FSA: Understanding the Income Statement

Question 1

Income Statement Equation =

Answer 1

revenus - expenses = net income

IFRS: can be combined with ‘other comprehensive income’/ statement of comprehensive income or presented separately

GAAP: same, but firms can also choose to out OCI in the statement of owners’ equity

Question 2

Investors/lenders look at the income statement for… =

Answer 2

Investors: valuation

Lenders: ability to make interest and principal payments

Question 3

Net income =

NOTE expenses may be notated in different ways on the test - with negative signs, in parentheses or with no indication (assumption that you know an expense should be subtracted)

Answer 3

Rev + Gains + Other Income - Exp - Losses - Other expenses

Question 4

NCI, non-controlling interest =

Answer 4

If a parent company owns a share in a subsidiary, the income from the part of the subsidiary not owned by the parent is SUBTRACTED from the parent’s net income

NCI on parent’s income statement is a NEGATIVE TOWARDS NET INCOME.

Question 5

Presentation: Single vs Multi step format =

Answer 5

single step: all revenues are grouped together, all expenses are grouped together

multi-step: gross profit is included (revenues - COGS)

Question 6

Gross Profit and Operating Profit/income =

Answer 6

Gross Profit = Revenues - COGS

Operating Profit/Income = Gross Profit - Operating expenses (SGA, Depreciation expense etc)

Operating Profit is before subtracting non-operating items, financin costs, income taxes etc. Subtracting these results in the EARNINGS/BOTTOM LINE

NOTE: For financial firms interest expense is normally considered an operating expense

Question 7

Revenue Recognition and unearned revenue =

Answer 7

IASB/FASB have different standards for when revenue should be recognized.

If a firm receives cash before revenue recognition is complete, UNEARNED REVENUE is reported

it is a liability and is reduced as revenue is earned in the future

Question 8

IASB revenue recognition conditions for sales of goods (x5) =

Answer 8

• The risk and reward of ownership is transferred.
• There is no continuing control or management over the goods sold.
• Revenue can be reliably measured.
• There is a probable flow of economic benefits.
• The cost can be reliably measured.

Question 9

IASB revenue recognition conditions services rendered (x4) =

Answer 9

• The amount of revenue can be reliably measured.
• There is a probable flow of economic benefits.
• The stage of completion can be measured.
• The cost incurred and cost of completion can be reliably measured.

Question 10

FASB revenue recognition conditions (x2 + x4) =

Answer 10

revenue is recognized on the income statement when a) realized or realizable and b) earned

Also:

• There is evidence of an arrangement between the buyer and seller.
• The product has been delivered or the service has been rendered.
• The price is determined or determinable.
• The seller is reasonably sure of collecting money.

Question 11

Specific RR Applications: LT Contracts =

Answer 11

For contracts longer than 1 accounting period.

Equal recognition method: revenue is recognized equally over the term of contract (service contracts, licensing agreements)

Percentage completion method: when outcome can be reliably estimated - Rev, Exp, Profit recognised as work is performed. % of completion is cost incurred/exp cost of project. IFRS and GAAP.

When the outcome cannot be reliably estimated

IFRS: Rev recognized equals costs, costs are expensed as incurred, profit recognized at completion

GAAP: completed contract method, rev, exp, profit recognized at completion

If a loss is expected it must be recognized immediately under both GAAP and IFRS

Question 12

Comparing LT contract Revenue Recognition methods =

Answer 12

Percentage of completion is more aggressive, as revenues are reported sooner.

Also more subjective as it involves cost estimates.

PoC method provides smoother earnings - better matching of revenues and expenses over time

Cash flows are the same under the PoC and CC

Question 13

Specific RR Applications: Installment Sales (x3+ IFRS) =

Answer 13

Firm finances a sale and payments are expected.

• collectibility is certain: regular RR conditions
• collectibility cannot be estimated: installment method: profit = cash collected x total expected profit/sale price, profit is a constant proportion of the payment. (limited applications, usually for sale of real estate or other firm assets)
• collectibility is highly uncertain: cost recovery method: profit recognized when cash received is greater than cost incurred.

for IFRS: discounted present value of installment paymesnts recognized at cost of sale. The difference between the installment payments and the discounted PV is recognized as interest over time. If the outcome cannot be reliably estimated RR is similar to cost recovery method

Question 14

Specific RR Applications: Barter transactions =

Answer 14

Two parties exchange goods/services without cash payment.

GAAP: revenue can only be recognized at fair value if the firm can determine this from historical cash exchanges of the same goods/services (otherwise rev is recorded at the carrying value of the asset surrendered)

IFRS: revenue must be based on fair value of revenue from similar non barter transactions with unrelated parties

Question 15

Specific RR Applications: Gross vs Net reporting of revenue =

Answer 15

Gross: selling firm reports sales revenue and COGS separately

Net: only the difference in sales revenue and COGS is reported

Profit is the same but sales is higher using gross revenue reporting.

**GAAP Requirements for firm using Gross: **

• Be the primary obligor under the contract
• Bear the inventory risk and credit risk
• Be able to choose its supplier
• Have reasonable latitude to establish price

Question 16

Specific RR implications =

Answer 16

Firm must disclose their RR methods in FS footnotes

Users of revenue information must consider:

• How aggressive a firm’s RR methods are
• How much the firm’s policies rely on judgment and estimates

Question 17

Expenses =

Answer 17

IASB: decreases in economic benefits from outflows of assets or incurrence of liabilities that result in a decrease of equity (other than those relating to distributions to equity participants)

Question 18

Expense recognition: Matching principle/period costs =

Answer 18

Matching principle: expenses to generate revenue are recognized in the same period as the revenue.

ie inventory that is bought in 4Q and sold in 1Q - expense is recognized along with revenue in 1Q.

Period Costs: expenses not directly tied to revenues - such as administrative costs - expensed in the period incurred.

Question 19

Inventory Expense Recognition: Specific identification =

Answer 19

If the firm can identify each item sold/still in inventory

Auto dealer that has vehicles sold/inventory by identification number

Question 20

Inventory Expense Recognition: FIFO =

Answer 20

COGS will be the oldest items, inventory will be the most recently purchased.

Appropriate for inventory with limited shelf life, ie food, where firm will sell the oldest and keep inventory fresh

Question 21

Inventory Expense Recognition: LIFO =

Answer 21

COGS is inventory most recently purchased.

Inventory is the oldest goods.

Appropriate for inventory that does not age.

A coal distributor will sell coal from the top of the pile.

TAX ADVANTAGE: in an inflationary environment COGS will be larger with LIFO - meaning lower taxable income.

Question 22

Inventory Expense Recognition: Weighted average cost =

Answer 22

cost of available goods/# of units = average unit cost, which is used for both COGS and inventory.

Valued for ease of use.

COGS and Inv will be between FIFO and LIFO

Question 23

IER: Who allows which method =

Answer 23

GAAP: allows FIFO, LIFO and average cost

IFRS: allows FIFO and average cost, NOT LIFO

Question 24

Depreciation expense recognition =

Answer 24

matching the cost of long lived (greater than one period) assets against revenues.

Depreciation (tangible assets), Depletion (natural resources), Amortization (intangible assets)

Question 25

DER: Straight line method =

Answer 25

equal allocation of depreciation over the asset’s useful life.

Will result in lower depreciation in early years, and higher net income, than accelerated depreciation.

Question 26

DER: Accelerated depreciation =

Answer 26

Total depreciation is the same as under straight line, but more is in early years (lower net income in early years)

Question 27

DER: DB (declinin balance) method =

Answer 27

applies a constant rate of depreciation to an asset’s (declining) book value each year.

The most common is the double declining balance (DDB)

If the useful life is 10 years then the rate for DDB would be 20% per year.

Depreciation ends once the estimated residual value is reached. A residual value of 0 will never be reached - often switched to straight line method at some point in this case.

Question 28

Amortization Expense Recognition =

Answer 28

allocation of the cost of an intangible asset over its useful life.

Will often use straight line amortization.

Question 29

Goodwill and Impairment =

Answer 29

Goodwill is an intangible asset with an indefinite life.

It is NOT amortized.

Instead, it may be ‘impaired’ - impairment must be tested at least every year.

If an asset is impaired an expense will be recorded to show this.

Question 30

Bad debt/Warranty expense =

Answer 30

A firm may provide goods/services to a customer on credit or with a warranty.

The matching principle says that the firm must estimate these expenses and recognize them in the period of the sale, rather than at a later date.

Question 31

Expense Recognition: Implications for financial analysis =

Answer 31

Delayed expense recognition increases current net income and is more aggressive

Analysts need to look at why expense recognition changes and how it compares to other firms’ ER - is there a legitimate reason or is it to manipulate net income.

Firms disclose their accounting policies and significant estimates in the FS footnotes and MDnA

Question 32

Non-Recurring Items: Discontinued operation =

Answer 32

management disposes of this business but has not done so yet, or it has generated income/loss this year

Must be physically and operationally distinct from the rest of the firm.

Question 33

NRI: DO: measurement date/phaseout period/accounting for losses and gains/implications =

Answer 33

measurement date: date when management develops a formal plan for disposal. on MD the firm accrues any estimated loss from the phaseout period and any loss from the sale of the DO. Any expected gain must be reported after the sale date.

Phaseout period between the measurement date and date of disposal

Income or loss from discontinued operations must be reported separately, net of taxes.

Past income statements must be adjusted with DO income/loss separated.

Implications: DO does not affect net income from continuing operations - they are separated (this may provide information on the future cash flows on the firm though)

Question 34

NRI: Unusual or infrequent items =

Answer 34

one or the other, NOT BOTH.

ex. gains or losses from the sale of assets, impairments/write-offs/downs/restructuring costs

Included in income from continuing operations and are reported before tax

even though they affect net income an analyst may want to review them w.r.t forecasting future income - should they be included?

Question 35

NRI: extraordinary items =

Answer 35

GAAP: material transaction or event that is both unusual and infrequent

examples: losses from an expropriation of assets, g&l from early retirement of debt, uninsured losses from natural disasters (if unusual and infrequent)

On INCOME STATEMENT: reported separately, net of tax, after income from continuing operations

IFRS: does not allow extraordinary items to be separated from operating results in the IS.

Implications: Judgment is reqd in determining Extr. items. An analyst might want to look at whether to consider them in forecasting future income - some companies appear to accident prone and have Extr items every year.

Question 36

Changes in Accounting Standards (principles, estimates, prior period adjustments) =

Answer 36

A change in accounting principle requires retrospective application, as in a change from LIFO to FIFO inventory accounting.

A change in accounting estimates is a change in judgment from management - ie changing the useful life of an asset, due to new information. Does NOT require restatements of priors.

A change in accounting method to one that is acceptable under GAAP or IFRS or correction of a previous error is reported as a prior period restatement - requires restatement of old statements and disclosure of the change.

These changes do not typically affect cash flow - analysts should consider how AE changes might affect future cash flows, and how PPR might suggest weakness in internal controls

Question 37

Operating and non-operating IS components for financial and non-financial firms =

Answer 37

For a financial firm investment income and financing expenses (incl interest expense) are usually considered operating activities - whereas they are not for non-financial firms.

Question 38

Simple vs Complex capital structure =

Answer 38

• A simple capital structure is one that contains no potentially dilutive securities. A simple capital structure contains only common stock, nonconvertible debt, and nonconvertible preferred stock.
• A complex capital structure contains potentially dilutive securities such as options, warrants, or convertible securities.

Question 39

Basic EPS =

Answer 39

Does not consider the effects of any dilutive securites.

Includes any income paid out as dividends to COMMON SHAREHOLDERS, excludes preferred dividends

Question 40

Stock Dividend and Split =

Answer 40

Have the same effect.

10% stock dividend - 100 shares goes to 110

2 for 1 split - 100 shares goes to 200

In an EPS calculation - first apply dividends/splits before weighting to find the WASO figure. Do not apply to repurchased stock, PRETTY OBVIOUS, NO?

Question 41

Diluted EPS =

**don’t understand properly (p67)

Answer 41

dilutive security would decrease EPS if exercised/converted into common stock (antidilutive is the opposite)

Numerator (income available to common shareholders) must be adjusted for DEPS

• dividends for dilutive convertible preferred stock must be added
• for dilutive convertible bonds, interest expense*(1-tax rate) must be added **

Denominator must be adjusted to include the number of common shares that would be created by conversion of outstanding dilutive securities

Dilutive stock options and warrants increase the denominator

Question 42

Diluted EPS (in detail) =

Answer 42

Question 43

DEPS: dilutive stock options and warrants/treasury stock method =

Answer 43

these are dilutive only when the exercise prices are less than the average market price of the stock over the year.

–> If they are dilutive, use treasury stock method

Assumption: funds from exercised options would be used to purchase shares of the company’s common stock @ the average market price

Net increase in shares outstanding (change in denominator) =

shares created from option being exercised

- number of shares repurchased from proceeds of exercise

Question 44

DEPS: shortcut for net increase in common shares from potential exercise of options/warrants =

Answer 44

ONLY WHEN EXERCISE PRICE IS LESS THAN AVERAGE MARKET PRICE

this is a shortcut for the treasury stock method

WHEN OPTIONS/WARRANTS ARE EXERCISED, ONLY THE NUMBER OF COMMON SHARES (DENOMINATOR) IN THE DEPS EQUATION CHANGES.

Question 45

DEPS: convertible debt/preferred stock dilution check =

Answer 45

Safety check: DEPS should be LESS than BEPS.

If not, the convertible bonds/pref stock were antidilutive and should not have been considered.

If the below equation is less than the basic EPS, the convertible debt is dilutive

For pref stock: preferred stock dividend/common stock that will be created from conversion

For both it is simply CHANGE IN THE NUMERATOR/CHANGE IN DENOMINATOR that conversion would have on the DEPS equation:

if it brings the BEPS ratio DOWN it is DILUTIVE

Question 46

Common-size income statements and effective tax rate =

Answer 46

Common-size income statements show IS items as a % of revenue.

This allows for comparison of income statements over time and between companies.

The exception is TAX EXPENSE, which is better shown as a % of pretax income (not rev) - this is known as the EFFECTIVE TAX RATE

Question 47

Gross/net profit margin and financial ratios =

Answer 47

GPM = gross profit/revenue

Increases from raising prices (could stem from having a differentiated product) or reducing production costs.

NPM = net income/revenue

Any subtotal on the IS can be expressed as a % of revenue, incl:

operating profit margin

pretax margin (pretax accounting profit/rev)

Question 48

(Other) Comprehensive income (x4) (incl Available for sale securities) =

Answer 48

net income + other comprehensive income

OCI is reported directly in stockholders equity and incl.(x4) :

Adjustments for minimum pension liability, FX G&L, Unrealized G&L from a) cash flow hedging derivs b) available-for-sale securities

Under IFRS: if firms choose to report long-lived assets at fair value (rather than historical cost), G&L is reported in OCI

AFSS: securities not expected to be sold in the near terma or held to maturity - reported on the BS at fair value,

Implications: analysts must examine comprehensive income (not just net income) when comparing firm, as firms have some discretion over what is in net income