The Income Statement (Sections 2.7 - 2.12)

Amortization

The allocation of the cost of intangible assets over the number of years that these assets are expected to help generate revenue for the company (i.e. basically depreciation, but for intangible assets).

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What are some of the main types of intangible assets?

Customer lists; franchise, memberships, licenses; patents & technology; trademarks and goodwill (indefinite useful life, not amortized —> won’t be incl. on income statement)

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For internally-generated intangible assets (e.g. patents, trademarks), are _____________ (i.e. _____________).

fully expensed ; no amortization

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Since trademarks have an indefinite useful life, they are _____________ as an expense on the income statement.

not recorded

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Like depreciation and amortization expenses, stock-based compensation (SBC) is __________ within the expense categories based on ___________.

embedded ; employee’s job function/employee’s regular cash compensation (e.g. corporate manager / salesperson’s salary in SG&A, software engineer in R&D, factory supervisor of tire manufacturer in COGS)

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SBC is a __________ form of compensation.

non-cash

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Like depreciation, there is no line item on the IS for SBC. Instead, it is included in ____________. However, SBC is identified separately on the ____________.

operating expenses in which the employee is classified ; cash flow statement

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Other Operating Expenses/Income

Companies will sometimes recognize expenses (or income) on the IS that, while still related to operating activities, are a little less typical. Examples:

• Gains/losses on sale of fixed assets

• Gains/losses from a legal settlement

• Restructuring expenses and severance costs

• Losses due to inventory spoilage (inventory write-down)

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Where are “other operating expenses/income” classified on the IS?

Unless these items are immaterial, they’ll usually be embedded in larger operating expense categories (e.g. SG&A), or in a separate line item (“Other operating expenses”). They’ll sometimes be mentioned in press releases by companies (called “non-GAAP” reconciliation). When the expense or income is very large, it may have its own separate line item.

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Non-operating income and expenses

Companies also generate income and expenses not directly tied to the core operations of their business.

• On the IS, this would be all line items below Operating Income

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Interest Expense and Interest Income

• Interest Expense: payments the company makes for its outstanding debt (owed to banks or other lenders)

• Interest Income: a company’s income from its cash holdings and investments (stocks, bonds, and savings accounts)

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Interest Expense is often presented on the IS as ___________.

Net Interest Expense

• Sometimes, interest income and expense are netted against one another when presented on the income statement

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Other Non-Operating Income/Expenses

Represents expenses/incomes that are not tied to the core operations of the business or are unusual (e.g. decreases in value and losses on sale on certain investments and debt).

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Where are “Other Non-Operating Income/Expenses” found on the IS?

Often netted together as a single line item on the IS as “Other non-operating income, net” while a breakdown of what’s inside may (or may not) be disclosed in footnotes.

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Under US GAAP and IFRS, companies report tax expense as a _____________ on the IS (usually below a line item called ____________ or _____________).

separate line item ; “Pretax Income” ; “Income before provision for income taxes”

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⭐️ Tax expense ___ cash taxes paid!!! This is because ____________.

≠ ; companies defer certain taxes (current vs. deferred in IS footnotes) due to a number of reasons (country’s tax code accounting “tax rules” vs. “book rules” from US GAAP/IFRS/etc. —> companies generating separate financial reports)

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Net Income

The final measure of profitability on the IS. It represents income after all expenses have been paid. Also called:

• Net earnings

• Net profit

• “Bottom line”

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Shares Outstanding (what is it, who owns it, and what are they entitled to)

The number of shares of common stock outstanding (i.e. the shares owned by actual shareholders). Shareholders usually include company founders, investors, management, and other employees of the firm. They are usually privy to company decisions based on the proportion of shares owned (e.g. 100 shares = 100 votes) as well as receiving dividends.

Note: companies are not required to pay dividends

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Treasury Stock

Shares that have been issued, but subsequently repurchased by the company and are no longer outstanding.

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State the equation for shares outstanding.

Shares Outstanding = Shares issued - Treasury stock

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What is the difference between basic shares outstanding and diluted shares outstanding? Which is the one analysts pay the most attention to?

Basic: includes only actual shareholders

Diluted: includes both actual shareholders and the impact of potentially dilutive security holders (i.e. could potentially be actual shareholders) such as stock option holders, convertible preferred stock, and convertible debt

Diluted is preferred when calculating EPS (earnings per share) since it’s considered to be more “real.”

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State the equation(s) for Earnings Per Share (EPS).

Basic EPS = Net Income / Basic shares outstanding

Diluted EPS = Net income / Diluted shares outstanding (preferred)

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Since the total number of shares outstanding fluctuates as shares from other securities are converted or the company repurchases shares, companies usually show the number of shares outstanding on the IS as a ____________ during the period of the IS (quarter or year).

weighted average of the amount of shares outstanding

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Dividends

A portion of the company’s net income that’s set aside and portioned out to the company’s shareholders (usually on a quarterly basis) in the form of cash.

Note: companies aren’t obligated to issue dividends; the dividend policy is set the BOD and disclosed in the company’s financial statements

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What metrics do analysts focus on when measuring company profitability?

EPS, EBIT, and EBITDA

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Why is EBITDA usually preferred over EBIT?

1. Adding back D&A allows for a more accurate picture of a company’s profits since D&A is a huge non-cash expense.

2. Useful for comparing companies; since companies vary in useful life assumptions and depreciation methods to calculate D&A, this can skew comparisons of profitability for two similar companies.

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Why should EBITDA not be used as a measurement of cash?

EBITDA is a blend of cash and accrual accounting (i.e. there are non-cash items embedded in EBITDA that prevents us from obtaining an accurate picture of a company’s cash flow).

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Where can we find D&A?

The cash flow statement

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How do we calculate EBITDA using financial documents?

Look at a company’s IS and subtract COGS and SG&A from Revenue. Then, go to the cash flow statement and find D&A. Add D&A back to the earlier result to obtain EBITDA.

Note: EBITDA is not a GAAP-recognized metric like EBIT (which can be found on the IS), so we must calculate it separately.

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