Reading 25 LOS's

Question 1

LOS 25a: Describe the components of the income statement and alternative presentation formats of that statement

Answer 1

Under IFRS the income statement may be presented as:

• A section of a single statement of comprehensive income
• a seperate statement followed by a statement of comprehensive income that begins with net income

Under US GAAP the income statement may be presented as:

• A section of a single statement of comprehensive income
• A seperate staetment followed by a statement of comprehensive income that begins with net income
• A seperate statement with the components of other comprehensive income presented in the statement of changes in shareholders equity

Components of the Income Statement

Revenue- Usually reported on the first line, revenues are amounts charged for goods and services in ordinary activities of business. Net Revenue is total revenue adjusted for product returns and amounts that are unlikely to be collected. Revenue can be recognized when the amount is measured reliably and the payment is probable.

Expenses- reflect outflows, depletion of assets, and incurrences of liabilities. Expenses can be grouped by nature or function. Depreciation of certain assets can be grouped to just be Depreciation (Nature). Combining direct product costs with COGS is an example of function

Gross profit or margin- is the difference between revenues and cost of goods sold. This can be shown through multi-step where all COGS are listed, or single step, where just COGs is listed

Operating Income- is calculated after subtracting all direct and indirect costs from revenue. It represents the profit earned by the company before accounting for taxes and for nonfinancials, interest expense. For financial companies, since interest income and expense is part of business, it is included in operating profits

Net Income- includes profits earned as well as gains and losses from nonoperating activites

• NI = Revenue - expenses (in ordinary business) + other income - other expenses + Gains - losses

NOTE If a company owns the majority of the shares of a subsidiary, it must present consolidated financial statements. If the sub is not wholly owned, the share of noncontrolling interests in net income is deducted from total income

Question 2

LOS 25b: 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

LOS 25c: Calculate revenue given information that might influence the choice of revenue recognition method

Answer 2

Income includes revenues and gains. Revenues arise from ordinary, core business activities, whereas gains arise from noncore activities.

The most important principle of revenue recognition is accrual accounting, which requires that revenues and costs are recognized independently of timing of cash flows

Under IFRS revenue is recognized for a sale of goods when:

• Significant risks and rewards of ownership are transferred to the buyer
• The entity retains no managerial involvement over goods sold
• The amount of revenue can be measured reliably
• It is probably economic benefits will flow to the entity
• Costs incurred can be measured reliably

Under IFRA revenue is recognized for the rendering of a service when:

• The amount of revenue can be measured reliably
• It is probable economic benefits will flow to entity
• the stage of completion on the transaction can be measured reliably
• The costs incurred can be measured reliably

Under US GAAP, revenue is recognized when:

• There is evidence of an arrangement between the buyer and seller
• the product has been delivered or the service rendered
• The price is determined or determinable
• The seller is reasonably sure of collecting money

Revenue Recognition in Special Cases

A) Long Term Contracts- Under both IFRS and US GAAP, if the outcome can be measured reliably, the percentage of completion method is used. The percentage of revenue, costs, and profits that is recognized during a period is calculated by dividing the total cost incurred during the period by the total estimated cost of the project.

If the outcome can not be reliably measured, then under US GAAP, the completed-contract method is used which allows no recognition until the project is substantially finished. Under IFRS revnue is recognized with costs incurred, and profits aren’t recognized until all costs have been recovered.

IMPORTANT Under IFRS and US GAAP, if a loss is expected on the contract, the loss must be recognized immediately, regardless of the revenue recognition method

B) Installment Sales

Under IFRS installment sales are seperated into the selling price and an interest component. The sale price is recognized on the day of sale, while the interest is recognized over time

Under US GAAP a sale is reported at the time of sale using the normal revenue recognition conidtions if the seller:

• Has completed the significant activities in the earnings process
• Is either assured of collecting the selling price or able to estimate the amounts that will not be collected

When these two conditions are not fully met, the followng two methods may be used:

• Installment method is used when collectability of revenues cannot be reasonably estimated. Under this method, profits are recognized as cash is received
  
  • Profit for Period = (Cash Collected in Period/ Selling price) x total profit
• Cost Recovery Method is used when collectability of revenue is highly uncertain. Under this method, profits are only recognized once total cash collections exceed total costs

Barter Transactions

Under IFRS revenue from barter transactions can be reported on the income statement based on the fair value of revenues from similar nonbarter transactions with unrelated parties

Under US GAAP revenue from barter transactions can be reported on the income statement at fair value, only if the company has a history of making or receiving cash payments for such goods. Otherwise, revenue should be reported at the carrying amount of the asset surrendered

Gross vs Net Reporting

Under gross revenue reporting, sales and cost of sales are reported separately, while under net reporting, only the difference between sales and cost of sales is reported on the income statement. Under US GAAP, only if the following conditions are met can a company recognize revenue based on gross reporting

• The company is the primary obligor under the contract
• the company bears inventory and credit risk
• the company can choose its suppliers
• the company has reasonable latitude to establish price

Question 3

LOS 25d: Decribe general principles of expense recognition, specific expense recognition applications, and implications of expense recognition choices for financial analysis

Answer 3

The most important principle of expense recognition is the matching principle, which requires that expenses be matched with associated revenues when recognizing them on the income statement. Certain expenses cannot be directly linked to the generation of revenues and they are called period costs (ex. admin costs).

Inventory Methods

If a company can specifically identify which units of inventory have been sold over the year and which one remains in stock, it can use the specific identification method for valuing inventory (ex. automobiles). When identical units are sold in high volumes, this method can be difficult, which leads to the following

First in First out (FIFO) this method assumes that items purchased first are sold first. Therefore ending inventory is composed of the most recent purchases. This is used for limited shelf life goods like food

Last in First out (LIFO) This method assumes that items purchased most recently are sold first. Therefore ending inventory is composed of the earliest purchases. An example would be stacks of lumber in a lumberyard

_Weighted-average costs-_under this method total inventory costs are allocated evenly across all units.

Issues in Expense Recognition

Doubtful Accounts

When sales are made on credit, there is a possibility that some customers will not be able to meet their payment obligations. The matching principle requires companies to estimate bad debts at the time of revenue recognition

Warranties

When companies provied warranties for their products, there is a posibility that they might have to pay for reparing or replacing a product. Again the matching principle will require companies to estimate future warranty-related expenses and recognize these amounts on the income statement in the period of sale, and then to update this amount to bring in line with actual expenses incurred over the life of the warranty

Depreciation

Depreciation is the process of allocating the cost of long-lived assets across the accounting periods that they provide economic benefits for. With regards to depreciation, IFRS requires the following:

• Each component of an asset should be depreciated separately
• Estimates of residual value and useful life should be reviewed annually

Under the straight-line method, the cost of the asset less its estimated residual value is spread evenly over the estimated useful life of the asset.

• (Cost - Residual Value) / useful life

Under accelerated methods of recording depreciation, a greater proportion of the asset’s cost is allocated to the initial years of its use and a lower proportion of the cost is allocated to later years. The double declining balance method uses an acceleration factor of 200 ( it depreciates the asset at 2x the rate of straight-line. DDB is calculated as:

(2/Useful Life) x (Cost - Accumulated Depreciation)

Annual depreciation expense is sensitive to two estimate - residual value and useful life. An increase in the value of these two estimates would decrease yearly depreciation expense and increase reported net income

Implications for Financial Analysis

A company’s estimates for doubtful accounts and warranties and estimates of useful lives and salvage values of long-lived assets directly affect net income. Therefore when analyzing financial statements, analysts must carefully scrutinize the validity of used estimates. Accounting estimates should also be compared to those of other companies that operate in the same industry to check their validity and evaluate management intergrity.

Accounting policies and estimates are disclosed in the footnotes to the financial statements and the management discussion and analysis (MD&A) section of the annual report

Question 4

LOS 25 e: 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

Answer 4

Two examples of nonrecurring items are:

1) Discontinued Operations

Under both IFRS and US GAAP

• Discontinued operations are reported net of tax as a seperate line after income from continuing operations
• As the disposed operation will not earn revenue for the company going forward, it will not be taken into account when formulating expectations regarding the future performance of the company

2)Extraordinary Items

IFRS does not allow any items to be classified as extraordinary. US GAAP defines extraordinary items as being both unusual in nature and infrequent in occurrence:

• Extraordinary items are reported net of tax and as a separate line item after income from continuing operations
• Analysts can eliminate extraordinary items from expectations about a company’s future financial performance unless there is an indication that these extraordinary items may reoccur

The likelihood of certain other items continuing in the future is not as clear. Here are 2 examples:

1) Unusual or Infrequent Items

These items are either one or the other, not both because then they would be extraordinary. An example would be gains or losses from selling an asset above or below carrying value

• These items are listed as seperate line items on the income statement but are included in income from continuing operations and hence, reported before-tax
• Analysts should not ignore all unusual items. When forecasting future profits, analysts should assess whether each of them is likely to reoccur

2) Changes in Accounting Policies

• A change in accounting policy could be required by standard setters or be decided by management to provide a better reflection of the company’s performance. Changes in policies are applied retrospectively meaning the financial data for all periods shown in the financial report must be presented as if the new principal were in use the entire time
• A change in accounting estimates are applied prospectively and only affect financial statements for the current and future periods
• A correction of prior-period errors is made by restating all prior-period financial statements presented in the financial report. In addition, disclosure about the error is required in the footnotes

Question 5

LOS 25f: Distinguish between the operating and non-operating components of the income statement

Answer 5

IFRS does not define operating activities. On the other hand US GAAP defines operating activites as those that generally involve producing and delivering goods and providing services. The sources of income that do not relate to the core business operations are listed under nonoperating

Question 6

LOS 25g: 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.

LOS 25h: Distinguish between dilutive and antidilutive securities, and describe the implications of each for the earnings per share calculation

Answer 6

Earning Per Share is one of the most important profitability measures for publicly listed firms. A firm can have a simple or complex capital structure. A company that has a simple structure, has no financial instruments outstanding that can be converted into common stock. With that said they only have to calculate basic EPS:

• Basic EPS = Net Income - Preferred Dividends / weighted average number of shares outstanding
• Preferred dividends are subtracted from net income to calculate earnings available to common shareholders
• The weighted average number of shares outstanding refers to the number of shares that were outstanding over the year, weighted according to the proportiong of the year they were outstanding

Stock repurchases result in a decrease in the number of shares outstanding

Stock Splits and Stock dividends result in an increase in shares outstanding

• Stock splits takes exisitng shares and splits them into more shares. Example 2 for 1 means 2 new shares are created for every 1 pre exisiting
• Stock dividend are when dividends are paid in the form of common stock. After a 25% stock dividend, the holder of 1000 shares will receive an extra 250 shares.

IMPORTANT if a company issues a stock split or dividend, the weighted average number of shares outstanding should be calculated based on the assumption that the additional shares have been outstanding since the date that the original shares were outstanding

A company with a complex capital structure is one that contains certain financial instruments that can be converted into common stock. Therefore they are required to report a basic and dilluted EPS. There are a number of ways shares can be dilluted as follows:

Convertible Preferred Stock Outstanding Diluted EPS

• We would add back dividends paid to convertible shares to our numerator
• We would increase the number of shares outstanding by the number of common shares that would be issued to convertible preferred upon conversion

Diluted EPS = Net income - Preferred dividends + Convertible Preferred Dividends

Weighted avg. # of shares outstanding + New common issued upon conversion

• A quick way to determine whether convertible preferred shares are dilutive is:

Convertible Preferred Dividends

New shares issued upon conversion

• If this value is lower than basic EPS, the shares are dilutive.
• If this value is higher than basic EPS, the shares are anti dilutive and therefore should be ignored in the calculation of diluted EPS

Convertible Debt Outstanding Diluted EPS

• We would add interest payments that were made to bondholders back to the numerator
• The number of shares outstanding will increase by the number of common shares that would be issued to convertible debt holders upon conversion

Diluted EPS = Net Income - Preffered Div. + Convertible Debt interest ( 1 - t)

Weighted avg. # of shares outstanding + New common shares issued conversion

• Again a quick way to determine if the bonds are dilutive is:

Convertible bond interest (1-t)

New Shares issued upon conversion

• If the value is less than basic EPS, they are dilutive
• If the value is more than basic EPS, they are anit-dilutive and do not need to be considered in diluted EPS

Stock Options, Warrants Diluted EPS

• In the calculation of diluted EPS, stock options and warrants are accounted for using the treasury stock method, which assumes that all the funds received by the company from the exercise of options and warrants are used by the company to repurchase shares at the average market price for that period. The resulting net increase in number of shares outstanding equals the increase in shares from the exercise of options and warrants minus the number of shares repurchased.
• No adjustment is needed for the numerator
• A shortcut for calculating the net increase in shares is

Market Price - Exercise Price X Number of shares created from

Market Price the exercise of options

• And then diluted EPS will be:

Diluted EPS = Net Income / Weight avg # shares out + New shares issued at option exercise - shares repurchased from proceeds of option exercise

• Because the exercise options only have an impact on the denominator of the EPS formula, options and warrants are always dilutive

IMPORTANT In determining which potentially dilutive financial instrument should be included in the diluted EPS calculation, each of the financial instruments must be evaluated individually and independently to determine wheter they are dilutive. If any are anit-dilutive, they must be ignored from the calculation of dilutive EPS

Question 7

LOS 25i: Convert income statements to common-size income statements

LOS 25j: Evaluate a company’s financial performance using common-size income statements and financial ratios based on the income statement

Answer 7

Common Size income statements present each line item on the income statement as a percentage of sale. This is useful for financial statement analysis, as the data can be used to conduct time-series and cross-sectional analysis.

While common-size present most items as percentage of sals, it is more appropriate to present income taxes as a percentage of pre-tax income, the ratio known as the company’s effective tax rate.

Income Statement Ratios

Items listed on the income statement are used to calculate ratios to evaluate a company’s profitability. 2 most commonoly used are:

1. Net profit margin = Net Income /Revenue
2. Gross Profit margin = gross profit / revenue

Question 8

LOS 25k: Describe, calculate, and interpret comprehensive income

LOS 25l: Describe other comprehensive income, and identify the major types of items included in it

Answer 8

IFRS defines total comprehensive income as “the change in equity during a period resulting from transaction and other events, other than those changes resulting from transactions with owners in their capacity as owners”

US GAAP defines comprehensive income as “ the change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners”

In summary, comprehensive income includes both net income and other revenues and expenses that are excluded from the net income calculation. We can determine other comprehensive income from:

Ending shareholders equity = beg shareholders equity + Net income + Other comprehensive income - dividends declared.

Items classified as other comprehensive income

Under US GAAP and IFRS there are 4 types:

1. Foregin currency translation adjustments
2. Certain costs relating to the company’s defined benefit post-retirement plans
3. Unrealized gains or losses on derivative contracts
4. Unrealized holding gains and losses on available for sale securities

IFRA also counts certain changes in the value of long-lived assets that are measured using the revaluation model