Income Statement Terms

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Income Statement Terms This is a printer-friendly version of the content included in the "Income Statement Line by Line" activities. You may want to print this page for future reference.

1 Income Statement Terms This is a printer-friendly version of the content included in the "Income Statement Line by Line" activities. You may want to print this page for future reference. Cost of Goods Sold (COGS) Cost of goods sold (COGS) represents all the costs incurred by the company in order to convert raw materials into finished products or to deliver the goods and services that created the net sales. For example, in the case of Astrobucks, the food and beverages sold in the store would be a direct material cost and the wages of the stores' food preparation staff and cashiers would be a direct labor cost. As we can see from its income statement, Astrobucks' cost of goods sold increased between Year One and Year Two. In Year One, its COGS was $1,350,011,000, which increased to $1,685,928,000 in Year Two. In total, cost of goods sold increased by $335,917,000. By comparing this to the increase in net sales of $786,614,000 over the same period, we can see that Astrobucks' net sales are increasing at a much faster pace than its cost of goods sold. This will mean that its gross profit, which we turn to next, will be rising over that period. Depreciation & Amortization Expenses As determined by the IRS and published in the Modified Accelerated Cost Recovery System (MARCS), depreciation is the allowance provided to represent the reduction in the value of an asset due to wear and tear over the course of the year. Each year's decline in the value of the company's assets would be captured here. Amortization is the decline in useful value of a tangible asset, such as an Astrobucks store or an espresso machine, over the course of the year. It is important to note that these values are only representations of the actual reduction in the value of the assets. The government determines these numbers. Types of assets are grouped together within the MARCS, such as computers and cash registers, or delivery trucks and forklifts. A useful life is established for assets within the group, and an annual depreciation amount is determined that will fully depreciate the asset over its assumed useful life. While an espresso machine's assumed useful life might be 3 years, it may actually last 5 years. In this case, we would have no allowance for depreciation after the third year. Or, it may break down in 2 years, in which case we would need to make an allowance after the second year to write off the full cost of the asset. Real estate can be even trickier since an Astrobucks store or the company's office building may get more valuable over time. 1

2 The government still allows the company to depreciate it each year and will tax any gains when the company sells the asset in the future. Finally, land, while costly and valuable, is not depreciated. Its value is maintained on the books at the purchase price until it is sold in the future. Gain (Loss) from Non-Recurring Activities Under ordinary conditions, the net income after taxes would be the end of the story. However, there are years in which companies may experience unusual and infrequent events called discontinuing operations and extraordinary items. Discontinuing operations occur when, for example, a business sells off one of its divisions and must recognize the gain or loss from that sale. Extraordinary items, on the other hand, could include pension plan terminations, litigation settlements, or tax loss carry-forwards. These events are isolated on a separate line, net of their tax effect, so that the reader of the income statement can distinguish between reductions in income that resulted from normal operations and those that are not likely to recur in the future. This way the reader can discriminate idiosyncratic or one-time losses from systemic or "normal" operating losses. Gross Profit Gross profit is the amount that net sales exceeds cost of sales. It represents the residual profit from sales after considering the direct and indirect cost of sales discussed above. We can see that the gross profit for Astrobucks went from $1,938,897,000 in Year One (which is equal to the Year One net sales of $3,288,908,000 minus the Year One cost of sales of $1,350,011,000) to $2,389,594,000 in Year Two (which is equal to the Year Two net sales of $4,075,522,000 minus the Year Two cost of sales of $1,685,928,000). This amounts to a total increase in gross profit of $450,697,000 between Year One and Year Two. Income before Income Taxes Income before income taxes is the amount that operating income exceeds the sum of interest expenses and non-operating income. It represents the residual profit from sales after deducting all of the operating and non-operating expenses (and income) discussed above. Between the end of Year One and the end of Year Two, income before income taxes increased from $338,999,000 to $436,335,000, for a total increase of $97,336,000. 2

3 Income Tax Expense Every company has a basic tax rate that depends on the level and nature of its income before income taxes. Large corporations such as Astrobucks are subject to the top corporate income tax rate, but tax credits can lower the overall tax rate. Astrobucks' income before income taxes is $338,999,000 in Year One and $436,335,000 in Year Two. The income tax expense on these amounts of income comes to $126,313,000 in Year One and $167,989,000 in Year Two, leaving net income after tax for Year One of $212,686,000 and of $268,346,000 for Year Two. The tax rate applied to the average level of income for the two years would then be 37.26% ($126,313,000 \ $338,999,000) and 38.5% ($167,989,000 \ $436,335,000), respectively. Interest Income (Expense) Interest expense is the interest paid to banks (as a result of taking out a loan) and bondholders (as a result of selling bonds to the public) for the use of their money. It is also referred to as a fixed financing charge because the interest must be paid year after year, whether the company is earning a profit or losing money. Interest differs from dividends on common stock (a financing charge associated with equity), which is payable only if the board of directors decides to declare them. Interest paid is another cost of doing business and is deductible from earnings in order to arrive at taxable income, which is used as a base for the payment of income taxes. Astrobucks has no interest expenses in either Year One or Year Two. Net Income Once all income and costs -- including discontinuing operations and extraordinary items -- are added and deducted, we arrive at net income. If there are no gains or losses from discontinuing operations or extraordinary items in a given year, the net income is exactly the same as the net income after income taxes. However, if any of these accounts has a positive or negative amount, we would have added or deducted accordingly. Astrobucks' net income is then $212,686,000 for Year One and $268,346,000 for Year Two, showing that the company improved its "bottom line," or net income, by $55,660,000 between Year One and Year Two. We can also look at this as a very reasonable growth in earnings of 26.17% between Year One and Year Two ($55,660,000 \ $212,686,000). 3

4 Net Income after Taxes Once all income and costs are added and deducted but before accounting for discontinuing operations and extraordinary items, we see the net income after taxes. Net Sales The first item on the income statement is called net sales. Net sales represents the primary source of money received by the company from its customers for goods sold or services rendered by the company. Net sales represents the amount received by the company as revenues less deductions from returned goods and the reduction of prices from early payment discounts. By comparing Year One and Year Two, we can see that Astrobucks had a better year in Year Two than in Year One. Specifically, the company had net sales of $4,075,522,000 in Year Two compared to $3,288,908,000 in Year One. In total, net sales for Astrobucks increased by $786,614,000 between Year One and Year Two. Operating Income Operating income is the amount that gross profits exceed the sum of sales, general, and administrative expenses, and depreciation and amortization expenses. It represents the residual operating profit from sales after considering the expenses discussed above. We can see that the operating income for Astrobucks went from $282,893,000 in Year One (which is equal to the Year One gross profit of $1,938,897,000 minus the Year One SG&A of $1,450,447,000 and the Year One depreciation and amortization expenses of $205,557,000) to $386,317,000 in Year Two (gross profit of $2,389,594,000 minus the SG&A of 1,765,470,000 and the depreciation and amortization expenses of $237,807,000). Between the end of Year One and the end of Year Two, operating income increased from $282,893,000 to $386,317,000 for a total increase of $103,424,000. Other Non-Operating Income (Expense) The primary sources of non-operating income (expense) are dividend income from the company's investments in other companies (minority stakes in other businesses), interest income from investments in marketable securities (which will be discussed in the balance sheet section), and the gains or losses (expense) earned or incurred when 4

5 the company sells off fixed assets and other investments. Astrobucks' non-operating income was $56,106,000 in Year One and declined to $50,018,000 in Year Two. Selling, General, and Administrative Expenses (SG&A) Selling, general, and administrative (SG&A) expenses are generally grouped separately from the cost of goods sold so that the reader of an income statement may distinguish between selling and administrative costs and those costs incurred as a direct part of the goods creation process. SG&A expenses include advertising and promotion expenses, travel and entertainment of people who work for the company, executives' salaries, office payroll, and office expenses. Operating expenses also include direct overhead costs associated with operating the Astrobucks store itself (rent, operating lease payments, utilities, supplies, maintenance and repairs, and store manager salaries). It is valuable to separate these costs from the cost of goods sold since the evaluation of income creation and cost control requires that we understand which expenses are directly related to revenue creation and which support the process of revenue creation. In Year One, Astrobucks incurred $1,450,447,000 in SG&A expenses, compared with $1,765,470,000 in Year Two, creating an increase of $315,023,000 in SG&A expenses between the end of Year One and the end of Year Two. 5

HAME513: Understanding Financial Statements

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