R21 Understanding Income Statements Flashcards
(18 cards)
Describe the components of the income statement
The components of an income statement (statem. of operations/ statem. of earnings/ Profit & Loss statem.) are:
•Revenue - amounts reported from the sale of goods and services in the normal course of business
- Expenses - amounts incurred to generate revenue and include the cost of goods sold, operating expenses, interest and taxes
- Gains and Losses - result from the increase (gains) or decrease (losses) of economic benefits. ex: firm might sell surplus equipment used in manufacturing production
- Net income: revenue (revenue + other income + gains) - expenses (ordinary expenses - other expenses - losses)
Net revenue - revenue minus adjustments for estimated returns and allowances.
Under IFRS and US GAAP income statem. and statem. of other comprehensive income can be presented separately or together in a single statem. of comprehensive income.
Describe alternative presentation formats of that statement
There are two ways of presenting an income statement:
- Single step format - All revenues and all expenses are grouped together.
- Multi-step format - It includes subtotals such as gross profit (revenue - the cost of goods sold /COGS) and operating profit/income ( profit before financing costs, income taxes and non-operating items).
Describe general principles of revenue recognition and accounting standards for revenue recognition
According to the accrual method of accounting, revenue is recognized when earned and expenses are recognized when incurred.
How is the Income statement presented if the firm has a controlling interest in a subsidiary:
If the firm has a controlling interest in a subsidiary, the statements of the 2 firms are consolidated; the earnings of both firms are included in the income statem.:
- noncontrolling interest (minority interest/ minority owners’ interest) - share/proportion of the subsidiary’s income not owned by the parent
- net income of the parent company = consolidated total net income - noncontrolling interest
Describe the recognising revenue process, given information that might influence the choice of revenue recognition method.
Firms can use any revenue recognition technique provided there is a rationale behind their choice.
Firms using an aggressive revenue recognition method will most likely inflate the earnings of the current period and later periods. For example, between the percentage completion method and the completed contract method, the percentage completion method is more aggressive.
An analyst should consider the effects different revenue recognition methods can have on the financial statements of a company
The converged standards identify a five-step process for recognizing revenue:
- Identify the contract(s) with a customer.
- Identify the separate or distinct performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the entity satisfies a performance obligation.
What is a contract according to the standards?
The standard defines a contract as an agreement between two or more parties that specifies
their obligations and rights. Collectability must be probable for a contract to exist, but
“probable” is defined differently under IFRS and U.S. GAAP so an identical activity could
still be accounted for differently by IFRS and U.S. GAAP reporting firms
What is a performance obligation?
A performance obligation is a promise to deliver a distinct good or service. A “distinct”
good or service is one that meets the following criteria:
- The customer can benefit from the good or service on its own or combined with other
resources that are readily available. - The promise to transfer the good or service can be identified separately from any other
promises.
What is the transaction price?
A transaction price is the amount a firm expects to receive from a customer in exchange for
transferring a good or service to the customer.
A transaction price is usually a fixed amount
but can also be variable, for example, if it includes a bonus for early delivery.
A firm should recognize revenue only when it is highly probable they will not have to reverse it. For example, a firm may need to recognize a liability for a refund obligation (and an offsetting asset for the right to returned goods) if revenue from a sale cannot be estimated reliably.
For long-term contracts, revenue is recognized based on a firm’s progress toward completing a performance obligation. Progress toward completion can be measured from the input side (e.g., using the percentage of completion costs incurred as of the statement date).
Progress can also be measured from the output side, using engineering milestones or percentage of the total output delivered to date.
How are costs capitalised for long-term contracts?
A final notable change to the standards for accounting for a long-term contract is that the costs to secure the contract and certain other costs must be capitalized; that is, they are put on the balance sheet as an asset.
The effect of capitalizing these expenses is to decrease reported expenses on the income statement, increasing reported profitability during the contract
period.
What are the required disclosures under the converged standards?
There are a significant number of required disclosures under the converged standards. They include:
- Contracts with customers by category.
- Assets and liabilities related to contracts, including balances and changes.
- Outstanding performance obligations and the transaction prices allocated to them.
- Management judgments used to determine the amount and timing of revenue recognition, including any changes to those judgments.
Describe general principles of expense recognition, specific expense recognition applications, and implications of expense recognition choices for financial analysis.
The most important principle of expense recognition is the matching principle, under which the expenses incurred to generate revenue are recognized in the same period as revenue.
Expenses that cannot be tied directly to generation of revenues are called periodic costs. They are expensed in the period incurred.
Inventory methods: Accounting standards permit the use of the following methods to assign inventory expenses:
- FIFO
- LIFO
- Weighted average cost
- Specific identification
What are the issues with expense recognition?
Some issues in expense recognition are:
- Doubtful accounts: Record an estimate of credit losses (using historical data) at the time of revenue recognition.
- Warranties: Expense an estimated amount at the time of revenue recognition.
•Depreciation: It is the process of systematically allocating costs of long-lived assets over the period during which the assets are expected to provide economic benefits.
Depreciation methods include:
•Straight line method.
•Declining balance method.
Using the above-mentioned accounts and information contained in the footnotes or disclosures, an analyst can recognize whether a company’s expense recognition policy is conservative or not.
Describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, unusual, or infrequent items) and changes in accounting standards.
Net income from discontinued operations is shown net of tax after net income from continuing operations. Both IFRS and U.S. GAAP allow recognition of unusual or infrequent (but not both) items.
Changes in accounting policies can be adopted retrospectively (the financial statements for all fiscal years are presented as if the newly adopted accounting principle had been used throughout the period) or prospectively (only the financial statements for the period of change and for future periods are changed).
Distinguish between the operating and non-operating components of the income statement
Non-operating items are typically reported separately from operating income because they are material and/or relevant to the understanding of the company’s financial performance.
Under IFRS, there is no definition of operating activities so judgment is required to distinguish between operating and non-operating income.
Under U.S. GAAP, operating activities generally involve producing and delivering goods and providing services. All other activities are non-operating.
Describe how earnings per share is calculated, and calculate and interpret a company’s earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures?
When a company has a simple capital structure, basic EPS is calculated using the formula:
Basic EPS = (Net Income − Preferred dividends) / Weighted Average Number of Shares Outstanding
When a company has a complex capital structure, diluted EPS is calculated using the formula:
Diluted EPS = (Net Income + After-tax interest Preferred dividend + convertible preferred dividends) / (Weighted Average Number of Shares Outstanding + New shares if the convertible debt is converted)
Distinguish between dilutive and anti-dilutive securities, and describe the implications of each for the earnings per share calculation.
Dilutive securities are stock options, convertible debt, warrants, and convertible preferred stock that decrease EPS when converted to common stock.
Antidilutive securities are stock options, convertible debt, warrants, and convertible preferred stock that increase EPS when converted to common stock
How can you convert income statements to common-size income statements?
Common-size analysis of the income statement can be performed by stating each line item on the income statement as a percentage of revenue.
Common-size statements facilitate comparison across time periods as well as across companies because the standardization of each line item removes the effect of size
How is evaluated a company’s financial performance using common-size income statements and financial ratios based on the income statement?
Net profit margin is calculated as: Net Income / Sales.
This indicates how much income a company was able to generate for each dollar of revenue.
Gross profit margin is calculated as: Gross Profit / Sales.
Where gross profit is calculated as revenue minus cost of goods sold.
Operating profit margin is calculated as Operating Profit/ Sales.
Analysts can use these profit margins to compare over time and with industry peers
