The Income Statement in Detail

1. The Income Statement in Detail MIM 517 Fall 2010 Class 3

2. Learning Objectives • Exposure to real income statement complexity • Overview of “more complex” line items • Introduction to earnings management • Understand definition of Other Comprehensive Income and distinguish from Net Income

3. U.S. Income Statement Sales - Cost of Goods Sold = Gross Profit on Sales - Selling General and Admin. Expenses - Research & Development Expenses - Restructuring Charges = Operating Income (EBIT) + (-) Other income (expenses) + (-) Interest/dividend income (expense + (-) Unrealized gain (loss) on trading securities + Income in equity investees • Net income attributable to the non-controlling (minority) interest = Income before taxes, disc op’s & extraordinary items - Income tax = Net income before disc op’s & extraordinary items + (-) Discontinued operations, net of tax + (-) Extraordinary gain (loss), net of tax = Net income

4. Requirement for I/S Format • U.S. • SEC Registrants: certain prescribed format and minimum disclosure items • Non-registrants: limited guidance • Revenue & expense must be broken out separately and not offset • IRFS • Certain items must be presented on the face of the income statement • Offset of revenue and expense not allowed

5. Revenue Recognition • Criteria – US and IFRS • Earned: The earnings process must be complete and the value of the transaction can be measured. • Realization: The revenue must have been collected OR there must be some assurance that it will be collected. • Sticky situation examples • Bundled sales (WSJ “Dell Details Accounting Woes”) • Multi-year deliverables • Gift cards (Starbucks)

6. Cost of Goods Sold (COGS) • What is the relationship between COGS and inventory? • How is product cost determined? • Allowable methods • U.S.: FIFO, LIFO, Average • IFRS: FIFO, Average • What goes into product cost? • Retailer • Wholesaler • Manufacturer • Service Provider

7. Operating Expenses • What is included? • U.S. and IFRS basically the same • What is broken out individually? • R&D • Items significant individually • Where else can information be found on specific operating expenses? • Footnotes • Proxy Statement

8. Restructuring Charges (US) • What are “restructuring charges”? • Changes in structure, strategies or organization to boost future N/I. • Includes: employee severance, new systems development, product line elimination, losses related to asset impairments and disposals, and costs to consolidate or relocate operations. • Reported as a separate line item within continuing operations. • U.S. & IRFS basically same treatment, some measurement difference • Examples: Kodak, Rubbermade, Alcoa • Issues • Why should these costs be broken out? • Are companies using them to take a “big bath” • What message are companies trying to send with restructuring charges?

9. Restructuring Charges (US) SEC Chairman Arthur Levitt gave a speech entitled, The Numbers Game. One of the accounting gimmicks that the Chairman cited in his speech was the abuse of restructuring charge accounting. He stated: ‘Let me first deal with "Big Bath" restructuring charges. Companies remain competitive by regularly assessing the efficiency and profitability of their operations. Problems arise, however, when we see large charges associated with companies restructuring. These charges help companies "clean up" their balance sheet – giving them a so-called "big bath." Why are companies tempted to overstate these charges? When earnings take a major hit, the theory goes Wall Street will look beyond a one-time loss and focus only on future earnings.

10. And if these charges are conservatively estimated with a little extra cushioning, that so-called conservative estimate is miraculously reborn as income when estimates change or future earnings fall short. When a company decides to restructure, management and employees, investors and creditors, customers and suppliers all want to understand the expected effects. We need, of course, to ensure that financial reporting provides this information. But this should not lead to flushing all the associated costs – and maybe a little extra – through the financial statements.’

11. Restructuring Charges Consider Starbucks • How much of a restructuring charge was recorded in 2009? • What changes in the business are captured by these charges?

12. Other Asset Write-Downs • “Impairments” • Impact on F/S Asset = Expense • What types of assets typically are subject to impairment? • Disclosure • Separate line item if material • Footnote • “The Crisis of Credit”

13. Income from ownership in other companies • Cost Method • Income takes form of dividends paid to company • Recorded as “interest and dividend income” • Gains (losses) from sales recorded separately • Unrealized gains (losses) recorded where???? • Equity Method • Income from subsidiary is separate line item • Consolidated Method • Revenues and expenses of subsidiary are added to the parent, then net income from non-controlling (minority) interest is subtracted out

14. Discontinued Operations • Accounting treatment • Distinct geographical or business segment • Record separately from continuing operations upon decision • Present separately • Income/loss from discontinued operations • Gain/loss on disposal of assets • Net of tax presentation • U.S. and IFRS substantially the same

15. Extraordinary Items • U.S. • Requirements: • Unusual in nature and • infrequent in occurrence • Presented “net of tax” • IFRS • Not allowed

16. Employee Stock and Benefit Plans • Generally: • Used to motivate (and compensate) employees. • Wide range of specific plans • Accounting issues: • When does expense get recognized (if at all) • What is disclosed in the financial statements?

17. Employee Stock and Benefit Plans - Definitions • Stock option plans • Granted the right to purchase stock at a set price at some point in the future. Price may be dramatically lower than the market price. • May or may not be taxable to the grantee • Co records as expense for stock option value over vesting period • Determining value of stock option is tricky… • Employee stock purchase plan • enables employees to purchase company's stock through payroll deduction, often at discount from market • Co records expense for discount and discloses details of plan

18. Employee Stock and Benefit Plans - Definitions • Restricted stock awards (RSA) • A form of equity compensation whereby the company grants company stock. • Recipient's rights in the stock are restricted until the shares vest. • Co records expense for award and discloses details of plan • Restricted stock units (RSU) • A form of equity compensation whereby the co grants an amount valued in terms of company stock. • Upon vesting, the co distributes either shares or the cash equivalent of the shares. • Co records expense for award and discloses details of plan

19. Other Comprehensive Income • What is it? • What items are included? • How should it be interpreted? • Lets look at Starbucks