3.3 Understanding Income Statement Flashcards
A company’s income statement
shows its financial performance over a period of time
Operating profit
reflects a company’s pre-tax earnings from its day-to-day activities
Typically, earnings before interest and taxes (EBIT) is used to measure operating profit
when is revenue recognized?
when it is earned
the matching principle
companies recognize certain expenses when the associated revenues are recognized
cost of goods sold (COGS) expenses should be recognized at the same time as the revenues for the associated goods or services.
Period costs
do not directly match revenues, so they are reflected in the period when the company makes the expenditure. Administrative costs are an example of period costs.
Issues in Expense Recognition
Doubtful Accounts
Warranties
Depreciation and Amortization
Long-lived assets
expected to provide benefits over periods of time greater than one year.
Examples include land, plant, equipment, and intangible assets (i.e., assets with no physical substance)
The cost of a long-lived asset is allocated incrementally over its useful life. This process is called?
depreciation for physical assets and amortization for intangible assets with finite lives.
straight-line method depreciation
allocates an asset’s cost (net of residual value) evenly over its estimated useful life
Accelerated methods of depreciation
allocate a greater proportion of costs in the early years of an asset’s useful life
diminishing balance method
a double-declining balance depreciation
Compared to straight-line depreciation, accelerated methods are more conservative because they defer profit recognition.
diminishing balance method
uses a multiple of the straight-line percentage
a double-declining balance depreciation
a double-declining balance depreciation
Discontinued operations
represent components of the operation that will have no effect on the future
t must be separable both physically and operationally. The earnings from these operations should be eliminated from forecasts.
Basic EPS
the income available to common shareholders divided by the weighted average number of common shares outstanding.
Diluted EPS
can never be more than the basic EPS.
Instruments such as convertible preferred, convertible debt, and employee stock options can all dilute the EPS.
represents the earnings per share if all these instruments were converted.
The if-converted method
should be used to calculate diluted EPS.
It assumes the convertible preferred shares convert at the beginning of the period.
This will increase the weighted average number of common shares outstanding and eliminate the preferred dividends.
Convertible Debt
The if-converted method is also used to calculate diluted EPS if there is convertible debt.
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The weighted average number of common shares outstanding will increase and the interest paid on the convertible debt will be eliminated.
treasury stock method.
Diluted EPS is calculated by assuming the instruments are exercised and the company uses the proceeds to purchase outstanding common stock at the average market price during the period
There is no effect on the numerator. The denominator is increased by the shares issued at exercise and decreased by the shares that could have been repurchased with the cash received at exercise. The instruments are assumed to be exercised at the earliest possible date during the period (e.g., beginning of the period if the instrument was issued prior to the period).
Net profit margin
the amount of income a company can earn for each dollar of revenue
gross profit margin
measures the amount of gross profit per dollar of revenue.
Gross profit is the net revenues less cost of sales.
Comprehensive income
represents all changes in equity for an enterprise during a period, excluding transactions with owners in their capacity as owners
It includes both net income and other comprehensive income
The following items are treated as other comprehensive income under both IFRS and U.S. GAAP:
Foreign currency translation adjustments.
Unrealized gains or losses on derivative contracts used for hedging.
Unrealized gains and losses on some investment securities (e.g., available-for-sale debt securities).
Certain costs related to defined-benefit pension plans.
Which of the following items would least likely impact a company’s total comprehensive income?
A
Dividend payments
B
Interest payments on debt
C
Unrealized gains on derivatives
A
Dividend payments
Dividend payments aren’t considered in total comprehensive income, as they result from transactions with owners in their capacity as owners.
Interest payments reduce net income, which is one of the two components of total comprehensive income. Unrealized gains on derivatives are included in other comprehensive income, which is the other component of total comprehensive income.
Which of the following would most likely impact a company’s other comprehensive income?
A
Stock dividend payments
B
Unrealized gains on trading securities
C
Unrealized gains on available-for-sale securities
C
Unrealized gains on available-for-sale securities
Unrealized gains on available-for-sale securities are recorded as other comprehensive income. By contrast, unrealized gains on trading securities are recognized on a company’s income statement.
