CH4 - Understanding Income Statement

CHAPTER 4
UNDERSTANDING INCOME STATEMENTS

Lecture by: Say Vichheka
LEARNING OUTCOMES
 Describe the components of the income statement and alternative
presentation formats of that statement.
 Describe general principles of revenue recognition and accrual
accounting, specific revenue recognition applications (including
accounting for long-term contracts, installment sales, barter
transactions, gross and net reporting of revenue), and implications of
revenue recognition principles for financial analysis.
 Calculate revenue given information that might influence the choice of
revenue recognition method.
 Describe general principles of expense recognition, specific expense
recognition applications, and implications of expense recognition
choices for financial analysis.
 Describe the financial reporting treatment and analysis of
nonrecurring items (including discontinued operations, extraordinary
items, unusual or infrequent items) and changes in accounting
standards.
Copyright © 2012 CFA Institute 2

LEARNING OUTCOMES (CON’T)
 Distinguish between the operating and non-operating components of
the income statement.
 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.
 Distinguish between dilutive and antidilutive securities, and describe
the implications of each for the earnings per share calculation.
 Convert income statements to common-size income statements.
 Evaluate a company’s financial performance using common-size
income statements and financial ratios based on the income
statement.
 Describe, calculate, and interpret comprehensive income.
 Describe other comprehensive income, and identify the major types
of items included in it.

OVERVIEW
• Income statement components and format

• Accounting issues
- Revenue recognition
- Expense recognition
- Inventory
- Depreciation
- Nonrecurring items
• Earnings per share
• Income statement analysis
• Comprehensive income

INCOME STATEMENT COMPONENTS
• Also called the “statement of earnings,” “statement of

operations,” and “profit and loss statement (P&L)”
• Presents results of operations for the accounting period
Revenues – Expenses = Net income
Revenue + Other Income + Gains – Expenses – Losses

= Net income

INCOME STATEMENT FORMAT
• Subtotals
- Gross profit (i.e., revenue less cost of sales)
- Multistep format: Income statement shows gross profit
subtotal
- Single-step format: Income statement excludes gross profit
subtotal
- Operating profit (i.e., revenue less all operating expenses)
- Profits before deducting taxes and interest expense and
before any other nonoperating items
- Operating profit and EBIT (earnings before interest and
taxes) are not necessarily the same
• Expense Grouping

INCOME STATEMENT FORMAT: EXAMPLE 1
COLGATE-PALMOLIVE COMPANY
Colgate Annual Report

L’OREAL GROUP
L'Oreal's Annual Report

PROCTER & GAMBLE
Proctor & Gamble Report

GENERAL PRINCIPLES OF REVENUE
RECOGNITION AND ACCRUAL ACCOUNTING
• Revenue recognition can occur independently of cash

movements—for example, in the case of the
- sale of goods and services on credit or
- receipt of cash in advance of providing goods and
services
• A fundamental principle of accrual accounting is that
revenue is recognized (reported on the income statement)
in the period in which it is earned.

WHEN TO RECOGNIZE REVENUE
• IFRS specify that revenue from the sale of goods is to be

recognized when the following conditions are satisfied:
- Entity has transferred to the buyer the significant risks
and rewards of ownership of the goods;
- Entity retains neither continuing managerial involvement
with nor effective control over the goods sold;
- Amount of revenue can be measured reliably;
- It is probable that the economic benefits associated with
the transaction will flow to the entity; and
- Costs incurred with respect to the transaction can be
measured reliably.

WHEN TO RECOGNIZE REVENUE
U.S. GAAP specify that revenue should be recognized when

it is “realized or realizable and earned.” The U.S. Securities
and Exchange Commission (SEC) provides guidance on
how to apply the accounting principles. This guidance lists
four criteria to determine when revenue is realized or
realizable and earned:
1. There is evidence of an arrangement between 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.

SPECIFIC REVENUE RECOGNITION
APPLICATIONS: LONG-TERM CONTRACTS
• Long-term contract: contract that spans a number of
accounting periods.
• Percentage-of-completion method
- Use when the outcome of a contract can be measured reliably.
- In each accounting period, the company estimates what
percentage of the contract is complete and then reports that
percentage of the total contract revenue in its income
statement.
- Contract costs for the period are expensed against the
revenue.
- Net income or profit is reported each year as work is
performed.

SPECIFIC REVENUE RECOGNITION APPLICATIONS:
LONG-TERM CONTRACTS EXAMPLE
Example that uses the percentage-of-completion method of

revenue recognition:
• Network Construction project: bid was $5,000,000 and
estimated costs to complete were $4,000,000
- Year 1: Costs incurred of $3,000,000 (assume this mirrors

the percentage complete)
- Revenue?
- Cost of revenue?
- Year 2: Job is completed with costs of $1,000,000

- Revenue?
- Cost of revenue?
Example that uses the percentage-of-completion method of

revenue recognition (continued):
• Network Construction project: bid was $5,000,000 and estimated
costs to complete were $4,000,000.
- Year 1: Costs incurred $3,000,000 (assume this mirrors the

percentage complete)
- Revenue?
- Cost of revenue?
- Year 2: Job is completed with costs of $1,250,000 (a cost

overrun)
- Revenue?
- Cost of revenue?

APPLICATIONS: LONG-TERM CONTRACTS
• Percentage-of-completion is the preferred method under both
IFRS and U.S. GAAP
• When the outcome of a contract cannot be measured reliably,
there are alternatives to the percentage-of-completion method
- Assuming it is probable that costs will be recovered, IFRS
permit recognition of revenue up to the amount of costs
incurred.
- U.S. GAAP (but not IFRS) permit the completed contract
method.
• Company does not report any income until the contract is
substantially finished.
• Completed contract method is also acceptable when the
entity has primarily short-term contracts.

• Assume the following:

- A company has a contract to build a network for a customer for a total
sales price of $10 million.
- Network will take an estimated three years to build.
- Considerable uncertainty surrounds total building costs because new
technologies are involved.
- The outcome cannot be reliably measured, but it is probable that the
costs up to the agreed-upon price will be recovered.
- Expenditures total $3 million, $5.4 million, and $6 million as of the
end of Year 1,2, and 3, respectively.
• Question: How much revenue, expense (cost of construction), and
income would the company recognize each year under IFRS and,
using the completed contract method, under U.S. GAAP?

• Question: How much revenue, expense (cost of construction), and income

would the company recognize each year under IFRS and using the completed
contract method under U.S. GAAP?
• Answer: Under IFRS, recognize revenue to the extent of contract costs

incurred. Company would recognize
- Year 1, $3 million construction cost, $3 million revenue, and thus, $0 income
- Year 2, $2.4 million construction cost, $2.4 million revenue, and thus, $0
income
- Year 3, $0.6 million construction cost, remaining $4.6 million revenue
(because the contract has been completed and the outcome is now
measurable), and thus, $4 million income.
• Answer: With the completed contract method under U.S. GAAP, no revenue
will be recognized until the contract is complete.
- Year 3, $6 million construction cost, $10 million revenue (because the
contract has been completed), and thus, $4 million income

APPLICATIONS: INSTALLMENT SALES
• Installment sales: Sales in which proceeds are to be paid

in installments over an extended period.
• IFRS separate the installments into the sale price (present
value of the installment payments) and an interest
component.
• Revenue attributable to the sale price is recognized at
the date of sale
• Revenue attributable to the interest component is
recognized over time.
• International standards note, however, that the guidance
for revenue recognition must be considered in light of local
laws regarding the sale of goods in a particular country.

APPLICATIONS: INSTALLMENT SALES
• Sale of real estate under U.S. GAAP
• A sale of real estate is reported at time of sale using normal revenue
recognition conditions when seller has completed the significant
activities in the earnings process and is either
1) assured of collecting the selling price or
2) able to estimate amounts that will not be collected.
• Otherwise, defer some of the profit using
- the installment method, in which the portion of the total profit
recognized in each period is determined by the percentage of the
total sales price for which the seller has received cash, or
- the cost recovery method, in which the seller does not report any
profit until the cash amounts paid by the buyer—including principal
and interest on any financing from the seller—are greater than all the
seller’s costs of the property.

APPLICATIONS: EXAMPLE
• Assume the following:
- Sales price and cost of a property are $2,000,000 and $1,100,000,
respectively, so that the total profit to be recognized is $900,000.
- Seller received a down payment of $300,000 cash, with the remainder
of the sales price to be received over a 10-year period.
- There is significant doubt about the ability and commitment of the
buyer to complete all payments.
- How much profit will be recognized attributable to the down payment if

1) the installment method is used?
2) the cost recovery method is used?

How much profit will be recognized attributable to the down payment if the
installment method is used?
- Installment method apportions the cash receipt between cost recovered and
profit using the ratio of profit to sales value.
- Here, the ratio of profit to sales value equals $900,000/$2,000,000 = 45%.
- Seller will recognize the following profit attributable to the down payment:
45% of $300,000 = $135,000.
How much profit will be recognized attributable to the down payment if the cost
recovery method is used?
- Under the cost recovery method, do not recognize any profit until cash
received from buyer exceeds all costs.
- Here, $300,000 cash paid by the buyer is less than the seller’s cost of
$1,100,000.
- Seller will recognize $0 profit attributable to the down payment.

APPLICATIONS: GROSS VS. NET REPORTING
• Merchandising companies typically sell products that they purchase
from a supplier. To account for the sales, they
- record the amount of the sale proceeds as sales revenue and
- record the cost of the products as the cost of goods sold.
• Some internet-based merchandising companies sell products that
they never hold in inventory; they simply arrange for the supplier to
ship the products directly to the end customer. Should they record
revenues of
- the gross amount of sales proceeds received from their customers?
- the net difference between sales proceeds and their cost?
• U.S. GAAP guidance
- Report revenues gross if the company is the primary obligor under
the contract, bears inventory risk and credit risk, can choose its
supplier, and has reasonable latitude to establish price.
- Otherwise, report revenues net.

Company OLR, an online retailer, buys tickets (airline,

concert, etc.), resells them for $100, and earns a 10% fee.
What is the correct accounting?
Alternative A: Gross
- Revenue $100
- Cost of goods sold $90
- Gross Profit $10
Alternative B: Net
- Revenue $10

“We evaluate whether it is appropriate to record the gross amount

of product sales and related costs or the net amount earned as
commissions. Generally, when we are primarily obligated in a
transaction, are subject to inventory risk, have latitude in
establishing prices and selecting suppliers, or have several but not
all of these indicators, revenue is recorded at the gross sales price.
We generally record the net amounts as commissions earned if we
are not primarily obligated and do not have latitude in establishing
prices.”
Amazon Inc. (2011), 10-K

GENERAL PRINCIPLES OF EXPENSE
RECOGNITION
• Fundamental principle: A company recognizes expenses in

the period in which it consumes (i.e., uses up) the
economic benefits associated with the expenditure.
• Matching principle: Costs are matched with revenues.
• As with revenue recognition, expense recognition can
occur independently of cash movements.
- Inventory and cost of goods sold
- Plant, property, and equipment and depreciation

SPECIFIC EXPENSE RECOGNITION
APPLICATIONS: INVENTORY
Inventory Cost Flow
Beginning Ending
Goods
Inventory Inventory
Available
Goods for
Sale Cost of
Purchased Goods Sold
Balance Sheet Income Statement

Inventory Purchases
First quarter 2,000 units at $40 per unit
Second quarter 1,500 units at $41 per unit
Third quarter 2,200 units at $43 per unit
Fourth quarter 1,900 units at $45 per unit
Total 7,600 units at a total cost of $321,600
Inventory sales during the year: 5,600 units at $50 per unit
What are the revenue and expense for these transactions during the
year?
Assume the company specifically identifies that

- the 5,600 units sold were those purchased in the 1st and 2nd quarter
plus 2,100 of the units purchased in the 3rd quarter and
- the 2,000 remaining units were 100 of those purchased in the 3rd
quarter plus the 1,900 purchased in the 4th quarter.

APPLICATIONS: EXAMPLE SOLUTION
• Revenue = $280,000
Total available
(5,600 units times $50 per unit)
for sale
• Cost of Goods Sold
The 5,600 units that were sold were specifically identified
as follows:
From 1st quarter: 2,000 units at $40 per unit $80,000
From 2nd quarter: 1,500 units at $41 per unit $61,500
From 3rd quarter: 2,100 units at $43 per unit $90,300
Total cost of goods sold $231,800
• Ending inventory
From the 3rd quarter: 100 units at $43 per unit $4,300
From the 4th quarter: 1,900 units at $45 per unit $85,500
Total remaining (or ending) inventory cost $89,800

Inventory Purchases
Inventory sales during the year 5,600 units at $50 per unit.
Revenue and expense for these transactions during the year?
Assume the company does not specifically identify the units, but instead
uses the weighted average cost method of inventory costing.

• Revenue = $280,000
(5,600 units times $50 per unit) Total available
for sale
• Average cost per unit =
Total cost of goods available divided by total units available =
$321,600/7,600 units = $42.3158 per unit
• Cost of goods sold =

5,600 units at $42.3158 per unit $236,968
• Ending inventory =
2,000 units at $42.3158 per unit $84,632

Inventory Purchases
Inventory sales during the year: 5,600 units at $50 per unit.
year?
Assume the company does not specifically identify the units, but instead
uses the FIFO (first in, first out) method of inventory costing.

Inventory Purchases
Using the FIFO method of inventory costing:
FIFO to determine COGS: 2,000 from 1st quarter at $40 per

unit + 1,500 from 2nd quarter at $41 per unit + 2,100 from
3rd quarter at $43 per unit
COGS = $231,800

Inventory Purchases
Inventory sales during the year: 5,600 units at $50 per unit.
year?
Assume the company reports
LIFO is under under
not allowed U.S. GAAP
IFRS.and uses the LIFO
Assume
(last the company
in, first does notofspecifically
out) method identify the units, but instead
inventory costing.
uses the LIFO method of inventory costing.

Inventory Purchases
Using the LIFO method of inventory costing:
LIFO to determine COGS: 1,900 from 4th quarter at $45 per

unit + 2,200 units at $43 per unit + 1,500 units at $41 per unit
COGS = $241,600

SUMMARY TABLE ON INVENTORY
COSTING METHODS
COGS when
Ending Inventory
prices are rising
when prices are
Method Description relative to the
rising relative to the
other two
other two methods
methods
FIFO Assumes that earliest
items purchased were Lowest Highest
sold first
LIFO Assumes most recent
items purchased were Highest* Lowest*
sold first
Average Averages total costs
Middle Middle
Cost over total units available
*Assumes no LIFO layer liquidation. LIFO layer liquidation occurs when the volume of sales exceeds the
volume of other purchases in the period so that some sales are assumed to be from existing, relatively low-priced
inventory rather than from more recent purchases.

INVENTORY METHOD: EXAMPLE DISCLOSURE
“Inventory Valuation Inventories are valued at the lower of cost

or market value. Product related inventories are primarily
maintained on the first-in, first-out method. Minor amounts of
product inventories, including certain cosmetics and commodities,
are maintained on the last-in, first-out method. The cost of spare
part inventories is maintained using the average cost method.
Procter & Gamble (2011), Annual Report
“Inventories are valued at the lower of cost or net realizable value.

Cost is calculated using the weighted average cost method.”
L’Oreal Group (2011), Registration Document

INVENTORY METHOD: EXAMPLE DISCLOSURE
“Inventories. Inventories are stated at the lower of cost or market. The

cost of approximately 80% of inventories is determined using the first-
in, first-out (FIFO) method. The cost of all other inventories,
predominantly in the U.S. and Mexico, is determined using the last-in,
first-out (LIFO) method.”
Colgate-Palmolive (2011), Annual Report (Note 2)
“Inventories valued under LIFO amounted to $271 and $263 at

December 31, 2011 and 2010, respectively. The excess of current cost
over LIFO cost at the end of each year was $30 and $52, respectively.
The liquidations of LIFO inventory quantities had no material effect on
income in 2011, 2010 and 2009.”
Colgate-Palmolive (2011), Annual Report (Note 16)

APPLICATIONS: DEPRECIATION
• Depreciation: Process of systematically allocating costs of long-lived

assets over the period during which the assets are expected to provide
economic benefits.
- Depreciation: term commonly applied for physical long-lived assets,
such as plant and equipment (NOT land)
- Amortization: Term commonly applied to this process for intangible
long-lived assets with a finite useful life
• Depreciation Methods:
- Straight line
- Accelerated (i.e., diminishing balance)
- Units of production

APPLICATIONS: DEPRECIATION EXAMPLE
• Equipment cost = $9,000. Estimated residual = $0. Useful life = 3 years.
• Annual depreciation expense = (Cost – Residual value)/Useful life.
Cost of equipment $9,000

Less Year 1 depreciation expense – 3,000
Book value at end of Year 1 $6,000
Book value at end of Year 2 $3,000
Book value at end of Year 3 $0

• Judgments and estimates needed in depreciation:

- estimated salvage value
- estimated useful life
• For example, given a purchase price of $10,000, what is

the annual straight-line depreciation expense
- if estimated salvage value = $5,000 and useful life = 10
years?
- if estimated salvage value = $0 and useful life = 2 years?

Diminishing Balance Depreciation
• Determine straight-line rate (100%/Useful life)
• Determine acceleration factor (e.g., 1.5× or 2×)
• Depreciation rate = (Straight-line rate x acceleration factor)
• Depreciation expense = Net book value (NBV) x Depreciation
rate
• Discontinue depreciation when net book value = Salvage value
Example: What is the annual depreciation expense each year?

Asset cost: $11,000
Estimated salvage value: $1,000
Estimated useful life: 5 years
Acceleration factor: 2×

SPECIFIC EXPENSE RECOGNITION APPLICATIONS:
DEPRECIATION EXAMPLE SOLUTION
NBV
Beginning of Depreciation Accumulated NBV End of
Year Year Expense Depreciation Year
1 11,000 4,400 4,400 6,600
2 6,600 2,640 7,040 3,960
3 3,960 1,584 8,624 2,376
4 2,376 950 9,574 1,426
5 1,426 426 10,000 1,000

NONRECURRING ITEMS AND CHANGES IN
ACCOUNTING STANDARDS
• Separating nonrecurring from recurring items of income

and expense can help an analyst assess a company’s
future earnings.
• Nonrecurring items:
- discontinued operations
- extraordinary items (not permitted under IFRS)
- unusual or infrequent items
• Changes in accounting standards

EARNINGS PER SHARE
• Earnings per share (EPS) is the net earnings available to

common stockholders for the period divided by the
weighted average number of common stock shares
outstanding
• If firm has a “complex” capital structure, it will report basic
and diluted EPS.
• EPS is extensively used by analysts in evaluating a firm.
Colgate's Annual Report
L'Oreal's Annual Report

EPS: EXAMPLE 1
• Basic EPS
- Earnings available to common shareholders divided by weighted
average number of shares outstanding
Basic EPS = (Net income – Preferred dividends)
Weighted average number of shares outstanding
Assume the following:

- Company had net income of $2,431 million for the year,
- 488.3 million weighted average number of common shares outstanding
- No preferred stock, no convertible securities, no options
What was the company’s basic EPS?

EPS: EXAMPLE 1 SOLUTION

- Company had net income of $2,431 million for the year
- 488.3 million weighted average number of common shares outstanding
- No preferred stock, no convertible securities, no options
What was the company’s Basic EPS?
Basic EPS
= (Net income – Preferred dividends)/Weighted average number of
shares outstanding
= ($2,431 – $0)/488.3
= $4.98
EPS: EXAMPLE 2
WEIGHTED AVERAGE NUMBER OF SHARES
Calculate
(1) the weighted average number of shares outstanding
(2) the company’s basic EPS

Company had net income of $2,500,000 for the year and paid $200,000
of preferred dividends.
1,000,000 Shares outstanding on 1 January 20XX
200,000 Shares issued on 1 April 20XX
(100,000) Shares repurchased on 1 October 20XX
1,100,000 Shares outstanding on 31 December 20XX

EPS: EXAMPLE 2 SOLUTION
WEIGHTED AVERAGE NUMBER OF SHARES
Weighted average number of shares outstanding
1,000,000 × (3 months/12 months) Jan, Feb, Mar
+ 1,200,000 × (6 months/12 months) April–Oct
+ 1,100,000 × (3 months/12 months) Oct, Nov, Dec
= 1,125,000 Weighted average number of shares outstanding
Basic EPS
= (Net income – Preferred dividends)/Weighted average number
of shares outstanding
= ($2,500,000 – $200,000)/1,125,000
= $2.04

EPS: EXAMPLE 3
IF-CONVERTED METHOD FOR CONVERTIBLE
PREFERRED STOCK
Assume a company has the following:
- net income of $1,750,000
- an average of 500,000 shares of common stock outstanding
- 20,000 shares of convertible preferred outstanding
- no other potentially dilutive securities
Each share of preferred pays a dividend of $10 per share, and each
is convertible into five shares of the company’s common stock.
Calculate the company’s basic and diluted EPS.
Diluted EPS
= Net income/(Weighted average number of shares outstanding
+ New shares issued at conversion)

EPS: EXAMPLE 3
IF-CONVERTED METHOD FOR CONVERTIBLE
PREFERRED STOCK SOLUTION
Diluted EPS Using
Basic EPS If-Converted Method
Net income $1,750,000 $1,750,000

Preferred dividend – 200,000 0
Numerator $1,550,000 $1,750,000
Weighted average number of shares

outstanding 500,000 500,000
If converted 0 100,000
Denominator 500,000 600,000
EPS $3.10 $2.92

EPS: EXAMPLE 4
IF-CONVERTED METHOD FOR CONVERTIBLE DEBT
Assume a company has the following:
- net income of $750,000
- an average of 690,000 shares of common stock outstanding
- $50,000 of 6% convertible bonds outstanding that are convertible into a
total of 10,000 shares
- An effective tax rate is 30%
Diluted EPS
= (Net income + After-tax interest on convertible debt – Preferred
dividends)/(Weighted average number of shares outstanding + Additional
common shares that would have been issued at conversion)

EPS: EXAMPLE 4
IF-CONVERTED METHOD FOR CONVERTIBLE DEBT
SOLUTION
Diluted EPS Using
Basic EPS If-Converted Method
Net income $750,000 $750,000
After-tax cost of interest 0 2,100
Preferred dividend –0 0
Numerator $750,000 $752,100
Weighted average number of shares

outstanding 690,000 690,000
If converted 0 10,000
Earnings per share (EPS) $1.09 $1.07

EPS: EXAMPLE 5
TREASURY STOCK METHOD FOR STOCK OPTIONS
Assume a company reported net income of $2.3 million for the
year ended 30 June 2005 and has the following:
- an average of 800,000 common shares outstanding
- 30,000 options with an exercise price of $35 outstanding
Over the year, its market price averaged $55 per share.
Diluted EPS
= (Net Income – Preferred dividends)/(Weighted average
number of shares outstanding + New shares issued at option
exercise – Shares that could have been purchased with cash
received upon exercise)
EPS: EXAMPLE 5
SOLUTION
Calculate Denominator
800,000 Weighted average number of shares outstanding

+ 30,000 New shares issued at option exercise
Shares that could be purchased with cash received

upon exercise, calculated as $1,050,000 ($35 for
– 19,091 each of the 30,000 options exercised) divided by
average market price of $55 per share = 19,091
shares
= 810,909 Shares
30,000 – 19,091 = 10,909

EPS: EXAMPLE 5
SOLUTION
Diluted EPS Using
Treasury Stock
Basic EPS Method
Net income $2,300,000 $2,300,000
Numerator $ 2,300,000 $2,300,000
Weighted average number

of shares outstanding 800,000 800,000
If exercised and treasury
shares purchased 0 10,909
EPS $2.88 $2.84

DILUTIVE VS. ANTIDILUTIVE SECURITIES
• Dilutive securities: securities that, if included in a diluted

EPS calculation, result in an EPS lower than the
company’s basic EPS
• Antidilutive securities: securities that, if included in a diluted

EPS calculation, would result in an EPS higher than the
company’s basic EPS
- Antidilutive securities are not included in the calculation of
diluted EPS.
- Diluted EPS should reflect the maximum potential dilution
from conversion or exercise of potentially dilutive financial
instruments.
- By definition, diluted EPS will always be less than or
equal to basic EPS.

COMMON-SIZE INCOME STATEMENTS
Panel A: Partial Income Statements for Companies A, B, and C
($) A B C
Sales $10,000,000 $10,000,000 $2,000,000
Cost of sales 3,000,000 7,500,000 600,000
Gross profit 7,000,000 2,500,000 1,400,000
Selling, general, and

administrative expenses 1,000,000 1,000,000 200,000
Research and development 2,000,000 — 400,000
Advertising 2,000,000 — 400,000
Operating profit 2,000,000 1,500,000 400,000

COMMON-SIZE INCOME STATEMENTS
Panel B: Common-Size Income Statements for Companies A, B, and C

A B C
Sales 100% 100% 100%

Cost of sales 30 75 30
Gross profit 70 25 70
Selling, general, and

administrative expenses 10 10 10
Research and development 20 0 20
Advertising 20 0 20
Operating profit 20 15 20
Each line item is expressed as a percentage of the
company’s sales.
INCOME STATEMENT RATIOS
• Net profit margin = Net income/Revenue
- Net profit margin measures the amount of income that a company
was able to generate for each dollar of revenue.
- Higher level of net profit margin indicates higher profitability
(generally more desirable).
- Net profit margin can also be found directly on the common-size
income statements.
- Also referred to as “return on sales.”
• Profitability ratios found directly on the common-size income statement.
- Gross profit margin = Gross profit/Revenue.
- Operating profit margin = Operating profit/Revenue
- Pretax profit margin = Pretax profit/Revenue
- Net profit margin
Colgate and L'Oreal Income Statements

COMPREHENSIVE INCOME
Beginning Equity + or – Change = Ending Equity

Retained earnings + Net income Retained earnings
– Dividends
Accumulated other + Other comprehensive Accumulated other
comprehensive income income comprehensive income
– Other comprehensive
loss
Stock + Issuances Stock
– Repurchases
1. Foreign currency translation adjustments

2. Unrealized gains or losses on derivatives contracts accounted for as
hedges
3. Unrealized holding gains and losses on available-for-sale securities
4. Certain costs of a company’s defined benefit post-retirement plans that
are not recognized in the current period

COMPREHENSIVE INCOME:
EXAMPLE
Assume the following about a company:

- beginning shareholders’ equity is €200 million
- net income for the year is €20 million
- cash dividends for the year are €3 million
- no issuance or repurchase of common stock.
- actual ending shareholders’ equity is €227 million.
What amount has bypassed the net income calculation by

being classified as other comprehensive income?
What is the company’s comprehensive income?

COMPREHENSIVE INCOME:
EXAMPLE SOLUTION
Assume the following about a company:
- beginning shareholders’ equity is €200 million
- net income for the year is €20 million
- cash dividends for the year are €3 million
- no issuance or repurchase of common stock
- actual ending shareholders’ equity is €227 million
What amount has bypassed the net income calculation by being

classified as Other comprehensive income?
Answer: €10 million.
What is the company’s total comprehensive income?
Answer: €30 million
SUMMARY
• Income statement shows how much revenue the company
generated during a period and what costs it incurred in
connection with generating that revenue.
• Accounting issues relate primarily to timing (revenue recognition,
expense recognition, nonrecurring items).
• The income statement also presents EPS (earnings per share),
an important metric.
• Tools for income statement analysis include common-size
analysis and profitability ratios.
• Comprehensive income includes net income and other
comprehensive income.

CH4 - Understanding Income Statement

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CH4 - Understanding Income Statement

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CHAPTER 4

UNDERSTANDING INCOME STATEMENTS

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• Income statement components and format

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• Also called the “statement of earnings,” “statement of

• Presents results of operations for the accounting period

Revenues – Expenses = Net income

Revenue + Other Income + Gains – Expenses – Losses

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Colgate Annual Report

L'Oreal's Annual Report

Proctor & Gamble Report

• Revenue recognition can occur independently of cash

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• IFRS specify that revenue from the sale of goods is to be

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U.S. GAAP specify that revenue should be recognized when

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Example that uses the percentage-of-completion method of

- Year 1: Costs incurred of $3,000,000 (assume this mirrors

- Year 2: Job is completed with costs of $1,000,000

Example that uses the percentage-of-completion method of

- Year 1: Costs incurred $3,000,000 (assume this mirrors the

- Year 2: Job is completed with costs of $1,250,000 (a cost

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• Assume the following:

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• Question: How much revenue, expense (cost of construction), and income

• Answer: Under IFRS, recognize revenue to the extent of contract costs

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• Installment sales: Sales in which proceeds are to be paid

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- How much profit will be recognized attributable to the down payment if

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Company OLR, an online retailer, buys tickets (airline,

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“We evaluate whether it is appropriate to record the gross amount

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• Fundamental principle: A company recognizes expenses in

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Balance Sheet Income Statement

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Assume the company specifically identifies that

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Revenue and expense for these transactions during the year?

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• Cost of goods sold =

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Using the FIFO method of inventory costing:

FIFO to determine COGS: 2,000 from 1st quarter at $40 per

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Using the LIFO method of inventory costing: