Handout for Unit 3

for
Financial Reporting and Analysis
 Unit 3
The Income Statement
Contents
1. Introduction
2. Income Statement Headers
3. Depreciation
4. Revenue and Expenses Recognition
5. Non-Recurring items
6. EPS in Income Statement
a. Calculation of Basic EPS and Diluted EPS
7. Analysis of Income Statements
a. Common-Size Income Statements and comprehensive Income Statements
8. Short Case
Income Statement
Profits are a measure of a company’s well being and perceived value addition by the customer.

The Profit & Loss account is a report card of the financial performance of the firm, for a particular period
(and not as on a particular day).

Profit & Loss Account is also known as P&L Statement or Income Statement. The words Earnings and
Profits are also used interchangeably. Accounting is the process of identifying, gathering, measuring and
communicating financial information about a company’s operations.

A Profit and Loss account gives an idea about what has transpired during the year, in terms of business
activities. It is one of the linking points for the 2 balance sheets – at the beginning of the year and at the
end of the year.

Profit & Loss account

Balance Sheet as on Balance Sheet as on

Business Activity
During the Year
March 31, 2016 March 31, 2017

Different Views of Profits

Based on the requirement of people working in a company or analyzing it, various views of profits are
available. These can be calculated from a basic income statement by moving from top to the bottom. Sales
are known as topline since they are at the top of an income statement. Profits are known as bottomline
since they appear as the last line on the Income Statement.
 Sales

Cost of Goods Sold

Gross Profit
Other Cash
Operating
Expenses
EBITDA
Depreciation &
Amortization
EBIT or Operating
Profit
Interest
Earnings Before
Tax
Tax

Net Profit

Gross Profit is useful for a specific product unit head, since they are looking at maximizing the profit from
the product sold. EBITDA is useful at a CEO level, since they are trying to maximize the benefits out of the
company’s operations. EBIT is useful as an indicator for lenders, since they want to evaluate the
company’s ability to repay interest. The tax department and government are concerned about the Profit
Before Taxes. Finally, shareholders are concerned about the net profit numbers.
Sample P&L Statement

Income

Expenses

Profit
Income Statement Headers
 Gross Sales - Revenue from sale of products or services
 Excise Duty / Service Tax - Tax Paid to the government on production or sale of services
 Other Income - Income from sources other than the normal operations of business - Such as
income from investments
 Raw Material - The Raw material used for manufacturing the products
 Staff Cost - Payments made to staff
 Other Expenditure - Ancillary expenses - electricity, marketing etc
 Total Expenses - Sum of all of the above
 EBITDA - Profits generated from the normal course of business. This is given by sales minus
expenses. Note that this excludes other income since that is not income generated by normal
operations of business
 Depreciation - Any fixed Asset purchased is not written off as an expense in the same year. The
capital expenditure is assumed to be divided over its life. Only the value which goes away in one
year is accounted as an expense in the P&L account.

 Interest - Interest paid on loans the company has raised

 PBT - Profits Before Tax ( EBITDA + Other Income - Depreciation - Interest)
 Tax - Corporate Tax
 Profits - Net profit available for distribution to shareholders
Depreciation
Refers to the gradual consumption of a long term resource or asset. This gradual consumption is captured
by reducing the accounting value of the resource in each period.

Year 1 Year 2 Year 3 Year 4

The gradual consumption of an asset. The Balance sheet shows a reduction in the value of the asset.

Let’s say a truck is purchased in year 2010 for Rs. 10 Lacs. We assume the truck can be useful for the next
10 years, after which, it will have to be replaced. The reason could be wear and tear or obsolescence of
the model.

The ‘value’ of the truck is ‘written – off‘ over the 10 years, as follows:

Year Value of the Truck Current & starting value

2010 1000000
2011 900000
2012 800000
2013 700000
2014 600000
2015 500000
2016 400000
2017 300000
2018 200000
2019 100000
2020 0
This is a pure accounting treatment & need not indicate actual sale of the truck in any year. Remember, if
we were to sell a truck, we may end up getting a different value as compared to the value depicted in the
financial statements.

Remember – Depreciation is a notional expense.

Actual outflow of cash took place in year 1, but is accounted for over 10 years.

Such deferring is important, since the asset is not consumed within a financial year, but over its entire
useful life.
 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

Rs 1 lakh of expense is booked each

Cash outflow of year. This is to show that the truck is
Rs 10 lakhs losing 10% of its value each year – over
its useful life.

Amortization

Depreciation for intangible assets is known as amortization. For example, if a telecom company bids for a
license for 10 years, and pays Rs 4000 crore, then every year, it will write off Rs 400 crore. This is known
as amortization.
Revenue Recognition
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.

Revenue is recognized in case of Sale of Goods when

 Risk and reward of ownership is transferred.

 No continuing control or management over the goods sold
 Revenue can be reliably measured
 Probable flow of economic benefits
 Cost can be reliably measured.

Revenue is recognized in case of Sale of Services when

 The amount of revenue can be reliably measured.

 Probable flow of economic benefits
 The stage of Completion can be measured
 Cost incurred and cost of completion can be reliably measured

Specific Situations – Revenue Recognition

 Long Term Contracts

o Contract Spanning over a number of accounting periods
o Here, percentage completion method is used – how much of the cost is undertaken
decides the revenue booking
 Installment Sales
o A sale with payments in installments.
o Under IFRS, present value of the sale value is booked as revenue in the first year, while
interest payments are booked yearwise
 Barter Transactions
o In a barter transactions, two parties exchange goods or services without cash payment.
o Under IFRS, revenue from barter transactions must be based on the fair value of revenue
from similar non barter transactions

Gross and Net Revenue reporting

We can understand this using an example. Take the case of Flipkart. It sells a book for Rs 300, while the
cost of the book is Rs 280. Under gross revenue reporting, sales would be Rs 300 and cost of materials or
goods sold would be Rs 280. Under net reporting, Flipkart is only trading the book. So the sales would be
Rs 20
Expense Recognition
The Fundamental principle is that 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.
o Inventory and cost of goods sold
o Plant, property, and equipment and depreciation

Inventory Recognition Problem

I buy Raw Material for 100 laptops at Rs 20,000 each, and then another 100 laptops at Rs 25,000 each. I
sell 100 laptops in this year for Rs 30,000 each. What should be my gross profit?

The answer depends on how I record my inventory. There are 3 methods of inventory recognition

• First in First Out - FIFO – First item purchased is assumed to be the first item sold. The cost of
inventory acquired first is used to calculate the cost of goods sold for the period.

• Last in First Out - LIFO – The last item purchased is assumed to be the first item sold. The cost of
inventory most recently purchased is assigned to the cost of goods sold for the period.

• Weighted Average Method – Makes no assumption about the physical flow of the inventory.
The cost per unit is calculated by dividing cost of available goods by total units available, and
average cost is used to determine cost of goods sold and ending inventory

The impact of the inventory methods is outlined here

Sample Problems

1. I buy RM for 200 water bottles at Rs 20 each, and then another 200 water bottles at Rs 15 each.
If I sell 250 water bottles during the year, what is my cost of goods sold
 Based on LIFO
 Based on FIFO
 Based on Weighted Average

2. A road project is going to get completed in 3 years. The total revenue expected from the project
is Rs 800 crore, while cost expected to be undertaken is Rs 600 crore. What would be the revenue
in year 1, 2 and 3, if the costs undertaken in these years is given as below
 Cost of Rs 120 crore in year 1
 Costs of Rs 420 crore in year 2
 Costs of Rs 60 crore in year 3
Non Recurring Items
Any item occurring as a one-off, which is not expected to come every year, is known as a non-recurring
item. If is important for an analyst to be able to segregate the non-recurring items, since it helps us project
what next year income would be.

Examples of non-recurring items could be

 Non-recurring expense on account of a penalty

 Non-recurring income on account of an award
 Non-recurring items on account of discontinued operations

Other Items on the Income Statements

Other Operational Income - Any revenue occurring as a byproduct of the business, which is not the main
business itself. For example, while producing zinc, lead is a byproduct. This is not core income for the firm,
but will not come if the company stops operations. So this is classified as other operational income.

Changes to Inventory - Changes to inventory show us if we have used items pertaining to the last period
or if we have not used the items we purchased the raw materials for in this period. This is to adjust the
cost of Raw Materials according to the matching principle

Deferred Tax - Deferred tax assets and liabilities show us if we have accounted for higher (lower) tax
today, and therefore will have to pay lower (higher) tax later.
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.

Basic EPS is calculated by dividing the total profit of the firm by the total shares outstanding today. If the
firm has some preferred dividends to be paid, those are subtracted.

The formula would be

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝐵𝑎𝑠𝑖𝑐 𝐸𝑃𝑆 =
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

Diluted EPS

Sometimes, the shares outstanding may change due to issue of new shares. These new shares could be
through some stock options given to employees (ESOP) or due to some convertible securities (Securities
which today are debt but can be converted into shares)

The formula would be

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝐷𝑖𝑙𝑢𝑡𝑒𝑑 𝐸𝑃𝑆 =
𝑇𝑜𝑡𝑎𝑙 𝑆ℎ𝑎𝑟𝑒𝑠 𝐴𝑠𝑠𝑢𝑚𝑖𝑛𝑔 𝑁𝑒𝑤 𝑆ℎ𝑎𝑟𝑒𝑠 𝑎𝑠 𝑤𝑒𝑙𝑙

The following figure shows how companies report basic and diluted EPS in the Annual report.
Common Size Statements
Common size income statement is an income statement in which each account is expressed as a
percentage of the value of sales. This type of financial statement can be used to allow for easy analysis
between companies or between time periods of a company.

Panel A: Partial Income Statements for Companies A, B, and C

Rs 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

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
Short Case

Look at the statements of the following companies, and calculate common size statements for them.
Based on those, comment on the

in Rs Crore Hero Motocorp Bajaj Auto TVS Motor

Revenue
Sales Turnover 29,303 23,981 12,232
Excise Duty 1,718 1,293 988
Net Sales 27,585 22,688 11,244
Other Income 338 913 51
Total Revenue 27,953 23,537 11,225
Expenditure
Raw Materials 19,891 15,435 8,006
Stock Adjustments (30) 63 71
Power & Fuel Cost 158 121 88
Employee Cost 1,173 918 664
Miscellaneous Expenses 2,851 1,371 1,664
Total Expenses 24,043 17,908 10,493

Operating Profit 3,542 4,780 751

PBDIT 3,880 5,693 802
Interest 11 0 46
PBDT 3,869 5,692 756
Depreciation 540 307 190
Profit Before Tax 3,329 5,385 566
PBT (Post Extra-ord Items) 3,329 5,385 566
Tax 943 1,733 134
Reported Net Profit 2,386 3,652 432
Shares in issue in Crores 19.97 28.94 47.51

1. Operating Profits for the companies?

2. Which company has the highest depreciation as per common size statements?
3. Calculate EPS for the 3 companies
4. Which company shows the highest employee cost as per the common size statements?
5. Based on the common size statements, which company appear the best in terms of net profitability?