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Chapter IVUnderstanding the Income Statement
Income Statement Components and Format
• It reports the revenues and expenses of the firm over a period of time.
• Also referred to as:– Statement of Operations– Statement of Earnings– Profit and Loss Statement
Income Statement Components and Format
• Ways of presentation:– Under IFRS
• It can be combined with “other comprehensive income” and presented as a single comprehensive income
• Statement of Comprehensive Income is reported separately.• Income Statement is reported separately.
Income Statement Components and Format
• Revenues– Reported from the sale of goods and services in the normal course of businessNET REVENUES =revenues – adjustment for estimated returns and allowances
• Expenses– Amounts incurred to generate revenue and include cost of goods sold, operating
expenses, interest and taxes– Grouped together by their nature or function– Grouping by nature: all deprecation expenses from manufacturing and
administration in one line – Grouping by function: combining all costs associated with manufacturing (Eg.
Raw materials, depreciation, labor, etc.) as costs of goods sold
Income Statement Components and Format
• Gains and Losses– Increase (gains) or decrease (losses) of economic benefits– May not result from the ordinary business activities
• Components of NET INCOME:= revenues – ordinary expenses + other income – other expenses + gains - losses
Presentation Formats
A. Single-Stepall revenues are grouped together and all expenses are grouped together
B. Multi-Stepincludes gross profit, revenues minus cost of goods sold
BGH Company Income StatementFor the year ended December 31, 2004
Revenue(Cost of Goods Sold)Gross Profit(Selling, General, and Administrative expense)(Depreciation expense)Operating Profit or Operating Income(interest Expense)Income before tax(Provision for income taxes)Income from continuing operationsEarnings (losses) from discontinued operations, net of tax
NET INCOME (LOSS)
Note:
Accrual Method of Accounting revenue is recognized when earned and expenses are recognized when incurred.
It does not necessarily coincide with the receipt or payment of cash
Consequently, firms can manipulate net income by recognizing revenue earlier or later or by delaying or accelerating the recognition of expenses.
According to IASB:for services rendered revenue is recognized when
1. The amount of revenue can be reliably measured.
2. There is a probable flow of economic benefits3. The stage of completion can be measured.4. The cost incurred and cost of completion can be
reliably measured
According to IASB:revenue is recognized from the sale of goods when:
1. The risk and reward of ownership is transferred.2. There is no continuing control or management
over the goods sold.3. Revenue can be reliably measured.4. There is a probable flow of economic benefits.5. The cost can be reliably measured
According to FASB:
Revenue is recognized in the income statement when (a) realized or realizable and (b) earned.
Additional guidance from the SEC:Criteria when revenue should be recognized
1. There is evidence of an arrangement between the buyer and seller
2. The product has been delivered or the services has been rendered.
3. The price is determine or determinable.4. The seller is reasonably sure of collecting money.
Unearned Revenue
• When the firm receives cash before revenue recognition is complete, the firm reports it as unearned revenue.
• Reported on the balance sheet as a liability. • Liability is reduced in the future as the revenue is
earned.
For contracts that extend beyond one accounting period:– Percentage-of-Completion method– Completed-Contract Method
For contracts service contracts or licensing agreement:– Revenue is recognized equally over the term of the
contract/agreement
Long term ContractsSpecific Revenue Recognition Applications
Percentage-of-Completion method • Under IFRS and US GAAP• when outcome can be reliably measured• Revenues, Expenses, Profit are recognized when
the work is performed.• Percentage of completion is measured by the
total costs incurred to date divided by the total expected cost of the project.
Long term ContractsSpecific Revenue Recognition Applications
Completed-Contract method • Under IFRS and US GAAP• when outcome can NOT be reliably measured• Revenue is recognized to the extent of contract
costs, costs are expensed when incurred, and profit is recognized only at completion.
• Revenues, Expenses, Profit are recognized when the contract is completed.
Long term ContractsSpecific Revenue Recognition Applications
When LOSS is expected, the loss must be recognized immediately.
-under IFRS and US GAAP
Long term ContractsSpecific Revenue Recognition Applications
Example: – AAA Construction Corp. has a contract to build a ship for
$1000 and a reliable estimate of the contract’s total cost is $800. Project costs incurred by AAA are as follows:
– Determine AAA’s net income using percentage-of-completion method and completed contract method
Year 2005 2006 2007 TotalCosts Incurred $400 $300 $100 $800
Long term ContractsSpecific Revenue Recognition Applications
Answer : Percentage-of-Completion Method
2005 2006 2007 TotalRevenue $500 $375 $125 $1000
Expenses $400 $300 $100 $800
Net Income $100 $75 $25 $200
Year 2005 2006 2007 TotalCosts Incurred $400 $300 $100 $800
%-of-completion
50% 37.5% 12.5%
Long term ContractsSpecific Revenue Recognition Applications
Answer : Completed Contract Method
2005 2006 2007 TotalRevenue $400 $300 $300 $1000
Expenses $400 $300 $100 $800
Net Income $0 $0 $200 $200
Year 2005 2006 2007 TotalCosts Incurred $400 $300 $100 $800
On the basis of the costs/expenses incurred
Long term ContractsSpecific Revenue Recognition Applications
Note:– Percentage-of-completion method is more aggressive
than completed contract since revenue is reported sooner.
– Percentage-of-completion method is more subjective because it involves costs estimates
– Percentage-of-completion method provides smoother earnings and results in better matching of revenues and expenses over time
Long term ContractsSpecific Revenue Recognition Applications
Occurs when a firm finances a sale and payments are expected to be received over an extended period.
– Collectability is certain, revenue is recognized at the time of sale using the normal revenue recognition criteria.
– Collectability cannot be reasonably estimated, installment method is used.
– Collectability is highly uncertain, cost recovery method is used.
Installment Sales
Specific Revenue Recognition Applications
Installment Method -profit is recognized as cash is collected -profit is equal to the cash collected during the period multiplied by the total expected profit as a percentage of sales.
-used in sale of real estate or other firm assets
Cost Recovery Method -profit is recognized only when cash collected exceeds costs incurred
Installment Sales
Specific Revenue Recognition Applications
Example: – Assume that BBB Property Corp. sells a piece of land for
$1000. The original costs of the land was $800. Collections received by BBB for the sale are as follows.
– Determine BBB’s profit under the installment and costs recovery method.
Year 2005 2006 2007 TotalCollections $400 $400 $200 $1000
Installment Sales
Specific Revenue Recognition Applications
Answer: Installment Method
– Total Expected Profit as Percentage of Sale is 20% [(1000-800)/1000]
Year 2005 2006 2007 TotalCollections $400 $400 $200 $1000
Installment Sales
Specific Revenue Recognition Applications
Year 2005 2006 2007 TotalCollections $400 $400 $200 $1000
Percent of Sale 20% 20% 20% 20%
Profit $80 $80 $40 $200
Answer: Cost Recovery MethodNote: profit is recognized only when cash collected exceeds costs incurred
* Cost incurred $800.* Therefore, cash collected is $1000 which exceeds cost incurred
of $800* Profit is recognized only during 2007 of $200 (1000-800).
Year 2005 2006 2007 TotalCollections $400 $400 $200 $1000
Installment Sales
Specific Revenue Recognition Applications
Gross and Net Reporting of Revenues
Gross Revenue Reporting-the selling firm reports sales revenue and cost of goods sold separately.
Net Revenue Reporting-only the difference between sales and costs is reported
Gross and Net Reporting of RevenuesExample:
Travel agent arranging a first class ticket for a customer flyingto Singapore. The ticket price is $10,000, and the travelagent receives a $1,000 commission.
Gross Reporting:Revenue 10000Expenses 9000 Profit 1000
Net Reporting:Revenue 1000No expense
Gross and Net Reporting of Revenues
Criteria in using Gross Revenue Reporting: Under US GAAP
1. Be the primary obligor under the contract2. Bear the inventory risk and credit risk3. Be able to choose its supplier4. Have reasonable latitude to establish the price
Seatwork(4 members in a group)
Specific Revenue Recognition Applications
Expenses -are subtracted from revenue to calculate net income.
According to IASB: Expenses are decreases in economic benefits during the accounting period in the form of :
* outflows/depletion of assets* incurrence of liabilities (resulting to decrease in equity)
Note:When the financial statements are prepared on cash basis, neither revenue nor expense recognition methods are issues.
Matching Principle Expenses to generate revenue are recognized in the same period as the revenue.
example: Inventory
Period Costs-costs/expenses that cannot be directlytied to revenue generation
-expensed when incurred
Inventory Expense Recognition Specific Identification Method
-this is used when the firm can identifyexactly which items were sold and which items remain in inventory.
ExampleAuto Dealer records each vehicle sold or in inventory by its identification number.
Inventory Expense Recognition First-in, First-out (FIFO) Method
-the first item purchased is assumed to be the first item sold.
-cost of inventory acquired first (beginning inventory and early purchases) is used to calculate ending inventory
-appropriate for those firms offering products that have limited shelf life.
ExampleFoods products company will sell its oldest inventory first to keep the inventory on hand fresh.
Inventory Expense Recognition Last-in, First-out (LIFO) Method
-the last item purchased is assumed to be the first item sold
-cost of inventory most recently purchased is assigned to the costs of goods sold for the period.
-appropriate for inventory that does not deteriorate with age.
ExampleA coal distributor will sell coal off the top of the pile
Note:• In US, LIFO is popular because of its net
income tax benefits.• In inflationary environment, LIFO results in
higher costs of goods sold Higher COGS
=lower taxable income=lower income taxes
Inventory Expense Recognition Weighted Average Costs Method
-makes no assumption about the physical flow of the inventory
-popular because of its ease of use
*Cost per unit=cost of available goods/total units available
*Average costs=is used to determine both cost of goods sold and ending
Inventory=results in cost of goods sold and ending inventory values
between LIFO and FIFO
Inventory Method Comparison
Method Assumption COGS consists of…
Ending Inv. consists of…
FIFO(US and IFRS)
The items first purchased are the
first item sold
First purchased Most recent purchases
LIFO(US only)
The items last purchased are the
first item sold
Last purchased Earliest purchases
Weighted Average cost(US and IFRS)
Items sold are a mix of purchases
Average cost of all items
Average cost of all items
Inventory DataJanuary 1 (beg. Inventory) 2 units @ $2/unit $4January 7 purchase 3 units @ $3/unit $9January 19 purchase 5 units @ $5/unit $25Cost of goods available 10 units $38Units sold during January 7 units
Inventory Expense Recognition
Inventory DataJanuary 1 (beg. Inventory) 2 units @ $2/unit $4January 7 purchase 3 units @ $3/unit $9January 19 purchase 5 units @ $5/unit $25Cost of goods available 10 units $38Units sold during January 7 units
Inventory Expense Recognition
* FIFO
FIFO COGS CALCULATIONValue the 7 units sold using the unit cost of FIRST units purchased.
From Beginning Inventory 2 units @ $2/unit $4From First purchase 3 units @ $3/unit $9From Second purchase 2 units @ $5/unit $10FIFO COGS 7 units $23Ending Inventory 3 units @ $5/unit $15
Inventory DataJanuary 1 (beg. Inventory) 2 units @ $2/unit $4January 7 purchase 3 units @ $3/unit $9January 19 purchase 5 units @ $5/unit $25Cost of goods available 10 units $38Units sold during January 7 units
Inventory Expense Recognition
* LIFO
LIFO COGS CALCULATIONValue the 7 units sold using the unit cost of LAST units purchased.
From Second Purchase 5 units @ $5/unit $25From First purchase 2 units @ $3/unit $6LIFO COGS 7 units $31Ending Inventory 2 units @ $2/unit +
1 unit @ $3/unit$7
Inventory DataJanuary 1 (beg. Inventory) 2 units @ $2/unit $4January 7 purchase 3 units @ $3/unit $9January 19 purchase 5 units @ $5/unit $25Cost of goods available 10 units $38Units sold during January 7 units
Inventory Expense Recognition
* WA
WEIGHTED AVERAGE COGS CALCULATIONValue the 7 units sold at the average unit cost of goods available
Average Unit Cost $38/10 units $3.8Weighted Average COGS 7 units @ $3.8/unit $26.60Ending Inventory 3 units @ $3.8/unit $11.40
Inventory Expense Recognition
SUMMARY
Inventory COGS Ending InventoryFIFO $23.00 $15.00LIFO $31.00 $7.00Average Cost $26.60 $11.40
Depreciation Expense Recognition The cost of long-lived assets must also be matched with revenues.
Depreciation Tangible AssetsDepletion Natural AssetsAmortization Intangible Assets
Straight-Line Method-recognizes an equal amount of depreciation expense each period.
Accelerated Depreciation Method-used when assets generate more benefits in the early years of their income
Depreciation Expense Recognition Effects:
In early years, the straight-line method will result in lower depreciation expense as compared to accelerated method.
Lower expense leads to higher net income.
*in later years, the effect is reversed.
SL depreciation Expense = Cost - Residual Value Useful Life
Straight-line Depreciation Method
Depreciation Expense Recognition
ExampleX Company recently purchased a machine at a cost of $12, 000. The machine is expected to have a residual value of $2,000 at the end of its useful life in five years. Calculate depreciation expenses using SL method.
Answer: $2,000
SL depreciation Expense = 12,000 – 2,000 5
DDB depreciation= [ 2 ] (cost-accumulated depreciation)Useful Life
Accelerated Depreciation Method
Depreciation Expense Recognition
Speeds up the recognition expense in a systematic way to recognize more depreciation expense in the early years of the asset’s life and less depreciation expense in the later years of its life.
Declining Balance Method (DB)-applies constant rate of depreciation to an asset’s (declining) book value each year-aka. Diminishing Balance Method
-Double-Declining Balance (DDB)
Accelerated Depreciation Method
Depreciation Expense Recognition
Declining Balance Method (DB) • does not explicitly use the asset’s residual value• depreciation ends once the estimated residual value is
reached
*if there is no Residual Value, DB method will never fully depreciate, so SL method is used.
DDB depreciation= [ 2 ] (cost-accumulated depreciation)Useful Life
Accelerated Depreciation Method
Depreciation Expense Recognition
Double-Declining Balance (DDB)
ExampleX Company recently purchased a machine at a cost of $12, 000. The machine is expected to have a residual value of $2,000 at the end of its useful life in five years. Calculate depreciation expenses using double-declining balance method.
Year 1: (2/5) (12,000) $4,800.00Year 2: (2/5) (12,000-4,800) $2,880.00Year 3: (2/5) (12,000-7,680) $1,728.00
Note:In year 4, Depreciation is $592.00 (since depreciation is only 10,000)
In year 5, the asset is fully depreciated so the expense is $0.00
Amortization Expense Recognition Amortization-allocation of the cost of an intangible asset (such as a franchise agreement) over its useful life.
-SL amortization is used (like SL depreciation)
* Intangible Assets with indefinite lives (ex. goodwill) are not amortized.
Bad Debt and Warranty Expense Recognition • When a firm sells g/s or provides a warranty to the
customer, the matching principle requires a firm to estimate bad debt expense and/or warranty expense
• The firm is recognizing the expense in the period of the sale, rather than a later period.
Implications for Financial Analysis
• Delayed expense recognition increases current net income.
• Analysts must:• consider underlying reasons for a change in an expense
estimate• Compare a firm’s estimates to those of other firms within the
firm’s industry.
Non-Recurring ItemsDiscontinued Operations• Is one that management has decided to dispose
of, but either has not yet done so, or has disposed of in the current year after the operation had generated income or losses.
• Measurement Date- the date at which the company develops a formal plan for disposing of an operation.
• Phase-out Date-the time between the measurement period and the actual disposal date
Non-Recurring ItemsUnusual or Infrequent Items• Events are either unusual in nature or infrequent
in occurrence, but not both.• Included in the income from continuing operations
and are reported before tax.
Non-Recurring ItemsExtraordinary Items• Under US GAAP
• Is a material transaction or event that is both unusual and infrequent in occurrence
• Reported separately in the income statement, net of tax, after income from continuing operations.
• Under IFRS, it does not allow extraordinary items to be separated from operating results in the income statement
Changes in Accounting StandardsInclude:
– Changes in accounting principles– Changes in accounting estimates– Prior-period adjustments
Changes in Accounting Principles• Change from one GAAP or IFRS method to another• Requires Retrospective application.• All prior-period financial statements currently
presented to reflect the change
Changes in Accounting StandardsInclude:
– Changes in accounting principles– Changes in accounting estimates– Prior-period adjustments
Changes in Accounting Estimates• Change in management’s judgment, usually due to
new information
• Note: changes do not affect cash flow
Changes in Accounting StandardsInclude:
– Changes in accounting principles– Changes in accounting estimates– Prior-period adjustments
Prior-Period Adjustments• Change from an incorrect accounting method to
one that is acceptable under GAAP or IFRS or the correction of an accounting error made in previous financial statements• Are made by restating results for all prior periods
in the current financial statements
Earnings Per Share
Earnings Per Share• One of the most commonly used corporate
profitability performance measures for publicly-traded firms (nonpublic companies are not required to report EPS data)
• Reported ONLY for shares of COMMON STOCK (aka ordinary stocks)
• Company may have simple or complex capital structure.– Simple
• no potentially dilutive securities, contains common stocks
Earnings Per Share• Company may have simple or complex capital
structure.– Simple
• no potentially dilutive securities, contains common stock, nonconvertible debt and nonconvertible preferred stock
– Complex• contains potentially dilutive securities such as options,
warrant or convertible securities
BASIC Earnings Per Share• Does not consider the effects of any dilutive
securities in the computation.
NOTE:• Net income - Preferred Stock Dividends = Net Income available
for Common Stockholders.
Basic EPS= Net Income-Preferred DividendsWeighted Average Number of CS outstanding
BASIC Earnings Per Share
Stock Dividend• distribution of additional shares to each stockholders in an
amount proportional to their current number of shares• If a 10% stock dividend is paid, the holder of 100 shares is
paid, the holder of 100 shares of stock would receive 10 additional shares.
Stock Split• Division of each “old” share into a specific number of “new”
(post-split) shares• The holder of 100 shares will have 200 new shares after a 2-
for-1 split or 150 shares after 3-for-2 split
BASIC Earnings Per Share
Example:During the past year, R&J Inc. had net income of $100,000, paid dividends of $50,000 to its preferred stockholders and paid $30,000 in dividends to its common stockholders. R&J’s common stock account showed the following:
Jan.1 Shares issued and outstanding at the beginning of the year 10,000Apr.1 Shares Issued 4,000July 1 10% stock dividendSept.1 Shares repurchased for the treasury 3,000
BASIC Earnings Per Share
Answer:Adjustment
Weighted Average Computation
Jan.1 Initial shares adjusted for the 10% dividend 11,000Apr.1 Shares issued adjusted for the 10% dividend 4,400Sept.1 Shares for treasury stocks repurchased (no adjustment) -3,000
Initial Shares 11,000 *12 mos. Outstanding 132, 000Issued Shares 4,400 * 9 mos. Outstanding 39,600`Sept.1 Shares for treasury stocks repurchased (no
adjustment)-3,000
BASIC Earnings Per ShareThings to note:• The weighting system is days outstanding divided by the
number of days in a year, but monthly approximation is used.• Shares issued enter into the computation from the date of
issuance• Reacquired shares are excluded from the computation from
the date of reacquisition.• Shares sold or issued in a purchase of assets are included from
the date of acquisition. • Stock split or stock dividends is applied to all shares
outstanding prior to the split or stock dividend and to the beginning-of-period weighted average shares
DILUTED Earnings Per Share
Dilutive Securities– are stock options, warrants, convertible debt or
convertible preferred stock that would decrease EPS if exercised or converted to common stock.
Antidilutive Securities– are stock options, warrants, convertible debt or
convertible preferred stock that would increase EPS if exercised or converted to common stock.