Income Statement Topic 2

Alexei Alvarez, CFA, FRM

Fabricio Chala, CFA, FRM
Definitions

❖  Reports revenues and expenses of the firm over a period of

time.
❖  Also known as the “profit and loss statement” (P&L).
❖  The income statement may be combined with “other
comprehensive income” and presented as a single statement of
comprehensive income.
What would different users look for?
❖  Investors
❖  Lenders
Components

Revenues (turnover): Generated from the sale of goods and services in

the normal course of business.
❖  Net revenues: Revenues adjusted for volume discounts, estimated
returns and allowances.
Expenses: amounts incurred to generate revenues. Includes: cost of
goods sold, operating expenses, interest and taxes.
❖  May be grouped together by their nature or function (e.g.
Depreciation, cost of manufacturing).
Gains and Losses: Increase or decrease of economic benefits. May or
may not result from ordinary business activities.
If firm has a controlling interest in a subsidiary: Should subtract the
pro-rata share of income not owned (noncontrolling interest)
Multi-Step Income Statement

Income Statement
Amount that remains after
direct costs are subtracted Revenues
from revenue Cost of goods sold / Cost of sales

Gross Profit

Selling, general and administrative expense

Subtracting operating
expenses Depreciation and amortisation expense

Operating Profit

Interest expense
After subtracting
Income before tax
non-ordinary business
activities Income tax

Income from continuing operations

Earnings (losses) from discontinued operations, net of tax

Earnings / Bottom line Net income

Revenue recognition

IASB (IFRS) FASB (US GAAP)

Goods:
1. Risk and reward of ownership is 1. Realized or realizable
transferred and
2. No control over the goods sold 2. Earned
3. Revenue can be measured
4. Probable flow of economic benefits SEC (additional guidance):
5. Costs can be measured 1. Evidence of an arrangement between
buyer and seller
Services: 2. Product has been delivered or service
1. Revenue can be measured has been rendered
2. Probable flow of economic benefits 3. Price is determined or determinable
3. Stage of completion can be measured 4. Seller is reasonably sure of collecting
4. Costs can be measured money

If criteria is not met: The firm has to report it as unearned revenue (a liability)
Revenue recognition

❖  Under the accrual method of accounting, revenue is recognized

when earned and expenses are recognized when incurred.
❖  Matching principle: expenses are matched against the revenue
they help generate
IMPORTANT:
❖  Accrual accounting does not necessarily coincide with the
receipt or payment of cash.
❖  So… how could firms manipulate earnings?
Revenue recognition varies
Revenue recognition at sale:

Revenue from sales of goods is recognized when both ownership and risk
of loss are effectively transferred to customer, which are generally occurred
upon shipment.
For certain transactions, risk of loss associated with goods-in-transit is
retained by the Group, in which the Group books revenue upon delivery of
products and defers the amounts of revenue based on the estimated days-
in-transit at the end of each month. The days-in-transit is estimated based
on the Group’s weighted average estimated time of shipment arrival. Cost
of in-transit products is deferred in deposits, prepayment and other
receivables in the balance sheet until revenue is recognized. The estimates
of days-in-transit are reviewed semi-annually
Revenue recognition at sale:

… We account for membership fee revenue, net of refunds, on a deferred

basis, whereby revenue is recognized ratably over one-year. Our Executive
members qualify for a 2% reward on qualified purchases (up to a maximum
reward of approximately $750 per year), which can be redeemed only at
Costco warehouses. We account for this reward as a reduction in sales. The
sales reduction and corresponding liability are computed after giving effect
to the estimated impact of non-redemptions based on historical data
Specific Revenue Recognition Applications:
Long-Term contracts

IFRS US GAAP

Percentage-of-completion method
Outcome of
contract can be
Revenue / expense (profit) are recognized as the work is performed
reliably estimated
( total cost incurred to date / total expected cost )

Revenue is recognized to the extent

Outcome of of contract costs. Costs are expensed Completed contract method
contract cannot be when incurred BUT PROFIT IS Revenue/expense (profit) are ONLY
reliably estimated ONLY RECOGNIZED AT RECOGNIZED AT COMPLETION
COMPLETION

If a loss is expected, the loss must be recognized

immediately, under both IFRS and US GAAP
Revenue recognition:
Long-Term contracts

❖  Contract accounting is used predominantly by the Military Aircraft and

Missile Systems and Space and Communications segments. The majority
of the business conducted in these segments is performed under contracts
for the U.S. Government and foreign governments that extend over a
number of years
❖  Revenues under contracts with fixed prices are generally recognized as
deliveries are made. For certain fixed-price contracts that require
substantial performance over an extended period before deliveries begin,
revenues are recorded based on the attainment of performance
milestones
Revenue recognition:
Long-Term contracts

❖  Revenue from the sale of integrated solutions, which includes

transactions that require significant production, modification or
customization of software, is recognized in accordance to contract
accounting.
❖  Under contract accounting, revenue is recognized by utilizing either the
percentage-of-completion method or completed contract method. The
company currently utilizes the completed contract method for all solution
sales, as sufficient history does not currently allow the Company to
accurately estimate total costs to complete transactions. Revenue from
other long-term contracts, primarily government contracts, is generally
recognized using the percentage-of-completion method.
Long-Term contracts
Example

Percentage of completion:
Cost expensed in “t” = Cost incurred in “t”
Revenue recognized in “t”
[(% 𝑐𝑜𝑚𝑝𝑙𝑒𝑡𝑒𝑑 𝑖𝑛 t)−(%𝑐𝑜𝑚𝑝𝑙𝑒𝑡𝑒𝑑 𝑖𝑛 t−1)]×𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑣𝑎𝑙𝑢𝑒
Example
On 1 January 2016, Verdi secured a 3-year contract with the city
hall of Lima to build an underground parking.
Total contract value is $ 6 billion. The cost details are:

Year 2016 2017 2018

Cost incurred 1,000 2,000 1,000
Long-Term contracts
Example

Determine Verdi’s income from this project using the percentage of

completion method.
Assume there is high uncertainty about construction costs, but they
would not be higher than the contract price, how would Verdi report
revenue under US GAAP and under IFRS?
What would happen if the total project cost changes to $5 bn due to
higher incurred costs in 2017 ($3 bn instead of $2 bn)? (use the
percentage of completion method)
Specific Revenue Recognition Applications:
Instalment Sales
A firm finances a sale and payments are expected to be received over an
extended period.

IFRS US GAAP
Discounted PV of the instalment
payments is recognized at the time of
Collectability
sale. The difference between the Revenue is recognized at the time of sale
is certain
instalment payments and the discounted
PV is recognized as interest over time

Collectability
Instalment method
cannot be
reasonably *Cost recovery method
Profit is recognized as cash is collected
estimated
Profit is recognized only when cash collected
exceeds costs incurred
Collectability
highly *Cost recovery method
uncertain

*Typically used only for sales of real estate

Instalment sales:
Example

In January 2016, Sam Ltd sold a piece of land for $200,000 to Ollie
Inc. The original cost of the land was $160,000. Ollie has paid 40%
of the sale price in 2016 and 2017, and the remaining 20% in 2018.
❖  How would you compute the profit using the instalment method?
Now, let’s assume that Ollie’s business is highly cyclical,
therefore, Sam Ltd considers Ollie may have trouble completing
all payments.
❖  How would your calculations change?
Specific Revenue Recognition Applications:
Barter Transactions

Two parties exchange goods or services without cash payment.

Should revenue be recognized?

IFRS US GAAP

Revenue can be recognized at fair

value only if the firm has historically
received cash payments for such
Revenue must be based on the fair goods and services
value of revenue from similar non- and can use this historical experience
barter transactions with unrelated to determine fair value.
parties
Otherwise, the revenue is
recorded at the carrying value of the
asset surrendered
Specific Revenue Recognition Applications:
Gross vs. Net Reporting

❖  Merchandising companies typically sell products that they

purchase from a supplier. To account for the sales, they
❖  record the amount of the sale proceeds as sales revenue and
❖  record the cost of the products as the cost of goods sold.
❖  Some internet-based merchandising companies sell products
that they never hold in inventory; they simply arrange for the
supplier to ship the products directly to the end customer.
Should they record revenues of
❖  the gross amount of sales proceeds received from their customers?
❖  the net difference between sales proceeds and their cost?
Specific Revenue Recognition Applications:
Gross vs. Net Reporting

❖  US GAAP guidance – Revenues should reported gross if:

❖  Company is primary obligor under the contract
❖  Bears inventory risk and credit risk
❖  Can choose its supplier
❖  Has reasonable latitude to establish price
❖  Otherwise, report revenues net
❖  Why should we care?
Gross vs. Net Reporting
Example

“Generally, we recognize gross revenue from items we sell from

our inventory as product sales and recognize our net share of
revenue of items sold by third-party sellers as service sales.”

Amazon.com (2017), 10-K

Gross vs. Net Reporting
Example

Flying.com sells tickets online from several airlines. The company

pays only for tickets it sells to its customers and once the tickets
are sold, the airline is responsible for providing all services.
Last year, Flying.com sold tickets for a total $ 1.1 million. The cost
of these tickets was $1 million and the company incurred in direct
costs of $8,000.
How should the company report revenue?
Implications for Financial Analysis

It is important to ask ourselves:

1.  How conservative are the firm’s revenue recognition policies?
(recognizing revenues sooner is more aggressive)
2.  To what extent the firm’s policies rely on judgment and estimates?
The firm’s stance can be aggressive or conservative:
1.  Are there valid reasons to change principles?

2.  How do other firms in the industry register?

Doubts about reported revenue:

❖  Does the company have the physical capacity (revenue per
employee, PP&E)
❖  Accounts receivable take longer to collect
IFRS-US GAAP Convergence

❖  Principles-based approach to revenue recognition

❖  New guidance issued May 2014: USGAAP effective Dec 2017
and IFRS effective Jan 2018.
❖  Five-step model for revenue recognition
1.  Identify contracts with customer
2.  Identify performance obligations in contracts
3.  Determine transaction price
4.  Allocate transaction price to performance obligations
5.  Recognize revenue when/as performance obligations are satisfied
IFRS-US GAAP Convergence

❖  The standard defines a contract as an agreement between two or

more parties that specifies their obligations and rights. Collectability
must be probable for a contract to exist.
❖  A performance obligation is a promise to deliver a distinct good or
service. A “distinct” good or service is one that meets the following
criteria:
❖  The customer can benefit from the good or service on its own or combined
with other resources that are readily available.
❖  The promise to transfer the good or service can be identified separately from
any other promises.
❖  A transaction price is the amount a firm expects to receive from a
customer in exchange for transferring a good or service to the
customer.
IFRS-US GAAP Convergence

❖  For long-term contracts, revenue is recognized based on a firm’s

progress toward completing a performance obligation. This
treatment is consistent with the percentage-of-completion
method currently in use, although the new standards do not call
it that.
Expense Recognition
General Principles

❖  Fundamental principle: A company recognizes expenses in the

period in which it consumes (i.e., uses up) the economic benefits
associated with the expenditure.
❖  Matching principle: Costs are matched with revenues.
❖  As with revenue recognition, expense recognition can occur
independently of cash movements.
❖  Inventory and cost of goods sold
❖  Plant, property, and equipment and depreciation
Expense Recognition:
Inventories

❖  Specific identification: A firm can identify exactly which items

were sold and which remain in inventory
❖  First-in, first-out (FIFO): first item purchased is assumed to be
the first item sold
❖  Last-in, first-out (LIFO): last item purchased is assumed to be
the first item sold
❖  Weighted average cost

IFRS US GAAP
FIFO
FIFO
LIFO
Weighted Average
Weighted Average
Expense Recognition:
Depreciation/Amortisation

❖  Long-lived assets are assets expected to provide economic

benefits over a future period of time greater than one year.
❖  The process of systematically allocating costs of long-lived
assets over their useful lives is known as:
❖  Depreciation (tangible assets)
❖  Depletion (natural resources)
❖  Amortisation (intangible assets with finite lives)
Expense Recognition:
Doubtful accounts and Warranties

❖  If a firm sells goods or services on credit or provides a

warranty to the customer, the matching principle requires the
firm to estimate bad debt expense and/or warranty expense.
❖  By doing so, the firm is recognizing the expense in the period of
the sale, rather than a later period.
IMPLICATIONS:
❖  Since estimates are involved, firms can delay or accelerate
recognition of expenses. Why would they do that? Why could a
firm’s bad debt expense decrease?
❖  Why could a firm’s warranty expense be significantly lower?
Compare estimates to those of other firms within the industry.
Check footnotes and MD&A
Non-recurring items

Discontinued operation
❖  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: Date when the company develops a formal
plan for disposing of an operation.
❖  Phaseout period: Between the measurement period and the actual
disposal date.
Non-recurring items

IMPORTANT
❖  Any income or loss from discontinued operations is reported
separately in the Income Statement, net of tax, after income from
continuing operations. (Why?)
❖  Any past income statements presented must be restated,
separating the income or loss from the discontinued operations.
❖  On the measurement date, the company will accrue any
estimated loss during the phaseout period and any estimated
loss on the sale of the business.
❖  Any expected gain on the disposal cannot be reported until after
the sale is completed
Discontinued Operation
Example

IBM
2014 Finance Report
Non-recurring items

Unusual or infrequent items

❖  Example: Gains/losses from the sale of assets or part of a
business, impairments, write-offs, write-downs and
restructuring costs.
They are included in income from continuing operations and are
reported before tax
Changes in Accounting Policies
❖  Either US GAAP or IFRS method changes to another.
A change in accounting principle requires retrospective application
(why?)
Non-recurring items

Change in accounting estimate

❖  Result of a change in management’s judgment, usually due to
new information. Typically do not affect cash flows. Why? (e.g.
useful life of an asset)
It is applied prospectively and does not require the restatement of prior
financial statements
Prior-period adjustment
❖  A change from an incorrect accounting method to one that is
acceptable or the correction of a previous accounting error.
Disclosure of the nature of the adjustment and its effect on net income is
required
Non-recurring items

Should be excluded when forecasting future

Discontinued Operations
earnings. Actual event may provide information

Unusual or infrequent
Which ones would be relevant “forward looking”?
items

Change in Accounting
Impact on previous and current FS
policies

Change in Accounting Doesn’t have an impact on cash flow, but it has an

estimate impact on future FS

May indicate weaknesses in the firm's internal

Prior-period adjustment
controls
Operating vs non-operating transactions

❖  Non-operating transactions are not part of the firm’s normal

business operations.
❖  For example: For an non-financial company
o  Dividends received from investments in other firms
o  Interests received
o  Gains/losses from the sale of a security
o  Interest expense (why?)
❖  What about a bank?
Earnings per share (EPS)

❖  One of the most commonly used corporate profitability performance

measures for publicly-traded firms. Earnings available to common
shareholders.
A company may have:
❖  Simple capital structure: Does not include potentially dilutive
securities, such as common stock, non-convertible debt, and non-
convertible preferred stock.
❖  Complex capital structure: Contains potentially dilutive securities
such as options, warrants, and/or convertible securities.
Firms with complex capital structures must report both (basic and diluted
EPS), while firms with simple capital structure report only basic EPS
But… what does dilution mean? Who can be affected?
Earnings per share (EPS): Basic EPS

❖  Does not consider the effects of any dilutive securities on the

computation of the EPS

net income − pref dividends

Basic EPS =
weighted avgnumber of commonstock

❖  Weighted average number of common shares: # of shares

outstanding during the year, weighted by the portion of the
year they were outstanding.
Earnings per share (EPS): Basic EPS
Example

Apple Inc has a net income of $ 100,000. The firm has to pay $
10,000 cash dividends to its preferred shareholders and $ 50,000
cash dividends to its common shareholders.
At the beginning of the year, there were 1,000 shares of common
stock outstanding. Management decided to issue 100 new shares
every quarter starting in April (Beginning of April, July and
October ).
What is Apple’s basic EPS?
Earnings per share (EPS)
Stock split

What happens if in July, Apple decides to pay a stock dividend, by

giving 50% more shares to its common shareholders in July? What if
Apple decides to make a 2-for-1 split (stock split)?
Hint:
❖  Each shareholder’s proportional ownership in the company is
unchanged by either of these events.
❖  A stock split or stock dividend is applied to all shares
outstanding prior to the split or dividend and to the beginning-
of-period weighted average shares.
Earnings per share (EPS): Diluted EPS
Convertible Bonds

Diluted EPS:
❖  A dilutive security would decrease EPS if exercised or converted into
common stock. An antidilutive security would have an opposite effect.
Convertible bonds:
❖  If bonds are converted into common stock, the number of shares
outstanding will increase.
❖  On the other hand, the firm won’t have to pay interest to those
bondholders anymore. Therefore, earnings should be higher.

Numerator Add: interest x (1- tax rate)

Denominator Add: Number of bonds x Conversion ratio

Why is the interest adjusted by (1-t)?

Earnings per share (EPS): Diluted EPS
Example (1)

During 2013, Bayern F.C. reported net income of €120,000 and had
10,000 shares of common stock outstanding for the entire year.
Bayern also had 1,000 shares of 10%, €100 par, preferred stock
outstanding during 2013.
In 2012, Bayern had decided to build a stadium and in order to
finance the construction phase, issued 500, €1,000 par, 5% bonds at
par. Each of these bonds is convertible to 10 shares of common
stock. The tax rate is 30%.
Compute the basic and diluted EPS, if the bonds are converted into
common shares. Are these bonds dilutive?

“Dilutive” if Basic EPS > Diluted EPS

Earnings per share (EPS): Diluted EPS
Convertible preferred stock

If preferred stock is converted into common stock, the number of

shares outstanding will increase. On the other hand, the firm will
not have to pay the “preferred dividend” anymore. Therefore,
earnings should be higher.

Numerator Add: Preferred dividends

Denominator Add: # shares of preferred stock x conversion ratio

Earnings per share (EPS): Diluted EPS
Example (2)

Bayern F.C. reported net income of € 120,000 and had 10,000

shares of common stock outstanding for the entire year.
Bayern also had 1,000 shares of 10%, $100-par preferred stock
outstanding. These shares are each convertible into 5 shares of
common stock.
Compute the basic and diluted EPS, if preferred shares are converted into
common shares. Are these shares dilutive?

“Dilutive” if Basic EPS > Diluted EPS

Earnings per share (EPS): Diluted EPS
Stock Options and Warrants

❖  Provide the right to buy shares of a company at a specific price.

❖  IMPORTANT: These securities are dilutive only when their exercise
prices are less than the average market price of the stock over the year.
Why?
❖  Treasury stock method:
a.  Assumes that the funds received by the company from the exercise of
the options would be used to hypothetically purchase shares of the
company’s common stock at the average market price.
b.  The net increase in the number of shares outstanding, is the number
of shares created by exercising the option less the number of shares
hypothetically repurchased with the proceeds of exercise.
Numerator No adjustment

Denominator Add: Shares executed – shares repurchased

Earnings per share (EPS): Diluted EPS
Example (3)

Bayern F.C. reported net income of €120,000 and had 10,000 shares
of common stock outstanding for the entire year.
Bayern also had 1,000 shares of 10%, €100 par, preferred stock
outstanding.
Bayern’s employees own 1,000 warrants, convertible into one
share each at €20 per share. The year-end price of Bayern’s stock
was €35, and the average stock price was €30.
Compute the basic and diluted EPS, if warrants are exercised. Are these
warrants dilutive?

“Dilutive” if Basic EPS > Diluted EPS

Earnings per share (EPS)

Remember:

net income − pref dividends

Basic EPS =
weighted avgnumber of commonstock

Diluted EPS =
( )
net income − pref dividends + ⎡⎣div.pref .conv.stocks ⎤⎦ + ⎡⎣int.conv. debt 1−tax ⎤⎦

WA# commonstock + stocks pref .conv.stocks + stocks int.conv. debt + stocks options
Earnings per share (EPS)
Wrapping up

❖  During 20X6, ZZZ reported net income of $115,600 and had

200,000 shares of common stock outstanding for the entire year.
❖  Moreover, ZZZ had:
❖  1,000 shares of 10%, $100-par convertible preferred stock, convertible
into 40 shares each, outstanding for the entire year.
❖  600, 7%, $1,000 par value convertible bonds, convertible into 100 shares
each, outstanding for the entire year.
❖  10,000 stock options outstanding during the year. Each option is
convertible into one share of stock at $15 per share.
❖  The average market price of the stock for the year was $20. What
are ZZZ's basic and diluted EPS? (Assume a 40% tax rate)
Common-size income statements

Express each category of the IS as a percentage of revenue

Why would it be useful?
Big Al Electronics LLC Little Joe Electronics Inc.
Revenues 75,000,000 100% 3,500,000 100%
COGS 52,500,000 70% 700,000 20%
Gross Profit 22,500,00 30% 2,800,000 80%

R&D 3,750,000 5% 700,000 20%

SG&A 11,250,000 15% 525,000 15%
Operating Profit 7,500,000 10% 1,575,000 45%
What could you infer from these FS?
Relationship with other Financial Statements

Balance Sheet
❖  Net Income increases the owners’ wealth, thus it is added to
equity through the Retained Earnings account.
Cash Flow Statement
❖  The indirect method for computing the cash flow from
operating activities (CFO) starts from Net Income and adds back
non-cash items such as depreciation expense before adjusting
for variation in balance sheet accounts.
Relationship with other Financial Statements

Statement of Comprehensive Income: Net Income + Other

Comprehensive Income (OCI)
❖  This financial statement includes transactions that affect the
owners’ equity but are NOT registered in the Income Statement
Net Income
Foreign currency translation gains and losses (e.g. foreign subsidiary)
Adjustments for minimum pension liability (e.g. defined benefit plans)
Unrealized gains and losses from cash flow hedging derivatives (e.g.
oil futures)
Unrealized gains and losses from *assets FVTOCI
Comprehensive Income
*FVTOCI: Assets measured at fair value in the balance sheet, whose unrealized
gains or losses are recognized in other comprehensive income (not in the P&L)
Statement of Comprehensive Income
Example

Roche
2009 Finance Report
Key concepts

❖  P&L ❖  Percentage-of-completion
method
❖  Revenues
❖  Completed contract method
❖  Expenses
❖  Cost recovery method
❖  Cost of sales, cost of goods sold
❖  Instalment method
❖  Operating expenses ❖  Net reporting
❖  Gains ❖  Non-recurring items
❖  Losses ❖  Earnings per share
❖  Noncontrolling interest ❖  Diluted EPS
❖  Revenue recognition ❖  Common-size IS
❖  Matching principle ❖  Other comprehensive income