MSc.

Thuy Tien Dinh | Faculty of Banking and Finance

Email: tiendt@ftu.edu.vn
CONTENT
v Components of the income statement
v Principles of revenue recognition
v Principles of expense recognition
v Non-recurring and non-operating items
v Earning per share (EPS)
COMPONENTS OF THE INCOME STATEMENT
v The income statement reports the revenues and expenses of the firm over a period of
time.

v The income statement equation:

Net
Revenue Expense
Income

v Investors examine a firm’s income statement for valuation purposes while lenders
examine the income statement for information about the firm’s ability to make the
promised interest and principle payments on its debt.
COMPONENTS OF THE INCOME STATEMENT
v Revenues (sales, turnover): Amounts reported from the sale of goods and services in the normal

course of business.

v Net revenue: Revenue less adjustments for estimated returns and allowances (e.g. for estimated

returns or for amount unlikely to be collected).

v Expenses: Amounts incurred to generate revenue and include cost of goods sold, operating

expenses, interest and taxes. Expenses can be grouped by nature or function.

v Gains and losses: assets inflows and outflows not directly related to the ordinary activities of the

business.

Ø For example, a company sell surplus land, the cost of land is subtracted from the sales price

and the net result is reported as a gain or a loss.

COMPONENTS OF THE INCOME STATEMENT
v Gross profit: the amount that remains after the direct costs of producing a product or service are

subtracted from revenue.

v Operating profit: gross profit minus operating expense (selling, general and administrative

expenses)

v Net profit (net income, earning, bottom line): operating profit minus interest expense and

income taxes

v Minority owners’ interest: the pro-rata share of the subsidiary’s income for the portion of the

subsidiary that the firm does not own.

Ø Notes: In Vietnam, interest expense is classified as operating expense and therefore operating

profit is equal to gross profit minus S&A expense and interest expense.
COMPONENTS OF THE INCOME STATEMENT
PRINCIPLES OF REVENUE RECOGNITION
v 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

vA fundamental principle of accrual accounting is that revenue is recognized (reported on the

income statement) in the period in which it is earned.

v Consequently, firms can manipulate net income by recognizing revenue earlier or later, or by

delaying or accelerating the recognition of expense.

PRINCIPLES OF REVENUE RECOGNITION

VAS, IFRS SEC

Seller has transferred most of risks and benefits There is evidence of an arrangement between the
associated with ownership of goods to buyer buyer and seller
Seller has no longer had management right of good The product has been delivered or the service has
management as owner or control right of goods. been rendered
Revenue is recognized reliably The price is determined or determinable
Seller has earned or will earn future economic The seller is reasonably sure of collecting money
benefits
Related expenses can be measured
Completed work can be measured on the date of
establishing the balance sheet (for service)
REVENUE RECOGNITION APPLICATIONS
v Long-term contracts: are contracts that may span a number of accounting periods (e.g.,
a construction contract). Such contracts raise issues in determining when the earnings
process has been completed and revenue recognition should occur.
§ Percentage-of-completion method: Use when the outcome of a contract can be
measured reliably.
ü Revenue is recognised based on the stage of completion of a transaction or
contract and is thus recognised when the services are rendered, then company
reports percentage of the total contract revenue in its income statement.
ü Contract costs for the period are expensed against the revenue. Therefore, net
income or profit is reported each year as work is performed.
ü The percentage of completion is measured by the total cost incurred to date
divided by the total expected cost of the project.
REVENUE RECOGNITION APPLICATIONS
v Long-term contracts - Percentage-of-completion method

Example: Builder Co.’s contract with Customer Co. to construct the commercial
building specifies consideration of $5,000,000. Builder Co.’s expected total costs to
complete are $4,000,000. The Builder incurs $3,000,000 in costs in the first year.
Assuming that costs incurred provide an appropriate measure of progress toward
completing the contract, how much revenue and costs should Builder Co. recognize for
the first year?

Suppose that on the second year, job is completed with costs of $1,250,000 (a cost
overrun). how much revenue and costs should Builder Co. recognize for this year?
REVENUE RECOGNITION APPLICATIONS
v Long-term contracts: are contracts that may span a number of accounting periods (e.g.,
a construction contract). Such contracts raise issues in determining when the earnings
process has been completed and revenue recognition should occur.
§ Completed contract method: use when the outcome of a contract cannot be
measured reliably.
ü US GAAP: Revenue, expense and profit are recognised only when the contract
is complete. If a loss is expected, the loss must be recognised immediately.
ü IFRS: Revenue is recognised to the extent of contract costs, cost are expensed
when incurred and profit is recognised only at completion.
REVENUE RECOGNITION APPLICATIONS
v Long-term contracts - Completed contract method
Example: 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.
How much revenue, expense (cost of construction), and income would the company
recognize each year under the completed contract method?
REVENUE RECOGNITION APPLICATIONS
v Installment sales: A firm finances a sales and payments are expected to be received over
an extended period
Ø If collectability is certain, revenue is recognised at the time of sale using the normal
revenue recognition criteria.
Ø Otherwise:
§ Installment method: use when collectability cannot be reasonably estimated.
ü The portion of the total profit of the sale that is recognised in each period is
determined by the percentage of the total sales price for which the seller has
received cash.
§ Cost recovery method: use when collectability is highly uncertain
ü 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.
REVENUE RECOGNITION APPLICATIONS
v Installment sales
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
(a) the installment method is used?
(b) the cost recovery method is used?
PRINCIPLES OF EXPENSE RECOGNITION
v Fundamental principle: A company recognizes expenses in the period in which it consumes

(i.e., uses up) the economic benefits associated with the expenditure.

v Matching principle: Costs are matched with revenues.

v As with revenue recognition, expense recognition can occur independently of cash

movements.

§ Inventory and cost of goods sold

§ Plant, property, and equipment and depreciation

PRINCIPLES OF EXPENSE RECOGNITION
v Doubtful Account

§ When a company sells its products or services on credit, it is likely that some
customers will ultimately default on their obligations (i.e., fail to pay).
§ Under the matching principle, at the time revenue is recognized on a sale, a
company is required to record an estimate of how much of the revenue will
ultimately be uncollectible.
§ Companies make such estimates based on previous experience with uncollectible
accounts. Such estimates may be expressed as a proportion of the overall amount of
sales, the overall amount of receivables, or the amount of receivables overdue by a
specific amount of time. The company records its estimate of uncollectible amounts
as an expense on the income statement, not as a direct reduction of revenues.
PRINCIPLES OF EXPENSE RECOGNITION
v Warranties

§ At times, companies offer warranties on the products they sell. If the product proves
deficient in some respect that is covered under the terms of the warranty, the company
will incur an expense to repair or replace the product. At the time of sale, the company
does not know the amount of future expenses it will incur in connection with its
warranties.

§ Under the matching principle, a company is required to estimate the amount of future
expenses resulting from its warranties, to recognize an estimated warranty expense in
the period of the sale, and to update the expense as indicated by experience over the
life of the warranty.
PRINCIPLES OF EXPENSE RECOGNITION
v Depreciation and Amortisation

§ 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
 NONRECURRING ITEMS &
CHANGES IN ACCOUNTING STANDARDS
v Separating nonrecurring from recurring items of income and expense can help an analyst assess
a company’s future earnings.

v Nonrecurring items:

§ discontinued operations

§ extraordinary items (not permitted under IFRS)

§ unusual or infrequent items

v Changes in accounting standards

EARNINGS PER SHARE
v Simple versus Complex Capital Structure
§ When a company has issued any financial instruments that are potentially
convertible into common stock, it is said to have a complex capital
structure.

Ø Examples of financial instruments that are potentially convertible into

common stock include convertible bonds, convertible preferred stock,
employee stock options, and warrants.

§ If a company’s capital structure does not include such potentially

convertible financial instruments, it is said to have a simple capital structure
 EARNINGS PER SHARE
v 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
v If firm has a “complex” capital structure, it will report basic and diluted EPS.
v Basic EPS: Earnings available to common shareholders divided by weighted average
number of shares outstanding
Net income – Preferred dividends
v Basic EPS =
Weighted average number of shares outstanding

Example: For the year ended 31 December 2018, Shopalot Company had net income of
$1,950,000. The company had 1,500,000 shares of common stock outstanding, no
preferred stock, and no convertible financial instruments. What is Shopalot’s basic EPS?
 EARNINGS PER SHARE
v Example:

Calculate
(1) the weighted average number of shares outstanding
(2) the company’s basic EPS
Assume the following:
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 2020
200,000 Shares issued on 1 April 2020
(100,000) Shares repurchased on 1 October 2020
1,100,000 Shares outstanding on 31 December 2020
 EARNINGS PER SHARE
v Effect of stock dividend and stock split:
§ A stock dividend is the distribution of additional shares to each shareholder in an
amount proportional to their current number of shares.
§ A stock split refers to the division of each “old” share into a specific number of
“new” (post-split) shares.
§ Each shareholder’s proportional ownership in the company is unchanged by either of
these events. Each shareholder has more shares but the same percentage of the total
share outstanding.
Example: Assume the same facts as Example 7 except that on 1 December 2018, a
previously declared 2-for-1 stock split took effect. Each shareholder of record receives
two shares in exchange for each current share that he or she owns. What is the
company’s basic EPS?
 EARNINGS PER SHARE
Example: During the past year, R&J Inc. had net income of $100,000, paid dividends
of $50,000 to its preferred stockholders, and paid $30,000 in dividends to its common
shareholders. R&J’s common stock account showed the following:
Time Event Number
01/01 Shares issued and outstanding at the beginning of the year 10,000
01/04 Shares issued 4,000
01/07 10% stock dividend
01/09 Shares repurchased for the treasury 3,000
Compute weighted average number of common shares outstanding during the year,
and compute EPS.
 EARNINGS PER SHARE
2. Diluted EPS
v Dilutive securities are stock options, warrants, convertible debt, or convertible
preferred stock that would decrease EPS if exercised or converted to common stock.
v Antidilutive securities are stock options, warrants, convertible debts, or convertible
preferred stock that would increase EPS if exercised or converted to common stock.
Net income – preferred dividends + convertible preferred dividends
+ convertible debt interest (1-t)
v Diluted EPS =
Weighted average number of shares outstanding + shares from
conversion of convertible preferred shares + shares from conversion
of convertible debt + Shares issuable from stock options
IF-CONVERTED METHOD FOR
CONVERTIBLE PREFERRED STOCK
Example: 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.
IF-CONVERTED METHOD FOR
CONVERTIBLE PREFERRED STOCK
Example: 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
§ No other potentially dilutive securities
§ An effective tax rate is 30%
Calculate the company’s basic and diluted EPS.