Reading 23: Understanding Income Statements

Diluted EPS Equation

(Adjusted Income available for Common Shares)/(Weighted-average common and potential common shares outstanding)

Analytical Implications of Unusual or Infrequent Items

-An analyst may want to review them to decide they should be included when forecasting future earnings. -They still affect net income from continuing operations.

Gains and losses

-also included on the income statement. Result in an increase (gains) or decrease (losses) of economic benefits. -gains and losses may or may not result from ordinary business activities.

Interest Expense for Financial Firms

-considered an operating expense

Long-term Contracts

-in some cases, revenue may be recognized before delivery occurs or even after delivery takes place. The percentage of completion method and completed-contract method are used for contract that extend beyond one accounting period, often related to construction projects.

Changes in Accounting Policies

1. Change in Accounting Principle 2. Changes in Accounting Estimates 3. Prior-period adjustments

Required Disclosures of converged standards for revenue recognition

1. Contracts with customers by category 2. Assets and liabilities related to contracts, including balances and changes. 3. Outstanding performance obligations and the transaction prices allocated to them. 4. Management judgement used to determine the amount and timing of revenue recognition, including any changes to those judgments.

Non-Recurring Items

1. Discontinued Operations 2. Unusual or Infrequent Items 3. Extraordinary Items

IASB and FASB Process for Revenue Recognition

1. Identify the contract(s) with a customer. 2. Identify the separate or distinct performance obligations in the contract. 3. Determine the transaction price. 4. Allocate the transaction price to the performance obligations in the contract. 5. Recognize revenue when (or as) the entity satisfies a performance obligation.

Inventory Expense Recognition Methods

1. Specific Identification 2. First-in, First-out 3. Last-in, First-out 4. Weighted Average Cost

Things to know about the weighted average shares outstanding calculation

1. The weighting system is days outstanding divided by the number of days in a year, but on the exam, the monthly approximation will probably be used. 2. Shares issued enter into the computation from the data of issuance. 3. Reacquired shares are excluded from the computation from the date of re-acquisition. 4. Shares sold or issued in a purchase of assets are included from the date of issuance. 5. A stock split or stock dividend is applied to all shares outstanding prior to the split or dividend and to the beginning -of-period weighted average shares. -A stock split or dividend is not applied to any shares issued or repurchased after the split or dividend date.

SEC criteria for revenue recognition

1. There is evidence of an arrangement between the buyer and seller. 2. The product has been delivered or the service has been rendered. 3. The price is determine or determinable 4. The seller is reasonably sure of collecting money.

Straight-Line Depreciation Formula

=(cost-residual value)/useful life

Full Formula for Diluted EPS

=[(net Income-preferred Dividends)+(Convertible preferred dividends)+(Convertible debt interest)*(1-t)]/[(weighted average shares)+(shares from conversion of convertible preferred shares)+(shares from conversion of convertible debt)+(Shares issuable from stock options)]

Operating Profit

=gross profit - operating expenses operating expenses include selling, general, and administrative expenses. -For nonfinancial firms, operating profit is profit before financing costs, income taxes, and non-operating items are considered Net Income= Operating profit-interest expense-income taxes.

Net Income

=income (revenues+gains) - expenses (including losses) =revenues-ordinary expenses+other income-other expense+gains-losses

Adjusted Income for potential shareholders

=net income - preferred dividends + dividends on convertible preferred stock +after-tax interest on convertible debt

FASB Revenue Recognition

According to FASB, revenue is recognized in the income statement when both 1. realized or realizable 2. earned

Expenses (IASB)

According to the IASB, expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity other than those relating to distributions to equity participants. -Detract from revenue to calculate net income

Analytical Implications of a Change in Accounting Estimates

Accounting estimate changes typically do not affect cash flow. Review changes in accounting estimates to determine the impact on future operating results.

Complex Capital Structure

Contains potentially dilutive securities such as options, warrants, or convertible securities.

Expense Recognition Implications on Financial Analysis

Expense recognition requires a number of estimates. -It is possible for a firm to delay or accelerate the recognition of expenses. -Delayed expense recognition increases current net income and is therefore more aggressive. Analysts must consider the underlying reasons for a change in an expense estimate. -If a firm's bad debt expense has recently decreased, did the firm lower its expense estimate because its collection experience improved, or was the expense decreased to manipulate net income? Compare a firm's estimates to those of other firms with the firm's industry. -If a firm's warranty expense is significantly less that that of a peer, is the lower warranty expense a result of higher quality of products or is the firm's expense recognition more aggressive than that of the peer firm? Firms disclose their accounting policies and significant estimates in the financial statement footnotes and in the MD&A section of the annual report.

How can expenses be expressed?

For a $1000 expense: 1. As a negative number: -$1000 2. As a positive numner: $1000 3. In parentheses: ($1000)

Expected Loss under IFRS and GAAP

For long-term contracts, if a loss is expected, the loss must be recognized immediately under IFRA and U.S. GAAP.

IFRS and FASb converged standard and long term contract revenue recognition

For long-term contracts, revenue is recognized based on a firm's progress toward completing a performance obligation. This treatment is consistent with the percentage-of-completion method currently in use, although the new standards do not call it that.

When Revenue is recognized under IASB (Services)

For services rendered, revenue is recognized when: 1. The amount of the revenue can be reliably measured. 2. There is a probable flow of economic benefits. 3. The stage of completion can be measured. 4. The cost incurred and cost of completion can be reliably measured.

Gross and Net Reporting of Revenue

Gross Revenue Reporting- The selling firm reports sales revenue and cost of goods sold separately. Net Revenue Reporting- Only the difference in sales and cost is reported. Profit is the same under both, but sales are higher using gross revenue reporting.

Specific Identification method

If a firm can identify exactly which items were sold and which items remain in inventory, it can use the specific identification method. ex: auto dealers records each vehicle sold or in inventory by its identification number.

Noncontrolling Interest

If a firm has a controlling interest in a subsidiary, the pro rata share of the subsidiary's income not owned by the parent is reported in parent's income statement as noncrontrolling interest. -subtracted in arriving at net income because the parent is reporting all of the subsidiary's revenue and expense.

Unearned Revenue

If a firm receives cash before revenue recognition is complete, it must report it as unearned revenue. -reported as a liability liability is reduced as the revenue is earned.

Bad Debt Expense and Warranty Expense

If a firm sells goods or services on credit or provides a warranty to the customer, the matching principle requires the firm to estimate bad debt expense and/or warranty expense. -The firm is recognizing the expense in the period of the sale, not in a later period.

IASB and FASB Revenue Recognition

In May 2014, IASB and FASB issued converged standards for revenue recognition. -the new standards take a principles-based approach to revenue recognition issues. -The central principle is that a firm should recognize revenue when it has transferred a good or service to a customer.

Straight-Line vs. Accelerated

In the early years of an asset's life, the straight-line method will result in lower depreciation expense and higher net income compared to the accelerated method. -In later years, the effect is reversed.

Dilutive Stock Options and Warrants

Increase the number of common shares outstanding in the denominator for diluted EPS. There is no adjustment needed for the numerator.

Professors note on Interest Paid on Bonds

Interest paid on bonds is typically tax deductible for the firm. If convertible bonds are converted to stock, the firms saves the interest cost but loses the tax deduction. Thus, only after-tax interest savings are added back to income available to common shareholders.

Purposes of the Income Statement

Investors examine a firm's income statement for valuation purposes. Lenders examine the income statement for information about the firm's ability to make the promises interest and principal payments on its debt.

Benefits of LIFO

LIFO is popular in the US because of its income tax benefits. -In an inflationary environment, LIFO results in higher cost of goods sold. -Higher cost of goods sold results in lower taxable income and lower income taxes. Allowed under US GAAP and IFRS

Depreciation Expense Recogntion

Long-lived assets are expected to provide economic benefits beyond one accounting period. The allocation of cost over an asset's life is know as: -Depreciation (tangible assets) -depletion (natural resources) -amortization (intangible assets)

Weighted Average Cost Method

Makes no assumption about the physical flow of the inventory. -popular because of its ease of use. The cost per unit is calculated by dividing cost of available goods by total units available, and this average cost is used to determine both cost of goods sold and ending inventory. Average cost results in cost of goods sold and ending inventory values between those of LIFO and FIFO.

Period Costs

Not all expenses can be directly tied to revenue recognition. These costs are known as period costs. -Period costs, such as administrative expenses, are expenses in the period incurred.

Intangible Assets with Indefinite Lives

Not ammortized. -goodwill The must be tested for impairment at least annually. -If the asset is impaired, an expense equal to the impairment amount is recognized on the income statement.

Simple Capital Structure

One that contains no potentially dilutive securities. -contains only common stock, nonconvertible debt, and nonconvertible preffered stock.

Distinct Good or Service

One that meets the following criteria: 1. The customer can benefit from the good or service on its own or combined with other resources that are readily available. 2. The promise to transfer the good or service can be identified separately from any other promises.

When Can revenue be recognized

Only when there is a high probability they will not have to reverse it.

Operating vs. Non-operating components of the income statement

Operating and nonoperating transactions are usually reported separately in the income statement. For a nonfinancial firm, nonoperating transactions may result from investment income and financing expenses. EX: A nonfinancial firm may receive dividends and interest from investments in other firms. The investment income and any gains and losses from the sale of these securities are not a part of the firm's normal business operations. -Interest expense is based on a firm's capital structure, which is independent of the firm's operations. For a financial firm, investment income and financing expenses are usually considered operating activities.

Analytical Implications of Prior-Period Adjustments

Prior-period adjustments usually involve errors or new accounting standards and do not typically affect cash flow. Analysts should review adjustments carefully because errors may indicate weaknesses in the firm's internal controls.

Cost Recovery Method

Profit is recognized only when cash collected exceeds costs incurred.

Change in Accounting Principle

Refers to a change from one GAAP or IFRS method to another. -Requires retrospective application. -All of the prior-period financial statements currently presented are restated to reflect the change. Retrospective Application enhances the comparability of the financial statements over time.

Stock Split

Refers to the division of each "old" share into a specific number of "new" shares. -The holder of 100 shares will have 200 shares after a 2-1 split. Proportional ownership in the company is unchanged.

Income Statement

Reports the revenues and expenses of a firm over a period of time. -aka statement of operations and profit and loss statement Income Statement Equation: Revenues-Expenses=Net Income

When Revenue is Recognized according to IASB (Goods)

Revenue is recognized from the sale of goods when: 1. The risk and reward of ownership is transferred. 2. There is no continuing control or management over the goods sold. 3. Revenue can be reliably measured. 4. There is a probable flow of economic benefits. 5. The cost can be reliably measured.

Accrual Accounting

Revenue is recognized when earned and expenses are recognized when incurred. -does not necessarily coincide with the receipt or payment of cash. -Firms can manipulate net income by recognizing revenue earlier or later by delaying or accelerating the recognition of expenses.

Effects of Converged Standards for Revenue Recognition

Revenue recognition will be little changed under the new standards. -industries that are expected to be affected the most are those that sell bundles of goods and services. -software, telecommunications

Dilutive Securities

Stock options, warrants, convertible debt, or convertible preferred stock that would decrease EPS if exercised or converted to common stock.

Antidilutive securities

Stock options, warrants, convertible debt, or convertible preferred stock that would increases EPS if exercised or converted to common stock.

Transaction Price

The amount a firm expects to receive from a customer in exchange for transferring a good or service to the customer. Usually a fixed amount but can be variable. -example: if it includes a bonus for early delivery.

Expenses

The amounts incurred to generate revenue and include: 1. cost of goods sold 2. operating expenses 3. interest 4. taxes -grouped by their nature or function. ex: Presenting all depreciation expense from manufacturing and administration together in one line

Measurement Date

The date when the company develops a formal plan for disposing of an operation. On the measurement date, the company will accrue any estimated loss during the phaseout period and any estimated loss from the sale of the business. Any expected gain on the disposal cannot be reported until after the sale is completed.

Installment Payments under IFRS

The discounted present value of the installment payments is recognized at the time of sale. The difference between the installment payments and the discounted present value is recognized as interest over time. If the outcome of the project cannot be reliably estimated, revenue recognition under IFRS is similar to the cost recovery method.

Stock Dividend

The distribution of additional shares to each shareholder in an amount proportional to their current number of shares. -If 10% stock dividend is paid, the holder of 100 shares of stock would receive 10 additional shares. -proportional ownership in the company is unchanged.

GAAP Gross Revenue Reporting Criteria

The following criteria must be met in order to use gross revenue reporting: 1. Be the primary obligor under the contract. 2. Bear the inventory risk and credit risk. 3. Be able to choose its supplier 4. Have reasonable latitude to establish the price

Presentation of Income Statement under IFRS

The income statement can be combined with "other comprehensive income" and presented as a single statement of comprehensive income. -Or they can be presented separately. Presentation is similar under GAAP

Double-Declining Balance Method

The most common declining balance method, which applies two times the straight line rate to the declining balance. EX: IF an asset's life is ten years, the SL rate is 10% and the DDB rate would be 20%. DDB Depreciation= (2/useful life)(Cost-accumulated depreciation) DB does not explicitly use the asset's residual value in the calculations, but depreciation ends once the estimated residual value has been reached. If the asset is expected to have no residual value, it will have to change to SL depreciation at some point as DB will never fully depreciate the asset.

Weighted average number of common shares

The number of shares outstanding during the year, weighted by the portion of the year they were outstanding.

Adjustments for Numerator of Dilutive EPS

The numerator of basic EPS contains income available to common stockholders. If there are dilutive securities, the numerator of Diluted EPS must be adjusted as follows: 1. If convertible preferred stock is dilutive, the convertible preferred dividends must be added to earnings available to common shareholders. 2. If convertible bonds are dilutive, then the bonds' 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

Completed Contract vs Percentage of Completion

The percentage-of-completion method is more aggressive since revenue is reported sooner. -the percentage-of-completion method is more subjective because it involves cost estimates. -the percentage of completion method provides smoother earnings and results in better matching of revenues and expenses over time. Cash flows are the same under both

Change in Accounting Estimate

The result of a change in management's judgment usually due to new information. -Ex: Management may change the estimated useful life of an asset because new information indicates the asset has a longer or shorter life than originally expected. A change in estimate is applied prospectively and does not require the restatement of prior financial statements.

Straight-ling Depreciation

The straight-line method recognizes an equal amount of depreciation expense each period. -However, most assets generate more benefits in the early years of their economic life and fewer benefits in the later years. In this case, an accelerated depreciation method is more appropriate for matching expenses with revenues.

Phaseout Period

The time between the measurement period and the actual disposal date.

Unusual or Infrequent Items

These events are either unusual in nature or infrequent in occurrence. Examples include: 1. Gains or losses from the sale of assets or part of a business, if these activities are not a firm's ordinary operations. 2. Impairments, write-offs, write-downs, and restructuring costs. -These are included in income from continuing operations and are reported before tax.

First-In, First-Out (FIFO)

Under FIFO, the first item purchased is assumed to be the first item sold. The cost of inventory acquired first is used to calculate the cost of goods sold for the period. The cost of the most recent purchases is used to calculate ending inventory. Appropriate for inventory with a limited shelf life. EX: food products Allowed under US GAAP and IFRS

Extraordinary Items

Under GAAP historically, an extraordinary item was a material transaction or event that was both unusual and infrequent in occurrence. -US GAAP and IFRS do not allow items to be treated as extraordinary.

Retrospective Application Exception under GAAP

Under GAAP, a firm that changes to LIFO from another inventory cost method does not apply the change retrospectively, but instead uses the carrying value of inventory as the first LIFO layer.

IFRS Long-term Contract revenue recognition

Under IFRS, if the firm cannot reliably measure the outcome of the project, revenue is recognized to the extent of contract costs, costs are expenses when incurred, and profit is recognized only at completion.

Barter Transcations under IFRS

Under IFRS, revenue from barter transactions must be based on the fair value of revenue from similar nonbarter transactions with unrelated parties.

Last-In, First-Out (LIFO)

Under LIFO, the last item purchased is assumed to be the first item sold. The cost of inventory most recently purchased is assigned to the cost of goods sold for the period. The costs of beginning inventory and earlier purchases are assigned to ending inventory. LIFO is appropriate for inventory that does not deteriorate with age. Ex: a coal distributor will sell coal off the top of the pile Allowed under US GAAP but not IFRS

Completed-Contract Method

Under U.S. GAAP, the completed-contract method is used when the outcome of the project cannot be reliably estimated. Accordingly, revenue, expense, and profit are recognized only when the contract is complete.

Barter Transactions under US GAAP

Under US GAAP, revenue from a barter transaction can be recognized at fair value only if the firm has historically received cash payments for such goods and services and can use historical experience to determine fair value -Otherwise the revenue is recorded at the carrying value of the asset surrendered.

Matching Principle (Expense Recognition)

Under accrual accounting, expenses to generate revenue are recognized in the same period as the revenue. ex: assume inventory is purchased in Q4 2018, but sold in Q1 of 2019. Both the revenue from those sales and the expenses of acquiring the inventory would be accounted for in Q1 2019.

Installment method

Under the installment method, profit is recognized as cash is collected. Profit is equal to the cash collected during the period multiplied by the total expected profit as a percentage of sales.

Implications of Revenue Recognition for Financial Analysis

Users of financial information must consider two points when analyzing a firm's revenue: 1. How conservative are the firm's revenue recognition policies 2. The extent to which the firm's policies rely on judgment and estimates.

Diluted EPS Denominator

When the firm has dilutive securities outstanding, the denominator is the basic EPS denominator adjusted for the equivalent number of common shares that would be created by the conversion of all dilutive securities outstanding with each one considered separately to determine if it is dilutive. If a dilutive security was issued during the year, the increase in the weighted average number of shares for diluted EPS is based only on the portion of the year the dilutive security was outstanding.

Percentage-of-Completion method

When the outcome of a long-term contract can be reliably estimated, the percentage-of-completion method is under both IFRS and GAAP. -Revenue, expense, and therefore profit, are recognized as the work is performed. =(total cost incurred to date)/(total expected cost of the project)

Barter Transaction

aka non monetary exchange when two parties exchange goods or services without cash payment. -should revenue be recognized?

Revenues

are the amounts reported from the sale of goods and services in the normal course of business. Net Revenue= revenue less adjustments for estimated returns and allowances -revenue and "sales" are sometimes used synonymously. However, sales is just one component of revenue in many firms. In some countries, revenue is called turnover.

What depends importantly on a firm's income statement?

estimates of future earnings and therefore estimates of firm value.

Round-trip transaction

involves the sale of goods to one party with the simultaneous purchase of almost identical goods from the same party -should revenue be recognized?

Accelerated Depreciation

speeds up the recognition of depreciation expense in a systematic way to recognize more depreciation expense in the early years of the asset's life and less depreciation expense in the later years of its life. -Total depreciation expense over the life of the asset is the same as in SL Depreciation. -Declining Balance method applies a constant rate of depreciation to an asset's book value each year.

Prior-Period Adjustment

A change from an incorrect accounting method to one that is acceptable under GAAP or IFRS or the correction of an accounting error made in previous Financial Statements. Prior-period adjustments are made by restating results for all prior periods in the current financial statements. Disclosure of the nature of the adjustment and its effect on net income is also required.

Income Statement Presentation Formats

A firm can present an income statement in two formats: 1. SIngle-step: all revenues are grouped together and all expenses are grouped together 2. Multi-step: Includes gross profit, =revenues-COGS

Amortization

Amortization is the allocation of the cost of an intangible asset (like a franchise agreement) over its useful life. -Should match the proportion of the asset's economic benefits used during the period. -Most firms use straight-line amortization -Calculated just like SL depreciation.

Gross Profit

Amount that remains after the direct costs of producing a good are subtracted from revenue.

Installment Sale

An installment sale occurs when a firm finances a sale and payments are expected to be received over an extended period. 1. If collectibility is certain, revenue is recognized at the time of sale using the normal revenue recognition criteria. 2. Is collectibility cannot be reasonably estimated, the installment method is used. 3. If collectibility is highly uncertain, the cost recovery method is used. -both the installment and cost recovery methods are used only for sales and real estate.

Discontinued Operations

An operation 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 must be physically and operationally distinct from the rest of the firm

How are Discontinued Operations Reported?

Any income or loss from discontinued operations is reported separately in the income statement, net of tax, after income from continuing operations. -Any past income statements that presented must be restated, separating the income or loss from the discontinued operations.

Contract

As defined by the converged standard under IASB and FASB. An agreement between two or more parties that specifies their obligations and rights. -collectability must be probable for a contract to exist. -"probable" is defined differently under GAAP and IFRS, so an identical activity can still be accounted for differently.

Performance Obligation

As defined under converged standard of revenue recognition. A promise to deliver a "distinct" good or service

Analytical Implications of Discontinued Operations

Discontinued operations do not affect net income from continuing operations. -Should be excluded when forecasting future earnings. -The actual event of discontinuing a business segment or selling assets may provide information about the future cash flows of the firm.

Basic EPS

Does not consider the effects of any dilutive securities. =(net income- preferred dividends)/(Weighted average number of common shares outstanding) Preferred dividends are subtracted from net income because EPS refers to the per-share earnings available to common shareholders. -net income minus preferred dividends is income available to common stockholders. Common stock dividends are not subtracted.

Earnings per share (EPS)

EPS is reported only for shares of common stocks. Must know whether a firm has simple or complex capital structure before computing EPS. All firms with complex capital structures must report both basic and diluted EPS. -Firms with simple capital structure only report basic EPS.