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Financial Reporting
and Analysis II
Understanding Income
Statements

LEVEL I
2
Financial Reporting and Analysis II

1. Understanding Income Statements

2. Understanding Balance Sheets
3. Understanding Cash Flow Statements
4. Financial Analysis Techniques
 UNDERSTANDING INCOME STATEMENTS

Components and Format of the Income Statement

Revenue Recognition

Expense Recognition

Non-Recurring Items and Non-Operating Items

Earnings per Share

Analysis of the Income Statement

Comprehensive Income

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 Components and Format of the Income Statement

 The income statement equation is:

Revenue – Expenses = Net Income

 Revenues: are the amounts reported from the sale of goods and services in the normal course of business.
Revenue – adj for estimated returns and allowance = Net Revenue

 Expenses: are the amounts incurred to generate revenue and include cost of goods sold , operating
expenses, interests, and taxes. Expenses can be grouped:
 By nature
 By function

Net Income = Revenues – Ordinary Expenses + Other Income – Other Expenses + Gains – Losses

 Controlling interest
 Non-controlling interest

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 Components and Format of the Income Statement

Presentation Format
 Single Step format
 Multi Step Format Example: Multi Step Income Statement
BHG Company Income Statement
For the year ended December 31, 2007
Revenue $579,312
Cost of goods sold (362,520)
Gross profit 216,792
Selling, general, and administrative expense (109,560)
Depreciation expense (69,008)
Operating profit 38,224
Interest expense (2,462)
Income before tax 35,762
Provision for income taxes (14,305)
Income from continuing operations 21,457
Earning (losses) from discontinued operations, net of tax 1,106
Net income $22,563

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 Revenue Recognition

A. General Principles(IFRS)
 As per IFRS revenue from the sale of goods is to be recognised, when the following conditions are
satisfied:

 the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;

 the entity retains neither continuing managerial involvement to the degree usually associated with
ownership nor effective control over the goods sold;

 the amount of revenue can be measured reliably;

 it is probable that the economic benefits associated with the transaction will flow to the entity; and

 the costs incurred or to be incurred in respect of the transaction can be measured reliably.

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 Revenue Recognition

B. General Principles(US GAAP)

 As per US GAAP revenue from the sale of goods is to be recognised, when the following conditions are
satisfied:

 There is evidence of an arrangement between buyer and seller.

 The product has been delivered, or the service has been rendered.

 The price is determined, or determinable.

 The seller is reasonably sure of collecting money.

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 Revenue Recognition

C. Revenue Recognition in Special Cases

1. Long-Term Contracts
 A long-term contract is one that spans a number of accounting periods.
 In long term contracts revenue recognition done through:
o Percentage of Completion method
 Under the percentage-of-completion method, revenue is recognized based on the stage of
completion of a transaction or contract and is, thus, recognized when the services are
rendered.
o Completed contract method
 Under the completed contract method, the company does not report any income until the
contract is substantially finished.
 Under both IFRS and US GAAP, if a loss is expected on the contract, the loss is reported immediately,
not upon completion of the contract, regardless of the method used.

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 Revenue Recognition

C. Revenue Recognition in Special Cases

1. Long-Term Contracts - Example
Assume that AAA Construction Corp. has a contract to build a ship for ₹1000, and a reliable estimate of
the contract's total cost is ₹800. Project costs incurred by AAA are as follows:
AAA Project Costs
Year 2005 2006 2007 Total
Costs incurred ₹400 ₹300 ₹100 ₹800
Determine AAA's net income from this project for each year using the percentage of completion and
completed contract methods in accordance with U.S. GAAP.

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 Revenue Recognition

C. Revenue Recognition in Special Cases

2. Instalment Sales
 Sales in which proceeds are to be paid in installments over an extended period.
 Under U.S.GAAP:
o if collectibility is certain, revenue is recognised at the time of sale as normal revenue recognition
criteria.
o If collectibility is uncertain, revenue recognised using the cost recovery method.
 Under IFRS:
o if collectibility is certain, revenue is recognised at the time of sale as the discounted present value
of instalments.
o If collectibility is uncertain, revenue recognised using the cost recovery method.

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 Revenue Recognition

C. Revenue Recognition in Special Cases

2. Instalment Sales - Example
Assume that BBB Property Corp. sells a piece of land for ₹1000. The original Cost of the land was ₹800.
Collections received by BBB for the sale are as follows:
BBB instalment Collections
Year 2005 2006 2007 Total
Collections ₹400 ₹400 ₹200 ₹1000
Determine BBB's profit under the instalment and Cost recovery methods.

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 Revenue Recognition

C. Revenue Recognition in Special Cases

3. Barter Transactions
 In a barter Transactions, two parties exchange goods or services without cash payment.
 A round-trip Transaction involves the sale of goods to one party with the simultaneous purchase of
identical goods from the same party.
 As per U.S GAAP, revenue from a barter transaction can be recognised at fair value only if the firm has
historically received cash payments for such goods and services.
 As per IFRS, revenue from barter transaction must be based on the fair value of the similar non-barter
transaction with unrelated parties.

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 Revenue Recognition

C. Revenue Recognition in Special Cases

4. Gross versus Net Reporting
 Under gross revenue reporting, the selling firm reports sales revenue and cost of goods sold separately.
 Under net revenue reporting, only the difference in sales and cost is reported.
 As per US GAAP, the gross Reporting can be done if the following criteria are met:
o the company is the primary obligor under the contract,
o bears inventory risk and credit risk,
o can choose its supplier, and
o has reasonable latitude to establish price.
 If these criteria are not met, the company should report revenues net.

D. Implications for Financial Analysis

 The following aspects of a company’s revenue recognition policy are relevant to financial analysis:
o whether a policy results in recognition of revenue sooner rather than later, and
o to what extent a policy requires the company to make estimates.

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 Revenue Recognition

Converged Accounting Standards for Revenue Recognition

 Five-step process:

• Identify the contract with a customer

1

• Identify the performance obligations in the contract

2

• Determine the transaction price

3

• Allocate the transaction price to the performance obligations in the contract.

4

• Recognize revenue when (or as) the entity satisfies a performance obligation.
5

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 Expense Recognition

 Under the IASB Framework, 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.”
A. General Principles
 Matching Principle
o Matching requires that a company recognizes cost of goods sold in the same period as revenues from
the sale of the goods.
 Period Costs
o Expenditures that less directly match revenues, are reflected in the period when a company makes the
expenditure or incurs the liability to pay.
o Administrative expenses are an example of period costs.

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 Expense Recognition

 Inventory Expense Recognition

o FIFO method
o LIFO method
o Weighted Average Cost method

Method Assumption Cost of goods sold Ending inventory

consists of…… consists of……
FIFO The items first First purchased Most recent purchase
(GAAP & IFRS) purchased are the first
to be sold
LIFO The items last purchased Last purchased Earliest purchases
(GAAP only) are the first to be sold
Weighted Average Cost Items sold are a mix of Average cost of all items Average cost of all items
(GAAP & IFRS) purchases

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 Expense Recognition

 Inventory Expense Recognition - Example

Use the inventory data in the table below to calculate the cost of goods sold and ending inventory under
each of the three methods.
Inventory Data

Jan 1 beginning inventory 2 units @ ₹2 per unit = ₹4

Jan 7 purchase 3 units @ ₹3 per unit = ₹9
Jan 19 purchase 5 units @ ₹5 per unit = ₹25
Cost of goods available 10 units ₹38
Units sold during Jan 7 units

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 Expense Recognition

B. Issues in Expense Recognition

1. Doubtful Accounts
 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.
 The company records its estimate of uncollectible amounts as an expense on the income statement,
not as a direct reduction of revenues.

2. 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.

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 Expense Recognition

3. Depreciation Expense Recognition

 Depreciation is the process of systematically allocating costs of long-lived assets over the period during
which the assets are expected to provide economic benefits.
 IFRS allow two alternative models for valuing property, plant, and equipment:
 the cost model and the revaluation model.
o Under the cost model, the depreciable amount of that asset (cost less residual value) is
allocated on a systematic basis over the remaining useful life of the asset.
 Under the revaluation model, the asset is reported at its fair value.
 The revaluation model is not permitted under US GAAP.
 IFRS require each component of an asset to be depreciated separately and US GAAP do not
require component depreciation; and
 IFRS require an annual review of residual value and useful life, and US GAAP do not explicitly
require such a review.

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 Expense Recognition

Straight-line depreciation allocates an equal amount of depreciation each year

 The method used to compute depreciation includes:

o Straight-line depreciation
o Accelerated depreciation
o Declining balance method
 IFRS do not prescribe a particular method for computing depreciation.

Straight-line depreciation - Example

Littlefield Company recently purchased a machine at a cost of $12000. The machine is expected to have a
residual value of $2000 at the end of its useful life in five years. Calculate depreciation expense using the
straight line method.

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 Expense Recognition

Accelerated depreciation method

Speeds up the recognition of depreciation expense in a systematic way to recognize more depreciation
expense in the yearly years, and less depreciation in the later parts of its life.
A commonly used accelerated method is double declining balance method.

Double declining balance method - Example

Littlefield Company recently purchased a machine at a cost of $12000. The machine is expected to have a
residual value of $2000 at the end of its useful life in five years. Calculate depreciation expense for all five
years using the double declining balance method.

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 Expense Recognition

4. Amortization Expense Recognition

Amortization is the allocation of the cost of an intangible asset over its useful life.
Amortization expense should match the proportion of the asset’s economic benefits used during the
period.
Most firms use the straight line method to calculate annual amortization expense for financial reporting.
Intangible assets with indefinite lives are not amortized, however such assets must be tested for
impairment at least annually.
If assets impaired , an expense is recognised on the income statement.

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UNDERSTANDING INCOME STATEMENTS 20
 Expense Recognition

C. Implications for Financial Analysis

Information about a company’s accounting policies and significant estimates are described in the foot
notes of the financial statements and in the MD & A section of a company’s annual report.
When possible monetary effect of differences in expense recognition policies and estimates can facilitate
more meaningful comparison with a single company’s historical performance or across a number of
companies.
An analyst can use the monetary effect to adjust the reported expenses so that they are on a
comparable basis.

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UNDERSTANDING INCOME STATEMENTS 21
 Non-Recurring Items and Non-Operating Items

A. Discontinued Operations
When a company disposes of or establishes a plan to dispose of one of its component operations and
will have to further involvement in the operation, the income statement reports separately the effect of
this disposal as a “discontinued” operation under both IFRS and US GAAP.
An analyst should eliminate the discontinued operations in formulating expectations about a company’s
future financial performance.
B. Extraordinary Items
IFRS prohibit classification of any income or expense items as being “extraordinary”.
For periods beginning after Dec 15, 2015, US GAAP too disallowed items to be treated as extraordinary.

C. Unusual or Infrequent Items

IFRS requires that items of income or expense that are material and /or relevant to the understanding of
the entity’s financial performance should be disclosed separately.
Under US GAAP, items that are unusual or infrequent should be disclosed separately.
Items that are unusual or infrequent are shown as part of a company’s continuing operations.

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UNDERSTANDING INCOME STATEMENTS 22
 Non-Recurring Items and Non-Operating Items

D. Changes in Accounting Policies

Change in accounting principles  retrospective application
Change in accounting estimates  prospective application

E. Non-Operating Items
Operating & non-operating should be reported separately

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UNDERSTANDING INCOME STATEMENTS 23
 Earning per Share

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UNDERSTANDING INCOME STATEMENTS 24