2015, Study Session # 8, Reading # 25

UNDERSTANDING THE INCOME STATEMENTS

IS
R
E
FV
SL
AFS

=
=
=
=
=
=

Income Statement
Revenue
Expenses
Fair Value
Straight-Line
Available For Sale Securities

I.S is sometimes referred to as statement of operations the statement

of earnings or profit & loss statement.

I.S equation= Revenue - expenses = net income.

RV
DO
CF
EP
AMP
OCI

= Residual Value
= Discontinued Operations
= Cash Flows
= Exercise Price
= avg. Market price
= Other Comprehensive
Income

25.a

Revenues sale of goods & services in normal course of business.

Revenue- adjustment for returns = net revenue.
Expenses outflows, depletion of assets, and incurrences of liabilities in the ordinary course of business.
Gains & losses result from incidental transactions outside firms primary business activities.

Presentation Formats

Single-Step format
All revenues are grouped
together & all expenses
are grouped together.

Multi-Step format
Includes gross profit
(revenue-cost of goods
sold) as a subtotal.

Gross profit - operating expense = operating profit.

Operating income - interest & tax expense = net income (non financial firms).

Pro rata share of subsidiarys income that the firm does not own is reported in
parents I.S as noncontrolling interest. This is subtracted.

25.b

Accrual method revenue is recognized when earned & expenses are recognized when incurred.

According to FASB revenue is recognized when realized & earned. Four additional guidance are:

Evidence of arrangement b/w buyer & seller.

Product has been delivered or service has been rendered.

Price is determined or determinable.

Seller reasonably sure surety of money collection.

Specific Revenue Recognition Applications

In some cases revenue may recognized before delivery or even after delivery.

Long Term Contracts

Often related to construction & long term projects.

Service contracts or licensing agreements firm may equally recognize revenue.

Long Term Contracts

Percentage of Completion Method

Appropriate when cost & revenue can reliably estimated.

R,E & profit recognized as work is performed.

Measured as total cost to date divided by total project cost.

Completed Contract Method

Suitable when uncertain outcomes or short term project.

R,E & profit at project completion.

Expected loss recognized immediately (either method).

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2015, Study Session # 8, Reading # 25

25.b

IFRS unreliable outcome, revenue is recognized to the extent of cost, cost is expensed & profit is
recognized at completion.

% of completion method is more aggressive & subjective due to cost estimates, provide smoother
earnings & better matching: C.F are same under both methods.

Installment Sales
Firm finances a sale & payments are expected over extended period.

Installment Sales

Normal revenue Recognition Method

Seller has competed a significant
part of earnings process and

Collection is certain or amount
which cannot be collected can be
estimated.

Installment Method

Cost Recovery Method

Profit recognized when cash
collected exceeds cost.

Collectability uncertain.

Profit recognized based on percentage of sales
price received as cash.


 =    

 



Barter Transaction

Two parties exchange goods or services without cash.

Round-trip transaction sale & simultaneously identical purchase from same party.

Barter Transaction

U.S.GAAP

IFRS

Revenue can be recognized at F.V. only if the

company has historically received cash
payments for such services.

Based on F.V of revenue from similar

non barter transactions with unrelated
parties.

Gross & Net Reporting of Revenue

Gross Revenue Reporting

Reports sales & COGS separately.

Net Revenue Reporting

Difference in sale & cost is reported.

Criteria to use gross revenue reporting under GAAP.

Be the primary obligor & bear inventory & credit risk.

Be able to choose supplier & establish price.

Implication for Financial Analysis

Firms discloses revenue recognition policies in footnotes.

Check how conservative firms revenue recognition policies.

Extent to which policy requires making judgment & estimates.

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2015, Study Session # 8, Reading # 25

25.c

Matching principle accrual based expense to generate revenue in the same period as
revenue recognized.

Period costs expenditure not directly tied to revenue generation. Expense in period of
incurrence.

Cost of long lived assets (depreciation) also matched with revenue.

Credit sale estimate bad debt expense.

Implication for Financial Analysis

Delayed exp increase net income, therefore more aggressive.

Analyst must consider the reasons for a change in expense estimate.
Analyst should compare firms estimate with industry peers.
Firms disclose policies & estimates in footnotes & MD&A.

Depreciation

25.d

Straight-line depreciation

Accelerated depreciation

Equal amount of dep. expense.

Early years, lower dep. expense & higher net income
compared to accelerated method.



SL dep. expense =

 

More dep. in early years.

Same total expense.
Declining balance method
Constant rate of dep. each year
Double declining balance

Depreciates the asset at two times the SL rate.

DDB dep. = 

 

 (cost Acc. Dep. )

No explicit RV in calculation but dep. ends once RV reached.

Inventory

Specific Identification

Can used if firm can identify

which items are sold and
which remain in inventory.

First-in, first-out

Last-in, first-out

Item 1st purchased is assumed

to be 1st sold.

COGS is charged with early
purchases & inventory with
recent purchases.

Last item purchased is

assumed to be 1st sold.

Recent purchases to COGS &
earlier purchases to inventory.

Suitable for durable inventory.

Weighted Avg. cost method

Easy to use.

Per unit cost =

cost of available goods
Total units

This per unit cost is used to

determine COGS & inventory

Intangible Assets

Amortization allocation of cost of an intangible asset over its useful life.

Amortization exp should match assets economic benefits.

Intangible assets with indefinite lives must be tested for impairment annually instead
of amortized.

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2015, Study Session # 8, Reading # 25

25.e

Nonrecurring items & changes in accounting standards

Discontinued operations

Unusual or infrequent items

Extraordinary items

Management has decided

to dispose of a component
operation but either has
not yet done so, or has
disposed of in current year.

The discontinued operation
must be physically &
operationally distinct from
rest of firm.

Measurement date the
date at which disposal is
decided.

Phase out period time
b/w measurement period &
actual disposal date.

G/L from DO is reported net
of tax after continuing
operations.

Unusual in nature or
infrequent in occurrence
but not both.

Examples are G/L from asset
sale, impairments & write
offs.

These items are included in
income from continuing
operations & reported
before tax.

Analyst may review these
items to determine whether
they should be used in
forecasting.

Extraordinary item that is

both unusual & infrequent
(U.S.GAAP).

Examples are loss from
expropriation of assets, G/L
from early debt retirement
& uninsured losses from
natural disaster.

Reported separately in I.S,
net of tax after continuing
operations.

IFRS does not allow
extraordinary items to be
separated from operating
results.

Change in accounting principle

From one (U.S. GAAP or
IFRS) policy to another.

Retrospective application.

Changes in accounting standards

Change in accounting estimate

Correction of a prior period error

Result of a change in managements judgment.

Applied prospectively.

Do not affect C.F.

Correction of a prior period error requires

retrospective restatement of financial statements/

25.f
Nonfinancial firm non operating transactions may result
from investment income & financing expenses.

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2015, Study Session # 8, Reading # 25

Earnings per Share

25. g & h

Corporate profitability performance measure.

Company may have simple (no potentially dilutive securities) or complex (potentially dilutive securities) capital structure.

Reported only for shares of common stock.

Basic EPS

  
 =

Dilutive EPS

 
   
 .
 

  


Weighted Avg. number of shares no. of shares outstanding during

the year, weighted by portion of the year.

Stock dividend additional shares to each shareholder.

Stock split division of each old share into specific number of
new shares.

Each shareholders proportional ownership is unchanged.

Stock split or stock dividend is applied to all shares outstanding prior
to split or dividend & to the beginning-of-period weighted avg.
shares.

Dilutive securities options: warrants, convertible debt or convertible

preferred stock that decrease EPS, if EPS
then anti dilutive securities.

In case of diluted EPS numerator must be adjusted as :

Convertible convertible preferred stock is dilutive; preferred
dividend must be added to earnings if preferred dividend is
deducted from earnings.

Convertible bonds are dilutive; interest exp multiplied by (1-tax rate)
must be added back to earnings.

If dilutive securities, denominator is adjusted for equivalent number
of common shares created by conversion of all dilutive securities.

Dilutive stock options or warrants (EP< AMP),
number of shares but no
numerator adjustment.

Treasury stock method

Hypothetical funds received from options used to purchase common
shares at AMP.

Net increase in shares (shares created by option- repurchased
shares).

Net income Preferred dividend +

convertible preferred dividends +
convertible debt interest1 T
Diluted EPS =
weighted Avg. shares +
shares from conversion of conv. pfd. shares +
shares from conversion of conv. debt +
shares issuable from stock options

25. i

Common Size IS

Vertical Common Size IS

Horizontal Common Size IS

Expresses each line item as a

percentage of sales.

Each line item is expressed in

relation to selected base year.

25. j

Margin Ratios

Gross Profit Margin

GPM =

Gross Profit
Sales

Operating Profit Margin

OPM
Operating Profit
=
Sales

Net Profit Margin

NPM =

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Net Profit
Sales

2015, Study Session # 8, Reading # 25

25. k & l

Comprehensive income all changes to equity other than owner contributions & distributions.

C.I = net income + OCI (foreign currency G/L, minimum pension liability adjustments, unrealized
G/L on derivative contracts accounted for as hedges & AFS securities).

Transactions included in OCI affect equity but not net income.

AFS securities reported on B/S at FV, unrealized G/L as component of OCI.

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