Reading 24 - Understanding Income Statements Flashcards
Under IFRS, the income statement may be presented as:
- A section of a single statement of comprehensive income; or
- A separate statement (showing all revenues and expenses) followed by a statement of comprehensive income (described later) that begins with net income. Under U.S. GAAP, the income statement may be presented as:
A section of a single statement of comprehensive income.
- A separate statement followed by a statement of comprehensive income that begins with net income.
- A separate statement with the components of other comprehensive income presented in the statement of changes in shareholders’ equity.
Define the REVENUE section of an income statement.
Revenue: Usually reported on the first line of the income statement, revenues are amounts charged (and expected to be received) for goods and services in the ordinary activities of a business. Net revenue is total revenue adjusted for product returns and amounts that are unlikely to be collected. Other commonly used terms for revenue include sales and turnover.
Define the REVENUE section of an income statement.
Revenue: Usually reported on the first line of the income statement, revenues are amounts charged (and expected to be received) for goods and services in the ordinary activities of a business. Net revenue is total revenue adjusted for product returns and amounts that are unlikely to be collected. Other commonly used terms for revenue include sales and turnover.
Define the EXPENSES section of an income statement.
Expenses reflect outflows, depletions of assets, and incurrences of liabilities in the course of the activities of a business.
Define the GROSS PROFIT or GROSS MARGIN section of an income statement.
Gross profit or gross margin is the difference between revenues and cost of goods that were sold. When an income statement explicitly calculates gross profit, it uses a multi-step format as opposed to a single-step format. Van Dort uses a single step format, while Johnson uses a multi-step format.
Define the OPERATING INCOME section of an income statement.
Operating income is calculated after subtracting all direct and indirect (period) costs from revenues. It represents the profit earned by a company from its ordinary business activities before accounting for taxes and, in the case of nonfinancial companies, before deducting interest expense. Operating profits are useful in evaluating the profitability of individual businesses as they are not affected by financing decisions of the firm. Exhibits 1-1 and 1-2 contain income statements of nonfinancial companies. For financial firms, interest income and expense are part of ordinary business activities, so they are included in operating profits.
Define the NET INCOME section of an income statement. Also, give the Net Income equation
Net income is the “bottom‐line” of the income statement. It includes profits earned from ordinary business activities as well as gains and losses (increases and decreases in economic benefits) from nonoperating activities.
Net income = Revenue − Expenses in the ordinary activities of the business + Other income − Other expenses + Gains − Losses
Define the NONCONTROLLING INTEREST section of an income statement.
If a company owns the majority of the shares of a subsidiary, it must present consolidated financial statements. Consolidation requires the parent to combine all the revenues and expenses of the subsidiary with its own and present the combined results on its income statement. If the subsidiary is not wholly owned, the share of noncontrolling interests in net income is deducted from total income, as it represents the proportionate share in the subsidiary’s net income that belongs to minority shareholders.
Define the requirement for subtotals on the income statement.
Some subtotals are required by IFRS (especially nonrecurring items), while others are not explicitly required. Examples of items that are required to be separately stated on the face of the income statement are revenues, finance costs, and taxes.
Under IFRS, revenue from rendering of services is recognized when:
1) The amount of revenue can be measured reliably;
2) It is probable that the economic benefits associated with the transaction will flow to
the entity;
3) The stage of completion of the transaction at the balance sheet date can be
measured reliably; and
4) The costs incurred for the transaction and the costs to complete the transaction can
be measured reliably.
Define how the IFRS permits the grouping of expenses.
IFRS permits the grouping of expenses by nature or by function. An example of grouping by nature would be combining depreciation of factory equipment with depreciation of transport vehicles and stating a single aggregate amount for depreciation on the income statement. An example of grouping by function would be combining direct product costs (raw material costs and freight charges) under costs of goods sold.
What are the income statement presentation formats most commonly used?
Income statement presentation formats: Van Dort’s and Johnson’s income statements also highlight the following differences that we might run into when analyzing financial statements of various companies.
Describe the differences in Van Dort’s and Johnson’s income statement presentation formats.
Income statement presentation formats: Van Dort’s and Johnson’s income statements also highlight the following differences that we might run into when analyzing financial statements of various companies:
- Van Dort presents the latest year in the extreme right column, while Johnson presents the most recent year on the extreme left.
- Van Dort presents expense items (e.g., costs of goods sold and interest expense) in parenthesis to show that they are being deducted. In contrast, Johnson does not present its expenses in parenthesis or with negative signs. It assumes that users know that expense items are subtracted from revenues.
- Van Dort deducts cost of goods sold from sales, while Johnson deducts cost of sales. Such differences in terminology are common across sets of financial statements.
How does the IASB framework define income?
The IASB framework defines income as “increases in economic benefits during the accounting period in the form of inflows or enhancements of assets, or decreases in liabilities that result in increases in equity, other than those relating to contributions from equity participants.”1 Income includes revenues and gains. Revenues arise from ordinary, core business activities, whereas gains arise from noncore or peripheral activities. For example, for a software development company the sale of software to customers is considered revenue, but the profit on the sale of some old office furniture is classified as a gain.
What is the most important principle of revenue recognition and what does it require?
The most important principle of revenue recognition is accrual accounting, which requires that revenues and costs are recognized independently of the timing of related cash flows. For example, under accrual accounting, rent expense is recognized in the month that a company uses the premises for its operations, not when the actual cash payment for rent is made. Accrual accounting allows firms to manipulate net income by recognizing revenue earlier or later, or by accelerating or deferring recognition of expenses.
Under IFRS, revenue is recognized for a sale of goods when:
1) Significant risks and rewards of ownership are transferred to the buyer.
2) The entity retains no managerial involvement or effective control over the goods
sold.
3) The amount of revenue can be measured reliably.
4) It is probable that the economic benefits from the transaction will flow to the entity.
5) Costs incurred or to be incurred for the transaction can be measured reliably.
IFRS specify similar criteria for recognizing revenue for the rendering of service. Revenue can be estimated reliably when all the following:
1) The amount of revenue can be measured reliably.
2) It is probable that the economic benefits associated with the transaction will flow to
the entity.
3) The stage of completion of the transaction at the balance sheet date can be
measured reliably.
4) The costs incurred for the transaction and the costs to complete the transaction can
be measured reliably.
IFRS specifies the criteria for recognizing interest, royalties, and dividends. Explain.
IFRS also specifies the criteria for recognizing interest, royalties, and dividends. These may be recognized when it is probable that the economic benefits associated with the transaction will flow to the entity and that the amount of the revenue can be measured reliably.
Under U.S. GAAP, revenue is recognized on the income statement when it is “realized or realizable and earned.”4The SEC provides specific guidelines to determine when these two conditions are met:
1) There is evidence of an arrangement between the buyer and seller.
2) The product has been delivered or the service has been rendered.
3) The price is determined or determinable.
4) The seller is reasonably sure of collecting money.
Describe revenue recognition in special cases.
The principles of revenue recognition listed above cater to most cases. However, there are some special circumstances in which revenue may be recognized prior to the sale of a good/service or even after the sale.
For long-term contracts, how are revenues recognized?
Long-term contracts are contracts that extend over more than one accounting period, such as construction projects. In long-term contracts, questions arise as to how revenues and expenses should be allocated to each accounting period. The treatment of these items depends on how reliably the outcome of the project can be measured.
Under both IFRS and U.S. GAAP, if the outcome of the contract can be measured reliably, what revenue recognition method is used?
Under both IFRS and U.S. GAAP, if the outcome of the contract can be measured reliably, the percentage of completion revenue recognition method is used. Under this method, revenues, costs, and profits are allocated to each accounting period in proportion to the percentage of the contract completed during the given period. The percentage that is recognized during a period is calculated by dividing the total cost incurred during the period by the estimated total cost of the project.
Under U.S. GAAP, if the outcome of a contract cannot be measured reliably, what revenue recognition method is used?
If the outcome cannot be measured reliably, the completed‐contract method is used under U.S. GAAP. Under this method, no revenues or costs are recognized on the income statement until the project is substantially finished. In the meantime, billings and costs are accumulated on the balance sheet (under a Construction-in-progress asset), rather than expensed on the income statement.
NOTE:
Under U.S. GAAP, the completed contract method is also appropriate when the contract is not a long-term contract. Note however, that when a contract is started and completed is the same period, there is no difference between the percentage-of-completion and completed contract methods.
Under IFRS, if the outcome of a contract cannot be measured reliably, what revenue recognition method is used?
Under IFRS, when the outcome cannot be measured reliably, revenue is recognized on the income statement to the extent of costs incurred during the period. No profits are recognized until all costs have been recovered.
What are the main differences and similarities between the revenue recognition methods? (percentage of completion method vs. completed contract method)
The percentage of completion method is a more aggressive (less conservative) approach to revenue recognition. It is also more subjective as it depends on management estimates and judgment relating to the reliability of estimates. However, the percentage of completion method matches revenues with costs over time and provides smoother, less volatile earnings. Remember, cash flows are exactly the same under both methods.
Under IFRS and U.S. GAAP, if a loss is expected on the contract, what must be done?
Important: Under IFRS and U.S. GAAP, if a loss is expected on the contract, the loss must be recognized immediately, regardless of the revenue recognition method used.
Define installment sales in the context of revenue recognition.
An installment sale occurs when a company finances a customer’s purchase of its products and customers make payments (installments) to the company over an extended period.
Under IFRS, how are installment sales separated and revenues recognized?
Under IFRS, installment sales are separated into the selling price (discounted present value of installment payments) and an interest component. Revenue attributable to the sale price is recognized at the date of sale, while the interest component is recognized over time.6 However, the standards provide that revenue should be recognized in light of local laws regarding the sale of goods. For transactions that require deferral of revenue and profit recognition (like sales of real estate on an installment basis) revenue recognition depends on specific aspects of the transaction.
Under U.S. GAAP, a sale of real estate is reported at the time of sale using the normal revenue recognition conditions if the seller:
- Has completed the significant activities in the earnings process; and
- Is either assured of collecting the selling price or able to estimate amounts that will not be collected.
Under U.S. GAAP, a sale of real estate is reported at the time of sale using the normal revenue recognition conditions if the seller:7
- Has completed the significant activities in the earnings process; and
- Is either assured of collecting the selling price or able to estimate amounts that will not be collected.
When these two conditions are not fully met, some of the profit must be deferred and one of the following two methods may be used:
Installment method
Cost-recovery method
Under U.S. GAAP, a sale of real estate is reported at the time of sale using the normal revenue recognition conditions if the seller:7
- Has completed the significant activities in the earnings process; and
- Is either assured of collecting the selling price or able to estimate amounts that will not be collected.
When these two conditions are not fully met, some of the profit must be deferred and one of the following two methods may be used: Define installment method.
Installment method: This method is used when collectability of revenues cannot be reasonably estimated. Under this method, profits are recognized as cash is received. The percentage of profit recognized in each period equals the proportion of total cash received in the period.
Profit for the period = (Cash collected in the period / Selling price) × Total profit
Under U.S. GAAP, a sale of real estate is reported at the time of sale using the normal revenue recognition conditions if the seller:7
- Has completed the significant activities in the earnings process; and
- Is either assured of collecting the selling price or able to estimate amounts that will not be collected.
When these two conditions are not fully met, some of the profit must be deferred and one of the following two methods may be used: Define cost recovery method.
Cost‐recovery method: This method is used when collectability of revenues is highly uncertain. Under this method, profits are only recognized once total cash collections (including principal and interest on any financing provided to the buyer) exceed total costs. The revenue recognition method under international standards is similar to the cost recovery method, but the term “cost recovery method” is not used.
Define barter transactions in the context of revenue recognition.
In barter transactions, goods are exchanged between two parties and there is no exchange of cash. One form of barter transaction is a round-trip transaction, in which a good is sold by one party in exchange for the purchase of an identical good. The issue with these transactions is whether revenue should be recognized.
How care barter transaction revenues recognized under the IFRS & U.S. GAAP?
Under IFRS, revenue from barter transactions can be reported on the income statement based on the fair value of revenues from similar nonbarter transactions with unrelated parties.
Under U.S. GAAP, revenue from barter transactions can be reported on the income statement at fair value only if the company has a history of making or receiving cash payments for such goods and services and hence, can use its historical experience to determine fair value. Otherwise, revenue should be reported at the carrying amount of the asset surrendered.
In gross vs. net reporting, how are sales and cost of sales reported?
Under gross revenue reporting, sales and cost of sales are reported separately, while under net reporting, only the difference between sales and cost of sales is reported on the income statement.
Under U.S. GAAP, only if the following conditions are met can a company recognize revenue based on gross reporting:
- The company is the primary obligor under the contract.
- The company bears inventory and credit risk.
- The company can choose its suppliers.
- The company has reasonable latitude to establish price.
Example: A travel agent purchases discounted tickets and sells them to customers. The agent only pays for the tickets that she manages to sell to customers. She purchases a ticket for $1,000 and sells it for $1,100. Assume that there are no other revenues and expenses involved. Demonstrate the reporting of revenues under gross and net reporting.
The travel agent should report revenue on a net basis because:
- She only pays for tickets that she is able to sell to customers. Therefore, she does not bear any inventory risk.
- The airline, not the travel agent, is the primary obligator under the contract.
Describe the implications for financial analysis for revenue recognition policies in the footnotes to their financial statements.
Companies are required to disclose their revenue recognition policies in the footnotes to their financial statements. The impact of a chosen policy on financial analysis depends on how conservative and objective the revenue recognition policy is. A conservative policy would recognize revenue later rather than sooner, and an objective policy would not leave too many estimates to management discretion. While it is difficult to attach a monetary value to differences in revenue recognition policies, analysts should be able to assess qualitative differences between sets of financial statements and evaluate how these differences affect important financial ratios.
How does the IASB framework define expenses?
The IASB framework defines expenses as “decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.”
What is the most important principle of expense recognition?
Expenses also include losses, which may or may not result from the ordinary activities of the business. The most important principle of expense recognition is the matching principle, which requires that expenses be matched with associated revenues when recognizing them on the income statement. If goods bought in the current year remain unsold at the end of the year, their cost is not included in the cost of goods sold for the current year to calculate current period profits.
Instead, the cost of these goods will be subtracted from next period’s revenues once they are sold. Certain expenses (e.g., administrative costs) cannot be directly linked to the generation of revenues. These expenses are called period costs and are allocated systematically with the passage of time.
List the various types of inventory methods and when they’re used.
If a company can specifically identify which units of inventory have been sold over the year and which ones remain in stock, it can use the specific identification method for valuing its inventory. Automobiles, for example, can be valued using this method. However, if sales are composed of identical units that are sold in high volumes (e.g., pencils), the separate identification method becomes difficult to administer. In such situations, the following methods of inventory valuation can be used:
First-in, first-out (FIFO)
Last-in, first-out (LIFO)
Weighted-average cost
Define the inventory method FIFO.
First‐in, first‐out (FIFO): This method assumes that items purchased first are sold first. Therefore, ending inventory is composed of the most recent purchases. FIFO is an appropriate method for valuing inventory that has a limited shelf life. For example, older food products will be sold first to ensure that available stock is fresh.
Define the inventory method LIFO.
Last‐in, first‐out (LIFO): This method assumes that items purchased most recently are sold first. Therefore, ending inventory is composed of the earliest purchases. The LIFO method is suitable when the physical flow of the item is such that the latest item must be sold first, for example, stacks of lumber in a lumberyard. This method is popular in the United States because of its income tax benefits.
What is the diluted EPS equation containing all three types of potentially dilutive financial instruments?
