Chapter 4:

Understanding
Income Statements
Bushra Ferdous Khan

Topics to be studied from this

chapter…
1. Revenue recognition
2. Expense recognition
3. Non-recurring items and non-operating income
4. Earnings Per Share
5. Comprehensive income

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 Topic 3.
Non-recurring Items and Non-
operating Items

Non-recurring Items and Non-operating Items

“To assess a company’s future earnings, it is helpful to
separate those prior years’ items of income and expense that are
likely to continue in the future from those items that are less likely
to continue.”

“Both IFRS and US GAAP specify that the results of discontinued

operations should be reported separately from continuing
operations.”

“Other items that may be reported separately on a company’s

income statement, such as unusual items, items that occur
infrequently, effects due to accounting changes, and non-
operating income, require the analyst to make some judgments.”

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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 Topic 4.
Earnings Per Share

Earnings Per Share

“One metric of particular importance to an equity investor is
earnings per share (EPS).”

“IFRS require the presentation of EPS on the face of the

income statement for net profit or loss (net income) and
profit or loss (income) from continuing operations.”

“This section outlines the calculations for EPS and

explains how the calculation differs for a simple versus
complex capital structure.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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Simple versus Complex Capital Structure
“A company’s capital is composed of its equity and debt.”

“Some types of equity have preference over others, and some debt (and other
instruments) may be converted into equity.”

“Under IFRS, the type of equity for which EPS is presented is

referred to as ordinary. Ordinary shares are those equity
shares that are subordinate to all other types of equity.
The ordinary shareholders are basically the owners of the company—the
equity holders who are paid last in a liquidation of the company and who
benefit the most when the company does well.”

“Under US GAAP, this ordinary equity is referred to as common stock or

common shares.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Simple versus Complex Capital Structure

“When a company has issued any financial instruments that are
potentially convertible into common stock, it is said to have a complex
capital structure.”

“Examples of financial instruments that are potentially convertible into

common stock include:
 convertible bonds,
 convertible preferred stock,
 employee stock options, and
 warrants. [Warrants are a derivative that give the right, but not the obligation, to buy or sell a
security—most commonly an equity—at a certain price before expiration. The price at which the
underlying security can be bought or sold is referred to as the exercise price or strike
price. Warrants that give the right to buy a security are known as call warrants; those that give
the right to sell a security are known as put warrants. ]”

“If a company’s capital structure does not include such potentially

convertible financial instruments, it is said to have a simple capital
structure.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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Basic versus Diluted EPS
“The distinction between simple versus complex capital structure is relevant to the
calculation of EPS because financial instruments that are potentially convertible into
common stock could, as a result of conversion or exercise, potentially dilute (i.e.
decrease) EPS.”

“Information about such a potential dilution is valuable to a company’s current and

potential shareholders; therefore, accounting standards require companies to
disclose what their EPS would be if all dilutive financial instruments were converted
into common stock.”

“The EPS that would result if all dilutive financial

instruments were converted is called diluted EPS.”

“In contrast, basic

EPS is calculated using the reported
earnings available to common shareholders of the parent
company and the weighted average number of shares
outstanding.” Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Basic EPS

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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Basic EPS Calculation

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Basic EPS Calculation: Solution to Example 13

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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 Basic EPS Calculation

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Diluted EPS
“If a company has a simple capital structure (in other words, one that includes no
potentially dilutive financial instruments), then its basic EPS is equal to its diluted
EPS.”

“However, if a company has potentially dilutive financial instruments, its diluted

EPS may differ from its basic EPS.”

“Diluted EPS, by definition, is always equal to or less than basic EPS.”

“If Diluted EPS > Basic EPS; Basic EPS value must be reported as Diluted
EPS.”

“The sections below describe the effects of three types of potentially dilutive
financial instruments on diluted EPS:
 convertible preferred,
 convertible debt,
 and employee stock options.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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Diluted EPS When a Company Has Convertible
Preferred Stock Outstanding
“When a company has convertible preferred stock outstanding, diluted
EPS is calculated using the if-converted method.”

“The if-converted method is based on what EPS would have been if the
convertible preferred securities had been converted at the beginning of
the period.”

“If the convertible shares had been converted, there would be two effects.
 First, the convertible preferred securities would no longer be outstanding; instead,
additional common stock would be outstanding. Thus, under the if-converted method,
the weighted average number of shares outstanding would be higher than in the basic
EPS calculation.

 Second, if such a conversion had taken place, the company would not have paid
preferred dividends. Thus, under the if-converted method, the net income available to
common shareholders would be higher than in the basic EPS calculation.”

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Diluted EPS When a Company Has Convertible

Preferred Stock Outstanding

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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 Diluted EPS Calculation: Solution to Example 15

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Diluted EPS When a Company Has Convertible

Debt Outstanding
“When a company has convertible debt outstanding, the diluted EPS
calculation also uses the if-converted method.”

“Diluted EPS is calculated as if the convertible debt had been converted at

the beginning of the period.”

“If the convertible debt had been converted, the debt securities would no
longer be outstanding; instead, additional shares of common stock would be
outstanding.”

“Also, if such a conversion had taken place, the company would not
have paid interest on the convertible debt, so the net income
available to common shareholders would increase by the after-tax amount of
interest expense on the debt converted.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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Diluted EPS When a Company Has Convertible Debt Outstanding

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Diluted EPS Calculation: Solution to Example 16

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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Diluted EPS When a Company Has Stock
Options, Warrants, or Their Equivalents
Outstanding
“When a company has stock options, warrants, or their equivalents outstanding, diluted EPS
is calculated as if the financial instruments had been exercised and the
company had used the proceeds from exercise to repurchase as
many shares of common stock as possible at the average market
price of common stock during the period.”

“The weighted average number of shares outstanding for diluted EPS is thus increased by
the number of shares that would be issued upon exercise minus the number of shares that
would have been purchased with the proceeds.”

“This method is called the treasury stock method under US GAAP because
companies typically hold repurchased shares as treasury stock. The same method is used
under IFRS but it has no name.”

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Diluted EPS When a Company Has Stock Options, Warrants, or Their Equivalents Outstanding

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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 Diluted EPS Calculation: Solution to Example 17

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Example: “If Diluted EPS > Basic EPS; Basic EPS value
must be reported as Diluted EPS.”
“Company R has issued a convertible bond of 250 at $200 par issued at par for a total of $50,000
with a yield of 15%. Company R has mentioned that each bond can be converted into 20 shares
of common stock. The weighted average outstanding number of common shares is 16000. The
net income of Company R for the year is $20,000, and the paid preferred dividends are $4000.
The tax rate is 25%.
Basic EPS = $20,000 – $4000 / 16000 = $16,000 / 16,000 = $1 per share.
To compute the diluted EPS, we need to calculate two things.
•First, we will calculate the number of common shares that would be converted from the convertible
bonds. In this situation, for each convertible bond, 40 common shares would be issued. If we convert all
of the convertible bonds into common shares, we will get = (250 * 20) = 5,000 shares.
•Second, we need to find out the earnings from the convertible bonds as well. Here’s the earnings = 250
* $200 * 0.15 * (1 – 0.25) = $5625.
Now, we will calculate the diluted EPS of Company R:
•Diluted EPS = ($20,000 – $4,000 + $5625) / (16,000 + 5000) = $1.03 per share
If, by any chance, the fully diluted EPS is more than the basic EPS, then the security is anti-
dilutive securities.
In the above example, we saw that the convertible bonds are anti-dilutive securities because the basic
EPS (i.e., $1 per share) is less than the dilutive EPS ($1.03 per share) when we take the convertible
bonds into account.”
Source: https://www.wallstreetmojo.com/anti-dilutive-securities/

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 Topic 5.
Comprehensive Income

Comprehensive Income
“Comprehensive income includes both net income and
other revenue and expense items that are excluded from
the net income calculation (collectively referred to as Other
.”
Comprehensive Income)

Comprehensive Income = Net Income +

Other Comprehensive Income
“Assume, for example, a company’s beginning shareholders’ equity is €110 million,
its net income for the year is €10 million, its cash dividends for the year are €2
million, and there was no issuance or repurchase of common stock. If the
company’s actual ending shareholders’ equity is €123 million, then €5 million
[€123 – (€110 + €10 – €2)] has bypassed the net income calculation by being
classified as other comprehensive income. If the company had no other
comprehensive income, its ending shareholders’ equity would have been €118
million [€110 + €10 – €2].”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

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Items Treated as ‘Other Comprehensive
Income’ under IFRS
“Foreign currency translation adjustments. In consolidating the financial statements of
foreign subsidiaries, the effects of translating the subsidiaries’ balance sheet assets and
liabilities at current exchange rates are included as other comprehensive income.”
“Unrealized gains or losses on derivatives contracts accounted for as hedges.
Changes in the fair value of derivatives are recorded each period, but certain changes in
value are treated as other comprehensive income and thus bypass the income statement.”
“Unrealized gains and losses for:
(a) “debt securities held within a business model whose objective is achieved both by collecting
contractual cash flows and selling financial assets”; and
(b) equity investments for which the company makes an irrevocable election at initial recognition
to show gains and losses as part of other comprehensive income.
These debt and equity investments are referred to as being measured at fair value through
other comprehensive income.”
“Certain costs of a company’s defined benefit post-retirement plans that are not
recognized in the current period.”
“Certain changes in the value of long-lived assets that are measured using the
revaluation model rather than the cost model.”

Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

Examples to Practice from Textbook

Example 2  Example 14
Example 5  Example 15
Example 7  Example 16
Example 8
 Example 17
Example 11
 Example 18
Example 12
 Example 19
Example 13
 Example 20
 Example 21
+ MCQs from the ‘Problems’ section at the end of chapter on topics discussed in class

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