3. Understanding Income Statements

Under the IASB Conceptual Framework, expenses are

"decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants."

Also under IFRS, unrealized gains and losses are reflected as other comprehensive income for:

(a) "debt securities held within a business model whose objective is achieved both by collecting contractual cash flows and selling financial assets"; and (b) equity investments for which the company makes an irrevocable election at initial recognition to show gains and losses as part of other comprehensive income. These debt and equity investments are referred to as being measured at fair value through other comprehensive income. Accounting for these securities is similar to accounting for US GAAP's available- forsale debt securities.

Under US GAAP, unrealized gains and losses are reflected in the income statement for:

(a) debt securities designated as trading securities; and (b) all investments in equity securities (other than investments giving rise to ownership positions that confer significant influence over the investee). The trading securities category pertains to a debt security that is acquired with the intent of selling it rather than holding it to collect the interest and principal payments. Also, under US GAAP, unrealized gains and losses are reflected as other comprehensive income for debt securities designated as available- for- sale securities. Available- for- sale debt securities are those not designated as either held- to- maturity or trading.

Under IFRS, unrealized gains and losses are reflected in the income statement for:

(a) investments in equity investments, unless the company makes an irrevocable election otherwise; and (b) debt securities, if the securities do not fall into the other measurement categories or if the company makes an irrevocable election to show gains and losses on the income statement. These debt and equity investments are referred to as being measured at fair value through profit or loss.

The diminishing balance method

(also known as the declining balance method). Under the diminishing or declining balance method, the first step is to determine the straight- line rate, the rate at which the asset would be depreciated under the straight- line method. The next step is to determine an acceleration factor that approximates the pattern of the asset's wear. Common acceleration factors are 150 percent and 200 percent.

Intangible assets

(assets lacking physical substance) such as trademarks. Examples of intangible long- lived assets with a finite useful life include an acquired mailing list, an acquired patent with a set expiration date, and an acquired copyright with a set legal life.

Four types of items are treated as other comprehensive income under both IFRS and US GAAP.

-Foreign currency translation adjustments. -Unrealized gains or losses on derivatives contracts accounted for as hedges. -Unrealized holding gains and losses on a certain category of investment securities. -Certain costs of a company's defined benefit post-retirement plans that are not recognized in the current period.

Alternative inventory costing methods

-Specific identification method -FIFO method -Weighted average cost method -LIFO method

Income Statement Ratios

-profitability

Correction of an error for a prior period

Another possible adjustment is a correction of an error for a prior period (e.g., in financial statements issued for an earlier year). This cannot be handled by simply adjusting the current period income statement. Correction of an error for a prior period is handled by restating the financial statements (including the balance sheet, statement of owners' equity, and cash flow statement) for the prior periods presented in the current financial statements.

Warranties

At times, companies offer warranties on the products they sell. If the product proves deficient in some respect that is covered under the terms of the warranty, the company will incur an expense to repair or replace the product. One possible approach would be for a company to wait until actual expenses are incurred under the warranty and to reflect the expense at that time. However, this would not result in a matching of the expense with the associated revenue. Under the matching principle, a company is required to estimate the amount of future expenses resulting from its warranties to recognize an estimated warranty expense in the period of the sale, and to update the expense as indicated by experience over the life of the warranty.

Changes in Accounting Policies

At times, standard setters issue new standards that require companies to change accounting policies. Depending on the standard, companies may be permitted to adopt the standards prospectively (in the future) or retrospectively (restate financial statements as though the standard existed in the past). Changes in accounting policies are reported through retrospective application unless it is impractical to do so.

Common- size analysis of the income statement

Common- size analysis of the income statement can be performed by stating each line item on the income statement as a percentage of revenue. Common- size statements facilitate comparison across time periods (time series analysis) and across companies (cross- sectional analysis) because the standardization of each line item removes the effect of size.

Depreciation and Amortisation

Companies commonly incur costs to obtain long- lived assets. The costs of most long- lived assets are allocated over the period of time during which they provide economic benefits. The two main types of long- lived assets whose costs are not allocated over time are land and those intangible assets with indefinite useful lives.

Issues in Expense Recognition

Doubtful Accounts Warranties Depreciation and Amortisation

Grouping by nature and grouping by function

Expenses may be grouped together either by their nature or function. Grouping together expenses such as depreciation on manufacturing equipment and depreciation on administrative facilities into a single line item called "depreciation" is an example of a grouping by nature of the expense. An example of grouping by function would be grouping together expenses into a category such as cost of goods sold, which may include labour and material costs, depreciation, some salaries (e.g., salespeople's), and other direct sales related expenses.

If the convertible shares had been converted, there would be two effects.

First, the convertible preferred securities would no longer be outstanding; instead, additional common stock would be outstanding. Thus, under the if- converted method, the weighted average number of shares outstanding would be higher than in the basic EPS calculation. Second, if such a conversion had taken place, the company would not have paid preferred dividends. Thus, under the if- converted method, the net income available to common shareholders would be higher than in the basic EPS calculation.

Gross profit margin

Gross profit (gross margin) is calculated as revenue minus cost of goods sold, and the gross profit margin is calculated as the gross profit divided by revenue. The gross profit margin measures the amount of gross profit that a company generated for each dollar of revenue. A higher level of gross profit margin indicates higher profitability and thus is generally more desirable.

There are two other differences between IFRS and US GAAP to note:

IFRS require each component of an asset to be depreciated separately and US GAAP do not require component depreciation; and IFRS require an annual review of residual value and useful life, and US GAAP do not explicitly require such a review.

Unusual or Infrequent Items

IFRS require that items of income or expense that are material and/or relevant to the understanding of the entity's financial performance should be disclosed separately. Under US GAAP, material items that are unusual or infrequent, and that are both as of reporting periods beginning after December 15, 2015, are shown as part of a company's continuing operations but are presented separately. For example, restructuring charges, such as costs to close plants and employee termination costs, are considered part of a company's ordinary activities. As another example, gains and losses arising when a company sells an asset or part of a business, for more or less than its carrying value, are also disclosed separately on the income statement. These sales are considered ordinary business activities.

Diluted EPS

If a company has a simple capital structure (in other words, one that includes no potentially dilutive financial instruments), then its basic EPS is equal to its diluted EPS. Diluted EPS, by definition, is always equal to or less than basic EPS.

simple capital structure

If a company's capital structure does not include potentially convertible financial instruments, it is said to have a simple capital structure.

Changes in accounting estimates

In contrast to changes in accounting policies (such as whether to expense the cost of employee stock options), companies sometimes make changes in accounting estimates (such as the useful life of a depreciable asset). Changes in accounting estimates are handled prospectively, with the change affecting the financial statements for the period of change and future periods.

Net income

Includes gains and losses, which are increases and decreases in economic benefits, respectively, which may or may not arise in the ordinary activities of the business. For example, when a manufacturing company sells its products, these transactions are reported as revenue, and the costs incurred to generate these revenues are expenses and are presented separately.

Other Issues with Diluted EPS

It is possible that some potentially convertible securities could be antidilutive (i.e., their inclusion in the computation would result in an EPS higher than the company's basic EPS). Under IFRS and US GAAP, antidilutive securities are not included in the calculation of diluted EPS. Diluted EPS should reflect the maximum potential dilution from conversion or exercise of potentially dilutive financial instruments. Diluted EPS will always be less than or equal to basic EPS.

net book value

Net book value, also known as net asset value, is the value at which a company reports an asset on its balance sheet. It is calculated as the original cost of an asset less accumulated depreciation, accumulated amortization, accumulated depletion or accumulated impairment.

Both IFRS and US GAAP allow companies two alternative presentations

One alternative is to present two statements—a separate income statement and a second statement additionally including other comprehensive income. The other alternative is to present a single statement of other comprehensive income. Particularly in comparing financial statements of two companies, it is relevant to examine significant differences in comprehensive income.

Net profit margin

One indicator of profitability is net profit margin, also known as profit margin and return on sales, which is calculated as net income divided by revenue (or sales). Net profit margin measures the amount of income that a company was able to generate for each dollar of revenue. A higher level of net profit margin indicates higher profitability and is thus more desirable. Net profit margin can also be found directly on the common- size income statements.

Operating profit (or, synonymously, operating income)

Operating profit results from deducting operating expenses such as selling, general, administrative, and research and development expenses from gross profit. Operating profit reflects a company's profits on its business activities before deducting taxes, and for non-financial companies, before deducting interest expense. For financial companies, interest expense would be included in operating expenses and subtracted in arriving at operating profit because it relates to the operating activities for such companies. Operating profit is sometimes referred to as EBIT (earnings before interest and taxes). However, operating profit and EBIT are not necessarily the same.

The basic equation underlying the income statement, ignoring gains and losses, is

Revenue minus Expenses equals Net income.

Income

The IASB Conceptual Framework for Financial Reporting (Conceptual Framework) defines income as: Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. In IFRS, the term "income" includes revenue and gains. Gains are similar to revenue, but they typically arise from secondary or peripheral activities rather than from a company's primary business activities. For example, for a restaurant, the sale of surplus restaurant equipment for more than its carrying value is referred to as a gain rather than as revenue. Similarly, a loss typically arises from secondary activities. Gains and losses may be considered part of operating activities (e.g., a loss due to a decline in the value of inventory) or may be considered part of non-operating activities (e.g., the sale of non-trading investments).

Specific identification method

The specific identification inventory valuation method is a system for tracking every single item in an inventory individually from the time it enters the inventory until the time it leaves it. Identifies which inventory items were sold and which remained in inventory to be carried over to later periods. It is generally not feasible to specifically identify which items were sold and which remain on hand, so accounting standards permit the assignment of inventory costs to costs of goods sold and to ending inventory using cost formulas (IFRS terminology) or cost flow assumptions (US GAAP).

LIFO method

This is the last in, first out (LIFO) method. Under the LIFO method, the newest goods purchased (or manufactured) are assumed to be sold first and the oldest goods purchased (or manufactured) are assumed to remain in inventory.

How to register interest and dividends under de US GAAP and IFRS

Under IFRS, interest and dividends received can be shown either as operating or as investing on the statement of cash flows, while under US GAAP interest and dividends received are shown as operating cash flows. Under IFRS, interest and dividends paid can be shown either as operating or as financing on the statement of cash flows, while under US GAAP, interest paid is shown as operating and dividends paid are shown as financing.)

comprehensive income

Under US GAAP, comprehensive income is defined as "the change in equity [net assets] of a business enterprise during a period from transactions and other events and circumstances from non- owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.". While the wording differs, comprehensive income is conceptually the same under IFRS and US GAAP.

Discontinued Operations

When a company disposes of or establishes a plan to dispose of one of its component operations and will have no further involvement in the operation, the income statement reports separately the effect of this disposal as a "discontinued" operation under both IFRS and US GAAP.

Diluted EPS When a Company Has Convertible Debt Outstanding

When a company has convertible debt outstanding, the diluted EPS calculation also uses the if- converted method. Diluted EPS is calculated as if the convertible debt had been converted at the beginning of the period. If the convertible debt had been converted, the debt securities would no longer be outstanding; instead, additional shares of common stock would be outstanding. Also, if such a conversion had taken place, the company would not have paid interest on the convertible debt, so the net income available to common shareholders would increase by the after- tax amount of interest expense on the debt converted.

Diluted EPS When a Company Has Convertible Preferred Stock Outstanding

When a company has convertible preferred stock outstanding, diluted EPS is calculated using the if- converted method. The if- converted method is based on what EPS would have been if the convertible preferred securities had been converted at the beginning of the period.

complex capital structure

When a company has issued any financial instruments that are potentially convertible into common stock, it is said to have a complex capital structure. Examples of financial instruments that are potentially convertible into common stock include convertible bonds, convertible preferred stock, employee stock options, and warrants.

Diluted EPS When a Company Has Stock Options, Warrants, or Their Equivalents Outstanding

When a company has stock options, warrants, or their equivalents outstanding, diluted EPS is calculated as if the financial instruments had been exercised and the company had used the proceeds from exercise to repurchase as many shares of common stock as possible at the average market price of common stock during the period. The weighted average number of shares outstanding for diluted EPS is thus increased by the number of shares that would be issued upon exercise minus the number of shares that would have been purchased with the proceeds. This method is called the treasury stock method under US GAAP because companies typically hold repurchased shares as treasury stock. The same method is used under IFRS but is not named.

Doubtful Accounts

When a company sells its products or services on credit, it is likely that some customers will ultimately default on their obligations (i.e., fail to pay). One possible approach to recognizing credit losses on customer receivables would be for the company to wait until such time as a customer defaulted and only then recognize the loss (direct write- off method). The company records its estimate of uncollectible amounts as an expense on the income statement, not as a direct reduction of revenues.

Generally, alternatives to the straight- line method of depreciation are called

accelerated methods of depreciation because they accelerate (i.e., speed up) the timing of depreciation. Accelerated depreciation methods allocate a greater proportion of the cost to the early years of an asset's useful life. These methods are appropriate if the plant or equipment is expected to be used up faster in the early years (e.g., an automobile). A commonly used accelerated method is the diminishing balance method.

straight-line method

allocates evenly the cost of long- lived assets less estimated residual value over the estimated useful life of an asset. (The term "straight line" derives from the fact that the annual depreciation expense, if represented as a line graph over time, would be a straight line.

In most cases under IFRS and US GAAP, amortisable intangible assets are

amortized using the straight-line method with no residual value. Goodwill and intangible assets with indefinite life are not amortized. Instead, they are tested at least annually for impairment (i.e., if the current value of an intangible asset or goodwill is materially lower than its value in the company's books, the value of the asset is considered to be impaired and its value in the company's books must be decreased).

According to the standard, a contract is

an agreement and commitment, with commercial substance, between the contacting parties. It establishes each party's obligations and rights, including payment terms.

Long-lived assets

are assets expected to provide economic benefits over a future period of time greater than one year. Examples are land (property), plant, equipment.

Ordinary shares

are those equity shares that are subordinate to all other types of equity. The ordinary shareholders are basically the owners of the company—the equity holders who are paid last in a liquidation of the company and who benefit the most when the company does well. Under US GAAP, this ordinary equity is referred to as common stock or common shares, reflecting US language usage.

Non-Operating Items

are typically reported separately from operating income because ythey are material and/or relevant to the understanding of the entity's financial performance. Under IFRS, there is no definition of operating activities, and companies that choose to report operating income or the results of operating activities should ensure that these represent activities that are normally regarded as operating. Under US GAAP, operating activities generally involve producing and delivering goods and providing services and include all transactions and other events that are not defined as investing or financing activities.

Weighted average cost method

assigns the average cost of goods available for sale to the units sold and remaining in inventory. The assignment is based on the average cost per unit (total cost of goods available for sale/total units available for sale) and the number of units sold and the number remaining in inventory.

two analytical tools to analyze the income statement:

common-size analysis and income statement ratios.

Three types of potentially dilutive financial instruments on diluted EPS:

convertible preferred, convertible debt, and employee stock options.

Double declining balance depreciation

depreciates the asset at double the straight-line rate. Determines an acceleration factor that approximates the pattern of the asset's wear. Common acceleration factors are 150 percent and 200 percent. Companies often adopt a depreciation policy that combines the diminishing balance and straight-line methods. Under accelerated depreciation methods, there is a higher depreciation expense in early years relative to the straight-line method.

The cost formula or cost flow assumption

determines which goods are assumed to be sold and which goods are assumed to remain in inventory. Both IFRS and US GAAP permit the use of the first in, first out (FIFO) method, and the weighted average cost method to assign costs.

Period costs

expenditures that less directly match revenues, are reflected in the period when a company makes the expenditure or incurs the liability to pay. Administrative expenses are an example of period costs.

The distinction between simple versus complex capital structure is relevant to the calculation of EPS because

financial instruments that are potentially convertible into common stock could, as a result of conversion or exercise, potentially dilute (i.e., decrease) EPS. Information about such a potential dilution is valuable to a company's current and potential shareholders; therefore, accounting standards require companies to disclose what their EPS would be if all dilutive financial instruments were converted into common stock. The EPS that would result if all dilutive financial instruments were converted is called diluted EPS.

Revenue

generally refers to the amount charged for the delivery of goods or services in the ordinary activities of a business. Revenue may also be called sales or turnover. Revenue is reported after adjustments (e.g., for cash or volume discounts, or for other reductions), and the term net revenue is sometimes used to specifically indicate that the revenue has been adjusted (e.g., for estimated returns).

How to register incremental costs of obtaining a contract

incremental costs of obtaining a contract and certain costs incurred to fulfill a contract must be capitalized under the new standards (i.e., reported as an asset on the balance sheet rather than as an expense on the income statement).

Minority interests in income statements

information about how much of that net income is attributable to the company itself and how much of that income is attributable to noncontrolling interests, also known as minority interests. The companies consolidate subsidiaries over which they have control. Consolidation means that they include all of the revenues and expenses of the subsidiaries even if they own less than 100 percent. Noncontrolling interest represents the portion of income that "belongs" to the minority shareholders of the consolidated subsidiaries, as opposed to the parent company itself.

Total comprehensive income

is "the change in equity during a period resulting from transaction and other events, other than those changes resulting from transactions with owners in their capacity as owners.

Profitability

is ability of a company to use its resources to generate revenues in excess of its expenses. In other words, this is a company's capability of generating profits from its operations.

Earnings per share (EPS)

is an input into ratios such as the price/earnings ratio. Additionally, each shareholder in a company owns a different number of shares. IFRS require the presentation of EPS on the face of the income statement for net profit or loss (net income) and profit or loss (income) from continuing operations. Similar presentation is required under US GAAP.

Basic EPS

is calculated using the reported earnings available to common shareholders of the parent company and the weighted average number of shares outstanding. Companies are required to report both basic and diluted EPS as well as amounts for continuing operations.

A company's capital

is composed of its equity and debt. Some types of equity have preference over others, and some debt (and other instruments) may be converted into equity. Under IFRS, the type of equity for which EPS is presented is referred to as ordinary.

Vertical common- size analysis of the income statement

is particularly useful in cross- sectional analysis—comparing companies with each other for a particular time period or comparing a company with industry or sector data. The analyst could select individual peer companies for comparison, use industry data from published sources, or compile data from databases based on a selection of peer companies or broader industry data

Goodwill

is recorded in acquisitions and is the amount by which the price to purchase an entity exceeds the amount of net identifiable assets acquired (the total amount of identifiable assets acquired less liabilities assumed).

Depreciation

is the process of systematically allocating costs of long- lived assets over the period during which the assets are expected to provide economic benefits.

amortisation

is the term commonly applied to this process for intangible long- lived assets with a finite useful life. The term "amortisation" is also commonly applied to the systematic allocation of a premium or discount relative to the face value of a fixed- income security over the life of the security.

The transaction price

is what the seller estimates will be received in exchange for transferring the good(s) or service(s) identified in the contract.

Retrospective application

means that the financial statements for all fiscal years shown in a company's financial report are presented as if the newly adopted accounting principle had been used throughout the entire period.

Income statement

presents information on the financial results of a company's business activities over a period of time. The income statement communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. The income statement is also sometimes referred to as the "statement of operations," "statement of earnings," or "profit and loss (P&L) statement.

pretax margin

profit before tax divided by revenue

operating profit margin

profit from operations divided by revenue

Expenses

reflect outflows, depletions of assets, and incurrences of liabilities in the course of the activities of a business.

Other comprehensive income

reported shareholders' equity of one period links with reported shareholders' equity of the next period, we must understand these excluded items, known as other comprehensive income. Under IFRS, other comprehensive income includes items of income and expense that are "not recognized in profit or loss as required or permitted by other IFRS.

A fundamental principle of accrual accounting is that

revenue is recognized (reported on the income statement) when it is earned, so the company's financial records reflect revenue from the sale when the risk and reward of ownership is transferred; this is often when the company delivers the goods or services. If the delivery was on credit, a related asset, such as trade or accounts receivable, is created.

IFRS do not prescribe a particular method for computing depreciation but note that several methods are commonly used

such as the straight- line method, diminishing balance method (accelerated depreciation), and the units of production method (depreciation varies depending upon production or usage).

Gross profit or gross margin

that is revenue less cost of sales. When an income statement shows a gross profit subtotal, it is said to use a multi-step format rather than a single-step format. Profit is a frequently used measure of performance and is composed of income and expenses.

Accounting Standards for Revenue Recognition: The core principle of the converged standard is

that revenue should be recognized to "depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in an exchange for those goods or services."

For purposes of assessing a company's future performance

the amount of financing expense will depend on the company's financing policy (target capital structure) and borrowing costs. The amount of investing income will depend on the purpose and success of investing activities. For a non- financial company, a significant amount of financial income would typically warrant further exploration.

IFRS allow two alternative models for valuing property, plant, and equipment:

the cost model and the revaluation model. Under the cost model, the depreciable amount of that asset (cost less residual value) is allocated on a systematic basis over the remaining useful life of the asset. Under the cost model, the asset is reported at its cost less any accumulated depreciation. Under the revaluation model, the asset is reported at its fair value. The revaluation model is not permitted under US GAAP.

Calculating depreciation and amortisation requires two significant estimates:

the estimated useful life of an asset and the estimated residual value (also known as "salvage value") of an asset. Under IFRS, the residual value is the amount that the company expects to receive upon sale of the asset at the end of its useful life.

A general principle of expense recognition is

the matching principle. Strictly speaking, IFRS do not refer to a "matching principle" but rather to a "matching concept" or to a process resulting in "matching of costs with revenues." Under matching, a company recognizes some expenses (e.g., cost of goods sold) when associated revenues are recognized and thus, expenses and revenues are matched. Matching requires that a company recognizes cost of goods sold in the same period as revenues from the sale of the goods.

Under the FIFO method

the oldest goods purchased (or manufactured) are assumed to be sold first and the newest goods purchased (or manufactured) are assumed to remain in inventory.

Even where unrealized holding gains and losses are excluded from a company's net income (profit and loss)

they are included in other comprehensive income and thus form a part of a company's comprehensive income.

Unearned revenue

when the cash is initially received, and revenue would be recognized as being earned over time as products and services are delivered. An example would be a subscription payment received for a publication that is to be delivered periodically over time.

The calculation of diluted EPS using the treasury stock method, the assumed exercise for financial instruments would have the following effects:

■ The company is assumed to receive cash upon exercise and, in exchange, to issue shares. ■ The company is assumed to use the cash proceeds to repurchase shares at the weighted average market price during the period.