CHAPTER 3
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 general principles of revenue recognition and accounting standards for revenue recognition;
• 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, unusual or infrequent items) and changes in accounting policies;
• 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

This chapter has presented the elements of income statement analysis. The income statement presents information on the financial results of a company’s business activities over a period of time; it communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. A company’s net income and its components (e.g., gross margin, operating earnings, and pretax earnings) are critical inputs into both the equity and credit analysis processes. Equity analysts are interested in earnings because equity markets often reward relatively high- or low-earnings growth companies with above-average or below-average valuations, respectively. Fixed-income analysts examine the components of income statements, past and projected, for information on companies’ abilities to make promised payments on their debt over the course of the business cycle. Corporate financial announcements frequently emphasize income statements more than the other financial statements.

Key points to this chapter include the following:

• 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.
• 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.
• As of the beginning of 2018, revenue recognition standards have converged. The core principle of the converged standards is that revenue should be recognized to “depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in an exchange for those goods or services.”
• To achieve the core principle, the standard describes the application of five steps in recognizing revenue. The standard also specifies the treatment of some related contract costs and disclosure requirements.
• 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, unusual and/or infrequently occurring items, which are material, are presented separately within income from continuing operations.
• Non-operating items are reported separately from operating items on the income statement. Under both IFRS and US GAAP, the income statement reports separately the effect of the disposal of a component operation as a “discontinued” operation.
• 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. 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.
7. A company previously expensed the incremental costs of obtaining a contract. All else being equal, adopting the May 2014 IASB and FASB converged accounting standards on revenue recognition makes the company’s profitability initially appear:
   1. lower.
   2. unchanged.
   3. higher.
8. 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.
9. Using the same information as in Question 8, what would Accent’s cost of goods sold be under the weighted average cost method?
   1. ₤120,000.
   2. ₤122,000.
   3. ₤124,000.
10. 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.
11. 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.
12. Using the same information as in Question 16, 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.
13. 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.
14. Under IFRS, a loss from the destruction of property in a fire would most likely be classified as:
    1. continuing operations.
    2. discontinued operations.
    3. other comprehensive income.
15. A company chooses to change an accounting policy. This change requires that, if practical, the company restate its financial statements for:
    1. all prior periods.
    2. current and future periods.
    3. prior periods shown in a report.
16. 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.
17. For its fiscal year-end, Calvan Water Corporation (CWC) reported net income of $12 million and a weighted average of 2,000,000 common shares outstanding. The company paid $800,000 in preferred dividends and had 100,000 options outstanding with an average exercise price of $20. CWC’s market price over the year averaged $25 per share. CWC’s diluted EPS is closest to:
    1. $5.33.
    2. $5.54.
    3. $5.94.
18. A company with no debt or convertible securities issued publicly traded common stock three times during the current fiscal year. Under both IFRS and US GAAP, the company’s:
    1. basic EPS equals its diluted EPS.
    2. capital structure is considered complex at year-end.
    3. basic EPS is calculated by using a simple average number of shares outstanding.
19. Laurelli Builders (LB) reported the following financial data for year-end December 31:

    Common shares outstanding, January 1	2,020,000
    Common shares issued as stock dividend, June 1	380,000
    Warrants outstanding, January 1	500,000
    Net income	$3,350,000
    Preferred stock dividends paid	$430,000
    Common stock dividends paid	$240,000

    Which statement about the calculation of LB’s EPS is most accurate?

    1. LB’s basic EPS is $1.12.
    2. LB’s diluted EPS is equal to or less than its basic EPS.
    3. The weighted average number of shares outstanding is 2,210,000.
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.
21. For its fiscal year-end, Sublyme Corporation reported net income of $200 million and a weighted average of 50,000,000 common shares outstanding. There are 2,000,000 convertible preferred shares outstanding that paid an annual dividend of $5. Each preferred share is convertible into two shares of the common stock. The diluted EPS is closest to:
    1. $3.52.
    2. $3.65.
    3. $3.70.
22. When calculating diluted EPS, which of the following securities in the capital structure increases the weighted average number of common shares outstanding without affecting net income available to common shareholders?
    1. Stock options.
    2. Convertible debt that is dilutive.
    3. Convertible preferred stock that is dilutive.
23. Which statement is most accurate? A common-size income statement:
    1. restates each line item of the income statement as a percentage of net income.
    2. allows an analyst to conduct cross-sectional analysis by removing the effect of company size.
    3. standardizes each line item of the income statement but fails to help an analyst identify differences in companies’ strategies.
24. Selected year-end financial statement data for Workhard are shown below.

    	$ millions
    Beginning shareholders’ equity	47500
    Ending shareholders’ equity	49300
    Unrealized gain on available-for-sale securities	500
    Unrealized loss on derivatives accounted for as hedges	−300
    Foreign currency translation gain on consolidation	200
    Dividends paid	100
    Net income	1500

    Workhard’s comprehensive income for the year:

    1. is $18 million.
    2. is increased by the derivatives accounted for as hedges.
    3. includes $4 million in other comprehensive income.
25. When preparing an income statement, which of the following items would most likely be classified as other comprehensive income?
    1. A foreign currency translation adjustment.
    2. An unrealized gain on a security held for trading purposes.
    3. A realized gain on a derivative contract not accounted for as a hedge.