The income (earnings, or profit and loss) statement shows Aldine's revenues, expenses, and net profits for the two fiscal years under discussion. The cost of goods sold represents the cost of actually producing the products that were sold during the period. Included here are the cost of raw materials, labor costs associated with production, and manufacturing overhead related to products sold. Selling, general, and administrative expenses as well as interest expense are shown separately from the cost of goods sold because they are viewed as period expenses rather than product costs.
For a manufacturing company, as in this case, depreciation expense is generally considered one component of the cost of goods manufactured and thus becomes part of the cost of goods sold. For a merchandising firm (wholesaler or retailer), depreciation is generally listed separately as another period expense (like interest expense) below the gross profit figure. Depreciation was discussed in Chapter 2, but remember that it is based on historical costs, which in a period of inflation may not correspond with economic costs.
Stock options give the holder the right to buy shares of common stock at a predetermined price on or before a fixed expiration date. Many companies grant them to employees, particularly to senior management, as part of their compensation. If a company awards some of its employees a cash bonus, the company is required to record a compensation expense for the amount of the bonus paid, thereby reducing reported earnings. Historically, however, companies that rewarded employees with stock options did not have a comparable reduction in earnings. Perhaps the sentiment of those in the investment community who complained long and hard about this double-standard is best captured by the following passage from Warren Buffett's 1992 Chairman's Letter to Berkshire Hathaway, Inc., shareholders: "It seems to me that the realities of stock options can be summarized quite simply: If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?" Finally bowing to public pressure, beginning January 1, 2006, the US Financial Accounting Standards Board (FASB) has required US companies to record stock-options expense using the "fair value method." Under this approach, compensation is measured by the fair value of the stock options on their grant date and is recognized over their vesting period (i.e., time period before employees gain control over their stock options).
Most companies will include stock option expense as part of Selling, General, and Administrative (SG&A) expenses. To estimate the fair value of employee stock options granted, companies use an option-pricing model such as the Black-Scholes model. (The Black-Scholes Option Model is discussed in Chapter 22, Appendix: Option Pricing.) The actual details pertaining to expensing stock options are contained in the FASB's Statement of Financial Accounting Standards No. 123 (Revised 2004) - SFAS 123R. It sets forth rules for valuing stock options, recognition of expense, accounting for income tax benefits and making the transition to the new method of accounting for stock options. At 295 pages, it is not "light" reading.
The last three rows of the income statement shown represent a simplified statement of retained earnings. Dividends are deducted from earnings after taxes to give the increase in retained earnings. The increase of $58,000 in fiscal year 20X2 should agree with the balance sheet figures in Table 6.1. At fiscal year end for two consecutive periods, retained earnings were $956,000 and $1,014,000, the difference being $58,000. Therefore, there is agreement between the two balance sheets and the most recent income statement. With this background in mind, we are now ready to examine financial statement analysis.