This reading introduces the readers to income statements, one of the three major financial statements. We will learn about the structure and presentation of income statement, calculation of various elements of income statements, and common ratios associated with it.

Understanding Income Statements

A lot of things hinge on a company’s profit. Profits determine bonuses, dividends to shareholders, timely repayments to banks and an important measure to attract investors.

To understand an income statement better, let us take a look at the income statement of Innovative Products Inc.

<img class="aligncenter size-full wp-image-9860" alt="Sample-Income-Statement" src="https://financetrain.com/wp-content/uploads/Sample-Income-Statement.jpg" width="487" height="703">

As you can see, the income statement of Innovative Products Inc. shows that the company earned a net profit of $422,500.

There are three key elements of the income statement:
<ul>
 	<li>Revenue – This is earned money, which is not recorded until the customer has received and approved goods. The customer either pays or promises to pay through credit. Earning revenue is not the same as receiving cash. Deposits and advance payments are not revenue.</li>
 	<li>Expenses – These are a part of doing business. Some of the money the company makes goes towards producing the company's product. This can include production costs, advertising costs, and selling costs. You can't tell how profitable a company is without knowing its expenses.</li>
 	<li>Net income – Net income takes into account all the company's costs, depreciation, interest, taxes, and other expenses and is determined by deducting all expenses from company's total revenues. The profit amount that takes into account only the direct expenses associated with the goods sold is called gross profit.</li>
</ul>
<h3>Calculating Gross Profits</h3>
The income statement provides information that is broken down into several elements. The following elements are used to calculate the company's gross profit:
<ul>
 	<li>Sales revenue – This is the total amount received or to be received from the sales of products or services to customers. This revenue is net, which means any deductions such as sales, returns, or discounts are already taken out.</li>
 	<li>Cost of goods sold expense – This is the total cost of products sold to customers. This may also include the costs of stolen, missing or damaged goods.</li>
</ul>
To calculate the company's gross profit, you need to firstly establish the amount of money the company made – sales revenue. Then you examine expenses associated with the cost of goods sold and balance this information against the company's sales revenue.

Although gross profit doesn't consider every expense the company faces, it takes into account some basic expenses that directly help companies earn their revenues. This number helps you see, at a high level, how much money the company is making.
<h3>Calculating Net Income</h3>
Net income is calculated by taking revenues and adjusting for the cost of doing business, depreciation, interest, taxes and other expenses. Net income is often referred to as “the bottom line” since net income is listed at the bottom of the income statement.

Income Statement

Earnings per share (EPS) is considered to be one of the best measures to summarize the performance of a company. The EPS for a company is reported only for common stock.

A company can have simple capital structure or complex capital structure.
<ul>
 	<li>A company with a simple capital structure can only have common stock, nonconvertible debt and non-convertible preferred stock. It cannot have any potentially dilutive securities (i.e., stock options, warrants, convertible&nbsp; bonds, and convertible preferred stock). For companies with simple capital structure, we calculate the Basic EPS.</li>
 	<li>A company with a complex capital structure also includes convertible securities, stock options and warrants. For these companies, we calculate both Basic EPS and Diluted EPS. The diluted ESP considers the impact of potentially dilutive securities.</li>
</ul>
The basic EPS is calculated as follows:

<img class="aligncenter size-full wp-image-14526" alt="eps1" src="https://financetrain.com/wp-content/uploads/eps1.gif" width="537" height="50">

Example

A company has net income of $1 million. It paid dividends of $100,000 to its preferred shareholders and also paid dividends of $200,000 to its common shareholders.

The company had 12,000 shares of common stock outstanding on January 1.&nbsp; On March 1, it issued 2700 shares; on July 1, it issued another 3,300 shares; and on December 1, it acquired 480 shares as treasury stock. The weighted average number of common shares is 15,860 shares as calculated below:

<img class="aligncenter size-full wp-image-14525" alt="eps2" src="https://financetrain.com/wp-content/uploads/eps2.gif" width="622" height="254">

The Basic EPS of the company will be:

<img class="aligncenter size-full wp-image-14524" alt="eps3" src="https://financetrain.com/wp-content/uploads/eps3.gif" width="506" height="31">

In the next article, we will look at the <a title="Impact of Stock Dividends and Stock Splits on Earnings Per Share (EPS)" href="https://financetrain.com/impact-of-stock-dividends-and-stock-splits-on-earnings-per-share-eps/">impact of stock dividends and stock splits on earnings per share (EPS)</a>.

How to Calculate Basic Earnings Per Share (EPS)

Stock dividends are payment of additional shares of stock to common shareholders. For example, assume a company announces a 5% stock dividend to all shareholders of record.&nbsp; For each 100 shares held, shareholders receive another 5 shares.

In case of stock splits, the firm increases the number of shares outstanding and reduces the price of each share. For example, assume that a company announces a 3-for-2 stock split.&nbsp; For each 100 shares held, shareholders receive another 50 shares.

Stock splits and stock dividends are economically the same. The number of shares outstanding increases and the price of each share drops.&nbsp; The value of the firm does not change. A 3-for-2 stock split is the same as a 50% stock dividend.&nbsp; For each 100 shares held, shareholders receive another 50 shares.

In the calculation of <a title="How to Calculate Basic Earnings Per Share (EPS)" href="https://financetrain.com/how-to-calculate-basic-earnings-per-share-eps/">EPS</a>, the Total Weighted Average Common Shares will be affected by stock dividends and stock splits. Let’s take an example to understand this.

Example

A company has net income of $1 million. It paid dividends of $100,000 to its preferred shareholders and also paid dividends of $200,000 to its common shareholders.

The company had 12,000 shares of common stock outstanding on January 1.&nbsp; On March 1, it issued 2700 shares; on July 1, it declared a 20% stock dividend; and on December 1, it acquired 480 shares as treasury stock. The weighted average number of common shares is calculated below:

Step 1: Adjust the pre-dividend number of shares to post-dividend number of shares.

This will be done by multiplying the number of shares prior to declaring dividends by 1.2 (20% dividend).

January 1&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp; 12,000*1.2 = 14,400

July 1&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp; 2700*1.2 = 3,240

December 1&nbsp;&nbsp;&nbsp; -480 (No adjustment)

Step 2: Calculate the Total Weighted Average Common Shares

<img class="aligncenter size-full wp-image-14530" alt="beps1" src="https://financetrain.com/wp-content/uploads/beps1.gif" width="625" height="219">

Step 3: Calculate <a title="How to Calculate Basic Earnings Per Share (EPS)" href="https://financetrain.com/how-to-calculate-basic-earnings-per-share-eps/">Basic EPS</a>

The Basic EPS of the company will be:

<img class="aligncenter size-full wp-image-14529" alt="beps2" src="https://financetrain.com/wp-content/uploads/beps2.gif" width="478" height="29">

Impact of Stock Dividends and Stock Splits on Earnings Per Share (EPS)

An income statement can be presented in a single-step format or multi-step format.



In single-step format, all revenues are grouped together and all expenses are grouped together.&nbsp;



The following is an example of single-step format.



<div class="wp-block-image"><figure class="aligncenter size-large"><img src="https://financetrain.com/wp-content/uploads/formay-1.png" alt="" class="wp-image-28683"/></figure></div>



In multi-step format, there are multiple groups for expenses, such as cost of goods sold, operating expenses, and other expenses. Several subtotals are computed before the net income is calculated. We will see gross profits as well as net profits in the multi-step format. The income statement presented earlier for Innovative Products Inc. was in multi-step format. The following is another example of multi-step format income statement.



<div class="wp-block-image"><figure class="aligncenter size-large"><img src="https://financetrain.com/wp-content/uploads/format-2.png" alt="" class="wp-image-28684"/></figure></div>

Formats of Income Statements

Income statement is constructed using the principles of accrual accounting. Under accrual account, the revenue is recognized when earned and expenses are recognized when incurred.



According to the revenue recognition principle, a company recognizes revenue only when it is earned once the goods are delivered or when the service is completed. So, if a retailer sells a laptop to you in June, the retailer will recognize the revenue in June itself. However, take the case of a manufacturer, who receives an order in June, delivers the goods in July, and receives the payment in August. When should he recognize the revenue? The answer is July when it delivered the goods. Bothe IASB and FASB have described when revenue can be recognized in case of sale of goods as well as rendering of services.



<h3>IASB: Revenue Recognition</h3>



IAS 18 provides guidance for recognising the following specific categories of revenue:



Sale of goods



Revenue arising from the sale of goods should be recognised when all of the following criteria have been satisfied: [IAS 18.14]



<ul><li>The seller has transferred to the buyer the significant risks and rewards of ownership</li><li>The seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold</li><li>The amount of revenue can be measured reliably</li><li>It is probable that the economic benefits associated with the transaction will flow to the seller, and</li><li>The costs incurred or to be incurred in respect of the transaction can be measured reliably</li></ul>



Rendering of services



For revenue arising from the rendering of services, provided that all of the following criteria are met, revenue should be recognised by reference to the stage of completion of the transaction at the balance sheet date (the percentage-of-completion method): [IAS 18.20]



<ul><li>The amount of revenue can be measured reliably;</li><li>It is probable that the economic benefits will flow to the seller;</li><li>The stage of completion at the balance sheet date can be measured reliably; and</li><li>The costs incurred, or to be incurred, in respect of the transaction can be measured reliably.</li></ul>



When the above criteria are not met, revenue arising from the rendering of services should be recognised only to the extent of the expenses recognised that are recoverable (a "cost-recovery approach". [IAS 18.26]



<h3>FASB: Revenue Recognition</h3>



According to FASB Statement of Financial Accounting Concepts No. 5, revenue is recognized when a transaction occurs, and&nbsp;



<ol type="1"><li>The revenue is realized or realizable</li><li>The revenue is earned</li></ol>



Revenue from a transaction must meet both criteria in order to be recognized. Revenue is generally considered realized when cash is received for the sale of a product or performance of a service. Revenue generally becomes realizable when a promise to pay is received in exchange for the sale of a product or performance of a service. The promise to pay could be verbal (account receivable) or written (note receivable). Revenue is generally earned when a legally enforceable exchange takes place (e.g., consideration has been tendered and the buyer takes possession of the product or benefits from the performance of a service).



SEC: Revenue Recognition



The Securities and Exchange Commission also provides guidance on revenue recognition. According to SEC guidelines, the two criteria (‘realized or realizable’ and ‘earned’) are met when all of the following criteria are established:



<ul><li>Persuasive evidence of an arrangement exists.</li><li>Delivery has occurred or services have been rendered.</li><li>The seller’s price to the buyer is fixed or determinable.</li><li>Collectability is reasonably assured.</li></ul>

Principles of Revenue Recognition

Long-term contracts are multi-year contracts such as construction project. For these contracts, the earnings process extends over several accounting periods. Delivery of the final product may occur years after the initiation of the project.



For these contracts the revenue is recognized before delivery, and there are two methods to do so.



1. Percentage of Completion method



<ul><li>The percentage-of-completion method recognizes revenue on a long-term project as work progresses.</li><li>Revenues, expenses, and gross profit are recognized each accounting period based on an estimate of the percentage of completion of the project.&nbsp;</li><li>The percentage of completion is generally measured by dividing the total cost incurred till date divided by the most recent estimate of the total cost of the project.</li><li>Project costs and gross profit to date are accumulated in the inventory account (construction in progress.)&nbsp;</li><li>Progress billings are accumulated in a contra inventory account (billings on construction in progress)</li></ul>



2. Completed Contract method



<ul><li>Revenues, expenses, and resulting gross profit are recognized only when the contract is completed.&nbsp;</li><li>As construction costs are incurred, they are accumulated in an inventory account (construction in progress).&nbsp;</li><li>Progress billings are not recorded as revenues, but are accumulated in billings on construction in progress account that is deducted from the inventory account (i.e., a contra account to inventory).&nbsp;</li><li>At the completion of the contract, all the accounts are closed, and the entire gross profit from the construction project is recognized.</li></ul>







US GAAP vs. IFRS



<ol type="1"><li>Long-term construction contracts when outcomes can be reasonably estimated:<ol><li>The percentage-of-completion method is used under both IFRS and GAAP.</li></ol></li><li>Long-term construction contracts when outcomes cannot be reasonably estimated:<ol><li>US GAAP: Must use Completed Contract Method (No revenue or expense is recognized until the end of the contract)</li></ol><ol><li>IFRS: Must use the zero-profit method (revenues are recognized only to the extent of costs)</li></ol></li><li>Service Revenue<ol><li>US GAAP: Follow specific industry guidance for revenue recognition</li></ol><ol><li>IFRS: Typically use the % Completion method (or straight-line if services are specified over a period of time)</li></ol></li><li>Losses<ol><li>Loss (if expected) must be recognized immediately under both IFRS and GAAP</li></ol></li></ol>



Example



Let’s say we have a 3-year contract to construct a bridge. The contract value is $1,000,000 and the estimated total cost is $700,000. During the next 3 years, the costs are incurred as follows and the project is completed by the end of the third year.



<figure class="wp-block-table"><table><tbody><tr><td>Year</td><td>2011</td><td>2012</td><td>2013</td></tr><tr><td>Cost Incurred</td><td>$350,000</td><td>$175,000</td><td>$175,000</td></tr></tbody></table></figure>



&nbsp;Let’s determine the recognition of revenue, expenses and profits under different methods.



US GAAP: Percentage-of-completion Method



This assumes that the project outcomes can be reliable estimated. Revenues, expenses, and gross profit are recognized each accounting period based on an estimate of the percentage of completion of the project.&nbsp;



<figure class="wp-block-table"><table><tbody><tr><td>Year</td><td>2011</td><td>2012</td><td>2013</td></tr><tr><td>Percentage Completion</td><td>=350,000/700,000 = 50%</td><td>=175/700,000 = 25%</td><td>=175/700,000 = 25%</td></tr><tr><td>Revenue</td><td>=50% of 1,000,000=5,00,000</td><td>=25% of 1,000,000=2,50,000</td><td>=25% of 1,000,000=2,50,000</td></tr><tr><td>Expenses</td><td>$350,000</td><td>$175,000</td><td>$175,000</td></tr><tr><td>Profit</td><td>$150,000</td><td>$75,000</td><td>$75,000</td></tr></tbody></table></figure>



IFRS: Percentage-of-completion Method



This assumes that the project outcomes can be reliable estimated. The results are same as above



GAAP: Completed Contract Method



This assumes that the project outcomes cannot be reliable estimated. Revenues, expenses, and resulting gross profit are recognized only when the contract is completed.



This means that no revenue, expense or profit will be recognized in 2011 and 2012. In 2013, the revenue of 1,000,000, cost of 700,000 and profits of 300,000 will be recognized.



IFRS: Zero-profit Method



Revenues, expenses, and resulting gross profit are recognized only when the contract is completed.&nbsp;Revenues are recognized only to the extent of costs as shown below:



<figure class="wp-block-table"><table><tbody><tr><td>Year</td><td>2011</td><td>2012</td><td>2013</td></tr><tr><td>Revenue</td><td>$350,000</td><td>$175,000</td><td>$475,000</td></tr><tr><td>Expenses</td><td>$350,000</td><td>$175,000</td><td>$175,000</td></tr><tr><td>Profit</td><td>0</td><td>0</td><td>$300,000</td></tr></tbody></table></figure>

Revenue Recognition - Long-term Contracts

An instalment sale occurs when a firm finances the sale of a product and the payments are expected to be received over multiple periods.



If the payment collectability is certain, the revenue is recognized when the sale is made as per normal revenue recognition principle.



However, when we are uncertain about the collectability of the sales revenue, we should defer revenue recognition. Two commonly used accounting methods are:



<ul><li>Instalment sales method</li><li>Cost recovery method</li></ul>



Instalment Sales Method



<ul><li>Sale and cost of sale recorded as usual.</li><li>Compute gross margin rate on the instalment sales.</li><li>Recognize gross margin as cash is received.</li><li>Gross margin not realized is deferred until a future period.</li></ul>



Cost Recovery Method



<ul><li>Like the instalment sales method, cost recovery is used when we are uncertain about the collectability of the sales revenue.</li><li>No profit is recognized until cost of item sold is fully recovered.</li></ul>



Example



Wonder’s Appliances made sales of $200,000 in 2012. The items sold have a cost $150,000.&nbsp;&nbsp;During 2012, the company collected cash from installment customers of $90,000.&nbsp;&nbsp;The remaining amount will be collected in 2013.



Under the&nbsp;instalment sales method, profit will be determined as follows:



Company’s gross margin is = (200,000 – 150,000)/200,000 = 25%



Profit recognized in 2012 = 25% of 90,000 = $22,500



Profit recognized in 2013 = 25% of 110,000 = $27,500



Note that 110,000 is the balance cash collected in 2013 (200,000 – 90,000).



Under the&nbsp;cost recovery method, the money collected in 2012 is applied to recovery of costs.&nbsp;So, profit reported in 2012 is zero, and the profit reported in 2013 is $50,000.



Treatment of Instalment Sales under IFRS



Under IFRS, if the outcome can be reliably estimated, we calculated the present value of the instalment payments and recognize them at the time of sale. The difference between the instalment payments when received and its present value is recognized as interest over time. If outcome cannot be reliably estimated, then treatment is similar to cost recovery method.

Revenue Recognition - Instalment Sales

A barter transaction occurs when two firms exchange goods or services with each other without and cash payments. One service is provided and another service is received. For example, buying and selling advertising space of equal value on their respective websites.



IFRS and GAAP provide the following treatment for these transactions.



US GAAP:&nbsp;Recognize revenue at fair value. Face value is determined using past/historical experience in selling such goods or services. Alternatively, recognise revenue based on the carrying value of assets provided in exchange.



IFRS:&nbsp;recognize revenue based on the fair value of similar nonbarter transactions.



<h3>Gross and Net Reporting of Revenue</h3>



The revenue can be reported as gross or net revenue.



Under gross revenue reporting, the sales and cost of goods sold are shown separately. Under net reporting, the company reports only net revenue which is calculated by subtracting cost of goods sold from sales. Net revenue reporting applies when the company has only earned a commission or fee on the project.



A company uses gross revenue method, when it is the primary party in a contract. The firm bears the risks and benefits associated with revenue-generated activities by: (1) acting as a principal in the transaction; (2) establishing prices; (3) being responsible for fulfilment of the order; (4) taking the risk of loss for collection, delivery and returns; and (5) marketing the products, among other things.



<h3>Implications for Financial Analysis</h3>



We learned that under different circumstances a company can recognize revenues before delivery, at the time of delivery or after delivery. While performing financial analysis an analyst must pay attention to the revenue recognition methods used. He should understand whether the company is aggressive or conservative in recognizing revenue and how much it relies on estimates for recognizing revenues.

Revenue Recognition - Barter Transactions

Expenses are decreases in economic resources, either by way of outflows or reductions of assets or incurrences of liabilities, resulting from an entity’s ordinary revenue generating or service delivery activities. Under accrual accounting, the expenses are recognized based on the matching principle.



According to the matching principle, the expenses incurred in the business must be matched to the revenue generated. For example, the salary paid to the employees should be reported in the month in which the employees worked, not in the month in which they were paid. Similarly, the company should report any sales commissions paid in the same period in which the sale was made, not in the period in which the commissions were paid. In such a case, the sales commission will be reported as sales commission due as a liability till the commission is actually paid in the following period. Similarly, if a company purchased some inventory in December and sold it in January next year, then both the sales and the expenses are recognized in January, not December.



There are certain cases where the matching principle does not apply. For example, in case of advertising, it is difficult to measure the future economic benefits. Therefore, advertising expense is recognized in the period in which it is incurred. Similarly administrative costs are recognized as expenses in which they are incurred. Such costs are called period costs.



We will now apply the principles of expense recognition in different situations such as inventory expense recognition, depreciation expense recognition, and amortization expense recognition.

Expense Recognition

Inventory refers to the short-term assets on a company’s balance sheet; example – a retail clothier’s stock of shirts, pants, etc.&nbsp;



The expense for inventory is a part of the cost of goods sold. The flow of inventory costs into the accounting system is determined based on the inventory accounting policy, not the physical flow of goods.



The commonly used methods are:



<ul><li>Specific cost identification</li><li>First-in, first-out (FIFO)</li><li>Last-in, first-out (LIFO)</li><li>Average cost</li></ul>



<h3>Specific Cost Identification</h3>



This method is used when the company can identify exactly which items were sold and which ones are still in the inventory. For example, a laptop dealer sells his inventory of laptops based on their serial number.



<h3>FIFO</h3>



First-in, first-out accounting method, where the costs of the oldest items in inventory are used to compute the cost of goods sold (COGS) expense on a company’s income statement.



FIFO ending inventory for the balance sheet is calculated based on values of the most recent inventory goods purchased.



<h3>LIFO</h3>



Last-in, first-out accounting method, where the costs of the newest inventory items are used to compute the COGS expense on the income statement.



LIFO ending inventory for the balance sheet is calculated based on values of the first inventory goods purchased.



<h3>Average Cost</h3>



Under the weighted average cost method, average cost is calculated by dividing the total cost of available goods with the no. of units available. The average cost is used to determine both the cost of goods sold and the ending inventory.



In some instances, the choice of LIFO or FIFO makes intuitive sense for a specific company.&nbsp;&nbsp;A farmer’s market shop would conceptually be a FIFO business, as the oldest produce should be sold first, given that it will spoil the soonest compared to younger produce.



In reality a company’s management is usually allowed some degree of flexibility in determining its inventory accounting method.&nbsp;&nbsp;If an analyst is comparing firms in a shared industry structure or market capitalization size, then differences in inventory accounting methods need to be reconciled through the financial statement adjustment process, so the analyst can be sure that the financial ratios for the firms are truly comparable.



The US GAAP permits the use of FIFO, LIFO as well as average cost method.



IFRS allows FIFO and average cost but prohibits LIFO method.



<h3>COGS Expense Calculation</h3>



Beginning Inventory (BI) + Purchases = Goods Available for Sale (GAS)



GAS – Ending Inventory (EI) = COGS



COGS is used in calculating a company’s gross profit and gross profit margin (the decimal is typically converted to a percentage)



Gross Profit = Net Revenue – COGS



<h3>Example</h3>



A company’s inventory data during a month are shown in the table below:



<figure class="wp-block-table"><table><tbody><tr><td>Date</td><td>Inventory</td><td>Cost</td></tr><tr><td>April 1 (Beginning inventory)</td><td>10 units @ $100 per unit</td><td>$1,000</td></tr><tr><td>April 10 (Purchases)</td><td>5 units @ $120 per unit</td><td>$600</td></tr><tr><td>April 20 (Purchases)</td><td>5 units @ $130 per unit</td><td>$650</td></tr><tr><td>Total</td><td>20 units</td><td>$2,250</td></tr></tbody></table></figure>



During the month the company sold, 17 units.&nbsp;



Let’s calculate the cost of goods sold and ending inventory under different methods.



First-in, First-out (FIFO)



Total 17 units are sold. The earlier units are sold first.



<figure class="wp-block-table"><table><tbody><tr><td>Beginning inventory</td><td>10 units @ $100 per unit</td><td>$1,000</td></tr><tr><td>April 10 (Purchases)</td><td>5 units @ $120 per unit</td><td>$600</td></tr><tr><td>April 20 (Purchases)</td><td>2 units @ $130 per unit</td><td>$260</td></tr><tr><td>FIFO Cost of Goods Sold</td><td>17 Units</td><td>$1,860</td></tr><tr><td>Ending inventory</td><td>3 units</td><td>=(2250 – 1860) = $390</td></tr></tbody></table></figure>



Last-in, First-out (FIFO)



Total 17 units are sold. The recently purchased units are sold first.



<figure class="wp-block-table"><table><tbody><tr><td>April 20 (Purchases)</td><td>5 units @ $130 per unit</td><td>$650</td></tr><tr><td>April 10 (Purchases)</td><td>5 units @ $120 per unit</td><td>$600</td></tr><tr><td>Beginning inventory</td><td>7 units @ $100 per unit</td><td>$700</td></tr><tr><td>FIFO Cost of Goods Sold</td><td>17 Units</td><td>$1,950</td></tr><tr><td>Ending inventory</td><td>3 units</td><td>=(2250 – 1950) = $300</td></tr></tbody></table></figure>



Average Cost



Average cost per unit = 2250/20 = $112.5



Cost of goods sold = 112.5*17 = $1,912.5



Ending Inventory = 112.5*3 = $337.5

Inventory Expense Recognition

A company’s long-lived assets refer to PPE, natural resources, and intangible assets. Since these assets provide economic value over multiple years, the cost of these assets is allocated over multiple years.



Depreciation is the allocation of the cost of an asset to expense over its useful life in a rational and systematic manner.



There are various depreciation methods used by firms. We will look at the following three methods:



<ul><li>Straight Line Method</li><li>Accelerated Methods of Depreciation</li></ul>



<h3>Straight Line Method</h3>



The straight-line method associates the long-lived asset’s usefulness with its age.



<div class="wp-block-group"><div class="wp-block-group__inner-container">
<div class="wp-block-group"><div class="wp-block-group__inner-container">
Straight-Line Expense = (Cost – Salvage Value)/n



where n = number of years in asset’s useful life
</div></div>
</div></div>



Example



A food processing company purchased equipment on January 1, 2012, at a cost of $50,000.&nbsp;&nbsp;Management expects the equipment to have a four-year life and a $2,000 residual value.



The annual depreciation expense will be = (50,000 – 2,000)/4 = $12,000



<h3>Accelerated Methods of Depreciation</h3>



Accelerated depreciation allocates a larger portion of the cost of a plant asset to expense early in the asset’s life.&nbsp;&nbsp;



The accelerated methods of depreciation include Sum-of-the-Years Digits (SYD) expensing method and declining balance methods.



<h3>SYD Method</h3>



SYD method treats an asset as more useful in its early life by raising the depreciation expense for the early years.



SYD Example:&nbsp;If a company’s factory has a new conveyor belt with a useful life of 5 years, then SYD = 1+2+3+4+5 = 15.&nbsp; This conveyor belt cost $100,000 and has a salvage value = $0.&nbsp; The year two depreciation expense under the SYD method for the company will be calculated as follows:



($100,000 – $0) * (5 – 2 +1)/15 = $100,000*(4/15) = $26,667



SYD Depreciation Expense for Year “i” = (Cost – Salvage Value) * ((n – “# of the ithyear” +1))/SYD



<h3>Declining Balance Method</h3>



Under this method, we apply a constant rate of depreciation to the book value of the asset every year. This method is also called diminishing balance method. Double-Declining-Balance (DDB) is an example of a declining balance method.



The DDB method accelerates the depreciation rate of the straight line method.



DDB Expense = (Cost – Accumulated Depreciation) * (2/n)



If the food processing company used double-declining-balance method, it would multiply the straight-line rate by two, e.g. 2/1 x ¼ = 2/4



In the first year, the double-declining-balance&nbsp;depreciation expense = 50,000 * 2/4 = $25,000



In the second year,&nbsp;the double-declining-balance&nbsp;depreciation expense = (50,000 – 25,000) * 2/4 = $12,500.



The depreciation schedule will be as follows:



<div class="wp-block-image"><figure class="aligncenter size-large"><img src="https://financetrain.com/wp-content/uploads/dep-expense-1-1024x459.png" alt="" class="wp-image-28700"/></figure></div>



Note that in the 4th&nbsp;year, the depreciation expense is equal to Beginning Book Value – Residual Value = 6,250 – 2,000 = 4,250.



Reasons for using Accelerated Depreciation



<ul><li>An asset is more useful earlier in its life than later, and the useful life may be difficult to estimate.</li><li>Depreciation expense is deductible in computing taxable income and income taxes.</li></ul>

Depreciation Expense Recognition

Amortization refers to the periodic allocation of the cost of capital assets over the useful life of the assets. This involves intangible assets such as franchise agreements.&nbsp;



The amortization expense is calculated in such a way that it matches the economic benefit from the asset in that period. The most commonly used method is the straight line method. Just like the straight line method to calculate the depreciation expense, the straight line method is used to calculate the amortization expense.



Note that some assets such as goodwill have infinite life. Such assets are not amortized. Instead goodwill is impaired under US GAAP. The companies are required to determine the fair value of the reporting units, using present value of future cash flow, and compare it to their carrying value (book value of assets plus goodwill minus liabilities.) If the fair value is less than carrying value (impaired), the goodwill value needs to be reduced so the fair value is equal to carrying value. The impairment loss is reported as a separate line item on the income statement as an expense, and new adjusted value of goodwill is reported in the balance sheet. This is done atleast annually.

Amortization Expense Recognition

A bad debt is a consequence of making a sale on credit. A warranty is a promise by a manufacturer or seller to ensure the quality or performance of the product for a specific period of time. Both bad debt and warranty are uncertain future costs arising as a consequence of making sales. The firms are required to estimate the bad debt expense and warranty expense and record these estimated expenses when the products are sold (matching principle). An equivalent liability is created.&nbsp;



<div class="wp-block-group has-background" style="background-color:#fffac1"><div class="wp-block-group__inner-container">
Warranty Expense&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;xx



&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;Estimated Warranty Liability&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;xx
</div></div>



When the costs are incurred, (usually in subsequent periods), the expense is charged to the warranty liability:



<div class="wp-block-group has-background" style="background-color:#fffac1"><div class="wp-block-group__inner-container">
Estimated Warranty Liability&nbsp;&nbsp;&nbsp;xx



&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;Cash, etc.&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;xx
</div></div>



Implications for Financial AnalysisAn analyst should pay close attention to the expense recognition practices followed by a company. Since many expenses are recognized based on estimates a company can delay recognizing an expense or recognize it early which will impact the net income. For example, a company’s LIFO gross margin could be materially different that its FIFO gross margin, if the cost of the first goods purchased for inventory is materially different from the cost of the most recent goods purchased for inventory. The choice of LIFO or FIFO can overstate or understate the real economic value of short-term assets on the balance sheet. Similarly, the choice of depreciation method will impact the financial statements. If straight-line method is used, earnings will be higher, as depreciation expense is lower in early years. If accelerated method is used, earnings will be lower, as depreciation expense is higher in early years.

Bad Debt Expense and Warranty Expense Recognition

<h3>Discontinued Operations</h3>



Under both IFRS and US GAAP, a discontinued operation represents a component of an entity that has been disposed of or is held for sale.



IFRS narrowly defines what qualifies as a discontinued operation. US GAAP more broadly defines discontinued operations and could include asset groups smaller than those allowed under IFRS. US GAAP also requires that: “(a) the operations and cash flows of the component have been (or will be) eliminated from the ongoing operations of the entity as a result of the disposal transaction and (b) the entity will not have any significant continuing involvement in the operations of the component after the disposal transaction.” There is no similar requirement in IFRS.



Both US GAAP and IFRS require the results of discontinued operations be shown separately from continuing operations on the income statement. The amount is reported “net of tax.” Discontinued Operations are reported after “Income from continuing operations.”



Example



Alpha Corporation had after tax income from continuing operations of $55,000,000 for the year.&nbsp;&nbsp;During the year, it disposed of its division at a pretax loss of $270,000.&nbsp;&nbsp;Prior to disposal, the division operated at a pretax loss of $450,000 for the year.&nbsp;&nbsp;Assume a tax rate of 30%.&nbsp;&nbsp;The partial income statement of the company will look as follows:&nbsp;&nbsp;



<h3>Extraordinary Items</h3>



These are nonrecurring material items that differ significantly from a company’s typical business activities. Extraordinary Item must be both of an 1) unusual nature and 2) occur infrequently



Under US GAAP, the extraordinary items are reported “net of tax” after “Income from continuing operations.”



Under IFRS, the extraordinary items are now allowed to be separated from operating results in the income statement.



Example of Extraordinary Item



An earthquake destroys one of the oil refineries owned by a large multi-national oil company. Earthquakes are rare in this geographical location. This will be considered an extraordinary item.



<h3>Unusual Gains and Losses</h3>



Material items that are&nbsp;unusual&nbsp;or&nbsp;infrequent, but not both, should be reported in a separate section just above “Income from continuing operations before income taxes.”



Examples can include:



<ul><li>Write-downs of inventories</li><li>Foreign exchange transaction gains and losses</li></ul>



These items are reported before tax. Net-of-tax treatment for these items is prohibited.



<h3>Changes in Accounting Standards</h3>



Accounting changes can include:



<ol type="1"><li>Change in an Accounting Principle.&nbsp;This type of change occurs when a company adopts a GAAP different from the one used previously for reporting purposes.&nbsp;For example, change from FIFO to average cost, or change from the percentage-of-completion to the completed-contract method.</li><li>Change in an Accounting Estimate.&nbsp;This type of change is required because an earlier estimate has proven to require modifying as new events occur, more experience is acquired, or additional information is obtained. For example, useful lives and salvage values of depreciable assets or allowance for uncollectible receivables.</li><li>Prior-period Adjustment.&nbsp;This refers to change from incorrect accounting method to the correct accounting method, or the correction of an accounting error made previously.&nbsp;&nbsp;</li></ol>



A change in an accounting principle is accounted for by the retrospective application of the new accounting principle. This refers to restating the financial statements of prior periods to reflect the change.



A change in an accounting estimate is accounted for prospectively. The restatement of prior financial statements is not required.



A company accounts for the correction of a material error of a past period that it discovers in the current period as a prior period adjustment.

Financial Reporting of Non-recurring Items

In the income statement of a company, a distinction is made between income and expenses from the operating and non-operating activities. 



Operating activities are the primary business activities arising from businesses’ normal operations. Non-operating items include secondary activities that are not a part of a business’s normal operations. For example, for a manufacturing company, any interest or dividend earned on an investment, or gains (losses) from a foreign exchange transaction are considered non-operating income. These are income and expenses related to investing and financing activities. However, for a financial firm such as a bank, any investing and financing transactions are considered to be operating activities.

Operating and Non-operating Components of Income Statement

Companies with complex capital structures are required to present both basic and diluted earnings per share.



In computing diluted EPS, the potential impact (i.e., the assumed conversion) of potentially dilutive securities is considered in addition to the weighted average shares.



The impact of assumed conversion of potentially dilutive securities on EPS will be on both numerator and denominator of EPS computation.



To be included in the diluted EPS calculation, the potentially dilutive securities must have dilutive effect on EPS, that is, the assumed conversion of the potentially dilutive security has a negative impact on the EPS (i.e., reduce the EPS). These are&nbsp;dilutive securities&nbsp;and they decrease EPS if exercised or converted into common stock. If the impact is that the EPS increases, then they are called antidilutive securities.



There are four main securities:



<ul><li>Convertible preferred stock</li><li>Convertible bonds</li><li>Stock options</li><li>Warrants</li></ul>



These securities will impact both the numerator and denominator of the EPS.&nbsp;



Stock options and warrants are dilutive if the exercise of the option results in an increase of common shares using a treasury stock method. We can also say that stock options and warrants are dilutive only when their exercise prices are less than the average market price of the stock over the year. If they are dilutive, they are the first to be included in the computation of Diluted EPS.



Example



Assume a corporation has 10,000 common shares and options to purchase 1,000 common shares at $20 per share outstanding for the entire year. The average market price for the common stock was $25 per share. The net increase in the denominator would be 200 computed as follow:



If the option is exercises, then the company will receive $20,000 and issue 1,000 shares. The treasury stock method assumes that the company uses this money to repurchase stocks at the average market price. The average market price is $25, So, the company will be able to purchase 20,000/25 = 800 shares. The net increase in common shares = 1,000 – 800 = 200.



Other potentially dilutive securities (i.e., convertible preferred stocks and convertible bonds) would be included in DEPS after stock options and warrants only if their inclusion has a dilutive effect on the EPS.

Diluted EPS

We have the following data for a company:



<ul><li>Net income= $12,000</li><li>Preferred dividend= $2,000</li><li>Weighted Average Shares Outstanding= 10,000</li><li>Convertible Preferred Stock Outstanding = 1,000</li></ul>



Case A: Each share of preferred stock is to be converted into four shares of common stock



Basic EPS = (12,000 – 2,000)/10,000 = 1



The convertible preferred stock should be included in the calculation of diluted EPS only if it is dilutive. To check if it is dilutive, we will divide the preferred dividend by the no. of common shares created from the preferred stock. If this is less that basic EPS, the security is dilutive.



In this example: $2,000/4,000 = 0.5 which is less than basic EPS of 1. Therefore the convertible preferred stock is dilutive and must be included in the calculation of diluted EPS.



Diluted EPS = 12,000/(10,000+4,000) = $0.857



Note that in the numerator we did not subtract the preferred dividend as the preferred stock is assumed to be converted into common stock.



Case B: Each share of preferred stock is to be converted into one shares of common stock



Impact of the assumed conversion: $2,000/1,000 shares = $2 &gt; Basic EPS



This security is anti-dilutive and should NOT be considered in the computation of DEPS.&nbsp;&nbsp;&nbsp;&nbsp;



The generalized formula for diluted EPS is presented below:



<div class="wp-block-image"><figure class="aligncenter size-large"><img src="https://financetrain.com/wp-content/uploads/deps-1-1024x311.png" alt="" class="wp-image-28719"/></figure></div>

Calculation of Diluted EPS (Convertible Preferred Stock)

We have the following data for a company:



<ul><li>Net income= $12,000</li><li>Preferred dividend= $2,000</li><li>Weighted Average Shares Outstanding= 10,000</li><li>Preferred Stock Outstanding = 1,000</li><li>50 convertible bonds, $1,000 par, 6%. Each bond is convertible into 100 shares</li></ul>



Basic EPS = (12,000 – 2,000)/10,000 = 1



If the convertible bonds are converted into shares, the total new shares issued will be:



= 50*100 = 5,000



If the convertible bonds are converted into shares, there will be no interest expense. Therefore the net income will increase by = 50*1000*0.06(1-0.40) = 1,800



Diluted EPS = (12,000 – 2,000+1,800)/(10,000+5,000) = 0.78



We should check whether the diluted EPS is less than basic EPS. Only if it is less, the convertible bonds will be considered to be dilutive and will be included in the calculation of dilutive EPS.

Calculation of Diluted EPS (Convertible Debt)

In a common size income statement each item is expressed as a percentage of revenue. A common-size statement helps in comparison of different companies as it eliminate the effects of size of the business. Common size income statement can be used to time-series analysis of the same company over time or to perform cross-sectional analysis across firms.



Presented below are the standard income statements and common size income statements of two companies ABC and XYZ for the year 2013.



<div class="wp-block-image"><figure class="aligncenter size-large"><img src="https://financetrain.com/wp-content/uploads/common-1-1024x528.png" alt="" class="wp-image-28724"/></figure></div>



Note that when you see the income statements in terms of absolute dollars, the Company ABC is bigger and more profitable than company XYZ. However, common size statements reveal that company XYZ has a higher net profit compared to company ABC.

Common Size Income Statement

Two commonly used measures of profitability&nbsp;of a company&nbsp;include Gross Profit Margin and Net Profit Margin.



Gross Profit Margin



Gross Profit Margin = (Gross Profit) ÷ (Gross Sales)



Gross profit margin measures gross profit as a percentage of gross revenue. This helps capture profit as a percentage of revenue, and helps assess components that affect profitability.



Net Profit Margin



Net Profit Margin = (Net Profit) ÷ (Gross Sales)



When net profit or the bottom line, profit after subtracting all costs is shown as a percentage of gross sales we call it net profit margin. This margin varies from industry to industry. For example a 5-6% profit in the steel manufacturing industry is considered very good, but poor for the pharmaceutical industry. It also needs to be considered with that firm’s historical performance.

Performance Measures of a Company

Total Comprehensive Income reflects the changes in a company’s equity during the accounting period which does not represent contributions by or distributions to the company’s owners.



Total Comprehensive Income = Net Income + / – Other Comprehensive Income (OCI)



OCI = Ending Shareholders’ Equity – Beginning Shareholders’ Equity – Net Income + Declared Dividends



<h3>Reporting Comprehensive Income</h3>



Firms can report comprehensive income below net income on the income statement, as an extra column on the statement of changes in shareholders’ equity, or through a statement of comprehensive income.



<h5>Items Under OCI Category</h5>



U.S. GAAP has four items that fall under the OCI category:



<ul><li>Unrealized Gains/Losses on Certain Investment Securities:&nbsp;These are gains or losses from intercorporate investments classified as available for sale (AFS). The unrealized gain/loss in the accounting period does not affect net income for the period, but does impact shareholders equity as part of OCI.</li><li>Unrealized Gains/Losses on Hedging Derivatives:&nbsp;A change in the fair value of derivatives contracts used for hedging is not part of net income, but is applied to equity through OCI.</li><li>Foreign Currency Translation Adjustments:&nbsp;When a company consolidates foreign subsidiaries using the current rate method, the gain or loss resulting from the foreign exchange adjustments is reported as part of OCI.</li><li>Pension Liability Adjustments:&nbsp;Actuarial gains and losses related to defined benefit retirement plans are recorded as part of OCI.</li></ul>

Comprehensive Income

This quiz is a part of the CFA Level 1 reading 'Understanding Income Statements'. 

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