fm4 chapter 4 (2)

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


• 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.


• 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


• 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.


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.


When LOSS is expected, the loss must be recognized immediately.

-under IFRS and US GAAP


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


Answer : Percentage-of-Completion Method

2005 2006 2007 TotalRevenue $500 $375 $125 $1000

Expenses $400 $300 $100 $800

Net Income $100 $75 $25 $200


%-of-completion

50% 37.5% 12.5%


Answer : Completed Contract Method

2005 2006 2007 TotalRevenue $400 $300 $300 $1000

Expenses $400 $300 $100 $800

Net Income $0 $0 $200 $200


On the basis of the costs/expenses incurred


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


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


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


Answer: Installment Method

– Total Expected Profit as Percentage of Sale is 20% [(1000-800)/1000]


Installment Sales



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).


Installment Sales


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)


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



* 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



* 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



* 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


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


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)



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



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 Estimates• Change in management’s judgment, usually due to

new information

• Note: changes do not affect cash flow



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


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


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.

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fm4 chapter 4 (2)