UNDERSTANDING INCOME

STATEMENTS

BINUS FINANCIAL ANALYST ACADEMY

CFA Preparation Program Level 1 Batch 24

2013 FA Level 1 Financial Statement Analysis 3

I. Income Statement

This financial statement is intended to provide

information related to the results of an entity's
operations for a specific time period; typically a year,
quarter, or month.
It is more formally known as the Statement of
LOS:
Describe the components of the income
Earnings
statement and construct an income statement using
the alternative presentation formats of that statement.

ACCRUAL BASIS OF ACCOUNTING

Los: discuss the general principles of expense recognition,
such as the matching principle, specific expense recognition
applications and the implications of expense recognition
principles for financial analysis
What is Accrual Accounting? What is Matching Principle?
The revenue recognition and matching principles are used
under the accrual basis of accounting.
Under cash-basis accounting, revenue is recorded only when
cash is received, and expenses are recorded only when paid.
Generally accepted accounting principles require accrual
basis accounting because the cash basis often causes
misleading financial statements.

 Accounting
income:
is
governed
by
generally accepted accounting principles
(GAAP / PSAK)
Under the accrual concept, revenue is
recognized when the earnings process is
completed and ultimate realization (cash
receipt) is assured
The matching concept mandates that the
cost of goods and service used is recognized
as an expense in the same period that its
generated revenue is recognized
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 Problem: timing of revenues and expense

recognition is subject to management. It

requires estimation and judgment;
Income computed using accrual concept
generally provides better forward looking
information than pure cash flow

Income Statement
LOS: Describe the components of the income statement and
construct an income statement using the alternative presentation
formats of that statement.

The net income equation is:

revenue expenses = net income
Revenue are the amounts reported from the sale of
goods and services in the normal course of business.
Expenses are the amounts incurred to generate
revenue and include cost of goods sold, operating
expenses, interest, and taxes. Expenses are grouped
together by the nature or function.

Revenue Recognition
LOS: explain the general principles of revenue recognition and accrual
accounting. Demonstrate specific revenue recognition applications and
discuss the implications of revenue recognition principles for financial
analysis.

According to the Financial Accounting Standards Board (FASB),

revenue is recognized in the income statement when (a) realized
or realizable and (b) earned. The Securities and Exchange
Commision (SEC) provides additional guidance by listing four
criteria to determine whether revenue should be recognized.
1. There is evidence of an arrangement between the
buyer and seller.
2. The product has been delivered or the service has
been rendered.
3. The price is determine or determinable.
4. The seller is reasonably sure of collecting money.

If a firm receives cash before revenue recognition is complete,

the firm reports it as unearned revenue. Unearned revenue is
reported on the balance sheet as a liability.

Income Statement Format

Line

Operating income from continuing operations is generally considered

to be the best indicators of future earnings

Specific Revenue Recognition

Applications

The percentage-of-completion method and completed contract

method are used for contracts related to construction projects.

The percentage-of-completion method is appropriate when

the projects cost and revenue can be reliably estimated.
Accordingly, revenue, expense and therefore profit, are recognized
as the work is performed. The percentage-of-completion is
measured by the total cost incurred to date divided by the total
expected ost of the project.

The completed-contract method is used when the outcome of

a project cannot be reliably measured or the project is short-term.
Accordingly revenue, expense and therefore profit, are recognized
only when the contract is complete. Under either method, if a loss
is expected, the loss must be recognized immediately.

Under International Financial Reporting Standards (IFRS), if the

firm cannot reliably measure the outcome of the project, revenue
is recognized to the extent of contract costs, costs are expensed
when incurred, and profit is recognized only at completion.
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Comparison between percentage of

completion and completed contract
Assume that AAA Construction has a contract to build a
ship for $1,000 while a reliable estimate of the contracts
total cost is $800. The project has the following end-year
billings and cost realization patterns:
2007 2008 2009 Total
Cost incurred
400 300
100
800

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Income Statement Percentage of Completion

2007

2008

2009

Total

Sales

500

375

125

1,000

Costs

400

300

100

800

% of
completion

50%

87.5%

100%

100%

Profit

100

75

25

200

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Income Statement Completed Contract

2007

2008

2009

Total

Sales

1,000

1,000

Expense

800

800

CIP

400

300

100

800

Profit

200

200

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Installment Sales

An installment sale occurs when a firm finances a sale and

payment are expected to be received over an extended
period. (i) If collectibility is certain, revenue is recognized at
the time of sale using the normal revenue recognition
criteria. (ii) If collectability cannot be reasonably estimated,
the installment method is used. If collectability is highly
uncertain, the cost recovery method is used.

Under the installment method, profit is recognized as

cash is collected. Profit is equal to the cash collected during
the period multiplied by the total expected profit as a
percentage of sales. The installment method is used in
limited circumstances, usually involving the sale of real
estate or other firm assets.

Under the cost recovery method, profit is recognized only

when cash collected exceeds costs incurred.
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Installment Sales
Assume a piece of land is sold at $1,000. Cost of land is

US$800. Collections received are $400, $400 and $200 for

2007, 2008 and 2009, respectively.

2007

2008

2009

Total

400

400

200

1,000

Expense (80% 320

of collection)

320

160

800

Profit (20% of 80
collection)

80

40

200

Collections

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Gross & Net Reporting of Revenues

Gross Revenue Reporting: reports sales and costs separately
Net revenue reporting: only the differences in sales and cost is
reported

Gross

Gross

Revenue

1,000

Costs

800

Profit

200

Net

Net

Revenue

200

Implications for financial analysis:

How conservative are the firms revenue recognition
policies
The extent to which the firms policies rely on judgment
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and estimates

Depreciation
Los: demonstrate the depreciation of long term
assets using each approved method.

Straight line depreciation allocates an equal amount of

depreciation each year over the assets useful life as
follows:
Cost Residual value
SL depreciation expense = ---------------------------------Useful life

Accelerated depreciation speeds up the recognition of

depreciation expense in a systematic way to recognize
more depreciation expense in the early years of the
assets useful life and less depreciation expense in the
later years of its life. Total depreciation expense over the
life of the asset will be the same as it would be if straightline depreciation were used.

The declining balance method (DB) applies a constant

rate of depreciation to a declining book value.
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Inventory Accounting
Methods

Los: demonstrate the depreciation of inventory using each

approved method.
Three methods of inventory accounting are :
1. First In, First Out ( FIFO)
- The cost of inventory first acquired ( beginning inventory and early
purchases ) is assigned to the cost of goods sold for the period.
- The cost of the most recent purchases is assigned to ending inventory.
2. Last In, First Out (LIFO)
- The cost of inventory most recently purchase is assigned to the cost of
goods sold for the period.
- The cost of beginning inventory is assigned to ending inventory.
3. Average cost
- The cost per unit is calculated by dividing cost of goods available by total
units available.
- This average cost is used to determine both cost of good sold and ending
inventory.
- Average cost results in cost of goods sold and ending inventory values
between LIFO and FIFO.
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Inventory Accounting
Methods
Assumption

COGS consists
of items ..

Ending
inventory
consists of

FIFO

Items first
purchased are
items first sold

First purchased

Most recent
purchases

LIFO

Items last
purchased are
items first sold

Last purchased

Earliest
purchases

Average

Items sold are a

mix of
purchases

Average cost of
all items

Average costs of
all items

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Other Items
Discontinued operations.
A discontinued operations is one that management has decided to dispose of,
but either has not yet done so, or has disposed of in the urrent year after the
operation had generated income or losses. To be accounted for as a
discontinued operation, the bussiness-in terms of assets, operations and
investing and financing activities-must be physically and operationally distinct
from the rest of the firm.
Unusual or infrequent items.
These events are either unusual in nature or infrequent in ocurence, but not
both. Examples of unusual or infrequent items include :
- Gains or losses from the sale of assets or part of bussiness.
- Impairent, write-offs, write-downs, and restructuring costs.
Extraordinary items.
Under U.S. GAAP, an extraordinary item is a material transaction or event
that is both unusual and infrequent in occurence. Examples of these include :
- Losses from an expropriation of assets.
- Gains or losses from early retirement of debt (when it is judged to be).
- Uninsured losses from natural disaters that are both unusual and infrequent.

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Changes in Accounting
Principles
This occurs when a company changes from one

acceptable accounting method to another.

Changes in inventory method. Example: change from

the FIFO inventory method to the LIFO method.

Changes in depreciation method
Changes in revenue recognition method

Sometimes these changes are voluntary for the

company, but sometimes they are forced by a

change in the accounting requirements.
A new FASB Statement often results in this type
of a required change.

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