(1) Income Statement Referencing this week?s readings and lecture, address the following: ? What are the two causes of an increasing or decreasing sales number? ? Discuss all the reasons that might explain an increase or decrease in gross profit. (2) Analyzing an Income Statement Income statements are presented in the table below for the Elf Corporation for the years ending December 31, 2010, 2009, and 2008. Write a one-paragraph analysis of Elf Corporation?s profit performance for the period. Create a common-sized income statement for the three years. What conclusions can you draw from the different parts of the statement? What are the causes and effects of Elf's performance for those three years? Elf Corporation Income Statements for the Years Ending December 31 (in millions) 2010 2009 2008 Sales $700 $650 $550 Cost of goods sold 350 325 275 Gross profit 350 325 275 Operating Expenses: Administrative 100 100 100 Advertising and marketing 50 75 75 Operating profit $200 $150 $100 Interest expense 70 50 30 Earnings before tax $130 $100 $ 70 Tax expense (50%) 65 50 35 Net income $ 65 $ 50 $ 35

3 The Income Statement Rudyanto Wijaya/iStock/Thinkstock Learning Objectives After reading this chapter, you should be able to: 1. Examine the elements of an income statement. 2. Describe the accounts that make up an income statement. 3. Describe the different types of profit shown on an income statement. 4. Explore the elements of the statement of shareholders' equity. 5. Examine and create a common-sized income statement. eps81356_03_c03_097-132.indd 97 3/26/14 12:54 PM Introduction Pre-Test 1. What is the purpose of an income statement? a. to determine whether the company earned any revenues during the period b.\t\u0007 determine how much the company spent to make revenues during the to period c.\t\u0007 determine whether the company made a profit from its operations during to the period d. to determine the financial position of the company during the period 2. What are the four basic groupings on an income statement? a. Revenues, Cost of Goods Sold, Expenses, Net Profit/Loss b. Expenses, Revenues, Inventory, Net Profit/Loss c. Cash, Expenses, Inventory, Net Profit/Loss d. Sales, Expenses, Inventory, Net Profit/Loss 3. What type of profit is shown on the income statement? a. gross profit b. operating profit c. net profit d. all of the above 4. Which of the following is/are found in the statement of shareholders' equity? a. treasury stock b. common stock c. retained earnings d. all of the above 5. Which section of the income statement includes information about advertising expenses? a. Cost of Goods Sold b. Sales and Administrative Expenses c. Other Expenses d. Advertising information is not found on the income statement. Answers can be found at the end of the chapter. Introduction Successful business owners and department managers often look forward to reading an income statement (also sometimes called a statement of earnings, statement of income, statement of operations, or profit and loss [P&L] statement) because it tells them just how much of a profit they have made in any given accounting period. The statement could be for a month, a quarter, a year, or some other time period that the manager deems necessary. Most businesses develop monthly, quarterly, and annual income statements. eps81356_03_c03_097-132.indd 98 3/26/14 12:54 PM The Sections of an Income Statement Section 3.1 For business owners or managers who are struggling to meet sales goals, the income statement is often no cause for celebrationand may even be a source of dread, if it reveals that the company is operating at a loss. Regardless of whether a business is successful or struggling, the income statement is always extremely important because it discloses the \"bottom line,\" or net profit/loss. However, the more important parts of the statement are how the company got to that number during the period being reported. In this chapter, we discuss how the numbers are crunched to get to the bottom line, and explore the critical rules of accounting that impact when those numbers can be reported on the income statement. As in previous chapters, we will be following Best General Company throughout this chapter and addressing decisions the budget committee and managers might make based on the document being discussed. Before we get to the income statement numbers, let's review the key elements of an income statement, discuss the dates that appear at the top, and explore possible formats. 3.1 The Sections of an Income Statement In addition to other information, every income statement includes the following four key sections: 1. Sales or Revenues: how much revenue the company brought in by selling its products or services. 2. Cost of Goods or Services Sold: how much the company spent to purchase or produce the products or services it sold. 3. Expenses: how much the company spent to keep the doors of the business open. Essentially, this includes all expenses except those spent specifically on the cost of goods or services sold. 4. Net Profit or Loss: the \"bottom line\" that tells whether the company made a profit or operated at a loss. Let's use the annual income statement of Best General Company (Figure 3.1) to explore how these key sections typically appear. Note that the income statement in Figure 3.1 shows three periods. This enables the business owner or manager to quickly see trends over time. eps81356_03_c03_097-132.indd 99 3/26/14 12:54 PM Section 3.1 The Sections of an Income Statement Figure 3.1: Best General Company income statement The income statement presents the \"bottom line\" showing a company's profit or loss. Best General Company Income Statement For the Years Ended December 31, 2013, 2012, and 2011 2013 Revenue Costs of Goods Sold Gross Profit Operating Expenses: Selling, General, and Administrative Expense Research and Development Expense Total Operating Expenses Operating Profit Other Income Other Expenses Depreciation Expense Income Tax Expense Net Profit 2012 2011 $ 100,000 73,000 $ 27,000 $ 110,000 78,000 $ 32,000 $ 120,000 84,000 $ 36,000 $ 22,000 500 22,500 $ 21,000 500 21,500 $ 20,000 500 20,500 $ 4,500 $ 10,500 $ 15,500 $ $ 2,500 $ (900) (2,400) (150) 3,550 $ 2,500 $ (900) (2,400) (1,500) 8,200 $ 2,500 (900) (2,400) (1,700) 13,000 In Figure 3.1, the Revenue section is only one line item. An internal report that a company manager sees could include more detail in this section. For example, the first line might be called Gross Revenues, with additional information provided about sales discounts and returns. The manager would therefore have more information about what was subtracted to get to the net revenue figure shown as the first line of the public statements. We discuss this information in greater detail in the Revenue section below. The Cost of Goods Sold section is also only one line item. Again, an internal report that a Best General Company manager sees could include more detail about the costs incurred to purchase or produce the goods sold. We discuss this information in greater detail in the Cost of Goods Sold section below. eps81356_03_c03_097-132.indd 100 3/26/14 12:54 PM The Sections of an Income Statement Section 3.1 For major corporations, the Expenses section is sometimes divided into Operating Expenses and Non-Operating Expenses. The simpler example shown in Figure 3.1 does not include a distinct non-operating expenses section; it lists the non-operating income and expenses as Other Income and Other Expenses. The Expenses section enables managers to know what expenses were incurred as part of the operations of the business and what expenses were incurred that were not from operations. We discuss this information in greater detail below. The Net Profit section in Figure 3.1 is only one line, but many companies present profits at various stages, such as earnings before taxes and interest (EBIT) or earnings before taxes, interest, depreciation, and amortization (EBITDA). We discuss why companies view profits in several different ways below. Our budget committee would be able to discern the following key trends from the income statement shown in Figure 3.1, each of which would need to be further explored: Revenue is decreasing. Note how revenues were $120,000 in 2011 but dropped to $100,000 by 2013. The budget committee would want to find out why revenue is on a downward trend. They would need a more detailed internal report to find out if there are fewer products being sold, or if a greater number of discounts are being offered to sell those products. They may find other reasons for the decrease as they get more detail. They would use this information to prepare a realistic budget projection for the next year. Cost of Goods Sold is also on a downward trend, from $84,000 in 2011 to $73,000 in 2013. That may be good news if the company has found a way to reduce the costs of buying its goods, or it could just be that fewer goods needed to be bought because products purchased or manufactured in previous years were sold in the current year. The budget committee may discover other reasons as they look at the details behind the numbers. These details also will be needed to project the Cost of Goods Sold for next year's budget. Operating Expenses are on an upward trend, from $20,500 to $22,500. Increases in salaries or some other factor could be driving that increase. The budget committee would need to see more details from the accounts that make up that line item to know why there is an upward trend. Now we will take a closer look at the key rules for the presentation of an income statement. We will then explore the various types of profits one might measure when looking at an income statement. Finally, we will explore the rules that accountants must follow when preparing these financial statements. Report Timing Unlike the balance sheet, which is a snapshot in time, the income statement shows the performance of a business over a longer period. The \"as of\" date on the balance sheet will be the same as the period ended date on the income statement. If the company operates on a calendar year basis, the phrase \"Year Ended\" will appear in the heading, at the top eps81356_03_c03_097-132.indd 101 3/26/14 12:54 PM The Sections of an Income Statement Section 3.1 of the statement; if it operates on another 12-month period, the phrase will read as \"Fiscal Year Ended.\" If the statements are issued monthly or quarterly, the phrasing will read as \"Month\" or \"Quarter\" Ended. Whatever phrase shown at the top will be followed by the ending date of the period. Remember, when a manager compares results from one year to the next in the same company, or compares one company to another, it is important to examine the same operating period. For example, if one company's statement shows \"Year Ended, December 31, 2013\" and another company shows \"Fiscal Year Ended, January 31, 2013,\" the manager needs to develop a spreadsheet that will enable him to calculate results for the same months. He can do this by getting a copy of the quarterly reports, where month-by-month data are usually shown. Suppose the manager works for a retail company that is highly dependent on holiday sales, and he wants to see how well his company did versus a competitor for the fourth quarter of the year. His company reports the fourth quarter using the months of November, December, and January. His competitor reports the fourth quarter using October, November, and December. (For many retail companies, October is a much slower month than January, because people use holiday gift cards to make purchases or exchange gifts after the first of the year). The manager would not be comparing apples to apples without adjusting the numbers to be sure he is looking at the results for the same three months. He would need to use a report that shows month-by-month results, if available, so he could prepare a spreadsheet with the same three months for each company before doing his analysis. It is generally a good idea to do the comparison with a company that uses the same time period. Luckily, companies in the same industry often report using the same time periods. Format Options Companies can format information on the income statement in either a single-step or multistep presentation. Both statements provide the same information, but the multi-step format uses various summary totals to make it easier to find the key profit totals, such as gross profit or operating profit, which we discuss below. Most companies use the multistep format because it is easier to read and analyze. Single-Step Format The single-step format groups all data into two categories: revenues and expenses (see Figure 3.2). Revenue includes income from sales, interest income, and gains from sale of equipment. In addition to income raised from regular operations, a company will also include income from one-time transactions, such as the sale of a building or piece of major equipment. Other types of revenue may also be possible. This varies by type of business. All types of expenses are grouped in the second category. This can be a very long list. Common expenses include advertising, salaries, administrative expenses, insurance expenses, vehicle expenses, office supplies, and so on. Gains or losses would also be shown, such as the loss from the sale of equipment or other assets. eps81356_03_c03_097-132.indd 102 3/26/14 12:54 PM Section 3.1 The Sections of an Income Statement The benefit of using a single-step format is that it is simpler to prepare. The limitation of the single-step format is that it does not indicate whether the company is actually making a profit from its operations; to determine this, we must reorder the information into a multi-step format. Figure 3.2: Single-step format income statement This singe-step format income statement shows one section for revenues and one section for expenses. Best General Company Income Statement (Single-Step) For the Year Ended December 31, 2013 Revenues: Sales Interest Income Gain on Sale of Equipment Total Revenues Expenses: Cost of Goods Sold Advertising Expense Depreciation Expense Income Tax Expense Insurance Expense Interest Expense Research and Development Expense Salaries and Wages Expense Supplies Expense Total Expenses Net Profit $ 10,000 500 5,000 $ $ 15,500 $ 11,100 $ 4,400 6,000 600 600 700 500 200 1,000 1,000 500 Multi-Step Format Income statements created using the multi-step format divide the statement into several groupings and provide critical subtotals to facilitate analysis of the information (see Figure 3.3). Even though they include essentially the same information, the additional groupings of the multi-step format help the reader quickly view the key profit lines: eps81356_03_c03_097-132.indd 103 3/26/14 12:54 PM Section 3.1 The Sections of an Income Statement Gross Profit: This shows the profit made from sales minus the costs of buying or manufacturing the products or services sold. Operating Profit: This shows the profit from the actual operations of the company. Profit Before Income Tax Expense: This shows the income before taxes and interest are subtracted. Net Profit (or Loss): This shows the bottom linewhether the company made a profit or experienced a loss. Many companies add additional profit lines, such as Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). Figure 3.3: Multi-step format income statement Compare the groupings of items to the single-step format of Figure 3.2. The multi-step format provides the operating income (or operating profit), which is the amount of profit after costs of goods sold and operating expenses have been subtracted. Best General Company Income Statement (Multi-Step) For the Year Ended December 31, 2013 Sales Cost of Goods Sold Gross Profit Operating Expenses: Advertising Expense Insurance Expense Research Development Expense Salaries and Wage Expense Supplies Expense Total Operating Expenses Operating Profit Operating Income: Interest Income Gain on Sale of Equipment Other Expenses: Interest Expense Depreciation Expense Profit Before Income Tax Expense Income Tax Expense Net Profit eps81356_03_c03_097-132.indd 104 $ $ $ $ $ $ 10,000 6,000 4,000 3,600 400 $ 5,500 600 500 1,000 1,000 500 500 5,000 (200) (600) $ $ (800) 5,100 (700) 4,400 3/26/14 12:54 PM Building Blocks of the Income Statement Section 3.2 When looking at the bottom line on the single-step format in Figure 3.2, Best General Company appeared to be making a profit of $4,400 on $10,000 of sales. But a closer look with the multi-step format in Figure 3.3 reveals that the business is not profiting on its operations. Operating profit was just $400. Using the single-step format in Figure 3.2 gave the impression that the business was profitable, but most of the profits came from a onetime sale of equipment. It is therefore critical to calculate the operating income, even if all you have is a single-step income statement. To do that, remove from the net profit all items not included in operations (minus interest income $500; minus gain on sale of equipment $5,000; plus depreciation expense $600; plus income tax expense $700; and plus interest expense $200) or reformat the single-step income statement into a multi-step format. 3.2 Building Blocks of the Income Statement Now we will take a closer look at the numbers on the income statement and explore how an income statement is created. We will start with Revenues, which are not always as simple as a total of the sales made. Then we will take a closer look at Cost of Goods or Services Sold. Finally we will explore the Expenses section of the income statement. Revenues For some types of businesses, such as retail stores or restaurants, recognizing revenue can be a relatively simple process. A manager adds up all the receipts for the day and enters total revenue earned. However, that's not the case for many other types of businesses, especially when sales and services involve construction, installation, or training. Sales for many types of consulting businesses also don't usually get fully recognized on the day the contract is signed. Revenue is only earned when the job is completed or a contract deadline is met. For example, a construction company that contracts to build a major project may earn its revenue over a number of years based on various deadlines set in the contract. A company like IBM that provides complex systems earns its revenue at various stages of completion after installation, after training is completed, and at the end of a service period. Note, when looking at IBM's income statement in Figure 3.4, its revenue is split into three line items: Services, Sales, and Financing. eps81356_03_c03_097-132.indd 105 3/26/14 12:54 PM Section 3.2 Building Blocks of the Income Statement Figure 3.4: Top portion of IBM's 2012 income statement To help readers navigate their income statement, IBM divides revenue into three line items: services, sales, and financing. Consolidated Statement of Earnings International Business Machines Corporation and Subsidiary Companies ($ in millions except per share amounts) For the year ended December 31: Revenue Services Sales Financing Total revenue Cost Services Sales Financing Total cost Gross profit Notes 2012 2011 2010 $ 59,453 43,014 2,040 104,507 $ 60,721 44,063 2,132 106,916 $ 56,868 40,736 2,267 99,870 39,166 13,956 1,087 54,209 50,298 40,740 14,973 1,065 56,778 50,138 38,383 14,374 1,100 53,857 46,014 Source: IBM. (2013). 2012 annual report. Retrieved from http://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf We'll take a closer look at how IBM actually recognizes these three different line items, which can all be part of one contract, when we review the notes to financial statements later in the chapter. First, let's examine the basic rules of revenue recognition. Revenue Recognition As explained in Chapter 2, the first rule in accrual accounting is that revenue is recognized when it is earned. Note that this is not true of companies that use cash-basis accounting, in which cash revenue is recognized when cash is received. However, all major companies that must file financial statements with the Securities and Exchange Commission (SEC) use accrual accounting. Most smaller companies use it, too, even if they do not report to the SEC, because it more accurately matches revenue earned to expenses at the time in which the transactions occur. Thus, in this book, we focus on the rules of accrual accounting. The key question that must be answered before recognizing revenue, then, is: Has the money been earned? The following are some common scenarios in which additional information, beyond the sale of a product, might be required in order to determine revenue recognition: eps81356_03_c03_097-132.indd 106 3/26/14 12:54 PM Building Blocks of the Income Statement Section 3.2 Price Negotiations: Suppose a company is in the middle of negotiating the price for a product and service. It is the end of the month and the salesperson wants credit for the sale, but there are still some details to be worked out before there is a final price. Revenue cannot be recognized until a final price is set, the contract has been signed, and the customer has accepted the product or service. Distribution Issues: Suppose the buyer of the product does not pay for the merchandise until it is sold to a third party, such as a retailer. This is common when an intermediary is involved in the distribution of the product. The company selling the product cannot recognize the revenue until the retailer pays for the product. Sending out the product to a third-party distributor means the revenue cannot be recognized until the product reaches the end customer who will remit payment. The determining factor is who actually has title (ownership) of the product and the provisions under which the product can be returned to the manufacturer. Service/Installation/Training Issues: Revenue is recognized when the service, installation, or training is complete and accepted by the customer. Sometimes a company is paid for a product in full before the revenue is earned. This would be shown as Prepaid Revenue, which is shown as a liability account on the balance sheet. This account may also be called Unearned Revenue or Deferred Revenue. For example, IBM not only sells its products, it also installs the systems, trains its customers, and services the systems. In some cases, IBM provides financing so the customer can buy the system as well. Revenues from a major sale will not be recognized until the related terms have been met. For example, IBM may be paid in full for the equipment when installation is complete, but it will not recognize the revenue for training and servicing until the terms of that part of the contract are met. Revenue from financing will be recognized as payments are made. Shipping Issues: Goods are shipped FOB (Free on Board) destination, whereas other times they are shipped FOB shipping point. When goods are shipped FOB destination, the buyer does not own and pay for the shipment until it is received. In this case, the revenue is not recognized until the buyer receives it. If the shipment is stolen or lost, the buyer is not responsible for paying for the goods. On the other hand, if the shipment is sent FOB shipping point, it is assumed the buyer takes title on the day they are shipped and revenue can be recognized upon shipment. In this case, if the shipment is lost or stolen, the buyer is responsible for the loss. Selling Within the Corporation: Sometimes sales are made between the parent company and a subsidiary company. In this case, the sale would not be recognized as revenue but instead would be considered a transfer of assets. Buyback Agreements: Sometimes a company agrees to buy back its inventory at some point in the future. If the buyback covers all costs of the inventory plus holding costs, this does not constitute a sale and the revenue is not recognized. This type of arrangement can be common in the financial services industry where financial products are sold with a promise to buy them back with interest. As illustrated in these scenarios, revenue recognition can be a complex question in certain types of businesses. A manager for a company with complex revenue issues may want to ask her accounting liaison to explain the revenue recognition rules under which their company operates. eps81356_03_c03_097-132.indd 107 3/26/14 12:54 PM Building Blocks of the Income Statement Section 3.2 Changes are being contemplated to simplify revenue recognition, as discussed in \"The New World of Financial Oversight.\" New World of Financial Report Oversight As U.S. regulators try to converge U.S. rules with international financial reporting rules, one of the major projects involves improving revenue reporting. Right now, there are many different requirements for specific transactions and industries, such as software, real estate, and construction contracting. Today there are over 200 specialized and industry-specific revenue recognition requirements under U.S. GAAP. Regulators are expected to issue revenue recognition guidance in 2014 that will improve the ability to respond to revenue recognition changes more quickly and increase comparability among industries. The goal will be to improve disclosures to users of financial statements so they can better compare and contrast the numbers. Read more about the revenue recognition project spearheaded by the U.S. Financial Accounting Standards Board and the international regulators here. Task Box 3.1: Recognizing Revenue Analyzing Industry Competitors, Part B Review the revenue recognition schemes for the two companies you chose to research in Chapter 2 (see Task Box 2.9). The information is most likely located in the first of the Notes to the Financial Statements, often called \"Significant Accounting Policies\" or \"Accounting Methods.\" Be prepared to discuss the way revenue is earned and recognized for each of the companies, and how it might be different for each. Sales Adjustments The recognition of revenue is not the only factor that comes into play when calculating net sales. Sales are adjusted for a number of reasons. In most cases, a company's external financial reports will not show any detail of how much sales were adjusted. Companies prefer to keep these details confidential and report them only on internal reports. Within a company, managers who are responsible for producing revenue will get a more detailed report that shows the accounts used to calculate Net Revenue shown on the income statement. Managers will only find details about these adjustments on these internal financial reports. These adjustments can have a major impact on a company's net revenue figures and reduce the net revenue reported. Anything that reduces revenues will ultimately reduce profits. eps81356_03_c03_097-132.indd 108 3/26/14 12:54 PM Building Blocks of the Income Statement Section 3.2 Revenue-producing managers want to keep a close watch on the adjustments to be sure they are accurate. Also, if any of the revenue adjustments show an increasing trend, managers want to determine the reason for the increase. Companies make three common adjustments to their gross sales or revenue totals: 1. Volume discounts: Companies use this incentive to offer major retailers a reduced price if they buy in large numbers. For example, a company may offer its widgets at $50 each if fewer than 1,000 units are ordered. However, it may cut the price to $45 when 1,001 to 5,000 units are ordered and further reduce the price to $40 for orders over 5,000 units. That's why big box retailers, such as Walmart and Target, can often offer lower prices: They can take advantage of volume discounts. Volume discounts reduce the gross sales for the seller but likely increase total sales volume. 2. Returns: Every company that produces tangible goods can expect that some items will be returned by buyers. Returns reduce the gross sales for the company. Accounting will track returns (usually accompanied by a credit memo) in a separate account and watch the trends for returns. If the trend goes up sharply, it can indicate that there is a problem with a product. Management will use this report to follow those trends and start an investigation if the numbers jump dramatically. 3. Allowances: Allowances are liabilities for a company. For example, a gift card is an allowance that people pay for up front but take no merchandise. These allowances must be monitored because at some point, someone will likely use that gift card and take some product, which would increase the costs of goods sold at a later date. Rebates are another type of allowance that people may or may not cash in. Companies will reduce their gross sales to account for these future liabilities. Sales Adjustments at IBM and 3M A sales manager can find out some information about how competitors are recognizing revenue. This research can help the sales manager discover new revenue opportunities or new methods for recognizing revenue that she may want to discuss with her accounting and finance staff if she believes this will improve the company's revenue and profits. Note 1 in 3M's Notes to the Financial Statements indicates that 3M reduces income for distributor incentives that include rebates and free goods, primarily at the time of sale. It says in the notes, \"These sales incentives are accounted for in accordance with ASC 605 Revenue Recognition [a GAAP standard]. The estimated reductions of revenue for rebates are based on the sales terms, historical experience, trend analysis and projected market conditions in the various markets serviced.\" Remember, 3M is a manufacturer that distributes most of its product through intermediaries, which then sell the products to the retailers, which ultimately sell the products to the customer. So its incentives are based primarily on ways to encourage volume sales. Note that 3M reduces revenues for rebates. These rebates are offered to encourage sales, but not eps81356_03_c03_097-132.indd 109 3/26/14 12:54 PM Building Blocks of the Income Statement Section 3.2 all rebates are redeemed. Consumer Reports indicates that 70 percent of consumers actually send in the request for rebates. Companies do not use general statistics such as these, however; instead they develop a percentage of rebates used based on historical company data (Consumer Reports Magazine, 2009). Most of IBM's sales are directly to the businesses it serves. Thus, the reductions to revenue discussed in Note A are very different. IBM indicates it reduces revenues for client returns, stock rotation (moving older products to the front so they are sold first), price protection (agreements to maintain a set price over a specific period of time), rebates, and other similar allowances based on \"historical results taking into consideration the type of client, the type of transaction and the specifics of each arrangement.\" Neither company provides exact details about how much these adjustments total in the Notes to the Financial Statements. Companies usually closely guard the details about costs and sales reductions, because they don't want to give their competitors information to use against them. This is why managers with direct responsibility for the revenue involved are often the only ones allowed to access this information. Task Box 3.2: Handling Revenue Reductions Analyzing Industry Competitors, Part C Read the Notes to the Financial Statements to find out how the companies you've chosen to research handle their revenue reductions. Do the two companies handle them in the same way or differently? What are the similarities and differences? Now let's take a closer look at cost of goods or services sold. Cost of Goods or Services Sold Every company, even a consulting company that offers only services, incurs costs for what it sells. In a service-based company, the costs may include those related to bidding on a project. For example, an architectural or engineering firm likely incurs staff costs and equipment costs in order to prepare a bid for a specific project. Those costs would be costs of services sold. Once the company wins the project, it may hire staff to work on that project with no other responsibilities in that company. These staff costs would be charged against that project's gross profit. Essentially, cost of goods or services sold includes any expenses that can be directly charged against the production of that product or service. eps81356_03_c03_097-132.indd 110 3/26/14 12:54 PM Section 3.2 Building Blocks of the Income Statement Advertising, for example, is considered an expense rather than a cost because it would be difficult to determine exactly which ad drove a customer to buy which product. Most advertising is much broader than one particular product or service. Tracking and figuring that out is not worth the staff time involved, so advertising becomes an expense rather than a cost and is not included in Cost of Goods Sold. Another factor that can impact the Cost of Goods Sold line is the inventory valuation method used. In Chapter 2, we discussed LIFO vs. FIFO vs. Average Costing. Below is a summary of the calculations we completed in that chapter: Average costing LIFO Beginning Inventory Cost of Goods Sold Ending Inventory FIFO $400.00 $400.00 $400.00 $3,250.00 $2,962.50 $3,063.50 $650.00 $937.50 $835.50 Clearly, the Cost of Goods Sold number usually is the highest when using the LIFO inventory value method; prices in most industries gradually increase because of inflation. This is not true in all industries, and, in some cases, the older inventory can be more expensive, as in the computer field, where costs sometimes go down for products. When a higher value is used for cost of goods sold, then the company's profits will be reduced. In the example above, company profits would be $287.50 ($3,250 2,962.50) less using LIFO rather than FIFO. If prices were going down, then FIFO would likely be the higher cost of goods sold number. Average costing always evens out the price differences. In a manufacturing company like 3M, costs include anything spent to produce a product. This includes the purchase of raw materials, the labor costs to make the product, and the cost involved in storing raw materials until they are needed. In addition, the costs of the machinery and tools for product production are also allocated to Cost of Goods Sold. Other types of businesses determine their Costs of Goods or Services Sold based on the purchases of products they made in order to sell their products or services. Financial report readers can see how complicated it is for a service company, such as IBM, to determine its costs of goods sold by reading Note A in IBM's Notes to the Financial Statements. That note states, for example, that \"Recurring operating costs for services contracts, including costs related to bid and proposal activities, are recognized as incurred.\" IBM tracks its costs on service contracts, including bid and proposal activities, and recognizes them when incurred. Since it can take months to actually win a proposal, IBM indicates that it reports operating costs periodically throughout the bidding process. (The rest of this note can be found in the \"World of Business,\" which discusses other difficult decisions regarding the recognition of costs.) eps81356_03_c03_097-132.indd 111 3/26/14 12:54 PM Building Blocks of the Income Statement Section 3.2 World of Business Recognizing Costs of Goods and Services Sold Determining when a company should recognize costs is not always easy. Discover the complexities to be considered in this excerpt from IBM's 2012 Notes to the Financial Statement, regarding the recognition of costs: \"For fixed-price design and build contracts, the costs of external hardware and software accounted for under the POC [percentage-of-completion] method are deferred and recognized based on the labor costs incurred to date, as a Franziska Kraufmann/picture-alliance/dpa/ percentage of the total estimated labor Associated Press costs to fulfill the contract. Certain eligible, nonrecurring costs incurred Companies like IBM must analyze a numin the initial phases of outsourcing ber of factors to determine when to recogcontracts are deferred and subsequently nize costs. amortized. These costs consist of transition and setup costs related to the installation of systems and processes and are amortized on a straight-line basis over the expected period of benefit, not to exceed the term of the contract. Additionally, fixed assets associated with outsourcing contracts are capitalized and depreciated on a straight-line basis over the expected useful life of the asset. If an asset is contract specific, then the depreciation period is the shorter of the useful life of the asset or the contract term. Amounts paid to clients in excess of the fair value of acquired assets used in outsourcing arrangements are deferred and amortized on a straight-line basis as a reduction of revenue over the expected period of benefit not to exceed the term of the contract. The company performs periodic reviews to assess the recoverability of deferred contract transition and setup costs. This review is done by comparing the estimated minimum remaining undiscounted cash flows of a contract to the unamortized contract costs. If such minimum undiscounted cash flows are not sufficient to recover the unamortized costs, an impairment loss is recognized.\" Consider This: 1. 2. Does your company have a complex set of rules for recognizing costs? Must you differentiate costs between services and goods in your company? Source: IBM. (2013). 2012 annual report. Retrieved from http://www.ibm.com/annualreport/2012/bin/assets/2012_ ibm_annual.pdf IBM's Notes to the Financial Statements demonstrate that the company must analyze a number of moving parts to determine its costs of goods sold. For service contracts: It must calculate operating costs for service contracts and costs related to bid and proposal activities. For fixed-price design contracts: It must calculate costs of external hardware and software based on the percentage of completion. The total estimated labor costs to fulfill the contract are calculated; then a percentage of those costs are allocated each period to determine Costs of Goods Sold. The company also calculates transition eps81356_03_c03_097-132.indd 112 3/26/14 12:54 PM Building Blocks of the Income Statement Section 3.2 and setup costs related to the installation of the systems and processes. Fixed assets are capitalized and depreciated on a straight-line basis over the expected useful life of the asset. In addition to a section on service costs, IBM includes a section regarding software costs and how they are calculated. Research and development becomes a critical part of calculating these costs. Hardware costs are not discussed in detail in the note, but these are either calculated as manufacturing costs (if IBM produces the product) or purchased costs (if IBM purchases the product from another company). Similar to how it separates Revenues, IBM differentiates its costs by services, sales, and financing on its income statement, as shown in Figure 3.4. Gross Profit The gross profit number is critical for determining how much profit a company is making from the actual sale of its goods or services before considering the operating expenses. If the company's gross profit is not high enough to cover operating expenses, managers must take actions to fix the problem as soon as it is recognized. There are essentially four ways managers can fix the problem: 1. Managers can recommend that the company increase its prices, if the market will bear it without the company losing too many sales. Sales and marketing managers will need to research competitors' pricing to determine if this is an option. If competitors are charging the same or lower prices, this option will likely decrease sales. 2. Managers can look for opportunities to expand sales into new markets. This will likely mean the company will incur additional sales and marketing expenses, so it needs to carefully analyze the impact of this choice. Sales and marketing managers will need to assess opportunities for expansion and their costs. They will then prepare a report for upper management. 3. Financial and purchasing managers can find a way to decrease costs. They can do this by finding other suppliers with whom they can negotiate a lower price. Another way to reduce costs may be to take advantage of volume discounts when ordering materials. Managers in a manufacturing company may be able to find other ways to reduce manufacturing costs. 4. Managers can recommend that the company lower its prices to increase sales. This may seem counterintuitive, but if the company can reduce its costs by purchasing or manufacturing at greater volumes, lowering the price to increase sales could improve the gross profit. These are the types of decisions companies must make at least yearly, and usually more often, after evaluating periodic financial reports. If managers or executives see gross profit trends moving lower, it is an indication that the company needs to make changes to maintain profitability in the long term. eps81356_03_c03_097-132.indd 113 3/26/14 12:54 PM Section 3.2 Building Blocks of the Income Statement Operating Expenses Recall that companies provide few details about their expenses on public financial reports because companies prefer to reveal as little information as possible on their public reports, because they know their competitors will read them. Now we will take a closer look at the Expense section of the income statement for the Best General Company, as shown in Figure 3.5. Figure 3.5: Expense section of the income statement for Best General Company The operating expenses of a company are shown in the expense section of the income statement. Best General Company Income Statement (Partial) For the Years Ended December 31, 2013, 2012, and 2011 2013 Expenses: Selling, General, and Administrative Expense Research and Development Expense Total Operating Expenses $ $ 22,000 500 22,500 2012 $ $ 21,000 500 21,500 2011 $ $ 20,000 500 20,500 Selling, General, and Administrative Expenses The Selling, General, and Administrative Expenses line item reflects all expenses the company incurs in selling its products or services (including sales commissions and advertising), as well as the expenses it incurs in running all its administrative and sales offices. All salaries and wages, insurance costs, professional fees, rents, office supplies, and other similar types of expenses are also included in this number. If the company operates retail stores, it will include the expenses of running those stores here as well, such as store rents, inventory warehousing, sales associates wages, and utilities. However, recall that because a retail store sells many products, companies cannot match the expenses of operating a retail store to the costs of one product sold. Therefore, retail store operations are considered an expense rather than a cost of goods sold. Note in Figure 3.5 that the Best General Company is experiencing an increase in these expenses. They have increased by $2,000 over the last three years. The budget committee would need to review the accounts that are used to calculate that number to determine eps81356_03_c03_097-132.indd 114 3/26/14 12:54 PM Building Blocks of the Income Statement Section 3.2 where the increases occurred. They would need to determine if there is a way to control these rising expenses by reviewing the accounts where expenses are increasing and determining if there is a way to cut some of these expenses in the next year's budget. Research and Development The Research and Development (R&D) line shows the total spent on investigating the viability and utility of future products. When comparing two companies in a similar industry, this can be a critical number. For example, if one company is spending a great deal more on R&D than the other, it might be seeking to develop more new products or improve the ones it currently sells. A company that is not spending on R&D, or is spending very little, may be too interested in the short-term bottom line and not investing enough money in the future growth of the company. Best General Company incurred the same level of expenses in each of the three years shown on the income statement. The budget committee may determine that R&D needs to be increased to enable the company to research new products. They may recommend that the executives form a committee to review this option and develop a plan for the R&D team. Task Box 3.3: Comparing Research and Development Spending Analyzing Industry Competitors, Part D Calculate the amount spent on R&D at the two companies you've chosen to investigate. Are they spending roughly equal amounts? If not, why not? Hint: You may find some discussion of R&D in the Management's Discussion and Analysis section of the annual report. Other Income and Other Expenses The Other Income line item is usually a catchall section where a company includes income that is not earned from operations. For example, if a company sells a building, a major piece of equipment, or some other asset, the income from that sale is shown here. Generally, items shown are one-time income. The same is true for the Other Expenses line item. Generally, these are one-time rather than recurring expenses that do not involve the day-to-day operations of the company. Figure 3.6 shows the Other Income and Other Expenses section of the Best General Company income statement. eps81356_03_c03_097-132.indd 115 3/26/14 12:54 PM Section 3.2 Building Blocks of the Income Statement Figure 3.6: \u0007 ther income and other expenses section of the income statement O for Best General Company Income and expenses that are not directly related to company operations are shown in the other income and expenses section of the income statement. Best General Company Income Statement (Partial) For the Years Ended December 31, 2013, 2012, and 2011 2013 Other Income Other Expenses Depreciation Expense Income Tax Expense $ 2,500 (900) ( 2,400) (150) 2012 $ 2,500 $ (900) ( 2,400) ( 1,500) 2011 2,500 (900) ( 2,400) ( 1,700) Depreciation and Amortization Expenses In Chapter 2, we discussed the calculation of depreciation and amortization for the purposes of portioning the cost of buying the asset over the life of the asset to better match the expenses with the revenue earned from using those assets. For example, these long-term assets can include buildings, equipment, and other assets held for more than one year. Each year, the amount of depreciation or amortization to be added to the accumulated depreciation line item on the balance sheet is offset by a depreciation or amortization expense. This expense line item is included on the income statement to show the expenses incurred for that year. Net Income As we've discussed, net income (loss) is the \"bottom line.\" This number allows an employee to quickly determine whether a company has made a profit or incurred a loss. Exploring a little of what is behind the numbers on the income statement reveals that there is a great deal to find out about the numbers that lead to the bottom line. Someone who looks only at the bottom line misses a lot of crucial information needed to assess whether a company is profitable. Let's take a closer look at how a manager can determine whether the business is earning a profit. eps81356_03_c03_097-132.indd 116 3/26/14 12:54 PM Profit Types Section 3.3 3.3 Profit Types The most important lines on any income statement are the lines that show whether the company made a profit. There are three key profit line items that enable managers to quickly determine a company's profitability using the multi-step income statement format. These three profit line items are shown in bold on Figure 3.3. Each of these profit line items provides a different type of information. 1. Gross Profit: Shows whether the company made a profit from selling its products or services before considering the expenses of operating the company. The line is shown in the top section with Revenues minus Cost of Goods Sold. 2. Operating Profit: Shows whether the company made a profit after all operating expenses are subtracted. The line is shown below the Expense section. 3. Net Profit (Loss): Shows whether the company made a profit after all operating and non-operating expenses are subtracted. This is the bottom line of the income statement. Using that information, we can test a company's profitability with three ratios: 1. Gross Profit Margin: This indicates how well the company is doing after taking into consideration the cost of goods or services sold. 2. Operating Profit Margin: This indicates how well the company is doing after taking into consideration the operating expenses. 3. Net Profit Margin: This indicates how well the company is doing after taking into consideration all operating and non-operating costs. We will now demonstrate how to calculate these margins and what they mean for managers trying to determine whether their company is profitable. Gross Profit Margin First we will calculate the gross profit margin using the Revenue section of the income statement for Best General Company, shown in Figure 3.7. eps81356_03_c03_097-132.indd 117 3/26/14 12:54 PM Section 3.3 Profit Types Figure 3.7: \u0007 ross profit section of the income statement for G Best General Company The gross profit section shows income after the cost of goods sold are subtracted. Best General Company Income Statement (Partial) For the Years Ended December 31, 2013, 2012, and 2011 2013 2011 $ 100,000 73,000 $ 27,000 Revenue Cost of Goods Sold Gross Profit 2012 $ 110,000 78,000 $ 32,000 $ 120,000 84,000 $ 36,000 The gross profit margin for each of the three years can be calculated by dividing the Gross Profit by the Revenue. The following shows the gross profit margin for each of the three years. Gross Profit Margin 5 Gross Profit Revenues 2013 Gross Profit Margin 2012 2011 $27,000 5 27.0% $100,000 $32,000 5 29.1% $120,000 $36,000 5 30.0% $110,000 Note that the gross profit margin gives the managers of Best General Company a way to quickly see that the company's profit is dropping on the goods it is selling. This is a bad sign for the company. The managers would need to ask accounting for the details of the accounts used to calculate the Revenue and Cost of Goods line items to determine what is driving this downward trend. Some key accounts to review would be: Revenue: Managers would need to determine whether revenue was going up or down. Sales Discounts: Did the company offer more discounts in 2011 than it did in 2013? If more discounts are being offered, managers would need to find out why this is happening. Sales Returns: Are more products being returned? If so, managers would need to determine whether a quality control problem exists or if something else is driving the returns. eps81356_03_c03_097-132.indd 118 3/26/14 12:54 PM Profit Types Section 3.3 Purchases: Is the company paying more for the products, which in turn is increasing the Cost of Goods Sold? If this is the case, managers may seek to find a new supplier, adjust profit expectations, or consider raising prices to cover additional costs. They could consider buying increased volumes to take advantage of volume discounts. In addition, the managers of Best General Company may want to compare the gross margin of the company to the gross margin for the industry to see how well the company is doing compared to its competitors. If the gross margins are significantly lower, more research would be needed to determine what the company can do to improve its performance. The marketing and sales manager would want to compare Best General's revenue results to those of its competitors. The purchasing manager may want to take a closer look at the company's Costs of Goods Sold compared to its competitors. All managers may want to review the key competitors' annual reports to find out how they are doing and possibly discover information that could be used to develop recommendations for improving the results of the Best General Company. For example, in reading the details in the annual reports of one company, the marketing manager may read information that gives her an idea for a new product line or new marketing campaign. Task Box 3.4: Calculating Gross Profit Margin Analyzing Industry Competitors, Part E Calculate the gross profit margin for the last five years for the companies you have chosen to research. Is gross profit going up or down? Are sales going up or down? Are costs going up or down? Determine from these numbers whether the companies are improving their profitability. Why did you come to that conclusion? Operating Profit Margin The managers would next want to determine whether the company is still making a profit after subtracting all its operating expenses. The operating profit margin indicates how much profit a company is making after taking all operating expenses into consideration. Figure 3.8 shows the Expenses section, followed by the Operating Profit line, for Best General Company. eps81356_03_c03_097-132.indd 119 3/26/14 12:54 PM Section 3.3 Profit Types Figure 3.8: \u0007 xpenses and operating profit section of the income statement for E Best General Company The operating profit section of the income statement shows profit after all operating expenses have been subtracted. Best General Company Income Statement (Partial) For the Years Ended December 31, 2013, 2012, and 2011 2013 Operating Profit $ 110,000 78,000 $ 32,000 $ 120,000 84,000 $ 36,000 $ 22,000 500 22,500 $ 21,000 500 21,500 $ 20,000 500 20,500 $ Expenses: Selling, General, and Administrative Expense Research and Development Expense Total Operating Expenses 2011 $ 100,000 73,000 $ 27,000 Revenue Costs of Goods Sold Gross Profit 2012 4,500 $ 10,500 $ 15,500 To calculate the operating profit margin, divide the operating profit by revenues shown in Figure 3.8. The results are shown in the table below. Operating Profit Margin 5 Operating Profit Revenues 2013 Operating Profit Margin 2012 2011 $4,500 5 4.5% $100,000 $10,500 5 9.5% $110,000 $15,500 5 12.9% $120,000 The Best General budget committee members can quickly see that the downward trend is even more significant when operating expenses are considered. The company was making an operating profit of 12.9% in 2011, and it is now down by more than half, to 4.5%. The managers would want to take a closer look at expenses to see which expenses are increasing and ask for more detail from the accounts that are used to calculate those line items. The key line item that shows increasing expenses is the Selling, General, and Administrative Expenses line item in Figure 3.8. Many accounts are used to calculate that line item, including selling expenses, office expenses, salaries expense, insurance expenses, and so on. eps81356_03_c03_097-132.indd 120 3/26/14 12:54 PM Section 3.3 Profit Types The Best General budget committee should ask to see a detailed report of all the accounts that are used to calculate Selling, General, and Administrative Expenses and investigate which ones are contributing to the increase in these expenses. It is important for a company to maintain a high operating profit margin. This gives the company more price flexibility during an economic downturn. Why? Because with higher operating profit margins, the company has the option to cut prices if needed to attract more business. It therefore has the flexibility needed to be competitive no matter how bad an economic downturn may be. Net profit may go down, but the company will have no trouble staying in business. Net Profit Margin The third key profit test is net profit margin, which looks at how well the company has done overall, considering both operating and non-operating activities. Non-operating activities can be as simple as interest income or expense, or they can be much more significant, such as the expenses related to the discontinuation of a product line or the closure of a plant. Figure 3.9 shows the non-operating expenses and the net profit for Best General Company. Figure 3.9: \u0007 on-operating expenses and net profit section of the income N statement for Best General Company Expenses not directly related to the company operations are shown in the non-operating expenses section of the income statement. Best General Company Income Statement (Partial) For the Years Ended December 31, 2013, 2012, and 2011 2013 Other Income $ 2,500 (900) (2,400) (150) $ $ 3,550 $ Other Expenses Depreciation Expense Income Tax Expense Net Profit eps81356_03_c03_097-132.indd 121 2012 2011 $ 2,500 (900) (2,400) (1,700) 8,200 $ 13,000 2,500 (900) (2,400) (1,500) 3/26/14 12:54 PM Section 3.3 Profit Types To calculate the net profit margin, divide the net profit by revenues. The results for Best General Company are shown in the table below. Net Profit Margin 5 Net Profit Revenues 2013 Net Profit Margin 2012 2011 $3,550 5 3.6% $100,000 $8,200 5 7.5% $110,000 $13,000 5 10.8% $120,000 The budget committee of Best General Company can see the company is barely making a profit of 3.5%. If the Other Income of $2,500 from non-operating sources were not available, the net profit would be only $1,050, or just above 1%. Any drop in revenues could mean the company would show a net loss rather than a net profit. Clearly, Best General Company needs to make some major changes to improve its profitability. In addition to reviewing the key accounts as discussed above, the budget committee members may also want to compare Best General Company's results with other companies in the same industry. They can do this by researching key industry statistics. Chapter 6 discusses analyzing financial results in more depth. Task Box 3.5: Industry Benchmarks One way to compare a company's results to industry statistics is by using the website BizStats.com. There you can search for industry financial benchmark reports and get industry profitability risk data as well as industry statistics. To see how IBM is doing, for example, you can use BizStats.com to find industry profit and loss benchmarks as follows: 1. 2. 3. 4. Select the company structure: Corporation (for IBM) Input annual sales: $104,507,000,000 (no commas when entering on the website) Pick industry: Professional-Scientific-Technical Services Pick specific industry: Computer systems design and related services You will then get industry income-expense statement benchmarks, as well as industry balance sheet benchmarks. The gross profit margin benchmark in this industry category is 72.67%. IBM is not a perfect match for this industry, since it also manufactures and sells hardware. Therefore, you might also want to find the benchmarks for computer manufacturing. However, when it comes to the bottom line, IBM is doing much better than others in this industry. This industry's net profit benchmark is 9.21%, whereas IBM's is 15.9%. (continued) eps81356_03_c03_097-132.indd 122 3/26/14 12:54 PM The Elements of a Statement of Shareholders' Equity Section 3.4 Task Box 3.5: Industry Benchmarks (continued) You can also examine IBM's results on the manufacturing side using BizStats.com: 1. 2. 3. 4. 5. Select the company structure: Corporation (for IBM) Input annual sales: $104,507,000,000 Pick industry: Manufacturing Pick specific industry: Computer and electronic product manufacturing Pick specific industry once more: Computers and peripheral equipment In the manufacturing industry segment, the gross profit margin is much lower than in the services industry. The gross profit margin is 38.91%. Remember that Cost of Goods Sold will always be much higher for a company that is manufacturing its products than for a service industry that has much lower cost of services sold. The net profit for the manufacturing sector is just 8.98%. IBM far exceeds the net profit here, as well. Practice using Bizstats.com by finding the benchmarks for your company or a company in which you are interested. How do those companies compare to others in their industry sectors? 3.4 The Elements of a Statement of Shareholders' Equity At the bottom of the income statement or on another page, a statement of Shareholders' equity is shown. This statement indicates how shareholders were affected by the company's results for the year. It also indicates other changes that might impact claims owners have against the company, such as the issuance of new stock or the buyback of stock already on the market. The first line is always the balance in each of the accounts that make up Shareholders' equity: Common Stock and Additional Paid-in Capital, Retained Earnings, Treasury Stock, Accumulated Other Comprehensive Income (Loss), and Non-controlling Interests. The bottom line of this statement is Total Equity. Figure 3.10 shows the statement of Shareholders' equity for Best General Company. Note that the net earnings from the income statement match the retained earnings on the statement of Shareholders' equity. Net earnings not paid out in dividends to the shareholders are held as retained earnings. The retained earnings total is an historical account that tracks all money reinvested into the business over the years. eps81356_03_c03_097-132.indd 123 3/26/14 12:54 PM Section 3.4 The Elements of a Statement of Shareholders' Equity Figure 3.10: Best General Company statement of shareholders' equity Details of the claims owners have against the assets of the company are shown in the statement of Shareholders' equity. Best General Company Statement of Shareholders' Equity For the Year Ended December 31, 2013 Number of Common Stock Issued Balance as of December 31, 2012 Common Stock and Paid-in Capital Retained Earnings Total Shareholders' Equity 2,000 shares $20,000 $3,900 $23,900 3,550 3,550 0 0 $7,450 $27,450 Net Earnings Cash Dividends Balance as of December 31, 2013 2,000 shares $20,000 The statement of shareholders' equity for Best General Company is relatively simple. On a major corporation's, however, there will be line items not shown here. Let's review the line items that can appear on a statement of shareholders' equity and what they show. Common Stock and Additional Paid-In Capital Public and private corporations divide the ownership of the company using shares of stock. Most of these shares are called common stock. Common shareholders can participate in the election of a board of directors and can vote on company policy. Most common shareholders in a major corporation own such a small share in the company that their vote holds little weight. The common shareholders of a small company often own a significant portion of the common stock of the company, often have a role on the Board of Directors, and possibly hold a position in upper management. eps81356_03_c03_097-132.indd 124 3/26/14 12:54 PM The Elements of a Statement of Shareholders' Equity Section 3.4 When common stock is first set up, a share value called \"par value\" is established. When the stock is first sold to investors, any money collected above the par value is listed as \"additional paid-in capital.\" So if a stock has a par value of $10 and 100 shares are sold for $20 each, the value of the common stock shown on the statement of Shareholders' equity would be $1,000 and the value of paid-in capital would be $1,000. Best General Company, when formed, set its par value at $10 per share for a total of $20,000 in common stock. Since it is a small company, it was not sold on the stock market. Its shareholders are the partners who started the company. Their proportion of ownership is based on the number of shares each partner owns. For example, if Partner A owns 500 shares, it means he invested $5,000 (500 x $10 per share) in the company to buy those shares. This section of a statement of Shareholders' equity can get very complex for a large corporation, especially if it issues stock at different prices. Another line item may show stockbased compensation. This reflects stock that was awarded to employees as part of their compensation plan. Other Line Items Some companies will have additional line items. For example, if there is preferred stock issued, there will be a line item detailing the value of the preferred stock, similar to the line item for common stock. We discussed preferred stock in Chapter 2. We also discussed treasury stock in Chapter 2. Any transactions involving the buying back of stock or reissuing of stock will be detailed in a line item on this statement. Non-Controlling Interests Sometimes there is a line item called Non-Controlling Interests. This line item shows ownership held in companies in which the holding company has no controlling interest. A company generally must hold between 5% and 10% of another company before it can push for a seat on the board and obtain some control. Let's now turn our attention to how we can use the information on the income statement to analyze some basic trends for a company using a common-sized