3.3 Understanding Income Statement

Question 1

A company’s income statement

Answer 1

shows its financial performance over a period of time

Question 2

Operating profit

Answer 2

reflects a company’s pre-tax earnings from its day-to-day activities

Typically, earnings before interest and taxes (EBIT) is used to measure operating profit

Question 3

when is revenue recognized?

Answer 3

when it is earned

Question 4

the matching principle

Answer 4

companies recognize certain expenses when the associated revenues are recognized

cost of goods sold (COGS) expenses should be recognized at the same time as the revenues for the associated goods or services.

Question 5

Period costs

Answer 5

do not directly match revenues, so they are reflected in the period when the company makes the expenditure. Administrative costs are an example of period costs.

Question 6

Issues in Expense Recognition

Answer 6

Doubtful Accounts

Warranties

Depreciation and Amortization

Question 7

Long-lived assets

Answer 7

expected to provide benefits over periods of time greater than one year.

Examples include land, plant, equipment, and intangible assets (i.e., assets with no physical substance)

Question 8

The cost of a long-lived asset is allocated incrementally over its useful life. This process is called?

Answer 8

depreciation for physical assets and amortization for intangible assets with finite lives.

Question 9

straight-line method depreciation

Answer 9

allocates an asset’s cost (net of residual value) evenly over its estimated useful life

Question 10

Accelerated methods of depreciation

Answer 10

allocate a greater proportion of costs in the early years of an asset’s useful life

diminishing balance method

a double-declining balance depreciation

Compared to straight-line depreciation, accelerated methods are more conservative because they defer profit recognition.

Question 11

diminishing balance method

Answer 11

uses a multiple of the straight-line percentage

Question 12

a double-declining balance depreciation

Answer 12

a double-declining balance depreciation

Question 13

Discontinued operations

Answer 13

represent components of the operation that will have no effect on the future

t must be separable both physically and operationally. The earnings from these operations should be eliminated from forecasts.

Question 14

Basic EPS

Answer 14

the income available to common shareholders divided by the weighted average number of common shares outstanding.

Question 15

Diluted EPS

Answer 15

can never be more than the basic EPS.

Instruments such as convertible preferred, convertible debt, and employee stock options can all dilute the EPS.

represents the earnings per share if all these instruments were converted.

Question 16

The if-converted method

Answer 16

should be used to calculate diluted EPS.

It assumes the convertible preferred shares convert at the beginning of the period.

This will increase the weighted average number of common shares outstanding and eliminate the preferred dividends.

Question 17

Convertible Debt

Answer 17

The if-converted method is also used to calculate diluted EPS if there is convertible debt.
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The weighted average number of common shares outstanding will increase and the interest paid on the convertible debt will be eliminated.

Question 18

treasury stock method.

Answer 18

Diluted EPS is calculated by assuming the instruments are exercised and the company uses the proceeds to purchase outstanding common stock at the average market price during the period

There is no effect on the numerator. The denominator is increased by the shares issued at exercise and decreased by the shares that could have been repurchased with the cash received at exercise. The instruments are assumed to be exercised at the earliest possible date during the period (e.g., beginning of the period if the instrument was issued prior to the period).

Question 19

Net profit margin

Answer 19

the amount of income a company can earn for each dollar of revenue

Question 20

gross profit margin

Answer 20

measures the amount of gross profit per dollar of revenue.

Gross profit is the net revenues less cost of sales.

Question 21

Comprehensive income

Answer 21

represents all changes in equity for an enterprise during a period, excluding transactions with owners in their capacity as owners

It includes both net income and other comprehensive income

Question 22

The following items are treated as other comprehensive income under both IFRS and U.S. GAAP:

Answer 22

Foreign currency translation adjustments.

Unrealized gains or losses on derivative contracts used for hedging.

Unrealized gains and losses on some investment securities (e.g., available-for-sale debt securities).

Certain costs related to defined-benefit pension plans.

Question 23

Which of the following items would least likely impact a company’s total comprehensive income?

A
Dividend payments

B
Interest payments on debt

C
Unrealized gains on derivatives

Answer 23

A
Dividend payments

Dividend payments aren’t considered in total comprehensive income, as they result from transactions with owners in their capacity as owners.

Interest payments reduce net income, which is one of the two components of total comprehensive income. Unrealized gains on derivatives are included in other comprehensive income, which is the other component of total comprehensive income.

Question 24

Which of the following would most likely impact a company’s other comprehensive income?

A
Stock dividend payments

B
Unrealized gains on trading securities

C
Unrealized gains on available-for-sale securities

Answer 24

C
Unrealized gains on available-for-sale securities

Unrealized gains on available-for-sale securities are recorded as other comprehensive income. By contrast, unrealized gains on trading securities are recognized on a company’s income statement.