[MUSIC] Welcome everyone. As we begin this second course on understanding financial statements, I hope most of you completed the first course. Just in case, let's highlight a few ideas before we get started. In the first course you were introduced to the idea that financial statements are representations or substitute attributes meant to measure attributes of the company. We saw that the balance sheet as a substitute attribute to the company's position, helped answer two measurement questions, what does the company own and what does the company owe. However, there's a third measurement question that the balance sheet does not address, and that's where we'll begin our conversation about the income statement. When we spoke about the balance sheet, we illustrated the balance sheet as a photograph taken of the company on some particular date. Let's say that the date of the photograph is the first day of the year, January 1st. Now, let's imagine we took the second photograph of the same company, but we take the photo on December 31st. If we compare the two photographs taken a year apart, it probably won't look the same. In other words, the company's position on December 31st will have changed since January 1st. What's the difference in the company's position and what caused this difference? Well, that's what the income statement captures. It depicts what occured during the period that changed the company's financial position from the beginning of the period to its position at the end of the period. The income statement answers the measurement question, how did the company perform, because it shows how the company's activities during the period impacted its assets and liabilities. Let's take a look at the simple income statement from the apparel manufacturer, Under Armour to see how it's organized. The first line item you see is an item called revenue, or net sales. Then you see something called cost of goods sold, or cost of sales. Notice that the cost of goods sold is subtracted from revenue to arrive at gross profit. Then, you run into an item that is selling general and administrative expenses. Under Armour uses this line item to aggregate several types of expenses that are subtracted from gross profit to yield net income before income taxes. We then subtract the line item for income taxes to arrive at net income. With some new information to process, it's time to see what we've learned so far. Here are a few check questions. With a broad overview of the income statement complete, let's take a closer look at the first line item, revenue. And to do that, let's take a road trip. Here we are at my favorite bakery in Champaign, Sweet Indulgence. I love walking into the bakery and seeing all the fantastic treats that the owner, Missy, has prepared that day. Of course, the point of the bakery is not to give people like me something to look at. No way. She wants someone to buy something. And, today, I am going to oblige. Ladies and gentlemen, Missy has just earned revenue. Why? Because revenue is an increase in Missy's asset or a decrease in her liabilities brought about by activities that are center to her normal operations. Let's break this down. Missy's business is to provide food and drink to customers. I took delivery of the most delicious cookie sandwich, Missy received cash from me which increases her assets. Yep, that's revenue. Let's see what else I might try to buy. Yeah, the monster mixer that I told my wife about. Boy, I'd be a hero if I brought home that baby. I wonder if Missy would sell it to me. Much for showing us the back room, all the things that you have, but by the way, how much would you charge me for the monster mixer? >> [LAUGH] Well if you could get it out of here, I don't know. Probably about 13,000, or 14,000, and that's a used one, so. >> Okay, I don't know. Okay, truthfully. I can't afford that mixer and if I bring it home to my wife, I wouldn't be much of a hero if she found out how much it costs. But let's pretend I did, and somehow I got the mixer in my car and drove it home. Would Missy have revenue? Let's have a look. Missy received cash from me, which increases her assets, check. I took delivery of the monster mixer, check. But wait a minute. Is Missy in business to sell monster mixers? Of course not. This last example suggests an important idea. A transaction that represents revenue for one company, may not represent revenue for a different company. If Jed at Body and Sole sells me a cupcake, then that wouldn't be revenue for Jed. Or if rather than going to Regent Dance for dance lessons, I pay one of Missy's employees for lessons, Sweet Indulgence would not increase its revenue. So, why is it so important to distinguish between what transaction represents revenue versus not being revenue? If the company's assets are increasing, who cares if it's revenue? Well, let's think about this. Let's say you are considering whether or not to lend $100,000 to Jed at Body and Sole or one of Jed's competitors, we'll call him Fred. Remember Jed's business is to sell athletic shoes and clothing and Fred has a similar business. So, what is your concern if you're a lender. Your concern is whether your loan will be repaid and you'd like to see evidence that your debtor can pay you back. Now, consider that both Jed and Fred have income statements that show each earned net income of $50,000. There's a difference however, Jed's net income is driven mostly by the revenue associated by his selling shoes and clothing, but Fred's net income is driven mostly by his selling an old treadmill he kept in the store and several display cases that remained empty during the last year. So who would you lend money to Jed or Fred? If it's me making the loan decision, I'm making the loan to Jed. Jed's net income is driven by revenue. He's earning income by doing what he's in business to do. As a result, I expect Jed's net income to look similar next year and the year after that, and maybe even the year after that, because his net income is associated with his normal business. Fred, on the other hand, I'm not so sure what his net income will look like next year. After all, Fred's net income came from selling off equipment, not from his normal business. So, if I want to lend money with the best hope of being repaid, I have to go with Jed because Jed's net income, being driven by revenue, suggests his net income performance will persist in the future. Well, this ends our lesson on revenue. Next time we meet, we'll spend some time at Jed's store as we discuss revenue's unpleasant little brother. Until then, be well. [MUSIC]
