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Needed: Lots More Detail
Management and the other interested parties that you read
about in chapter one (including you) need lots more detail than
this skeleton shows.
Figure 2-1 on page 22 shows a fictitious income statement
for a company we™ll call Avaricious Industries. It™s a modest little

firm that, if it lives up to its mission statement, hopes to control
every aspect of your life someday.
To create a detailed income statement, useful for internal re-
porting and control, A.I.™s accounting department and manage-
ment information systems would compile detailed information
in categories like:
Gross sales, sales returns and allowances, and sales discounts

that went to produce net sales.
Information about the methods that were used to value

inventory and calculate depreciation on machinery and
Individual balances for each of the selling and general-and-

administrative expense accounts. Management needs to track
the changes in each account from one period to the next
and decide whether a particular expense is getting out of
control or if the company should spend more money to
meet marketing challenges from competitors.
A.I.™s income statement as shown here is relatively simple for
a company its size. It would also have a version for internal use
that lists every expense account and greater detail in areas like
cost of goods sold.

A Word About Accounting Jargon
When it comes to jargon, accounting”like data processing,
law, and other highly specialized areas”has its own. Pity. You
have to get used to the fact that several different terms mean the
same thing or refer to the same idea. This can drive you nuts
unless you™ve been forewarned.
So, while not putting too fine a point on it:
Revenue and sales are used synonymously. Accountants may

prefer “revenue” because it sounds more impressive and helps
them defend billing $100 an hour.
Profit, net income, and earnings all refer to how much

money the company made.
Understand the Income Statement

Inventory, merchandise, and goods all mean about the same

thing: stuff the company bought and intends to sell to cus-
tomers for a profit.
When accountants speak casually (an event so moving that

it merits immortalization in
BT est
a Normal Rockwell print),
they may call an income
statement a “profit and loss” Don™t look for detail on an
or “P&L” statement. That™s income statement. Account
because it indeed shows balances are often condensed
whether the company made and summarized.
a profit or a loss.
Lists or summaries of things

like expenses or equipment are typically referred to as “state-
ments” or “schedules.” Just don™t try to read one to find out
when the next bus runs.
Accountants never just “do” or “make out” these statements

or schedules. Heavens, no.They prepare them. It sounds much
more dignified, mystical, and professional”and beyond the
reach of mere mortals. And they never charge you money.
They have fees for which they send “statements for services
rendered.” All these discreet euphemisms sound genteel and
politically correct, but it™s easy to see past the smoke screen.

A Closer Look
So much for an overall view. Climb up on your stool, don
your green eyeshade, and let™s have a close-up look at Figure 2-1.
Net sales (or revenue). As mentioned, this is what was really
sold after customers™ returns, sales discounts, and other allow-
ances were taken away from gross sales. Companies usually just
show the net sales amount on their income statements and don™t
bother to show returns, allowances, and the like.
Cost of goods sold. This usually appears as one amount on
an annual report, but it takes a little figuring to come up with.
Let™s see how we arrived at the numbers by taking a closer look:

Figure 2-1

Avaricious Industries
Consolidated Earnings Statement
For Year Ended December 31, 19XX

Net sales $38,028,500
Cost of goods sold:
Inventory, January 1 4,190,000
Purchases (net) 25,418,500
Goods available for sale 29,608,500
Less inventory, December 31 3,250,000
Cost of goods sold: 26,358,500
Gross profit 11,670,000
Operating expenses
Sales salaries expense 1,991,360
Advertising expense 3,527,650
Sales promotion expense 987,745
Depreciation expense”
selling equipment 403,850 6,910,605
General and administrative:
Office salaries expense 1,124,650
Repairs expense 112,655
Utilities expense 39,700
Insurance expense 48,780
Equipment expense 63,750
Interest expense 211,020
Misc. expenses 650,100
Depreciation expense”
office equipment 73,900 2,324,555
Total operating expenses 9,235,160
Earnings before income tax 2,434,840
Income tax 925,239
Net income $1,509,601

Common stock shares outstanding: 2,500,000
Earnings per share of common stock: $0.60
Understand the Income Statement

Inventory, January 1 $4,190,000
Purchases (net) 25,418,500
Goods available for sale 29,608,500
Less inventory, December 31 3,250,000
Cost of goods sold: $26,358,500
The January 1 inventory was the goods that Avaricious started
the year with, but the company bought lots more to resell dur-
ing the year. Again, details such as purchases returns and allow-
ances may be omitted, so just the net amount of purchases shows
up on the statement.
New purchases are added to the beginning inventory to get
the dollar amount of goods available for sale. That™s what the
company paid for everything it could have sold this year if it
were down to the bare shelves. But it™s not; it has an inventory of
goods still on the shelves on December 31. When that ending
inventory is subtracted from goods available for sale, Bingo! You™ve
got the cost of goods sold.
Note: Avaricious Industries is”for now”a distributor. It buys
finished goods and resells them to retail stores and individuals.
But Avaricious hopes one day to live up to its name and actually
make things. When that happens, its cost of goods sold will be
made up of purchases of raw materials, finished components,
and a bunch of other things like the labor that goes into pro-
ducing what it makes.
Gross profit. How much the company made before expenses
and taxes are taken away.
Operating expenses. This section of the income statement adds
up how much money was spent to run the company this year.
Selling expenses include everything spent to run the sales end
of the business, like sales salaries, travel, meals and lodging for
salespeople, and advertising.
General-and-administrative expenses are the total amount
spent to run the non-sales part of the company. These expenses
include rent, office salaries, interest on loans, depreciation, and
any other non-sales expenses such as renting stretch limos and
chauffeurs for top managers.

Earnings before income tax. This is the profit the company
made before income taxes (sob).
Income tax. What the company had better have paid the
IRS if it wants to stay in business.
Net income. (Bet you thought we™d never get here.) This is
the profit the company made after all the dust clears. If the busi-
ness lost money (a thought that makes accountants break out in
hives), this line would be labeled “Net loss,” and several scape-
goat middle managers would probably be flogged publicly in
front of the fountain at corporate headquarters.
Earnings per share of common stock. You™ll find out more
about this item when we get to
BT financial analysis and start uncov-
ip ering hidden information on the
statements. For now, let™s just di-
Read the notes in an annual
vide the net income by the num-
report. That™s where the
ber of shares of common stock
bodies are buried.
the company has sold (shares
The higher earnings per share are, the more spectacular job
management is doing running “your” company”if you own
shares. (Just don™t ask to borrow that stretch limo for the week-
end. Your picture will show up in the executive dining room as
“Moron Stockholder of the Month.”)

A Note About Notes
Every annual report has several pages of notes at the end.
These discuss finer points about its operations and accounting
Such notes would explain which methods were applied to
calculate certain items, the Generally Accepted Accounting Prin-
ciples (GAAP) followed, and a variety of other arcane informa-
tion that may contain some real eye-opening facts if you can
read them without falling asleep. Good luck!
For example:
Understand the Income Statement

1. Notes might point out that 20 percent of this year™s sales
are the proceeds from selling off one of the Picasso paintings in
the boardroom. Such one-shot deals/isolated or unusual trans-
actions may make the company™s financial condition look better
or worse than it normally would.
2. Notes may also reveal information about lease contracts
for facilities or office equipment (which may require payments
of several million dollars a year) that the company has agreed to
pay for the next few years. This information may have a major
impact on future profits if sales decline or the annual payments
are scheduled to escalate.
3. Notes should disclose if the company has been named as a
defendant in any product-liability, environmental-pollution, an-
titrust, or patent-infringement lawsuits. They should also discuss
its likely “exposure” (how much of its shirt the company may
lose, including attorneys™ fees) if the other side wins. In these
cases, the notes should also discuss what amount of the potential
loss is covered by insurance and whether losing the case would
have a “material adverse affect” (as it™s sometimes called) on the
company™s financial condition.

The Agile Manager™s Checklist
An income statement covers a period of time, like a
quarter or a year. By subtracting various expenses from
sales, it reveals the fabled “bottom line.”
“Revenue” and “sales” are synonymous. So are “net
income,” “profit,” and “earnings.”
Gross profit is sales minus cost of goods sold. Net profit
(or net income) is gross profit minus expenses and taxes.
Chapter Three

The Balance Sheet


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