Reading 25 Understanding Income Statement
- The components of the income statement and alternative presentation formats of that statement
Net income = Revenues – ordinary expenses + other income – other expense + gains – losses
- Single – step: all revenues are grouped together and all expenses are grouped together.
- Multi – step: includes: Gross profit = revenues – cost of goods sold
Operating profit = Gross profit – operating expense (selling, general, administrative)
- Revenue recognition method & calculate revenue
IFRS: Revenue is recognized from sale of goods when:
- The risk & reward of ownership is transferred.
- No continuing or management over the goods sold
- Revenue can be reliable measured.
- There is a probable flow of economic benefits.
- The cost can be reliably measured.
Revenue is recognized from sale of services when:
- The amount of revenue can be reliably measured.
- There is a probable flow of economic benefits.
- The stage of completion can be measured.
- The cost incurred and cost of completion can be reliably measured.
US.GAAP: Revenue is recognized when realized/realizable and earned
SEC: 4 criteria
- There is evidence of arrangement between the buyer & seller
- The product has been delivered or the service has been rendered
- The price is determined or determinable
- The seller is reasonably sure of collecting money
Specific revenue recognition applications
- Inventory expense recognition
– First in – first out (FIFO): first item purchased ⇒ first item sold
– Last in – first out (LIFO): last item purchased ⇒ first item sold (only US.GAAP)
– The weighted average cost: weighted cost of all item in period.
- Depreciation expense recognition
– Straight – line depreciation method (SL)
– Accelerated depreciation: more depreciation expense in early year of asset’s life
– Double – declining balance method (DDB)
– Amortization expense recognition
- The allocation of the cost of an intangible asset (ex: trademark) over its useful life ⇒ use the straight-line method to calculate annual amortization expense
- Intangible assets with indefinite lives (goodwill) are not amortized, but must be tested for impairment at least annually.
– Bad debt expense and warranty expense recognition: The firm is recognizing the expense in the period of the sale rather than a later period.
- The financial reporting treatment and analysis of nonrecurring items (including discontinued operations, extraordinary items, unusual or infrequent items) and changes in accounting standard
- Discontinued operations is one that management has decided to dispose of, but either has not yet done so, or has disposed of in the current year after the operation had generated income or losses. To be accounted for as a discontinued operation, the business in terms of assets, operations and investing & financing activities must be physically and operationally distinct from the rest of the firm.
– The date develops a formal plan for dispose of an operation: measurement date.
– The time between measurement period and the actual disposal: phase out period
– Analytical implication: straight forward. Discontinued operations do NOT affect net income from continuing operations.
- Unusual or infrequent items: these events are either unusual in nature or infrequent in occurrence, but NOT both. Ex: + Gains or losses from the sales of assets or part of a business.
+ Impairments, write-offs, writ -downs & restructuring costs.
– Unusual or infrequent items are included in income & reported before tax
– Analytical implications: they affect net income, so analyst may review them to determine whether they truly should be included when forecasting future firm earnings.
- Extraordinary items
Under IFRS: they are considered Continuing operations.
Under US.GAAP, they are a material transaction of event that is both unusual and infrequent in occurrence.
Ex: + Losses from an expropriation of assets
+ Gains or losses from early retirement of debt.
+ Uninsured losses from natural disasters that are both unusual & infrequent
Extraordinary items are reported separately in the income statement, net of tax, after income.
Analytical implications: they do NOT affect income from continuing operations, an analyst may want to review to determine whether some portion should be included when forecasting future income.
Changes in accounting standards
Include changes in accounting principles, changes in accounting estimates & prior period adjustment.
- A change in accounting principle: change from one US.GAAP or IFRS to another. Require: retrospective application. ⇒ all of the prior period financial statements currently presented are restated to reflect the change.
- The change in accounting estimate is the result of a change in management’s judgment, usually due to new information. A change in estimate is applied prospectively & do NOT require the restatement of prior financial statement.
- Prior-period adjustment: Change from incorrect accounting method to one is acceptable under US.GAAP & IFRS. Restating results for all prior periods presented in the current financial statements. Disclosure: nature of adjustment & effects on net income.
- Distinguish between the operating and non- operating components of the income statement Operating & non-operating transactions are reported separately in the income statement.
Non – operating transactions result from investment income & financing expenses for non – financial firm. But conversely, for a financial firm, investment income & financing expenses ⇒ operating activities.
- Distinguish between dilutive & antidilutive securities and describe the implications of each for earning per share calculation
Earnings per shares (EPS) is one of the most commonly used corporate profitability performance measures for publicly traded firms (nonpublic companies are not required report EPS).
A company may have either a simple or complex capital structure:
- Simple capital structure is one that contains no potential dilutive securities. Contains only: common stock, nonconvertible debt and nonconvertible preferred stock.
- Complex capital structure contains potentially dilutive securities such as : options, warrants or convertible securities…
- Common stock dividends are NOT subtracted from net income because it is a part of net income.
- The weighted average number of common shares (12 months)
- Effect of stock dividends & stock splits:
+ Stock dividend is the distribution of additional shares to each shareholder in an amount proportional to their current number of shares. Ex: 10% stock dividends for 100 shares ⇒ received additionally 10 shares.
+ Stock split refers to the division of each “old” share into a specific number of “new” shares. Ex: Holder of 100 shares will have 200 shares after a 2-for-1 split or 150 shares after 3-for-2.
- Dilutive securities: stock options, warrants, convertible debt or convertible preferred stock that would decrease EPS if exercised or converted to common stock.
- Antidilutive securities: increase EPS.
- Convertible preferred stock dilutive ⇒ convertible preferred dividends must be added to earnings available to common shareholders.
- Convertible bonds dilutive: the bond’s after tax interest expense is NOT considered an interest expense for diluted EPS. Hence, interest expense multiplied by (1 – tax rate) must be added back to the numerator.
Stock option (warrant): (highly testable)
Share issuable = [(AMP – EP)/AMP] x N
Where: AMP: average market price
EP: exercise price of the option or warrant
N: number of common share that option can be converted into
- Convert income statements to common – size income statement
A vertical common-size income statement expresses each category of the income statement as a percentage of revenue ⇒ eliminating the effects of size & allow for comparison of income statement items over time (time-series analysis) and across firms (cross-sectional analysis).
- Evaluate a company’s financial performance using common-size income statement and financial ratios based on the income statement
Gross profit margin = Gross profit / revenue
Net profit margin = Net income / revenue
Operating profit margin = Operating profit / revenue
Pretax margin = Pretax accounting profit / revenue
- Other comprehensive income and identify major types of items included on it
At the end of each accounting period, the net income is added to stockholder’s equity through an account known as retained earnings. Any transaction effect net income ⇒ effect stockholder’s equity.
Comprehensive income is a more inclusive measure that includes all changes in equity except for owner contributions and distributions. ⇒ Comprehensive income is the sum of net income & other comprehensive income.
Other comprehensive income included transactions that are not included in net income. Such as:
- Foreign currency translation gains & losses.
- Adjustments for minimum pension liability.
- Unrealized gains & losses from cash flow hedging derivatives
- Unrealized gains & losses from available-for-sale securities.