Part 3. Understanding Income Statements

Question 1

P&L/ Income Statement

Answer 1

revenues - expenses = net income

• Investors examine firms income statement for valuation purposes
• Lenders examine the income statement for information about the firm’s ability to make a promised interest and principle payments on its debt.

Question 2

Revenues

Answer 2

The amounts reported from the sale of goods and services in the normal course of business.

Question 3

Net revenues

Answer 3

Revenue less adjustments for estimated returns and allowances.

Question 4

Expenses

Answer 4

The amounts incurred to generate revenue and include cost of goods sold, operating expenses, interest and taxes.

Question 5

Grouping expense/Cost of sales method

Answer 5

Presenting all depreciation expense from manufacturing and administration together in one line of income of the income statement.

i.e. combining all costs associated with manufacturing (e.g. raw materials, depreciation, labor etc) as cost of goods sold.

Question 6

Gains and Losses

Answer 6

The income statement result in an increase (gains) or decrease (losses) of economic benefits.

e.g. a firm might sell surplus equipment used in its manufacturing operation that is no longer needed.

Question 7

Net income (extended formula)

Answer 7

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

Question 8

Non controlling interest

Answer 8

The share (proportion) of the subsidiary’s income not owned by the parent is reported in parents income statement.

This is subtracted from the consolidated total income to get the net income of the parent company.

Question 9

Gross profit

Answer 9

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

Question 10

Operating profit

Answer 10

Subtracting operating expenses, such as selling, general and administrative expenses from gross profit.

For non-financial firms, operating profit is profit before financing costs, income taxes, and non-operating items.

Question 11

Net income

Answer 11

Subtracting interest expense and income taxes from operating profit.

Question 12

Recognition of revenue

Answer 12

The central principle is that a firm should recognize revenue when it has transferred a g/s to a customer, consistent with the familiar accrual accounting principle that revenue should be recognized when earned.

Question 13

The converged standards identify 5 step process for recognising revenue:

Answer 13

1. identify the contract with a customer.
2. Identify the separate or distinct performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognise revenue when entity satisfies a performance obligation.

Question 14

Contract

Answer 14

An agreement between 2 or more parties that specify their obligations and rights.

Question 15

Performance obligation

Answer 15

A promise to deliver a distinct good or service, meeting the following criteria:

1. The customer can benefit from the g/s on its own or combined with other resources that are readily available.
2. The promise to transfer the g/s can be identified separately from any other promises.

Question 16

Transaction price

Answer 16

The amount a firm expects to receive from a customer in exchange for transferring a g/s to the customer.

i.e. a bonus for early delivery

Question 17

Examples of revenue recognition under various scenarios:

Answer 17

1. Performance obligation and progress towards completion
2. Variable consideration - performance bonus
3. Contract revisions
4. Acting as an agent

Question 18

Required disclosures under the converged standards, include:

Answer 18

• Contracts with customers by category
• Assets and liabilities related to contracts, including balances and changes.
• Outstanding performance obligations and transactions prices allotted to them.
• Management judgements used to determine the amount and timing of revenue recognition, including any changes to those judgements.

Question 19

IASB definition of expenses

Answer 19

These are decreases in economic benefits during accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity other than those relating to distributions to equity participants.

Question 20

Expense recognition

Answer 20

This is based on matching principle whereby expenses to generate revenue are recognised in the same period as the revenue.

e.g. inventory purchased during Q4 of one year and sold during Q1 of following year, using matching principle both revenue and expense are recognised in Q1, when inventory is sold not the period in which inventory was purchased.

Question 21

Period costs

Answer 21

Not all expenses can be directly tied to revenue generation, such as admin costs, are expensed in period incurred.

Question 22

Inventory expense recognition methods:

Answer 22

1. Specific identification method - a firm can identify exactly which item were sold and remain in inventory, such as an auto dealer records each vehicle sold or in inventory by its identification number.
2. First in First out method (FIFO) - the cost of inventory acquired first is used to calculate the cost of goods sold for the period, with cost of recent purchases used to calculate ending inventory. E.g. a food products company will sell oldest inventory first to keep inventory on hand fresh.
3. Last in First Out method (LIFO) - the cost of inventory most recently purchased is assigned to the cost of goods sold for the period, where costs of beginning inventory and earlier purchases are assigned to ending inventory. E.g. a coal distributor will sell coal off the top of the pile.
4. Weighted average cost method - The cost per unit calculated by dividing cost of available goods by total units available, and this average cost is used to determine both cost of goods sold and ending inventory.
   - AC results in cost of good sold and ending inventory values between those of LIFO and FIFO.

Question 23

Depreciation expense recognition

Answer 23

Long lived assets are expected to provide economic benefits beyond one accounting period, where its costs must be matched with revenues.

The allocations of cost over an assets life is known as depreciation (tangible assets), depletion (natural resources), or amortization (intangible assets).

Methods include:

• Straight-line depreciation
• Accelerated depreciation
• Decling balanced method

Question 24

Straight-line depreciation

Answer 24

For financial reporting purposes, which recognises an equal amount of depreciation expense each period, but most assets generate more benefit in early years of economic life and fewer in later years.

This will result in lower depreciation expense as compared to accelerated method, and results in higher net income in earlier assets life, but in later the effect is reversed compared to accelerated methods.

Question 25

Accelerated depreciation

Answer 25

This speeds up the recognition of depreciation expense in a systematic way to recognise more depreciation expense in the early years of assets life, and less depreciation expense in later years of its life.

Total depreciation expense over life of asset will be the same as if SL depreciation were used.

Question 26

Declining balanced method (DB)

Answer 26

This applies a constant rate of depreciation to an assets (declining) book value each year.

The most common being double declining balance (DDB), which applies 2x the SL rate to the declining balance.

i.e. if an assets life is 10 years, the SL rate is 1/10 or 10%, and DDB rate would be 2/10 or 20%.

DB means depreciation ends once the estimated residual value has been reached, if asset expected to have no residual value, the DB method will never fully depreciate, thus DB method is typically changed to SL at some point in assets life.

Question 27

Amortisation

Answer 27

The allocation of the cost of an intangible asset (such as franchise agreement) over the useful life, where its expense should match the proportion of the assets economic benefits used during the period.

• SL method is used to calculate annual amortization expense for financial reporting.
• Intangible assets with indefinite lives (e.g. goodwill) are not amortized, but must be tested for impairment at least annually.
• if asset value is impaired, an expense equal to impairment amount is recognised on income statement.

Question 28

Bad expense/Warranty expense recognition

Answer 28

If the firm sells g/s on credit or provides a warranty to the customer, the matching principle requires firm to estimate this expense.

From this the firm is recognising the expense in the period of the sale rather than later period.

Question 29

Implications for financial analysis

Answer 29

• Expense recognition requires a number of estimates, so possible for firms to delay/accelerate the recognition of expenses, if delayed this increases current net income, hence more aggressive.
• Must consider reasons for change in expense estimate, if bad debt expense of a firm has decreased, did the firm lower expense as collection experience improved, or expense decreased to manipulate net income.
• Also should compare firms estimates of other firms within industry, as if warranty expense is significantly less than peer firm, the lower warranty expense result in higher quality products or firms recognition more aggressive than of peer firm.
• If firm disclose accounting policies, and significant estimates in financial statement footnote, and in management discussion, and analysis (MD&A) section of annual report.

Question 30

Discontinued operation

Answer 30

The one that management has decided to dispose of, but not done so yet or has disposed of in current year after operation generated income or losses.

Measurement date - a formal plan for disposing an operation.
Phaseout period - The time between the measurement period and actual disposal date.

On measurement date, a company will accrue any estimated loss during phaseout period, and any estimated loss on sale of business, and gain on disposal cannot be reported until after sale is completed.

Question 31

Implications of discontinued operation:

Answer 31

• Do not affect net income from continuing operations.
• Analysts may exclude discontinued operations when forecasting future earnings, where actual event of discounting a business segment or selling assets may provide info about future cash flows of the firm.

Question 32

Unusual/infrequent items

Answer 32

These eevnts are either unusual in nature or infrequent in occurrence, for example:

• gains or losses from sale of assets or part of a business, if these activities are not a firms ordinary operations.
• impairments, write-offs, write-downs, and restructuring costs.
• these items are included in income from continuing operations and are reported before tax.

Question 33

Implications of unusual/infrequent items

Answer 33

• These affect net income from continuing operations, where an analyst may want to review them to determine whether they truly should be included when forecasting future firm earnings.
• some companies appear to be accident prone, and have ‘unusual/infrequent’ losses every year or every few years.

Question 34

Retro perspective application

Answer 34

Any prior-period financial statements presented in firms current financial statements must be restated, applying the new policy to those statements, as well as future statements.

This application enhances the comparability of financial statements overtime.

Question 35

Prospective application

Answer 35

Prior statements are not restated, and the new policies are applied only to future financial statements.

Question 36

Change in accounting policy

Answer 36

A firm may sometimes change which accounting policy it applies e.g. by changing its inventory costing method, or capitalising than expensing specific purchases, unless impractical, changes require retrospective application.

Question 37

Modified retrospective application

Answer 37

This application does not required restatement of prior-period statements, but beginning values of affected accounts are adjusted for cumulative effects of the change.

Question 38

Change in accounting estimate

Answer 38

This is the result of a change in management’s judgement, usually due to new information.

e.g. management may change estimated useful life of an asset as new information indicates asset has longer or shorter life than originally expected.

These are applied prospectively and do not require restatement of prior financial statements.

Question 39

Implications of change in accounting estimate

Answer 39

These typically not affect cash flow, but analyst should review changes to determine their impact on future operating results.

Question 40

Prior-period adjustment

Answer 40

A correction of an accounting error made in previous financial statements, and requires retrospective application, where results are restated, and disclosure of nature of any significant PP adjustment and its effect on net income is also required.

Question 41

Implications of prior-period adjustments

Answer 41

Usually involves errors or new accountign standards not typically affecting cash flow.

People should review adjustments carefully as errors may indicate weakness in firms internal controls.

Question 42

Non-operating transactions

Answer 42

These result from investment income and financing expenses, such as nonfinancial firmmay receive dividend and interest (based on firms capital structure) from investments in other firms.

For a financial firm, investment income and financing expenses usually considered operating activities.

Question 43

Earnings per share (EPS)

Answer 43

Most commonly used corporate profitability performance measure for publicly traded firms, only reported for shares of common stock.

Question 44

Simple capital structure

Answer 44

Contains no potentially dilutive securities, only common stock, nonconvertible debt, and nonconvertible preferred stock.

Must report basic EPS.

Question 45

Complex capital structure

Answer 45

Contains potentially dilutive securities such as options, warrants or convertible securities.

Must report basic and diluted EPS.

Question 46

Weighted average number of common shares

Answer 46

The number of shares outstanding during the year, weighted by the portion of the year they were outstanding.

Question 47

Stock dividend

Answer 47

The distribution of additonal shares to each shareholder in an amount proportional to their current number of shares.

e.g. if 10% stock dividend is paid, the holder of 100 shares of stock would receive 10 additional shares.

Question 48

Stock split

Answer 48

Refers to the division of each old share into a specific number of ‘new’ (post split) shares.

e.g. the holder of 100 shares will have 200 shares after a 2 for 1 split or 150 shares after 3 for 2 split, so 3 new shares for every 2 old.

Each of shareholders proportional ownership in the company is unchanged by either of these events, each shareholder has more shares but same percentage of total shares outstanding.

Question 49

Things to know about weighted average shares outstanding calculation:

Answer 49

• The weighting system is days outstanding divided by number of days in a year, but mainly monthly approx. method will be used.
• Shares issued enter into computation from date of issuance.
• Reacquired sares are excluded from computation from date of reacquisition.
• Shares sold or issued in purchase of assets included from date of issuance.
• Stock split/dividend applied to all shares outstanding prior to split or dividend and beginning of period weighted average shares, adjustment not applied to any shares issued or repurchased after the split or dividend date.

Question 50

Dilutive securities

Answer 50

These are stock options, warrants, convertible debt or convertible preferred stock that would decrease EPS if exercised or converted in common stock.

e.g. stock options and warrant are dilutive when exercise prices are less than the average market price of stock over the year.

Question 51

Antidilutive securities

Answer 51

These are stock options, warrents, convertible debt, or convertible preferred stock that would increase EPS of exercised or converted to common stock.

Question 52

With diluted EPS, if dilutive securities then numerator must be adjusted:

Answer 52

1. If convertible preferred stock is dilutive (EPS will fall if converted to common stock), the convertible preferred dividends must be added to earnings available to common shareholders.
2. If convertible bonds are dilutive, the bonds after tax interest expense is not considered an interest expense for diluted EPS, hence interest expense *(1 - the tax rate) must be added to numerator.

Question 53

Treasury stock method

Answer 53

To calculate the numer of shares used in denominator:

• Assumers funds received by company fromexercise of options would be used to hypothetically purchase of the companies common stock in market at average market price.
• Net increase in the number of shares outstanding (adjustment to denominator) is the number of shares created by exercising options less the number of shares hypothetically repurchased with proceeds of exercise.

Question 54

Vertical common-size income statement

Answer 54

Each category of teh income statement as a percentage of revenue, with the format standardized the income statement by eliminating the effects of size.

• Allows form time-series analysis and cross-sectional analysis.
• Can be used to examine a firms strategy.

Question 55

Effective tax rate

Answer 55

Tax expense as a percentage of pre-tax income.

Question 56

Retained earnings

Answer 56

At the end of each accounting period, the net income of the firm (less any dividends declared) is added to stockholders equity through an account.

Question 57

Comprehensive income

Answer 57

A more inclusive measure includes all changes in equity except for owner contributions and distributions.

Sum of net income + other comprehensive income (OCI)

Question 58

Under US GAAP and IFRS, OCI includes transactions that are not included in net income, such as:

Answer 58

1. Foreign currency translation gains and losses.
2. Adjustemnst for minimum pension liability

3, Unrealised gains and losses from cash flow hedging derivatives.

4. Unrealised gains and losses from available for sale securities.

Question 59

Unrealised gains or losses (US GAAP)

Answer 59

Gains or losses in the value of securities that a firm owns and has not yet sold.

Question 60

Trading securities (US GAAP)

Answer 60

Debt securities that firm owns but intends to sell.

Question 61

Held to maturity (US GAAP)

Answer 61

Debt securities the firm does not intend to sell prior to maturity.

Securities classified as held to maturity are reported at amortised cost on the balance sheet (not fair value).

Unrealised g/s are not reported on income not comprehensive income statement.

Question 62

Available for sale securities (US GAAP)

Answer 62

Debt securities that are not expected to be held to maturity or sold in the near term, with unrealised g/l reported as other comprehensive income, not on income statement.

Question 63

Unrealised gains or losses (IFRS)

Answer 63

These can be reported on income statement, included in other comprehensive income or not reported (for securities carried at amortised cost than fair value).

Question 64

IFRS categories are:

Answer 64

1. Securities measured at fair value through P&L (corresponds to trading securities under US GAAP).
2. Securities measured at amortised cost (corresponds to held-at-maturity under US GAAP).
3. Securities measured at fair value through other comprehensive income (corresponds to available for sale under US GAAP).

Comparing ratios between US GAAP and IFRS, has potential impact on accounting difference on specific ratios involving net income, such as net profit margin, and price-to-earnings.