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 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 implications of revenue recognition principles for financial analysis;
• calculate revenue given information that might influence the choice of revenue recognition method;
• describe general principles of expense recognition, specific expense recognition applications, and implications of expense recognition choices for financial analysis;
• describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, extraordinary items, unusual or infrequent items) and changes in accounting standards;
• distinguish between the operating and non-operating 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 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; non-operating income and expenses; gains and losses; non-recurring 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 multi-step 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 US 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 US 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.
• Non-operating 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

1. Expenses on the income statement may be grouped by:
   1. nature, but not by function.
   2. function, but not by nature.
   3. either function or nature.
2. An example of an expense classification by function is:
   1. tax expense.
   2. interest expense.
   3. cost of goods sold.
3. Denali Limited, a manufacturing company, had the following income statement information:

   Revenue	$4,000,000
   Cost of goods sold	$3,000,000
   Other operating expenses	$ 500,000
   Interest expense	$ 100,000
   Tax expense	$ 120,000

   Denali's gross profit is equal to

   1. $280,000.
   2. $500,000.
   3. $1,000,000.
4. Under IFRS, income includes increases in economic benefits from:
   1. increases in liabilities not related to owners' contributions.
   2. enhancements of assets not related to owners' contributions.
   3. increases in owners' equity related to owners' contributions.
5. Fairplay had the following information related to the sale of its products during 2009, which was its first year of business:

   Revenue	$1,000,000
   Returns of goods sold	$ 100,000
   Cash collected	$ 800,000
   Cost of goods sold	$ 700,000

   Under the accrual basis of accounting, how much net revenue would be reported on Fairplay's 2009 income statement?

   1. $200,000.
   2. $900,000.
   3. $1,000,000.
6. If the outcome of a long-term contract can be measured reliably, the preferred accounting method under both IFRS and US GAAP is:
   1. the cost recovery method.
   2. the completed contract method.
   3. the percentage-of-completion method.
7. At the beginning of 2009, Florida Road Construction entered into a contract to build a road for the government. Construction will take four years. The following information as of 31 December 2009 is available for the contract:

   Total revenue according to contract	$10,000,000
   Total expected cost	$ 8,000,000
   Cost incurred during 2009	$ 1,200,000

   Assume that the company estimates percentage complete based on costs incurred as a percentage of total estimated costs. Under the completed contract method, how much revenue will be reported in 2009?

   1. None.
   2. $300,000.
   3. $1,500,000.
8. During 2009, Argo Company sold 10 acres of prime commercial zoned land to a builder for $5,000,000. The builder gave Argo a $1,000,000 down payment and will pay the remaining balance of $4,000,000 to Argo in 2010. Argo purchased the land in 2002 for $2,000,000. Using the installment method, how much profit will Argo report for 2009?
   1. $600,000.
   2. $1,000,000.
   3. $3,000,000.
9. Using the same information as in Question 8, how much profit will Argo report for 2009 using the cost recovery method?
   1. None.
   2. $600,000.
   3. $1,000,000.
10. Under IFRS, revenue from barter transactions should be measured based on the fair value of revenue from:
    1. similar barter transactions with unrelated parties.
    2. similar non-barter transactions with related parties.
    3. similar non-barter transactions with unrelated parties.
11. Apex Consignment sells items over the internet for individuals on a consignment basis. Apex receives the items from the owner, lists them for sale on the internet, and receives a 25 percent commission for any items sold. Apex collects the full amount from the buyer and pays the net amount after commission to the owner. Unsold items are returned to the owner after 90 days. During 2009, Apex had the following information:
    • Total sales price of items sold during 2009 on consignment was 2,000,000.
    • Total commissions retained by Apex during 2009 for these items was 500,000.

    How much revenue should Apex report on its 2009 income statement?

    1. 500,000.
    2. 2,000,000.
    3. 1,500,000.
12. During 2009, Accent Toys Plc., which began business in October of that year, purchased 10,000 units of a toy at a cost of 10 per unit in October. The toy sold well in October. In anticipation of heavy December sales, Accent purchased 5,000 additional units in November at a cost of 11 per unit. During 2009, Accent sold 12,000 units at a price of 15 per unit. Under the first in, first out (FIFO) method, what is Accent's cost of goods sold for 2009?
    1. 120,000.
    2. 122,000.
    3. 124,000.
13. Using the same information as in Question 12, what would Accent's cost of goods sold be under the weighted average cost method?
    1. 120,000.
    2. 122,000.
    3. 124,000.
14. Which inventory method is least likely to be used under IFRS?
    1. First in, first out (FIFO).
    2. Last in, first out (LIFO).
    3. Weighted average.
15. At the beginning of 2009, Glass Manufacturing purchased a new machine for its assembly line at a cost of $600,000. The machine has an estimated useful life of 10 years and estimated residual value of $50,000. Under the straight-line method, how much depreciation would Glass take in 2010 for financial reporting purposes?
    1. $55,000.
    2. $60,000.
    3. $65,000.
16. Using the same information as in Question 15, how much depreciation would Glass take in 2009 for financial reporting purposes under the double-declining balance method?
    1. $60,000.
    2. $110,000.
    3. $120,000.
17. Which combination of depreciation methods and useful lives is most conservative in the year a depreciable asset is acquired?
    1. Straight-line depreciation with a short useful life.
    2. Declining balance depreciation with a long useful life.
    3. Declining balance depreciation with a short useful life.
18. Under IFRS, a loss from the destruction of property in a fire would most likely be classified as:
    1. an extraordinary item.
    2. continuing operations.
    3. discontinued operations.
19. For 2009, Flamingo Products had net income of $1,000,000. At 1 January 2009, there were 1,000,000 shares outstanding. On 1 July 2009, the company issued 100,000 new shares for $20 per share. The company paid $200,000 in dividends to common shareholders. What is Flamingo's basic earnings per share for 2009?
    1. $0.80.
    2. $0.91.
    3. $0.95.
20. Cell Services Inc. (CSI) had 1,000,000 average shares outstanding during all of 2009. During 2009, CSI also had 10,000 options outstanding with exercise prices of $10 each. The average stock price of CSI during 2009 was $15. For purposes of computing diluted earnings per share, how many shares would be used in the denominator?
    1. 1,003,333.
    2. 1,006,667.
    3. 1,010,000.