Financial Reporting and

Analysis-Understanding

Income Statement

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Session Agenda

• Understanding the Income Statement

– Introduction to Income statement and its components

– Principles of Revenue recognition

• Discussion of Quiz question 1

– Depreciation expense recognition

• Discussion of Quiz question 4

– Inventory expense recognition

• Discussion of Quiz question 2

– EPS and diluted EPS calculations

• Discussion of Quiz question 3

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Introduction to the Income Statement

• Income statement is also known as:

– “Statement of operations”/ “statement of earnings”/ "profit and loss statement (P&L)”

• An income statement equation:

– Revenues - Expenses = Net Income

• Revenue

– Gross Revenue

– Net Revenue : Gross revenue adjusted for estimated returns & allowance

– Example

• Expenses can be grouped based on their function / nature:

– By Function

• Manufacturing Expenses: Raw material, labor and direct expenses are included in cost of goods sold

• Selling and General & Administrative expenses

– By Nature

• Depreciation: Both on assets in manufacturing and administration are combined together

• Research and development expenses

• Estimated Gains/ Losses from discontinued operations:

– Gain or loss which are not related to their normal business activities

– For example, Gain (Loss) on sale of fixed assets (difference between book value and sale vale)

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• Presentation formats of Income Statements:

1. Single-step

• Revenue less Expenses : all items are grouped

together as revenue or expenses

2. Multi-step

• Shows detailed presentation including

calculation of gross profit, operating profit & net

income

• Gross profit / loss: Revenue – Cost of Good

Sold

• Operating profit / loss (EBIT): Gross profit –

Other Operating expenses (like SGA)

• Income from continuing operations: Operating

profit - Interest expense - Income taxes

• Net Income = Income from continuing

operations + Earnings/ loss from discontinued

operations

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Introduction to the Income Statement (Cont…)

Sample Income Statement

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Single Step

Revenue 3855.38

Expenses 3318.29

Profit 537.09

Multi-Step Income for year 2012

Sales 8,000,000

COGS 4,500,000

Gross Profit 3,500,000

Selling, General and

Administrative expenses

600,000

Depreciation, Amortization 50,000

EBIT 2,850,000

Interest 400,000

EBT 2,450,000

Taxes 857,500

Net Income 1,592,500

Revenue Recognition

• According to the IASB, the term "income“ includes revenue and gains:

– “Income is defined as increases in economic benefits during the accounting period in

the form of inflows or enhancements of assets or decreases of liabilities that result in

increases in equity, other than those relating to contributions from equity participants”

• Revenue is recognized in the income statement when:

– It is earned

– Need not necessarily be recognized at the time of cash exchange

• IASB guidelines for revenue recognition:

1. Transfer of ownership’s risk and rewards to buyer

2. Reliable Measurement of Revenues

3. Reliable Measurement of associated costs

4. Probable that economic benefits on sale will flow to the entity

Income is broad concept and includes gains / losses from non operating activities

as well.

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Example: Quiz question

• Question 1: An electronic goods company allows only its most valued customers to buy goods

on credit in their store. For this, a background check of those customers is conducted to gauge

their credibility. A customer ordered a laptop from the company in August. The good was

shipped and delivered in September. The payment was made in full by the due date in

November. Assuming that the company follows accrual method of accounting, the most

appropriate month in which the company should recognize the revenue is:

A. August

B. September

C. November

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Solution

• Answer: B

• Explanation: Since the delivery took place in September, the ownership “risk” is transferred.

Also, there is a good probability of future flow of economic benefits because the credibility of the

customers has already been tested. Hence, September is the right time to recognize the

revenue.

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Long term Contracts: Revenue recognition methods

Generally for the entities engaged in construction projects

• Percentage of completion method:

– Appropriate when the project's cost and revenue can be reliably estimated

– Amount of revenue to be recognized =

Total contract value x total cost incurred to date / total expected cost of the project

– Accordingly, revenue, expense, and therefore profit, are recognized based on the % completed

• Completed Contract Method:

– Used when the outcome of a project cannot be reliably measured or

– The project is short-term

– Revenue, expense, and profit are recognized only when the contract is completed

– But, if a loss is expected, the loss must be recognized immediately (Principal of conservatism)

• Compared to completed contract method, percentage of completion method:

– Recognizes revenue early hence it is more aggressive

– Requires estimation of total costs hence subjectivity is involved

– Provides smoother earnings and results in better matching of revenues and expenses over time

• No impact on Cash flow: cash flows is same under both methods

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* Important concept

Expenses Recognition

• According to the IASB:

“Expenses are decreases in economic benefits during the accounting period in the form of

outflows or depletions of assets or incurrence of liabilities that result in decreases in equity

other than those relating to distributions to equity participants”

• Matching Principle:

– Both revenue and associated expenses are matched and recognized in same period

– Matching concept requires expenses to be recognized in the same period when revenues are

recognized for which expenses were incurred

• E.g. inventory is purchased in Q4, 2008 and the goods are sold in Q1 2009, then, using the matching

principle, both the revenue and the cost of goods sold are recognized in Q1 2009

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Depreciation and Amortization

• Depreciation:

– Long-lived assets provide economic benefits beyond one accounting period hence their cost

must be matched with revenues of more than one accounting period

– Depreciation is a charge for allocation of cost of long lived assets over their economic lives

• It is the cost of using long-lived assets in business matched with revenues

• Hence it requires to estimate the life as well as the rate of depreciation

– Depreciation is charged for tangible assets like plant and equipment whereas amortization is

charged for intangible assets like patents / copyrights

– Land is the fixed asset which is not depreciated while Goodwill is not amortized

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* Important concept

Method Used for

Depreciation Tangible Fixed Assets

Amortization Intangible Fixed Assets

with finite lives

Impairment Intangible Fixed Assets

with infinite lives

Depreciation Recognition Methods

1. Straight-line depreciation

– Equal amount of depreciation expense each period

– Requires significant estimate for residual value and useful life

2. Accelerated method of depreciation:

– Allocates high depreciation in early period of assets life

– Accelerated method is a conservative method because of low net income in early periods

– Matching of expenses to revenues better in this method

– Declining balance method is one of these methods

• Applies a constant rate of depreciation to a declining book value

– Double-declining balance method

• DB does not explicitly use the asset's residual value in the calculations, but depreciation ends once the

estimated residual value has been reached.

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Example: Quiz question

• Question 4: In January 2013, Starperf Company purchased a new equipment to use for its

operations. The cost of equipment was $ 1, 20,000 and is expected to last for 8 years. The

salvage value of the equipment is $ 20,000. The depreciation expense for the second year using

the double declining balance method is closest to:

A. 12,500

B. 22,500

C. 32,500

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Solution

• Answer: B

• Explanation:

For year 1, Depreciation = (2/8)* (120000-0) = 30000

For year 2, Depreciation= (2/8) * (120000-30000) = 22500

Similarly, for year 3, Depreciation = (2/8) * (120000- 52500) = 16875

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Inventory Recognition

• Specific identification method:

– Use this method when a firm can identify exactly which items were sold and which remain in inventory

– For example: an auto dealer records each vehicle sold or in inventory by its identification number

• First-In, First-Out (FIFO) method:

– The first item purchased is assumed to be the first item sold

• Cost of goods sold (COGS) consists of costs of early purchases including beginning inventory

• Inventory consists goods which are purchased more recently

– FIFO is appropriate for inventory that has a limited shelf life.

• For example: A company dealing in perishable goods will follow this method to sell its oldest inventory

first to keep the inventory on hand fresh

• Last-in, First-out (LIFO) method:

– The last item purchased is assumed to be sold first

• Cost of goods sold (COGS) consists of costs which were purchased more recently

• Inventory consists goods which were purchased early including beginning inventory

– LIFO is appropriate when goods does not deteriorate with age

• For example, a mining company will sell goods off the top of the pile

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Inventory Recognition Cont…

• Weighted average cost:

– Not affected by the physical flow of the inventory

– Calculate weighted average cost of purchases to value both

• Cost of goods sold

• Closing inventory

– Cost per unit is calculated by dividing cost of goods available by total units available

– It is popular because of its ease of use

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* Important concept

Method COGS value Ending Inventory value

FIFO Initial purchases Recent purchases

LIFO Recent purchases Initial purchases

Weighted

Average

Average of all Average of all

Example: Quiz question

• Question 2: Akash motors made the following inventory transactions in the current year:

If the beginning inventory is 15 units @ $ 30, the year-end inventories using FIFO and LIFO

methods respectively are closest to

A. $ 4200, $ 2950

B. $ 3750, $ 2950

C. $ 4200, $ 3400

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Purchase Sales

50 units @ $ 50 20 units @ $ 60

30 units @ $ 30 25 units @ $ 40

60 units @ $ 60 30 units @ $ 50

Solution

• Answer: C

• Explanation: Year-end inventory using FIFO= (60X60) + (5X30) + beginning inventory

= 3600+150+ (15X30)

= 4200

• Year-end inventory using LIFO= (50X50) + (15X30) + beginning inventory

= 2500 + 450 +450

= 3400

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Earnings per share (EPS)

• Most commonly used profitability performance measure for publicly-traded firms

– Basic EPS – (company has only equity shares)

– Diluted EPS – (company has both equity shares & convertible debentures)

– All firms with complex capital structures must report both

• Non-public companies are not required to report EPS data

• Company’s capital structure:

– Simple capital structure (basic EPS)

• Contains only common stock, nonconvertible debt and nonconvertible preferred stock

– Complex capital structure (basic and diluted EPS)

• Contains potentially dilutive securities like Options, Warrants, or Convertible securities along with

common stock

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Basic EPS

• The concept is simple- we use the income available to “common” stockholders in the

numerator and the average number of outstanding shares in the denominator to get Earnings

per share for a common shareholder

• Weighted average number of common shares

– Number of shares outstanding during the year weighted by the period they were outstanding for

in a year

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* Important concept

Diluted EPS

• Diluted EPS is lower than Basic EPS

• Diluted EPS is calculated when capital structure contains dilutive securities like stock options,

warrants, convertible debt, or convertible preferred stock

– These securities will decrease EPS if exercised / converted to common Stock

• Each potentially dilutive security must be examined separately to determine if it is actually

dilutive

• These securities could be anti-dilutive as well if these would increase EPS when they are

exercised or converted to common stock

• Anti dilutive securities are not considered in the calculation of diluted EPS

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* Important concept

Example: Quiz question

• Question 3: Lakshmi Corporation had 10,000 shares of outstanding common stock at the

beginning of the year. The company issued 4,000 new shares of common stock on July 1. The

company also issued 5% stock dividends on July 1. Finally, it issued 100 convertible bonds

which are each convertible into 15 common stock shares on September 1. Assuming that the

convertible bonds are dilutive, the weighted average numbers of shares to be used in computing

basic and diluted EPS respectively are closest to:

A. 12000, 12500

B. 12100, 12600

C. 12000, 12500

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Solution

• Answer: B

• Explanation:

The weighted average numbers of shares to be used in computing basic EPS

= (10000)*(12/12) + (4000)*(6/12)*(1.05)

= 12100

The weighted average numbers of shares to be used in computing diluted EPS

= (10000)*(12/12) + (4000)*(6/12)*(1.05) + (15X100)*(4/12)

= 12600

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Additional Questions for Practice

1. What will be the operating profit and net profits given following information

Sales = $10,000 COGS = $6,000 SG&A = $1000 Depreciation = $500

Interest = $100 Income Tax = $100 Extraordinary Expenses = $300

Dividend to common shareholders = $100

Operating Profit Net Profits

A. $3000 $2000

B. $2500 $2000

C. $2000 $1900

2. Which of the following condition need not to be satisfied as per IASB guideline for revenue

recognition

A. Evidence of an arrangement between the buyer and seller

B. Transfer of ownership’s risk and rewards to buyer

C. Reliable Measurement of Revenues

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3. Calculate revenue to be recognized under percentage of completion method in 2009 for

following contract awarded in 2008 beginning

Total Contract Size = $100,000 , Total Estimated Costs = $80,000

Costs incurred in 2008 = $20,000, Costs incurred till 2009 = $60,000

A. $25,000

B. $50,000

C. $75,000

4. What will be depreciation under double declining balance method given following information

– PP&E Net Value = $50,000

– PP&E Accumulated Depreciation = $10,000

– Useful Life = 5

A. $10,000

B. $16,000

C. $20,000

Questions

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5. Calculate diluted EPS given following information:

– Net Income = $50,000; Dividend on preference shareholders = $5,000

– No of shares outstanding at beginning of the year = 4000

– No of shares issued mid of the year = 1000

– Stock warrants: 100 – each warrant = 1 share; Exercise price = $50

– Convertible Debt: 300, 8% bonds with par value of $30000; each bond is convertible in 2 common share

– Average share market price = $75; Closing price = $60 ; Tax Rate = 30%

A. $9.09

B. $9.16

C. $9.29

6. Inventory is reported in books at

A. Cost using FIFO, LIFO or weighted average costs

B. Net realizable value

C. Lower of cost or net realizable value

Questions

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Answers

1. B.

– Operating profit = $10,000 - $6,000 - $1,000 - $500 = $2,500

– Net Profit = 2,500 - $100 - $100 - $300 = $2,000

2. A.

– Evidence of an arrangement between the buyer and seller is pre requisite under SEC guidelines

3. B.

– Revenue Recognized in 2008 = 20000 / 80000 * 100000 = 25000

– Revenue Recognized till 2009 = 60000 / 80000 * 100000 = 75000

– Revenue Recognized in 2009 = 75000 - 25000 = 50000

4. B.

– DDB depreciation = ( 2 / useful life) * (cost – accumulated depreciation) = (2 / 5) * (50,000-10000) = 16,000

– Net value is equal to cost – accumulated depreciation.

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Answers

5. A.

– Basic EPS: (50000 – 5000) / (4000*6/12 + 5000*6/12) = $10

– Check whether each of securities are anti dilutive or not

– Warrants = anti dilutive as exercise price is less than average market price

– Convertible Debt =

– Impact on Basic EPS => Interest * (1-tax rate) / shares to be issued on conversion

= ((30000 * 8%)* (1-30%)) / (300*2) = $2.8

= $2.8 is less than current basic EPS of $10 hence these bonds are dilutive

– Diluted EPS = Nominator = (50000 – 5000) + ((30000 * 8%)* (1-30%)) = 46,680

– Denominator = (4000*6/12 + 5000*6/12) + (100 – (100*50/75)) + (600) = 4500 + 33.33 + 600 = 5133.33

– Diluted EPS = $9.09

6. C.

– Inventory is reported at the lower of Cost or Net realizable value. Net realizable value is the selling price of inventory less the estimated cost of completion and disposal costs.

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Other Webinars

Here are the links for the other recent blogs, quizzes and webinars on our

website to help you with CFA/FRM preparation

Understanding Income statement (12/04/2013)

Blog: http://www.edupristine.com/blog/cfa-tutorial-understanding-income-

statement-from-cfa-perspective/

Linear regression analysis (11/04/2013)

Blog: http://www.edupristine.com/blog/demystifying-linear-regression-analysis-

for-frm-level-1-exam/

Quiz: http://www.edupristine.com/quizes/linear-regression-for-frm/

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Upcoming Webinar

Hedging strategies using futures (13/04/2013- Upcoming)

Registration: https://attendee.gotowebinar.com/register/1355617922242090752

Blog: http://www.edupristine.com/blog/frm-tutorial-hedging-strategies-using-futures-for-frm-level-1-

exam/

Quiz: http://www.edupristine.com/hedging-strategies-quiz/

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