Understanding Income Statements

Reading: Understanding Income Statements
Disclaimer: Certain materials contained within this text are the copyright property of CFA Institute. The
following is the source for these materials: “CFA® Program Curriculum Level I Volume 3, page no. 71 to
126”.
C1: Basic principles based upon which financial statements are prepared.
 Matching
 Accrual
 Conservative / Prudence
 Consistent
LOS 1: Describe the components of the income statement and alternative presentation formats of that
statement.
The income statement shows an entity’s revenues, expenses, gains and losses during a reporting
period.
Revenues 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 their nature or function. Presenting all depreciation expense from
manufacturing and administration together in one line of the income statement is an example of
grouping by nature of the expense. Combining all costs associated with manufacturing (e.g., raw
materials, depreciation, labour, etc.) as cost of goods sold is an example of grouping by function.
The income statement also includes gains and losses, which result in an increase (gains) or decrease
(losses) of economic benefits. Gains and losses may or may not result from ordinary business activities.
For example, a firm might sell surplus equipment used in its manufacturing operation that is no longer
needed.
If a firm has a controlling interest in a subsidiary, the pro rata shares of the subsidiary’s income not
owned by the parent is reported in parent’s income statement as the noncontrolling interest (also
known as minority interest or minority owners’ interest). The noncontrolling interest is subtracted in
arriving at net income because the parent is reporting all of the subsidiary’s revenue and expense.
LOS 2: Describe general principles of revenue recognition and accounting standards for revenue
recognition.
LOS 3: Calculate revenue given information that might influence the choice of revenue recognition
method.
Under the accrual method of accounting, revenue is recognized when earned and expenses are
recognized when incurred. The important point to remember is that accrual accounting does not
necessarily coincide with the receipt or payment of cash.
If a firm receives cash before revenue recognition is complete, the firm reports it as unearned revenue.
Understanding Income Statements
Accounting standards identify a five-step process for recognizing revenue:

1. Identify the contract(s) with a customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the entity satisfies a performance obligation.
Information that can influence the choice of revenue recognition method includes progress toward
completion of a performance obligation, variable considerations and their likelihood of being earned,
revisions to contracts, and whether the firm is acting as a principal or an agent in a transaction.
LOS 4: Describe general principles of expense recognition, specific expense recognition applications,
and implications of expense recognition choices for financial analysis.
The matching principle requires that firms match revenues recognized in a period with the expenses
required to generate them. One application of the matching principle is seen in accounting for
inventory, with cost of goods sold as the cost of units sold from inventory that are included in current-
period revenue. Other costs, such as depreciation of fixed assets or administrative overhead, are
period costs and are taken without regard to revenues generated during the period.
Depreciation methods:
 Straight-line
 Declining balance
Inventory valuation methods:

 FIFO
 LIFO
 Average cost
Intangible assets with limited lives should be amortized using a method that reflects the flow over
time of their economic benefits. Intangible assets with indefinite lives (e.g., goodwill) are not
amortized.
Users of financial data should analyze the reasons for any changes in estimates of expenses and
compare these estimates with those of peer companies.
LOS 5: Describe the financial reporting treatment and analysis of nonrecurring items (including
discontinued operations, unusual or infrequent items) and changes in accounting policies.
Results of discontinued operations are reported below income from continuing operations, net of tax,
from the date the decision to dispose of the operations is made. These results are segregated because
they likely are non-recurring and do not affect future net income.
Unusual or infrequent items are reported before tax and above income from continuing operations.
An analyst should determine how “unusual” or “infrequent” these items really are for the company
when estimating future earnings or firm value.
Changes in accounting standards, changes in accounting methods applied, and corrections of

accounting errors require retrospective restatement of all prior-period financial statements included
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in the current statement. A change in an accounting estimate, however, is applied prospectively (to
subsequent periods) with no restatement of prior-period results.
LOS 6: Distinguish between the operating and non- operating components of the income statement.
Operating income is generated from the firm’s normal business operations. For a nonfinancial firm,
income that results from investing or financing transactions is classified as non-operating income,
while it is operating income for a financial firm since its business operations include investing in and
financing securities.
LOS 7: Describe how earnings per share is calculated and calculate and interpret a company’s earnings
per share (both basic and diluted earnings per share) for both simple and complex capital structures.
LOS 8: Distinguish between dilutive and antidilutive securities and describe the implications of each
for the earnings per share calculation.
Important points:
 The weighted average number of common shares is the number of shares outstanding during
the year, weighted by the portion of the year they were outstanding.
 A stock split or stock dividend is applied to all shares outstanding prior to the split or dividend
and to the beginning-of-period weighted average shares. A stock split or stock dividend
adjustment is not applied to any shares issued or repurchased after the split or dividend date.
 If a dilutive security was issued during the year, the increase in the weighted average number
of shares for diluted EPS is based on only the portion of the year the dilutive security was
outstanding.
 Remember, each potentially dilutive security must be examined separately to determine if it
is actually dilutive (i.e., would reduce EPS if converted to common stock).
Example: EPS with convertible preferred stock

During 2021, ABC reported net income of $4,350,000 and had 2,000,000 shares of common stock
outstanding for the entire year. ABC’s 7%, $5,000,000 par value preferred stock is convertible into
common stock at a conversion rate of 1.1 shares for every $10 of par value. Compute basic and diluted
EPS.
Example: EPS with convertible debt

During 2021, XYZ Corp. had earnings available to common shareholders of $2,500,000 and had
1,000,000 shares of common stock outstanding for the entire year, for basic EPS of $2.50. During 2020,
XYZ issued 2,000, $1,000 par, 5% bonds for $2,000,000 (issued at par). Each of these bonds is
convertible to 120 shares of common stock. The tax rate is 30%. Compute the 2021 diluted EPS.
Example: EPS with stock options

During 20X6, XXX reported earnings available to common shareholders of $1,200,000 and had 500,000
shares of common stock outstanding for the entire year, for basic EPS of $2.40. XXX has 100,000 stock
options (or warrants) outstanding the entire year. Each option allows its holder to purchase one share
of common stock at $15 per share. The average market price of XXX’s common stock during 20X6 is
$20 per share. Compute diluted EPS.
LOS 9: Convert income statements to common- size income statements.

<< to be discussed in class>>
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LOS 10: Evaluate a company’s financial performance using common- size income statements and
financial ratios based on the income statement.
LOS 11: Describe, calculate, and interpret comprehensive income.

LOS 12: Describe other comprehensive income and identify major types of items included in it.
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Learning Outcome as per CFA Institute:

a. Describe the components of the income statement and alternative presentation formats of that
statement.
b. Describe general principles of revenue recognition and accounting standards for revenue
recognition.
c. Calculate revenue given information that might influence the choice of revenue recognition
method.
d. Describe general principles of expense recognition, specific expense recognition applications, and
implications of expense recognition choices for financial analysis.
e. Describe the financial reporting treatment and analysis of nonrecurring items (including
discontinued operations, unusual or infrequent items) and changes in accounting policies.
f. Distinguish between the operating and non- operating components of the income statement.
g. Describe how earnings per share is calculated and calculate and interpret a company’s earnings
per share (both basic and diluted earnings per share) for both simple and complex capital
structures.
h. Distinguish between dilutive and antidilutive securities and describe the implications of each for
the earnings per share calculation.
i. Convert income statements to common- size income statements.
j. Evaluate a company’s financial performance using common- size income statements and financial
ratios based on the income statement.
k. Describe, calculate, and interpret comprehensive income.
l. Describe other comprehensive income and identify major types of items included in it.
1. Expenses on the income statement may be grouped by:

A. nature, but not by function.
B. function, but not by nature.
C. either function or nature.
2. An example of an expense classification by function is:

A. tax expense.
B. interest expense.
C. cost of goods sold.
3. 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.
4. Under IFRS, income includes increases in economic benefits from:

A. increases in liabilities not related to owners’ contributions.
B. enhancements of assets not related to owners’ contributions.
C. increases in owners’ equity related to owners’ contributions.
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5. 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.
6. 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.
How much revenue should Apex report on its 2009 income statement?
A. €500,000.
B. €2,000,000.
C. €1,500,000.
7. A company previously expensed the incremental costs of obtaining a contract. All else being equal,
adopting the May 2014 IASB and FASB converged accounting standards on revenue recognition
makes the company’s profitability initially appear:
A. lower.
B. unchanged.
C. higher.
8. 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.
9. Using the same information as in Question 8, what would Accent’s cost of goods sold be under
the weighted average cost method?
A. ₤120,000.
B. ₤122,000.
C. ₤124,000.
10. Which inventory method is least likely to be used under IFRS?

A. First in, first out (FIFO).
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B. Last in, first out (LIFO).

C. Weighted average.
11. 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.
12. Using the same information as in Question 11, 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.
13. Which combination of depreciation methods and useful lives is most conservative in the year a
depreciable asset is acquired?
A. Straight- line depreciation with a short useful life.
B. Declining balance depreciation with a long useful life.
C. Declining balance depreciation with a short useful life.
14. 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.
15. 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.
16. 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.
17. For its fiscal year- end, Calvan Water Corporation (CWC) reported net income of $12 million and
a weighted average of 2,000,000 common shares outstanding. The company paid $800,000 in
preferred dividends and had 100,000 options outstanding with an average exercise price of $20.
CWC’s market price over the year averaged $25 per share. CWC’s diluted EPS is closest to:
A. $5.33.
B. $5.54.
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C. $5.94.
18. A company with no debt or convertible securities issued publicly traded common stock three times
during the current fiscal year. Under both IFRS and US GAAP, the company’s:
A. basic EPS equals its diluted EPS.
B. capital structure is considered complex at year- end.
C. basic EPS is calculated by using a simple average number of shares outstanding.
19. Laurelli Builders (LB) reported the following financial data for year- end 31 December:
Common shares outstanding, 1 January 2,020,000
Common shares issued as stock 380,000
dividend, 1 June
Warrants outstanding, 1 January 500,000
Net income $3,350,000
Preferred stock dividends paid $430,000
Common stock dividends paid $240,000
Which statement about the calculation of LB’s EPS is most accurate?
A. LB’s basic EPS is $1.12.
B. LB’s diluted EPS is equal to or less than its basic EPS.
C. The weighted average number of shares outstanding is 2,210,000.
20. 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.
21. For its fiscal year- end, Sublyme Corporation reported net income of $200 million and a weighted
average of 50,000,000 common shares outstanding. There are 2,000,000 convertible preferred
shares outstanding that paid an annual dividend of $5. Each preferred share is convertible into
two shares of the common stock. The diluted EPS is closest to:
A. $3.52.
B. $3.65.
C. $3.70.
22. When calculating diluted EPS, which of the following securities in the capital structure increases
the weighted average number of common shares outstanding without affecting net income
available to common shareholders?
A. Stock options
B. Convertible debt that is dilutive
C. Convertible preferred stock that is dilutive
23. 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.
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C. standardizes each line item of the income statement but fails to help an analyst identify
differences in companies’ strategies.
24. Selected year- end financial statement data for Workhard are shown below.
$ millions
Beginning shareholders’ equity 475
Ending shareholders’ equity 493
Unrealized gain on available- for- sale securities 5
Unrealized loss on derivatives accounted for as hedges -3
Foreign currency translation gain on consolidation 2
Dividends paid 1
Net income 15
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.
25. 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
26. At the start of the year, a company acquired new equipment at a cost of €50,000, estimated to
have a three-year life and a residual value of €5,000. If the company depreciates the asset using
the double declining balance method, the depreciation expense that the company will report for
the third year is closest to:
A. €3,328.
B. €555.
C. €3,705.
27. An equity analyst is forecasting next year’s net profit margin of a heavy equipment manufacturing
firm by using the average net profit margin over the past three years. In making his profit
projection, he identifies the following three items:
1) The company reported losses from discontinued operations in each of the past three years.
2) The most recent year’s tax rate was only half of the prior two years’ rate as a result of a fiscal
stimulus.
3) The company reported gains on the sale of investments in each of the past three years.
Which of the following statements about the preparation of the forecast is most accurate? The
analyst would:
A. use the most recent tax rate because it is the best predictor of future tax rates.
B. exclude the gains on the sale from investments because the company is a manufacturing firm.
C. include the losses from discontinued operations because they appear to be an ongoing feature
for this company.
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28. The following information is available on a company for the current year.
Net income $1,000,000
Average number of common shares outstanding 100,000
Details of convertible securities outstanding:
Convertible preferred shares outstanding 2,000
Dividend/share $10
Each preferred share is convertible into five shares of common
stock
Convertible bonds, $100 face value per bond $80,000
8% coupon
Each bond is convertible into 25 shares of common stock
Corporate tax rate 40%
The company’s diluted EPS is closest to:
A. $7.72.
B. $7.57.
C. $7.69.
29. Other comprehensive income is least likely to include gains or losses on:
A. the sale or disposal of discontinued operations.
B. derivative contracts accounted for as hedges.
C. the translation of foreign currency–denominated subsidiary financial statements.
30. Net revenue most likely refers to revenue minus:

A. revenues attributable to non-controlling interests.
B. estimates of warranty expense.
C. volume discounts and estimated returns.
31. The following information is from a company’s accounting records:

€ millions
Revenues for the year 12,500
Total expenses for the year 10,000
Gains from available-for-sale securities 1,475
Loss on foreign currency translation adjustments on a foreign subsidiary 325
Dividends paid 500
The company’s total comprehensive income (in € millions) is closest to:
A. 1,150.
B. 3,150.
C. 3,650.
32. Information about a company’s historical performance for the last two years and additional
information are summarized in the following table.
($ thousands) 2013 2012
Sales 5,500.0 5,350.0
Cost of goods sold –2,200.0 –2,140.0
Operating expenses –2,350.0 –2,350.0
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($ thousands) 2013 2012

Gain on sale of short-term investments 0 140.0
Tax expense –237.5 –325.0
Income (loss) from discontinued operations (net of tax) –312.5 112.5
Net income 400.0 787.5
Industry sales are expected to increase 5%, and the company expects to maintain its current
market share and gross profit margin. Operating expenses are not expected to change with the
increase in sales.
The company sold off its portfolio of marketable securities in 2012 and used the funds to purchase
operating assets. In 2012, the company announced its intention to sell off a division, and that sale
was completed in 2013. The results from the division and the gain or loss incurred on the sale are
classified as discontinued operations.
The projected net income (in thousands) for 2014 is closest to:
A. $745.
B. $836.
C. $635.
33. A company with a tax rate of 40% sold a capital asset with a net book value of $500,000 for
$570,000 during the year. Which of the following amounts related to the asset sale will most likely
be reported as a line item on its income statement for the year?
A. $570,000
B. $42,000
C. $70,000
34. The following financial information is available at the end of the year.
Share Information
Issued and
Security Authorized Outstanding Other Features
Common stock 500,000 250,000 Currently pays a dividend of $1 per share.
Preferred 50,000 12,000 Nonconvertible, cumulative; pays a dividend of
stock, Series A $4 per share.
Preferred 50,000 30,000 Convertible; pays a dividend of $7.50 per share.
stock, Series B Each share is convertible into 2.5 common
shares.
Additional information:
Reported income for the year $1,000,000
The diluted EPS (earnings per share) is closest to:
A. $3.08.
B. $2.93.
C. $2.91.
35. A company sells a non-refundable, two-year service contract for €420. Based on historical
patterns, the company expects to incur 25% of service costs in the first year of the contract and
the remainder in the second year. The amount of revenue the company recognizes in the first year
is closest to:
A. €105.
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B. €420.
C. €210.
36. An artists’ cooperative sells its artwork on a consignment basis through a local art gallery. The
cooperative should most likely recognize revenue when the art gallery:
A. sells the artwork.
B. remits payment for the artwork.
C. receives the artwork.
37. Under general principles of expense recognition, a company should:

A. apply uniform treatment for administrative and depreciation costs.
B. recognize expenses in the period that it consumes the associated economic benefits.
C. allocate lost economic benefits prospectively over the expected period in which the benefits
would have been earned.
38. Unless it is impractical to do so, changes in accounting policies are to be reported:

A. prospectively.
B. retrospectively.
C. at the bottom of the income statement in the year of change.
39. Selected year-end financial data for Mega Industries follows:

Net income $100 million
Tax rate 25 percent
Weighted average number of common shares outstanding 25 million
Convertible preferred shares* 10 million
Preferred dividend per share $1.00
* Each share is convertible into 0.5 shares of common stock.
The net difference between Mega’s reported basic EPS and its diluted EPS is closest to:
A. $0.74.
B. $0.27.
C. $0.37.
40. An Australian company that reports under International Financial Reporting Standards (IFRS)
purchases a plane with an expected useful life of 20 years. All costs are reported in Australian
dollars.
 TOTAL cost is A$10 million.
 A$1 million of the total cost is allocated to the plane’s interior (galleys and seating), which is
completely refurbished every four years.
 A$4 million of the total cost is allocated to the turbines, which are replaced every eight years.
 No residual value is expected.
If the company uses straight-line depreciation, the depreciation expense for the first full year
related to the plane would be closest to:
A. A$1,000 thousand.
B. A$500 thousand.
C. A$750 thousand.
41. An income statement in a single-step format presents a subtotal for:

A. amortization of intangibles.
B. operating income.
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C. gross margin.
42. The following data are available on a company:

Metric Company
Stock price per share $60.75
Comprehensive income (millions) $193.0
Other comprehensive income $87.6
(millions)
Common shares outstanding $46.5
(millions)
On a net income basis, the company’s P/E is closest to:
A. 10.1.
B. 14.6.
C. 26.8.
43. The following common-size income statement data and tax rates are available on a company.
Current Year
Financial Item (%)
Revenues 100
Cost of goods sold 38.6
Interest expense 3.1
Research expenses 4.4
Selling and general expenses 32.9
Income tax rate 22%

Prior Year’s Profitability
Ratios
Gross profit margin 60.5%
Operating profit margin 23.3%
Net profit margin 15.8%
The profitability ratio that had the largest absolute increase in value in the current year is the:
A. operating profit margin.
B. net profit margin.
C. gross profit margin.
44. The following information for the current year is available for a company that prepares its financial
statements in accordance with US GAAP.
$
thousands
Revenue 7,000
Cost of goods sold 4,200
Other operating 500
expenses
Restructuring costs 250
Interest expense 200
The company’s operating profit (in thousands) is closest to:
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A. $2,050.
B. $2,300.
C. $1,850.
45. Company A owns 60% of Company B. Company A’s consolidated income statement most likely
includes 100% of Company A’s revenues and expenses and what portion of Company B's?
A. 0%
B. 100%
C. 60%
46. The following data is available on two companies that operate in the same industry:
Metric ($ millions) Company X Company Y
Sales 11.2 14.5
Cost of goods sold 5.7 7.7
Administration costs 1.9 2.2
Interest expense 0.3 0.7
Research and development 1.5 1.7
expenses
Which of the following statements is most appropriate? Better margin performance will be
reported by:
A. Company Y at the gross margin level and Company X at the operating margin level.
B. Company Y at both the gross margin and operating margin levels.
C. Company X at the gross margin level and Company Y at the operating margin level.
47. The following data are available on a company:

Metric ($ millions)
Total assets 145
Total revenues 282
Total expenses 241
Research and development 12
expenses
Under a common-size analysis, the value used for research and development expenses is closest
to:
A. 4.2%.
B. 8.3%.
C. 5.0%.
48. A company sells a product with a three-year warranty included in the price. According to IFRS,
which of the following is the most appropriate accounting treatment for the warranty?
A. Fully recognizing the revenue at the time of the sale but waiting until the actual warranty costs
are incurred to recognize the expense.
B. Fully recognizing the revenue and estimated warranty expense at the time of the sale and
updating the expense as indicated by experience over the life of the warranty.
C. Deferring all of the revenue and recognizing it over the life of the warranty period.
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49. The following table shows changes to the number of common shares outstanding for a company
during 2012:
1 January 180,000 shares
outstanding
1 June 60,000 shares issued
1 August 2-for-1 stock split
31 480,000 shares
December outstanding
To calculate earnings per share for 2012, the company’s weighted average number of shares
outstanding is closest to:
A. 315,000.
B. 215,000.
C. 430,000.
50. The following information is available about a company for the current year:
 Net income of $32 million
 Weighted average number of common shares outstanding of 4.5 million
 $15 million of 12% convertible bonds, convertible into 50,000 shares
 200,000 options with an exercise price of $50 per share
 Average market price of $80 per share during the year
 Tax rate of 30%
The company’s diluted EPS is closest to:
A. $6.99.
B. $7.19.
C. $6.81.
51. In applying the principles of expense recognition, companies should:

A. record any estimates of uncollectible amounts as a direct reduction of revenues.
B. exclude costs of intangible assets with indefinite useful lives.
C. recognize credit losses on customer receivables when defaults occur.
52. The following data are available on a company for the current year:
£
Metric thousands
Comprehensive income 246,000
Dividends paid 60,000
Ending retained earnings 821,000
Opening retained 580,000
earnings
The company will most likely report other comprehensive income (OCI) (in £ thousands) as a:
A. loss of 55,000.
B. gain of 186,000.
C. gain of 301,000.
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53. The following table summarizes income statement data for a manufacturing company:
2020 2021
(€ (€
thousands) thousands)
Net Revenue 2,325 2,611
Cost of Goods Sold 1,550 1,700
Gross Profit 775 930
Selling, General & Administrative 260 295
Expense
Operating Income 515 635
Interest Expense 55 55
Pre-Tax Income 460 580
Income Tax 120 155
Net Income 340 425
Compared with 2020, the 2021 common-size income statement most likely indicates:
A. a lower tax rate.
B. cost cutting in selling, general and administration.
C. sale of a new, differentiated product.
54. A company incurred the following unrealized holding gains in the current year:
 $100,000 on securities held for trading
 $500,000 on the foreign currency translation adjustment of a self-sustaining non-domestic
subsidiary
Other comprehensive income for the year is closest to:
A. $600,000.
B. $100,000.
C. $500,000
55. An analyst gathers the following information about a company’s common stock:
 1 January 2013: 200,000 shares outstanding
 1 June 2013: 50,000 shares issued
 1 August 2013: two-for-one stock split
 31 December 2013: 500,000 shares outstanding
To calculate earnings per share for 2013, the company’s weighted average number of shares
outstanding is closest to:
A. 333,333.
B. 350,000.
C. 458,332.
56. Under US GAAP, which of the following would most likely be reported as an operating item on a
manufacturing company’s income statement?
A. A gain on the sale of non-strategic investments
B. An impairment loss on obsolete inventory
C. Interest expense on long-term debt
57. For which of the examples given would common-size income statements generally provide the
greatest insight?
A. A liquidity analysis of two companies within the same industry
B. A time-series analysis of a rapidly expanding single company
Page 16 of 39
C. A comparison of similarly sized companies from different industries
58. Common-size income statements are shown for three companies in the same industry. Which
company is most likely to have a technically superior product?
Company X Company Y Company Z
Revenue 100% 100% 100%
Cost of goods sold 65 50 30
Administrative expenses 20 20 20
Research and 0 5 30
development
Advertising expenses 5 15 10
Operating profit 10 10 10
A. Company Z
B. Company Y
C. Company X
59. Non-operating items reported on the income statement:

A. include interest expense and interest revenue for non-financial service firms.
B. are shown as either financing or investing items on the cash flow statement.
C. are required to be reported as separate entries.
60. Oceanaqua Apparel (OA) is a manufacturer of swimwear. Abbreviated common-size income

statements and relevant industry data are presented below.
OA Common-Size Income
Statement 2015 2014 2013
Net Revenues 100.0% 100.0% 100.0%
Cost of Sales 64.3 62.5 59.5
Gross Profit 35.7 37.5 40.5
Selling, General & Admin 23.5 23.2 25.5
Advertising 0.5 2.9 3.1
Operating Income 11.7 11.4 11.9
Interest Expense 1.8 2.2 3.8
Earnings Before Taxes 9.9 9.2 8.1
Taxes 2.0 2.0 1.9
Net Income 7.9 7.2 6.2
Swimwear Industry
Gross Profit Margin 38.4% 39.1% 40.7%
Net Profit Margin 7.1 6.8 6.1
Which statement about OA’s three-year financial performance is most accurate? OA’s:
A. effective tax rate has been holding steady at approximately 2%.
B. revenues per dollar of sales costs are falling over the time period.
C. profit margins indicate performance superior to the industry average.
61. Which of the following expense recognition choices is least consistent with conservative
accounting of reported net income?
A. Recognizing expenses later rather than earlier
B. Reflecting lower warranty expenses due to improved product quality
Page 17 of 39
C. Estimating lower uncollectible accounts due to stricter credit policies
62. Which of the following best describes a component of the income statement?
A. Amounts that a company owes its vendors for purchases of goods and services
B. Outflows or depletions of assets in the course of a business's activities
C. Obligations from past events that are expected to result in an outflow of economic benefits
63. At year end, a company has non-convertible debt, ordinary shares, and employee stock options
outstanding. The company’s capital structure is considered to be:
A. complex, because the company has both debt and equity.
B. complex, because the options are convertible into ordinary shares.
C. simple, if the options are antidilutive.
64. For a company paying preferred dividends, the components needed to compute basic EPS are net
income:
A. and the weighted average number of common shares outstanding.
B. preferred dividends, and the weighted average number of common shares outstanding.
C. preferred dividends, additional shares issued if preferred is converted, and the weighted
average number of common shares outstanding.
65. Selected year-end financial data for Smalley Enterprises follows:

Net income: $200,000
Tax rate: 15 percent
Weighted average number of common shares outstanding: 125,000
12% bond convertible into 3,000 common shares (potentially dilutive): $60,000
Given this information, Smalley’s diluted EPS is closest to:
A. $1.61.
B. $1.60.
C. $1.51.
66. A firm with convertible securities initially calculates that its diluted EPS is greater than its basic
EPS. The firm will:
A. not be required to report diluted EPS.
B. report basic EPS that is not equal to reported diluted EPS.
C. report basic EPS that is equal to reported diluted EPS.
67. When preparing a common-sized income statement, the appropriate denominator for converting
the reported cost of sales is:
A. revenues.
B. net income.
C. pretax income
68. Using a common-size income statement to compare a company to its peers, an analyst can
determine the company’s:
A. relative performance.
B. size.
C. revenue recognition policies.
Page 18 of 39
69. An analyst gathers the following annual information on three companies:

Company A Company B Company C
Sales $40,000 $200,000 $450,000
Cost of sales 21,000 110,000 240,000
Selling, general and administrative 6,000 24,000 48,000
All other operating expenses 1,000 2,000 5,000
Operating income 12,000 64,000 157,000
Interest and other expense 2,000 0 14,000
Taxes 4,000 26,000 58,000
Net income $6,000 $38,000 $85,000
The company with the highest gross profit margin is:
A. Company A.
B. Company C.
C. Company B.
70. Under US GAAP, a company’s comprehensive income is reported as:

A. net income less common stock dividends.
B. the change in equity during a period from transactions and other events and circumstances
from non-owner sources.
C. revenue less expense items that are excluded from the net income calculation.
71. An analyst notes that a company’s most recent financial statements show £65 million in net
income, £7 million in dividends paid to common shareholders, and £5 million of other net expense
items excluded from the net income calculation. The company’s comprehensive income is:
A. £60 million.
B. £65 million.
C. £53 million.
72. Selected financial data follows for Companies A, B, C:

All values in millions except price per Company A Company B Company C
share
Price per share for common shares $27 $88 $53
Net income $150 $500 $800
Other comprehensive income (loss) ($17) $65 $50
Common stock dividends paid $45 $100 $300
Shares outstanding 100 125 300
Which company has the lowest price/earnings (P/E) ratio calculated using comprehensive
income?
A. Company A
B. Company C
C. Company B
73. Which of the following items is treated as other comprehensive income under both IFRS and US
GAAP?
A. Costs of a company’s defined benefit post-retirement plans that are recognized in the current
period
B. Foreign currency translation adjustment from consolidating financials of foreign subsidiaries
C. Certain changes in the value of long-lived assets measured using the cost model
Page 19 of 39
74. Unrealized gains and losses on securities categorized as available-for-sale:

A. do not affect shareholders’ equity.
B. affect the profit and loss statement as unrealized holding gains or losses.
C. affect shareholders’ equity through other comprehensive income.
Solution
1. C is correct. IAS No. 1 states that expenses may be categorized by either nature or function.
2. C is correct. Cost of goods sold is a classification by function. The other two expenses represent
classifications by nature.
3. C is correct. Gross margin is revenue minus cost of goods sold. Answer A represents net income
and B represents operating income.
4. B is correct. Under IFRS, income includes increases in economic benefits from increases in assets,
enhancement of assets, and decreases in liabilities.
5. 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.
6. A is correct. Apex is not the owner of the goods and should only report its net commission as
revenue.
7. C is correct. Under the converged accounting standards, the incremental costs of obtaining a
contract and certain costs incurred to fulfill a contract must be capitalized. If a company expensed
these incremental costs in the years prior to adopting the converged standards, all else being
equal, its profitability will appear higher under the converged standards.
8. 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.
9. C is correct. Under the weighted average cost method:

October purchases 10,000 units $100,000
November purchases 5,000 units $55,000
Total 15,000 units $155,000
$155,000/15,000 units = $10.3333 × 12,000 units = $124,000.
10. B is correct. The last in, first out (LIFO) method is not permitted under IFRS. The other two methods
are permitted.
11. A is correct. Straight- line depreciation would be ($600,000 – $50,000)/10, or $55,000.
12. 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.
Page 20 of 39
13. C is correct. This would result in the highest amount of depreciation in the first year and hence
the lowest amount of net income relative to the other choices.
14. 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.
15. 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 them 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.
16. 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.
17. B is correct. The formula to calculate diluted EPS is as follows:

Diluted EPS = (Net income – Preferred dividends)/[Weighted average number of shares
outstanding + (New shares that would have been issued at option exercise – Shares that could
have been purchased with cash received upon exercise) × (Proportion of year during which the
financial instruments were outstanding)]. The underlying assumption is that outstanding options
are exercised, and then the proceeds from the issuance of new shares are used to repurchase
shares already outstanding:
Proceeds from option exercise = 100,000 × $20 = $2,000,000
Shares repurchased = $2,000,000/$25 = 80,000
The net increase in shares outstanding is thus 100,000 – 80,000 = 20,000.
Therefore, the diluted EPS for CWC = ($12,000,000 – $800,000)/2,020,000 = $5.54.
18. A is correct. Basic and diluted EPS are equal for a company with a simple capital structure. A
company that issues only common stock, with no financial instruments that are potentially
convertible into common stock has a simple capital structure. Basic EPS is calculated using the
weighted average number of shares outstanding.
19. B is correct. LB has warrants in its capital structure; if the exercise price is less than the weighted
average market price during the year, the effect of their conversion is to increase the weighted
average number of common shares outstanding, causing diluted EPS to be lower than basic EPS.
If the exercise price is equal to the weighted average market price, the number of shares issued
equals the number of shares repurchased. Therefore, the weighted average number of common
shares outstanding is not affected and diluted EPS equals basic EPS. If the exercise price is greater
than the weighted average market price, the effect of their conversion is antidilutive. As such,
they are not included in the calculation of basic EPS. LB’s basic EPS is $1.22 [= ($3,350,000 –
$430,000)/2,400,000]. Stock dividends are treated as having been issued retroactively to the
beginning of the period.
20. A is correct. With stock options, the treasury stock method must be used. Under that method, the
company would receive $100,000 (10,000 × $10) and would repurchase 6,667 shares
($100,000/$15). The shares for the denominator would be:
Page 21 of 39
Shares outstanding 1,000,000

Options exercises 10,000
Treasury shares purchased (6,667)
Denominator 1,003,333
21. C is correct.
Diluted EPS = (Net income)/(Weighted average number of shares outstanding + New common
shares that would have been issued at conversion)
= $200,000,000/[50,000,000 + (2,000,000 × 2)]
= $3.70
The diluted EPS assumes that the preferred dividend is not paid and that the shares are converted
at the beginning of the period.
22. A is correct. When a company has stock options outstanding, diluted EPS is calculated as if the
financial instruments had been exercised and the company had used the proceeds from the
exercise to repurchase as many shares possible at the weighted average market price of common
stock during the period. As a result, the conversion of stock options increases the number of
common shares outstanding but has no effect on net income available to common shareholders.
The conversion of convertible debt increases the net income available to common shareholders
by the after- tax amount of interest expense saved. The conversion of convertible preferred shares
increases the net income available to common shareholders by the amount of preferred dividends
paid; the numerator becomes the net income.
23. 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.
24. 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.
25. 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
Page 22 of 39
foreign subsidiaries, the effects of translating the subsidiaries’ balance sheet assets and liabilities
at current exchange rates are included as other comprehensive income.
26. B is correct. Under the double declining balance method, the depreciation rate is 2 × Straight-line
rate. The straight-line rate is 33.3% (i.e., 1/3 years), so the double declining rate is 66.6%, or two-
thirds depreciation rate per year. But the asset should not be depreciated below its assumed
residual value in any year.
Double Declining Balance Method of Depreciation
Net Book Value at Start of Net Book Value at End of
Year Year Depreciation Year
1 €50,000 €33,333 €16,667
2 16,667 11,111 5,555
3 5,555* 555** 5,000
* Alternative calculation for start of Year 3 net book value: €50,000 ×(1 − 0.667) ×(1 − 0.667) =
€5,555.
** Depreciation cannot be 2/3× €5,555 = €3,705 because that would reduce book value to less
than the estimated €5,000.
A is incorrect because it depreciates the asset value less its estimated salvage value over the 3
years.
BV at start of Year 3:
(50,000 − 5,000) × (1 − 0.667) × (1 − 0.667) = 4,990
Depreciation at 66.7% = 4,990 × 0.667 = 3,328.
Alternatively: (50,000 − 5,000) × (1 − 0.667)2 × 0.667 = 3,328
C is incorrect because it depreciates the asset below the estimated salvage value in year 3.
BV at start of Year 3:
50,000 × (1 − 0.667) × (1 − 0.667) = 5,555
Depreciation at 66.7% = 5,555 × 0.667 = 3,705.
Alternatively: (50,000) × (1 − 0.667)2 × 0.667 = 3,698 (rounding)
27. B is correct. The company is a heavy equipment manufacturer. Because gains on investments are
not a core part of the company’s business, they should not be viewed as an ongoing source of
earnings. Discontinued operations are considered to be non-recurring items (even though they
have occurred in the past three years); they are normally treated as random and unsustainable
and should not be included in a short-term forecast. The change in the current tax rate is best
viewed as temporary in the absence of additional information and should not be the basis of the
calculation of the average tax rate.
A is incorrect because the long(er) run tax rate should be used; the change in the current tax rate
is best viewed as temporary in the absence of additional information and should not be the basis
of the calculation of the average tax rate.
C is incorrect because the discontinued items should be considered random and unsustainable for
a short-term forecast.
Page 23 of 39
28. A is correct. Because both the preferred shares and the bonds are dilutive, they should both be
converted to calculate the diluted EPS. Diluted EPS is the lowest possible value.
Diluted
Diluted EPS: Diluted
EPS: Bond Preferred EPS: Both
Basic EPS Converted Converted Converted
Net income $1,000,000 $1,000,000 $1,000,000 $1,000,000
Preferred dividends −$20,000 −$20,000 0 0
After-tax cost of interest $3,840 $3,840
8% × $80,000 × (1 − 0.40)
Numerator $980,000 $983,840 $1,000,000 $1,003,840
Average common shares 100,000 100,000 100,000 100,000
outstanding
Preferred converted 10,000 10,000
Bond converted 20,000 20,000
Denominator 100,000 120,000 110,000 130,000
B is incorrect because preferred dividends were included after preferred conversion (see table).
C is incorrect because after-tax interest on bonds was not added back after bond conversion: after-
tax interest is (1 − 0.40) × 8% × $80,000 = 3,840 (see table).
29. A is correct. Gains or losses on the disposal of discontinued operations are reported separately
near the bottom of the income statement and are included in net income, not other
comprehensive income.
B is incorrect. Gains or losses on derivative contracts accounted for as cash flow hedges are
included in other comprehensive income.
C is incorrect. Gains or losses on the translation of certain foreign currency–denominated

subsidiary financial statements are included in other comprehensive income.
30. C is correct. Net revenue means that the revenue number is reported after adjustments for cash
or volume discounts or for estimated returns.
A is incorrect. Revenues attributed to non-controlling interests are not segregated on the income
statement.
B is incorrect. Warranty expenses are operating expenses and not netted from revenues.
31. C is correct.
Total comprehensive income = Net income + Other comprehensive income
Net Income = Revenues – Expenses.
Other comprehensive income includes gains or losses on available-for-sale (AFS) securities and
translation adjustments on foreign subsidiaries.
(Revenues – Expenses) + Gain on AFS securities – Loss on FX translation
(12,500 – 10,000) + 1,475 – 325 = 3,650.
Page 24 of 39
A is incorrect because it is just the other comprehensive income (1,475 – 325) and not the total
comprehensive income.
B is incorrect because it also deducts dividends, which are deducted when calculating the change
in shareholders’ equity but not total comprehensive income.
32. B is correct. The loss (gain) from discontinued operations and the gain on the sale of the portfolio
investments should not be included in the forecast because they are not recurring items. First, the
recurring operating margin before tax should be forecasted, noting that the operating costs are
fixed costs, and then the tax rate from 2013 should be used to determine net income.
2014
($ thousands) forecast 2013 2012
Sales (increase 5%) $5,775 $5,500.0 100% $5,350.0 100%
Cost of goods sold (40% each year) 2,310 2,200.0 40% 2,140.0 40%
Operating expenses (fixed cost) 2,350 2,350.0 2,350.0
Recurring operating income 1,115 950.0 860
Tax expense (25% × operating 279 237.5 (237.5/950) =
income) 25%
Net income $836
A is incorrect. It adjusts for the discontinued operations before calculating the margins
($ thousands) 2014 Forecast 2013 2012
Sales 5,775 5,500 5,350
Net income as reported $400 $787.5
Discontinued operations loss (gain) 312.5 (112.5)
Recurring EAT 712.5 675
Recurring EAT margin 12.9% 12.6%
Using the EAT margin of 12.9% × 5,775 = 745
C is incorrect. It takes the average margin of the two previous years without any adjustments for
the non-recurring items or change in tax rate. (400/5,500 = 7.3%) and (787.5/5,350 = 14.7%).
½[7.3% + 14.7%] = 11.0%
0.11 × 1.05 × 5,500 = $635
33. C is correct. The disposition of a capital asset is reported as a net gain or loss ($570,000 – $500,000
= $70,000) on the income statement before tax effects.
A is incorrect. It shows the proceeds from the sale, which would apply if the sale were related to
regular operating activities.
B is incorrect. It shows the gain net of tax [70,000 × (1 – 0.40) = 42,000], which applies to
discontinued operations, but not regular assets dispositions.
Page 25 of 39
34. C is correct. The convertible preferred shares are anti-dilutive, as shown in the following table.
Therefore, the diluted EPS is the same as the basic EPS, $2.91.
Diluted EPS
(using if-converted
Basic EPS method)
Net income $1,000,000 $1,000,000
Preferred stock, Series A (48,000) (48,000) 12,000 shares ×
$4/share
Preferred stock, Series B (225,000) 0 30,000 shares ×
$7.50/share
Earnings available to common $727,000 $952,000
shareholders
Weighted Average Number of Common Shares (WACS)

Shares outstanding 250,000 250,000
If converted — 75,000 2.5 common/preferred
× 30,000 preferred
WACS 250,000 325,000
EPS = Earnings available to $2.91 $2.93*
common shareholders/WACS
* Exceeds Basic EPS; Series B is anti-dilutive and is thus not included.
A is incorrect. It ignores the Series A dividends and incorrectly includes the anti-dilutive effect of
converting the Series B shares.
From the table:
Earnings to Common = 1,000,000 (ignores Series A, converts)
Common shares outstanding = 325,000, as per table with conversion of convertible
EPS = $1,000,000/325,000 shares = $3.08/share
B is incorrect. It includes the conversion of the convertible securities, which are anti-dilutive.
35. A is correct. Service revenues are recognized by reference to the stage of completion of the service
contract. Historical patterns provide evidence that 25% of the services performed under the
contract are incurred during the contract’s first year. As such, only 25% of the contract revenue
would be recognized in the first year:
Calculation
Total contract value €420
Stage of completion at end of first year 25%
Revenue recognized in first year €105 25% × €420
B is incorrect. This calculation incorrectly implies that all of the services provided under the
warranty have been rendered by the end of the first year.
Page 26 of 39
C is incorrect. This calculation incorrectly implies that half of the services provided under the
warranty have been rendered by the end of the first year. In fact, historical experience indicates
that only 25% of the services provided will have been rendered by the end of that year.
36. A is correct. Revenue is recognized by the cooperative when the art gallery sells the artwork
because that is the point at which the risks and rewards transfer from the cooperative to a third
party and the amount of revenue is measurable.
B is incorrect. This would be appropriate only if there was a significant collectability concern.
C is incorrect. This would be the usual revenue recognition timing for the sale of goods to a third
party directly.
37. B is correct. In general, a company recognizes expenses in the period that it consumes (i.e., uses
up) the economic benefits associated with the expenditure or loses some previously recognized
economic benefit.
A is incorrect because administrative and depreciation costs are not treated uniformly;
administrative costs are expensed immediately, and depreciation is allocated over time.
C is incorrect because a company recognizes expenses in the period that it loses some previously
recognized economic benefit or consumes the economic benefits associated with the expenditure,
not when benefits would have been earned.
38. B is correct. Changes in accounting policies are reported through retrospective application unless
it is impractical to do so.
A is incorrect because companies may be permitted to adopt new standards prospectively, but
changes in accounting policies are reported through retrospective application unless it is
impractical to do so.
C is incorrect because in years prior to 2005, but not now, under both IFRS and US GAAP, the
cumulative effect of changes in accounting policies was typically shown at the bottom of the
income statement in the year of change instead of using retrospective application.
39. B is correct. As the calculations below show, the basic and diluted EPS are $3.60 and $3.33,
respectively, and the resulting net difference is $0.27.
Basic EPS =
$ [ ×$ . ]
= = ($100−$10)/25 = $3.60
Diluted EPS =
$
= [
=$3.33
× . ]
Net difference = $3.60 – $3.33 = $0.27
C is incorrect because in the basic EPS calculation, the preferred dividends subtracted are not tax
adjusted:
Basic EPS=
Page 27 of 39
[ ×( )]
=
$ [ ×$ . ×( . )]
=
$ $ .
=$3.70
Diluted EPS
=
$
= [
=$3.33
× . ]
Net difference = $3.70 – $3.33 = $0.37
A is incorrect because the conversion of the preferred shares into common stock for determining
diluted EPS is miscalculated:
Basic EPS =
$ [ ×$ . ]
= = ($100−$10)/25 = $3.60
Diluted EPS
=
=
$
=$2.86
Net difference = $3.60 – $2.86 = $0.74
The correct number of new shares for the preferred stock conversion in the denominator of the
diluted EPS calculation is 5 million (each preferred share is convertible into 0.5 common shares),
not 10 million shares.
40. A is correct. IFRS requires each component of an asset to be separately depreciated.

Cost Useful Life Annual Depreciation Expense
(thousands) (years) (thousands)
Interior A$1,000 4 A$250
Engines 4,000 8 500
Remainder of 5,000 20 250
plane
Total A$10,000 A$1,000
B is incorrect. This calculation ignores the components and reflects depreciation of the entire
plane over 20 years: $10 million/20 years = $500,000.
C is incorrect. It deals with the depreciation of the components but ignores the rest of the plane.
41. B is correct. Single-step income statements present a subtotal for operating income.
A is incorrect because income statements in single-step format do not present a subtotal for
amortization of intangibles.
Page 28 of 39
C is incorrect because income statements in single-step format do not present a subtotal for gross
margin. When an income statement shows a gross profit subtotal, it is said to use a multi-step
format rather than a single-step format.
42. C is correct.
Net income =Comprehensive income−Other comprehensive income
= $193.0−$87.6
= $105.4 million
Net income per share (EPS) = Net income/Common shares outstanding
= $105.4/46.5
= $2.27 million
P/E = Stock price/EPS
= $60.75/$2.27
= 26.76
A is incorrect because other comprehensive income was incorrectly added to comprehensive

income.
Net Income = Comprehensive Income+Other comprehensive income
= $193.0+$87.6
= $280.6
Net Income per share (EPS) = Net income/Shares outstanding
= $280.6/46.5
= $6.03
P/E = Stock Price/EPS
= $60.75/$6.03
=10.07
B is incorrect because the comprehensive P/E was used.

Comprehensive income per share = Comprehensive income/Shares outstanding
=$193.0/46.5
=$4.15
Comprehensive P/E = Stock price/Comprehensive income per share
= $60.75/$4.15
= 14.64
43. C is correct. The gross profit margin increased the most in the current year:
Current Year Prior Year
(%) (%) Increase
Revenues 100
Cost of goods sold 38.6
Gross profit margin 61.4 60.5 +0.9
Research expenses 4.4
Selling and general 32.9
expenses
Operating margin 24.1 23.3 +0.8
Interest expense 3.1
Earnings before tax 21.0
Minus income tax expense 22% × 21 = 4.6
Net profit margin 16.4 15.8 +0.6
Page 29 of 39
A is incorrect because the operating profit margin would have the greatest increase if interest
expense was incorrectly included in the calculation:
(%) (%) Decrease
Correct operating margin (as calculated 24.1 23.3
above)
Less: Interest expense 3.1
Incorrect operating margin 21 23.3 −2.3
The operating profit margin would have the greatest increase if research expenses were
mistakenly excluded from the calculation:
(%) (%) Increase
Correct gross margin (as calculated above) 61.4 60.5
Less: Selling and general expenses 32.9
Incorrect operating margin 28.5 23.3 +5.2
B is incorrect because the net profit margin would have the greatest increase if income tax
expense was incorrectly omitted:
(%) (%) Increase
Net income before tax (as calculated above) 21 15.8 +5.2
44. A is correct.
$
thousands
Revenue 7,000
Minus cost of goods sold −4,200
Minus other operating −500
expenses
Minus restructuring expenses −250 Under US GAAP, restructuring charges are
operating items.
Operating profit 2,050
B is incorrect because it doesn’t deduct the restructuring expenses: 7,000 − 4,200 − 500 = 2,300.
C is incorrect because it includes interest expense as an operating expense: 2,050 − 200 = 1,850.
45. B is correct. Because Company A owns more than 50% of the shares in Company B it must present
consolidated financial statements, which will include 100% of Company B’s revenues and
expenses.
A is incorrect because all subsidiaries, even those that are partially owned, are included in a
consolidated statement.
Page 30 of 39
C is incorrect because all subsidiary revenues and expenses are included, even if they are not 100%
owned by the parent.
46. C is correct. Common size statements offer a convenient way to compare companies of different
magnitudes. Company X reports better (higher) gross margin performance. Company Y reports
better (higher) operating margin performance.
Metric (common size) Company X Company Y Comparison
Sales 100% 100%
Cost of goods sold 51 53
Gross margin (GM) 49 47 X’s GM is
higher
Administrative costs 17 15
Research and development 13 12
expenses
Operating margin (OM) 19 20 Y’s OM is
higher
A is incorrect because on a common-size basis, Company Y has a lower gross margin, as discussed
above. Company X has a lower operating margin as calculated above.
B is incorrect because on a common-size basis, Company Y has a lower gross margin.
47. A is correct. The appropriate base for a common-size income statement is revenue. As such, the
value used for research and development expenses is $12 million/$282 million × 100 = 4.25%.
B is incorrect because it uses total assets as a base: 12/145 × 100 = 8.28%. This is appropriate for
common-size balance sheets.
C is incorrect because it uses total expenses as a base: 12/241 × 100 = 4.97%.
48. B is correct. Under the matching principle, a company is required to estimate the amount of future
expenses resulting from its warranties and to update the expense as indicated by experience over
the life of the warranty. Waiting until actual costs are incurred will not match the expense with
the associated revenue.
A is incorrect because waiting until actual expenses are incurred will not match the expense with
the associated revenue.
C is incorrect because it is appropriate to record the estimated expense at the time of the sale.
49. C is correct. The weighted average number of shares outstanding is time weighted:
1 January to 1 June: 5/12 × 180,000 = 75,000
1 June to December 31: 7/12 × (180,000 + 60,000) =140,000
Weighted average before considering stock split: 215,000
Stock split is treated retroactively to the start of the year: 215,000 × 2 = 430,000
A is incorrect because it fails to make the stock split retroactive to the beginning of the year:
[(180,000 × 5) + (240,000 × 2) + (480,000 × 5)]/12 = 315,000.
Page 31 of 39
B is incorrect because it does not take the stock split into account: [180,000 × (5/12)] + [240,000
× (7/12)] = 215,000.
50. A is correct. Basic EPS = (Net income − Preferred dividends)/Weighted average number of shares
outstanding. The company’s structure includes two potentially dilutive securities: convertible debt
(which may be dilutive or anti-dilutive) and options (which are always dilutive). Diluted EPS
includes the effects of the dilutive securities and must be less than basic EPS.
Determine whether the convertible bonds are dilutive.
Basic EPS Diluted EPS
Net income (there are no preferred dividends) $32,000,000 $32,000,000
Plus: After-tax cost of interest = $15,000,000 × 0.12 = +$0 +$1,260,000

$1,800,000 × (1 − 0.30) =
Numerator (net income) $32,000,000 $33,260,000
Weighted average number of shares outstanding 4,500,000 4,500,000
Plus: Convertible bonds, if converted +50,000
Denominator (number of shares) 4,500,000 4,550,000
Basic EPS: 32,000,000/4,500,000 $7.11
Diluted EPS with convertible bonds: 33,260,000/4,550,000 $7.31
Because diluted EPS is greater than basic EPS ($7.31 > $7.11), the convertible bonds are anti-
dilutive and must be excluded from the diluted EPS calculation. Calculate diluted EPS using only
the options.
Diluted EPS
Numerator (net income) $32,000,000
Weighted average number of shares outstanding 4,500,000
Options if converted = 200,000 options outstanding × $50 per share = +75,000

$10,000,000, which at $80 per share can be used to repurchase 125,000
shares ($10,000,000/80.00).
Results in incremental 200,000 − 125,000 = 75,000 shares issued.
Denominator (number of shares) (4,500,000 + 75,000) 4,575,000
Diluted EPS with options = 32,000,000/4,575,000 $6.99
Page 32 of 39
B is incorrect because $7.19 includes both the convertible bonds and options together in the
diluted EPS calculation: $33,260,000/(4,500,000 + 50,000 + 75,000).
C is incorrect because it correctly included only the options in the diluted EPS calculation, but
failed to allow for the hypothetical buyback of shares at the average price.
51. B is correct. The two main types of long-lived assets whose costs are not allocated over time are
land and those intangible assets with indefinite useful lives.
A is incorrect because a company records an estimate of uncollectible amounts as an expense on

the income statement, not as a direct reduction of revenues.
C is incorrect because 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.
52. A is correct.
Metric £ thousands
Ending retained earnings 821,000
Less: opening retained earnings (580,000)
Add back: dividends paid 60,000
Net income 301,000
Comprehensive income 246,000
OCI = Comprehensive income − net 55,000
income LOSS
B is incorrect because this is comprehensive income less dividends (£246,000 − £60,000 =

£186,000).
C is incorrect because this is net income.
53. C is correct. Gross profit margin improved from 33.3% (€775/€2,325) to 35.6% (€930/€2,611). This
may be reflective of selling a new, more highly differentiated product.
A is incorrect because the tax rate (which is expressed as tax paid as a percentage of net income)
increased year over year, from 26.1% (€120/€460) to 26.7% (€155/€580). This is also true of tax
paid as a percentage of revenue, which increased from 5.2% (€120/€2,325) to 5.9% (€155/€2,611
year over year. The company’s profitability was reduced because of the higher tax rate.
B is incorrect because SG&A as a percentage of revenue slightly increased year over year: 2020 =
€260/€2,325 = 11.2% and 2021 = €295/€2,611 = 11.3%.
54. C is correct. Unrealized holding gains foreign currency translation adjustments are included in
other comprehensive income.
A is incorrect because this calculation incorrectly includes the gain on securities held for trading.
These gains are recognized in net income, not other comprehensive income: $100,000 + $500,000
= $600,000.
Page 33 of 39
B is incorrect because this calculation incorrectly excludes the foreign currency translation
adjustment and fails to include the gains on securities held for trading. These gains are recognized
in net income, not other comprehensive income.
55. C is correct. The weighted average number of shares (WACS) is determined by the length of time
each quantity of shares was outstanding. A stock split is treated as if it occurred at the beginning
of the year.
Event WACS
200,000 × 5/12 (January−May) 83,333
250,000 × 7/12 145,833
(June−December)
Total before split 229,166
Including effect of 2:1 split 458,332
A is incorrect because it only splits from Aug 1: 83,333 + (250,000 × 2/12) = 125,000 to Aug 1.
125,000 + 500,000 × 5/12 = 125,000 + 208,333 = 333,333.
B is incorrect because it is a simple average of beginning and ending shares outstanding: (200,000
+ 500,000)/2 = 350,000.
56. B is correct. Under US GAAP, operating activities generally involve producing and delivering goods
and providing services. Hence, an impairment loss on inventory that has become obsolete would
be considered an operating item on the income statement.
A is incorrect because non-operating income includes amounts earned through investing

activities.
C is incorrect because interest expense on debt securities is considered a non-operating item for
a non-financial service company.
57. B is correct. Common-size income statements facilitate comparison across time periods (time-
series analysis) because the standardization of each line item removes the effect of size. They
would be particularly useful in neutralizing the size effect for a company experiencing rapid
growth. For example, efficiencies gained from increased volume may be more readily apparent.
Common-size income statements would be less useful for similarly sized companies from different
industries because the size effect is less important in the comparison.
A is incorrect because the income statement is of little use in performing a liquidity analysis.
C is incorrect because common-size income statements eliminate the effect of size, so they would
be less useful in a comparison of similarly-sized companies.
58. A is correct. Company Z has spent the most on research and development and is able to support
the highest gross margin (lowest cost of goods sold). It likely has the technically superior product.
B is incorrect because Company Y spends significantly less than Company Z on research and
development. It is unlikely to have a technically superior product.
C is incorrect because Company X spends nothing on research and development. It is unlikely to

have a technically superior product.
Page 34 of 39
59. A is correct. Non-financial service companies disclose interest received, dividends, or profits from
the sale of securities held as investments as non-operating items. Interest expense is also disclosed
as a non-operating item.
B is incorrect because the characterization of certain non-operating items on the income

statement is not necessarily consistent with their classification on the statement of cash flows.
Some items will be shown as either investing or financing activities, but others may be classified
as operating.
C is incorrect because non-operating items such as investing or financing activities (e.g., interest
expense and interest income) may be reported on a net basis with the components disclosed
separately in the notes.
60. B is correct. OA’s cost of sales have been steadily rising, causing the firm’s gross profit margin to
fall below the industry average. A falling gross margin indicates falling revenue per dollar of sales
costs.
A is incorrect because the effective tax rate did not average 2% over the period. In the case of
taxes, it is more meaningful to compare the amount of taxes paid with the amount of pre-tax
income, then examine the causes for any differences in effective tax rates. Although taxes as a
percent of sales has held steady at roughly 2%, OA’s corporate tax rate exceeded 20% each year.
Tax rate = Taxes/Earnings before taxes
2013: 1.9%/8.1% = 23.5%
2014: 2.0%/9.2% = 21.7%
2015: 2.0%/9.9% = 20.2%
C is incorrect because OA’s industry-relative performance shows below-average gross margin

results, in contrast to the net profit margin, which exceeds the industry average.
61. A is correct. All else equal, recognizing expenses later rather than sooner is considered to be less
conservative in reporting net income.
B is incorrect because reflecting fewer warranty claims as a percentage of sales could be due to
improved product quality and a change in business operations, not to an aggressive calculation of
reported net income.
C is incorrect because estimating lower uncollectible accounts due to stricter credit policies would
reflect a change in business operations and not indicate a more aggressive accounting approach.
62. B is correct. Expenses are a component of the income statement and are defined as outflows,
asset depletions, and liabilities incurred in the course of a business’s activities.
A is incorrect because accounts payable is a liability, a component of the balance sheet, and is
defined as amounts that a company owes its vendors for purchases of goods and services.
C is incorrect because liabilities are a component of the balance sheet and are defined as
obligations from past events that on settlement are expected to result in an outflow of economic
benefits.
Page 35 of 39
63. B is correct. When a company has issued any financial instruments that are potentially convertible
into common stock, it is said to have a complex capital structure. Potentially convertible financial
instruments include convertible bonds, convertible preferred stock, employee stock options, and
warrants. Any antidilutive effect of a convertible security relates to the calculation of EPS and is
not part of the distinction of simple vs. complex capital structure.
A is incorrect because the existence of debt does not make the capital structure complex. The
structure is complex because the employee stock options are convertible into ordinary shares.
C is incorrect because a capital structure is considered complex if the company has issued any
financial instruments that are potentially convertible into common stock, such as employee stock
options. It does not matter if these instruments are antidilutive.
64. B is correct. Basic EPS is calculated by subtracting preferred dividends from net income and then
dividing the result by the weighted average number of shares outstanding.
A is incorrect because preferred dividends must be subtracted from net income before dividing
by the weighted average number of shares outstanding.
C is incorrect because basic EPS is not adjusted for additional ordinary shares issued, an
adjustment which uses the if-converted method for potentially dilutive securities. This method is
applicable when determining diluted EPS.
65. B is correct. First determine the basic EPS, calculated as follows:

Basic EPS=
= ($200,000−$0)/125,000
= $1.60
Next, calculate diluted EPS using the if-converted method for the convertible debt:
Diluted EPS
=
=
$ , [$ , × . ×( . )]
, ,
=$206,120/128,000
=$1.61
The calculated diluted EPS is greater than the basic EPS. By definition, the diluted EPS is always
equal to or less than basic EPS and this means that the diluted EPS will be $1.60.
C is incorrect because it miscalculates the effect of the after-tax interest on debt in the if-
converted method used for the convertible debt to determine the diluted EPS:
Diluted EPS
=
$ , [$ , × . ×( . )]
= , ,
=$193,880/128,000
=$1.51
The $1.51 is a result due to mistakenly subtracting the after-tax interest on the debt. It should be
added.
Page 36 of 39
A is incorrect because it shows a diluted EPS greater than basic EPS.
66. C is correct. A higher diluted EPS indicates that the company’s convertible securities are
antidilutive (i.e., their inclusion in the computation would result in an EPS higher than the
company’s basic EPS), and the company is required to report a basic EPS that equals diluted EPS.
This occurs because, by definition, diluted EPS has to be equal to or lower than basic EPS.
A is incorrect because a company is required to report both basic and diluted EPS if it has any
convertible securities.
67. A is correct. For a common-sized income statement, each line item, including cost of sales, is
stated as a percentage of revenue. Common-size statements facilitate comparison across time
periods and across companies because the standardization of each line item removes the effect
of size.
B is incorrect because common-size analysis of the income statement is performed by stating each
line item on the income statement as a percentage of revenue, not net income.
C is incorrect because pretax income is most appropriately used in conjunction with the reported
amount of taxes to ultimately examine the cause of differences in effective tax rates across
companies and project their future amounts of net income.
B is incorrect because a higher diluted EPS indicates that the company’s convertible securities are
antidilutive, and IFRS and US GAAP do not include antidilutive securities in the calculation of
dilutive EPS. Therefore, the company’s calculated and reported basic EPS and diluted EPS will be
equal.
68. A is correct. A company’s relative performance can be evaluated by examining and comparing the
percentages shown across the common-size income statements.
B is incorrect because size data, such as total sales, is not shown on common-sized income
statements; for the company and its peers, the common-sized income statements show revenue
as 100% for each company. The resulting standardization of each line item removes the effect of
size.
C is incorrect because a company’s revenue recognition policies are disclosed in the notes to its
financial statements, not in a common-size income statement. This statement is designed to
assess a company’s performance over a period of time (time series analysis) and/or across
companies (cross-sectional analysis).
69. A is correct. The gross profit is sales minus cost of sales and the gross profit margin is calculated
as gross profit divided by sales. The calculations for the three companies are as follows:
Company A: Gross profit = $40,000 – $21,000 = $19,000 and the gross profit margin is 47.5%
($19,000/$40,000). Of the three companies, this gross profit margin is the highest.
Company B: Gross profit = $200,000 – $110,000 = $90,000 and the gross profit margin is 45.0%
($90,000/$200,000).
Company C: Gross profit = $450,000 – $240,000 = $210,000 and the gross profit margin is 46.7%
($210,000/$450,000).
C is incorrect because Company B has the highest net profit margin (net income divided by sales)
at 19.0% ($38,000/$200,000), but it does not have the highest gross profit margin ([Sales – Cost
of sales]/Sales).
Page 37 of 39
B is incorrect because Company C has the highest gross profit (sales – cost of sales) at $210,000
($450,000 – $240,000) and operating profit margin (operating income divided by sales) at 34.9%
($157,000/$450,000), but it does not have the highest gross profit margin ([Sales – Cost of
sales]/Sales).
70. B is correct. Comprehensive income includes all changes in equity during a period except those
resulting from investments by owners and distributions to owners, which means comprehensive
income is the sum of all transactions and other events and circumstances from non-owners.
A is incorrect because common stock dividends are distributions to owners and, as such, they
result in a change in equity and therefore are not a subtraction in determining comprehensive
income.
C is incorrect because this choice is describing other comprehensive income, but comprehensive
income is the combination of net income and other comprehensive income.
71. A is correct. Given that comprehensive income includes net income and both other revenue and
expense items that are excluded from the net income calculation (other comprehensive income),
then the company's comprehensive income is:
£65 million – £5 million = £60 million.
C is incorrect because £53 million results from incorrectly subtracting £7 million in common stock
dividends from comprehensive income:
£65 million – £5 million – £7 million = £53 million
B is incorrect because £5 million of other net expense items excluded from the net income
calculation is other comprehensive income and it should be subtracted from net income when
calculating the company’s comprehensive income.
72. B is correct. The following table shows the calculation of each company's P/E using comprehensive
income.
All values in millions except price per Company A Company B Company C
share
Price per share for common shares $27 $88 $53
Net income 150 500 800
Other comprehensive income (loss) (17) 65 50
Total comprehensive income $133 $565 $850
Shares outstanding 100 125 300
Comprehensive income per share $1.33 $4.52 $2.83
Adjusted P/E ratio 20.3 19.5 18.7
Company C, has the lowest P/E based on using comprehensive income.
A is incorrect because Company A has the lowest unadjusted P/E at 18.0 (27/[150/100]), but it has
the highest adjusted P/E based on comprehensive income.
C is incorrect because Company B has the lowest adjusted P/E only if the common stock dividends
paid are erroneously subtracted in finding the comprehensive income used for the adjusted P/Es.
Page 38 of 39
73. B is correct. Foreign currency translation adjustments resulting from consolidating foreign
subsidiaries are included in other comprehensive income.
A is incorrect because costs of a company’s defined benefit post-retirement plans that are
recognized in the current period are not included in comprehensive income because they already
are reflected in current period income.
C is incorrect because, under IFRS, certain changes in value of long-lived assets measured using
the revaluation model, not the cost model, are included in other comprehensive income.
74. C is correct. Unrealized gains and losses on available-for-sale securities are treated as other
comprehensive income under both IFRS and US GAAP.
A is incorrect because unrealized gains and losses on available-for-sale securities do affect

shareholders’ equity. They bypass the income statement and go directly to shareholders’ equity
through other comprehensive income.
B is incorrect because unrealized gains and losses on available-for-sale securities are not reflected
in the profit and loss statement.
Page 39 of 39

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Understanding Income Statements

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Reading: Understanding Income Statements

Accounting standards identify a five-step process for recognizing revenue:

Inventory valuation methods:

Changes in accounting standards, changes in accounting methods applied, and corrections of

Example: EPS with convertible preferred stock

Example: EPS with convertible debt

Example: EPS with stock options

LOS 9: Convert income statements to common- size income statements.

LOS 11: Describe, calculate, and interpret comprehensive income.

Learning Outcome as per CFA Institute:

1. Expenses on the income statement may be grouped by:

2. An example of an expense classification by function is:

4. Under IFRS, income includes increases in economic benefits from:

10. Which inventory method is least likely to be used under IFRS?

B. Last in, first out (LIFO).

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

30. Net revenue most likely refers to revenue minus:

31. The following information is from a company’s accounting records:

($ thousands) 2013 2012

37. Under general principles of expense recognition, a company should:

38. Unless it is impractical to do so, changes in accounting policies are to be reported:

39. Selected year-end financial data for Mega Industries follows:

41. An income statement in a single-step format presents a subtotal for:

42. The following data are available on a company:

Income tax rate 22%

47. The following data are available on a company:

51. In applying the principles of expense recognition, companies should:

C. A comparison of similarly sized companies from different industries

59. Non-operating items reported on the income statement:

60. Oceanaqua Apparel (OA) is a manufacturer of swimwear. Abbreviated common-size income

C. Estimating lower uncollectible accounts due to stricter credit policies

65. Selected year-end financial data for Smalley Enterprises follows:

69. An analyst gathers the following annual information on three companies:

70. Under US GAAP, a company’s comprehensive income is reported as:

72. Selected financial data follows for Companies A, B, C:

74. Unrealized gains and losses on securities categorized as available-for-sale:

9. C is correct. Under the weighted average cost method:

11. A is correct. Straight- line depreciation would be ($600,000 – $50,000)/10, or $55,000.

17. B is correct. The formula to calculate diluted EPS is as follows:

Shares outstanding 1,000,000

C is incorrect. Gains or losses on the translation of certain foreign currency–denominated

Weighted Average Number of Common Shares (WACS)

40. A is correct. IFRS requires each component of an asset to be separately depreciated.

A is incorrect because other comprehensive income was incorrectly added to comprehensive

B is incorrect because the comprehensive P/E was used.

B is incorrect because on a common-size basis, Company Y has a lower gross margin.

C is incorrect because it uses total expenses as a base: 12/241 × 100 = 4.97%.

Basic EPS Diluted EPS

Net income (there are no preferred dividends) $32,000,000 $32,000,000

Plus: After-tax cost of interest = $15,000,000 × 0.12 = +$0 +$1,260,000

Numerator (net income) $32,000,000 $33,260,000

Weighted average number of shares outstanding 4,500,000 4,500,000

Plus: Convertible bonds, if converted +50,000

Denominator (number of shares) 4,500,000 4,550,000

Basic EPS: 32,000,000/4,500,000 $7.11

Diluted EPS with convertible bonds: 33,260,000/4,550,000 $7.31

Numerator (net income) $32,000,000

Weighted average number of shares outstanding 4,500,000