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Income Statement: Results of
Operating Performance
15
...

SEC requires quarterly reporting
...
Is that the case?

4

Financial Accounting Principles:
Objectivity and Conservatism
Objectivity: financial accounting information must be
verifiable and reliable
...
Why?
Management’s incentive to report good information, hide bad
information
Asymmetric payoff to bondholders
Credibility of information in valuation

Conservatism does not suggest that financial statements
should arbitrarily understate assets and overstate liabilities
...
g
...

Losses
Other revenues and expenses
Interest revenue, dividend income, interest
expense for a manufacturing or merchandising
firm
...
Toward this end, two key principles
are
Revenue Recognition:
Earnings process substantially complete
Cash collection reasonably assured
Conservatism principle is applicable

The Matching Principle for Expenses:
Match efforts to the benefits generated
Capitalize expenditures that will benefit future periods,
expense as benefits are realized
Recognize liabilities when efforts benefiting the current
period require cash payment in the future
Produces a difference between cash flows and earnings

7

*

Matching Example
Blockbuster video buys a copy of the Matrix
Reloaded video for $20
...


Buy Video

13

Recording video expenses
Cash
Buy Video (20)

Video Asset
20

Retained Earn
...


Rent 50x
@$3each

15

Recording video expenses
Buy Video
Rent 50x
@$3each

Cash
(20)
150

Video Asset
20

Retained Earn
...


150

End of Y1

17

Recording video expenses
Buy Video
Rent 50x
@$3each
End of Y1

Cash
(20)

Video Asset
20

150

Retained Earn
...


150
(15)

(15)

19

Recording video expenses
Buy Video
Rent 50x
@$3each
End of Y1
Rent 17x
@$3each

Cash
(20)

Video Asset
20

150

150
(15)

51

Retained Earn
...


(15)
51

21

Recording video expenses
Buy Video
Rent 50x
@$3each
End of Y1
Rent 17x
@$3each
End of Y2

Cash
(20)

Video Asset
20

150

Retained Earn
...


150
(15)

51

(15)
51

(5)

Total video expenses = $20

(5)
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Recording video expenses
Estimate 1 and Estimate 2
Buy Video
Rent 50x
@$3each
End of Y1
Rent 17x
@$3each
End of Y2
End of Y3

Cash
(20)

Video Asset
20

150

Retained Earn
...

Assets
= L + OE
Cash
Inventory
-10,000 +10,000
Exchange of one asset for another asset
Operating outflow = $10,000
25

What is Cost of Goods Sold?
Freshest Grocer sold one-half of the cereals
for $8,000 cash
Assets
=
L + Owners’ Equity
Cash
Retained Earnings
+8,000
+8,000
What is the most significant matching
expense?
26

What is Cost of Goods Sold?
The cost to Freshest Grocer of buying the
cereal that was sold for $8,000
one-half of $10,000 = $5,000
= Cost of Goods Sold or Cost of Sales
Assets = L + Owners’ Equity
Inventory
Retained Earnings
-5,000
-5,000

27

What is Gross Profit or Margin?
Assets
= L + Owners’ Equity
Cash Inventory
Retained Earnings
-10,000 +10,000
+8,000
+8,000
-5,000
-5,000
Increase in retained earnings
+3,000
Gross Profit or Margin = Sales Revenue (-)
Cost of Goods Sold = $3,000
GM rate = $3,000/$8,000 = 37
...

The below-the-line items are each shown net
of income tax
...
"2002 Annual Report
...
C-4
...
"2002 Annual Report
...
C-6
...
e
...

In 1997, A’s total income was $100,000 (M
earned $70,000 and N earned $ 30,000)
All numbers are assumed after tax
33

Advantages of Income Statement
Components
1997 Net Income (= ICO) = $100,000
In 1998, the total income was $100,000 also
...

On December 31, 1998, Firm A decides to
discontinue the business segment N
...

i
...
, it will generate $15,000 less cash compared
to the net book value of the assets of segment N
...
Ops
...
Ops
...
Ops

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