CFA 25: Understanding Income Statements

Question 1

revenue

Components and Format of the Income Statement

Answer 1

Revenue generally refers to amounts charged (and expected to be received) for the delivery of goods or services in the ordinary activities of a business.

Question 2

net revenue

Components and Format of the Income Statement

Answer 2

Net revenue means that the revenue number is reported after adjustments (e.g. for cash or volume discounts, or for estimated returns).

Question 3

expenses

Components and Format of the Income Statement

Answer 3

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

Question 4

gains and losses

Components and Format of the Income Statement

Answer 4

Gains and losses are increases and decreases in economic benefits, respectively which may or may not arise in the ordinary activities of the business, and are included in net income.

Question 5

net income

Components and Format of the Income Statement

Answer 5

Net income can be defined as: a) income minus expenses, or equivalently b) revenue plus other income plus gains minus expenses, or equivalently c) revenue plus other income plus gains minus expenses in the ordinary activities of the business minus other expenses, and minus losses. The last definition can be rearranged as follows: net income equals (i) revenue minus expenses in the ordinary activities of the business, pluss (ii) other income minus other expenses, plus (iii) gains minus losses.

Question 6

grouping by nature

Components and Format of the Income Statement

Answer 6

Grouping by nature means grouping together expenses such as depreciation on manufacturing equipment and depreciation on administrative facilities into a single line item called “depreciation”.

Question 7

grouping by function

Components and Format of the Income Statement

Answer 7

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, and other direct sales related expenses.

Question 8

gross profit (gross margin)
Components and Format of the Income Statement

Answer 8

Gross profit is sales minus the cost of sales (COGS).

Question 9

multi-step format

Components and Format of the Income Statement

Answer 9

With respect to the format of the income statement, a format that presents a subtotal for gross profit (revenue minus cost of goods sold).

Question 10

single-step format

Components and Format of the Income Statement

Answer 10

With respect to the format of the income statemtn, a format that does not subtotal for gross profit.

Question 11

operating profit

Components and Format of the Income Statement

Answer 11

Operating profit results from deducting operating expenses such as selling, general, administrative, and research and development expenses from gross profit.

Question 12

long-term contract

Components and Format of the Income Statement

Answer 12

A long-term contract is one that spans a number of accounting periods. Such contracts raise issues in determining when the earnings process has been completed and revenue recognition should occur.

Question 13

percentage-of-completion

Revenue Recognition

Answer 13

Under the percentage-of-completion method, in each accounting period, the company estimates what percentage of the contract is complete and then reports that percentage of the total contract revenue in its income statement. Contract costs for the period are expensed against the revenue. Therefore, net income or profit is reported each year as work is performed.

Question 14

completed contract

Revenue Recognition

Answer 14

Under the completed contract method, the company does not report any income until the contract is substantially finished (the remaining costs and portential risk are insignificant in amount), although provision should be made for expected losses. Note that if a contract is started and completed in the same period, there is no difference between the percentage-of-completion and completed contract methods.

Question 15

installment sales

Revenue Recognition

Answer 15

Installment sales are sales in which proceeds are to be paid in installments over an extended period.

Question 16

installment method

Revenue Recognition

Answer 16

Under the installment method, the portion of the total profit of the sale that is recognized in each period is determined by the percentrage of the total sales price for which the seller has received cash.

Question 17

cost recovery method

Revenue Recognition

Answer 17

Under the cost recovery method, the seller does not report any profit until the cash amounts paid by the buyer - including principal and interest on any financing from the seller - are greater than all the seller’s costs of the property.

Question 18

matching principle

Expense Recognition

Answer 18

The accounting principle that expenses should be recognized when the associated revenue is recognized.

Question 19

period costs

Expense Recognition

Answer 19

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

Question 20

specific identification method

Expense Recognition

Answer 20

An inventory accounting method that identifies which specific inventory items were sold and which remained in inventory to be carried over to later periods.

Question 21

FIFO method

Expense Recognition

Answer 21

Under the FIFO method, the oldest goods purchased (or manufactured) are assumed to remain in inventory. Cost of goods in beginning inventory and costs of the first items purchased (or manufactured) flow into cost of goods sold first, as if the earliest items purchased sold first. Ending inventory would, therefore, include the most recent purchases.

Question 22

weighted average cost method

Expense Recognition

Answer 22

The 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.

Question 23

LIFO method

Expense Recognition

Answer 23

a

Question 24

direct write-off method

Expense Recognition

Answer 24

An approach to recognizing credit losses on customer receivables in which the company waits until such time as a customer has defaulted and only then recognizes the loss.

Question 25

long-lived assets

Expense Recognition

Answer 25

Long-lived assets are assets expected to provide economic benefits over a future period of tiem greater than one year. Examples are land (property), plan, equipment, and intangible assets such as trademarks. 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.

Question 26

straight-line method

Expense Recognition

Answer 26

A depreciation method that allocates evenly the cost of a long-lived asset less its estimated residual value over the estimated useful life of the asset.

Question 27

acclerated methods

Expense Recognition

Answer 27

Depreciation methods that allocate a relatively large proportion of the cost of an asset to the early years of the asset’s useful life.

Question 28

diminishing balance method

Expense Recognition

Answer 28

An accelerated depreciation method, i.e. one that allocates a relatively large proportion of the cost of an asset to the early years of the asset’s useful life.

Question 29

double declining balance depreciation

Expense Recognition

Answer 29

An accelerated depreciation method that involves depreciating the asset at double the straight-line rate. This rate is multiplied by the book value of the asset at the beginning of the period (a declining balance) to calculate depreciation expense.

Question 30

net book value

Expense Recognition

Answer 30

The remaining (undepreciated) blance of an asset’s purchase cost. For liabilities, the face value of a bond minus an unamortized discount, or plus any unamortized premium.

Question 31

goodwill

Expense Recognition

Answer 31

An intangible asset that represents the excess of the purchase price of an acquired company over the value of the net assets acquired.

Question 32

diluted EPS

Earnings per Share

Answer 32

The EPS that would result if all dilutive securities were converted into common shares.

Question 33

basic EPS

Earnings per Share

Answer 33

Net earnings available to common shareholders (i.e. net income minus preferred dividends) divided by the weighted average number of common shares outstanding.

Question 34

if-converted method

Earnings per Share

Answer 34

A method for accouting for the effect of convertible securities on earnings per share (EPS) that specifies what EPS would have been converted at the beginning of the period, taking account of the effects of conversion on net income and the weighted average number of shares outstanding.

Question 35

treasury stock method

Earnings per Share

Answer 35

A method for accounting for the effect of options (and warrants) on earnings per share (EPS) that specifies what EPS would have been if the options and warrants had been exercised and the company had used the proceeds to repurchase common stock.

Question 36

antidilutive

Earnings per Share

Answer 36

With reference to a transaction or a security, one that would increase EPS or result in EPS higher than the company’s basic EPS - antidilutive securities are not included in the calculation of diluted EPS.

Question 37

other comprehensive income

Comprehensive Income

Answer 37

Items of comprehensive income that are not reported on the income statement; comprehensive income minus net income.

Question 38

total comprehensive income

Comprehensive Income

Answer 38

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.

Question 39

comprehensive income

Comprehensive Income

Answer 39

The change in equity of a business enterprise during a period from nonowner sources; includes all changes in equity furing a period except those resulting from investments by owners and distributions to owners; comprehensive income equals net income plus other comprehensive income.

Question 40

trading securities

Comprehensive Income

Answer 40

Securities held by a company with the intent to trade them.

Question 41

available-for-sale

Comprehensive Income

Answer 41

Debt and equity securities not classified as either held-to-maturity or held-for-trading securities. The investor is willing to sell but not actively planning to sell. In general, available-for-sale securities are reported at fair value on the balance sheet.