Lesson 3- Income Statement

Question 1

Income Statement

Answer 1

“statement of operation”; “statement of earnings”; P&L

presents information on financial results of firm´s business activities over PERIOD

communicates how much REVENUE firm generates and COST incurred when generated those revenues (matching)

Question 2

Income Statement

Structure

Answer 2

Net Revenue/Net sales
- COGS
GROSS PROFIT
- operating expenses
OPERATING INCOME
- investing expenses
Earnings before taxes (and minoity interest)
- financial expenses (taxes)
Earnings before minority interest
- minority interest in earnings from cont. operatons, net
Earnings from cont. operatons

(Loss) Earnings from discontinued operations, net of income taxes

Net Earnings

Question 3

Income Statement

Operating Income

Answer 3

operating income is essential - especially when one is interested in a firm (how it is doing) - you check how much money is able to make from core business (operations)

Question 4

Income Statement

Income Definition

Answer 4

it is an INCREASE in eco. benefits during accounting period in the form of:

a) inflows
b) enhancements of assets
b) decrease in liabilities which results in an increase in equity (other than those relating to contribution form equity participant)

IFRS:

• use term to include revenues &gains
  a) revenues = arise from course of ordinary activities
  b) gains represent other items that meet definition of income, but may/may not arise from orindary activities
• but gains arise from secondary peripheral activities rather than from a company´s primary business activities

Question 5

Income

Revenue Recognition

Answer 5

Revenue can occur independently from cash movements
Accrual accounting principle
–> revenue is recognised WHEN it is EARNED
FASB:
–> revenue is recognised WHEN it is “REALISED, REALISABLE, EARNED”
–> should be recognised when it is highly probable that IT WON´T BE REVERSED

Example:

• sale of goods
• rendering services
• use by others of entities assets yielding interest, royalties, dividends

NOT:

• construction companies
• insurance contracts
• lease agreements
• changes in FV of financial A/L

Question 6

Revenue Recognition

5 steps recognising Revenue

Answer 6

1. indentify contract with customer
2. indentify separate o distinct performance obligations in the contract
3. determine the transaction price
4. allocate transaction price to performance obligations of contract
5. recognise revenue when (or as) entity satisfies a `performance obligation

Question 7

Revenue Recognition
Special Case 1
Long Term Contract

Answer 7

contract that spans number of years
R&E recognition based on:

a) percentage-completion method:
= each year, firm estimates what % of contract is completed and reports % of total contract revenue on income statement

b) completed contract method
= if outcome of contract cannot be measured reliably
a) cost are expensed in period incurred - not profit reported until completion of contract
b) company doesn´t report any revenue until contract is finished

Question 8

Revenue Recognition
Special Case 2
Instalment Sales

Answer 8

Revenue reported when g/s are delivered (independently if cash payments come through)
but significant doubt of ability of buyer to complete payment
sales in which proceeds are to be paid in installments over an extended period of time. IFRS separates the installments into the sale price, which is the discounted present value of the installment payments, and an interest component.
The revenue which is attributable to the sale price is recognized at the date of sale, and revenue attributable to the interest component is recognized over time.

two methods:
a) instalment method:
portion of total profit recognised in each period = % of total sales price for which seller receives the cash

b) cost recovery method:
seller doesn´t report any profit until cash amounts paid by buyer >seller´s cost of property

Question 9

Revenue Recognition
Special Case 3
Barter

Answer 9

firm A sells ad. sevices to B and almost simult. buys an identical product from B

Under IFRS, revenue from barter transactions must be measured based on the fair value of revenue derived from similar non-barter transactions with unrelated parties.

US GAAP, on the other hand, states that revenue can be recognized at fair value only if a company has historically received cash payments for such services and can, therefore, use this historical experience as a basis for determining fair value; otherwise, the revenue should be recorded at the carrying amount of the asset surrendered.

Question 10

Revenue Recognition
Special Case 4
Gross vs Net Reporting

Answer 10

US GAAP provides guidance for determining when revenue should be reported gross versus net. Before revenue is reported on a gross basis, US GAAP states that it should be established that the company (i) is the primary obligor under the contract, (ii) bears credit risk and inventory risk, (iii) can choose its supplier, and (iv) has reasonable latitude to establish prices. If these criteria are not met, the company should report net revenues.

A principal recognises revenue and expenses in gross amounts, whereas an agent recognises only fees or commissions, even if gross cash flows go through the agent

Question 11

Expense Recognition

Answer 11

IASB:
“decrease in eco. benefit during accounting period in form of
a) ouflows or depletions of assets or
b) incurrence of liabilities that result in a decreases in equity (other than those related to distribution to equity participants)

“matching principle” = “matching cost with revenues”
firms should directly match the expenses with associated revevenues

period costs
= expenses that less directly match timing of revenues
- these are reflected in period when the firm makes the expenditure or incurs the liability to pay

Question 12

Expenses

Inventory costing method

Answer 12

FIFO (first in first out)
- assumes that earliest items purchase is sold first

LIFO
- assumes most recent items purchased are sold first

Weighted Average
- average total costs/ total units sold

Question 13

Revenue vs

Profit

Answer 13

Revenue is the total amount of income generated by the sale of goods or services related to the company’s primary operations. …

Profit is the amount of income that remains after accounting for all expenses, debts, additional income streams, and operating costs.

Gain is what business earns on selling such assets which is not an inventory of the business.

Question 14

Expenses
Inventory costing method

cost of good sold

Answer 14

when prices are rising (of goods)
lowest is the FIFO (first items cheaper)
higst is LIfO (newest are more expensive)
middle is average

Question 15

Expenses
Inventory costing method

ending inventory

Answer 15

when prices are rising (relative to other methods)
highest FIFO (last, newest items are kept)
lowest LIFO ( last newest items are sold firms)
middle - average

Question 16

Expenses
Inventory costing method
rising inventory cost

Answer 16

Net income:
LIFO< FIFO

COGS:
LIFO>FIFO

WC; TA; CA; ROE; CRatio
LIFO>FIFO

Asset turnover; debt-to-equity
LIFO> FIFO

Question 17

Issues in Expense Recognition

1. Doubtful accounts

Answer 17

selling products on credit hence high chance that default happens
a) direct write off method:
wait until time occur where default happens and only then recognise credit losses

b) matching principle
firm is required to record an estimate of how much of revenue will ultimately be uncollectible
estimate = proportion of overall amount of sales (receivables)

second method is better - more accurate,m conservative (analysts prefer second)

Question 18

Issues in Expense Recognition

2. Warranties

Answer 18

=a written guarantee, issued to the purchaser of an article by its manufacturer, promising to repair or replace it if necessary within a specified period of time.

offer warranties for product sold (of you don´t like it you can exit contract)

a) wait until actual expenses are incurred and reflect expenses at that time; but not matching expenses with associated revenue of warranty contract

b) matching P:
estimate amount of future expenses resulting from warranties:
- recognised estimate warranty expense during period of sale
- update expense as indicated by experience over life of warranty

Question 19

Issues in Expense Recognition

3. Amortisation

Answer 19

A) Depreciation
= process of allocating costs of lt assets over the period which assets are expected to provide eco. benefit

B) Amortisation
= term applied for intangible LT assets with a finite useful life

Cost - Residual Value / Estimated useful life

Methods:
a) straight-line:
even allocation of cost

b) accelerated method:
declining balance method
matches higher depreciation expenses with higher revenue in earlier years of asset´s useful life when asset is more efficient
Expense = NBV * (2/ Useful life)
Annual computation ignores residual value
(each year you take new RV)

Question 20

Nonrecurring, operating expenses

Answer 20

items which aren´t expected to continu in future periods
separately disclosed on a company´s income statements
Examples:
discontinued operations
extraordinary items

Question 21

discontinued operations

definition

Answer 21

when firm establishes a plan to dispose on of is component operation (core business)
and it won´t have further involvement in operation
–> income reports separately the effect of disposal as “DO”
fron continues operation item

When companies merge, understanding which assets are being divested can give a clearer picture of how a company will make money in the future.

Question 22

discontinued operations

evaluation

Answer 22

when assessing a firm´s future earnings it´s helpful to separate those prior year´s item which are likely to continue in future with those that don´t and hence should be separately disclosed

–> analyst can eliminate discounted operations in formulating expectations about company´s future financial perfomance

Question 23

discontinued operations

IFRS

Answer 23

A discontinued operation must meet two criteria:

1. the asset or business component must be disposed of or reported as being held for sale.
2. the component must be distinguishable as a separate business that is being removed from operation intentionally or a subsidiary of a component being held with the intent to sell.

Question 24

Discontinued operations

1. unusual item
2. infrequent item

Answer 24

nonrecurring or one-time gain or loss that is not considered part of normal business operations.
cannot be shown as extraordinary, hence shown as continuous operation but reported separately:
- restructuring charges considered part of firm´s ordinary activities
- gans/losses arising when firm sells an asset or `part of business for more or less than carrying value
- also disclosed separately on IS but are not considered EXTRAORDINARY

reported in the “Other revenues and gains” or “Other expenses and losses” section of the income statement, not as a subdivision of the noncontrolling interest section. They are not reported net of tax.

Question 25

Discontinued operations

Nonrecurring vs extraordinary items

Answer 25

Extraordinary items
= gains or losses in a company’s financial statements that are unlikely to happen again.
A nonrecurring item
= refers to an entry that is infrequent or unusual that appears on a company’s financial statements.

The difference between extraordinary items and nonrecurring items is often subjective, and therefore extraordinary items are often lumped under nonrecurring items.

The International Financial Reporting Standards (IFRS) does not recognize extraordinary items, only nonrecurring items.

Question 26

Discontinued operations
unusual item
Examples

Answer 26

include gains or losses from a lawsuit;
losses or slowdown of operations due to natural disasters; restructuring costs; gains or losses from the sale of assets; costs associated with acquiring another business;
losses from the early retirement of debt; and plant shutdown costs.

Question 27

Discontinued operations

3. Charges in accounting policies

Answer 27

reported through retrospective application unless its impractical to do so

Retrospective application
= Fs for all fiscal years shown in a firm´s financial report are presented as if the newly adopted accounting principle had been used throughout the entire period

Notes to FS

• -> describe the change and explain the justification for this change
• -> since it´s a retrospective change the FS that appear in the financial report are comparable

Question 28

Discontinued operations

4. Non operating activities

Answer 28

typically reported separately from operating income as they are material and/or relevant to the understanding of entity´s financial performance

Question 29

EPS: Concepts

Answer 29

metric that enables each SH to compute his share of the firm´s earnings

Question 30

EPS simple

Answer 30

= capital structure consisting only of common stock or includes no potential common stock  that upon conversion/exercise could dilute EPS 
Calculation includes 4 items:
- Net income
- preferred stock dividends (NI)
- weighted average nr of shares
- stock split/dividend (WANS)

Question 31

EPS simple

1. Preferred Stock

Answer 31

receive stocks/dividends before common shareholders

a) old vs new
b) cumulative (have to be included) vs non-cum (ignored if not issued)

Question 32

EPS simple

2. Capital Movements

Answer 32

Increase/Decrease
–> redemption or new shares

Stock split/ S. Dividend
–> Restatement (multiply accordingly before split to match)

Question 33

EPS Diluted

Answer 33

complex capital structure
simple fails to recognised potential dilutive impact when a corporation has dilutive securities in its capital structure
a) convertibles = “if-converted method”
b) Options, warrants = “treasury stock method”

when a firm has a complex CS both simple&diluted EPS are generally reported
the computation of diluted is similar to basic but it includes impact of convertible, warrant

Generally, if a company has convertible securities, the diluted EPS is less than its basic EPS.

Question 34

EPS Diluted

convertibles

Answer 34

at conversion converibles are exchange to common stock
if-converted method assumes:
1. conversion at beginning or time of issue
2. elimination of related interest net of tax
3. denominator is increased by add. nr of shares ( + nr shares)
4. numerator is increased by amount of interest expense net of tax (+ % * nominal * (1- taxrate))

notes:
- assuming maximum dilution use the most adv. conversion rate to holder
- issues at premium or discount adjust interest expense (not only cash flow)

Convertibles:
old vs new
dilutive vs nondilutive

Question 35

accretive (non dilutive)

Answer 35

not included
as it increases EPS or reduces loss per share)

convertible debt is ANTIDIL. if the addition to income, net of tax has greater % increase income (num) than % in shares outstanding (denom)

O&W are antidilutiv whenever the exercise price is higher than the market (only affect nr. shares)

If interest not paid, net of tax or dividends not paid ÷ weighted avg of add. shares > EPS without CSE - hence antidilutive
hence check before when to include and when not before computing!!

Question 36

Dilutive EPS

options &warrants

Answer 36

“treasury stock method”
it assumes that proceeds from exercise of O&W ae used to purchase common stock
a) if exercise price of option < market price –> DILUTION occurs
b) if exercise price of option > market price –> common shares are reduce (ANTIDILUTION)

Example:
stock price 50.
Hence only include warrants with strike price <50
Warrant both with strike of 30, but one with 5,000 shares is more dilutive (increase denominator)
warrant with 25 but 1000 shares not sure vs warrant with 35 but 5.00 shares ??

Question 37

Common size Analysis of IS

Answer 37

can be performed by stating each line of item on the IS as % of Revenue
it facilitates comparison
a) across time periods (time series analysis)
b) and across companies of diff. sizes (cross sectional)

Vertical common size analysis of IS:
useful in cross-sectional analysis
comparing companies with each other for a part. time period
or comparing a company with industry or sector data

performance of an indv. company can b compared with industry or peer data to evaluate its relative performance

Question 38

Comprehensive Income

Answer 38

certain items of revenue or expenses that, by accounting conversion, are EXCLUDED from NET INCOME calculation

these excluded items are key to understand reported SH equity of one period to next one

total CI includes boh net Income + other revenue/expenses items excluded in IS
Items:
1. foreign currency translation adjustment
2. minimum pension liability adjustment
3. unrealised gains/losses on derivative contracts accounted for hedging purposes
4. unrealised holding gains/losses on a certain category of investment securities, namely available-for-sales securities

Trading Securities—These securities are usually purchased with the intention to make profits in the short term. This is why they are not held for a longer period of time.
- hence reported under operating income, hence in IS

Available-for-Sale—These financial instruments are not actively managed with the intention to sell to make short-term profits.
E.g. debt or equity securities purchased with intend of selling before reaching maturity
reported at fair value
Investments in debt or equity securities purchased must be classified as held to maturity, held for trading, or available for sale.

Question 39

Treasury Stock method

options/warrants

Answer 39

1. Used in the computation of diluted EPS with respect to exercisable securities that are dilutive.
2. Impacts only the denominator, i.e., weighted average # shares of common stock outstanding.
3. Exercise is assumed to have taken place at the later of the beginning of the period or the date of issuance of the security.
4. it assumes that the proceeds received upon the assumed exercise of the security are immediately used to buy the company’s common stock on the open market at the average market price.
5. The weighted average # shares of common stock outstanding (denominator) is adjusted by
   adding to it the weighted average net increase in the number of shares outstanding (# shares
   assumed on exercise - # shares repurchased).

Incorporate in diluted earnings per share
calculation before any consideration of convertible securities.

Question 40

If converted method

convertible debt

Answer 40

1. Used in the computation of diluted earnings per share with respect to convertible securities
   that are dilutive.
2. Impacts both the numerator and the denominator of the earnings per share computation.
3. Conversion is assumed to have taken place at the later of the beginning of the period or the
   date of issuance of the security.
4. The net income figure (numerator) is adjusted by adding back any interest expense, net of tax
   on convertible bonds, and/or any dividends on convertible preferred stock, if the security is
   dilutive.
5. The weighted average # shares of common stock outstanding (denominator) is adjusted by
   adding to it the weighted average number of shares assumed to have been issued on
   conversion.
6. If multiple convertible securities, determine conversion ratio for each security (interest net of
   tax ÷ weighted average # shares issued on conversion) or (dividends not paid ÷ weighted
   average # shares issued on conversion).
   a. Rank conversion ratio from smallest to largest.
   b. Incorporate in EPS calculation from smallest to largest, until resultant EPS calculation is larger than the previous one.