Understanding The Income Statement

Financial Reporting & Analysis Understanding The Income Statement Reading - 25 www.proschoolonline.com/ 1

Format of Income Statement Revenue from Sale of goods and services - Operating Expenses Operating Income From continuing Operations + Other Income and Expenses Recurring Income Before Interest and Taxes from continuing operations - Financing Costs + / - Unusual or Infrequent items Pretax from Continuing opereations + / - Income Tax Expense Net Income from Continuing Operations + Income from discontinued operations + / - Extraordinary Items + / - Cumulative effect of accounting changes Net Income Basic - EPS Diluted EPS Income Statement Format www.proschoolonline.com/ 2

Example : Apple Inc. - Income Statement Apple Inc. - Income Statement Year ended 26 September 2009 2008 2007 Net sales 36,537 32,479 24,006 Cost of sales 23,397 21,334 15,852 Gross margin 13,140 11,145 8,154 Operating expenses: Research and development 1,333 1,109 782 Selling, general & administrative 4,149 3,761 2,963 Total operating expenses 5,482 4,870 3,745 Operating income 7,658 6,275 4,409 Interest Income, net 326 620 599 Income before provision for 7,984 6,895 5,008 income taxes Provision for income taxes 2,280 2,061 1,512 Net income 5,704 4,834 3,496 Earnings per common share: Basic $ 6.39 $ 5.48 $ 4.04 Diluted $ 6.29 $ 5.36 $ 3.93 Shares used in computing earnings per share: Basic 893,016 881,592 864,595 Diluted 907,005 902,139 889,292 www.proschoolonline.com/ 3

Subtotals in Income Statement International Accounting Standards (IAS) requires that certain line items like revenue, finance cost and tax expense be separately stated. According to IAS No.1 expenses can be grouped together by their nature or function. Expenses Grouping By Nature Grouping By Function Eg. Depreciation on manufacturing expenses and depreciation on administrative facilities to be combined into line item Depreciation Eg. Grouping expenses into category like COGS will include expenses on wages of workers, material costs, depreciation, etc. www.proschoolonline.com/ 4

Revenue Recognition IASB Standards Revenue is to be recognized if the following conditions are satisfied Risk rewards of ownership of the goods is transferred to the buyer Entity gives away the control and managerial involvement on the goods Revenue amount is measured reliably Probable economic benefits flow to the entity Incurred costs for the transaction can be reliably measured www.proschoolonline.com/ 5

Revenue Recognition SEC Standards According to FASB revenue should be recognized when it is realized or realizable and earned SEC criteria for revenue recognition is: Evidence of arrangement between buyer and seller Product has been delivered or the services have been rendered Price is determined Seller is reasonably sure of collecting money www.proschoolonline.com/ 6

Revenue Recognition IASB Standards for Services Revenue When the outcome of a transaction can be estimated reliable, revenue associated with the transaction shall be recognized per the stage of completion Outcome of a transaction is estimated reliably if: Revenue amount is measured reliably Economic benefits of the transaction will flow to the entity Completion of transaction at balance sheet date can be measured reliably Costs incurred for the transaction can be measured reliably www.proschoolonline.com/ 7

Revenue Recognition Long Term Contracts Percentage Completion Method Each accounting period the company estimates what percentage of the contract is complete and then reports that percentage of the total contract revenue in its income statement This method is preferred only when reliable estimates of revenues, costs and completion time are available Completed Contract Method Under this method no revenue is reported by the company until the contract is completed This method is used when the estimates of revenue and costs are unreliable www.proschoolonline.com/ 8

Revenue Recognition Long Term Contracts Example Company ABC has a contract to build roads worth $ 10 million. It will take three years to build these roads. The total costs to build the road are estimated to be $ 7 million. If ABC recognizes the contract revenues on a percent of completion basis and estimates percentage complete on the basis of expenses incurred then what would be the revenues of ABC for the next 3 years are per the percent of completion basis? Year 1 Year 2 Year 3 Expenses Incurred 3 2 2 Total Project Expenses 3 5 7 If ABC recognizes the revenues on a completed contract basis then what would be the revenues of ABC for the next 3 years per the completed contract basis revenue recognition technique? www.proschoolonline.com/ 9

Revenue Recognition Long Term Contracts Solution Revenue Recognition - Percent of Completion Basis Revenue Recognition - Completed Contract Method All Numbers are in $Million All Numbers are in $Million Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 Total Project Cost $ 7.00 Total Project Cost $ 7.00 Total Expected Revenue $ 10.00 Total Expected Revenue $ 10.00 Expenses Incurred $ 3.00 $ 2.00 $ 2.00 Expenses Incurred $ 3.00 $ 2.00 $ 2.00 % of Costs Incurred in % of Costs Incurred in that year 42.86% 28.57% 28.57% that year 42.86% 28.57% 28.57% % of Project Complete 42.86% 71.43% 100.00% % of Project Complete 42.86% 71.43% 100.00% Expected Revenue $ 4.29 $ 2.86 $ 2.86 Expected Revenue $ - $ - $ 10.00 Percent of Completion Method Revenue recognized every year to the extent for which project is completed. Completed Contract Method Revenue recognized only when the project is completed. www.proschoolonline.com/ 10

Revenue Recognition Installment Sales & Cost Recovery Installment Sales Method Used when likelihood of collection cannot be estimated, though cost of goods and services are known Revenue and profit are based on percentage of cash collected Apportions the cash receipt between cost recovered and profit using the profit to sales ratio Cost Recovery Method Used when cost of goods and services are unknown and likelihood of collection cannot be estimated Profit is recognized only when all the costs are recovered www.proschoolonline.com/ 11

Revenue Recognition Installment Sales & Cost Recovery Example Assume the total sales price and cost of a property are $ 300,000 and $150,000, respectively. The profit on this transaction is $150,000. The amount of cash received by the seller as a down payment is $100,000 with the remainder of the sales price to be recognized over 5-year period. It has been determined that there is significant doubt about the ability and commitment of the buyer to complete all payments. How much profit will be recognized attributable to the down payment if: The installment method is used? The cost recovery method is used? www.proschoolonline.com/ 12

Revenue Recognition Installment Sales & Cost Recovery Solution Installment Sales method Profit to Sales ratio = 150,000/300,000 = 0.50 Cash Received in form of down payment = 100,000 The profit attributable to the down payment amount = 50,000 Cost Recovery Method Under cost recovery method profits will be attributed if costs are exceeded. In this case the costs are 150,000 and the down payment is 100,000. Thus no profit will be attributed to the down payment amount per the cost recovery method. 0 1 2 3 4 5 Installment Sales Method Cash Receipts 100,000 40,000 40,000 40,000 40,000 40,000 Costs 50,000 20,000 20,000 20,000 20,000 20,000 Profits 50,000 20,000 20,000 20,000 20,000 20,000 Cost Recovery Method Cash Received 100,000 40,000 40,000 40,000 40,000 40,000 Costs Attributed 100,000 40,000 10,000 - - - Costs Remaining 50,000 10,000 - - - - Profits - - 30,000 40,000 40,000 40,000 www.proschoolonline.com/ 13

Barter Transactions Exchange of goods and not of cash is termed as a barter transaction The issue with a barter transaction is whether to recognize the revenue or not IFRS: Revenues can be reported in the income statement based on the fair value of revenues from a similar non-barter transaction with unrelated parties US GAAP: The barter transaction can be reported in the income statement at their fair values if the company has a history of making or receiving cash payments for such good and services www.proschoolonline.com/ 14

Gross v/s Net Revenues Gross Revenue Reporting : Sales and cost of sales are reported separately Net Revenue Reporting : Only the difference between sales and costs of sales is reported on the income statement US GAAP Only under the following conditions can a company report revenues based on the gross reporting Company is a primary obligor under the contract Company bears the inventory and credit risk Company can choose its suppliers Company has reasonable latitude to establish price Example Internet Based merchandising companies sell products, but don t maintain inventory Revenues = $100 COGS = $80 Gross Profit = $20 Net Revenue: Instead of Gross Profit as $20 show the revenues as Net Revenues = $20 www.proschoolonline.com/ 15

Expense Recognition General Principles Matching Principle Match expenses with associated revenues Example Some current period revenues are made from inventory purchased in the previous period The matching principle requires that the company matches the COGS with the revenues of the period Period Costs Expenses that less directly matching the timing of revenues Example Administrative Expenses www.proschoolonline.com/ 16

Inventory Matching Example Consider a company which started an year with an inventory of 100 units bought at $10 each. During the year company purchased an additional inventory of 800 units at an average cost of $11 each. Total sales made by the company were 750 units at $15 each. It is been identified that the beginning inventory is completely sold this year. Estimate the gross profit of the company Estimate the inventory value left www.proschoolonline.com/ 17

Inventory Matching Solution Units Per Unit Value Beginning Inventory 100 $ 10.00 1,000 Purchases 800 $ 11.00 8,800 Sales 750 $ 15.00 11,250 Closing Inventory 150 $ 11.00 1,650 COGS 750 $ 10.87 8,150 Part - 1 100 $ 10.00 1,000 Part - 2 650 $ 11.00 7,150 Estimation of Closing Inventory can be done using FIFO LIFO AVCO Sales 11,250 COGS 8,150 Gross Profit 3,100 Inventory Value 1,650 www.proschoolonline.com/ 18

Comparison of Inventory Costing Methods Method Description COGS Inventory Rising prices Falling Prices FIFO Earliest items purchased were sold first Lowest Highest LIFO Latest items purchased were sold first Highest Lowest Weighted average total costs over Average Cost total units available Middle Middle LIFO Method is not permitted under IFRS www.proschoolonline.com/ 19

Depreciation Long lived assets are assets expected to provide economic benefits over a future period of time greater than one year Example Property, Plant and Equipment Depreciation is a process of systematically allocating costs of long lived assets over the period during which the assets are expected to provide economic benefits Methods of depreciation Straight Line Method : Allocates evenly the cost of Long lived asset over the useful life of the asset Depreciation = (Cost Residual Value) / Estimated Useful Life Accelerated Method : Allocates a greater proportion of costs to early years of the useful life of the asset Depreciation = Opening NBV * Factor Cost Accumulated Depreciation = Net Book Value (NBV) Factor = 150% or 200% of Straight line depreciation rate 200% is called the double declining rate www.proschoolonline.com/ 20

Amortization Depreciation of Intangibles It spreads costs of intangibles (e.g. Patents, Copyrights, etc.) over life For intangible assets that must be amortized the process is same as for depreciation Per IAS No. 38, if the pattern cannot be determined over the useful life, then straight line method should be used Goodwill generated during acquisition is not amortized Goodwill impairment happens on the bass of annual reviews www.proschoolonline.com/ 21

Unusual or Infrequent Items Reported pre-tax before net income from continuing operations Items include: Gain (Loss) from disposal of a business segments or assets Gain (Loss) from sale of investment in subsidiary Provisions for environmental remediation Impairments, write-offs, restructuring, Integration expense for recently acquired business www.proschoolonline.com/ 22

Discontinued Operations Operations that management has decided to dispose off but Has not done so, yet Did so in current year after it generated profit or loss Reported net of taxes after net income from continuing operations Assets, operations and financing activities must be physically and operationally distinct from firm www.proschoolonline.com/ 23

Extraordinary Items Items that are both unusual and infrequent Reported net of taxes after the net income from continuing operations Items include: Losses from expropriation of assets Uninsured losses from natural disaster Prohibited under IAS 1, US GAAP allows for its qualification as stated above www.proschoolonline.com/ 24

Accounting Changes Change in accounting principle e.g. LIFO to FIFO Retrospective application: IFRS and US GAAP require prior years data shown in financial statements to be adjusted Changes in accounting estimate e.g. change in estimated life of a depreciable asset Does not require restatement of prior period earnings Disclosed in footnotes Prior Period Adjustments Correcting errors or changing from an incorrect accounting method to one that is acceptable typically requires restatement of prior period financial statements Must disclose the nature of the error and its effect on the net income www.proschoolonline.com/ 25

Non-Operating Items Financial Service Companies : Following are the major operating activities Interest Dividends Gains / Losses on Disposal of assets Non Financial Service Companies : Non Operating activities will be investing activities The above activities (interest, dividends, etc. ) qualify as non operating activities If these are on a rise in a company then further investigation in the footnotes becomes essential www.proschoolonline.com/ 26

Simple versus Complex Capital Structure A simple Capital structure contains no potentially dilutive securities In this case firm will report only basic EPS A complex capital structure contains potentially dilutive securities Firm has to report both the basic and diluted EPS Dilutive Securities include Stock Options Warrants Convertible Debt Convertible Preferred Stock Dilutive Securities decrease EPS if exercised or converted to common stock Anti-dilutive securities increase EPS if exercised or converted to common stock www.proschoolonline.com/ 27

Basic EPS Basic EPS Amount of income available to common shareholders divided by the weighted average number of common shares outstanding over a period. Basic EPS = Net Income - Preferred Dividends Weighted Average number of shares outstanding In case of stock splits: 2 for 1 stock split increases the shares outstanding by 100% For EPS calculation purposes, a stock split is treated as if it occurred at the beginning of the year In case of dividends: The weighted average outstanding shares increases with the dividend 10% dividend results in a 10% increase in the shares outstanding www.proschoolonline.com/ 28

Computation of Weighted Average Shares & Basic EPS Example Consider the following data on the companies number of outstanding shares. Date Activity Number of Shares 01/01/2009 Shares Outstanding 100000 01/04/2009 Shares Issued 50000 01/07/2009 10% Sock Dividend 01/09/2009 Shares Repurchased 25000 If the company has a net income of $250,000 and no preferred stock What is the weighted average number of shares outstanding for the company? What is the Basic EPS of the company? www.proschoolonline.com/ 29

Computation of Weighted Average Shares & Basic EPS Solution Date Activity Number of Shares 01/01/2009 Shares Outstanding 100000 01/04/2009 Shares Issued 50000 01/07/2009 10% Sock Dividend 01/09/2009 Shares Repurchased 25000 Shares Adjusted for 10% Dividend Month * Adjusted shares Number of Date Activity Number of Shares months 01/01/2009 Shares Outstanding 100,000 110,000 12 1,320,000 01/04/2009 Shares Issued 50,000 55,000 9 495,000 01/07/2009 10% Sock Dividend - 01/09/2009 Shares Repurchased 25,000 27,500 3 82,500 Total Weighted Shares = 1732500 Weighted Average Shares = 144375 Basic EPS = = Net Income - Preferred Dividends Weighted Average number of shares outstanding 250,000 144,375 Basic EPS = 1.73 www.proschoolonline.com/ 30

Diluted EPS If a company has dilutive securities then, diluted EPS will be lower than Basic EPS There are 3 types of dilutive securities: Convertible Preferred Stock Convertible Outstanding Debt Stock Options, Warrants If the security is dilutive i.e. it reduces the Diluted EPS < Basic EPS then it is converted. Else conversion does not occur. Diluted EPS = (Net Income - Preferred Dividend) Weighted Average Shares + + Included only if diluted security is present Convertible Preferred Dividend Shares From Conversion of Convertible Preferred Stock + + Convertible Debt Interest * (1-t) Shares from conversion of convertible debt Included only if diluted security is present + Shares issuable for warrants and options www.proschoolonline.com/ 31

Diluted EPS Convertible Preferred Stock Example 31/21/2009 Net Income $500,000,000 Common Stock of $10 each 20000000 Tax Rate 40% = Number of Shares Preferred stock outstanding ($10 each) = $ 7,500,000 Preferred Dividend Rate = 6% One preferred stock is converted into 1.25 common shares Calculate fully diluted EPS for 2009 www.proschoolonline.com/ 32

Diluted EPS Convertible Preferred Stock Solution Net Income $500,000,000 Preferred Dividend 450000 Basic EPS = Net Income - Preferred Dividends Weighted Average number of shares outstanding Basic EPS = 24.98 Number of common shares if preferred shares are coverted Outstanding all year 20000000 On Conversion of Preferred Stock 937500 Total Shares - Diluted 20937500 Diluted EPS = 500000000 20937500 = 23.88 EPS Basic > Diluted EPS, security is dilutive in nature www.proschoolonline.com/ 33

Diluted EPS Convertible Debt Example 31/21/2009 Net Income $500,000,000 Common Stock of $10 each 20000000 Tax Rate 40% Convertible Debt outstanding ($1000 each) = $ 25,000,000 Bond Rate = 5% One bond is converted into 125 common shares Calculate fully diluted EPS for 2009 = Number of Shares www.proschoolonline.com/ 34

Diluted EPS Convertible Debt Solution Net Income $ 500,000,000 Add : Interest Saved $ 1,250,000 Less : Tax Impact $ (750,000) $ 500,500,000 Basic EPS = 25.00 Number of common shares if debt is coverted Outstanding all year 20000000 On Conversion of Debt 3125000 Total Shares - Diluted 23125000 Diluted EPS = 500,500,000 23125000 = 21.64 EPS Basic > Diluted EPS, security is dilutive in nature www.proschoolonline.com/ 35

Diluted EPS Stock Options Solution If all options are exercised - Number of new shares issued 1000000 Cash Proceeds if all options exercised Number of shares that can be purchsed at average price $ 15,000,000 15000000 20 = 750,000 Net increase in common stock Total Shares needed 1000000 Shares purchased with 750,000 New Shares issued 250000 Diluted EPS = 500,000,000 20250000 = 24.69 EPS Basic > Diluted EPS, security is dilutive in nature www.proschoolonline.com/ 36

Common Size Income Statement Expresses each income statement line item as a percentage of sales Used to analyze changes in cost structure and profitability Used for both cross sectional (across industry) and time series analysis www.proschoolonline.com/ 37

Common Size Income Statement Apple Inc. - Income Statement Year ended 26 September 2009 2008 Net sales 36,537 32,479 Cost of sales (23,397) (21,334) Gross margin 13,140 11,145 Operating expenses: Research and development (1,333) (1,109) Selling, general & administrative (4,149) (3,761) Total operating expenses 5,482 4,870 Operating income 7,658 6,275 Apple Inc. -Common Size Income Statement Net sales 100% 100% Cost of sales -64% -66% Gross margin 36% 34% Operating expenses: Research and development -4% -3% Selling, general & administrative -11% -12% Total operating expenses -15% -15% Operating income 21% 19% www.proschoolonline.com/ 38

Measures of Operating Performance Operating Profitability ratios: Gross Profit Margin = Gross Profit Net Sales Net Profit Margin = Net Profit Net Sales Both are obtained from the common size statement www.proschoolonline.com/ 39

Comprehensive Income Comprehensive income is the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. Total Comprehensive Income = Net Income + Foreign Currency Translation Adjustment + Unrealized gains or losses on derivatives contracts accounted for as hedges + Unrealized gains and losses on available for sale securities + Pension Adjustment to funded status www.proschoolonline.com/ 40

Comprehensive Income Example Opening stock holders equity was $300m. Closing stock holders equity was $500m. On review of statement of stockholders equity we discover that owners contributed $40m of equity during the year. Net Income for the year was $100m and dividends paid were $15m. Calculate the comprehensive income Solution Closing Equity 500 Opening Equity 300 Change in Equity 200 Owners Contribution 40 Other Comprehensive Income 75 Net Income 100 Dividend Paid -15 Net Income 100 125 Other Comprehensive Income 75 Comprehensive Income 175 www.proschoolonline.com/ 41

Diluted EPS Stock Options Example 31/21/2009 Net Income $500,000,000 Common Stock of $10 each 20,000,000 Average Price of stock $20.00 Exercise Price $15.00 Number of Options outstanding 1000000 Basic EPS $25.00 Calculate fully diluted EPS for 2009 = Number of Shares www.proschoolonline.com/ 42