Understanding Income Statemets

Question 1

Income statements report the revenues and expenses of the firm over a period of time.

Answer 1

Income statement equation

revenues - expenses = net income

Question 2

Net Revenue

Answer 2

= revenue less adjustments for estimated returns and allowances

Question 3

Net Income equation

Answer 3

net income = revenues - ordinary expenses + other income - other expenses + gains - losses

Question 4

Gross profit

Answer 4

the amount that remains after the direct costs of producing a product or service are subtracted from revenue.

Question 5

Accrual accounting method recognizes revenue when earned and expenses when they are incurred. It doesn’t follow the payment of cash.

Answer 5

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Question 6

Revenue is recognized when it is realized and earned.

Answer 6

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Question 7

SEC’s four criteria for revenue recognition:

Answer 7

1. Evidence of arrangement between buyer and seller
2. Product has been delivered
3. Price is determined
4. Seller is reasonably sure of collecting money

Question 8

Unearned revenue

Answer 8

• when a firm receives cash before revenue recognition

- Unearned Revenue = liability, Assets ^ and Liabilities^

Question 9

Long-term contracts

Answer 9

• percentage of completion is measured by the total cost incurred to date divided by the total expected cost of the project.
• Under GAAP, contract completed method is used when the outcome of a project cannot be reliably estimated.
• Revenue, expense and profit are recognized only when contract is complete.
• Loss must be immediately recognized under both.

Question 10

Installment Sales

Answer 10

• An installment sale occurs when a firm finances a sale and payments are expected to be received over a period of time
• If collectability is certain, revenue is recognized at time of sale. If collectability is not certain, installment method is used.
• In installment method, profit is recognized as cash is collected.
• profit = cash collected * total expected profit as % of sales

Question 11

Cost-recovery method

Answer 11

profit is recognized only when cash collected exceeds costs incurred.

Question 12

Barter Transactions

Answer 12

• In barter transaction, 2 parties exchange goods/services without cash payment

Question 13

Roundtrip Transaction

Answer 13

involves sale of goods to one party with the simultaneous purchase of almost identical goods for same payment.

Question 14

Gross revenue reporting

Answer 14

the selling firm reports sales revenues and COGS separately

Question 15

Net revenue reporting

Answer 15

= difference in sales and COGS reported

Question 16

Under US GAAP, gross revenue reporting must have a firm that:

Answer 16

1. Primary obligor in contract
2. Bear the inventory and credit risk
3. Be able to choose its supplier
4. Have reasonable latitude to establish the price

Question 17

FIFO v. LIFO

Answer 17

• LIFO is utilized often due to its tax benefits.

- LIFO is prohibited by IFRS

Question 18

Weighted average cost

Answer 18

• Makes no assumption about physical flow of inventory.

- COGS / units available

Question 19

The depletion of an assets life, by category, is known as…

Answer 19

1. depreciation – for tangible
2. depletion – for natural resources
3. amortization – for intangible

Question 20

Straight-line depreciation

Answer 20

• equal amount of depreciation per period.

= (cost - residual value) / useful life

Question 21

Accelerated depreciation

Answer 21

lower depreciation in early age of asset, and generally increases as the asset ages.

Question 22

Declining balance method

Answer 22

• applies a constant rate of depreciation to an assets book value
  = (2/useful life)( cost- accumulated depreciation)

Question 23

Amortization

Answer 23

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

• firms use straight-line depreciation on intangibles
• goodwill not amortized

Question 24

Discontinued operations

Answer 24

• nonrecurring item
• management decided the dispose of, but either not yet done so, or has disposed of in current year after the operation has generated income/losses.
• recorded separately on income statement net of tax

Question 25

Examples of unusual/infrequent items

Answer 25

• gains/losses from sale of asset
• write offs for restructuring debts
• • REPORTED BEFORE TAX

Question 26

Extraordinary items

Answer 26

Under GAAP, it is a material transaction or event that is unusual and infrequent.

Examples:

• gains/losses from early retirement of debt
• Uninsured losses from natural disasters

Reported separately on IS, net of tax
IFRS does not allow it to be separated from operating results

Question 27

Non-operating transactions

Answer 27

Income from investments or expense from financing

Question 28

Earnings per Share

Answer 28

EPS is a common measure of firm profitability

= (net income - preferred dividends) / (weighted average of common shares outstanding)

Question 29

Dilutive Security

Answer 29

examples = options, warrants and convertible security

Question 30

Indilutive Security

Answer 30

examples = common stock, nonconvertible debt

Question 31

Simple capital structure contains no potentially dilutive securities.

Answer 31

Complex capital structures contains potentially dilutive securities.
- firms must report basic and diluted EPS if complex

Question 32

Dilutive securities would decrease EPS if exercised or converted to common stock.

Answer 32

Indilutive securities would increase EPS if exercised.

Question 33

For convertible preferred stock being dilutive, converted preferred dividends must be added to earnings available to common stockholders

Answer 33

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Question 34

If convertible bonds are dilutive, then the bonds after-tax interest expense is not considered an interest expense for diluted EPS. Interest expense multiplied by (1-tax rate) must be added back to the numerator

Answer 34

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Question 35

Treasury Stock Method

Answer 35

Assumes that the funds received by the company from the exercise of the options would be hypothetically purchase share of the company’s common stock at average market price.
- a net increase in the number of shares created by exercising the options less number of shares hypothetically repurchased with proceeds of exercise.

Question 36

Diluted EPS

Answer 36

= (adjusted income available for common shares) / (weighted average common and potential common shares)

= [(net income - preferred dividends) + (convertible preferred dividends) + (convertible debt interest)*(1-tax rate)] / [(weighted average shares) + (shares from conversion of convertible preferred shares) + (shares from conversion of convertible debt) + (shares issued from stock options)]

Question 37

Common size income statement expresses each category of the income statement as a percentage of revenue

Answer 37

• it eliminates the effects of size, allowing for a comparison across time (time-series) and across firms (cross-sectional)

Question 38

Tax expense is more meaningful when expressed as a percentage of pretax income

Answer 38

= effective tax rate.

Question 39

Gross profit margin

Answer 39

= gross profit / revenue = revenue - COGS

Question 40

Net profit margin

Answer 40

net income / revenue

Question 41

Net income = Retained Earnings in stockholders’ equity

Answer 41

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Question 42

Comprehensive Income

Answer 42

Sum of net income and all other income, including:

1. Foreign currency translation
2. Adjustment for minimum pension liability
3. Unrealized gains/losses from cash flow hedging derivatives
4. Unrealized gains/losses from available for-sale securities