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