in a separate statement of comprehensive income, in the statement of stockholders equity

discontinued operations

operations that will not continue in the future because the firm sold a major portion of its business

multiple step format

presentation of income statement that provides several intermediate profit measures

single step format

presentation of income statements that groups all revenue items, then deducts all expenses, to arrive at net income

equity method

proportionate recognition of investee's net income for investments in voting stock of other companies

cost method

recognition of income from investments in voting stock of other companies to the extent of cash dividend received

why is the figure for operating profit important?

the figure for operating profit provides a basis for assessing the success of a company apart from its financing and investment activities and separate from its tax status