Reading 21 Understanding Income Statements

Reading 21§Understanding Income Statementsbalances, remaining performance obligationsand transaction price allocated to thoseobligations, and any significant judgments andchanges in judgments related to revenuerecognition.Industries where bundled sales are common(e.g. the telecommunications and softwareindustries) are expected to be significantlyaffected by the converged standard.4.EXPENSE RECOGNITIONAccording to IASB: Expenses are defined as “decrease ineconomic benefits during the accounting period in theform of outflows or depletions of assets or increase ofliabilities that result in decrease in equity (excludingdistributions to equity participants)”.4.1FinQuiz.comGeneral PrinciplesUnder the accrual method of accounting, expenserecognition is based on the matching principle.Matching principle: According to matching principleexpenses incurred to generate revenue are recognizedin the same period when the revenue is recognized.NOTE:In IFRS, matching principle is known as “matchingconcept” or “matching of costs with revenues”.Example:Suppose that the inventory is purchased during the thirdquarter of one year and sold during the fourth quarter ofthat year. Then using the matching principle, both therevenue and the expense (i.e. cost of goods sold) will berecognized in the fourth quarter, when the inventory issold, not in the third quarter when the inventory waspurchased.According to Matching Principle, firm needs to estimatebad debt expense and/or warranty expense in order torecognize the expense in the period of the sale ratherthan later period.Types of Expenses:Period costs: Period costs are expenses that are notdirectly related to revenue generation and areexpensed in the period in which they are incurred e.g.Administration costs. Period costs also include costs thatmay benefit several accounting periods e.g.depreciation of long-term assets. The allocation of costover an asset’s useful life is called depreciation,depletion, or amortization expense.Practice: Example 1.Volume 3, Reading 23.Alternative Inventory Costing MethodsSpecific identification method: The specific identificationmethod is based on the actual physical flow of thegoods. It is most frequently used when the company sellsa limited variety of high unit-cost items. However,specific identification is often viewed as impractical.Cost Formulas (IFRS) or Cost Flow Assumptions (U.S.GAAP):i. First-in, First-out (FIFO): In FIFO method, earliest goodspurchased is the first to be sold and the newest goodspurchased (or manufactured) are assumed to remainin inventory. The costs of the most recent goodspurchased are recognized as the ending inventory.Advantage: In FIFO, ending inventory represents thecurrent replacement costs.ii. Weighted Average cost: In the weighted averagecost method, it is assumed that the goods availablefor sale are homogeneous; therefore, allocation ofthe cost of goods available for sale is based on theweighted average unit cost incurred. The weightedaverage unit cost is then multiplied by the units sold todetermine the cost of goods sold and to the units inhand to determine the ending inventory.Advantage: It smoothed out price changes.

Reading 21Understanding Income StatementsFinQuiz.comNet IncomeEnding InventoryCGS Average costfalls in themiddle. Average costfalls in themiddle.lower incometaxes. Average costfalls in themiddle.iii. Last-in, first-out (LIFO): In the LIFO method, it isassumed that the recent goods purchased are thefirst to be sold and that the earliest goods purchasedremain in ending inventory. This method is permittedunder U.S. GAAP only; not under IFRS.Advantage: It better matches current costs in CGS withrevenues.Example:In periods of falling pricesNet IncomeEnding InventoryCGS FIFO reportsthe lowestnet income FIFO reports thelowest endinginventory. LIFO reports thehighest endinginventory(assumes noLIFOliquidation)*. Average costfalls in themiddle. FIFO reports thehighest CGS. LIFO reportsthe highestnet incomeBeginning inventory: 200 units @ 10/unit 2,000Quarter1234Scenario 1: StablePricesPurchasesPurchasesUnitsUnit costDollars100 10 1,000150 10 1,500150 10 1,500100 10 1,000500 5,000Scenario 2: RisingPricesPurchasesUnit costDollars 11 1,100 12 1,800 13 1,950 14 1,400 6,250Units sold: 100 units per quarter, or in total 400 unitsEnding inventory: 300 units Averagecost falls inthe middle. LIFO reports thelowest CGS(assumes noLIFOliquidation)*. Average costfalls in themiddle.When prices are constant: All cost flow methods willprovide the same results.*NOTE:LIFO Liquidation occurs when the units of goods sold aregreater than units of goods purchased in the period;thus, sales are made from the existing, low-pricedinventory rather than from recent purchases.Practice: Example 1 & 2.Volume 3, Reading 23.4.2Issues in Expense Recognition4.2.1) Doubtful AccountsWhen goods or services are sold on credit, there isprobability that some customers will fail to pay. Underthe matching principle, a company is required to recordan estimate of revenue that will be uncollectible (i.e.doubtful accounts) at the time revenue is recognized.This estimate can be calculated as follows:In periods of rising pricesNet IncomeEnding InventoryCGS FIFO reportsthe highestnet income. FIFO reportsthe highestendinginventory. FIFO reportsthe lowestCGS. LIFO reportsthe lowest netincome; andthus, results in LIFO reportsthe lowestendinginventory. LIFO reportsthe highestCGS.i. As a proportion of the overall amount of sales.ii. As a proportion of overall amount of receivables.iii. As a proportion of the amount of receivablesoverdue by a specific amount of time.Accounting Treatment: Estimate of uncollectibleamounts is reported as an expense on the Incomestatement rather than as a deduction from revenues.NOTE:A Direct Write-off Method is a method in which acompany recognizes credit losses on accountsreceivables only when a customer default. This method is

Reading 21Understanding Income StatementsFinQuiz.comNOT consistent with generally acceptable accountingprinciples.4.2.2) WarrantiesUnder matching principle, a company is required toestimate and recognize the amount of future expensesassociated with warranties in the period of sale. Acompany must also update the warranty expensebased on the experience over the life of the warranty.4.2.3) Depreciation and AmortizationMethods of depreciation:1. Straight line depreciation method: In this method, anequal amount of depreciation expense is recognizedeach year of the asset’s useful life.Straight Line Depreciation expense %&' ) * &,-./0 1/0. ()234567 7854where,Residual value or salvage value Amount of an assetthat a company expects to receive upon its sale at theend of the useful life. Annual Depreciation expense is inversely relatedto useful life of an asset and residual value. Straight-line depreciation is appropriate when anasset’s economic value decreases at anapproximately constant rate over time.Example:Cost 20,000Life 5 yearsResidual value 2,000Depreciation (Cost – Residual value) / Life ( 20,000 – 2,000) / 5 3,6002. Accelerated depreciation method orDiminishing/Declining balance method (DDB):In thismethod, a constant rate of depreciation is applied tothe declining book value until book value equalsresidual value. It is considered more appropriatemethod for matching expenses to revenues. Anaccelerated depreciation method is appropriate touse when a long-term asset generates proportionallymore of its economic benefits in the early years of itslife.DDB uses 200% of the Straight-Line rate as the % rateapplied to the declining balance of the asset.DDB depreciation (2/useful life)(cost - accumulateddepreciation)Example:Cost 20,000,Life 5years,Residual Value 2,000Generally, assets generate more benefits in the earlyyears of their economic life and fewer benefits in thelater years. However, In early years of an assets life, an accelerateddepreciation method results in higherdepreciation expense relative to straight linedepreciation method. It results in higher expensesand lower net income in the early depreciationyears. In later years, an accelerated depreciationmethod results in lower depreciation expenserelative to straight line depreciation method. Itresults in lower expenses and higher net income inlater years.3. Units of Production method: In this method,depreciation varies with production or usage.Intangible assets: Intangible assets refer to assets thatlack physical substance e.g. trademarks. Intangibleassets with limited useful lives should be amortized. Theamortization expense for intangible assets with limitedlives is similar to depreciation i.e. the amortizationexpense should match the proportion of the assetseconomic benefits used during the period. Intangibleassets with finite/limited useful lives include patent,copyright etc.NOTE:Land and intangible assets with indefinite useful lives(e.g. goodwill) are assets, which are neither depreciatednor amortized.Intangible assets with indefinite useful lives (e.g. goodwill)are tested for impairment at least annually. Asset isimpaired when the recoverable or fair value of anintangible asset is materially less than its book value.Under IFRS: Two alternative models can be used to valueproperty, plant & equipment.1) Cost Model: In cost model, asset’s depreciableamount (i.e. cost – residual value) is allocated on asystematic basis over the remaining useful life of theasset; and asset is reported at its cost – accumulateddepreciation. Note that IFRS does not explicitlyprescribe a specific method for depreciation.2) Revaluation Model: In revaluation model, asset isreported at its fair value. It is important to note thatrevaluation model is not allowed under U.S. GAAP.

Reading 21Understanding Income StatementsDifferences between IFRS and U.S. GAAP:i.ii.Under IFRS, unlike U.S. GAAP, each component ofan asset must be depreciated separately.Unlike U.S. GAAP, IFRS requires an annual reviewof residual value and useful life.Practice: Example 3 & 4,Volume 3, Reading 23.5.Following are the items that must be reported separatelyfrom the continuing operations.Discontinued Operations :A discontinued operation refers to the operation thatcompany has decided to dispose of or plans to disposeof and thus will not have any involvement in thatoperation in the future.Under both IFRS and U.S. GAAP, discontinued operationsare reported separately in the income statement.However, to be accounted for as a discontinuedoperation, the discontinued component must bephysically and operationally separable from the rest ofthe firm. The discontinued operations are not expected togenerate earnings or cash flow; therefore, analystsmust remove these items when formulatingexpectations about a company. These items are reported net of tax.5.2The Implications for Financial AnalysisThe firm has a choice to either delay or accelerate therecognition of expenses. An analyst: Must evaluate the underlying reasons for achange in an expense estimate of a firm e.g.o Determine whether the decrease in bad debtexpense is due to improvement in collectionexperience of the firm or the bad debt expensewas decreased to manipulate earnings. Should compare expense estimates of a firm tothose of other firms within the industry e.g.evaluate whether the firm’s warranty expense islower than the peer firm due to its higher qualitygoods or it is due to use of aggressive expenserecognition.NON-RECURRING ITEMS AND NON-OPERATING ITEMSCompanies should separately report items that areexpected to continue in the future from items that aretemporary. This helps in assessing companies’ futureearnings more reasonably .5.14.3FinQuiz.comUnusual or Infrequent Items: Under both IFRS and US GAAP, unusual orinfrequent items that are material and/or relevantto the company’s financial performance arereported as part of the continuing operations of acompany and must be disclosed separately. Examples include, restructuring charges,gains/losses on sale of an asset or part of abusiness etc. These items are included in income fromcontinuing operations ‘below the line’ and arereported before tax.In formulating expectations about a company, analystsmust assess whether these items are expected to reoccur in the future or not.These items are reported separately Below the LineExample:2001Net Sales 3,957Cost of goods sold(1.364)Gross profit 2,593SG&A(1,093)Special or unusual charges(251)Income from continuing operations before tax 1,249expense“Above the line”Income tax expense(406)*Income from continuing operations 843**Discontinued operations:“Below the line” 203Income, net of taxGain on disposal, net of tax98Income before extraordinary item and change 1,144in accounting principleExtraordinary loss, net of tax---Cumulative effect of change in accounting(118)principle, net of taxNet Income 1,026* Income from continuing operations is intended to capture thesustainable part of income.

Reading 21Understanding Income Statements** The items appearing below income from continuingoperations, called the non-recurring items (gain/losses),represent the transitory portion of earnings.5.3acceptable under accounting standards e.g. U.S. GAAPor IFRS or a correction of an error. These changes do not typically affect cash flows.However, analysts should evaluate these changescarefully because these errors may indicateweaknesses of internal controls and accountingsystems of a company.Changes in Accounting PoliciesA change in accounting principle refers to a changefrom one standard e.g. U.S. GAAP or IFRS method toanother standard (i.e. a change in inventory costingmethod from FIFO (IFRS) to LIFO (U.S. GAAP)). A change in accounting principle is appliedretrospectively i.e. all of the prior-period financialstatements currently shown are restated to reflectthe change unless it is impractical to do so. Retrospective application facilitates analysts to docomparison of the financial statements over time.Practice: Example 5,Volume 3, Reading 23.5.4Correction for an error for a prior period is appliedretrospectively. It refers to change from an incorrectaccounting method to the accounting method that is6.Example: For a non-financial company, dividendsand/or interest received on investments represent nonoperating income. Whereas for a financial company (i.e.insurance companies, banks etc.), interests paymentsreceived represent operating income.EARNINGS PER SHARE (EPS)EPS represents shareholder’s share of company’searnings.6.1Non-Operating Items Under IFRS, there is no specific definition ofoperating activities. Companies have a choice toreport operating income or outcomes ofoperating activities after ensuring that theseactivities are treated as operating. Under U.S. GAAP, operating activities are thosewhich are related to producing and delivering ofgoods and services whereas transactions relatedto investing and financing activities are regardedas non-operating.Change in Accounting Estimate is applied prospectivelyi.e. by adjusting only current and future years. Estimatesinclude useful life of a depreciable asset or bad debtexpense etc. Companies should disclose significantchanges in estimates in the notes. Changes in accounting estimates do not changeCash Flows. However, an analyst should evaluatechanges in accounting estimates in order todetermine the effect of these changes on futureoperationsFinQuiz.comdilute (decrease) EPS. When a company has complexcapital structure, they must compute Diluted EPS.Simple Versus Complex Capital StructureA company’s capital has two major components i.e.equity and debt. Under IFRS, EPS is presented forOrdinary shares. Ordinary shares are equity shares thatare subordinate to all other types of equity i.e. when acompany is liquidated, ordinary shareholders are paidlast. Under U.S. GAAP, ordinary shares are known ascommon stock or common shares.Simple Capital Structure: A company has a simplecapital structure when it does not include financialinstruments that are potentially convertible into commonshares.Complex Capital Structure: A company has a complexcapital structure when it includes financial instrumentsthat are potentially convertible into common shares i.e.convertible bonds, convertible preferred stock,employee stock options and warrants. Potentiallyconvertible financial instruments have the potential to6.2Basic EPS𝐁𝐚𝐬𝐢𝐜 𝐄𝐏𝐒 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 ��ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔Shares outstanding are weighted by fraction of year.Example:DateDetailsSharesissued(000)1 January 20 7Balance at beginningof year17031 May 20 7Issue of new shares forcash8031 December20 7Balance at year end250

Reading 21Understanding Income StatementsThe weighted average number of shares can becalculated in two ways:a) (170,000 5/12) (250,000 7/12) 216,667 sharesb) (170,000 12/12) (80,000 7/12) 216,667 sharesExample:On January 1, 2001 ABC Corporation had: 160,000 common shares outstanding. 10,000 preferred shares, 100 par value, Paying adividend of 7% On September 1, 2001 the company issued 40,000additional common shares. The net income for 2001: 1,257,331 Preferred dividends 10,000 x 100 x0.07 70,000FinQuiz.com6.3.1) Diluted EPS when a Company has ConvertiblePreferred Stock Outstanding Increase in EPS denominator: The weightedaverage number of shares is increased by theadditional common shares assumed to be issued. Increase in EPS numerator: Convertible preferreddividends are added to earnings available tocommon shareholders.Diluted EPS Net income / (Weighted average numberof common shares outstanding Newcommon shares that could have beenissued at conversion)6.3.2) Diluted EPS when a Company has ConvertibleDebt Outstanding(a) Shares (b) Portion Weighted sharesTime spanoutstanding of year(col. a x col. b)Jan 1 - Aug 31160,0002/3106,667Sep1 - Dec 31200,0001/366,667173,333𝐁𝐚𝐬𝐢𝐜 𝐄𝐏𝐒 1,257,331 70,000 6.85 per share173,334 sharesPractice: Example 6, 7 & 8,Volume 3, Reading 23.6.3Diluted EPSWhen a company has simple capital structure, Basic EPS Diluted EPS.Diluted EPS is always Basic EPS.Dilutive Securities: They represent securities e.g. stockoptions, warrants, convertible debt or convertiblepreferred stocks that result in reduction in earnings pershare when they are exercised or converted intocommon shares.Anti-dilutive Securities

1. Multi-Step Format of Income Statement: In a multi-step format, income statement exhibits a gross profit subtotal. Purpose of Multi-Step Format: To separate permanent items from transitory items. Advantage of Multi-Step Format: It facilitates analysts to have an accurate prediction of future earnings and future cash-flows. 2. Single-Step .