The Foundation
2.3 Income Statement
Concept Check 2.2
1 What is the basic accounting identity followed in a firm’s balance sheet?
2 An analyst suggests that firms should use market value amounts on the balance sheet. What are some of the advantages and disadvantages of this approach?
3 Why may items based on historical cost differ from their market values?
26 THEFOUNDATION
The Home Depot, Inc. and Subsidiaries
Fiscal Year Ended
Amounts in millions, except per share data February 2, February 3, January 28,
2003 2002 2001
Net sales $58,247 $53,553 $45,738
Cost of merchandise sold 40,139 37,406 32,057
Gross profit 18,108 16,147 13,681
Operating expenses
Selling and store operating 11,180 10,163 8,513
Pre-opening 96 117 142
General and administrative 1,002 935 835
Total operating expenses 12,278 11,215 9,490
Operating income 5,830 4,932 4,191
Interest and investment income 79 53 47
Earnings before interest and taxes 5,909 4,985 4,238
Interest expense 37 28 21
Earnings before provision for income taxes 5,872 4,957 4,217
Provision for income taxes 2,208 1,913 1,636
Net earnings $3,664 $3,044 $2,581
Weighted average common shares 2,336 2,335 2,315
Basic earnings per share $1.57 $1.30 $1.11
Diluted weighted average common shares 2,344 2,353 2,352
Diluted earnings per share $1.56 $1.29 $1.10
Figure 2.3 Consolidated statements of earnings
With total operating expenses of $12,278 million, Home Depot reports an operating income of $5,830 million for the period. Home Depot breaks down its operating expenses into selling and store operating, pre-opening, and general and administrative expenses. Analysts pay close attention to a firm’s operating income because it provides an important indication of the firm’s profitability from its continuing operations before considering other income or expenses. Examining the trends in a firm’s operating income may provide a good indication of its past continuing operations and may also provide a basis for extrapolating future operating profitability.
As we will show later when we examine the balance sheet, Home Depot uses a limited amount of debt financing and has a low interest expense of $37 million in fiscal year 2002.
When firms borrow, they repay the lender by making a debt payment that consists of both interest expense and a portion of the principal repayment. The interest expense is subtracted on the income statement to arrive at a firm’s income before tax. Thus, the interest expense associated with debt financing is a tax-deductible expense. In addition to paying interest on its debt, Home Depot receives interest and income on its investments that exceed the tax-deductible interest that it pays. We find that Home Depot actually earned more interest
on its investments than it paid ($79 million earned versus $37 million paid in fiscal year 2002) in the income statement periods shown in Figure 2.3.
With earnings before tax of $5,872 million and an income tax provision of $2,208 million, Home Depot reports net earnings (commonly referred to as net income) of $3,664 million for fiscal year 2002. This represents an increase of 20.4 percent over the $3,044 million net income that Home Depot earned in fiscal year 2001 and a 42.0 percent increase in the
$2,581 million net income reported in fiscal year 2000. The net income generated by a firm is either paid out as dividends to common or preferred stockholders or reinvested into the firm as retained earnings (stockholders’ equity account on the firm’s balance sheet).
Analysts and investors pay close attention to the earnings per share reported on a firm’s income statement. The presentation of earnings per share figures depends on whether the firm has a simple or complex capital structure. A simple capital structure occurs when a firm is financed only with common stock and other non-convertible senior securities. That is, the firm’s financing structure does not contain any potentially dilutive securities. This firm will report basic earnings per share, which is calculated by dividing the net income less any preferred dividends paid out by the weighted average number of outstanding shares of common stock.
Basic EPS =
Net income Preferred dividends Weighted average common shares
− (2.2)
Firms with complex capital structures have potentially dilutive securities such as convert- ible securities, options, and warrants that could potentially dilute earnings per share. These firms must report both basic and diluted earnings per share figures. The diluted earnings per share figure provides a more conservative earnings estimate by assuming the total shares of common stock in the denominator includes all shares of common stock plus future potential shares from the likely future conversion of outstanding convertible securities, stock options, and warrants.1
With approximately 2,336 million shares of common stock outstanding, Home Depot reports its basic earnings per share as $1.57 per share for fiscal year 2002. Home Depot also reports diluted earnings per share of $1.56 by using 2,344 million shares assuming dilution.
The calculations are summarized below:
Basic EPS = Net income / Number of shares of common equity Basic EPS = $3,664 million / 2,336 million = $1.57 per share
Diluted EPS = Net income / Number of shares of common equity assuming dilution Diluted EPS = $3,664 million / 2,344 million = $1.56 per share
The calculation of diluted EPS includes potential future common shares from the likely future conversion of outstanding stock options and warrants in the denominator of the EPS calculation.
1 Most financial accounting textbooks provide explanations of how to calculate diluted earnings per share.
28 THEFOUNDATION
Net Income versus Cash Flow
The net income reported on a firm’s income statement typically does not equal the actual net cash flow generated by that firm over the particular time period. Net income and actual net cash flow may differ because accountants use an accrual accounting process for recog- nizing revenues and expenses, and because of the treatment of depreciation and taxes. We discuss each of these items in the following sections.
Accrual accounting
Firms normally record revenues on their income statement when the sale is made, not when the cash is actually collected from that sale. Firms recognize the expense of producing an item when the activity that generates the expense is performed, not when the firm actually pays out the cash for that expense. Accountants refer to recognizing the timing of revenues and expenses in this manner as accrual accounting. Under an accrual accounting process, for a given reporting period, the cash receipts from sales will not equal the revenue re- ported, nor will the cash disbursed equal the expenses recognized.
We cannot tell directly from a firm’s income statement how these timing differences may cause net income and cash flow to differ. But we can get a good idea if we also examine the firm’s balance sheet. Home Depot, for example, lists its accounts receivable (net) in the fiscal years ending on February 3, 2002, and February 2, 2003, as $920 million and $1,072 million, respectively, an increase of $152 million. Thus, about $152 million of the $58,247 million in net sales in the fiscal year ending in February 2003 (fiscal year 2002) did not represent actual cash inflows for Home Depot. Similarly, increases or decreases in accounts payable and accrued expenses between the balance sheet dates February 3, 2002, and February 2, 2003, indicate that the expenses reported on their income statement for fiscal year 2002 do not represent the actual cash outflows associated with these expenses during the fiscal year.
Moreover, the cost of goods sold on a firm’s income statement for a given year reflects only the expenses for goods that the firm actually sold during the year. Thus, any cash outflows associated with the increase in merchandise inventories are not included as ex- penses until the items are sold. With the large increase in merchandise inventories from
$6,725 million on February 3, 2002, to $8,338 million on February 2, 2003, the expenses listed on the income statement probably understate the actual cash outflows incurred by the firm for these expenses during the year (unless, of course, Home Depot has not yet paid their suppliers for these inventories). We will examine more closely how to disentangle these differences between net income and cash flow when we examine the Statement of Cash Flows in a later section.
Depreciation
An income statement usually includes several non-cash expenses of which the most common include depreciation and amortization. When a firm makes capital expenditures for long- term fixed assets, such as for plant and equipment, it normally cannot include the entire expense for these purchases during the year in which the capital expenditures are incurred.
Instead, the firm must spread or allocate that capital expenditure over a future period of time that reflects the estimated life of the tangible asset. Thus, depreciation is the allocation of the cost of property, plant, and equipment over its useful life. Similarly, firms spread the cost of intangible assets, such as patents and brand names, over future years in a process referred to as amortization.
For example, if a firm purchased some equipment for $13 million that has an estimated life of 5 years and an estimated salvage value of $3 million, the firm might use the straight- line method of depreciation to obtain a depreciation expense of $2 million each year over the 5-year life of the equipment.
Annual depreciation (straight-line) =
Original cost Estimated salvage value Estimated life in years
− (2.3)
Annual depreciation (straight-line) =
$13 million $ million 5 Years
− 3 = $2 million
Of course, these future depreciation expenses do not represent actual net cash flows in the years in which they are reported on the firm’s income statement – the cash flow occurred in the year in which the firm paid for the purchased equipment. Table 2.1 summarizes these timing differences between the actual cash flows and the depreciation reported on the income statement.
Home Depot does not list its depreciation expense separately on its income statements, but includes depreciation expense under General and Administrative expenses. Home Depot reports a combined depreciation and amortization of $903 million on its Statement of Cash Flows for fiscal year 2002 (refer to Figure 2.4). In Note 1 in the Notes to Consolidated Financial Statements in the Annual Report, Home Depot provides some additional information on its depreciation and amortization. We discuss other useful information provided in the Notes to the Financial Statements section of an Annual Report in Section 2.7.
Table 2.1 Timing differences: Actual cash flow versus depreciation on income statement
Year Cash flow Depreciation on income statement
0 $10 million –
1 – $2 million
2 – $2 million
3 – $2 million
4 – $2 million
5 – $2 million
30 THEFOUNDATION
Taxes
Home Depot reports an income tax expense of $2,208 million on its fiscal year 2002 income statement. However, the actual income tax paid by Home Depot differs from this amount.
Many differences exist between treatments of items under tax and book accounting. These differences are reflected in what is shown on the financial statements and what is paid to the Internal Revenue Service (IRS). One example is the different depreciation methods allowed for tax purposes as opposed to book (financial statement) purposes:
• When preparing the income statement for the public, firms tend to use straight-line depreciation over periods of time that reflect the estimated lives of the assets being depreciated.
• When determining taxable income for the IRS, firms can use accelerated depreciation methods that allow depreciation over shorter time periods with accelerated rates in the early years of the assets’ lives. Accelerated depreciation methods allow higher deprecia- tion rates in the early years, resulting in lower taxable income and lower immediate tax payments for the firm.
The choice of depreciation methods affects both the income statement and balance sheet, especially for capital intensive companies. When compared to accelerated methods, straight-line depreciation has lower depreciation expense in the early years of asset life, which tends to lead to a higher tax expense but higher net income. On the balance sheet, both assets and equity are higher under straight-line depreciation versus accelerated methods during the early years of an asset. Toward the end of an asset’s life, these relationships reverse.
Thus, we would expect Home Depot’s taxable income expense of $2,208 million in fiscal year 2002 to understate its actual tax payment made. We can confirm that this is the case by noting that the liability for deferred income taxes on the balance sheet increased by about $173 million between the February 3, 2002, and February 2, 2003, balance sheet dates.
Concept Check 2.3
1 Why should analysts pay close attention to a firm’s operating income?
2 Why may a firm’s net income differ from its net cash flow?
3 Some users of financial statements become frustrated that firms use varying formats for the income statements and balance sheets. What would be the advantages and disadvantages of requiring all firms to use the same format?
4 If a firm reports a wide difference between its basic and diluted earnings per share, should this difference concern investors? Why or why not?
5 How can the choice of depreciation methods affect a firm’s income statement and balance sheet? Give several examples.
Practical Financial Tip 2.2
The actual cash flows generated by a firm may differ from its net income during a given period due to accrual accounting practices, noncash revenues and expenses, and taxes.
• Accrual accounting: revenues are normally recorded on an income statement when the sale is made and not when the cash is actually collected from that sale, and the corresponding expense of producing an item is recorded when the rev- enue is recorded, not when the cash is actually paid out for that expense.
• Noncash revenues and expenses: the income statement usually includes noncash expenses such as depreciation and amortization.
• Taxes: firms in the US can use one depreciation method for determining taxable income for their financial statements for reporting purposes and another method for determining their taxable income reportable to the tax authority (IRS).