4.understanding The Income Statement

Understanding the Income
Statement
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Format of Income Statement
Income Statement Format
Revenue from Sale of goods and services
- Operating Expenses
Operating Income From continuing Operations
+ Other Income and Expenses
Recurring Income Before Interest and Taxes from
continuing operations
- Financing Costs
+ / - Unusual or Infrequent items
Pretax from Continuing opereations
+ / - Income Tax Expense
Net Income from Continuing Operations
+ Income from discontinued operations
+ / - Extraordinary Items
+ / - Cumulative effect of accounting changes
Net Income
Basic - EPS
Diluted EPS

Example : Apple Inc. - Income Statement
Apple Inc. - Income Statement
Year ended 26 September
2009 2008 2007
Net sales 36,537 32,479 24,006

Cost of sales 23,397 21,334 15,852
Gross margin 13,140 11,145 8,154
Operating expenses:
Research and development 1,333 1,109 782
Selling, general & administrative 4,149 3,761 2,963
Total operating expenses 5,482 4,870 3,745
Operating income 7,658 6,275 4,409
Interest Income, net 326 620 599
Income before provision for 7,984 6,895 5,008
income taxes
Provision for income taxes 2,280 2,061 1,512
Net income 5,704 4,834 3,496
Earnings per common share:

Basic $ 6.39 $ 5.48 $ 4.04
Diluted $ 6.29 $ 5.36 $ 3.93
Shares used in computing earnings per share:
Basic 893,016 881,592 864,595
Diluted 907,005 902,139 889,292

Subtotals in Income Statement
International Accounting Standards (IAS) requires that certain line items like
revenue, finance cost and tax expense be separately stated.
According to IAS expenses can be grouped together by their nature or function.
Expenses
Grouping By Grouping By
Nature Function
Eg. Depreciation on manufacturing

Eg. Grouping expenses into
expenses and depreciation on
category like COGS will include
administrative facilities to be
expenses on wages of workers,
combined into line item
material costs, depreciation, etc.
Depreciation

Revenue Recognition IASB Standards
Revenue is to be recognized if the following conditions are satisfied:
Risk rewards of ownership of the goods is transferred to the buyer

Entity gives away the control and managerial involvement on the
goods
Revenue amount is measured reliably
Probable economic benefits flow to the entity
Incurred costs for the transaction can be reliably measured
For Services: When the outcome of a transaction can be estimated
reliable, revenue associated with the transaction shall be recognized
per the stage of completion

Contra Examples for Revenue Recognition
IASB provides that revenue is Example when you cannot recognize revenue
to be recognized when:
Significant risks and rewards Goods are delivered to a retail store to be sold on
are transferred to buyer consignment or refund is possible
No managerial involvement is Real estate still in the course of construction and is

retained unavailable for use
Amount of revenue can be An company enters into a barter transaction for

measured reliably advertising services
Probable that the economic A sale happens in a foreign country but it is uncertain if
benefits will flow to the entity the foreign governmental authority will allow the
remittance of the money collected from that sale
Costs incurred or to be Cost of warranties for product defects cannot be
incurred can be measured measured reliably
reliably

Revenue Recognition SEC Standards
According to FASB revenue should be recognized when it is realized

or realizable and earned
SEC criteria for revenue recognition is:

Evidence of arrangement between buyer and seller
Product has been delivered or the services have been rendered
Price is determined
Seller is reasonably sure of collecting money

Revenue Recognition Long Term Contracts
Each accounting period the company estimates what

Percentage percentage of the contract is complete and then reports
that percentage of the total contract revenue in its income
Completion statement
Method This method is preferred only when reliable estimates of
revenues, costs and completion time are available
IFRS revenue is only reported to extent of contract costs

incurred
US GAAP completed contract method
Completed
No profit or revenue reported until completion of the
Contract contract
Method Revenue, cost and profit all are recorded at the end of
contract

Company ABC has a contract to build roads worth $ 12 million. It will take
three years to build these roads. The total costs to build the road are
estimated to be $ 10 million.
If ABC recognizes the contract revenues on a percent of completion basis
and estimates percentage complete on the basis of expenses incurred then
what would be the revenues of ABC for the next 3 years are per the
percent of completion basis?
Year 1 Year 2 Year 3

Project Expenses 5 3 2
Total Project Expenses 5 8 10
If ABC recognizes the revenues on a completed contract basis then what

would be the revenues of ABC for the next 3 years per the completed
contract basis revenue recognition technique?

Revenue Recognition - Percent of Revenue Recognition - Completed Contract
Completion Method Method
All Numbers are in All Numbers are in
$ Million $ Million
Year 1 Year 2 Year 3 Year 1 Year 2 Year 3

Total Project
Cost 10 Total Project Cost 10
Total Expected Total Expected
Revenue 12 Revenue 12
Expenses Expenses
Incurred 5 3 2 Incurred 5 3 2
% of Costs % of Costs
Incurred in that Incurred in that
Year 50 30 20 Year 50 30 20
% of Project % of Project
Complete 50 80 100 Complete 50 80 100
Expected Expected
Revenue 6 4 2 Revenue 0 0 12

Revenue Recognition Installment Sales & Cost Recovery
Used when likelihood of collection cannot be estimated,

though cost of goods and services are known
Installment
Revenue and profit are based on percentage of cash
Sales collected
Method Apportions the cash receipt between cost recovered and
profit using the profit to sales ratio
Cost Used when cost of goods and services are unknown and
Recovery likelihood of collection cannot be estimated
Method Profit is recognized only when all the costs are recovered

Revenue Recognition Installment Sales & Cost
Recovery - Example
Assume the total sales price and cost of a property are $ 300,000 and
$150,000, respectively.
The profit on this transaction is $150,000.
The amount of cash received by the seller as a down payment is $100,000
with the remainder of the sales price to be recognized over a 5-year period.
It has been determined that 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:
The installment method is used?
The cost recovery method is used?

Revenue Recognition Installment Sales &
Cost Recovery
Installment Sales method
Profit to Sales ratio = 150,000/300,000 = 0.50
Cash Received in form of down payment = 100,000
The profit attributable to the down payment amount = 50,000
Cost Recovery Method
Under cost recovery method profits will be attributed if costs are exceeded.
In this case the costs are 150,000 and the down payment is 100,000.
Thus no profit will be attributed to the down payment amount per the cost
recovery method. 0 1 2 3 4 5
Installment Sales Method
Cash Receipts 100,000 40,000 40,000 40,000 40,000 40,000
Costs 50,000 20,000 20,000 20,000 20,000 20,000
Profits 50,000 20,000 20,000 20,000 20,000 20,000
Cost Recovery Method

Cash Received 100,000 40,000 40,000 40,000 40,000 40,000
Costs Attributed 100,000 40,000 10,000 - - -
Costs Remaining 50,000 10,000 - - - -
Profits - - 30,000 40,000 40,000 40,000

Barter Transactions
Exchange of goods and not of cash is termed as a barter transaction

The issue with a barter transaction is whether to recognize the revenue or not
IFRS: Revenues can be reported in the income statement based on the fair
value of revenues from a similar non-barter transaction with unrelated
parties
US GAAP: The barter transaction can be reported in the income statement
at their fair values if the company has a history of making or receiving
cash payments for such good and services

Gross v/s Net Revenues
Gross Revenue Reporting : Sales and cost of sales are reported

separately
Net Revenue Reporting : Only the difference between sales and costs
of sales is reported on the income statement
US GAAP Only under the following conditions can a company report
revenues based on the gross reporting
Company is a primary obligor under the contract
Company bears the inventory and credit risk
Company can choose its suppliers
Company has reasonable latitude to establish price

Gross vs. Net: Example
Company pays only for tickets sold to customers
Total revenue = $ 4,400,000
Costs of tickets = $ 4,000,000
Direct selling costs = $ 4,000
Gross Reporting Net Reporting

Revenues $ 4,400,000 $ 400,000
Cost of sales $ 4,004,000 $ 4,000
Gross profit $ 396,000 $ 396,000
Which method should be used?

Net reporting, because company pays only for tickets sold to customers,
so no inventory costs
Company is not primary obligor under the contract
US GAAP: Revenue reported are $ 400,000

Expense Recognition General Principles
Matching Principle
Match expenses with associated revenues
Example
Some current period revenues are made from inventory purchased in
the previous period
The matching principle requires that the company matches the COGS
with the revenues of the period
Period Costs
Expenses that less directly matching the timing of revenues
Example
Administrative Expenses

Issues in Expense Recognition
Doubtful accounts
When companies sell on credit, customers may default
At the time of sale company estimates how much will be
uncollectible based on previous experience
The estimated amount is written off as expense
Warranties
Company estimates the amount of future expenses resulting from
warranties, to recognize an estimated warranty expense, and to
update the expense over the life of the warranty

Inventory Matching
Consider a company which started a year with an inventory of 100 units

bought at $10 each.
During the year company purchased an additional inventory of 800
units at an average cost of $11 each.
Total sales made by the company were 750 units at $15 each.
It has been identified that the beginning inventory is completely sold
this year.
Estimate the gross profit of the company

Estimate the inventory value left

Inventory Matching
Units Per Unit Value
Solution
Beginning Inventory 100 $ 10.00 1,000
Purchases 800 $ 11.00 8,800
Sales 750 $ 15.00 11,250
Closing Inventory 150 $ 11.00 1,650 Estimation of
Closing Inventory
can be done using
COGS 750 $ 10.87 8,150
FIFO
Part - 1 100 $ 10.00 1,000 LIFO
Part - 2 650 $ 11.00 7,150 AVCO
Sales 11,250
COGS 8,150
Gross Profit 3,100 Inventory Value 1,650

Depreciation
Long lived assets are assets expected to provide economic benefits over a
future period of time greater than one year Example Property, Plant and
Equipment
Depreciation is a process of systematically allocating costs of long lived assets
over the period during which the assets are expected to provide economic
benefits
Methods of depreciation:
Straight Line Method: Allocates evenly the cost of Long lived asset over the
useful life of the asset
Accelerated Method: Allocates a greater proportion of costs to early years
of the useful life of the asset

Amortization
Depreciation of Intangibles
It spreads costs of intangibles (e.g. Patents, Copyrights, etc.) over life
For intangible assets that must be amortized the process is same as
for depreciation
Per IAS No. 38 , if the pattern cannot be determined over the useful
life, then straight line method should be used
Goodwill generated during acquisition is not amortized
Goodwill impairment happens on the bass of annual reviews

Unusual or Infrequent Items
Reported pre-tax before net income from continuing operations

Included as part of operating income and explained in the footnotes
The nature of these items should be highlighted to know if they will recur
Items include:
Gain (Loss) from disposal of a business segments or assets
Gain (Loss) from sale of investment in subsidiary
Provisions for environmental remediation
Impairments, write-offs, restructuring, Integration expense for
recently acquired business

Extraordinary Items
Items that are both unusual and infrequent

Reported in a separate category below income from continuing (and
discontinued) operations
Are shown net of tax
Items include:
Losses from expropriation of assets
Uninsured losses from natural disaster
Prohibited under IFRS, US GAAP allows for its qualification as stated
above
Should be excluded when forecasting future earnings of the company

Discontinued Operations (IFRS and GAAP)
Operations that management has decided to dispose off one of the

operations but
Has not done so, yet
Did so in current year after it generated profit or loss
Reported separately net of taxes after net income as Discontinued
Operations
Assets, operations and financing activities must be physically and
operationally distinct from firm
Placed in a separate category below income from continuing
operations

Accounting Changes
Change in e.g. LIFO to FIFO

Accounting Retrospective application: IFRS and US GAAP require prior years data
shown in financial statements to be adjusted
Principle
Changes in e.g. change in estimated life of a depreciable asset

Accounting Does not require restatement of prior period earnings
Estimate Disclosed in footnotes
Correcting errors or changing from an incorrect accounting method to one

Prior Period that is acceptable typically requires restatement of prior period financial
Adjustments statements
Must disclose the nature of the error and its effect on the net income

Non-Operating Items
Financial Service Companies : Following are the major operating activities:

Interest
Dividends
Gains / Losses on Disposal of assets
Non Financial Service Companies : Non Operating activities will be
investing activities
The above activities (interest, dividends, etc. ) qualify as non operating
activities
If these are on a rise in a company then further investigation in the
footnotes becomes essential

Simple versus Complex Capital Structure
A simple Capital structure contains no potentially dilutive securities

In this case firm will report only basic EPS
A complex capital structure contains potentially dilutive securities
Firm has to report both the basic and diluted EPS
Dilutive Securities include
Stock Options
Warrants
Convertible Debt
Convertible Preferred Stock
Dilutive Securities decrease EPS if exercised or converted to common stock
Anti-dilutive securities increase EPS if exercised or converted to common stock

Basic EPS
Basic EPS: Amount of income available to common shareholders divided
by the weighted average number of common shares outstanding over a
period.
Net Income - Preferred Dividends

Basic EPS =
Weighted Average number of shares outstanding
In case of stock splits:
2 for 1 stock split increases the shares outstanding by 100%
For EPS calculation purposes, a stock split is treated as if it occurred
at the beginning of the year
In case of dividends:
The weighted average outstanding shares increases with the dividend
10% dividend results in a 10% increase in the shares outstanding

Computation of Weighted Average Shares &
Basic EPS
Consider the following data on the companies number of outstanding shares.

Date Activity Number of Shares
01/01/2009 Shares Outstanding 100000
01/04/2009 Shares Issued 50000
01/07/2009 10% Sock Dividend
01/09/2009 Shares Repurchased 25000
If the company has a net income of $250,000 and no preferred stock

What is the weighted average number of shares outstanding for the
company?
What is the Basic EPS of the company?

Computation of Weighted Average Shares &
Basic EPS
Date Activity Number of Shares
01/01/2009 Shares Outstanding 100000
01/04/2009 Shares Issued 50000
01/07/2009 10% Sock Dividend
01/09/2009 Shares Repurchased 25000
Shares Month *
Adjusted for Number of Adjusted
Date Activity Number of Shares 10% Dividend months shares
01/01/2009 Shares Outstanding 100,000 110,000 12 1,320,000
01/04/2009 Shares Issued 50,000 55,000 9 495,000
01/07/2009 10% Sock Dividend -
01/09/2009 Shares Repurchased 25,000 27,500 3 82,500
Total Weighted Shares = 1732500
Weighted Average Shares = 144375

Basic EPS =
250,000
=
144,375
Basic EPS = 1.73

Diluted EPS
If a company has dilutive securities then, diluted EPS will be lower than Basic EPS
There are 3 types of dilutive securities:
Convertible Preferred Stock
Convertible Outstanding Debt
Stock Options, Warrants
If the security is dilutive i.e. it reduces the Diluted EPS < Basic EPS then it is converted.
Else conversion does not occur.
Included only if diluted security is present

(Net Income -
Convertible Preferred Convertible Debt
Preferred + +
Dividend Interest * (1-t)
Dividend)
Diluted EPS =
Shares From Conversion Shares from Shares issuable
Weighted
+ of Convertible + conversion of + for warrants and
Average Shares
Preferred Stock convertible debt options
Included only if diluted security is present

Diluted EPS Dilution Check
Convertible preferred:
if (dividends/new shares) < basic EPS, then security is dilutive
Convertible debt:
if (interest (1 t)/new shares) < basic EPS, then its dilutive
Options and warrants:
if (average market price of share ) > exercise price, then its
dilutive

Diluted EPS Convertible Preferred Stock
Example
31/21/2009
Net Income $500,000,000
Common Stock of $10 each 20000000 = Number of Shares
Tax Rate 40%
Preferred stock outstanding ($10 each) = $ 7,500,000

Preferred Dividend Rate = 6%
One preferred stock is converted into 1.25 common shares
Calculate fully diluted EPS for 2009

Diluted EPS Convertible Preferred Stock
Net Income $500,000,000
Preferred Dividend 450000

Basic EPS =
Basic EPS = 24.98
Number of common shares if preferred shares are coverted

Outstanding all year 20000000
On Conversion of
Preferred Stock 937500
Total Shares - Diluted 20937500
Diluted EPS = 500000000

20937500
= 23.88 EPS Basic > Diluted EPS, security is
dilutive in nature

Diluted EPS Convertible Debt
Example
31/21/2009
Net Income $500,000,000
Common Stock of $10 each 20000000 = Number of Shares
Tax Rate 40%
Convertible Debt outstanding ($1000 each) = $ 25,000,000

Bond Rate = 5%
One bond is converted into 125 common shares

Diluted EPS Convertible Debt
Net Income $ 500,000,000
Add : Interest Saved $ 1,250,000
Less : Tax Impact $ (750,000)
$ 500,500,000
Basic EPS = 25.00
Number of common shares if debt is coverted

Outstanding all year 20000000
On Conversion of Debt 3125000
Total Shares - Diluted 23125000
Diluted EPS = 500,500,000

23125000
dilutive in nature

Diluted EPS Stock Options
Example
31/21/2009
Net Income $500,000,000
Common Stock of $10 each 20,000,000 = Number of Shares
Average Price of stock $20.00
Exercise Price $15.00
Number of Options outstanding 1000000
Basic EPS $25.00

Diluted EPS Stock Options
If all options are exercised -
Number of new shares issued 1000000
Cash Proceeds if all options $ 15,000,000

exercised
Number of shares that can be 15000000

purchsed at average price 20
= 750,000
Net increase in common stock

Total Shares needed 1000000
Shares purchased with 750,000
New Shares issued 250000
Diluted EPS = 500,000,000

20250000
dilutive in nature

Common Size Income Statement
Expresses each income statement line item as a percentage of sales

Used to analyze changes in cost structure and profitability
Used for both cross sectional (across industry) and time series analysis

Common Size Income Statement
Apple Inc. - Income Statement
Year ended 26 September
2009 2008
Net sales 36,537 32,479

Cost of sales (23,397) (21,334)
Gross margin 13,140 11,145
Operating expenses:
Research and development (1,333) (1,109)
Selling, general & administrative (4,149) (3,761)
Total operating expenses 5,482 4,870
Operating income 7,658 6,275
Apple Inc. -Common Size Income Statement
Net sales 100% 100%

Cost of sales -64% -66%
Gross margin 36% 34%
Operating expenses:
Research and development -4% -3%
Selling, general & administrative -11% -12%
Total operating expenses -15% -15%
Operating income 21% 19%

Measures of Operating Performance
Operating Profitability ratios:
Gross Profit
Gross Profit Margin =
Net Sales
Net Profit
Net Profit Margin =
Net Sales
Both are obtained from the common size statement

Comprehensive Income
Comprehensive income is the change in equity of a business enterprise

during a period from transactions and other events and circumstances
from non-owner sources.
Total Comprehensive Income =
Net Income +
Foreign Currency Translation Adjustment +
Unrealized gains or losses on derivatives contracts accounted for as
hedges +
Unrealized gains and losses on available for sale securities +
Pension Adjustment to funded status

Comprehensive Income
Opening stock holders equity was $300m. Closing stock holders equity was
$500m. On review of statement of stockholders equity we discover that
owners contributed $40m of equity during the year. Net Income for the year
was $100m and dividends paid were $15m .
Calculate the comprehensive income
Closing Equity 500

Opening Equity 300
Change in Equity 200
Owners Contribution 40 Other Comprehensive Income 75

Net Income 100
Dividend Paid -15 Net Income 100
125 Other Comprehensive Income 75
Comprehensive Income 175

Ratio Analysis

Profitability Ratios
Profitability Ratios Numerator Denominator
Gross profit margin Gross profit Revenue
Return on sales
Operating profit margin Operating income Revenue

Pretax margin EBT (earnings before tax but Revenue
after interest)
Net profit margin Net income Revenue
Operating ROA Operating income Average total assets

Return on investment
ROA Net income Average total assets

Return on total capital EBIT Short- and long-term
debt and equity
ROE Net income Average total equity
Return on common equity Net income Preferred Average common equity

dividends

Interpretation of Profitability Ratios
Gross Profit Margin
indicates % or revenue available to cover operating and other expenses
higher margin means company has competitive advantage in product
costs
Operating Profit Margin

Gross margin minus operating costs
Operating margin increasing faster than gross margin indicates
improvement in controlling operating costs
Pretax Margin
Operating Profit minus interest
effects of leverage and non-operating income on profitability

Net Profit Margin
Revenue minus all expenses
Net Income includes both recurring and nonrecurring components
ROA (Return on Assets)
Measures the return earned on assets
Higher ratio means more income on a given level of assets
1) Net Income
Average Total Assets
2) Net Income + Interest Expense (1 Tax Rate)
3) Operating Income or EBIT

Return on Total Capital

Measures profits on all capital (short-term debt, long-term debt,
and equity)
ROE (Return on Equity)

Measures return on all equity (minority equity, preferred equity,
common equity)
Return on common equity measures return earned on common
equity only

Practice Questions
1.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
Denalis gross profit is equal to:

A. $280,000
B. $500,000
C. $1,000,000

Practice Questions
2.If the outcome of a long-term contract can be measured reliably, the preferred
accounting method under both IFRS and U.S. GAAP is:
A. Cost recovery method
B. The completed contract method
C. The percentage-of-completion method
3. Apex Consignment sells items over the internet for individuals on a
consignment basis. Apex receives the items from the owner, lists them for sale on
the internet, and receives a 25 percent commission for any items sold. Apex
collects the full amount from the buyer and pays the net amount after
commission to the owner. Unsold items are returned to the owner after 90 days.
During 2009, Apex had the following information:
Total sales price of items sold during 2009 on consignment was 2,000,000.
Total commissions retained by Apex during 2009 for these items was 500,000.
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Practice Questions
How much revenue should Apex report on its 2009 income statement?
A. 500,000
B. 2,000,000
C. 1,500,000
4.Cell Services Inc. (CSI) had 1,000,000 average shares outstanding during all of
2009. During 2009, CSI also had 10,000 options outstanding with exercise prices
of $10 each. The average stock price of CSI during 2009 was $15. For purposes
of computing diluted earnings per share, how many shares would be used in
the denominator?
A. 1,003,333
B. 1,006,667
C. 1,010,000

Practice Questions
5.Under IFRS, revenue from barter transactions should be measured based on
the fair value of revenue from:
A. Similar barter transactions with unrelated parties
B. Similar non-barter transactions with related parties
C. Similar non-barter transactions with unrelated parties
Questions 1 2 3 4 5
Answer Key C C A C C

4.understanding The Income Statement

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Understanding the Income

IMS Proschool | www.proschoolonline.com 1

IMS Proschool | www.proschoolonline.com 2

Net sales 36,537 32,479 24,006

Earnings per common share:

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Eg. Depreciation on manufacturing

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Revenue is to be recognized if the following conditions are satisfied:

Risk rewards of ownership of the goods is transferred to the buyer

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No managerial involvement is Real estate still in the course of construction and is

Amount of revenue can be An company enters into a barter transaction for

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According to FASB revenue should be recognized when it is realized

SEC criteria for revenue recognition is:

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Each accounting period the company estimates what

IFRS revenue is only reported to extent of contract costs

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Year 1 Year 2 Year 3

If ABC recognizes the revenues on a completed contract basis then what

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Year 1 Year 2 Year 3 Year 1 Year 2 Year 3

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Used when likelihood of collection cannot be estimated,

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Cost Recovery Method

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Exchange of goods and not of cash is termed as a barter transaction

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Gross Revenue Reporting : Sales and cost of sales are reported

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Gross Reporting Net Reporting

Which method should be used?

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Consider a company which started a year with an inventory of 100 units

Estimate the gross profit of the company

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Reported pre-tax before net income from continuing operations

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Items that are both unusual and infrequent

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Operations that management has decided to dispose off one of the

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Change in e.g. LIFO to FIFO

Changes in e.g. change in estimated life of a depreciable asset

Correcting errors or changing from an incorrect accounting method to one

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Financial Service Companies : Following are the major operating activities:

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A simple Capital structure contains no potentially dilutive securities

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Net Income - Preferred Dividends

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Consider the following data on the companies number of outstanding shares.

If the company has a net income of $250,000 and no preferred stock