CHAPTER 4

UNDERSTANDING INCOME STATEMENTS

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

• Describe the components of the income statement and alternative presentation formats of that statement.
• Describe the general principles of revenue recognition and accrual accounting, specific revenue recognition applications (including accounting for long-term contracts, installment sales, barter transactions, gross and net reporting of revenue), and the implications of revenue recognition principles for financial analysis.
• Calculate revenue given information that might influence the choice of revenue recognition method.
• Describe the general principles of expense recognition, specific expense recognition applications, and the implications of expense recognition choices for financial analysis.
• Describe the financial reporting treatment and analysis of nonrecurring items (including discontinued operations, extraordinary items, unusual or infrequent items) and changes in accounting standards.
• Distinguish between the operating and nonoperating components of the income statement.
• Describe how earnings per share is calculated and calculate and interpret a company’s earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures.
• Distinguish between dilutive and antidilutive securities, and describe the implications of each for the earnings per share calculation.
• Convert income statements to common-size income statements.
• Evaluate a company’s financial performance using common-size income statements and financial ratios based on the income statement.
• Describe, calculate, and interpret comprehensive income.
• Describe other comprehensive income, and identify the major types of items included in it.

SUMMARY OVERVIEW

• The income statement presents revenue, expenses, and net income.
• The components of the income statement include: revenue; cost of sales; sales, general, and administrative expenses; other operating expenses; nonoperating income and expenses; gains and losses; nonrecurring items; net income; and EPS.
• An income statement that presents a subtotal for gross profit (revenue minus cost of goods sold) is said to be presented in a multistep format. One that does not present this subtotal is said to be presented in a single-step format.
• Revenue is recognized in the period it is earned, which may or may not be in the same period as the related cash collection. Recognition of revenue when earned is a fundamental principal of accrual accounting.
• In limited circumstances, specific revenue recognition methods may be applicable, including percentage of completion, completed contract, installment sales, and cost recovery.
• An analyst should identify differences in companies’ revenue recognition methods and adjust reported revenue where possible to facilitate comparability. Where the available information does not permit adjustment, an analyst can characterize the revenue recognition as more or less conservative and thus qualitatively assess how differences in policies might affect financial ratios and judgments about profitability.
• The general principles of expense recognition include a process to match expenses either to revenue (such as cost of goods sold) or to the time period in which the expenditure occurs (period costs such as administrative salaries) or to the time period of expected benefits of the expenditures (such as depreciation).
• In expense recognition, choice of method (i.e., depreciation method and inventory cost method), as well as estimates (i.e., uncollectible accounts, warranty expenses, assets’ useful life, and salvage value) affect a company’s reported income. An analyst should identify differences in companies’ expense recognition methods and adjust reported financial statements where possible to facilitate comparability. Where the available information does not permit adjustment, an analyst can characterize the policies and estimates as more or less conservative and thus qualitatively assess how differences in policies might affect financial ratios and judgments about companies’ performance.
• To assess a company’s future earnings, it is helpful to separate those prior years’ items of income and expense that are likely to continue in the future from those items that are less likely to continue.
• Under IFRS, a company should present additional line items, headings, and subtotals beyond those specified when such presentation is relevant to an understanding of the entity’s financial performance Some items from prior years clearly are not expected to continue in future periods and are separately disclosed on a company’s income statement. Under U.S. GAAP, two such items are specified (1) discontinued operations and (2) extraordinary items (IFRS prohibit reporting any item of income or expense as extraordinary). Both of these items are required to be reported separately from continuing operations, under U.S. GAAP.
• For other items on a company’s income statement, such as unusual items and accounting changes, the likelihood of their continuing in the future is somewhat less clear and requires the analyst to make some judgments.
• Nonoperating items are reported separately from operating items on the income statement.
• Basic EPS is the amount of income available to common shareholders divided by the weighted average number of common shares outstanding over a period. The amount of income available to common shareholders is the amount of net income remaining after preferred dividends (if any) have been paid.
• If a company has a simple capital structure (i.e., one with no potentially dilutive securities), then its basic EPS is equal to its diluted EPS. If, however, a company has dilutive securities, its diluted EPS is lower than its basic EPS.
• Diluted EPS is calculated using the if-converted method for convertible securities and the treasury stock method for options.
• Common-size analysis of the income statement involves stating each line item on the income statement as a percentage of sales. Common-size statements facilitate comparison across time periods and across companies of different sizes.
• Two income-statement-based indicators of profitability are net profit margin and gross profit margin.
• Comprehensive income includes both net income and other revenue and expense items that are excluded from the net income calculation.

PROBLEMS