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CFA Financial Reporting and Analysis
Understanding Income Statement
60
Finance
Undergraduate 4
05/16/2013

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Term
income statement
Definition
-presents info on the financial results of a co.'s business activities over a period of time
-communicates how much rev the co generated during a period and cost incurred in connection w generating that rev
Term
Components of Income Statement
Definition
Revenue; Expenses; Gross Profit; Operating Profit; Net Income
Term
Alternative Presentation Formats of IS
Definition
-firm can present its income stmt using a single step or multi-step format
-single step: all rev are grouped together and all expenses are grouped together
-Multi step: income stmt shows subtotals, especially gross profit
-placement of most recent year
-explicit use of parenthesis to indicate deduction, no indication of deduction
-COGS = Cost of Sales
-grouping of expenses by nature (e.g. depreciation) or by function (e.g. COGS <-- direct product costs)
Term
IFRS vs. U.S. GAAP (IS presentation)
Definition
IS may be presented as
IFRS:
-section of a single stmt of comprehensive income
-separate stmt followed by a stmt of comprehensive income that begins w NI
US GAAP
-section for a single stmt of comprehensive income
-separate stmt followed by a stmt of CI that begins w NI
-separate stmt w the components of other comprehensive income presented in the statement of changes in shareholders' equity
Term
Revenue
Definition
Revenues
-amounts from the sale of goods and services in the normal course of business
-sales; turnover = rev
-revenue - returns = net revenue
Term
Expenses
Definition
-amounts incurred to generate rev and include COGS, operating expenses, interest and tax
-revenue - expenses = Net income
Term
Gross Profit
Definition
Gross Profit = Revenues - COGS
Term
Operating Profit
Definition
-calculated after subtracting all direct and indirect costs from revenues
-represents profit earned by a co. from its ordinary business activities before accounting for taxes and (for non-financial firms) interest expense
--> financial firms, interest and expense are part of ordinary business activities and included in operating profit
-not affected by financing decisions of the firm
-EBIT
Term
Net Income
Definition
NI= Rev - Expenses in ordinary activities of the business + Other income - Other Expenses + Gains - Losses
-'bottom-line' of IS
-profits earned from ordinary business activities as well as gains and losses from non-operating activities
Term
Non-Controlling Interests
Definition
-if a co. owns the majority of the shares of a subsidiary, it must present consolidated financial statements
-consolidation requires parent to combine all rev and exp of subsidiary w its own and present combined results on its is
-is subsidiary is not wholly-owned, share of non-controlling interests in NI is deducted from total income as it represents the proportionate share in the subsidiary's NI that belongs to minority shareholders
Term
general principles of revenue recognition (US GAAP)
Definition
-revenue is recognized on IS when it is "realized or realizable and earned"
all conditions must hold
1) evidence of an arrangement between buyer and seller
2) product has been delivered, or the service has been rendered
3) price is determined, or determinable
4) seller is reasonable sure of collecting money
Term
genreal principles of revenue recognition (IFRS)
Definition
revenue is recognized for sale of goods when:
1) significant risks and rewards of ownership are transferred to the buyer
2) the entity retains no managerial involvement or effective control over the goods sold
3) the amount of revenue can be measured reliably
4) probably that the economic benefits from the transaction will flow to the entity
5) costs incurred or to be incurred for the transaction can be measured reliably
Term
Specific Revenue Recognition Applications
Definition
certain special circumstances in which rev may be recognized prior to the sale of a good/service or even after the sale
-LT contracts
-installment sales
-barter transactions
-gross and net reporting of revenue
Term
Revenue Recognition for LT Contracts
Definition
Contracts that extend over more than one accounting period..how should rev and exp be allocated to each acctng period?
1) Percentage of Completion Method
-use when outcome of contract can be measured reliably (IFRS AND U.S. GAAP)
-rev, costs, and profits are allocated to each accounting period in proportion the percentage of the contract completed during the given period
2) Completed Contract Method
-project outcome can't be reasonably measured in SR
- under U.S. GAAP, no revenues or costs are recognized on the IS until entire project is completed. billings and costs are accumulated on BS (under Construction in progress ASSET) rather than expensed on IS
-under IFRS, rev is recognized on the IS to the extent of costs incurred during the period. no profits recognized until completion of the project
** if loss is expected on contract, the loss must be recognized immediately, regardless of rev recognition method
Term
Installment Sales Revenue Recognition
Definition
payments are expected over extended period; firm finances a customer's purchase of its products
-deliver product immediately but receive pmt for it over time
-if sure of getting cash then recognize revenue immediately
-if collectability of rev cannot be reasonably estimated use: installment method:
Profit = Cash * Expected Profit as % of Sales
-if collectabilist is uncertain use: cost recovery method
Recognize profit after cash collection exceeds costs
Term
Revenue Recognition of Barter Transactions
Definition
-goods are exchanged between two parties and there is no exchange of cash
-round trip transaction: sale of goods to one party happens w simultaneous purchase of almost identical goods from same party (possibly used to artificially inflate revenue)
US GAAP
-fair value of rev only if the firm has historically received cash payments for such g&s and can use historical experience to determine fair value
IFRS
Fair value of revenue from similar non barter transaction w unrelated party
Term
Revenue Recognition for gross vs net reporting
Definition
gross reporting
-revenue and COGS are reported separately
net reporting
-only the difference in sales and cost is reported
US GAAP criteria for gross reporting:
-entity reporting rev must be the primary obligor
-bear inventory and credit risk
-ability to chose supplier
-latitude to establish price
Term
implications of revenue recognition principles for financial analysis
Definition
-co's are required to disclose their revenue recognition policies in the footnotes to they financial statements
-impact of a chosen policy on financial analysis depends on how conservative and objective the rev recognition policy is
-conservative policy would recognize revenue later rather than sooner
-objective policy would not leave too many estimates to mgmt discretion
Term
General Principles of Expense Recognition
Definition
Matching Principal: requires that expenses be matched w associated revenues when recognizing them on the IS
-if goods bought in current year remain unsold at end of year, their cost is not cinluded in the COGS for the current year to calculate current period profits and will instead be subtracted from next period's revenue once they are sold
Term
Period costs
Definition
cannot be directly linked to the generation of revenues and are reflected int he period when company makes expenditure or incurs liability
-ex) electricity bill, rent
Term
Inventory Expense Recognition
Definition
specific identification method
FIFO
LIFO
weighted average cost
Term
Specific identification Method
Definition
-use if co. can specifically identify which units of inventory have been sold over the year and which ones remain in stock
-difficult if sales are composed of identical units sold in high volumes
Term
First in, First-out (FIFO)
Definition
-items purchased first are sold first
-ending inventory is composed of the most recent purchases
-appropriate method for valuing inventory that has a limited shelf life
Term
Last in, First Out LIFO
Definition
-assumes items purchased most recently are sold first
-suitable when physical flow of item is such that latest item must be sold first (e.g. stack of lumber)
***not permitted under IFRS
Term
Weighted Average Cost
Definition
-total inventory costs are allocated evenly across all units
Term
Doubtful Accounts
Definition
-at time of sale, not known which cutomers will default
-matching principle requires that at time of revenue recognition, an estimate of bad debts is made
-estimated bad debts are expensed on the IS for the period during which the related sales were made
Term
Warranties
Definition
-at the time of sale, the co. does not know the amount of future expenses it will incur in connection w its warranties
-under matching principle, a co. is required to estimate the amount of future expenses resulting from its warranties, to recognize an estimated warranty expense in the period sale, and to update the expense as indicated by experience over the life of warranty
Term
Depreication
Definition
-non cash expense
-allocate cost of long lived assets over life of assets
-straight line method
-accelerated method of depreciation
Term
Straight Line method
Definition
evenly allocates the cost of long lived assets less estimated residual value over the estimated useful life of an asset
Term
accelerated depreciation
Definition
allocates a greater proportion of the cost to the early years of an asset's useful life
Term
Amortization expense
Definition
allocation of the cost of an INTANGIBLE asset over its useful life
-intangible assets w indefinite lives are not amortized (e.g. goodwill : additional amount above fair value that you pay when purchasing a co)
--> test for impairment at least annually
--> if the asset is impaired, an expense equal to impaired amount is recognized as an expense in IS
Term
Implications of expense recognition choices for financial analysis
Definition
-company's estimates for doubtful accounts and warranties, and estimates of useful lives and salvage values of long lived assets directly affect net income
-subjective nature of estimates allows for mgmt manipulation of reported f/s
-analysts must carefully scrutinize the validity of used estimates
-accting policies and estimates are disclosed int he footnotes to the financial stmts and the MD&A section of the annual report
Term
Treatment and analysis of Non-Recurring Items
Definition
Non-recurring items
Discontinued Operations
Extraordinary Items
Unusual or Infrequent Items
-to forecast a co. futures earnings, must use prior years' income and expense items as base figures..so we must separate revenues and expenses that are likely to continue in the future from those that aren't
Term
Discontinued Operations
Definition
-IS must separately report an operation as a discontinued operation after income from continuing operations
-reported net of tax
Term
Extraordinary Items
Definition
-unusual in nature and infrequent in occurrence
-reported separately in the IS, net of tax, after income from continuing operation
-co.'s can overstate income from continuing operations by classifying items as extraordinary items
Term
Unusual or Infrequent Items
Definition
-either unusual in nature OR infrequent in occurrence, but
-included in income (separate line item) from continuing operation and are reported before tax
Term
Changes in Accounting standards
Definition
change in account policy
change in accounting estimate
correction of prior-period errors
Term
change in accounting policy
Definition
-applied retrospectively; financial data for all periods shown in the financial report must be presented as if the new principal were in use through the entire period
Term
Change in an accounting estimate
Definition
-applied prospectively and only affects financial statements for the current and future periods; no adjustments to prior statements
Term
Correction of Prior-period errors
Definition
-restating all prior-period financial statements presented in the financial report
-disclosure of error in foot notes
Term
Operating components of the IS
Definition
-associated w core operations of the business
-generally involve producing and delivering goods and providing services and include all trisections and other events that are not defined as investing or financing activities
Term
Non-Operating Expenses
Definition
-expenses that are not part of core operation (e.g. interest exp for non-financial firms
Term
Earnings Per Share
Definition
-one of the most important profitability measures for publicly listed firms
-reported only for common stock
-refers to the share of NI of a co. that is owned by common shareholders only
Term
EPS Calculation
Definition
EPS = (N.I. - Preferred Div) / Weighted Avg. # of Shares
-weighted average # of shares is the # of shares outstanding during the year, weighted by the portion of year they were outstanding
-preferred dividends are not included in expenses on the income statement in the calculation of net income
Term
Simple capital structure
Definition
does not have any financial instruments outstanding that can be converted into common stock
Term
complex capital structure
Definition
has financial instruments outstanding that CAN be converted into common stock
-potentially dilutive so co's are required to report basic AND diluted EPS
Term
Stock repurchases
Definition
result in a decrease in the # of shares outstanding and are excluded from the computation of weighted avg # of shares from the date of repurchase
Term
weighted average # of shares
Definition
the # of shares outstanding during the year, weighted by the portion of year they were outstanding
-stock repurchase, stock splits and stock dividends effect weighted avg # of shares
-if a co. declares a stock dividend or split, the weighted avg # of shares outstanding should be calculated based on the assumption that the additional shares have been outstanding since the date that the original shares were outstanding
Term
Stock dividend
Definition
-distribution of additional shares to each shareholder in an amount proportional to their current number of shares
-no extra money is paid out and no wealth is created
ex) if 10% stock dividend is paid, the holder of 100 shares of stock would receive 10 additional shares
Term
stock split
Definition
-refers to the division of each "old" shares in to a specific # of "new" shares
Term
diluted security
Definition
-dilutive security is one whose conversion into shares of common stock would result in a reduction in EPS
-financial instruments that can be converted into common stock, but whose conversion does not reduce EPS below basic EPS, are anti-dilutive and are not considered in dilutive EPS calculation
Term
dilutive vs. anti-dilutive
Definition
-if Basic EPS > Diluted EPS then the convertible preferred shares/bonds are dilutive
-quick way to determine whether dilutive:
convertible preferred dividends / new shares issued up on conversion
if lower than basic EPS, then it is dilutive
-anti dilutive: basic EPS < or equal to dilutive EPS
not included in calculation of diluted EPS
Term
Treasury stock method
Definition
-use to account for stock options and warrants
-assumes all the funds received by the co. from the exercise of options and warrants are used by the co. to repurchase shares at the avg market price
-no adjustments must be made to the numerator bc the exercise of options or warrants has no impact on income available to common shareholders
-number of shares outstanding increase by number of shares issued upon exercise of options minus the number of shares repurchased with the proceeds of option exercise
Term
Converting I/S to Common-size I/S
Definition
-present each line item on the IS as a percentage of SALES
-present income taxes as a percentage of pre-tax income (effective tax rate)
Term
Common Size IS
Definition
-standardization of each item removes the effect of company size and facilitates financial statement analysis
-data can be used to conduct time series and cross sectional analysis
Term
Income Statement Ratios
Definition
-items listed on IS are used to calculate ratios to evaluate a co.'s profitability
-gross profit margin and net profit margin and two most commonly used indicators of profitability
Term
Gross Profit Margin
Definition
Gross Profit/Revenue
Term
Net Profit Margin
Definition
Net Income/Revnue
Term
Comprehensive Income
Definition
Comprehensive Income = NI + Other Comprehensive Income
-certain income and expense items that are excluded from IS; instead these items are reported directly in shareholder equity (US GAAP only) or Other Comprehensive Income
Term
Other Comprehensive Income
Definition
1) foreign currency translation gains/losses
2) certain costs relating to the company's defined benefit post-retirement plans
3) unrealized gains or losses on derivatives contracts, accounted for as hedges
4) unrealized holding gains and losses on available for sale securities
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