Analyzing Income Statements

Question 1

What is the fundamental principle of revenue recognition?

Answer 1

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; when the company delivers the goods or services.

Question 2

What is unearned or deferred revenue?

Answer 2

When the payment by the customer has already been made but the product or service is yet to be delivered.

Question 3

What are the five steps of recognizing revenue according to both the US GAAP and IFRS?

Answer 3

1. Identify the contract 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 the entity satisfies a performance obligation

Question 4

According to the standards, 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. In addition, a contract exists only if collectability is probable. Each standard uses the same wording, but the threshold for probable collectability differs. Under IFRS, probable means more likely than not, and under US GAAP, it means likely to occur.

Question 5

Revenue is recognized when a performance obligation is fulfilled, and when it is highly probable that it will not be subsequently reversed.

Question 6

In general, when should a company recognize expenses?

Answer 6

In the period that it consumes the economic benefits associated with the expenditure

Question 7

What are three common expense recognition models?

Answer 7

Matching principle
Expensing as incurred
Capitalization with subsequent depreciation / amortization

Question 8

What is the matching principle?

Answer 8

Under matching, a company recognizes expenses when associated revenues are recognized, and thus, expenses and revenues are matched.

Question 9

What are period costs?

Answer 9

Expenditures that less directly match revenues are generally expensed as incurred = when the company makes the expenditure in cash or incurs the liability to pay. Administrative costs, managerial costs, IT costs, R&D costs etc.

Question 10

Why do depreciation and amortization not influence the cash flow statement?

Answer 10

Because they are non cash expenses

Question 11

What is the salvage value of an asset?

Answer 11

Restwaarde

Question 12

Capitalizing the expenditures typically result in greater amounts reported as cash from operations! Therefore, analysts should be alert to companies manipulating cash from operations by capitalizing expenditures that should be expensed.

Question 13

Companies may choose to capitalize more expenditures to achieve earnings targets for a given period. However, they can also choose expensing since that reduces current profits but enhances future profitability, creating an upward profit trend.

Question 14

How does the capitalization of interest rates work?

Answer 14

When interest is capitalized, it does not appear as an expense on the income statement immediately. Instead, it is added to the asset’s cost on the balance sheet. This means reported net income is higher in the short term since less interest is deducted as an expense. The capitalized interest is gradually expensed over the asset’s useful life through depreciation or amortization.

Question 15

US GAAP reporting companies are required to categorize interest in operating cash flow, and IFRS reporting companies can categorize expensed interest in operating or financing cash flows.

Question 16

What is the interest coverage ratio?

Answer 16

A solvency indicator measuring the extent to which a company’s earnings in a period cover its interest costs.

Total interest expenditure / income + depreciating interest

Question 17

Maintaining a minimum interest coverage ratio is a financial covenant that is often included in lending agreements.

Question 18

An expense recognition policy that results in recognition of expenses later rather than sooner is considered less conservative.

Question 19

What do both IFRS and US GAAP standards say about non-recurring items, unusual items, infrequent items, non-operating income etc.?

Answer 19

They have to be reported separately

Question 20

What are basic shares called under IFRS and US GAAP?

Answer 20

IFRS = ordinary shares
US GAAP = common shares

Question 21

When does a firm is said to have a complex capital structure?

Answer 21

When it has financial instruments convertible into common stock

Question 22

What is the diluted EPS versus basic EPS?

Answer 22

The earnings per share if all financial instruments were converted to common stock.

Question 23

How to calculate basic EPS?

Answer 23

Net income - preferred dividends / weighted average number of shares outstanding

Question 24

How to calculate diluted EPS when a company has convertible preferred stock outstanding?

Answer 24

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. The number of shares outstanding will be higher when fully converted, and the preferred dividends will disappear making the net income also higher.

Question 25

How to calculate diluted EPS when a company has convertible preferred debt outstanding?

Answer 25

Net income increases by the after-tax interest on the convertible debt AND the number of shares outstanding increase

Question 26

What is the treasury stock method to calculate diluted EPS under US GAAP?

Answer 26

When a company has stock options, warrants etc., 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. Thus, the number of shares outstanding increases with the number of shares that would be issued upon exercise but decreases with the number of shares that would have been purchased with the proceeds.

Question 27

What is an antidilutive EPS?

Answer 27

When convertible securities would result in a higher EPS than the basic one.

Question 28

In calculating average number of shares outstanding, stock-splits are done at the end!

Question 29

If the diluted EPS > basic EPS, the calculation of that financial instrument must be excluded!!!!!

Question 30

What is common-size analysis of the income statement?

Answer 30

Stating each line item on the income statement as a percentage of revenue. Common-size statements facilitate comparison across time periods and across companies because the standardization of each line item removes the effect of size.

Question 31

Vertical common-size analysis of the income statement is particularly useful in cross-sectional analysis.