Welcome back. In our last conversation, we began addressing our third measurement question, how did you perform? We're going to continue that discussion as we look at what's next on the income statement. We started our conversation by examining revenue and cost of goods sold, and saw how these two line items determined gross profit. Proceeding down the income statement, we see a line item that captures several different expenses beyond the cost of goods sold. I have an idea. Let's see if we can return to Body and Soul and identify what are likely to be expenses for Jed. But before we take another look in Jed store, let's make sure we know what we're looking for. What exactly are expenses? Expenses represent outlays of resources as part of the normal operating activities. In other words, expenses are associated with operating transactions that either decrease the company's assets or increase the company's liabilities. With that in mind, let's revisit our tour of Body and Soul and see if we can identify some likely expenses for Jed. What do you see? [MUSIC] What did you come up with? Well, here are a few things I saw that likely are expenses for Jed. This was an easy one. An employee is selling merchandise and I'm guessing he expects to be paid for his efforts. So that's likely to be an expense on the income statement. Either shown separately as salaries and wages or included in the category like selling general and administrative expenses. Let's see what else we can find. Here are some lights. Now I'm not too concerned about the light bulbs, but Jed will need to pay for the electricity needed to power the lights and for air conditioning or heat. That requires a decrease in an asset like cash for an increase in the liability like accrued expenses. So we would probably see the expenses also included in selling general and administrative expenses. One likely expense I picked up has to do with the company's use of signage and posters. Jed must have hired someone to develop the posters and signs along with other media buys. This could show up on the income statement as advertising expense as with the toy manufacturer Mattel, or be aggregated with other expenses related to selling general and administration. To clarify, these three examples of likely expenses for Jed are not the only expenses companies incur. Some companies will have more items included on their income statement as expenses, and some smaller companies may list fewer items. There's tremendous variation in what expenses companies incur depending on the company's size, its industry, its strategy, and its structure. One expense that's so common across a number of companies and often is listed explicitly on the income statement is something called depreciation expense. Let's go back to Missy's bakery to explain this idea of depreciation expense. IS, remember when we toured Missy's kitchen and came across the monster mixer. Okay, you know how much I love the monster mixer. So there are two things to point out about Missy's mixer. First, the mixer is really expensive. It was acquired at a high cost. Second, and this is great, Missy will be able to use the mixer for a number of years. But these two points create a problem for the income statement. Remember the income statement is meant to capture the bakery's performance for a period of time. So let's say Missy purchases the monster mixer in 2012 and it's total cost is recorded as an expense for the 2012 years, because the cost of a mixer is so large. The income statement would suggest that Missy didn't perform very well in 2012. On the other hand, in 2013, the mixer is helping Missy produced tons of cookies, but with no expense for the mixer showing up in the income statement. In this case, the income statement would suggest Missy performed better in 2013 than she actually did. This looks like a problem, Missy's income statement is making her performance looked to poor in 2012, but too good in 2013. Well, the concept of depreciation expense helps resolve this problem. Let's assume that the monster mixer cost $50,000 rather than recording the entire $50,000 as an expense in 2012. Missy will record equipment on the balance sheet for the mixers total cost $50,000. Missy then will estimate the number of years, she expects to use the mixer and allocate a portion of the mixers total cost to each of those years. If we estimate Missy will use the mixer for 10 years, she'll record depreciation expense to the 2012 income statement for $5,000. The 2013 income statement would also show depreciation expense for $5,000, and each of the remaining eight years Missy expects to use the mixer would have $5,000 of depreciation expense. Thus depreciation expense allows a company to spread the cost of an asset over the periods it expects to benefit from the asset. So when we see depreciation expense on the income statement, we know that it represents the cost of the company's property plant equipment that have been allocated to that period. Time to take a break to see how well you understand where we've gone so far. Now let's turn our attention to a related scenario that has implications for the income statement. What if Missy were to sell the monster mixer at the end of 2013 for $42,000. Notice that Missy received $2,000 more than the $40,000 of unallocated cost of the mixer. Remember, Missy is not in the business of selling mixers so the transaction shouldn't increase revenue. Instead, she would record a gain on the sale of equipment for $2,000. I have a few other things on the income statement I want to point out before we finish our lesson. First, you'll likely see a line item for the amount of the company's tax obligation related to the company's earnings for the year. Unfortunately, this is a concept we're all pretty familiar with. Second, you might see a line item on the income statement just below net income from operations listed as income from discontinued operations. This refers to income related to a line of business or unit that the company discontinued during the period. An example might be Body and Soul. If Jed decided in 2015 to only sell shoes and discontinue selling apparel, then the income that apparel sales generated in 2015 would be reported as income from discontinued operations on the 2015 income statement. Finally, you might also see an income statement line item listed as extraordinary gain or loss. Like the line item for discontinued operations, you would find this item below net income from operations. A standard English dictionary would define the word extraordinary as unusual. So we might guess that a gain or loss that is extraordinary represents an unusual gain or loss, that's pretty close. In accounting extraordinary gains or losses are those that arise from events that are both unusual and infrequent? Where unusual means that the event could be judged as unforeseen, in other words, you couldn't have seen it coming? What does that mean? Well, if Jed owns a warehouse that stores his athletic shoes and that warehouse explodes, we could argue that the exploding warehouse was an extraordinary event. On the other hand, if rather than storing shoes, Jed decided he would also store jet fuel, then the exploding warehouse should probably be considered a foreseeable event and thus not extraordinary. A loss from the exploding warehouse of shoes would be included in the income statement as an extraordinary loss. But the loss from the exploding warehouse of jet fuel wouldn't be extraordinary, but would show up on the income statement as other income or losses. What's the final word on our lesson for today? Remember we started at gross profit. And I've looked at some common items that either are added to gross profit, like gains on sales of equipment or subtracted from gross profit, like depreciation expense. That some of these adjustments to gross profit yields net income. That often serves as a summary measure for the company's performance. And that's how the income statement helps answer the measurement question, how did the company perform? The next time we meet, we'll start looking at a financial statement that is important but gets a lot less attention. Until then be well. [MUSIC]
