Reading 18: Understanding Income Statement Flashcards
Describe the components of the income statement and alternative presentation formats of that statement.
The income statement shows an entity’s revenues, expenses, gains and losses during a reporting period.
A multi-step income statement provides a subtotal for gross profit and a single step income statement does not. Expenses on the income statement can be grouped by the nature of the expense items or by their function, such as with expenses grouped into cost of goods sold.
Describe general principles of revenue recognition and accountig standards for revenue recognition.
Revenue is recognized when earned and expenses are recognized when incurred.
Accounting standards identify a five-step process for recognizing revenue:
- Identify the contract(s) with a customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the entity satisfies a performance obligation.
Calculate revenue given information that might influence the choice of revenue recognition method.
Information that can influence the choice of revenue recognition method includes progress toward completion of a performance obligation, variable considerations and their likelihood of being earned, revisions to contracts, and whether the firm is acting as a principal or an agent in a transaction.
Describe general principles of expense recognition, specific expense recognition applications, and implications of expense recogition choices for financial analysis.
The matching principle requires that firms match revenues recognized in a period with the expenses required to generate them. One application of the matching principle is seen in accounting for inventory, with cost of goods sold as the cost of units sold from inventory that are included in current-period revenue. Other costs, such as depreciation of fixed assets or administrative overhead, are period costs and are taken without regard to revenues generated during the period.
Depreciation methods:
- Straight-line: Equal amount of depreciation expense in each year of the asset’s useful life.
- Declining balance: Apply a constant rate of depreciation to the declining book value until book value equals residual value.
Inventory valuation methods:
- FIFO: Inventory reflects cost of most recent purchases, COGS reflects cost of oldest purchases.
- LIFO: COGS reflects cost of most recent purchases, inventory reflects cost of oldest purchases.
- Average cost: Unit cost equals cost of goods available for sale divided by total units available and is used for both COGS and inventory.
- Specific identification: Each item in inventory is identified and its historical cost is used for calculating COGS when the item is sold.
Intangible assets with limited lives should be amortized using a method that reflects the flow over time of their economic benefits. Intangible assets with indefinite lives (e.g., goodwill) are not amortized.
Users of financial data should analyze the reasons for any changes in estimates of expenses and compare these estimates with those of peer companies.
Describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, unusual or infrequent items) and changes in accounting policies.
Results of discontinued operations are reported below income from continuing operations, net of tax, from the date the decision to dispose of the operations is made. These results are segregated because they likely are non-recurring and do not affect future net income.
Unusual or infrequent items are reported before tax and above income from continuing operations. An analyst should determine how “unusual” or “infrequent” these items really are for the company when estimating future earnings or firm value.
Changes in accounting standards, changes in accounting methods applied, and corrections of accounting errors require retrospective restatement of all prior-period financial statements included in the current statement. A change in an accounting estimate, however, is applied prospectively (to subsequent periods) with no restatement of prior-period results.
Contrast operating and non-operating components of the income statement.
Operating income is generated from the firm’s normal business operations. For a nonfinancial firm, income that results from investing or financing transactions is classified as non-operating income, while it is operating income for a financial firm since its business operations include investing in and financing securities.
Describe how earnigs per share is calculated and calculate and interpret a company’s earnings per share (both basic and diluted earning per share) for both simple and complex capital structures.
Contrast dilutive and antidilutive securities and describe the implications of each for the earnings per share calculation.
A dilutive security is one that, if converted to its common stock equivalent, would decrease EPS. An antidilutive security is one that would not reduce EPS if converted to its common stock equivalent.
Formulate income statement into common-size income statements.
A vertical common-size income statement expresses each item as a percentage of revenue. The common-size format standardizes the income statement by eliminating the effects of size. Common-size income statements are useful for trend analysis and for comparisons with peer firms.
Evaluate a company’s financial performance using common-size income statements and financial ratio based on the income statement.
Common-size income statements are useful in examining a firm’s business strategies.
Two popular profitability ratios are gross profit margin (gross profit / revenue) and net profit margin (net income / revenue). A firm can often achieve higher profit margins by differentiating its products from the competition.
Describe, calculate and interpret comprehensive income.
Comprehensive income is the sum of net income and other comprehensive income. It measures all changes to equity other than those from transactions with shareholders.
Describe other comprehensive income and identify major types of items included in it.
Transactions with shareholders, such as dividends paid and shares issued or repurchased, are not reported on the income statement.
Other comprehensive income includes other transactions that affect equity but do not affect net income, including:
- Gains and losses from foreign currency translation.
- Pension obligation adjustments.
- Unrealized gains and losses from cash flow hedging derivatives.
- Unrealized gains and losses on available-for-sale securities.
