Understanding Income Statements

Question 1

Different names for the I.S.

Answer 1

• statement of operations
• statement of earnings
• profit and loss (P&L) statement

Income - expenses = net income

Question 2

Expenses on I.S. can be grouped together by either:

Answer 2

• Grouping by nature

- Grouping by function

Question 3

Grouping by nature:

Answer 3

• Grouping expenses method

- group multiple line items of depreciation expenses into one line item, “Depreciation”

Question 4

Grouping by function:

Answer 4

• grouping expenses method

- “cost of goods sold”: grouping labor, materials costs, depreciation, salaries, etc

Question 5

I.S. presentation formats

Answer 5

• single-step: all revenues and all expenses are grouped together with no sub-totals
• multi-step: includes subtotals such as gross profit and operating profit

Question 6

On the I.S., Accounts receivables is a ___________ and unearned revenue is a _____

Answer 6

AR: and asset on the I.S.

Unearned revenue: a liability on the I.S.

Question 7

The 5 steps to follow in order to recognize revenue:

for IASB and FASB

Answer 7

1. identify the contract(s) with the customer
2. identify the performance obligations in the contract
3. determine the transaction price
4. allocate the transaction price to the performance obligations in the contract
5. recognize revenue when (or as) the entity satisfies a performance obligation

Question 8

Matching principle

Answer 8

• expenses incurred to generate revenue are recognized in the same period as revenue
• ex. if some goods bought in the current year remain unsold at the end of the year, they are not included in the cost of goods sold for the current year. If they are sold in the next year, they will be included in the cost of goods sold for the next year.

Question 9

Periodic costs

Answer 9

• cant be tied directly to the generation of revenues
• rent paid
• these costs are expensed in the period paid

Question 10

Inventory methods

Answer 10

• FIFO
• LIFO
• Weighted avg cost
• Specific identification

Question 11

Doubtful account estimate required by the matching principle:

Answer 11

• record an estimate of credit losses, using historical data, at the time of revenue recognition

Question 12

Warranty expense required by the matching principle:

Answer 12

• estimate a warranty expense, using historical data, at the time of revenue recognition

Question 13

Conservative approach to expense recognition - can affect net income

Answer 13

• recognition of expenses early (doubtful accts, warranty expenses, and depreciation amounts)

Question 14

Aggressive approach to expense recognition - can affect net income

Answer 14

• the company delays the recognition of expenses

Question 15

Retrospective approach

Answer 15

• financial statements in previous years are presented as if the newly adopted accounting principle had been used throughout the period
• a change in accounting policy is applied retrospectively, ex: shifting from LIFO to FIFO

Question 16

Prospective application

Answer 16

• only financial statements for the period of change and for future periods are changed
• changes in accounting estimates are applied prospectively, ex changing accounting estimates of the useful life of a depreciable asset

Question 17

Operating items and non-operating items under IFRS:

Answer 17

• no definition of operating activities - companies use judgement to classify

Question 18

Operating items and non-operating items under GAAP:

Answer 18

• operating activities involve producing and delivering goods and providing services
• all others are considered investing or financing activities
• ex interest expense, extraordinary items

Question 19

Potentially dilutive securities:

Answer 19

• will decrease EPS when exercised
• securities that can be converted into ordinary shares
• includes convertible bonds, convertible preferred stock, and employee stock options

Question 20

Simple v Complex capital structure

Answer 20

• complex capital structure: if a company has potentially dilutive securities, simple if not

Question 21

Anti-dilutive securities

Answer 21

• if exercised, it increases EPS

- only dilutive securities are included in diluted EPS calculations

Question 22

Basic EPS formula =

Answer 22

basic EPS = (( NI - PREFERRED dividends) / weighted avg # sh.o )

Question 23

total sh.o Jan 1: 10,000
additional shs added 7/1: 2000

find weighted avg sh.o EOY =

Answer 23

• the number of sh.o during the year, weighted by the portion of the year they were outstanding

10,000 sh to start the year and 12,000 total at EOY
= (10,000 sh * 6 months/12months) + (12,000 sh / 6months/12months)

Question 24

Diluted EPS (If-converted) formula =

Answer 24

Diluted EPS =
(NI + after tax interest - preferred dividends + convertible pref divs / weighted avg shs + new shs if convertible debt is converted)

After tax interest: conv debt int (1 - t)
- applies to convertible bonds
- add the after-tax interest cost savings to the numerator
= (# of convt bonds * par * coupon %) * (1 - t)

Question 25

Diluted EPS: for stock options

Answer 25

• use the “treasury stock method”
• assumes that the funds received by the company from the exercise of options are used to purchase shs of the company’s common stock at the avg market price over the reporting period

denominator = # of shs created with the exercise - # of shs hypothetically repurchased with the proceeds of the exercise

1. # of options * strike price = x (proceeds to firm)
2. x / avg stock price = y (the number of shs the firm repurchased)
3. x - y (the net new shares issued)

Question 26

In general, EPS increases if:

Answer 26

• EPS increases if

NI increases, a decrease in the number of sh.o, or a combination of both

Question 27

Common-size analysis of I.S.

Answer 27

• shows each line item on the I.S. as a percentage of revenue
• removes effects of company size

Question 28

Gross profit margin:

Answer 28

= gross profit / revenue

Question 29

Operating profit margin:

Answer 29

= operating profit / revenue

Question 30

Net profit margin:

Answer 30

= net profit / revenue

Question 31

Higher margin ratios are better and achieved by:

Answer 31

increasing selling prices and or lowering costs

Question 32

Other comprehensive income (OCI):

Answer 32

• includes transactions that are not included in net income
• “amount that bypassed the I.S.

Both IFRS and GAAP:

• unrealized gain/losses from available for sale securities
• foreign currency translation adjustments
• unrealized gains/losses on derivative contracts used for hedging
• adjustments for minimum pension liability

Question 33

Comprehensive Income (CI)

Answer 33

Both IFRS and GAAP

• the sum of NI and OCI
• measures all changes to equity apart from owner contributions and distributions (ie, those resulting from transactions with shareholders: dividends paid and stock repurchases are not included in CI)

Question 34

OCI formula:

Answer 34

OCI =

ending sh.e - (beg sh.e + NI - divids paid)