FINANCIAL STATEMENT

CFA LEVEL 1 ANALYSIS

CHAPTER 3
“CRAFTING YOUR
CFA TRIUMPH
WITH EFFECTIVE
SUMMARIES.”
CONCEPT NOTES
Understanding Income Statements
-Income statement basics 1
-Presentation format 3

-Revenue recognition 5

-Expense recognition 6

-Inventory expense recognition 8

-Depreciation expense recognition 10

-Amortization expense recognition 11

-Bad debt expense & Warranty expense recognition 12

-Non recurring items 14

-Changes in accounting policies & estimates 15

-EPS & Dilutive securities 16

-Common size income statements 19

-Other comprehensive income 21

TABLE OF
CONTENTS
Understanding
Income Statements
What is an income statement?
An income statement, often referred to as a profit and loss statement (P&L), is a
crucial financial document that provides a snapshot of a company's financial
performance over a specific period, typically a quarter or a year. It serves as a
powerful tool for investors, analysts, and business owners to assess how well a
company is generating revenue and managing its expenses.
In simple terms, an income statement tells you whether a company is making
money or losing money during a given time frame. It consists of two main
sections:
Revenue (or Sales): This section outlines the money a company earns
from its primary business activities, such as selling products or providing
services. It's essentially the "top line" of the income statement.
Expenses: In this part, the income statement lists all the costs associated
with running the business. These expenses can include things like salaries,
rent, materials, marketing, and interest on loans. This section is often
referred to as the "bottom line."
Gains and losses are distinct from revenue and expenses on an income
statement, although they all contribute to a complete income statement.
Gains: Gains are positive financial events that arise from activities outside a
company's usual business operations. They are typically infrequent or non-
recurring and often result from events like selling assets (e.g., selling an
investment property at a profit), receiving insurance proceeds, or winning a
legal settlement. Gains are not part of a company's primary income-
generating activities and are reported separately on the income statement.
Losses: Losses, on the other hand, represent negative financial events
outside the normal course of business operations. Similar to gains, losses are
infrequent or non-recurring and typically result from events like asset write-
downs, legal settlements, or the sale of assets at a loss.

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In summary, the net income on the income statement comprises of the following
equation:

Net Income

Revenues

Ordinary Expenses

Other Income

Other Expenses

Gains

Losses

What is non-controlling interest?

Non-controlling interest (NCI), also known as minority interest, is a significant
accounting concept that pertains to the portion of a subsidiary's equity (net
assets) not owned by the parent company. It represents the ownership interest
in a subsidiary that is held by external parties, such as minority shareholders or
investors, rather than the controlling parent company.
Net income attributable to the non-controlling interest is subtracted from the
consolidated net income to arrive at the net income attributable to the
controlling interest (parent company). This distinction is important because it
reflects the true earnings available to the parent company's shareholders.
Non-controlling interest is important for the income statement because it
ensures accurate representation and allocation of earnings between the
controlling parent company and minority shareholders in subsidiaries.

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What are different presentation formats for income statement?
The single-step and multi-step presentation formats are two common ways to
present an income statement, each offering a different level of detail and
organization for reporting a company's financial performance.
Single-Step Income Statement:
The single-step income statement is a simplified format that presents all
revenues and gains together and all expenses and losses together,
without categorizing them into multiple sections. It provides a
straightforward view of a company's profitability by subtracting total
expenses and losses from total revenues and gains in a single step.
The single-step format is often used by small businesses and for internal
reporting because it provides a concise overview of the company's
overall profitability. However, it may lack the detailed breakdown
needed for in-depth analysis.

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Multi-Step Income Statement:
The multi-step income statement is a more detailed and structured
format that categorizes revenues and expenses into multiple sections,
providing a clearer picture of a company's financial performance. It
breaks down the calculation of net income into several steps, making it
easier to assess various aspects of profitability.
The multi-step format provides a more comprehensive view of a
company's financial performance, making it suitable for external
financial reporting and analysis. It helps stakeholders assess various
aspects of profitability and understand the factors that contribute to a
company's net income.

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What is the revenue recognition procedure?
Both the International Financial Reporting Standards (IFRS) and the Generally
Accepted Accounting Principles (GAAP) in the United States have converged
their revenue recognition standards to create a consistent framework. The five-
step process for recognizing revenue under both IFRS and US GAAP is outlined
in the IFRS 15 (IFRS) and ASC 606 (US GAAP) standards. Here are the five
steps:
Identify the Contract with the Customer:
In this step, a company determines whether a contract with a customer
exists. A contract is an agreement that creates enforceable rights and
obligations between the parties involved.
Key considerations include identifying parties to the contract, the
contract's terms, payment terms, and whether both parties have
approved and committed to fulfilling their obligations.
Identify the Performance Obligations:
A performance obligation is a promise to transfer a distinct good or
service to the customer. Companies need to identify all the separate
performance obligations within the contract.
A performance obligation is considered distinct if the customer can
benefit from it on its own or together with other readily available
resources.
Determine the Transaction Price:
The transaction price is the amount of consideration (payment) that a
company expects to receive in exchange for transferring goods or
services to the customer.
Companies consider variable consideration, time value of money, non-
cash consideration, and other factors that may affect the transaction
price.
Allocate the Transaction Price to Performance Obligations:
If a contract has multiple performance obligations, the transaction price
is allocated to each obligation based on its standalone selling price.

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 Standalone selling price is what the company would charge for each
performance obligation if sold separately to a customer.
Recognize Revenue When or As Performance Obligations are
Satisfied:
Revenue is recognized when a company satisfies a performance
obligation by transferring control of the promised goods or services to
the customer.
Control is typically transferred over time as the customer receives and
consumes the goods or services, or at a specific point in time when
control is relinquished.
Any unearned revenue (deferred revenue) represents a liability until the
performance obligations are satisfied.

What is expense recognition?

As per The International Accounting Standards Board (IASB), "expenses are
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."
Under the accrual method of accounting, expense recognition is based on the
matching principle which states that expenses should be recognized in the
income statement in the same period in which they contribute to generating
revenue. In other words, expenses should be "matched" to the revenue they help
generate. This principle is essential for providing a more accurate depiction of a
company's profitability and financial performance over time.
The matching principle guides accountants to record expenses when they are
incurred, regardless of when the cash is paid. This means that even if a company
hasn't actually paid for a particular expense yet (e.g., through a bill or invoice), it
should still be recorded as an expense in the financial statements if it is
associated with revenue earned during that accounting period.
The IASB's definition of an expense aligns with the matching principle by
emphasizing that expenses should be recognized when economic benefits are
consumed or when obligations are incurred.

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What are product costs and period costs?
Product costs and period costs are two categories of costs in accounting, and
they differ in terms of when they are recognized and how they are treated on the
income statement.
Product Costs:
Definition: Product costs, also known as inventoriable costs, are expenses
associated with the production of goods. These costs are directly tied to the
manufacturing or acquisition of products that a company intends to sell.
Common examples include raw materials, labor, and manufacturing
overhead.
Recognition: Product costs are recognized as assets (inventories) on the
balance sheet until the products are sold. When products are sold, their
associated product costs are transferred to the income statement as part of
the cost of goods sold (COGS).
Matching Principle: For product costs, the matching principle is applied
when the products are sold. At that point, the accumulated product costs are
matched against the revenue generated from selling those products. This
ensures that the expenses incurred to produce or purchase the products are
matched with the revenue earned from selling them, resulting in the
calculation of gross profit.
Period Costs:
Definition: Period costs, also known as operating expenses or non-
manufacturing costs, are expenses that are not directly tied to the
production of goods. Instead, they are incurred to support a company's
overall business operations during a specific accounting period. Examples
include salaries, rent, utilities, marketing expenses, and administrative costs.
Recognition: Period costs are expensed on the income statement in the
accounting period in which they are incurred. They are not capitalized as
assets on the balance sheet because they do not contribute to the production
of specific products.
Matching Principle: For period costs, the matching principle is applied in
the period in which the costs are incurred.

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This means that expenses like salaries or rent are recognized as expenses on the
income statement in the same accounting period in which they are paid or
otherwise become due. They are matched with the revenue generated during
that period to determine the company's net income.

"Product costs are the costs of creating

tomorrow's value, while period costs are the
price of today's operations."

"Product costs are the seeds of future revenue,

while period costs are the water and sunlight
nurturing the present."

What are the rules regrading inventory expense recognition?

Inventory valuation is initially performed (often periodically) in order to identify
what cost needs to be allocated to it for its recognition. Typically there are four
primary inventory valuation methods as following:
First-In, First-Out (FIFO):
Description: FIFO assumes that the first items added to inventory are the
first to be sold. In other words, the cost of the earliest acquired items is
assigned to the cost of goods sold (COGS), while the cost of the most recent
purchases remains in ending inventory.
Example: Let's say a company buys 100 widgets at $10 each, then later
buys 200 more widgets at $12 each. When 150 widgets are sold, under
FIFO, the COGS would be calculated as (100 * $10) + (50 * $12) = $1,000 +
$600 = $1,600.
Industries: FIFO is commonly used in industries where products have a
short shelf life, such as the food and beverage industry.

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Last-In, First-Out (LIFO):
Description: LIFO assumes that the most recently acquired items are the
first to be sold. This method assigns the cost of the most recent purchases to
COGS, while the older costs remain in ending inventory.
Example: Using the same widget example, under LIFO, the COGS for the
first 150 widgets sold would be (150 * $12) = $1,800.
Industries: LIFO is more common in industries where prices tend to rise
over time, such as the oil and petroleum industry. However, it's important to
note that LIFO is prohibited under both IFRS and US GAAP since it doesn't
reflect the actual flow of inventory.
Weighted Average Cost:
Description: This method takes the average cost of all units available for
sale during a specific period and assigns it to both COGS and ending
inventory. It is calculated by dividing the total cost of goods available for sale
by the total number of units available for sale.
Example: If a company has 100 widgets at $10 each and 200 widgets at
$12 each, the weighted average cost per widget would be [(100 * $10) +
(200 * $12)] / (100 + 200) = ($1,000 + $2,400) / 300 = $3,400 / 300 =
$11.33 per widget.
Industries: Weighted average cost is commonly used in industries where
prices are relatively stable, such as manufacturing.
Specific Identification:
Description: Under this method, the actual cost of each individual item is
used to determine COGS and ending inventory. It's often used for high-
value, unique, or easily distinguishable items.
Example: In an art gallery, where each piece of art has a unique value,
specific identification would involve tracking the cost of each artwork
individually.
Industries: Specific identification is typically used in industries where items
are not interchangeable and have distinct values, such as art, antiques, and
customized manufacturing.

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Regarding the permissibility of these methods under IFRS and US GAAP:

IFRS allows US GAAP allows

FIFO LIFO

Weighted Average FIFO

Specific Weighted Average

Identification

Specific
Identification

What are the rules regarding depreciation expense recognition?

Under both IFRS and US GAAP, the basic rules for recognizing depreciation
expense involve allocating the cost of a tangible asset (e.g., property, plant, and
equipment) over its useful life to match the expense with the revenue it helps
generate. Here are some key points:
Useful Life: The estimated useful life of the asset is determined, which
represents the period over which it's expected to provide economic benefits
to the entity.
Residual Value: The asset's estimated residual value (its value at the end
of its useful life) is considered when calculating depreciation.
Depreciation Method: A depreciation method is chosen to allocate the
asset's cost over its useful life. Common methods include the straight-line
method, declining balance method, double declining balance method, and
units of production method.
The allocation of cost over an asset’s useful life is known as depreciation for
tangible assets, depletion for natural resources, and amortization for intangible
assets.

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Is goodwill an exception to amortization?
Goodwill is an exception to amortization in accounting because it is not
amortized systematically over a set period of time like most other intangible
assets. Instead, goodwill is subject to an annual impairment test under both
IFRS and US GAAP. Here's how goodwill is treated and what happens if it's not
amortized:
Goodwill and Amortization:
Goodwill is an intangible asset that represents the excess of the purchase
price of a business (or a subsidiary) over the fair value of its identifiable net
assets at the time of acquisition.
Unlike most intangible assets, which are typically amortized (i.e., expensed
gradually over their useful lives), goodwill is not amortized under IFRS or
US GAAP. Instead, it remains on the balance sheet at its original cost.
Impairment Testing:
Goodwill is subject to an annual impairment test. This means that the
carrying amount of goodwill (the amount recorded on the balance sheet) is
assessed each year to determine if it exceeds its recoverable amount.
The recoverable amount of goodwill is the higher of its fair value less costs to
sell and its value in use. If the carrying amount of goodwill exceeds its
recoverable amount, an impairment loss is recognized.
Impairment Loss and Goodwill Write-down:
If the impairment test reveals that the carrying amount of goodwill is greater
than its recoverable amount, the excess is written off as an impairment loss.
The impairment loss reduces the carrying amount of goodwill on the balance
sheet, which reflects the revised, lower value of the goodwill.
Disclosure:
If an impairment loss is recognized, it is typically reported in the income
statement as an expense.
Companies are also required to disclose the details of the impairment,
including the amount, the reasons for the impairment, and the method used
to determine the recoverable amount.

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What are the rules regarding bad debt & warranty expense
recognition?
Bad Debt Expense Recognition:
Bad debt expense recognition pertains to accounting for accounts receivable that
are unlikely to be collected from customers. This is important for companies that
extend credit to customers, as they need to account for the possibility of not
receiving full payment for goods or services. The two primary methods for
recognizing bad debt expense are the Direct Write-Off Method and the
Allowance for Doubtful Accounts Method.
Direct Write-Off Method:
Description: Under this method, bad debt expense is recognized only
when a specific account is deemed uncollectible. This occurs when the
company determines that a particular customer or invoice is unlikely to
be paid.
Example: If a company has a $1,000 accounts receivable from a
customer who declares bankruptcy and it is clear that the amount will
not be collected, the company writes off the $1,000 as a bad debt
expense.
Applicability: The direct write-off method is typically used by small
businesses and is not in accordance with Generally Accepted Accounting
Principles (GAAP) for larger entities, as it does not match expenses with
revenues.
Allowance for Doubtful Accounts Method (Provision for Doubtful
Debts):
Description: Under this method, a company estimates the portion of
its accounts receivable that is expected to be uncollectible and records it
as a bad debt expense in advance, rather than waiting for specific
accounts to be deemed uncollectible.
Example: If a company estimates that 2% of its total accounts
receivable of $100,000 will be uncollectible, it records a bad debt
expense of $2,000 (2% of $100,000) by creating an allowance for
doubtful accounts (contra-asset account).

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 Applicability: The allowance method is in accordance with GAAP and
is considered a more conservative and accurate way to match expenses
with revenues.
Warranty Expense Recognition:
Warranty expense recognition involves accounting for potential warranty claims
on products sold. When a company sells a product with a warranty, it needs to
recognize an estimated warranty expense based on the expected costs of
providing warranty service. The two main methods for recognizing warranty
expense are the Expense Warranty Method and the Accrual Warranty Method.
Expense Warranty Method:
Description: Under this method, companies recognize warranty
expenses as they are incurred. In other words, when a warranty claim is
made and service or repairs are provided, the cost is expensed at that
point.
Example: If a company incurs $500 in warranty repair costs for a
product during a particular month, it recognizes a warranty expense of
$500 in that month.
Applicability: The expense warranty method is simple but may not
accurately match expenses with the revenue generated from product
sales.
Accrual Warranty Method:
Description: The accrual warranty method involves estimating the
future warranty expenses when products are sold and recognizing those
estimated expenses at the time of sale. This creates a liability called the
"warranty liability" or "unearned warranty revenue."
Example: If a company estimates that it will incur $10,000 in warranty
expenses for products sold during the year, it recognizes a warranty
expense of $10,000 and creates a corresponding warranty liability
account at the time of sale.
Applicability: The accrual warranty method is more accurate for
matching expenses with revenue and is typically preferred under
Generally Accepted Accounting Principles (GAAP).

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What are non-recurring items and its rules regarding
accounting?
Non-recurring items on an income statement are financial events or transactions
that are not expected to recur regularly or frequently in a company's ongoing
operations. These items are typically considered unusual or infrequent and may
distort the true picture of a company's core operating performance. Accounting
standards require companies to separately disclose non-recurring items on their
income statements to provide investors and analysts with a clearer
understanding of the company's underlying financial performance.
Two main categories of non-recurring items are:
(i) Discontinued Operations:
Description: Discontinued operations refer to a component of a company's
business that has been sold, abandoned, or is being held for sale. It
represents a significant shift in the company's ongoing operations and
financial structure.
Accounting Rules (IFRS and US GAAP):
When a component qualifies as discontinued operations, its results are
reported separately on the income statement, including the gain or loss
from the sale or disposal.
The income statement should show the operating results of the
discontinued component for the current period and prior periods for
comparison purposes.
Any gain or loss from the disposal of the discontinued component is also
reported separately.
Tax effects related to discontinued operations are disclosed separately as
well.
(ii) Unusual or Infrequent Items:
Description: Unusual or infrequent items are events or transactions that
are not expected to occur regularly within the normal course of business.
They are typically significant in nature and may include items such as
restructuring costs, asset impairments, or gains or losses from events like
natural disasters.

14 | CFA L1 NOTES
 Accounting Rules (IFRS and US GAAP):
Unusual or infrequent items are disclosed separately on the income
statement to highlight their non-recurring nature.
They are typically reported below the line, after operating income and
before income tax, to clearly distinguish them from normal operating
results.
Companies are required to provide additional information in the
financial statements or footnotes to explain the nature and financial
impact of these items.

What are changes in accounting policies and estimates?

Changes in accounting policies and estimates are adjustments made by a
company to its accounting methods, principles, or estimates used in preparing
its financial statements. These changes can arise due to various reasons,
including updates in accounting standards, new information, or changes in
business circumstances. It's essential to distinguish between changes in
accounting policies and changes in accounting estimates:
Changes in Accounting Policies:
These are changes in the specific accounting principles, methods, or
rules applied by a company in the preparation of its financial statements.
A change in accounting policy involves adopting a different accounting
method for a particular transaction or type of event.
For example, a company may change from the FIFO (First-In, First-Out)
method of inventory valuation to the LIFO (Last-In, First-Out) method.
Changes in Accounting Estimates:
These are revisions to the estimated amounts used in recognizing certain
assets, liabilities, revenues, or expenses in the financial statements.
Changes in estimates do not involve a change in accounting principles or
policies.
For example, a company may revise its estimate of the useful life of a
piece of equipment, which affects the calculation of depreciation
expense.

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The treatment of changes in accounting policies and estimates depends on
whether they are applied prospectively or retrospectively:
Prospective Application:
When a change in accounting policy or estimate is applied prospectively,
it means that the change is applied to current and future transactions
and does not require restatement of prior periods.
Retrospective Application:
When a change in accounting policy or estimate is applied
retrospectively, it means that the change is applied to prior periods as if
the new policy or estimate had always been in effect. This approach
requires restating the financial statements of prior periods.
The choice between prospective and retrospective application depends on
accounting standards, regulations, and the nature of the change. However, as
per current norms, changes in accounting policies, standards and
errors have retrospective application, while changes in accounting
estimates have prospective application.

What is earnings per share (EPS) and its importance?

Earnings Per Share (EPS) is a financial metric that measures the portion of a
company's profit or earnings attributable to each outstanding share of common
stock. It is a key indicator of a company's profitability and is widely used to
assess a company's financial performance and profitability on a per-share basis.
The classification of a company's capital structure as simple or complex depends
on the composition of its outstanding securities, particularly with regard to
potential common stock equivalents (e.g., stock options, convertible securities).
This needs to be understood for analysing two categories of EPS.
Simple Capital Structure:
A company has a simple capital structure when it has no potentially
dilutive securities outstanding, or if it has only common shares and non-
convertible preferred shares.
In a simple capital structure, there are no securities that could
potentially dilute the EPS.

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 Complex Capital Structure:
A company has a complex capital structure when it has potentially
dilutive securities outstanding. These potentially dilutive securities can
include stock options, convertible bonds, convertible preferred shares,
and other instruments that, if exercised or converted, could result in the
issuance of additional common shares.
In a complex capital structure, diluted EPS is calculated to account for
the potential dilution from these securities.
The distinction between simple and complex capital structures is important for
the calculation of diluted EPS, as it determines whether potentially dilutive
securities should be factored into the EPS calculation. Companies with complex
capital structures are required to report both basic and diluted EPS in their
financial statements to provide a more comprehensive view of earnings per
share, considering the potential impact of convertible or exercisable securities.

What are dilutive and anti-dilutive securities?

Dilutive Securities: Dilutive securities are financial instruments or securities,
such as stock options, convertible bonds, or convertible preferred stock, that
have the potential to decrease, or dilute, the earnings per share (EPS) of
common stock when they are converted, exercised, or otherwise converted into
common shares.
In other words, if these securities are converted or exercised, they may increase
the number of outstanding common shares, which could reduce EPS. Dilutive
securities are typically considered when calculating diluted EPS, and their
potential impact on EPS is factored in.
Anti-Dilutive Securities: Anti-dilutive securities, on the other hand, are
securities that, when converted, exercised, or otherwise converted into common
shares, would not decrease the earnings per share (EPS) of common stock. In
fact, they may have the opposite effect of increasing EPS.
Anti-dilutive securities are not considered when calculating diluted EPS because
they would not result in a reduction in EPS. These securities do not pose a threat
to the existing shareholders' interests and are often ignored in the EPS
calculation.

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What is basic EPS & diluted EPS?
Basic EPS is a simple calculation of earnings per share based on common shares
outstanding, while diluted EPS considers the potential dilution from convertible
securities and other potentially dilutive instruments that could increase the
number of common shares outstanding.

Basic EPS

Net Income Preferred Dividends

Weighted Avg. Number of Shares Outstanding

Diluted EPS

Convertible Convertible
Net Preferred
Preferred Debt (1 - t)
Income Dividends
Dividends Interest

Weighted Converted Converted Shares issued

Avg. shares from shares from from Stock
Shares C.Pref.Shares C.Debt Options

Analysts often pay close attention to diluted EPS because it provides a more
conservative estimate of a company's earnings per share, which is important for
assessing the potential impact on existing common shareholders when all
convertible securities are exercised or converted. It helps investors understand
the worst-case scenario in terms of earnings dilution. Thus, It's essential to
consider both basic and diluted EPS figures to gain a comprehensive
understanding of a company's earnings potential and the potential risks
associated with dilution.

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What is a common-size income statement analysis?
A vertical common-size income statement and a horizontal common-
size income statement are two different financial analysis tools that help
investors and analysts assess a company's financial performance in different
ways. They both involve expressing financial data as percentages, making it
easier to compare different companies or track changes over time.
Vertical Common-Size Income Statement:
Definition: A vertical common-size income statement expresses each line
item of the income statement as a percentage of total revenue (sales). In this
analysis, the total revenue is set as the base (100%), and all other line items
are represented as a proportion of that revenue.
Purpose: It helps assess the composition of a company's income statement
by showing the relative size of various expenses and income components
compared to total revenue. This analysis is useful for understanding the cost
structure and profit margins of a company.
Information Provided:
It highlights the percentage of revenue allocated to different expense
categories such as cost of goods sold (COGS), operating expenses,
interest, and taxes.
It reveals the proportion of revenue that contributes to net income,
indicating a company's profitability.
It allows for easy comparison of income statements across different
periods or with competitors, as it normalizes the data relative to
revenue.
Example: If a company has a cost of goods sold (COGS) of $50 million and
total revenue of $100 million, the vertical common-size income statement
would show COGS as 50% (50 million / 100 million) of revenue.

"A vertical common-size income statement is

like a fun mirror—it stretches everything to
show you which items are doing the limbo and
which ones are reaching for the stars."

19 | CFA L1 NOTES
Horizontal Common-Size Income Statement:
Definition: A horizontal common-size income statement expresses each
line item for a specific period (usually years) as a percentage of that period's
total revenue. Unlike the vertical analysis, which focuses on a single period's
income statement, the horizontal analysis looks at how each line item
changes as a percentage of revenue over several periods.
Purpose: It helps analyze the trend and growth patterns of various income
statement components over time. This analysis is valuable for identifying
significant changes in expense categories, revenue, or profitability ratios.
Information Provided:
It shows how the composition of an income statement has evolved over
time, indicating whether certain expenses or income sources are
increasing or decreasing in importance relative to revenue.
It identifies trends in key financial metrics like gross margin, operating
margin, and net profit margin.
It helps evaluate the effectiveness of a company's cost control measures
or revenue growth strategies over multiple periods.
Example: If a company's research and development expenses were 8% of
revenue in year 1, 10% in year 2, and 12% in year 3, the horizontal common-
size income statement would show the trend of increasing R&D expenses
relative to revenue.

“Horizontal common-size income statement is

like a time machine, looking at the past to see
which items are hitting the gym, bulking up, or
maybe even going on a diet over the years."

In summary, a vertical common-size income statement provides insights into

the composition of an income statement for a specific period, while a horizontal
common-size income statement tracks changes in income statement
components over time.

20 | CFA L1 NOTES
What is meant by other comprehensive income (OCI)?
Other Comprehensive Income (OCI) is a component of a company's financial
statements that includes certain gains and losses that are not part of the
traditional net income or profit and loss statement. OCI represents items that
bypass the income statement initially but might be recognized in the income
statement in the future. OCI is reported in the statement of comprehensive
income, which is often presented alongside the income statement or as a
separate financial statement.
Four main transactions that can be included in Other Comprehensive Income:
Unrealized Gains/Losses on Available-for-Sale Securities: When a
company holds investments in stocks, bonds, or other securities classified as
"available-for-sale," the changes in the fair value of these investments are
initially recognized in OCI. These unrealized gains and losses are not part of
the net income until the investments are sold.
Foreign Currency Translation Adjustments: If a company operates
internationally and has subsidiaries in different currencies, it may
experience fluctuations in the exchange rates between these currencies. The
translation adjustments resulting from converting the financial statements
of foreign subsidiaries from their functional currency to the reporting
currency are reported in OCI.
Pension and Post-Employment Benefit Adjustments: Companies
that offer defined benefit pension plans or other post-employment benefit
plans may experience actuarial gains or losses. These gains and losses, as
well as changes in the fair value of plan assets, are recognized in OCI and can
impact the funded status of the plans.
Cash Flow Hedges: Companies use derivatives like futures or options to
hedge against changes in interest rates, commodity prices, or foreign
exchange rates. Gains or losses on effective cash flow hedges are initially
recorded in OCI until the underlying transactions being hedged impact the
income statement.
These items may eventually be reclassified to the income statement when certain
conditions or events are met, or they may remain in OCI indefinitely, depending
on accounting standards and regulations.

21 | CFA L1 NOTES
CFA L1 Notes

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Published: October 2023