Reading 24 - Understanding Income Statements Flashcards
1
Q
Under IFRS, the income statement may be presented as:
A
- A section of a single statement of comprehensive income; or
- A separate statement (showing all revenues and expenses) followed by a statement of comprehensive income (described later) that begins with net income. Under U.S. GAAP, the income statement may be presented as:
2
Q
A section of a single statement of comprehensive income.
A
- A separate statement followed by a statement of comprehensive income that begins with net income.
- A separate statement with the components of other comprehensive income presented in the statement of changes in shareholders’ equity.
3
Q
Define the REVENUE section of an income statement.
A
Revenue: Usually reported on the first line of the income statement, revenues are amounts charged (and expected to be received) for goods and services in the ordinary activities of a business. Net revenue is total revenue adjusted for product returns and amounts that are unlikely to be collected. Other commonly used terms for revenue include sales and turnover.
4
Q
Define the REVENUE section of an income statement.
A
Revenue: Usually reported on the first line of the income statement, revenues are amounts charged (and expected to be received) for goods and services in the ordinary activities of a business. Net revenue is total revenue adjusted for product returns and amounts that are unlikely to be collected. Other commonly used terms for revenue include sales and turnover.
5
Q
Define the EXPENSES section of an income statement.
A
Expenses reflect outflows, depletions of assets, and incurrences of liabilities in the course of the activities of a business.
6
Q
Define the GROSS PROFIT or GROSS MARGIN section of an income statement.
A
Gross profit or gross margin is the difference between revenues and cost of goods that were sold. When an income statement explicitly calculates gross profit, it uses a multi-step format as opposed to a single-step format. Van Dort uses a single step format, while Johnson uses a multi-step format.
7
Q
Define the OPERATING INCOME section of an income statement.
A
Operating income is calculated after subtracting all direct and indirect (period) costs from revenues. It represents the profit earned by a company from its ordinary business activities before accounting for taxes and, in the case of nonfinancial companies, before deducting interest expense. Operating profits are useful in evaluating the profitability of individual businesses as they are not affected by financing decisions of the firm. Exhibits 1-1 and 1-2 contain income statements of nonfinancial companies. For financial firms, interest income and expense are part of ordinary business activities, so they are included in operating profits.
8
Q
Define the NET INCOME section of an income statement. Also, give the Net Income equation
A
Net income is the “bottom‐line” of the income statement. It includes profits earned from ordinary business activities as well as gains and losses (increases and decreases in economic benefits) from nonoperating activities.
Net income = Revenue − Expenses in the ordinary activities of the business + Other income − Other expenses + Gains − Losses
9
Q
Define the NONCONTROLLING INTEREST section of an income statement.
A
If a company owns the majority of the shares of a subsidiary, it must present consolidated financial statements. Consolidation requires the parent to combine all the revenues and expenses of the subsidiary with its own and present the combined results on its income statement. If the subsidiary is not wholly owned, the share of noncontrolling interests in net income is deducted from total income, as it represents the proportionate share in the subsidiary’s net income that belongs to minority shareholders.
10
Q
Define the requirement for subtotals on the income statement.
A
Some subtotals are required by IFRS (especially nonrecurring items), while others are not explicitly required. Examples of items that are required to be separately stated on the face of the income statement are revenues, finance costs, and taxes.
Under IFRS, revenue from rendering of services is recognized when:
1) The amount of revenue can be measured reliably;
2) It is probable that the economic benefits associated with the transaction will flow to
the entity;
3) The stage of completion of the transaction at the balance sheet date can be
measured reliably; and
4) The costs incurred for the transaction and the costs to complete the transaction can
be measured reliably.
11
Q
Define how the IFRS permits the grouping of expenses.
A
IFRS permits the grouping of expenses by nature or by function. An example of grouping by nature would be combining depreciation of factory equipment with depreciation of transport vehicles and stating a single aggregate amount for depreciation on the income statement. An example of grouping by function would be combining direct product costs (raw material costs and freight charges) under costs of goods sold.
12
Q
What are the income statement presentation formats most commonly used?
A
Income statement presentation formats: Van Dort’s and Johnson’s income statements also highlight the following differences that we might run into when analyzing financial statements of various companies.
13
Q
Describe the differences in Van Dort’s and Johnson’s income statement presentation formats.
A
Income statement presentation formats: Van Dort’s and Johnson’s income statements also highlight the following differences that we might run into when analyzing financial statements of various companies:
- Van Dort presents the latest year in the extreme right column, while Johnson presents the most recent year on the extreme left.
- Van Dort presents expense items (e.g., costs of goods sold and interest expense) in parenthesis to show that they are being deducted. In contrast, Johnson does not present its expenses in parenthesis or with negative signs. It assumes that users know that expense items are subtracted from revenues.
- Van Dort deducts cost of goods sold from sales, while Johnson deducts cost of sales. Such differences in terminology are common across sets of financial statements.
14
Q
How does the IASB framework define income?
A
The IASB framework defines income as “increases in economic benefits during the accounting period in the form of inflows or enhancements of assets, or decreases in liabilities that result in increases in equity, other than those relating to contributions from equity participants.”1 Income includes revenues and gains. Revenues arise from ordinary, core business activities, whereas gains arise from noncore or peripheral activities. For example, for a software development company the sale of software to customers is considered revenue, but the profit on the sale of some old office furniture is classified as a gain.
15
Q
What is the most important principle of revenue recognition and what does it require?
A
The most important principle of revenue recognition is accrual accounting, which requires that revenues and costs are recognized independently of the timing of related cash flows. For example, under accrual accounting, rent expense is recognized in the month that a company uses the premises for its operations, not when the actual cash payment for rent is made. Accrual accounting allows firms to manipulate net income by recognizing revenue earlier or later, or by accelerating or deferring recognition of expenses.
16
Q
Under IFRS, revenue is recognized for a sale of goods when:
A
1) Significant risks and rewards of ownership are transferred to the buyer.
2) The entity retains no managerial involvement or effective control over the goods
sold.
3) The amount of revenue can be measured reliably.
4) It is probable that the economic benefits from the transaction will flow to the entity.
5) Costs incurred or to be incurred for the transaction can be measured reliably.
17
Q
IFRS specify similar criteria for recognizing revenue for the rendering of service. Revenue can be estimated reliably when all the following:
A
1) The amount of revenue can be measured reliably.
2) It is probable that the economic benefits associated with the transaction will flow to
the entity.
3) The stage of completion of the transaction at the balance sheet date can be
measured reliably.
4) The costs incurred for the transaction and the costs to complete the transaction can
be measured reliably.
18
Q
IFRS specifies the criteria for recognizing interest, royalties, and dividends. Explain.
A
IFRS also specifies the criteria for recognizing interest, royalties, and dividends. These may be recognized when it is probable that the economic benefits associated with the transaction will flow to the entity and that the amount of the revenue can be measured reliably.
19
Q
Under U.S. GAAP, revenue is recognized on the income statement when it is “realized or realizable and earned.”4The SEC provides specific guidelines to determine when these two conditions are met:
A
1) There is evidence of an arrangement between the buyer and seller.
2) The product has been delivered or the service has been rendered.
3) The price is determined or determinable.
4) The seller is reasonably sure of collecting money.
20
Q
Describe revenue recognition in special cases.
A
The principles of revenue recognition listed above cater to most cases. However, there are some special circumstances in which revenue may be recognized prior to the sale of a good/service or even after the sale.
21
Q
For long-term contracts, how are revenues recognized?
A
Long-term contracts are contracts that extend over more than one accounting period, such as construction projects. In long-term contracts, questions arise as to how revenues and expenses should be allocated to each accounting period. The treatment of these items depends on how reliably the outcome of the project can be measured.
22
Q
Under both IFRS and U.S. GAAP, if the outcome of the contract can be measured reliably, what revenue recognition method is used?
A
Under both IFRS and U.S. GAAP, if the outcome of the contract can be measured reliably, the percentage of completion revenue recognition method is used. Under this method, revenues, costs, and profits are allocated to each accounting period in proportion to the percentage of the contract completed during the given period. The percentage that is recognized during a period is calculated by dividing the total cost incurred during the period by the estimated total cost of the project.
23
Q
Under U.S. GAAP, if the outcome of a contract cannot be measured reliably, what revenue recognition method is used?
A
If the outcome cannot be measured reliably, the completed‐contract method is used under U.S. GAAP. Under this method, no revenues or costs are recognized on the income statement until the project is substantially finished. In the meantime, billings and costs are accumulated on the balance sheet (under a Construction-in-progress asset), rather than expensed on the income statement.
NOTE:
Under U.S. GAAP, the completed contract method is also appropriate when the contract is not a long-term contract. Note however, that when a contract is started and completed is the same period, there is no difference between the percentage-of-completion and completed contract methods.
24
Q
Under IFRS, if the outcome of a contract cannot be measured reliably, what revenue recognition method is used?
A
Under IFRS, when the outcome cannot be measured reliably, revenue is recognized on the income statement to the extent of costs incurred during the period. No profits are recognized until all costs have been recovered.
25
**What are the main differences and similarities between the revenue recognition methods? (percentage of completion method vs. completed contract method)**
The percentage of completion method is a more aggressive (less conservative) approach to revenue recognition. It is also more subjective as it depends on management estimates and judgment relating to the reliability of estimates. However, the percentage of completion method matches revenues with costs over time and provides smoother, less volatile earnings. Remember, cash flows are exactly the same under both methods.
26
**Under IFRS and U.S. GAAP, if a loss is expected on the contract, what must be done?**
**Important**: Under **IFRS** and **U.S. GAAP**, if a loss is expected on the contract, the loss must be recognized immediately, regardless of the revenue recognition method used.
27
**Define installment sales in the context of revenue recognition.**
An installment sale occurs when a company finances a customer’s purchase of its products and customers make payments (installments) to the company over an extended period.
28
**Under IFRS, how are installment sales separated and revenues recognized?**
Under **IFRS**, installment sales are separated into the selling price (discounted present value of installment payments) and an interest component. Revenue attributable to the
sale price is recognized at the date of sale, while the interest component is recognized over time.6 However, the standards provide that revenue should be recognized in light of local laws regarding the sale of goods. For transactions that require deferral of revenue and profit recognition (like sales of real estate on an installment basis) revenue recognition depends on specific aspects of the transaction.
29
**Under U.S. GAAP, a sale of real estate is reported at the time of sale using the normal revenue recognition conditions if the seller:**
- Has completed the significant activities in the earnings process; and
- Is either assured of collecting the selling price or able to estimate amounts that will
not be collected.
30
**Under U.S. GAAP, a sale of real estate is reported at the time of sale using the normal revenue recognition conditions if the seller:****7**
**-** **Has completed the significant activities in the earnings process; and**
**-** **Is either assured of collecting the selling price or able to estimate amounts that will**
**not be collected.**
**When these two conditions are not fully met, some of the profit must be deferred and one of the following two methods may be used:**
Installment method
Cost-recovery method
31
**Under U.S. GAAP, a sale of real estate is reported at the time of sale using the normal revenue recognition conditions if the seller:****7**
**-** **Has completed the significant activities in the earnings process; and**
**-** **Is either assured of collecting the selling price or able to estimate amounts that will**
**not be collected.**
**When these two conditions are not fully met, some of the profit must be deferred and one of the following two methods may be used: Define installment method.**
Installment method: This method is used when collectability of revenues *cannot be reasonably estimated.* Under this method, profits are recognized as cash is received. The percentage of profit recognized in each period equals the proportion of total cash received in the period.
Profit for the period = (Cash collected in the period / Selling price) × Total profit
32
**Under U.S. GAAP, a sale of real estate is reported at the time of sale using the normal revenue recognition conditions if the seller:****7**
**-** **Has completed the significant activities in the earnings process; and**
**-** **Is either assured of collecting the selling price or able to estimate amounts that will**
**not be collected.**
**When these two conditions are not fully met, some of the profit must be deferred and one of the following two methods may be used: Define cost recovery method.**
Cost‐recovery method: This method is used when collectability of revenues is *highly uncertain*. Under this method, profits are only recognized once total cash collections (including principal and interest on any financing provided to the buyer) exceed total costs. The revenue recognition method under international standards is similar to the cost recovery method, but the term “cost recovery method” is not used.
33
**Define barter transactions in the context of revenue recognition.**
In barter transactions, goods are exchanged between two parties and there is no exchange of cash. One form of barter transaction is a round-trip transaction, in which a good is sold by one party in exchange for the purchase of an identical good. The issue with these transactions is whether revenue should be recognized.
34
**How care barter transaction revenues recognized under the IFRS & U.S. GAAP?**
Under **IFRS**, revenue from barter transactions can be reported on the income statement based on the fair value of revenues from similar *nonbarter* transactions with *unrelated parties.*
Under **U.S. GAAP**, revenue from barter transactions can be reported on the income statement at fair value only if the company has a history of making or receiving cash payments for such goods and services and hence, can use its historical experience to determine fair value. Otherwise, revenue should be reported at the carrying amount of the asset surrendered.
35
**In gross vs. net reporting, how are sales and cost of sales reported?**
Under gross revenue reporting, sales and cost of sales are reported separately, while under net reporting, only the difference between sales and cost of sales is reported on the income statement.
36
**Under U.S. GAAP, only if the following conditions are met can a company recognize revenue based on gross reporting:**
- The company is the primary obligor under the contract.
- The company bears inventory and credit risk.
- The company can choose its suppliers.
- The company has reasonable latitude to establish price.
Example: A travel agent purchases discounted tickets and sells them to customers. The agent only pays for the tickets that she manages to sell to customers. She purchases a ticket for $1,000 and sells it for $1,100. Assume that there are no other revenues and expenses involved. Demonstrate the reporting of revenues under gross and net reporting.
The travel agent should report revenue on a *net basis* because:
- She only pays for tickets that she is able to sell to customers. Therefore, she does
not bear any inventory risk.
- The airline, not the travel agent, is the primary obligator under the contract.
37
**Describe the implications for financial analysis for revenue recognition policies in the footnotes to their financial statements.**
Companies are required to disclose their revenue recognition policies in the footnotes to their financial statements. The impact of a chosen policy on financial analysis depends on how conservative and objective the revenue recognition policy is. A conservative policy would recognize revenue later rather than sooner, and an objective policy would not leave too many estimates to management discretion. While it is difficult to attach a monetary value to differences in revenue recognition policies, analysts should be able to assess qualitative differences between sets of financial statements and evaluate how these differences affect important financial ratios.
38
**How does the IASB framework define expenses?**
The IASB framework defines expenses as “decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.”
39
**What is the most important principle of expense recognition?**
Expenses also include losses, which may or may not result from the ordinary activities of the business. The most important principle of expense recognition is the *matching principle*, which requires that expenses be matched with associated revenues when recognizing them on the income statement. If goods bought in the current year remain unsold at the end of the year, their cost is not included in the cost of goods sold for the current year to calculate current period profits.
Instead, the cost of these goods will be subtracted from next period’s revenues once they are sold. Certain expenses (e.g., administrative costs) cannot be directly linked to the generation of revenues. These expenses are called ***period costs*** and are allocated systematically with the passage of time.
40
List the various types of inventory methods and when they’re used.
If a company can specifically identify which units of inventory have been sold over the year and which ones remain in stock, it can use the *specific identification method* for valuing its inventory. Automobiles, for example, can be valued using this method. However, if sales are composed of identical units that are sold in high volumes (e.g., pencils), the separate identification method becomes difficult to administer. In such situations, the following methods of inventory valuation can be used:
First-in, first-out (FIFO)
Last-in, first-out (LIFO)
Weighted-average cost
41
**Define the inventory method FIFO.**
First‐in, first‐out (FIFO): This method assumes that items purchased first are sold first. Therefore, ending inventory is composed of the most recent purchases. FIFO is an appropriate method for valuing inventory that has a limited shelf life. For example, older food products will be sold first to ensure that available stock is fresh.
42
**Define the inventory method LIFO.**
Last‐in, first‐out (LIFO): This method assumes that items purchased most recently are sold first. Therefore, ending inventory is composed of the earliest purchases. The LIFO method is suitable when the physical flow of the item is such that the latest item must be sold first, for example, stacks of lumber in a lumberyard. This method is popular in the United States because of its income tax benefits.
43
**Define the inventory method weighted-average cost.**
Weighted‐average cost: Under this method, total inventory costs are allocated evenly across all units. Inventory valuation and analysis is covered in detail in Reading 29.
44
**Describe the different views of U.S. GAAP vs. IFRS on inventory methods?**
All three methods are allowed under U.S. GAAP. IFRS allows FIFO and weighted-average cost methods, but does not permit use of LIFO.
45
**What are some issues in expense recognition?**
Doubtful accounts
Warranties
Depreciation
Amortization
46
**For issues in expense recognition, define doubtful accounts.**
When sales are made on credit, there is a possibility that some customers will not be able
to meet their payment obligations. Companies can choose to wait for actual customer defaults to recognize these losses (direct write-off method). However, the matching principle requires companies to estimate bad debts at the time of revenue recognition. These estimated uncollectable amounts are expensed on the income statement for the period during which the related sales were made (they are not directly adjusted to revenues).
47
**For issues in expense recognition, define warranties.**
When companies provide warranties for their products, there is a possibility that they
might have to pay for repairing or replacing defective products in the future. Rather than recognizing these expenses only when they are actually incurred (when warranty claims
are made), the matching principle requires companies to estimate future warranty-related expenses and recognize these amounts on the income statement in the period of sale, and to update this amount to bring in line with actual expenses incurred over the life of the warranty.
48
**For issues in expense recognition, define depreciation.**
Companies incur significant costs to acquire long‐lived assets that provide economic benefits over an extended period of time. Under **IFRS**, long**-**lived assets may either be valued using the cost model or the revaluation model. On the other hand, **U.S. GAAP** only permits the use of the cost model.
49
**For issues in expense recognition, under depreciation, define the cost model.**
Under the cost model, the asset is reported at a cost less than any accumulated depreciation. Depreciation is the process of allocating the cost of long-lived assets across the accounting periods that they provide economic benefits for. The allocation of costs to several periods matches these costs with associated revenues. With regard to depreciation, **IFRS** requires the following:
- Each component of an asset should be depreciated separately.
- Estimates of residual value and useful life should be reviewed annually.
50
**How do you choose depreciation methods and what do they depend on? What are the two deprecation methods?**
The choice of depreciation method depends on how a company expects to utilize the benefits from a long-lived asset over time.
Strait-line method
Accelerated methods
51
**Define the deprecation method: Strait-line method**
Under the **straight****‐****line** method, the cost of the asset less its estimated residual value is spread evenly over the estimated useful life of the asset. This method requires estimates of residual value and useful life. Residual value is the amount that the company expects to receive upon sale of the asset at the end of its useful life.
52
**Define the deprecation method: accelerated methods**
Under **accelerated methods** of recording depreciation, a greater proportion of the asset’s cost is allocated to the initial years of its use and a lower proportion of the cost is allocated to later years. Accelerated methods are used when the asset is expected to be utilized more heavily in the years immediately following its purchase.
Accelerated methods of depreciation result in higher depreciation expense and lower net income in the early years of an asset’s life. In later years, accelerated methods recognize less depreciation expense in every accounting period, resulting in higher net income.
53
**Define amortization.**
Amortization refers to the allocation of the cost of an intangible asset over its useful life.
54
**How are intangible assets with identifiable useful lives amortized?**
Intangible assets with identifiable useful lives are amortized evenly over their lives in the same way as long**-**term assets are depreciated using the straight-line method. However, there are no estimates for residual value involved in the calculation.
55
**How are intangible assets with indefinite lives amortized?**
Intangible assets with indefinite lives (e.g., goodwill) are not amortized; instead they are tested annually for impairment. An asset is impaired when its current value is lower than its book value. If an asset is deemed impaired, an impairment charge (expense) is made on the income statement to bring its value down to its true current value.
56
**Describe how depreciation methods are demonstrated?**
A variety of methods can be used to calculate depreciation expense. While annual depreciation expense might vary from method to method, total depreciation expense over the life of the asset will be the same under all methods.
57
**How can depreciation methods be demonstrated?**
A variety of methods can be used to calculate depreciation expense. While annual depreciation expense might vary from method to method, total depreciation expense over the life of the asset will be the same under all methods.
Straight-line depreciation
Declining balance depreciation
58
**Define, with equation, the straight-line deprecation**
Straight‐line depreciation: An equal amount of depreciation expense is charged every year during the asset’s useful life. Annual depreciation expense is calculated as:
(Cost − Residual value) / Useful life
59
**Define, with equation, declining balance depreciation.**
Declining balance depreciation: This is an accelerated method of depreciation, which applies a constant rate of depreciation to a declining book value. To compute depreciation expense, we must determine the *straight-line rate*, which equals 100% divided by the number of years that the asset is expected to remain in use. For example, if the asset’s useful life is 5 years, the straight-line rate would be 20% (100/5). Next, we must determine the acceleration factor, which is multiplied by the straight-line rate. The product of the two is then applied to the net book value of the asset to determine depreciation expense.
60
**Define, with equation, double-declining balance depreciation.**
The double-declining balance method uses an acceleration factor of 200 (it depreciates the asset at a rate that is two times the straight-line rate). Depreciation expense under the double‐declining balance (DDB) method is calculated as:
(2 / Useful life) × (Cost − Accumulated depreciation)
61
**Unlike straight-line depreciation, what does the declining balance method not explicitly take into account?**
Unlike straight‐line depreciation, the declining balance method does not explicitly take into account the residual value of the asset in determining depreciation expense each year. Under the declining balance method, the asset is only depreciated until its net book value equals its residual value.
62
**Annual depreciation expense is sensitive to two estimates, what are they?**
Annual depreciation expense is sensitive to two estimates—residual value and useful life.
An increase in the value of these two estimates would decrease yearly depreciation expense and increase reported net income. Let’s tweak the information provided in Example 2-5 to illustrate this. If the residual value of the generator is increased to $6,000 (from $3,000) and the useful life is increased to 8 years (from 5 years), annual depreciation expense under the straight‐line method would equal $4,000 [(38,000 – 6,000)/8]. The increase in residual value and useful life estimates leads to a reduction in depreciation expense (from $7,000 to $4,000).
63
**What are the implications from financial analysts when analyzing depreciation?**
A company’s estimates for doubtful accounts and warranties and estimates of useful lives and salvage values of long-lived assets directly affect net income. The subjective nature of these estimates allows management to manipulate reported financial statements. Therefore, when analyzing financial statements, analysts must carefully scrutinize the validity of used estimates. For example, if a company reports lower warranty expense in the current year compared to the previous year, an analyst should consider whether this is due to better and more reliable products, or because management had recognized an artificially high warranty expense in the previous period to inflate net income in the current period.
Accounting estimates should also be compared to those of other companies that operate in the same industry to check their validity and evaluate management integrity. If a company has a lower provision for doubtful accounts compared to a peer company, an analyst should assess whether this is because of stricter credit policies or because the company has a more aggressive accounting approach. As with revenue recognition, relative conservatism in expense recognition has a direct impact on reported financial ratios.
Accounting policies and estimates are disclosed in the footnotes to the financial statements and the management discussion and analysis (MD&A) section of the annual report.
64
**Describe the financial reporting treatment and analysis of non-recurring items.**
In order to forecast a company’s future earnings, analysts must project the company’s revenues and expenses into the future. The most popular way of doing this is to use prior years’ income and expense items as base figures, and to separate revenues and expenses that are likely to continue in the future from those that are not as likely to occur in the future (nonrecurring items). Nonrecurring items are discontinued operations, extraordinary items, unusual or infrequent items, and accounting changes.
65
**The financial treatment and analysis of non-recurring items, define how discontinued operations are treated.**
Under both **IFRS** and **U.S. GAAP**, the income statement must separately report an operation as a “discontinued operation” when the company disposes of, or decides to dispose of, one of its component operations, and the component is operationally and physically separable from the rest of the firm.
- Discontinued operations are reported *net of tax* as a *separate* line item *after* income from continuing operations (this treatment is permitted under **IFRS** and **U.S. GAAP**).
* - As the disposed operation will not earn revenue for the company going forward, it will not be taken into account when formulating expectations regarding the future performance of the company.*
66
**The financial treatment and analysis of non-recurring items, define how extraordinary items are treated**
**IFRS** does not allow any items to be classified as extraordinary. **U.S. GAAP** defines extraordinary items as being **both** unusual in nature **and** infrequent in occurrence. A significant degree of judgment is involved in classifying an item as extraordinary. For example, losses caused by Hurricane Katrina in the Unites States were not classified as extraordinary items because natural disasters could reasonably be expected to reoccur.
- Extraordinary items are reported *net of tax* and as a *separate* line item *after* income from continuing operations (below discontinued operations).
- *Analysts can eliminate extraordinary items from expectations about a company’s future financial performance unless there is an indication that these extraordinary items may reoccur.*
The likelihood of certain other items continuing in the future is not as clear and requires analysts to make judgments regarding their impact on future profits. Two examples of such items are unusual or infrequent items and changes in accounting standards.
67
**The financial treatment and analysis of non-recurring items, define how unusual or infrequent items are treated.**
These items are **either** unusual in nature **or** infrequent in occurrence. Examples of such items include restructuring charges and gains and losses arising from selling an asset for more or less than its carrying value.
- These items are listed as separate line items on the income statement but are *included* in income from continuing operations and hence, reported *before-tax.*
- *Analysts should not ignore all unusual items. When forecasting future profits, analysts should assess whether each of them is likely to reoccur.*
68
**The financial treatment and analysis of non-recurring items, the treatment of changes accounting can be subdivided in three areas:**
A change in accounting policy
Change in an accounting estimate
A correction of prior-period errors
69
**The financial treatment and analysis of non-recurring items, accounting specifically, define how a change in accounting policy is treated.**
A change in accounting policy could be required by standard setters or be decided on by management to provide a better reflection of the company’s performance. An example of change in accounting policy is moving away from LIFO to the FIFO method of inventory valuation. Changes in accounting policies are applied *retrospectively*, unless it is impractical to do so. This means that financial data for all periods shown in the financial report must be presented as if the new principal were in use through the entire period. This retrospective change facilitates comparisons across reporting periods. Further, a description of and justification for the change are provided in the footnotes to the financial statements.
70
**The financial treatment and analysis of non-recurring items, accounting specifically, define how a change in accounting estimate is treated.**
A change in an accounting estimate (e.g., a change in the residual value of an asset), is applied *prospectively* and only affects financial statements for the current and future periods. No adjustments are made to prior statements and the adjustment is not shown on the face of the income statement. Significant changes in accounting estimates should be disclosed in the footnotes.
71
**The financial treatment and analysis of non-recurring items, accounting specifically, define how a correction of prior-period errors are treated.**
A correction of prior‐period errors is made by restating all prior‐period financial statements presented in the financial report. In addition, disclosure about the error is required in the footnotes. Analysts should carefully assess these disclosures, as they may point to weaknesses in the company’s accounting system or financial controls.
72
**Distinguish between the operating and non-operating components of the income statement.**
**IFRS** does not define operating activities. Therefore, companies that choose to report operating income or the results of operating activities need to ensure that such activities would normally be regarded as operating.
On the other hand, **U.S. GAAP** defines operating activities as those that generally involve producing and delivering goods and providing services, and include all transactions and other events that are not defined as investing or financing activities.9
For example, a cloth manufacturer might receive dividend and interest income from investments in securities issued by other entities. These sources of income do not relate
to the core business operations of the manufacturer and will be listed under nonoperating components of net income. Interest payments on loans taken by the manufacturer are
also nonoperating items because interest expense is incurred due to a financing decision. Analysts typically use a firm’s earnings before interest and taxes (EBIT) as a measure of its operating income. For financial services companies however, interest expense and income are related to their core businesses and constitute operating components of their business.
73
**Define earnings per share.**
Earnings per share is one of the most important profitability measures for publicly listed firms. Earnings refer to the share of net income of a company that is owned by common shareholders only.
74
**A firm can have which types of capital structure?**
A firm can have a simple capital structure or a complex capital structure.
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**Define a simple capital structure.**
A company has a simple capital structure when it does not have any financial instruments outstanding that can be converted into common stock. Firms with simple capital structures are required to report basic earnings per share (EPS) only.
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**How is Basic EPS calculated?**
Basic EPS = (Income available to common shareholders)/(Weighted average number of shares outstanding)
Basic EPS = (Net income – Preferred dividends)/(Weighted average number of shares outstanding)
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**Define preferred dividends.**
Preferred dividends are subtracted from net income to calculate earnings available to common shareholders. This is because preferred dividends are not included in expenses on the income statement in the calculation of net income.
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**Define the weighted average number of shares outstanding.**
The weighted average number of shares outstanding refers to the number of shares that were outstanding over the year (adjusted for stock splits and stock dividends), weighted according to the proportion of the year that they were outstanding.
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**What are the effects of stock repurchases in the number of shares outstanding?**
Stock repurchases result in a *decrease* in the number of shares outstanding. Therefore, reacquired shares are excluded from the computation of weighted average number
of shares from the date of repurchase. For example, if a company had 1,000 shares outstanding at the start of the year and repurchased 100 shares in July, the weighted average number of shares outstanding would be calculated as:
Weighted average number of shares = (1,000 × 12/12) − (100 × 6/12) = 950
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**What are the effects of stock splits and stock dividends (stock bonus) in the number of shares outstanding?**
In contrast, stock splits and stock dividends (stock bonus) result in an *increase* in the number of shares outstanding.
- In a stock split, existing shares in a company are “split” into more shares. A 2‐for‐1 stock split will increase the number of shares held by a holder of 1,000 shares by 1,000 shares to 2,000 shares. After a 3‐for‐2 stock split, the owner of 1,000 shares will see her shareholding increase by 500 shares to 1,500 shares.
- A stock dividend is a dividend paid as additional shares of stock rather than cash. These additional shares are granted to each shareholder in proportion to her current holding. After a 25% stock dividend, the holder of 1,000 shares will get 250 (25%) more shares to take her total shareholding to 1,250 shares.
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**What is an important point if a company declares a stock slit or a stock dividend?**
**Important:** If a company declares a stock split or a stock dividend, the weighted average number of shares outstanding should be calculated based on the assumption that the additional (newly granted) shares have been outstanding since the date that the original shares were outstanding.
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**Define a complex capital structure.**
A **complex capital structure** is one that contains certain financial instruments that can
be converted into common stock (e.g., convertible bonds, convertible preferred stock, warrants, and options). These financial instruments are potentially dilutive, so companies with complex capital structures are required to report basic and diluted EPS.
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**What is a dilutive security and define diluted EPS.**
A dilutive security is one whose conversion into shares of common stock would result in a reduction in EPS. EPS calculated after taking into account all dilutive financial instruments in the capital structure is known as diluted EPS. Financial instruments that can be converted
into common stock, but whose conversion does not reduce EPS below basic EPS, are anti-dilutive. Anti-dilutive financial instruments are not considered in the calculation of diluted EPS. Accounting standards require companies to disclose diluted EPS because this information is important for existing common shareholders.
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**The diluted EPS when a company has convertible preferred stock outstanding, how would convertible preferred shares be converted into common shares?**
If convertible preferred shares were converted into common shares:
- We would add back dividends paid to convertible preferred shareholders to our
numerator (earnings available to common shareholders). This is because the company would not be required to pay any preferred dividends on convertible preferred shares if these shares were converted into ordinary shares.
- We would increase the number of shares outstanding by the number of common shares that would be issued to convertible preferred shareholders upon conversion.
Diluted EPS = (Net income – preferred dividends + convertible preferred dividends) / (Weighted average number of shares outstanding + New common shares issued upon conversion)
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**A quick way to determine whether convertible preferred shares are dilutive is by calculating:**
(Convertible preferred dividends) / (New shares issued upon conversion)
If this per share figure is lower than basic EPS, the convertible preferred shares are dilutive, and should be included in the calculation of diluted EPS. If this figure is greater than basic EPS, the convertible preferred shares are anti-dilutive and should be ignored in the calculation of diluted EPS.
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**How is diluted EPS treated when a company has convertible debt outstanding?**
If convertible bonds were converted into ordinary shares:
- We would add interest payments that were made to bondholders back to the numerator. This is because the company would not be required to make any interest payments to holders of convertible bonds if these bonds were converted to ordinary shares. However, the increase in earnings available to common shareholders is not the entire amount of interest savings from inversion. Recall that interest expense is deducted from operating profits before the calculation of net income before tax, so interest expense results in a tax shield for the company. Interest savings adjusted for the tax shield benefits that have already been realized will be added to the numerator.
- The number of shares outstanding will increase by the number of common shares that would be issued to convertible debt holders upon conversion.
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**If convertible bonds were converted into ordinary shares, what is the diluted EPS equation?**
Diluted EPS = (Net income – Preferred dividends + Convertible debt interest x (1-t)) / (Weighted average number of shares outstanding + New common shares issued upon conversion)
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**A quick way to determine whether convertible bonds are dilutive is by calculating:**
(Convertible bond interest (1-t)) / (New shares issued upon conversion)
If this per share figure is lower than basic EPS, the convertible bonds are dilutive and should be included in the calculation of diluted EPS. If this figure is greater than basic EPS, the convertible bonds are anti-dilutive and should be ignored in the calculation of diluted EPS.
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**How are diluted EPS calculated when a company has stock options, warrants, or their equivalents outstanding?**
In the calculation of diluted EPS, stock options and warrants are accounted for using the treasury stock method (required under **U.S. GAAP**). The treasury stock method assumes that all the funds received by the company from the exercise of options and warrants are used by the company to repurchase shares at the average market price for the period. The resulting net increase in number of shares outstanding equals the increase in shares from the exercise of options and warrants minus the number of shares repurchased.
Stock options and warrants are assumed to be exercised if the strike or exercise price is lower than the average market price during the year. The proceeds to the company from the exercise of the options equal the exercise price multiplied by the number of options. These proceeds are used to repurchase shares at the average market price.
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**Define the EPS calculation when a company has stock options, warrants, or their equivalents outstanding.**
In calculating diluted EPS:
- No adjustment must be made to the numerator because the exercise of options or warrants has no impact on income available to common shareholders.
- The number of shares outstanding increases by the number of shares issued upon exercise of options minus the number of shares repurchased with the proceeds of option exercise. A shortcut for calculating the net increase in the number of shares is:
[(Market price – Exercise price) / (Market price)] x (Number of shares created from the exercise of options)
Diluted EPS = (Net income) / (Weighted average number of shares outstanding + New shares issued at option exercise – Shares repurchased from proceeds of option exercise)
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**What is an important note about determining whether options or warrants are exercised?**
Year-end stock prices do
NOT matter in determining whether options and warrants are exercised.
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**What is the difference between IFRS and U.S. GAAP when calculated diluted EPS when a company has stock options, warrants, or their equivalents outstanding?**
**IFRS** requires the use of a similar method, but does
not refer to it as
the treasury stock method. The proceeds of option exercise are assumed to be used to repurchase shares at the average market price and these shares are known as inferred shares. The excess of new issued shares over inferred shares is added to the weighted average number of shares outstanding.
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**What is the overall effect on EPS when options/warrants are exercised?**
When options/warrants are exercised (average market price is greater than exercise price) they result in an increase in the number of shares outstanding. Because their exercise only has an impact on the denominator of the EPS formula, options and warrants are always dilutive if exercised.
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**What is an important note in determining which potentially dilutive financial instruments should be included in the diluted EPS calculation?**
**Important:** In determining which potentially dilutive financial instruments should be included in the diluted EPS calculation, each of the financial instruments must be evaluated individually and independently to determine whether they are dilutive. If there are any anti‐dilutive financial instruments, they must be ignored from the diluted EPS calculation.
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**What is the diluted EPS equation containing all three types of potentially dilutive financial instruments?**
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**Give one final note about if dilutive financial instruments were issued during the year.**
**One final note:** If dilutive financial instruments were issued during the year, the denominator of the diluted EPS formula would increase by the number of shares issued upon conversion/ exercise multiplied by the proportion of the year that they were outstanding for. For example, if dilutive convertible preferred shares that can be converted into 10,000 shares of common stock were issued after 9 months of the accounting year had passed, the denominator of the diluted EPS formula would be increased by 10,000 × (3/12) = 2,500.
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**Define common-size income statement.**
**Common****‐****size income statements** present each line item on the income statement as a percentage of *sales*. The standardization of each item removes the effect of company size and facilitates financial statement analysis, as the data can be used to conduct time-series (across time periods) and cross-sectional (across companies) analysis.
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**Define effective tax rate ratio**
While common‐size income statements present most items as a percentage of sales, it is more appropriate to present income taxes as a percentage of pre-tax income. This ratio is known as the company’s effective tax rate. In cross-sectional analysis, effective tax rates are compared across companies and sources of any differences are analyzed in detail.
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**Define income statement ratios and the two most commonly used indicators of profitability.**
**Income Statement Ratios**
Items listed on the income statement are used to calculate ratios to evaluate a company’s profitability. Gross profit margin and net profit margin are the two most commonly used indicators of profitability.
Net profit margin = Net income / Revenue
Gross profit margin = Gross profit / Revenue
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On income statements, how are any sub-totals on the income statement expressed?
Any sub‐total on the income statement can also be expressed as a margin ratio by dividing it by total revenue. For example, operating margin is calculated as operating income (EBIT) divided by sales, and pre-tax margin is calculated as earnings before tax (EBT) divided by total revenue.
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**Most revenues, gains, expenses, and losses are reported on the income statement to determine a company’s net income. However, there are certain income and expense items that are excluded from the income statement. Explain**
Most revenues, gains, expenses, and losses are reported on the income statement to determine a company’s net income. However, there are certain income and expense items that are excluded from the income statement; instead these items are reported directly
in shareholders’ equity (**U.S. GAAP** only), or in a separate statement of comprehensive income (**IFRS** and **U.S. GAAP**) as a part of **other comprehensive income**.
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**How does the IFRS define total comprehensive income?**
**IFRS** defines total comprehensive income as “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.”
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**Under U.S. GAAP, how is comprehensive income defined?**
Under **U.S. GAAP**, comprehensive income is defined as “the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.”
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**Define comprehensive income.**
Comprehensive income includes both net income and *other* revenues and expenses that are excluded from the net income calculation (other comprehensive income). Both net income and other comprehensive income have an impact on retained earnings.
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