Understanding Income

Statement
Income statement (also known as: statement of operations/earnings, Profit & Loss
Income statement: shows performance (revenue, expense) of a
company over a period of time

Net income = revenue – expense

or
Net income = (revenue + gain + other income)
– ordinary expense – other expense – losses

 !Both IFRS & GAAP :

 can combine IS with OCI and present as CI (IS + OCI=CI);
 or present OCI and IS as separate statements.
 Income statement -
Components
Revenues (sales, turnover) amounts from the sale of goods
and services in the normal course of business

Net Revenue = Revenue -

adjustments for estimated returns and
allowances

sales returns: return of expired/broken

goods;
allowance: discount to buyer because of
partially broken good or incorrect color/size etc.

Details about presentation of revenue can be found

in footnotes, sometimes in MD&A
 Income statement - Components

Expenses amounts incurred to generate revenue and include COGS, operating

expenses, interest & taxes.
Expenses are grouped:
 by their nature: depreciation, wages, salaries, rent expense
 by function: according to the activity for which the expense were
incurred (manufacturing (COGS), selling, general administrative,
financing)

Gain & losses occurring from non-primary operations, typically

from
disposal of long lived assets (ex: sales price – book value of asset)
 Quick test
Denali Limited, a manufacturing company, had the following income
statement information:
• Revenue $4,000,000
• Cost of goods sold $3,000,000
• Other operating expenses $500,000
• Interest expense $100,000
• Tax expense $120,000
Denali’s gross profit is equal to:
A $280,000.
B $500,000.
C $1,000,000.
 Answer
C is correct. Gross margin is revenue minus cost of goods sold. Answer A
represents net income and B represents operating income.
 Quick test
Fairplay had the following information related to the sale of its products
during 2009, which was its first year of business:
• Revenue $1,000,000
• Returns of goods sold $100,000
• Cash collected $800,000
• Cost of goods sold $700,000
Under the accrual basis of accounting, how much net revenue would be
reported on Fairplay’s 2009 income statement?
A $200,000.
B $900,000.
C $1,000,000.
 Answer
B is correct. Net revenue is revenue for goods sold during the period less any
returns and allowances, or $1,000,000 minus $100,000 = $900,000.
 Income statement - Components
Noncontrolling interest (minority interest) if a firm has
controlling interest in subsidiary, the pro rate share of the subsidiary’s net income
not owned by parent
 Presentation formats of IS
Firm can present IS using a single-step or multi-step format:
 Single-step format: all revenues are grouped together and all expenses are
grouped together.
 Multi-step format: includes gross profit, revenues minus COGS

Single-step Multi-step
Revenue recognition (general principles)
Under accrual method of accounting,
Revenue recognized when earned and Expenses when incurred.
not necessarily coincide with the receipt or payment of cash.

Unearned revenue (L)

When payments are received, both assets (cash) and liabilities (unearned revenue) increase.
The liability is reduced in the future as the revenue is earned

Account receivable (A)

When revenue earned, asset (account receivable) and equity (through revenue) increase
The asset is reduced in the future as the cash received

Accruals require an accounting entry when the earliest event occurs (cash exchange or
provision of goods/services)
Revenue recognition (general principals)
In 2014, IASB and FASB issued converged standards for revenue recognition
Principal based approach: revenue should be recognized when
transferred to a customer
goods/services
Contract exists only if collectability is probable.
IFRS, probable means more likely than not,
Five step model for revenue recognition: US GAAP it means likely to occur.
1. Identify contracts with customer As a result, economically similar contracts may be
2. Identify performance obligation in contracts treated differently under IFRS and US GAAP.
3. Determine transaction price
4. Allocate transaction price to performance obligations
5. Recognize revenue when/as performance obligations are satisfied

Disclosure requirements:
1. Contracts with customers, disaggregated into different categories
2. Contract-related assets and liabilities:
1. Balance and changes
2. Remaining performance obligations, transaction prices allocated to them
3. Significant judgments, changes in judgment
 Revenue recognition
For long-term contracts, revenue is recognized based on “Progress toward
completion of a performance obligation” or “Percentage-completion” method,
which can be measured:
 by input (e.g., % of total estimated costs incurred to date) or
 by output (e.g., % of performance obligation completed to date)

Revenue should be recognized only when it is high probable that it will not
be reversed in the future
 Revenue recognition
ABC Ltd. enters into a four-year contract to build bridge for $4 mln and
estimates its total costs to be $3 mln.

1st Year
Cost: ABC incurs $ 600,000 in costs
Revenue: (0.6 mln / 3 mln ) * 4 mln = 0.8
mln

2
nd Year
Cost:
• estimated total cost increased to $
3.2 mln
• ABC incurs additional $ 600,000 in
costs
Revenue:
 Revenue recognition
3rd Year
Cost:
• Customer agrees to pay a bonus of $ 0.4 mln if the bridge is completed by the
end of the fourth year
• Highly probable bridge can be completed in four years
• ABC incurs additional $1 mln in costs

Revenue:
• Cumulative revenue: (2.2 mln / 3.2 mln) * 4.4 mln = $ 3.025 mln
• Year 3 revenue: 3.025 mln – 0.8 mln – 0.7 mln = $1.525 mln
 Expense recognition
Revenue – expense = net
Expenses are decreases
income in economic benefits during the accounting period in the
form of outflows or depletions of assets or incurrence of liabilities that result in
decreases in equity other than those relating to distributions to equity
participants.

Accrual method – matching principal

Expenses recognized in the same period as the revenue
Example: Inventory related expenses reflected when sold,
not when buy; depreciation expense; warranty expense,
doubtful debt expense

Period expenses: expenditures that less directly match the timing

of
revenues (e.g. administrative costs)
 Inventory expense recognition
COGS should be matched with items sold and recorded as revenue over
the period
Inventory cost flow should match goods flow

Specific Weighte
FIFO LIFO
identification d
average
 Inventory expense recognition
Specific identification: If a firm can identify exactly which
items were sold and which items remain in inventory. e.g.: an
auto dealer

LIFO => popular in US ‘cos of tax saving

(in inflationary env: higher COGS > lower tax income > lower
income tax
Weighted average cost => easy to use
Cost per unit = Cost of average goods
No. of units
Inventory expense recognition
 Quick test
During 2009, Accent Toys Plc., which began business in October of that year,
purchased 10,000 units of a toy at a cost of ₤10 per unit in October. The toy
sold well in October. In anticipation of heavy December sales, Accent
purchased 5,000 additional units in November at a cost of ₤11 per unit.
During 2009, Accent sold 12,000 units at a price of ₤15 per unit. Under the
first in, first out (FIFO) method, what is Accent’s cost of goods sold for 2009?
A ₤120,000.
B ₤122,000.
C ₤124,000.
 Answer
B is correct. Under the first in, first out (FIFO) method, the first 10,000 units
sold came from the October purchases at £10, and the next 2,000 units sold
came from the November purchases at £11.
Depreciation expense recognition
The cost of long-lived assets must also be matched with revenues.
Long-lived assets are expected to provide economic benefits beyond one
accounting
period.
The allocation of cost over an asset’s life is known as:
 depreciation (tangible assets);
 depletion (natural resources);
 amortization (intangible assets).
Depreciation:
 Straight line: recognizes an equal amount depreciation
expenseofeach period;
 Quick test
At the beginning of 2009, Glass Manufacturing purchased a new machine for
its assembly line at a cost of $600,000. The machine has an estimated useful
life of 10 years and estimated residual value of $50,000. Under the straight-
line method, how much depreciation would Glass take in 2010 for financial
reporting purposes?
A $55,000.
B $60,000.
C $65,000.
 Answer
A is correct. Straight-line depreciation would be ($600,000 – $50,000)/10, or
$55,000.
Depreciation expense recognition
Most assets generate more benefit in the early years of their economic life. So
accelerated method more appropriates for matching expenses with revenues.

Accelerated depreciation method:

 Speeds up the recognition of depreciation expense;
 More depreciation expense (less income) in early years,
 less depreciation expense (more income) in later years.
 Total dep. expense in the same;
Declining balance method:
 constant rate of depreciation to an asset’s (declining) book value
each year;
Double-declining balance (DDB):
 two times the straight-line rate to the declining balance;
Depreciation expense recognition
 Quick test
At the beginning of 2009, Glass Manufacturing purchased a new machine for
its assembly line at a cost of $600,000. The machine has an estimated useful
life of 10 years and estimated residual value of $50,000. How much
depreciation would Glass take in 2009 for financial reporting purposes under
the double-declining balance method?
A $60,000.
B $110,000.
C $120,000.
 Answer
C is correct. Double-declining balance depreciation would be $600,000 ×
20 percent (twice the straight-line rate). The residual value is not subtracted
from the initial book value to calculate depreciation. However, the book value
(carrying amount) of the asset will not be reduced below the estimated
residual value.
 Amortization expense recognition
Amortization is the allocation cost of an intangible asset (e.g.: franchise
agreement) over its useful life.
Should match the proportion of the asset’s economic benefits used during the
period.
IFRS and U.S.GAAP firms both typically amortize straight-line method

Intangible assets with indefinite lives (e.g., goodwill) are not amortized
Goodwill not amortized - checked annually for impairment
Tested for impairment at least annually
If impaired, an expense recognized on IS.

If a firm sells goods/services on credit or provides a warranty to the

customer, according matching principle: bad debt expense and/or
warranty expense recognized in the period of the sale, rather than a later
period.
 Non-recurring items
Discontinued operations:
Operations that management decided to dispose of, but either has not yet
done so, or did so in current year after it generated income or losses.
Measurement date – when formal plan for disposing is developed;
Phaseout period - Time between the measurement period and the actual
disposal date.
Any income or loss: separately in the income statement, net of tax, after income from continuing operations.
Past Income Statements must be restated, separating income or loss from
the Disc. operations.
Estimated loss – must be accrued on measurement date
Expected gain – can’t be reported until sale is completed
Assets, operations and financing activities must be physically and
operationally distinct from firm
Analytical implication: Disc. Op don’t affect NI from cont.
operations.
Should be excluded for forecasting.
 Non-recurring items
Unusual or infrequent items:
Events which either unusual in nature or infrequent in
occurrence.

Reported pretax before and included in income from

continuing operations

Items include:
 Gain (loss) from sale of investment in subsidiary
 Gain (loss) from the sale of assets or part of a business, if these
activities
are not a firm’s ordinary operations
 Provisions for environmental remediation
 Impairments, write-offs, write-downs, and restructuring costs.
 Quick test

Under IFRS, a loss from the destruction of property in a fire would most
likely be classified as:
A. continuing operations.
B. discontinued operations.
C. other comprehensive income.
 Answer

A is correct. A fire may be infrequent, but it would still be part of

continuing operations and reported in the profit and loss statement.
Discontinued operations relate to a decision to dispose of an operating
division.
 Accounting changes

Change in accounting estimate: is the result of a change in management’s judgment (e.g., change
in the estimated useful life of an asset)
Disclosed in footnotes, typically changes do not affect cash flow
 Quick test

A company chooses to change an accounting policy. This change requires that, if practical,
the company restate its financial statements for:
A. all prior periods.
B. current and future periods.
C. prior periods shown in a report.
 Answer
C is correct. If a company changes an accounting policy, the financial statements for all
fiscal years shown in a company’s financial report are presented, if practical, as if the
newly adopted accounting policy had been used throughout the entire period; this
retrospective application of the change makes the financial results of any prior years
included in the report comparable. Notes to the financial statements describe the change
and explain the justification for the change.
Operating vs non-operating components of IS

(G/L on sell of securities)

 EPS (earnings per share)
EPS (earnings per share) – most commonly used profitability performance
measure. For publicly traded companies (non public companies not required to report
EPS)

Simple capital structure - no potentially dilutive securities.

Contains only common stock, nonconvertible debt and
nonconvertible preferred stock.
Report only basic EPS

Complex capital structure - contains potentially dilutive

securities
(such as options, warrants, or convertible securities)
Must report both basic and diluted EPS
 Basic EPS
EPS is per-share earnings available to common shareholders
(NI - Preferred dividends) = earnings available to common shareholders

Note! Common stock dividends are not subtracted form Net income
 Basic EPS

Weighted average number of common shares:

Example: beginning of the year, there were 10,000 shares. 2,000
new shares issued on July 1. = 11,000 shares
Weighted average # of shares is: (10,000 x 12) + (2,000 x 6 )
12
 Quick test

For 2009, Flamingo Products had net income of $1,000,000. At 1 January 2009, there were
1,000,000 shares outstanding. On 1 July 2009, the company issued 100,000 new shares for
$20 per share. The company paid $200,000 in dividends to common shareholders. What is
Flamingo’s basic earnings per share for 2009?
A. $0.80.
B. $0.91.
C. $0.95.
 Answer
C is correct. The weighted average number of shares outstanding for 2009 is 1,050,000.
Basic earnings per share would be $1,000,000 divided by 1,050,000, or $0.95.
Common Size Income Statement
Vertical common size income statement:
 expresses each category of IS as a % of revenue (sales);
 standardizes IS;
 allows comparison of IS items over time (time series) &
across
firms (cross sectional);
What impacts gross/net margin?

Across firms
(cross sectional)

Exception!
The TAX expense is more
meaningful when
expressed as % of pretax
income - effective tax
rate
 Quick test

Which statement is most accurate? A common size income statement:

A. restates each line item of the income statement as a percentage of net income.
B. allows an analyst to conduct cross-sectional analysis by removing the effect of company
size.
C. standardizes each line item of the income statement but fails to help an analyst identify
differences in companies’ strategies.
 Answer
B is correct. Common size income statements facilitate comparison across time periods
(time-series analysis) and across companies (cross-sectional analysis) by stating each line
item of the income statement as a percentage of revenue. The relative performance of
different companies can be more easily assessed because scaling the numbers removes
the effect of size. A common size income statement states each line item on the income
statement as a percentage of revenue. The standardization of each line item makes a
common size income statement useful for identifying differences in companies’ strategies.
Quick test
 Comprehensive Income
Comprehensive Income =
Income Statement + Other comprehensive income

Includes:
1.Foreign currency translation gains and losses
2.Adjustments for minimum pension liability
3.Unrealized gains and losses on derivative contracts
accounted as hedge
4.Unrealized gains and losses from available-for-sale/fair
value through OCI securities.
 Quick test
Selected year-end financial statement data for Workhard are shown below.

Workhard’s comprehensive income for the year:

A. is $18 million.
B. is increased by the derivatives accounted for as hedges.
C. includes $4 million in other comprehensive income.
 Answer
C is correct. Comprehensive income includes both net income and other comprehensive
income.
Other comprehensive income = Unrealized gain on available-for-sale securities –
Unrealized loss on derivatives accounted for as hedges + Foreign currency translation gain
on consolidation
= $5 million − $3 million + $2 million
= $4 million
Alternatively, Comprehensive income – Net income = Other comprehensive income
Comprehensive income = (Ending shareholders equity – Beginning shareholders equity) +
Dividends
= ($493 million − $475 million) + $1 million
= $18 million + $1 million = $19 million
Net income is $15 million so other comprehensive income is $4 million.
 Quick test

When preparing an income statement, which of the following items would most likely be
classified as other comprehensive income?
A. A foreign currency translation adjustment
B. An unrealized gain on a security held for trading purposes
C. A realized gain on a derivative contract not accounted for as a hedge
 Answer
A is correct. Other comprehensive income includes items that affect shareholders’
equity but are not reflected in the company’s income statement. In consolidating
the financial statements of foreign subsidiaries, the effects of translating the
subsidiaries’ balance sheet assets and liabilities at current exchange rates are
included as other comprehensive income.
Thank you for attention!