Friday, January 17, 2014

Income Statement Outline: Accounting for Lawyers

Income Statement Outline: Accounting for Lawyers
  • Statement of profit and loss, of operations, of operating activity:
    • Provides information on profitability,
    • Reports economic inflows & outflows for a period of time,
      • Corporate life is infinite- can’t stop business to measure business,
    • Goal in creating an income statement: best guess for revenues of next period,
    • Represented by the Basic Income Equation:
      • Net income = Revenues – Expenses
  • Revenues, a.k.a. sales, sales revenues, turnover
    • Measures the inflow of assets (or reduction in liabilities) from selling goods and providing services to customers
    • Records economic performance- recorded at cash value of goods or services provided
    • Recognition: when the transaction meets both of the following conditions:
      • Completion of earnings process
      • Receipt of assets from the customer
    • Earned in a given time period (timing is important)
      • Matching principle: expenses are matched with the revenues produced in a given time period
  • Expenses
    • Measure the outflow of assets (or increase in liabilities) used in generating revenues
    • Timing of expense recognition focuses on when the firm consumes the benefits
    • Recognized when either of the following conditions hold:
      • Asset consumption results from transactions that lead to revenue recognition
      • Asset consumption results from the passage of time
  • Other Comprehensive Income (OCI): refers to changes in net assets that are not transactions with owners and that do not appear on income statement
    • Ex: currency conversions, adjustments
  • Cost of Goods Sold (CGS)
    • Costs that can be allocated to the goods that were sold
    • Ex: cost of raw materials, assembly-line labor, depreciation of machines used in production
  • Selling, General and Administrative (SG&A)
    • Costs incurred to sell products/services as well as cost of administration
  • Interest income
    • Income earned on amounts lent to others or from investments in securities
  • Gross profit: Sales – CGS (Cost of Goods Sold)
  • Operating Expenses (Op Exp)
    • Costs that do not depend on quantity sold
    • Ex: rent, executive and office salaries
  • EBIT: earnings before interest & tax, often called “operating profit”
    • Measure of profit that is shared by equity, debt, and the government
    • Measure of profit that is (mostly) independent of financing choices (debt/equity mix) because interest expense is not subtracted
  • EBT: earnings before tax
    • The base from which taxes are taken- after interest expenses are taken away
  • Net income (NI), aka profit, earnings
    • Measure of profit that belongs only to the equity holders
    • Note that NI does depend on leverage
    • Earnings-per-share (EPS) is the Net Income divided by the number of shares outstanding
Capitalizing vs. expensing
  • What purchases should be treated as assets (capitalized) and what should be expensed?
  • General rule: expense when benefits are immediate, or future benefits are too uncertain or immaterial (R&D expenditures)
Income statements do not tell us anything about sources and uses of funds
  • Where is the cash coming from and where is it going?
  • Many important trends do not show up on the income statement (like asset buildup and capital structure changes)
Relationship between income statement & balance sheet
  • Income statement links the balance sheet at the beginning of the period with the balance sheet at the end of the period
  • Retained earnings is increased by net income and decreased by dividends
Interpreting & Analyzing the Income Statement

  • Provides information on the profitability of the firm over the long-term
  • Three tools are useful in the analysis:
    • Common-size statements: revenues are set to 100% and each expense item is shown as percentage of revenue
    • Time series analysis: changes from year to year are calculated in both revenue and expense items
    • Cross-section analysis: revenues and expenses are compared to competitors

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