UNDERSTANDING THE INCOME STATEMENTS

Transcription

1 UNDERSTANDING THE INCOME STATEMENTS 1 IS = Income Statement R = Revenue E = Expenses FV = Fair Value SL = Straight-Line AFS = Available For Sale Securities I.S is sometimes referred to as statement of operations the statement of earnings or profit & loss statement. I.S equation= Revenue - expenses = net income. RV = Residual Value DO = Discontinued Operations CF = Cash Flows EP = Exercise Price AMP = avg. Market price OCI = Other Comprehensive 25.a Revenues sale of goods & services in normal course of business. Revenue- adjustment for returns = net revenue. Expenses outflows, depletion of assets, and incurrences of liabilities in the ordinary course of business. Gains & losses result from incidental transactions outside firm s primary business activities. Presentation Formats Single-Step format Multi-Step format All revenues are grouped together & all expenses are grouped together. Includes gross profit (revenue-cost of goods sold) as a subtotal. Gross profit - operating expense = operating profit. Operating income - interest & tax expense = net income (non financial firms). Pro rata share of subsidiary s income that the firm does not own is reported in parent s I.S as noncontrolling interest. This is subtracted. 25.b Accrual method revenue is recognized when earned & expenses are recognized when incurred. According to FASB revenue is recognized when realized & earned. Four additional guidance are: Evidence of arrangement b/w buyer & seller. Product has been delivered or service has been rendered. Price is determined or determinable. Seller reasonably sure surety of money collection. Specific Revenue Recognition Applications In some cases revenue may recognized before delivery or even after delivery. Long Term Contracts Often related to construction & long term projects. Service contracts or licensing agreements firm may equally recognize revenue. Long Term Contracts Percentage of Completion Method Appropriate when cost & revenue can reliably estimated. R,E & profit recognized as work is performed. Measured as total cost to date divided by total project cost. Completed Contract Method Suitable when uncertain outcomes or short term project. R,E & profit at project completion. Expected loss recognized immediately (either method).

2 2 25.b IFRS unreliable outcome, revenue is recognized to the extent of cost, cost is expensed & profit is recognized at completion. % of completion method is more aggressive & subjective due to cost estimates, provide smoother earnings & better matching: C.F are same under both methods. Installment Firm finances a sale & payments are expected over extended period. Installment Normal revenue Recognition Method Installment Method Cost Recovery Method Seller has competed a significant part of earnings process and Collection is certain or amount which cannot be collected can be estimated. Collectability uncertain. Profit recognized based on percentage of sales price received as cash. = h Profit recognized when cash collected exceeds cost. Barter Transaction Two parties exchange goods or services without cash. Round-trip transaction sale & simultaneously identical purchase from same party. Barter Transaction U.S.GAAP IFRS Revenue can be recognized at F.V. only if the company has historically received cash payments for such services. Based on F.V of revenue from similar non barter transactions with unrelated parties. Gross & Net Reporting of Revenue Gross Revenue Reporting Net Revenue Reporting Reports sales & COGS separately. Difference in sale & cost is reported. Criteria to use gross revenue reporting under GAAP. Be the primary obligor & bear inventory & credit risk. Be able to choose supplier & establish price. Implication for Financial Analysis Firms discloses revenue recognition policies in footnotes. Check how conservative firm s revenue recognition policies. Extent to which policy requires making judgment & estimates.

3 3 25.c Matching principle accrual based expense to generate revenue in the same period as revenue recognized. Period costs expenditure not directly tied to revenue generation. Expense in period of incurrence. Cost of long lived assets (depreciation) also matched with revenue. Credit sale estimate bad debt expense. Implication for Financial Analysis Delayed exp increase net income, therefore more aggressive. Analyst must consider the reasons for a change in expense estimate. Analyst should compare firm s estimate with industry peers. Firms disclose policies & estimates in footnotes & MD&A. 25.d Depreciation Straight-line depreciation Equal amount of dep. expense. Early years, lower dep. expense & higher net income compared to accelerated method. SL dep. expense = Accelerated depreciation More dep. in early years. Same total expense. Declining balance method Constant rate of dep. each year Double declining balance Depreciates the asset at two times the SL rate. DDB dep. = (cost Acc. Dep. ) No explicit RV in calculation but dep. ends once RV reached. Inventory Specific Identification First-in, first-out Last-in, first-out Weighted Avg. cost method Can used if firm can identify which items are sold and which remain in inventory. Item 1 st purchased is assumed to be 1 st sold. COGS is charged with early purchases & inventory with recent purchases. Intangible Assets Last item purchased is assumed to be 1 st sold. Recent purchases to COGS & earlier purchases to inventory. Suitable for durable inventory. Easy to use. Per unit cost = cost of available goods Total units This per unit cost is used to determine COGS & inventory Amortization allocation of cost of an intangible asset over its useful life. Amortization exp should match asset s economic benefits. Intangible assets with indefinite lives must be tested for impairment annually instead of amortized.

4 4 25.e Nonrecurring items & changes in accounting standards Discontinued operations Unusual or infrequent items Extraordinary items Changes in accounting standards Management has decided to dispose of a component operation but either has not yet done so, or has disposed of in current year. The discontinued operation must be physically & operationally distinct from rest of firm. Measurement date the date at which disposal is decided. Phase out period time b/w measurement period & actual disposal date. G/L from DO is reported net of tax after continuing operations. Unusual in nature or infrequent in occurrence but not both. Examples are G/L from asset sale, impairments & write offs. These items are included in income from continuing operations & reported before tax. Analyst may review these items to determine whether they should be used in forecasting. Extraordinary item that is both unusual & infrequent (U.S.GAAP). Examples are loss from expropriation of assets, G/L from early debt retirement & uninsured losses from natural disaster. Reported separately in I.S, net of tax after continuing operations. IFRS does not allow extraordinary items to be separated from operating results. Change in accounting principle Change in accounting estimate Correction of a prior period error From one (U.S. GAAP or IFRS) policy to another. Retrospective application. Result of a change in management s judgment. Applied prospectively. Do not affect C.F. Correction of a prior period error requires retrospective restatement of financial statements/ 25.f Nonfinancial firm non operating transactions may result from investment income & financing expenses.

5 5 25. g & h Earnings per Share Corporate profitability performance measure. Company may have simple (no potentially dilutive securities) or complex (potentially dilutive securities) capital structure. Reported only for shares of common stock. Basic EPS =. Weighted Avg. number of shares no. of shares outstanding during the year, weighted by portion of the year. Stock dividend additional shares to each shareholder. Stock split division of each old share into specific number of new shares. Each shareholder s proportional ownership is unchanged. Stock split or stock dividend is applied to all shares outstanding prior to split or dividend & to the beginning-of-period weighted avg. shares. Dilutive EPS Dilutive securities options: warrants, convertible debt or convertible preferred stock that decrease EPS, if EPS then anti dilutive securities. In case of diluted EPS numerator must be adjusted as : Convertible convertible preferred stock is dilutive; preferred dividend must be added to earnings if preferred dividend is deducted from earnings. Convertible bonds are dilutive; interest exp multiplied by (1-tax rate) must be added back to earnings. If dilutive securities, denominator is adjusted for equivalent number of common shares created by conversion of all dilutive securities. Dilutive stock options or warrants (EP< AMP), number of shares but no numerator adjustment. Treasury stock method Hypothetical funds received from options used to purchase common shares at AMP. Net increase in shares (shares created by option- repurchased shares). Net income Preferred dividend + convertible preferred dividends + convertible debt interest 1 T Diluted EPS = weighted Avg. shares + shares from conversion of conv. pfd. shares + shares from conversion of conv. debt + shares issuable from stock options 25. i Common Size IS Vertical Common Size IS Horizontal Common Size IS Expresses each line item as a percentage of sales. Each line item is expressed in relation to selected base year. 25. j Margin Ratios Gross Profit Margin Operating Profit Margin Net Profit Margin GPM = Gross Pro it OPM Operating Pro it = NPM = Net Pro it 25. k & l Comprehensive income all changes to equity other than owner contributions & distributions. C.I = net income + OCI (foreign currency G/L, minimum pension liability adjustments, unrealized G/L on derivative contracts accounted for as hedges & AFS securities). Transactions included in OCI affect equity but not net income. AFS securities reported on B/S at FV, unrealized G/L as component of OCI.