Chapter 32- Understanding The Income Statement
Income Statement / Statement of Operations / Statement of Earnings / Profit and Loss Statement
Revenue – Expense = Net Income
Revenue (Turnover)
· Top Line
· Revenue is for goods and services; Sale is for goods only
· Revenue is from main business; Gain(like Profit) is from secondary business (like asset selling)
· Def -
ü Amount Charged
ü For delivering Goods and Services
ü In ordinary activities of business
Profit / Income
· Bottom Line / Final Line in IS
· Net Earnings
· Increase in economic benefits during the accounting period in the form of
§ Inflow of assets
§ Decrease in liabilities
· Both of above result in increase in equity (Retained earnings here; Equity not contributed by owners)
Gains & losses (Bottom line)– Not directly related to business activities
Grouping of Expense (IAS-1)
· Grouping by NATURE –
§ Depreciation = Dep of M/g equipment + Dep on admin facilities
§ Income Taxes
· Grouping by FUNCTION –
§ COGS = Salary + Material Cost + Depreciation + Direct Sales related expenses
Gross Profit (Gross Margin)
§ Income Statement is using Multi-Step Format if it has gross profit
§ = Revenue – COGS (Direct cost of producing a service / product)
§ Single Step format – All revenues are grouped together & all expenses are grouped together
Operating Profit / Operating income
§ = Gross Profit – SG&A – R&D (Selling, General & administrative expenses)
§ Company’s profit on its usual business activities before deducting taxes
§ Include Interest expense as Operating expense for financial firm only
Net Income / Net Earnings / Bottom Line / Net Profit / Profit
= Operating Profit – Interest Expense (non financial firm) – Income Tax
Minority Interest –
§ If a firm has a controlling interest in a subsidiary, the pro-rata share of the subsidiary’s income for the portion of the subsidiary that the firm does not own is reported in the parent’s income statement as the non-controlling interest /minority interest / minority owner’s interest.
§ This is subtracted since a controlling interest means the subsidiary’s entire net income is included in the firm’s income statement.
§ MI shows the portion of income that belongs to minority shareholders of the subsidiaries, as opposed to the parent company
§ If ‘A’ owns 75% in ‘a’, then in consolidated BS of ‘A’ (showing subsidiaries), show 100% ownership in company ‘a’, but reduce 25% value of company ‘a’ as MI (Reduction done in Equity)
Revenue is recognized in IS when it is (IASB)
§ Realized / Realizable
§ Earned
Additional guidelines by SEC for above
§ There is evidence of an arrangement between buyer & seller
§ The product has been delivered or the service has been rendered
§ The price is determined or determinable
§ The seller is reasonably sure of collecting the money
Specific Revenue Recognition Applications
Revenue may be recognized before, on, or after delivery of goods or services
Long Term Contracts
§ It is the one that spans over a number of accounting periods
§ % of completion method & completed contract method are used for contracts that extend beyond 1 accounting period, often contracts related to construction project
§ Revenue is recognized …… (as per following scenarios)
| Before Goods are delivered | As & when Goods are delivered | After Goods are delivered |
| % Completion Method | Normal criterion | § Installment Method § Cost Recovery Method |
Ratable Recognition –
§ For long term Service contract or licensing arrangement
§ Recognize revenue equally (per annum) over project completion time
§ Ex – Project cost = $1 million; Time = 5 years. Every year, revenue recognized is $0.2 million
% completion method –
§ For Construction Contracts
§ Project costs and revenue can be measured reliably
§ Revenue recognized when service is rendered
§ Revenue reported = % of completed contract
§ It provides smoother earnings; better matching of revenues and expenses over time
Ex – Total Project Revenue = $10 million; Total Project Cost = $6 Million. Total amount spent at end of 1st year = $3 million; Total Amount spent at the end of 2nd year = $5.4 million
| | Year 1 | Year 2 | Year 3 | Total |
| Cost | 3.0 | 2.4 (5.4-3) | 0.6 (6.0-5.4) | 6.0 |
| Revenue | 5.0 | 4.0 | 1.0 | 10.0 |
| Profit | 2.0 | 1.6 | 0.4 | 4.0 |
Completed contract method (Only in US GAAP) –
§ Outcome of the project can’t be measured reliably
§ Project is short term
§ Loss to be recognized immediately if expected
§ Revenue, expense (cost) & profit to be recognized only when contract is complete
| | Year 1 | Year 2 | Year 3 | Total |
| Cost | 0.0 | 0.0 | 6.0 | 6.0 |
| Revenue | 0.0 | 0.0 | 10.0 | 10.0 |
| Profit | 0.0 | 0.0 | 4.0 | 4.0 |
In case of IFRS, if outcome of the project can’t be measured reliably (like above) then,
§ Recognize revenue in proportion to contract cost incurred (if costs are recoverable)
§ Costs are expensed when incurred
§ Profit is recognized only at completion (Similar to US GAAP)
| | Year 1 | Year 2 | Year 3 | Total |
| Cost | 3.0 | 2.4 (5.4-3) | 0.6 (6.0-5.4) | 6.0 |
| Revenue | 5.0 | 4.0 | 1.0 | 10.0 |
| Profit | 0.0 | 0.0 | 4.0 | 4.0 |
Installment Sales
An installment sale occurs when a firm finances a sale & payments are expected to be received over an extended period. Example – Certain sales of real estate.
· If collectability is certain, revenue is recognized at the time of sale using normal revenue recognition criterion
· If collectability can’t be reasonably estimated, installment method is used
· If collectability is highly uncertain, cost recovery method is used
Installment Method –
· Profit is recognized as & when cash is collected (for sales)
· Profit (recognized) = Cash Collected * (Total Expected Profit / Total Expected Sale)
· Used in limited circumstances, usually involving sale of real estate or other firm asset
Cost recovery Method –
· Profit is recognized only when cash collected > cost incurred
Example – Property sales price = $2 million; Property cost price = $1.1 million. Cash received by seller (of property) as down payment = $0.3 million. Remainder of sales price to be received over a period of 10 years from buyer (Significant doubt of receiving payment from buyer). Find profit using above method.
Answer –
Installment Method
| | Actual | Cash received |
| Sales | 2 | 0.3 |
| Cost of Sales | 1.1 | |
| Profit | 0.9 | 0.135 = 0.3*(0.9/2) |
Cost Recovery Method
· Cash collected = $0.3 million
· Cost incurred = $1.1 million
· Cash Collected < Cost Incurred. Hence, no profit is recognized.
Barter Transactions
· 2 parties exchange goods or services without cash payment
· IFRS – Revenue recognized at fair value of revenue from similar non-barter transactions with unrelated parties
· US GAAP – Revenue recognized at fair value only if the firm has historically received cash for payments for such goods & services (The historical experience is used to determine fair value)
· Round trip transaction –
§ It involved sale of goods to one party with the simultaneous purchase of almost identical goods from the other party
§ Underlying issue – Whether revenue should be recognized
§ In 1990s, several internet companies increased their revenue significantly by buying equal value of advertising space on each other’s website
Gross & Net Revenue Reporting
· Under gross revenue reporting, the selling firm reports sales revenue & COGS separately. Under net revenue reporting, only the difference between sales & cost is reported.
· While profit is same, Sales are higher using gross revenue reporting
· Example – A travel agent arranges a 1st class ticket for a customer flying to Singapore. Price of ticket is $10,000 & agent’s commission is $1000.
§ Using Gross reporting system, travel agent would report Revenue = $10,000, Expense = $9000 & Profit = $1000
§ Using Net Reporting system, the travel agent would simply report Revenue = $1000 & no expense
Following criterion should be met in order to use gross revenue reporting under US GAAP. The firm must:
§ Be the primary obligor under the contract
§ Bear the inventory risk & credit risk
§ Be able to choose its supplier
§ Have reasonable latitude to establish price
Implications of Financial Analysis –
§ Firms disclose their revenue recognition (when is revenue to be recognized – before, at, after delivery) in the financial footnotes.
§ Use of financial information must consider 2 points when analyzing a firm’s revenue –
§ How conservative are firm’s revenue recognition policies (Sooner revenue recognition = Aggressive)
§ Extent to which firm’s policy rely on judgment & estimates
Expense Recognition
Expense –
· Definition -
ü Decrease in economic benefits during the accounting period in the form of
§ Outflow / Depletion of Assets
§ Incurrence of Liabilities
ü Both of above result in decrease in equity (not contributed by equity participants)
· If financial statements were prepared on cash basis, neither revenue nor expense recognition would be an issue. The firm would simply recognize cash received as revenue & cash payment as expense.
· Expense definition encompasses losses
· Expense because of ordinary activities
ü Cost of Sales (COGS)
ü Wages
ü Depreciation
· Loss – It is an expense, NOT from ordinary business activity, but may arise during its course. Example – Loss due to fire, flood etc.
General Principles –
· Matching Principle
ü Matching directly expense with associated revenue in the same accounting period.
§ Ex – Revenue from Inventory is recognized when it is sold & not when it was purchased (when inventory was purchased, it was an asset)
ü Not all expenses can be directly tied to revenue generation. They are known as period cost. Ex – Administrative costs. They are expensed in the period they incur.
· Long Lived Assets
ü They are expected to provide economic benefits beyond 1 accounting period.
ü Example – PPE (Land / Property, Plant, Equipment), Trademark (Intangible Asset)
ü The allocation of cost over asset’s useful life is called depreciation, depletion or amortization
· Warranties (Contingent Liability)
ü If a firm is selling goods on credit or provides warranty to the customer, the matching principle requires the firm to estimate the bad debt expense and / or warranty expense
ü By doing so, the firm is recognizing the expense in the period of the sale, rather than a later period
Implications for financial analysis
· Delayed expense recognition increases net income & is therefore more aggressive
· Firms disclose their accounting policies & significant estimates in the financial statement footnotes & in MD&A section of the annual report (Management discussion & analysis)
· Less warranty claims
§ Less claims received previously
§ Company wants to deliberately improve net income
· Goodwill = Price paid to purchase an entity – Value of net asset acquired (asset – liability)
Depreciation
· Land is not depreciated
· Straight Line Method of depreciation – Equal depreciation expense in each period
· Accelerated depreciation method - Here, assumption is asset generates more economic benefit in initial part of life & fewer in later. Hence, more depreciation in early part of asset’s life than later. It is more appropriate for matching expenses with revenues. Ex – Automobile
ü Conservative – Because of lower net income reported (high dep exp) in the early years of asset.
· SL Depreciation expense = (Cost – Residual Value) / Useful life
· Salvage value / Residual Value = Amount expected to be received upon sale of asset at the end of useful life
· Impairment = When Book Value (Price paid) > Current Market Price of Asset, book value is reduced to current market price & loss is shown as impairment.
· Diminishing / Declining Balance Method – Applies a constant rate of depreciation to an asset’s (declining) book value
ü D(Double)DB = 2 * (Cost –Accumulated Depreciation) / Useful life
ü Here 2 is called Acceleration Factor (=200%)
| Depreciation | Impairment | Amortization |
| Physical Long Lived Asset | Intangible Asset | Intangible Asset |
| | Infinite Life | Finite Life |
| Ex – PPE | Ex – GoodWill (Has Infinite Life) | Ex – Patent with expiry date |
| | Goodwill needs to be tested annually for impairment | Use Straight Line Method of Depreciation to calculate Amortization Expense |
Example – Cost of Asset = $12,000; Salvage Value = $2,000; Useful Life = 5 Years. Calculate depreciation expense using DDB.
Answer –
| | Depreciation Expense | Cumulative Depreciation Expense (at the end of Year) | Whether crossed the total allowed depreciation of 10,000 |
| Year 1 | 2*(12,000-0)/5 = 4,800 | 4800 | No |
| Year 2 | 2*(12,000-4800)/5 = 2,880 | 7680 | No |
| Year 3 | 2*(12,000-7680)/5 = 1,728 | 9408 | No |
| Year 4 | 2*(12,000-9408)/5 = 1,036.80. But it should be 592 so that cumulative dep is 10000 | 10,444.80. Should be 10,000 | Yes, Hence Dep expense will be 1036.80 – 444.80 = 592 |
| Year 5 | 0 | | |
Non Recurring Items (Transitory Items)
· Some items of prior years which are not expected to continue in future periods are separately disclosed on a company’s income statement
ü Discontinued Operations
ü Extraordinary Items (Not in IFRS)
Discontinued Operations
· It is the one where management has
ü Decided to dispose of operations, but not yet done so
ü Has disposed of in the current year after operations has generated income or losses
· To be accounted for discontinued operations, business must be physically & operationally distinct from rest of firm (in terms of asset, operations, investing & financing activities)
· Measurement Date = Date when the company develops a formal plan for disposing of an operation
· Phase-out Period = Actual Disposal Date – Measurement Date
· Income / Loss Reporting
ü Reported separately in IS, net of tax, after income from continuing operations
ü Any past income statement must be restarted, separating Income & Loss from discontinued operations
ü Any expected gain can’t be reported until the Sale is complete
ü Any loss estimated in phase out period will be reported on measurement date
· They do not affect net income from continuing operations
· It provides information about future cash flows of the firm
Unusual or Infrequent Items
· These items are either unusual in nature or infrequent in occurrence, but not both.
· Example –
ü Gains / Losses from the sale of assets / part of business
ü Impairments, write-offs, write-downs & restructuring costs
· Income / Loss Reporting
ü They are reported in Income from continuing operations
ü They are reported before tax
· Analyst must review whether these items should be included when forecasting future firm earnings
Extraordinary Items
· Only reported in US GAAP, not in IFRS / IAS-1
· They are both unusual and infrequent in occurrence
· Income / Loss Reporting
ü Reported separately in IS, net of tax, after income from continuing operations
ü IFRS does not allow separate reporting of extraordinary items from operating results in the income statement
· Examples –
ü Gains / Losses from early retirement of debt (when it is judged to be both unusual or infrequent)
ü Uninsured losses from natural disaster
ü Losses from expropriation of asset
Loss due to fire is infrequent, but not unusual
Changes in Accounting Standard
1) Changes in Accounting Principles
a. Change in inventory accounting from LIFO to FIFO
i. In US GAAP, changing to LIFO does not apply changes retrospectively
b. Requires retrospective application –
i. All prior financial statements are restarted (usually FS 2-3 years old) to reflect the change
ii. Enhances comparability of the financial statements over time
2) Changes in Accounting Estimates
a. Changes in asset’s estimated useful life due to new information available showing asset has a longer or shorter life than originally expected
b. Changes are applied prospectively & do not require the restatement of prior financial statements
c. They do not affect cash flows
3) Prior Period Adjustments
a. Correction of accounting error made in previous financial statements is reported as prior period adjustments
b. Need to restart all prior period statements presented in current FS
c. Disclosure of nature of adjustment & its effect on net income is also required
d. They do not typically affect the cash flow
EPS
Simple Vs Complex Capital Structure
· Simple Capital Structure –
§ They do not contain any potentially dilutive securities. They contain only common stock, non-convertible debt & non-convertible preferred stock
§ Anti-dilutive Securities – They increase EPS when converted to common stock
§ They report only basic EPS
· Complex Capital Structure –
§ They contain potentially dilutive securities such as options, warrants or convertible securities
§ Dilutive Securities – They decrease EPS when converted to common stock
§ All firms with complex capital structure must report both basic & diluted EPS
Basic EPS
· = (Net Income – Preferred Dividends) / (Wt. Avg. No. of common shares outstanding)
ü Net Income – Preferred Dividends = Available to common shareholders
· Stock dividend – 10% stock dividend means shareholder will receive 10 new shares for existing 100 shares
· Stock Split – 3-for-2 split for shareholder having currently 100 shares will receive 150 shares
· In both the above cases, proportional share in company remains same but count of shares increases
Example –
Net Income = $10,000; Cash Dividend to preferred shareholders = $1,000; Cash Dividend to common shareholders = $1,750. 10,000 shares in beginning of year; 2,000 new shares issued on July 1. Assuming simple capital structure, find basic EPS
Answer –
· Wt Avg No. of common shares outstanding = (10,000*12 + 2,000*6) / 12 = 11,000
· EPS = (10,000 – 1,000) / 11,000 = 0.8181
Example –
· Jan 1 – Shares outstanding = 10,000 (10,000*12)
· April 1 – Shares issued = 4,000 (4000*9)
· July 1 – Stock Dividend = 10% (10,000*12 + 4,000*9) * 0.1
· September 1 – Share Repurchase = 3,000 (-3,000*4)
Solution –
Wt. Avg. No. of common shares outstanding = [(10,000*12 + 4,000*9) * 1.1 – 3,000*4] / 12 = 13,300
Stock Dividend works from the day original shares were purchased & not when it was declared
Dilutive EPS
| Basic EPS | Net Income – Preferred Dividend | Wt. Avg. No. of common shares outstanding |
| When the company has outstanding ……. | Numerator | Denominator |
| Convertible Preferred Stock | (+) Net Income Preferred Dividend converted to common stock, hence, not considered | (+) Wt. Avg. No. of common shares outstanding (+) New common shares issued because of conversion |
| Convertible Debt | (+) Net Income (+) After Tax Interest on convertible debt = Int on Debt * (1-Tax Rate) Interest not paid, hence saved on debt because debt is converted to equity (-)Preferred Dividend It is paid as only debt is converted & not equity | (+) Wt. Avg. No. of common shares outstanding (+) New common shares issued because of conversion |
| Stock Option, Warrants or equivalent (Treasury Stock Method) | (+) Net Income (-)Preferred Dividend | (+) Wt. Avg. No. of common shares outstanding (+)New shares issued because of option exercise (-)Shares repurchased from cash received by exercising option |
Example – Net Income = 2,300,000; Common Shares = 800,000; Options = 30,000 with exercise price of 35 per option. Average price of share during the year = 55. Calculate Denominator for Treasury Stock option.
Answer
· Part 1 –
ü Shares issued because of option = 30,000
ü Shares bought back because of cash received from option = Cash Received / Average price of share = - (30,000 * 35) / 55 = - 19,091
ü Net shares = 30,000 – 19,091 = 10,909
· Part 2 –
ü Weighted Average Number of Shares = 800,000
· Denominator = 800,000 + 10,909 = 810,909
· Net Income (Given) = 2,300,000
· EPS = 2,300,000 / 81,909 = 2.84 ($)
Example – EPS with convertible bond
ü In 2006, Net Income = 115,600 Common stock for the year = 200,000.
ü Company has 1,000 shares of 10% par, preferred stock outstanding during 2006.
§ Will be used to calculate only preferred dividend
ü During 2005, company issued 600, $1,000 par, 7% bonds for 600,000 (issued at par); Each of these bond is convertible to 100 shares of common stock
ü Tax Rate = 40%
ü Calculate Basic or Diluted EPS for 2006
Answer –
Basic EPS
ü = (Net Income – Preferred Dividends) / (Wt. Avg. No. of common shares outstanding)
ü = (115,600 – 10,000) / 200,000 = $0.53
§ Where Preferred Dividend = 1,000*10%*$100 = $10,000
Diluted EPS – When convertible debt is converted to common stock
ü Shares Issued (Because of Debt conversion) = 600 * 100 = 60,000 (600 bonds with each bond equivalent to 100 shares)
ü Increase in Income (Because of tax not paid on debt) = Int*(1-Tax Rate) = (600*1,000*7%)*(1-40%) = $25,200
ü Diluted EPS = (115,600 – 10,000 + 25,200) / (200,000 + 60,000) = $0.50
Check – Diluted EPS < Basic EPS. If not, then convertible bonds are anti-dilutive in nature & should not be treated as common stock in computing diluted EPS. In that case, Diluted EPS = Basic EPS.
Example – EPS with convertible bonds, Convertible preferred stock & options
§ Net Income = $115,600, Common Stock = 200,000
§ Company had 1,000 shares of 10%, $100 par convertible preferred stock; convertible into 40 shares, outstanding for the entire year
§ Company also had 600, 7%, $1,000 par value convertible bonds; convertible into 100 shares, outstanding for the entire year
§ Company had 10,000 stock options outstanding during the year; each option = 1 share @ $15. Average market price of stock = $20
§ Tax Rate = 40%
Calculate Basic & Diluted EPS?
Answer –
Basic EPS
ü = (Net Income – Preferred Dividends) / (Wt. Avg. No. of common shares outstanding)
ü = (115,600 – 10,000) / 200,000 = $0.53
§ Where Preferred Dividend = 1,000*10%*$100 = $10,000
Diluted EPS Calculation (From Basic EPS)
Numerator
§ Basic EPS = 115,600-10,000
§ Add convertible preferred dividend = $10,000
§ Add tax advantage from convertible bond = (600*1000*7%) * (1-40%) = $25,200
§ Total Numerator = 140,800
Denominator
§ Basic EPS = 200,000
§ Add new shares from convertible preferred stock = 1000*40 = 40,000
§ Add new shares from convertible bonds = 600 * 100 = 60,000
§ Add new shares from stock option = 10,000 – (10,000 * 15/20) = 2,500
§ Total Denominator = 307,500
Diluted EPS = 140,800 / 302,500 = $0.4655 = $0.47
Check - Basic EPS ($0.53) > Diluted EPS ($0.47). Hence, dilution is OK.
Comprehensive Income
· It measures all the changes to equity other than owner’s contribution / distribution
· They do not affect IS, but do affect equity
· It includes -
ü Foreign currency translation gains & losses
ü Adjustments for minimum pension liability
ü Unrealized gains & losses from cash flow hedging derivatives
ü Unrealized gains & losses from available-for-sale securities
§ Not to be help till maturity, will be sold in near future
§ They are reported at fair value
* * Trading securities are shown in IS as unrealized gain or loss
Example –
ü Beginning Shareholder’s Equity = 200
ü Net Income = 20
ü Cash dividend distributed = 3
ü No stock repurchase
ü Ending Shareholder’s Equity = 227
Calculate other Comprehensive Income
Answer –
· Increase in Shareholder’s equity = 27
· Profit hitting Retained Earnings = 20-3 = 17
· Since, equity increased by 27, but retained earnings increased only by 17 implies 27-17 is comprehensive income amount increasing the shareholder’s equity by further 10.
· Other Comprehensive Income = 10
Common size analysis of IS
· Each line item as a % of Revenue
· It helps in comparison across
ü Time Periods (Time Series Analysis)
ü Companies of different sizes (Cross Sectional Analysis)
· Taxes should be compared with pre-tax income & not revenue
Income Statement Ratio
· Net Profit Margin = Net Income / Revenue
ü (Net Income = Revenue – COGS – SGA – R&D – Interest Expense – Tax)
· Gross Profit Margin = Gross Income / Revenue
ü (Gross Income = Revenue – COGS)
ü Example – Apple
§ High Gross Profit as SP >>>> COGS
§ Medium Net Profit because of high R&D and Marketing Cost
Exercise –
· For a non-financial firm, depreciation is ops exp & interest is non ops exp
· Decreasing the residual (salvage) value = Higher Depreciation expense = Lower Pre-Tax Income
Question – Calculate year-end inventory using LIFO & FIFO
| PURCHASE | SALE |
| 40 @ $30 | 13 @ $35 |
| 20 @ $40 | 35 @ $45 |
| 90 @ $50 | 60 @ $60 |
Answer – If there in inventory left at year end, it implies PURCHASE > SALE
FIFO = 13+35+60-40-20 = 48. Hence, for last purchase, units left are 90-48=42. Price of 42 units = 42*50=$2100
LIFO = 13+35+60-90=18. Hence, for 2nd purchase, 20-18=2 units are left & all 40 units from 1st purchase are left. Total Cost = 2*40+40*30 = $1280
Exercise –
· 50,000 common shares outstanding at beginning of the year
· Warrants outstanding all year on 50,000 shares, exercisable at $20 per share
· Average price of stock for the year= $15
Calculate number of shares for diluted EPS
Answer –
Warrants are anti-dilutive. Avg. price ($15) < Exercise Price ($20)
Number of shares = Count of common stock = 50,000
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