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Prior to beginning work in this discussion thread, read pages 51 through 80 of Understanding Corporate Annual Reports, Voluntary disclosures in corporate annual reports – More than meets the eye, and Integrated Performance Report. This is the time to share in discussion format your critical learnings and any details from your AOR. These thoughts should be qualitative, quantitative, generic, and specific. The learnings should be related to your AOR and what you can put to work in the short- and long-term in the real world. Please use 150 words or more.

two general categories: operating leases and capital leases. On the one
hand, operating leases are often viewed as temporary rentals, with rent
expense being reported in the income statement of the company needing
the asset. This company renting is referred to as the lessee. Operating
leases can be short-term relative to the total life of the asset being rented.
In addition, the rentals over the lease period do not provide a significant
recovery of the asset’s value over the term of the lease for the company
providing the asset. Regardless of this fact, minimum lease payments
under operating lease agreements often represent a substantial fixed
charge awaiting the lessee.

A capital lease, on the other hand, is generally long-term. It requires rentals
that are significant and approximate the value (excluding future interest) of the
asset being rented. When this type of agreement is executed, the lessee must
view the leased asset as if it had been purchased using a long-term financing
arrangement. The company that owns the asset is willing to receive installment
payments over the lease term, and in this case provides the financing. Keep in
mind that there is no transfer of title to the lessee. The transaction is simply
accounted for as if it were a capital asset acquisition.

The rationale for this accounting treatment is to prevent companies from
not reporting the liability that parallels a lease agreement of this nature.
Since the lease agreement emulates a purchase with long-term financing,
companies are required to account for them in a manner similar to a pur-
chase. Therefore, leases of this nature require balance sheet recognition of a
capitalized leased asset and the associated long-term liability.

According to its balance sheet, The Home Depot has capitalized leases
that total $261 million. Since the leases are reported as assets, they will be
associated with a related liability as well. Capital lease obligations are
reported in both the current and long-term liability sections of the balance
sheet.

As the leased assets are used in The Home Depot Company’s operations,
they will decline in usefulness similar to a purchased asset. Therefore, cap-
italized leased assets are depreciated as well. In most instances, assets of this
nature are written off over the lease term. Upon the termination of the lease
agreement, the leased asset should be fully depreciated and the lease obli-
gation fulfilled by the lessee. At this point, the asset simply transfers back to
the lessor, or is sold to the lessee at a bargain purchase price.

Long-Term Investments

Long-term investments, discussed along with their short-term counterpart,
are recorded when a company invests in another company’s debt or equity.

ELEMENTS OF THE BALANCE SHEET 51

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If management intends to hold these investments beyond one year, these
investments must be categorized under the heading long-term investments.
Occasionally management reclassifies long-term investments as market con-
ditions change from one period to the next.

Long-term stock investments can be accounted for under the (1) cost, (2)
fair value, (3) equity, or (4) consolidation approach. A careful review of the
investments footnote (following the financial statements) may identify the
types of investments and their related valuation. On occasion, if the reported
investment is minimal, the note will provide little assistance.

According to the footnote, The Home Depot classifies its debt invest-
ments as AFS and accounts for them at their current market price. AFS
investments are classified as short- or long-term investments, depending on
management’s intent. In either case, changes in market value are recognized
in stockholders’ equity as unrealized gain or loss on AFS securities. Upon
careful review we find no mention of gain or loss under other comprehen-
sive income. This suggests that no material change in the market value of the
AFS securities has taken place.

NOTES RECEIVABLE A note receivable is a written promise to pay a specific
amount or amounts at some point forward. Most notes receivable are loans
but can result from a conventional sales arrangement that allows for
extended terms. Occasionally, accounts receivable can be converted to a note
receivable to extend the original terms of the agreement, generate a rate of
return for the holder of the note, and strengthen legally the agreement
between the parties. The Home Depot reports $77 million in notes receiv-
able at the close of fiscal year 2000.

Intangible Assets, Including Costs in Excess of Fair Value
of Net Assets Acquired

Previous classifications included assets that were generally tangible in
nature. Intangible assets, however, generally lack physical substance and
possess a greater degree of uncertainty in regard to future benefits than do
tangible assets. They represent rights, privileges, and competitive advan-
tages, backed by a legal agreement. Nonetheless, intangible assets, when
properly created or acquired, can enhance the profitability of the enterprise
for years to come. Once recorded, these assets operate no differently than
tangible assets such as property, buildings, equipment, or fixtures. Their
costs are capitalized and generally allocated to future periods through a

52 BALANCE SHEET

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Account: s8856897

method known as amortization. Amortization of intangible assets and depre-
ciation of fixed assets both represent cost allocation processes that satisfy
the matching principle. Examples of intangible assets include patents, copy-
rights, trademarks, organizational costs, and goodwill:

■ Patents grant to the organization the exclusive right to manufacture,
sell, or control a product or process for a specific period of time.

■ Copyrights give the owner the right to reproduce and sell a published
work or artistic creation.

■ Trademarks are rights that relate to brand or trade names.
■ Organizational costs include all costs incurred in the formation

of the enterprise and would include attorney and accounting fees,
federal and state filing costs, underwriting costs, and so on. They
are regarded as expenditures that will benefit the organization over
its life. These costs are capitalized and generally written off over
a period of 5 to 10 years (5-year write-off period for taxable enti-
ties).

■ Goodwill is recognized when one company acquires another com-
pany and pays more than the value of its net identifiable assets (assets
less liabilities). It is often said that goodwill is the most intangible of
the intangible assets group.

The Home Depot reports goodwill (cost in excess of the fair value of net
assets acquired) at $314 million at the close of fiscal year 2000. Goodwill
can only result from the purchase of another company and represents the
expected value of better-than-normal future operating performance. It is
measured as the difference between the purchase price of an acquired firm
and the fair value of its identifiable net assets.

Goodwill has traditionally been written off over a period not to
exceed 40 years. This write-off can place a significant drag on earnings
for an extended period of time.2 A recent change in accounting for good-
will by the Financial Accounting Standards Board (FASB) requires com-
panies to no longer write off newly acquired goodwill. The FASB believes
that companies should write down goodwill only when its value appears
to be permanently impaired. The Board’s rationale is that the synergistic
benefits derived through business combinations often have indefinite
lives. To arbitrarily write down goodwill does not follow the matching
principle. In a sense, the FASB is suggesting that goodwill is similar to
land in that it need not be written off unless its value becomes impaired.

ELEMENTS OF THE BALANCE SHEET 53

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EBSCO Publishing : eBook Collection (EBSCOhost) – printed on 1/4/2018 5:25 PM via ASHFORD UNIVERSITY
AN: 81992 ; Stanko, Brian, Zeller, Thomas L..; Understanding Corporate Annual Reports : A User’s Guide
Account: s8856897

Current Liabilities

Liabilities and stockholders’ equity support a company’s investment in
assets. Liabilities must be recognized on the date they were incurred.
Liabilities, much like assets, can be classified according to when they will
be satisfied. Current or short-term liabilities are obligations that will be sat-
isfied in the upcoming year; noncurrent liabilities will be settled at some
point beyond the current period. The Home Depot balance sheet reports a
number of current liabilities:

■ Accounts payable
■ Accrued salaries payable and related expenses
■

Sales taxes payable

■

Other accrued expenses

■

Income taxes payable

■

Current installments of long-term debt

A pie chart can be used to quickly identify large liabilities. Figure 3.6
clearly shows that accounts payable is 45 percent and other accrued
expenses are 32 percent of total current liabilities. Graphing this information
over time, as demonstrated with inventory, will point to respective growth,
stability, or decline in these areas.

ACCOUNTS PAYABLE Accounts payable, also known as trade accounts
payable, represent amounts owed to other companies as a result of goods,
services, materials, supplies, and so on acquired throughout the year.
Almost 50 percent of The Home Depot’s current liabilities, or $1.976 bil-

54 BALANCE SHEET

Current Liabilities

Accounts Payable

Accrued Salaries

Sales taxes payable
Other accrued expenses
Income taxes payable
Current installments of long-term debt

45%

14%

32%

45%

(Percentage amount is less than 1%
and not shown in pie chart.)

Figure 3.6 Analysis of current liabilities.

lion, is tied to accounts payable. Obviously, to support the operation of
more than 1,100 stores, The Home Depot must continually purchase sig-
nificant quantities of goods from product supply houses. Conventional
payment terms might require satisfaction of these obligations within 30 to
60 days of the invoice date, depending on The Home Depot’s relationship
with the vendor.

ACCRUED SALARIES PAYABLE AND RELATED EXPENSES The recognition of
accrued salaries and related expenses results from the application of accrual
basis accounting. Accrual accounting requires revenues to be recognized
when earned and expenses when incurred. The actual receipt of or payment
with cash is not essential to the recognition of revenues and expenses in the
accounting records. The key issue is whether product sales have occurred
and what costs or expenses relate to the sale. Salaries are accrued because
they are an expense that relates to the generation of revenue in the current
period.

When an accrual takes place, it is often related to a transaction that
does not coincide with the close of the fiscal year or the exact amount is
not yet known (in the case of a contingent liability). For example, The
Home Depot may distribute compensation to a certain group of employ-
ees on a weekly basis and others twice a month, on the 10th and 25th.
Because the distribution of wage does not cover services provided by
employees through the close of the fiscal year, an accrued liability for
wages earned between the last payment date and the end of the year must
be reported in the balance sheet. The accrued liability for salaries and
other related expenses reported by The Home Depot amounts to $627 mil-
lion. This amount would also include payroll taxes that the company is
responsible for and would include FICA, FUTA, and SUTA payroll taxes.
This amount was computed at the close of the business year and recorded
via a year-end adjusting entry.

SALES TAXES PAYABLE State and federal mandates require corporations to
collect sales tax when sales of tangible personal property are executed. Upon
receipt from its customers, corporations have a legal obligation to remit
these taxes to an appropriate government agency. Sales taxes are remitted
periodically; therefore, any amounts collected represent a liability for the
company collecting them.

The Home Depot reports $298 million of sales taxes payable at the close
of the fiscal year. This is classified as a current liability because satisfaction
of this obligation will take place in the following quarter.

ELEMENTS OF THE BALANCE SHEET 55

OTHER ACCRUED EXPENSES Other accrued expenses can include a variety
of obligations. For example, this may include interest accrued on The Home
Depot notes payable. The company presently has 6 percent senior notes out-
standing that require interest payments each March 15 and September 15.
Because the interest payment date does not fall at the end of The Home
Depot’s fiscal year, there must be an accrual of interest from the last interest
payment date through the end of the fiscal year. The company has additional
obligations in the form of leases and installment notes that would require
similar accounting accruals.

Accrued expenses can also include estimated liabilities that will be settled
in the upcoming year. This could include property tax expense that has been
assessed for the current year but will be paid in the upcoming year, a litigation
loss that has been accrued for but not yet settled, or bonuses that have been
earned by key executives but will be paid in the upcoming quarter. Revenues
received in advance (unearned revenue), such as deposits for goods ordered by
The Home Depot customers, would also be recognized as a current liability.

INCOME TAXES PAYABLE Income taxes payable represents an estimated lia-
bility that is generally satisfied with periodic payments by the corporation to
several taxing authorities. Income tax payments are based on an estimate of
corporate pretax income. As estimates change with the passage of time, so
will the periodic installments paid by the firm. Any estimated liability
should be reported at the close of the fiscal year.

To understand what constitutes pretax income, one must first under-
stand the difference between before tax financial reported income
(income statement) and pretax income (tax return). Revenues and
expenses for tax purposes are determined in accordance with the rules set
forth by the Internal Revenue Code and other IRS regulations. Revenues
and expenses for financial reporting purposes are based on generally
accepted accounting principles (GAAP). The result can be a significantly
different income measure depending on which set of rules is applied.
Because of this, companies generally report future tax liabilities and/or
assets. Any income tax obligation (benefit) due in the following year is
reported as a current liability (asset).

The Home Depot reports a current liability of $78 million to various tax
authorities at the close of the 2001 fiscal year. However, as will be seen later,
The Home Depot has a noncurrent or deferred obligation to the income tax
authorities of $195 million as a result of operations. The issue of deferred
income taxes will be more thoroughly discussed in the “Long-Term Debt
(Excluding Current Installments)” section in this chapter.

56 BALANCE SHEET

CURRENT INSTALLMENTS OF LONG-TERM DEBT The final item shown under
current liabilities involves components of long-term debt that are due in the
upcoming period. This is typically referred to as the current maturities of
long-term debt and may include obligations such as installment notes, mort-
gages, leases, and bond issues.

Upon review of The Home Depot notes to the financial statements, we
notice it has issued high-grade, commercial paper that bears an average
interest cost of 6.1 percent. Commercial paper generally represents short-
term debt. The Home Depot is also a party to a number of capital leases that
require period payments of principal and interest. The portion of principal
that will be settled in the coming year is reported as a current portion of that
long-term debt. Mortgage notes or other installment notes operate in much
the same way. The Home Depot has $4 million of long-term obligations that
will be settled in the coming year.

Long-Term Debt (Excluding Current Installments)

Long-term liabilities generally represent the most significant obligation
for the corporation. Although this obligation does not impact a firm’s cur-
rent liquidity, ultimately it becomes payable. Thus, there is significant
concern with regard to the payment of ongoing interest and the ability to
retire the obligation, either over time or when it becomes due as a single
amount.

Long-term liabilities are obligations arising from past events that are
not payable in the coming year. Generally, there is a much greater degree
of formality when an organization incurs long-term debt. Long-term capi-
tal leases, mortgage obligations, pensions, and other retirement benefit
obligations are examples of long-term liabilities. Most of these examples,
as was illustrated, require the recognition of both a short- and a long-term
obligation.

According to note 2, The Home Depot’s long-term debt comprises
$754 million of commercial paper (usually short-term notes with original
maturities of 30 to 270 days issued by highly rated corporations but clas-
sified by The Home Depot as long-term because of their rollover status),
$500 million of senior notes due in 2004, $230 million of capital lease
obligations payable in varying installments through 2027, and another
$75 million in notes payable in varying installments through 2018. All of
these obligations must be managed properly to prevent a decline in the
company’s credit rating.

ELEMENTS OF THE BALANCE SHEET 57

Other Long-Term Liabilities

Other long-term liabilities outside of those discussed in note 2 are not
clearly identifiable from the notes to the financial statements. Companies
that raise capital through the issuance of bonds would recognize a
long-term obligation: bonds payable. Additionally, many companies pro-
vide to employees pension and health-care benefits upon retirement.
Generally, these employee benefits are not earned until the employee
has been with the company for a number of years, known as a vesting
period.

From an accounting perspective, companies that provide employee
retirement benefits must accrue for them with the passage of time. If com-
panies fund less than 100 percent of the accrued pension or other post-
employment expense, a liability for the future obligation must be recognized.
Obligations relating to pension plans and other post-employment benefit
(OPEB) programs are reported under long-term liabilities as accrued pension
cost obligation or accrued other post-employment benefit obligation. Table
3.2 illustrates the magnitude of pension and other post-employment benefit
obligations for Abbott Laboratories at the close of its 1998 fiscal year. Four
components are of special interest:

1. Projected benefit obligation is the actuarial present value of
employee benefits earned using projected salary levels and present
years of service.

2. Pension or OPEB plan assets are placed in trust by the company,
invested, and then distributed to employees upon retirement. Their
value fluctuates with the stock market and the economy.

3. Prepaid (accrued) benefit cost is the pension or OPEB asset or lia-
bility being reported in the balance sheet.

4. Net cost is the pension or OPEB expense for the current reporting
year.

Although it is beyond the scope of this book to discuss the calculations
that led to the following numbers, it is necessary to highlight two important
points. First, Abbott Laboratories reported 1998 pension and OPEB expense
(or cost) in the amount of $62.1 million and $69.5 million. The expense
comprises four items:

1. Service cost increases pension expense because of an additional year
of service benefits (pension and OPEB) earned by Abbott
Laboratories employees.

58 BALANCE SHEET

ELEMENTS OF THE BALANCE SHEET 59

Table 3.2 Note 5: Post-Employment Benefits, Abbott Laboratories

Defined Benefit Medical and
(in thousands) Plans Dental Plans

1998 1998

Projected benefit obligations,
January 1 $2,000,329 $646,448

Service cost — benefits earned
during the year 108,754 30,664

Interest cost on projected benefit
obligations 140,287 43,770

Actuarial loss (gain), primarily
changes in discount rate and lower
than estimated health care costs 182,829 18,057

Benefits paid (85,722) (23,993)

Other, primarily translation 2,143 —

Projected benefit obligations,
December 31 $2,348,620 $714,946

Plans’ assets at fair value,
January 1, principally listed
securities $2,192,486 $86,600

Actual return on plans’ assets 426,023 18,656

Company contributions 18,945 1,265

Benefits paid (85,722) (23,993)

Other, primarily translation (761) —

Plans’ assets at fair value,
December 31, principally
listed securities $2,550,971 $82,528

Projected benefit obligations
less than (greater than) plans’
assets, December 31 $202,351 ($632,418)

Unrecognized actuarial (gains)
losses, net (143,876) 137,701

Unrecognized prior service cost 6,134 —

Unrecognized transition obligation (21,015) —

Prepaid (accrued) benefit cost $43,594 ($494,717)

60 BALANCE SHEET

Table 3.2 Note 5: Post-Employment Benefits, Abbott Laboratories (Continued)

Service cost—benefits earned
during the year $108,754 $30,664

Interest cost on projected benefit
obligations 140,287 43,770

Expected return on plans’ assets (179,194) (7,211)

Net amortization (7,728) 2,290

Net pension or OPEB cost $62,119 $69,513

2. Interest cost is the cost of the projected benefit obligation, measured
on a present value basis. The mere passage of time increases the pro-
jected benefit obligation and pension expense.

3. Expected return on plan assets is used in the calculation of pension
and OPEB expense to reduce its potential volatility. The reduction of
pension and OPEB expense by an expected return on plan assets
yields net pension or OPEB expense (or cost).

4. Net amortization relates to the actuarial adjustments (changes in discount
rates, mortality rates, etc.) that are made periodically, thereby increasing
or decreasing the projected benefit obligation. Rather than adjust pension
or OPEB expense dollar for dollar, the resulting gains and losses (known
as liability gains/losses) are often amortized over time.

A second adjustment often involves asset gains/losses. Asset
gains/losses result from the difference between the expected return on
pension or OPEB plan assets and the actual return on plan assets.
Because of the potential for large swings in the stock market, the use
of an average expected return over time reduces volatile reporting.

Next, Abbott Laboratories reports an asset prepaid benefit cost of $43.5 mil-
lion for its defined benefit pension plan and an accrued liability of $494.7 million
for OPEB. This means that there are sufficient (actually an excess of ) pension
plan assets to cover Abbott Laboratories’ projected benefit obligation. However,
the OPEB obligation is currently under-funded, thus the recognition of the $494.7
million obligation. Accrued pension and OPEB obligations emerge when the
company’s pension or OPEB expense is not covered by an equal cash contribu-
tion to the respective plans. This recognition simply follows the accrual basis of
accounting.

Deferred Income Taxes

Deferred income tax liabilities and assets represent future income tax obli-
gations or future income tax benefits as a result of past events. They ariseC
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EBSCO Publishing : eBook Collection (EBSCOhost) – printed on 1/4/2018 5:25 PM via ASHFORD UNIVERSITY
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Account: s8856897

when GAAP and the Code conflict with regard to the timing of revenues,
expenses, gains, and losses. The resulting timing differences are temporary
(in most cases), but nonetheless create a reporting difference between tax-
able income and financial income. Timing differences result when revenues,
gains, expenses, or losses affect financial reported income in one period but
taxable income in another period.

As an example, let’s assume The Home Depot depreciates a

$50,000

asset over 5 years for financial reporting purposes but uses a 3-year acceler-
ated cost recovery schedule for tax purposes. Table 3.3 illustrates deprecia-
tion expense timing differences.

As noted, depreciation expense in year 1 is $25,000 for tax purposes and
$10,000 for financial reporting purposes. The $15,000 difference is called an
originating temporary difference. When we move to year 2, another $5,000
originating temporary difference results. The combination of the two differ-
entials then becomes a future reversing difference. While no reversals occur
in year 3, years 4 and 5 show a combined total of $20,000 reversing differ-
ences. What this means is that The Home Depot would report a deferred
income tax liability in anticipation of greater taxable income down the road
when compared to financial reported income. Keep in mind that while
depreciation expense differences exist within periods, they are equal in
amount over the life of the asset. In either reporting, $50,000 of depreciation
expense is recognized. This is why these originating differences are noted as
temporary differences.

If we take this example one step further and assume that this company
has $80,000 of income before depreciation, Table 3.4 illustrates what would
be reported as taxable and financial reported income (ignoring taxes).

Therefore, in years 1 and 2, taxable income will be lower than financial
reported income and reduce that year’s income tax obligation. In year 3 there
will be no difference in reported income and in years 4 and 5 taxable income
exceeds financial reported income. Nonetheless, because greater tax benefits

ELEMENTS OF THE BALANCE SHEET 61

Table 3.3 Example of Timing Differences

Year Tax Depreciation Book Depreciation Difference

1 $25,000 $10,000 $15,000

2 15,000 10,000 5,000

3 10,000 10,000 —

4 — 10,000 (10,000)

5 — 10,000 (10,000)

$50,000 $50,000

were achieved in year 1, a deferred tax liability is reported in the balance
sheet based on the difference in year 1. Ultimately, deferred tax liabilities
become current tax liabilities.

Depreciation timing differences are often the largest contributor to the
magnitude of deferred tax liabilities. Because most companies take advan-
tage of the accelerated depreciation schedules, deferred tax liabilities appear
in the long-term liabilities section of corporate balance sheets. However,
another expense related to health care benefits upon retirement give rise to a
deferred income tax benefit (an asset). Companies that provide for employee
healthcare coverage upon retirement must recognize an expense and a
related liability (if not funded) with the passage of time. The IRS does not
allow the recognition of this expense until the distribution of benefits takes
place. When companies accrue for this expense, they create future
deductible amounts for tax purposes. Ultimately these expenses will lower
taxable income and reduce future income tax obligation. Future deductible
amounts are reported as deferred tax assets.

Common examples of temporary (timing) differences include:

■ Depreciation. Generally results in a deferred tax liability
■ Bad debt expense. Generally results in a

deferred tax asset

■ Prepaid or deferred expenses. Generally results in a deferred tax liability
■ Unearned revenues. Generally results in a deferred tax asset
■ Accrued warranty liabilities. Generally results in a deferred tax asset
■ Other post-retirement benefit expenses. Generally results in a

deferred tax asset

Minority Interest

Because The Home Depot reports a minority interest of $11 million between
the liability and stockholders’ equity sections of the balance sheet, this indi-
cates that it has an ownership interest of more than 50 percent but less than
100 percent in another company. When this situation occurs, 100 percent of
the assets of the subsidiary company are included in the asset section of The

62 BALANCE SHEET

Table 3.4 Year 1 Income before Depreciation

Tax Book

Income before depreciation $80,000

$80,000

Less: Depreciation expense 25,000 10,000

Income after depreciation $55,000 $70,000

ELEMENTS OF THE BALANCE SHEET 63

Home Depot’s balance sheet. The amount reported as minority interest is the
amount of the assets The Home Depot does not own. The $11 million
amount is reported neither as a liability nor equity but simply represents
another investor’s (company’s) interest in the consolidated net assets of a
Home Depot subsidiary.

Stockholders’ Equity

Assets are financed both by debt and equity. Equity represents the net assets
of a corporation. This concept can be compared to owning a house (asset)
with an outstanding mortgage note (liability). If the house is valued at
$200,000 and the payoff on the mortgage note is $140,000, then the equity
in the house is $60,000. A company’s balance sheet is viewed in much the
same way. It is composed of many assets, a variety of liabilities, and a resid-
ual interest (equity) in those assets. The relationship between the three
defines the balance sheet equation.

Furthermore, there continues to exist an inverse relationship between a
company’s debt and its equity. If equity increases relative to total assets, then
debt decreases proportionally. The greater the equity component in a balance
sheet, the less pressure on the organization to cover related interest costs and
generate a profit. Stockholders’ equity is generally divided into two cate-
gories: contributed capital and earned capital.

CONTRIBUTED CAPITAL Contributed capital is recognized when a company
acquires assets through the sale or exchange of common stock. When this
occurs, companies recognize additional contributed capital in the balance
sheet as well as an asset or reduction in an existing liability. Most often the
asset received is cash, but occasionally a building and/or equipment can be
received as well. Companies also have the flexibility to settle existing debt
obligations with the issuance of common shares. In all of these cases, the net
assets of the companies change because of management’s decision.

The Home Depot balance sheet shows that contributed capital consists
of common stock and additional paid-in capital. Alongside these elements is
The Home Depot’s disclosure of authorized common shares, issued com-
mon shares, and outstanding common shares. Authorization establishes the
ceiling on the total number of shares that may be issued by the company. The
Articles of Incorporation identify this number, which can be exceeded only
if the corporate charter is amended. The issued number of shares is the
shares sold over time, while the number of shares outstanding can be less
than or equal to the number of shares issued. If the number of shares out-
standing is less than the number of shares issued, the company has reac-
quired some of its own common stock. Companies do this to enhance future

earnings per share, reduce total future dividends paid, support executive
compensation programs, or help fend off hostile takeovers. Reacquired
shares are called treasury shares.

At the close of 2000, The Home Depot reported approximately 2.323
million shares of common stock at a par value of $.05 per share. Understand
that par value and fair market value are unrelated measures. Multiplying the
number of shares outstanding by a par value of $.05, a value of $116 million
is recorded in The Home Depot balance sheet. The $116 million also con-
stitutes the legal capital of the firm. Legal capital is used as a protective
means to prevent companies from distributing dividends in excess of earn-
ings and additional paid-in capital. It provides some measure of value to
creditors in case of liquidation.

The paid-in capital account represents the excess of selling price per
common share over par value per share. Because company stock is sold peri-
odically, the selling price will often vary depending on market conditions.
Thus, paid-in capital can accumulate in different amounts with each public
offering of the firm. To date, The Home Depot has been paid $4.81 billion
in excess of par value by its shareholders.

EARNED CAPITAL The other component of shareholders’ equity is called
earned capital or retained earnings. Earned capital represents the accumulated
earnings of that company since its inception, less any dividends paid to the
company’s shareholders. Many newly established companies pay limited divi-
dends and instead concentrate on growth. Rather than acquire capital externally
at an additional cost, they can use these internally generated funds in a more
efficient way. Established companies, on the other hand, attract a different type
of investor who looks to dividends as a source of periodic revenue.

When a company first begins operations, accumulated or retained earn-
ings are zero. With the passage of time however, earnings are reported and
dividends are distributed. As a result, retained earnings may be positive or
negative. A positive measure indicates that the company has attained some
level of profitability (net income) and has distributed less than those earn-
ings to shareholders. Negative retained earnings suggest that the company
has sustained net losses over time or paid out dividends in excess of profits
achieved. There is no relationship between retained earnings and a com-
pany’s cash position. Remember that retained earnings are a subset of
equity, and equity supports all assets.

ACCUMULATED OTHER COMPREHENSIVE INCOME An additional component
of stockholders’ equity is accumulated other comprehensive income.
Accumulated other comprehensive income includes gains and losses related

64 BALANCE SHEET

to certain events that have historically bypassed the income statement for
income smoothing reasons. Therefore, for many years, the only reported
measure of a company’s performance was net income. A recent change in
financial reporting now requires companies to report a more complete mea-
sure of income called comprehensive income. In essence, comprehensive
income includes not just net income but other comprehensive income. As
increases and decreases in other comprehensive income occur during the
reporting period, these are reported in the statement of change in stock-
holders’ equity or in a separate statement of comprehensive income. But any
accumulated balance of these unrealized gains and losses is reported under
stockholders’ equity in the balance sheet. These items normally include
unrealized gains and losses on available for sale securities, translation gains
and losses on foreign currency, and excess of additional pension liability
over unrecognized prior service cost.

According to The Home Depot’s balance sheet, the only item of accu-
mulated other comprehensive income is foreign currency translation
adjustments. These arise when assets and liabilities denominated in a for-
eign currency are translated into U.S. dollars. Careful review of The
Home Depot annual report discloses that the company operates 67 stores
in Canada, 5 stores in Chile, 2 stores in Argentina, and 2 stores in Puerto
Rico. When consolidation takes place, the assets and liabilities denomi-
nated in foreign currencies must be combined with the assets and liabili-
ties denominated in U.S. dollars. Note 1 to the financial statements
provides additional disclosure of this action, as well as what rates are
used in the translation process.

SHARES PURCHASED FOR COMPENSATION PLANS The last element that appears
on the balance sheet is the cost of shares reacquired for compensation plans,
also known as a company’s treasury stock. Treasury stock represents stock that
has been repurchased by the issuer for some intended purpose. For example,
companies that buy back their shares do the following:

■ Take advantage of current market conditions and lower stock prices.
Reacquisition of shares at low prices eliminates future dividend pay-
ments to existing shareholders, therefore enhancing future cash flow.

■ Support ongoing executive compensation programs. If key executives
exercise stock options, the company must have existing shares to issue
to these individuals. A stock option gives the holder the right to buy
company stock at a predetermined price, often at a great discount.
Essentially, stock options represent a form of deferred compensation.

ELEMENTS OF THE BALANCE SHEET 65

■ Enhance future earnings per share. If shares of stock are no longer
outstanding, they are removed from the computation of earnings per
share. Fewer outstanding shares increases earnings per share in sub-
sequent accounting periods. Companies often seek opportunities to
enhance this measure.

According to The Home Depot’s balance sheet, the cost of their reac-
quired treasury shares is $6 million. Most companies use the cost method to
account for the acquisition of treasury stock. This means that they measure
treasury stock based on the current market price at the time of acquisition.
For example, if The Home Depot reacquires 100,000 shares to be held in
treasury and pays $30 per share, treasury stock is reported at $3 million. On
the balance sheet, treasury stock is a contra-equity account and is therefore
deducted from stockholders’ equity. Some users of financial information
believe treasury stock should be considered an asset but fail to recognize that
a company cannot own itself.

CONCLUSION

The balance sheet provides important information regarding a company’s
liquidity and solvency. Shortcomings, however, involve a myriad of valua-
tion approaches and management estimates. This chapter was designed to
help the reader understand the structure of the balance sheet and its related
elements. Financial statements from The Home Depot 2000 annual report
were used for illustrative purposes. As we proceed to Chapter 4 and Chapter
5 and discuss the statement of earnings and the statement of cash flow, you
should begin to better understand the interrelationships that exist between
the mandatory financial statements.

NOTES

1. Accounting Trends and Techniques, 1993 (New York: AICPA, 1993), Table
2–28.

2. As an example, AOL purchased Time Warner in January 2001 for $147 billion.
The purchase took place when Time Warner net assets amounted to $51 billion;
therefore the remaining $96 billion was classified as goodwill. The subsequent
amortization of goodwill (an expense) for AOL amounts to $1.5 billion per
quarter.

66 BALANCE SHEET

4
INCOME STATEMENT

Steve Ray cannot believe the wealth of information tucked into the company
annual report. The previous chapters of this book have given him much
greater understanding of a company’s financial status, and now he is looking
forward to studying the income statement. Upon studying this chapter, he will
be able to tell whether Baker is generating profits from day-to-day operations.
Operating income (loss) is a separate line item on an income statement and is
much different from net income (loss). Net income (loss) includes profits or
losses from day-to-day operations plus several other transactions, such as
taxes, interest, gains/losses on equipment sales, and more. It is becoming clear
to Steve how a business can report losing money from day-to-day operations
and still show a robust net income.

The income statement, also labeled the statement of operations, mea-
sures a company’s performance over a specified period of time. For this rea-
son, the statement is titled for a period of time—for example, year ending
January 28, 2001. The statement is different from the balance sheet because
it is a cumulative record of activity for a month, quarter, multiple quarters,
or for one year. Creditors, investors, and many others use the income state-
ment as a measuring stick of how a company has performed, where it
appears to be heading, and what its future cash flows will be.

In Chapter 7 we explore the numbers and evaluate The Home Depot’s
income statement. To complete a thorough analysis of The Home Depot, it
is necessary to have a solid understanding of the income.

IMPORTANCE OF THE INCOME STATEMENT

Creditors, employees, suppliers, investors, and more use the income state-
ment. The report serves as a measuring stick of how a company has per-
formed, where it appears to be heading, and what future cash flows are likely
to be. For example, Figure 4.1 compares the performance of The Home

Depot and Kmart. The Home Depot amount and trend in net income points
to future success. Success appears to have eluded Kmart for the most recent
periods and is questionable in the future. Kmart is losing money, and its per-
formance is inconsistent. This information certainly sends a signal to ques-
tion management’s strategic focus in an effort to position Kmart for
long-term success. The 5-year financial summary in the annual report serves
as the source of this information.

Figure 4.1 also provides clues regarding future cash flows. Operating cash
flows are generated from day-to-day operations. This type of cash flow is
essential for success. Although further analysis is required, The

Home Depot

trend points to the ability to generate future cash flows. This does not seem to
be the case for Kmart. In the final analysis, only a company’s operating activ-
ities provide continuous cash flow. Cash received from selling assets, loans
(debt), and stock (equity) may be significant on an occasional basis, but can-
not be relied on as a year-to-year source of funds.

LIMITATIONS OF THE INCOME STATEMENT

The income statement provides a measure of performance that can be chal-
lenged on certain grounds. First, some believe that the organization’s perfor-
mance should be measured as its increase/decrease in net assets (equity). This
economic theory of income measurement is premised on an organization’s

68 INCOME STATEMENT

$(500) 1996 1997

1998 1999 2000

$500

$1,000

$1,500

$2,000

$2,500

$3,000

Home Depot Kmart

Figure 4.1 Net income (loss) analysis.

change in wealth and is referred to as a capital-maintenance approach. The
weakness of this measure is that it fails to identify the specific elements of
income and thus removes a company’s flexibility to include or exclude certain
events from income. Accountants generally use a transactional approach to
measure performance (excess of revenues and gains over expenses and losses)
from one year to the next. This model has been expanded recently to include
items of other comprehensive income previously discussed in Chapter 3. The
popularity of the transactional approach will likely continue.

A second income statement limitation is closely tied to a manager’s
accounting choice. For example, one manager might depreciate an asset
using a straight-line approach, while another selects an accelerated
approach. The end result is different reported expenses and different
reported earnings. Because various methods of cost allocation exist, compa-
nies are required to disclose their choice(s) in the notes to the financial state-
ments. This allows informed users to better compare companies.

Third, in some cases accounting rules are more specific, yet manage-
ment intent drives the accounting. To illustrate, assume that two companies
invest $3 million in the stock of a third, unrelated company. Current account-
ing rules require managers to disclose whether they intend to hold the invest-
ment for the short term or for an extended period. A manager’s decision in
this case changes the accounting for the investment. For one assumption, a
change in market value is recognized in the income statement, the invest-
ment held for trading. Here the unrealized gains and losses are reported as
part of net income. Under the second assumption, unrealized gains and
losses are reported outside income, as a component of other comprehensive
income, the investment held as available for sale (AFS). Financial statement
users must realize that earnings outcomes often influence management’s
accounting decisions. The subject of managed earnings and earnings quality
will be more formally discussed in Chapter 8.

The fourth weakness of the income statement is its basis of preparation.
Accrual accounting, while it provides a better measure of performance,
includes noncash expenses in the calculation of income. For example, depre-
ciation expense is an allocation of cost that has no associated cash outflow,
yet it decreases net income.

Fifth, net income ignores when future cash receipts tied to current rev-
enues will be received and when future cash payments tied to current
expenses will be paid. This occurs because accounting rules require the
recognition of earned revenue prior to the cash receipt. Accounting rules
also require the recognition of an expense prior to its cash payment. An
example of this would be a company that recognizes pension and other post-
employment expenses. Some companies may contribute to this expense

LIMITATIONS OF THE INCOME STATEMENT 69

immediately while others may not. Therefore, cash flow from operations in
the early years for a non-contributing company will be much higher than
reported income because of these accruals. This is an important point from
an employee retirement perspective. A company can expense the cost of
funding a retirement, yet not set aside all the cash necessary to pay the ben-
efits to the recipients. For the interested reader, Appendix B carefully
explains the accounting rules regarding the recording of transactions before
the cash flows have occurred.

FORMAT OF THE INCOME STATEMENT

The income statement is generally divided into two sections: operating and
nonoperating. The operating section of the income statement includes revenues
and expenses that correspond to the principal operations of the company (i.e.,
day-to-day operations). The combination of operating revenues and operating
expenses leads to a reported measure of operating income or operating loss.

The nonoperating section of the income statement, however, includes
income/expense items and gain/loss items that are routine to most any type of
business entity but are viewed as peripheral to day-to-day business operations.
Examples include interest earned on investments, interest incurred on borrow-
ings, and gains and/or losses associated with the disposal of assets and/or
elimination of liabilities. An example of a peripheral activity would be the sale
of a piece of equipment. If the equipment has a book value of $20,000 and it
is sold for $15,000, there is a realized loss of $5,000. While the loss is reported
on the income statement, it is recognized in the nonoperating section under
other expenses and losses. This loss is excluded from operating income
because it is related to a support activity rather than an operating activity.

The sum of operating income (loss) and nonoperating income (loss) is
simply income (loss) before income tax expense. Once income tax expense
or benefit is considered, net income (loss) is the residual. The level of detail
disclosed between operating income and net income varies among compa-
nies. We will show in Chapter 7 that when evaluating a company, a study of
operating income from one year to the next is much more meaningful than
a study of net income from one year to the next.

Often, the nonoperating income or loss and tax expense components pro-
vide subtle signals of a company’s financial complexity that deserve careful
study. Figure 4.2 shows a difference between operating income and net income
for The Home Depot ranging between $1,000 to $1,500 million. A careful
review of the income statement shows that much of the difference is due to
income taxes. This is not the case for Enron. Figure 4.2 shows a difference

70 INCOME STATEMENT

between operating income and net income ranging between $1,000 and $1,500
million, as well. A careful review of the income statement shows that this dif-
ference is attributable to a host of complex economic events and taxes. This level
of detail is a signal that the financial backbone of the company is complex and
deserves careful study. In addition, how can the difference between operating
income and net income be so different in 1998 and 2000, yet have very similar
values in 1999? The user should read these as signals that professional guidance
is necessary to untangle the intricacy and understand the implications surround-
ing the many different financial transactions underway at Enron.

Irregular Items

Three items of special importance are also included in the conventional
income statement but are reported beyond the operating and non-operating
sections: discontinued operations, extraordinary events, and changes in
accounting principles. Accounting professionals view these events as irreg-
ular items and generally prefer that their effects be removed from the main
body of the income statement. Lucent Technologies’ comparative income
statement (Table 4.1) illustrates the effects of a discontinued operation and
an accounting principle change on net income. Net income decreased in
2000 and increased due to restructuring in 1999 and 1998.

Discontinued Operations

One of the most-often-occurring irregular items is the gain/loss associated with
the disposal of a business segment. Just as many companies have recently
expanded operations through business acquisitions, many of these same com-
panies have disposed of other operating segments along the way. For a disposal

FORMAT OF THE INCOME STATEMENT 71

Home Depot

$-
$500

$1,000
$1,500
$2,000
$2,500
$3,000
$3,500
$4,000
$4,500

Operating income Net income

Enron

$-
$500
$1,000
$1,500
$2,000

$2,500
Operating income Net income

m
il
li
o

n
s

m
il
li
o
n
s

1998 1999 2000 1998 1999 2000

Figure 4.2 Operating and net income analysis.

to qualify as a discontinued operation, the assets, results of operations, and
activities of a business segment must be clearly distinguishable, physically and
operationally, from the balance of the enterprise. Table 4.1 shows that Lucent
lost $462 million from discontinued operations in 2000.

An example of a discontinued operation would be the elimination of an
automobile line by General Motors. The economic substance of this event
(revenues and expenses related to the Oldsmobile line, for example) would
be removed from the upper portion of the statement of operations and
reported separately beyond continuing operations. This method of segre-
gated reporting highlights the significance of the event and illustrates the
business unit’s profitability or lack thereof. Furthermore, assets that are
being sold by a company generally receive fewer economic commitments
from the organization and have a tendency to underperform. A separate
reporting of the discontinued operation prevents its measure of performance
from contaminating the record of performance of the ongoing enterprise
when the organization is under review by outside analysts.

Extraordinary Items

A second irregular item that gets special accounting consideration is an
extraordinary event. An extraordinary item is a transaction or event that is

72 INCOME STATEMENT

Table 4.1 Lucent Technologies Three-Year Comparative Income (Loss)
Information

Results of Operations (in Millions) 2000 1999 1998

Revenues $33,813 $30,617 $24,367

Gross margin 14,274 15,012 11,429

Depreciation and amortization
expense 2,318 1,580 1,228

Operating income 2,985 4,694 1,953

Income from continuing operations 1,681 3,026 769

Income (loss) from discontinued
operations (462) 455 296

Income before cumulative effect of

accounting change 1,219 3,481 1,065

Cumulative effect of accounting
change — 1,308 —

Net income $1,219 $4,789 $1,065

FORMAT OF THE INCOME STATEMENT 73

both unusual and infrequent in occurrence, taking into account the environ-
ment in which the company operates. According to APB Opinion 30, para-
graphs 30–32:

■ Unusual nature means the underlying event or transaction should pos-
sess a high degree of abnormality and be of a type clearly unrelated
to, or only incidentally related to, the ordinary and typical activities
of the entity, taking into account the environment in which the entity
operates.

■ Infrequency of occurrence means the underlying event or transaction
should be of a type that would not reasonably be expected to recur in
the foreseeable future, taking into account the environment in which
the entity operates.

The APB was clear in suggesting that specific characteristics of the
entity, such as type and scope of operations, lines of business, and operating
policies should be considered in determining ordinary and typical activities
of an entity. The environment in which an entity operates is a primary con-
sideration in determining whether an underlying event or transaction is
abnormal and significantly different from the ordinary and typical activities
of the entity. The environment of an entity includes such factors as the char-
acteristics of the industry or industries in which it operates, the geographi-
cal location of its operations, and the nature and extent of governmental
regulation.

For example, assume two companies sustain significant flood loss dam-
age. One company might classify the loss as extraordinary, yet the other
might not. Flood loss sustained by an enterprise located in a flood plain
would not constitute an unusual occurrence and would not warrant extraor-
dinary classification. Nor would an earthquake loss for a company located
in California.

One extraordinary item addressed by the FASB is the economic affect of
the September 11, 2001, terrorist attack on the World Trade Center and the
Pentagon. Certain businesses, as a consequence of the attack, have sustained
significant personnel losses and severe economic damage. Many of these
companies, as well as associated businesses, were forced to report extraor-
dinary losses in their 2001 current year financials.

Another item, known as a corporate restructuring charge, may appear
to be unusual or infrequent but is still reported as a component of continu-
ing operations. The FASB considers organizational restructuring a part of
today’s normal business environment. However, restructuring charges, if

material, can be shown as a separate line item. For example, Sara Lee
Corporation experienced a $2,040 million restructure in fiscal year 1998. As
a result, Sara Lee reported a loss before income taxes of $443 million. Had
the restructuring charge not been taken, it would have earned a profit before
income tax of $1.597 million. Many companies use proforma-reporting
techniques as a means of softening the effects of reported restructuring
changes. They essentially highlight what earnings would have been had
they not experienced a corporate restructure. Many believe that this type of
reporting is misleading and helps to disguise management shortfalls.

Change of Accounting Principle

A third irregular event that requires special accounting treatment is an
accounting principle change. A change in accounting principle results
when a company switches from one generally accepted accounting prin-
ciple to another or when the FASB issues a new accounting pronounce-
ment. A change in an accounting principle often requires an adjustment to
specific asset or liability accounts, as well as an adjustment to net income
or retained earnings (prior year changes where necessary). When income
is affected, the firm is said to be applying the “current approach.” When
retained earnings are affected, the firm is said to be applying the “retroac-
tive approach.” Firms may not select one method over the other. Each
new accounting standard specifies which approach to use in a given situ-
ation. Most changes in accounting principles are accounted for under the
current approach, with a cumulative effect of the change reported in
current year income.

Cumulative prior-year differentials often occur when companies switch
depreciation methods or change inventory cost-flow assumptions.
Essentially, the cumulative effect is the total income difference between
what was reported using the current depreciation method versus what would
have been reported under the newly adopted depreciation method. Most
often these changes target assets acquired over, let’s say, the past five years,
rather than those assets acquired in the current year. This allows manage-
ment to report an outcome that might have a favorable impact on earnings.
This is referred to as a discretionary change by a company and is not the
result of a new accounting rule.

Retroactive adjustments generally pertain to changes in a company’s
revenue recognition practices or changes in inventory cost-flow assumptions
that involve last-in, first-out (LIFO). Rather than take the cumulative differ-
entials to reported earnings of the current year as with the current approach,
the effect is recognized as an adjustment to retained earnings. This allows

74 INCOME STATEMENT

FORMAT OF THE INCOME STATEMENT 75

the effect to bypass current year income but requires restatement of related
prior year information. Most users of financial information dislike this
approach because of the changes to previously reported values.

The economic consequence of a mandatory change in accounting prin-
ciple can also have a dramatic effect on reported earnings.1 General Motors,
for example, recorded a $20.8 billion accounting charge in 1992 as a result
of a new accounting rule issued by the Financial Accounting Standards
Board. The rule, FAS 106 “Employers Accounting for Postretirement
Benefits Other than Pensions” required companies to change their account-
ing for postretirement benefits from a pay-as-you (cash) basis to an accrual
basis. According to the Board:

“a defined postretirement benefit plan set forth the terms of an exchange
between the employer and employee. In exchange for the current services
provided by the employee, the employer promised to provide, in addition to
current wages and other benefits, health and other welfare benefits after the
employee retires. It follows from that view that postretirement benefits are not
gratuities but are part of an employee’s compensation for services rendered.
Since payment is deferred, the benefits are a type of deferred compensation.
The employer’s obligation for that compensation is incurred as employees
render the services necessary to earn their postretirement benefits.”

The Board’s objectives in issuing this FAS was to improve employers’
financial reporting for postretirement benefits in the following manner:

a) To enhance the relevance and representational faithfulness of the
employer’s reported results of operations by recognizing net peri-
odic postretirement benefit cost as employees render the services
necessary to earn their postretirement benefits.

b) To enhance the relevance and representational faithfulness of the
employer’s statement of financial position by including a measure
of the obligation to provide postretirement benefits based on a
mutual understanding between the employer and its employees of
the terms in the underlying plan.

c) To enhance the ability of users of the employer’s financial state-
ments to understand the extent and the effects of the employer’s
undertaking to provide postretirement benefits to its employees by
disclosing relevant information about the obligation and cost of the
postretirement benefit plan and how those amounts are measured.

d) To improve the understandability and comparability of amounts
reported by requiring employers with similar plans to use the same
method to measure their accumulated postretirement benefit obliga-
tions and the related costs of the postretirement benefits.2

76 INCOME STATEMENT

As a result of General Motor’s $20.8 billion accounting charge, it lost close
to $23 billion in 1992. The balance of this chapter is devoted to a discussion of
the elements of The Home Depot consolidated statement of earnings.

ELEMENTS OF THE HOME DEPOT’S STATEMENT OF EARNINGS

The Home Depot’s statement of earnings can be divided into two sections:
operating and nonoperating. The operating section includes sales revenues,
cost of goods sold, and other operating expenses.

Operating Section

NET SALES The operating section begins with The Home Depot’s net sales
of goods and services, reported at $45,738 million. The figure includes rev-
enues generated from the sale of merchandise, tool and equipment rental,
and product installation service revenue. Net sales result when the Home
Depot Company deducts from gross sales:

■ Cost of goods returned by customers
■ Cash discounts earned by contractors when they pay within the dis-

count period
■ Allowances granted to customers when goods are defective

These items generally are not disclosed in the annual report but
are tracked for internal reporting purposes. Information about returned mer-
chandise, allowances granted to customers, and discounts taken by contrac-
tors are important for managing suppliers, customers, and cash flow.

Net sales in whole dollars and percentage growth are often included in the
financial highlights and 5- to 10-year summary. These measures are designed
to provide the user a perspective of company size and growth. Figure 4.3 shows
that The Home Depot is substantially larger than Lowe’s in terms of sales, yet
both are growing at the same approximate rate of 20 percent. This growth rate
appears reasonable given management’s historical track records. Most interest-
ing will be to see what happens next year with the growth rates of each com-
pany. For Enron, the signals are different. Note, we had to graph sales dollars
and growth rates separately for Enron because of the magnitude of the values.
Any and all users should question a business that goes from $40,000 million to
$100,000 million in one year, at a growth rate in excess of 150 percent. The
message is simple: If it looks too good to be true, it probably is!

COST OF MERCHANDISE SOLD The next line item, cost of merchandise sold,
is generally the most significant expense reported in the income statement.

Cost of goods sold is only recognized when a sale of merchandise has taken
place, $32,057 million for The Home Depot.

Cost of goods sold as a percentage of net sales is an important measure
of a firm’s performance. The percentage can be compared from year to year
as well as across firms within the same industry. Figure 4.4 shows that the
percentage of cost of goods sold is very similar for The Home Depot and
Lowe’s, with both resting near 70 percent. However, a small percentage dif-
ference can have a larger impact on the bottom line when sales are in the bil-
lions of dollars. For example, reducing The Home Depot cost of goods sold
by 1 percent would contribute approximately $400 million to operating prof-
its. Remember that cost of goods sold is directly related to the cost-flow
assumption that is chosen by the company to value its inventory (i.e., first-in,
first-out (FIFO), LIFO, weighted average). Inventory valuation was previ-
ously discussed in Chapter 3’s “Current Assets.”

ELEMENTS OF THE HOME DEPOT’S STATEMENT OF EARNINGS 77

Net Sales in
Dollars
(millions)

$10,000

$20,000

$30,000

$40,000

$50,000
Home Depot

Lowe’s

Net Sales Growth Rate

15%

17%

19%

21%

23%

25%

27%

29%

Home Depot Lowe’s

Net Sales in
Dollars
(millions)
$-
$20,000
$40,000

$60,000

$80,000

$100,000

$120,000

Enron
Net Sales Growth Rate

20%

40%

60%
80%

100%

120%

140%
160%

Enron
1998 1999 2000 1998 1999 2000
1998 1999 2000 1998 1999 2000

Figure 4.3 Net sales in dollars and growth percent.

GROSS PROFIT The difference between net sales and cost of goods sold is a
company’s gross profit or gross margin. A reported gross profit is essential to
cover operating expenses that a company incurs during the operating year.
Management’s effective control over inventory acquisition cost can lead to an
improved or at least stable gross profit measure from one year to the next.

Companies that report lower operating profits often have been quoted as
saying, “Product price increases could not be passed along to the consumer
in a timely manner.” Circumstances like these create a squeeze on gross mar-
gins that ultimately filters down to a company’s bottom line. Many times
price increases cannot be passed along because of existing market condi-
tions such as an economic downturn. To increase prices would simply cre-
ate less product demand.

According to The Home Depot’s 2000 income statement, gross profit is
$13,681 million and has increased by more than 60 percent over the past 3
years. Likewise, gross profit as a percentage of net sales has steadily
improved and is currently 30 percent ($13,681 million/$45,738 million).
The decline in cost of goods sold as a percent of net sales shown in Figure
4.4 translates to an increase in gross profits. For The Home Depot, 30 cents
($1.00 – .70) of every sales dollar is used to meet current-period operating
expenses. The improvement of gross profit as a percentage of sales (29.9
percent in 2000 versus 29.7 percent in 1999), according to management, is
the direct result of three company-wide initiatives:

■ A lower cost of merchandise as a result of product line reviews
■ Benefits from global sourcing programs
■ An increase in revenue from tool rental centers

78 INCOME STATEMENT

68.0%
69.0%
70.0%
71.0%
72.0%
73.0%
74.0%

Home Depot Lowe’s
1998 1999 2000

Figure 4.4 Comparative analysis of cost of goods sold, percent of net sales.

ELEMENTS OF THE HOME DEPOT’S STATEMENT OF EARNINGS 79

Additional insight is available to a user who has a solid understanding
of the relationship between costs of goods sold and sales revenues. When
costs of goods sold are compared to revenue, a company’s product mark-up
percentage becomes more visible. During 2000, The Home Depot had an
average mark-up on product costs and services of approximately 43 percent
($45,738/$32,057 minus 1). A sufficient mark-up is essential for a company
to maintain a consistent bottom line.

SELLING AND STORE OPERATING EXPENSES Selling expenses are expenses
that directly relate to the selling of goods and/or services. For example,
The Home Depot employs thousands of sales personnel whose job is to
assist customers throughout the store and monitor inventory levels. These
employee salaries represent a significant selling expense for a company
of The Home Depot’s size. As a result, these costs will increase as the
company opens new locations or as employees become “more seasoned.”
A careful review of The Home Depot’s management discussion and
analysis (MD&A) section of the annual report illustrates this point.
According to management, a higher payroll expense was realized in 2000
as a result of market wage pressures and an increase in employee
longevity. In addition, medical costs increased due to higher family
enrollment in the Company’s medical plans, rising health care costs, and
higher prescription drug costs.

Television and radio advertising production costs, as well as media
placement costs, are other examples of selling expenses for The Home
Depot. Most of these costs are initially capitalized but become an expense
as the advertising occurs throughout the year. Selling expenses for The
Home Depot as well as other companies might include sales commissions,
sales office salaries, travel and entertainment, and depreciation expense on a
sales office or sales training facility.

Store operating expenses or occupancy expenses are another significant
cost for The Home Depot. Once again, as desirable growth rates are
achieved, total occupancy expenses should increase proportionately to the
number of stores that are opened. On average, however, expenses should
remain the same. For example, average depreciation expense per store
should remain relatively constant from one year to the next (assuming a
straight-line depreciation method). But should new construction prices
increase, the average expense per period accelerates. This is the result of a
greater capitalized cost being allocated to a consistent useful life (say, 45
years). This causes the average depreciation expense per store and in total to
increase.

In certain instances, operating expenses will rise regardless of expan-
sion. Consider, for example, a company’s utility costs and property taxes.
Typically, these expenses increase because of utility industry conditions and
government budgetary pressures. As local taxing authorities and utility ser-
vice providers increase rates, a company’s income statement is adversely
affected. The Home Depot management addresses these issues in the
MD&A section of the annual report and states that “store occupancy costs
such as property taxes, property rent, depreciation and utilities, increased in
year 2000 as a result of new store growth and energy rate increases.”

PRE-OPENING EXPENSES Consistent with management’s initiative to
aggressively expand its operations, The Home Depot opened 204 new stores
and relocated 8 others during fiscal year 2000. In advance of these store
openings, new personnel were hired, trained, and required to assist in the
organization of the new facility. Expenses associated with these activities are
called pre-opening expenses. These expenses can be incurred over a few
weeks or a much longer period, depending on the complexity of the opera-
tion. Accounting rules do not allow for these costs to be capitalized; there-
fore they are expensed as they are incurred, generally in the year in which
the store opens for business. Within the MD&A section, management
explains that pre-opening costs were higher during fiscal year 2000 due to
the opening of more EXPO Design Centers and the expansion of The Home
Depot stores into new markets, including international locations, which
involve higher training, relocation, and travel costs. This expense amounted
to $142 million in 2000, as opposed to only $88 million in fiscal year 1998.

GENERAL AND ADMINISTRATIVE EXPENSES A company’s general and admin-
istrative expenses often include a variety of costs that relate to other than its
sales operations. For example, the depreciation of a company’s corporate
headquarters constitutes a general and administrative expense. Depreciation
of a sales training center, conversely, would constitute a selling expense.
Management salaries, utility costs, and property taxes are further examples
of general and administrative expenses.

An explicit comparison of the above operating expenses deserves careful
study on an individual company basis. The expense titled: Store selling and
operating expense as a percent of sales can be drawn from The Home Depot
10-year summary. The summary shows this expense category has recently
increased to 18.6 percent of sales from 17.8 percent the previous year. This is
a signal to management that store selling and operating expenses must be care-
fully controlled. Comparability of general, selling, and operating expenses
across different companies is difficult because each will likely have a different

80 INCOME STATEMENT

definition and classification system. To overcome this comparability obstacles,
the user can simply graph total operating expenses as a percent of sales.

OPERATING INCOME Operating income (or loss) is the difference between
operating revenues and operating expenses. Operating income is essentially
the most useful measure of a company’s performance from one year to the
next. The reason for this is that it excludes nonoperating gains and losses
that often can distort measures of performance.

The Home Depot Company generated $4,191 million of operating
income in 2000, an increase of $383 million over its 1999 reporting year.
Even with the increase, however, operating income as a percentage of sales
had fallen from the preceding year, as shown in Figure 4.5. The percentage
decrease can be attributed to an increase (27 percent) in operating expenses
during 2000, which management discusses in the MD&A section.

Figures 4.3 to 4.5 point to a comprehensive view of financial operating
performance. At this point in our study of The Home Depot and Lowe’s
income statements, we see solid growth in sales and a stable operating
income percent of sales. Good management teams will stabilize and work to
decrease operating costs in an effort to maintain and grow the operating rev-
enue and income in total and percent of sales. The Home Depot and Lowe’s
leadership teams have successful track records, so sound management is
expected in the future.

The Enron story is quite different. Figure 4.3 shows substantial sales
growth, yet Figure 4.5 shows a poor operating income of just 2 percent and
no increase in the current year when sales grow from $40,000 to $100,000
million. This is a signal that any student in a beginning financial analysis
class should question. The immediate reaction is that the upbeat and positive
qualitative discussion spread throughout the Enron annual report is not
worth the paper it is written upon. Figures 4.3 and 4.5 point to a situation

ELEMENTS OF THE HOME DEPOT’S STATEMENT OF EARNINGS 81

0.0%
2.0%
4.0%
6.0%
8.0%

10.0%
12.0%

Home Depot Lowe’s Enron

1998 1999 2000

Figure 4.5 Operating income as a percent of sales.

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