R17 Understanding Income Statements IFT Notes

R17 Understanding Income Statements 2022 Level I Notes
R17 Understanding Income Statements
1. Introduction...................................................................................................................................................... 2
2. Components and Format of the Income Statement .......................................................................... 2
3. Revenue Recognition .................................................................................................................................... 3
3.1 General Principles ................................................................................................................................... 3
3.2 Accounting Standards for Revenue Recognition ......................................................................... 3
4. Expense Recognition: General Principles ............................................................................................. 4
4.1 General Principles ................................................................................................................................... 4
5. Issues in Expense Recognition: Doubtful Accounts, Warranties ................................................. 5
6. Issues in Expense Recognition: Depreciation and Amortization ................................................. 5
7. Implications for Financial Analysts: Expense Recognition ............................................................ 6
8. Non-Recurring Items and Non-Operating Items: Discontinued Operations and Unusual
or Infrequent Items ............................................................................................................................................ 6
8.1 Discontinued Operations ...................................................................................................................... 6
8.2 Unusual or Infrequent Items ............................................................................................................... 6
9. Non-Recurring Items: Changes in Accounting Policy ....................................................................... 7
10. Non-Operating Items .................................................................................................................................. 7
11. Earnings per Share and Capital Structure and Basic EPS............................................................. 8
11.1 Simple versus Complex Capital Structure ................................................................................... 8
11.2 Basic EPS .................................................................................................................................................. 9
12. Diluted EPS: The IF-Converted Method .............................................................................................. 9
13. Diluted EPS: The Treasury Stock Method ........................................................................................ 10
14. Other Issues with Diluted EPS and Changes in EPS...................................................................... 11
15. Common-Size Analysis of the Income Statement .......................................................................... 11
16. Income Statement Ratios ........................................................................................................................ 12
17. Comprehensive Income ........................................................................................................................... 12
Summary .............................................................................................................................................................. 14
Practice Questions ............................................................................................................................................ 17
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1. Introduction
The income statement presents information on the financial results of a company’s business
activities over a period of time. It is also known as the ‘statement of operations’, ‘statement
of earnings’, or ‘profit and loss (P&L) statement’. The basic equation underlying the income
statement is:
Income - Expenses = Net Income
Equity analysts carefully analyze a company’s income statements for use in valuation models
while fixed-income analysts analyze income statements to measure a company’s debt
servicing ability.
2. Components and Format of the Income Statement
Components of the income statement
The components of an income statement are:
Revenues: Income generated from the sale of goods and services in the normal course of the
business. Net revenue is the total revenue minus products that were returned and amounts
that are unlikely to be collected.
Expenses: Costs incurred to generate revenues. Expenses may be grouped and reported in
different formats, subject to some specific requirements.
Gains and losses: Amounts generated from non-operating activities.
Net income: Net income can be calculated as Net income = Revenues – Expenses + Gains –
Losses.
Expenses can be grouped together either by their nature or function.
• Grouping by nature: For example, depreciation on manufacturing equipment and
depreciation on administrative facilities can be grouped together into a single line
item called “depreciation”.
• Grouping by function: For example, labor and material costs, depreciation, salaries of
sales peoples and other direct sales related expenses can be grouped together into a
single line item called ‘cost of goods sold’.
Presentation formats
Income statements can be presented in the following two formats:
• Single-step: All revenues and all expenses are grouped together. There are no sub-
totals.
• Multi-step: It includes subtotals such as gross profit and operating profit.
The table below shows samples for both formats.

Multi-step format Single-step format

$ million 2018 2017 $ million 2018 2017
Sales 35,310 31,600 Sales 35,310 31,600
Cost of sales 10,300 9,060 Cost of sales 10,300 9,060
Gross Profit 25,010 22,540 Gain from sale of equipment 900 860
Administrative expenses 3,400 2,900
Gain from sale of equipment 900 860 Advertising expense 1,000 900
Administrative expenses 3,400 2,900 Depreciation 960 850
Advertising expense 1,000 900 Other expenses 6,500 6,100
Depreciation 960 850 Operating Income (EBIT) 14,050 12,650
Other expenses 6,500 6,100 Interest Expense 10 70
Operating Income (EBIT) 14,050 12,650 Profit before tax (EBT) 14,040 12,580
Interest Expense 10 70 Tax Expense 3,945 3,300
Profit before tax (EBT) 14,040 12,580
Tax Expense 3,945 3,300 Profit after tax 10,095 9,280
Profit after tax 10,095 9,280
3. Revenue Recognition
3.1 General Principles
Under the accrual method of accounting, revenue should be recognized when earned and not
necessarily when cash is received. Let us consider three simple examples to illustrate this
point.
• If a company sells goods for $100 cash in Period 1, can it recognize revenue in Period
1? The answer is yes. Revenue is recorded in the period it is earned, i.e., when goods
or services are delivered.
• What if the company sells goods on credit in Period 1 and expects to receive cash in
Period 2? Can revenue be recognized in Period 1? The answer is that revenue is
recorded in Period 1. In addition, since the goods are sold on credit, an asset called
accounts receivable is created.
• What if an advance payment is received in Period 1 but goods and services are to be
delivered in Period 2. When will the revenue be recognized? The revenue will be
recognized in Period 2 because that is when delivery of goods will take place. In this
case, the company will record a liability called unearned revenue when the advance
payment is received.
Companies must disclose their revenue recognition policies in the notes to their financial
statements, and analysts should read these carefully to understand how and when a
company recognizes revenue.
3.2 Accounting Standards for Revenue Recognition
In May 2014, the IASB and FASB issued converged standards for revenue recognition. The
standards take a principles-based approach to revenue recognition issues. The core principle

behind the converged standard is that revenue should be recognized to “depict the transfer
of promised goods or services to customers in an amount that reflects the consideration to
which the entity expects to be entitled in an exchange for those goods or services.”
According to the standard, the following five steps must be followed in order to recognize
revenue:
1. Identify the contract(s) with a customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the entity satisfies a performance obligation.
When revenue is recognized, a contract asset is added to the balance sheet. If an advance is
received but performance obligations have not been met, then a contract liability is added to
the seller’s balance sheet.
Treatment of related costs
Specific accounting treatment for related costs is summarized below:
• Incremental costs of obtaining a contract or fulfilling a contract must be capitalized.
• If incremental costs were expensed in the years before adopting the converged
standard, then the company’s profitability will appear higher under the converged
standards.
Disclosure requirements
The converged standard mandates the following disclosure requirements:
• Companies must disclose information about contracts with customers after
segregating them into different categories of contracts. The categories may be based
on the geographic region, the type of product, the type of customer, pricing terms, etc.
• Companies must disclose information related to revenue recognition. For example,
any change in judgments, remaining performance obligations, and transaction price
allotted to those obligations, and balances of contract-related assets and liabilities.
4. Expense Recognition: General Principles
Expenses are ‘decreases in economic benefit during the accounting period in the form of
outflows or depletion of assets or incurrences of liabilities that result in decreases in equity.’
For example, if a company pays rent, its cash reduces and the rent is recognized as an
expense.
4.1 General Principles
Matching principle
The most important principle of expense recognition is the matching principle, under which
the expenses incurred to generate revenue are recognized in the same period as revenue.

For example, if some goods bought in the current year remain unsold at the end of the year,
they are not included in the cost of goods sold for the current year. If they are sold in the
next year, they will be included in the cost of goods sold for the next year.
Periodic costs
Expenses that cannot be tied directly to generation of revenues are called periodic costs.
They are expensed in the period incurred. For example, the rent paid for office premises are
simply expensed in the period for which the rent was paid.
Inventory methods
Accounting standards permit the use of following methods to assign inventory expenses:
• ‘First in, first out (FIFO)’ assumes that the earliest items purchased are sold first.
• ‘Last in, first out (LIFO)’ assumes that the most recent items purchased are sold first.
• ‘Weighted average cost’ averages total cost over total units available.
• ‘Specific identification’ identifies each item in the inventory and uses its historical
cost for calculating COGS, when the item is sold.
Instructor’s Note:
We will learn more about these inventory valuation methods in a later reading.
5. Issues in Expense Recognition: Doubtful Accounts, Warranties
Some issues in expense recognition are:
Doubtful accounts
When sales are made on credit, there is a chance that some customers will default. There are
two methods of recognizing credit losses. The first one is to wait for a customer to default
and then recognize a loss. This is called the ‘direct write-off’ method. The second is to record
an estimate of credit losses (using historical data) at the time of revenue recognition. The
matching principle requires the use of the second method.
Warranties
When a company provides warranty, there is a chance that some defective product may need
to be replaced or repaired. There are two methods of recognizing warranty expense. The
first one is to recognize warranty expense when warranty is claimed. The second is to
estimate a warranty expense (using historical data) at the time of revenue recognition. The
matching principle requires the use of the second method.
6. Issues in Expense Recognition: Depreciation and Amortization
Depreciation
It is the process of allocating costs of long-lived assets over the period during which the
assets are expected to provide economic benefits. The first method is called the straight-line

method, where we expense an equal amount of depreciation in each year of the asset’s useful
life. The second method is the declining balance method, where a greater proportion of
deprecation is allocated in the initial years and a lower proportion is allocated in later years.
Amortization
It is the process of allocating costs of intangible assets (a non-physical asset) over its useful
life. Intangible assets with identifiable useful lives (for example a patent that will expire in a
few years) are amortized evenly over their lives. Intangible assets with indefinite lives (for
example goodwill) are not amortized. They are tested for impairment annually. If the asset
value has come down an expense is recorded in the income statement to bring its value
down to the current value.
We will learn more about depreciation and amortization in a later reading.
7. Implications for Financial Analysts: Expense Recognition
A company’s estimates for doubtful accounts, warranty expenses, and depreciation amounts
can affect its net income. If a company’s policies result in early recognition of expenses, it can
be considered a conservative approach. On the other hand, if a company’s polices delay the
recognition of expenses, it can be considered an aggressive approach. Using this as well as
other information contained in the footnotes or disclosures, an analyst can recognize
whether a company’s expense recognition policy is conservative or not. The analyst should
also recognize that it is possible that two companies in the same industry have very different
expense recognition policies.
8. Non-Recurring Items and Non-Operating Items: Discontinued
Operations and Unusual or Infrequent Items
Analysts are generally trying to estimate and assess future earnings of a company. Hence,
reporting standards require firms to separate income and expense items that are likely to
continue in the future, from items that are not likely to continue. (You will be more
interested in items that will continue as compared to one-time items.)
8.1 Discontinued Operations
A discontinued operation is an operation which a company has disposed of or plans to
dispose of. Net income from discontinued operations is shown (as a separate line item on
the income statement) net of tax after net income from continuing operations.
Since the discontinued operation will no longer provide earnings to the company, an analyst
may exclude discontinued operations when forecasting future earnings.
8.2 Unusual or Infrequent Items
Both IFRS and US GAAP allow recognition of items that are unusual or infrequent (but not
both). These items are also called exceptional items i.e. items not “inherent” to the

company’s current activities. Examples include restructuring charges and gains/losses from
sale of equipment, receipts from a legal case, costs of integrating an acquisition, and
impairment of intangible assets, etc. These items are shown as part of a company’s
continuing operations.
While forecasting future earnings, an analyst should asses whether the items reported as
unusual or infrequent are likely to reoccur. Analysts should not simply ignore all unusual
items.
9. Non-Recurring Items: Changes in Accounting Policy
At times, new accounting standards may require companies to change accounting policies.
An example can be changing the inventory valuation method from last in, first out (LIFO) to
first in, first out (FIFO). Companies are allowed to adopt standards prospectively (in the
future) or retrospectively.
• Retrospective application means that the financial statements for previous years are
presented as if the newly adopted accounting principle had been used throughout the
period. A change in accounting policy is applied retrospectively. For example, if a
company shifts from LIFO valuation method to FIFO valuation method, this change will
require a retrospective application.
• Prospective application means that only the financial statements for the period of change
and for future periods are changed. Financial statements for previous years are not
changed. At times, new standards might require companies to change accounting
estimates such as the useful life of a depreciable asset. Changes in accounting estimates
are applied prospectively.
• Correction of an error for a prior period is another possible adjustment which requires a
restatement of the four major financial statements. If a company is making corrections
very often, this gives a negative signal and investors will avoid investing in such a
company.
Modified retrospective approach: According to new revenue recognition standards,
companies can also use “modified retrospective” method of adoption. Under this approach,
companies can adjust opening balances of retained earnings (and other applicable accounts)
for the cumulative impact of the new standard. They are not required to revise previously
reported financial statements.
10. Non-Operating Items
Non-operating items are typically reported separately from operating income because they
are material and/or relevant to the understanding of the company’s financial performance.
Under IFRS, there is no definition of operating activities and companies need to use
judgment about which items can be classified as operating and non-operating.

Under US GAAP, operating activities generally involve producing and delivering goods and
providing services. All other transactions and events are defined as investing or financing
activities. For example, interest expense would be an operating item for a bank but would be
non-operating for a manufacturing firm.
In practice, investing and financing activities may be disclosed on a net basis. For example, a
manufacturing firm may report net interest expense (interest expense minus interest
revenue) in its income statement. The footnotes to the financial statements can provide
further disclosure about the net interest expense. The figure below shows a visual depiction
of an income statement for a manufacturing firm following US GAAP.
Revenue or Income
Operating Expenses
Cost of Goods Sold
SG&A
Depreciation
Unusual or Infrequent Items
Operating Income
Non-Operating Expenses
Interest Expense
Extraordinary Items
EBT (continuing operations)
Taxes
NI (continuing operations)
Earnings from discontinued operations net of taxes
Net Earnings or Net Income
11. Earnings per Share and Capital Structure and Basic EPS
11.1 Simple versus Complex Capital Structure
Earnings per share (EPS) is a very important profitability measure. It depicts the earnings
per ordinary share. Some basic terminologies related to EPS are:
• Potentially dilutive securities: Securities that can be converted into ordinary shares
are called potentially dilutive securities. This includes convertible bonds, convertible
preferred stock, and employee stock options.
• Simple capital structure: If a company has no potentially dilutive securities it is said
to have a simple capital structure.
• Complex capital structure: If a company has potentially dilutive securities it is said to
have a complex capital structure.
• Dilutive securities: A potentially dilutive security that decreases EPS when exercised
is called a dilutive security.

• Antidilutive security: A potentially dilutive security that increases EPS when

exercised is called an antidilutive security.
11.2 Basic EPS
Basic EPS is the amount of income available to common shareholders divided by the
weighted average number of common shares outstanding over a period. Basic EPS is
calculated as:
Net income − Preferred dividends
Basic EPS =
Weighted average number of shares outstanding
In this calculation we do not consider the effect of any potentially dilutive securities.
Weighted average number of shares outstanding is the number of shares outstanding
during the year, weighted by the portion of the year they were outstanding. Stock splits and
stock dividends are applied retroactively to the beginning of the year, so the old shares are
converted to new shares for consistency.
Example
During 2018, Company ABC had a net income of $100,000. It paid $22,000 as dividends to its
preference shareholders and $12,000 as dividends to its common shareholders. The number
of common shares outstanding during 2018 was as follows:
Shares as of January 1, 2018: 10,000
Additional shares issue on July 1, 20181: 2,000
Calculate the basic EPS of the company for 2018.
Solution:
We had 10,000 shares outstanding for the first 6 months and 12,000 shares outstanding for
the last 6 months.
Therefore weighted average number of shares outstanding = 10,000 x 6/12 + 12,000 x 6/12
= 11,000 shares.
$100,000 − $22,000
Basic EPS = = $8
11,000
Note: We ignore dividend paid to common shareholders.
12. Diluted EPS: The IF-Converted Method
In this calculation, we consider the effect of potentially dilutive securities. If a firm has a
complex capital structure it has to report both basic and diluted EPS. Diluted EPS is
calculated as:
Net Income + After tax interest − Preferred dividend + convertible preferred dividends
Diluted EPS =
Weighted Average Shares + New shares if convertible debt is converted
For preference shares, we need to subtract preference share dividends from the numerator
and add new shares issued from conversion to the denominator.

Example
During 2018, Company ABC had a net income of $100,000. It paid $22,000 dividends to its
preference shareholders and $12,000 dividends to its common shareholders. It had 2,200
preference share and 11,000 common shares outstanding during 2018. Each preference
share is convertible into 2 shares of common stock. Calculate the diluted EPS for the
company.
Solution:
Number of common shares issued upon conversion = 2,200 x 2 = 4,400
NI + conv debt int (1 − t) − pref div + conv pref div
Diluted EPS =
Wt avg shares + New shares issued
$100,000 + 0 − $22,000 + $22,000
Diluted EPS = = $6.5
11,000 + 4,400
For convertible bonds, we need to add the after tax interest cost savings to the numerator
and new shares issued from conversion to the denominator.
Example
During 2018, Company ABC had a net income of $100,000. The capital structure of the
company for 2018 was as follows:
11,000 common shares
1,000 convertible bonds with par value of $100 and 10% coupon; convertible to 5,000
shares
The tax rate of the company is 30%.
Calculate diluted EPS.
Solution:
Number of common shares issued upon conversion = 5,000
Interest payable on the bonds = 100 x $1,000 x 10% = $10,000
Diluted EPS =
$100,000 + $10,000 x 0.7 − $0 + $0
11,000 + 5,000
13. Diluted EPS: The Treasury Stock Method
For stock options, we use the ‘Treasury Stock Method’, which assumes that the
hypothetical funds received by the company from the exercise of options are used to
purchase shares of the company’s common stock at the average market price over the
reporting period. Thus, the numerator is unchanged and the number of shares to be added to

the denominator = the number of shares created by exercising the options – number of
shares hypothetically repurchased with the proceeds of the exercise.
Example
During 2018, Company ABC had a net income of $100,000. It paid $22,000 dividends to its
preference shareholders and $12,000 dividends to its common shareholders. The capital
structure of the company for 2018 was as follows:
11,000 common shares
1,000 stock options outstanding, that have an exercise price of $20.
During 2018, the average market price for the company’s share was $25.
Calculate the diluted EPS.
Solution:
Number of common shares issued upon conversion = 1,000
Cash proceeds from the exercise of options = 1,000 x 20 = $20,000
Number of shares that can be purchased at the average market price with these funds =
$20,000/25 = 800
Net increase in common shares outstanding = 1,000 – 800 = 200
Diluted EPS =
$100,000 + $0 − $22,000 + $0
11,000 + 200
14. Other Issues with Diluted EPS and Changes in EPS
Some potentially convertible securities could be antidilutive. Including them in the
calculations would result in an EPS that is higher than the company’s basic EPS. Such
securities should not be included in the calculation of diluted EPS.
Assess each instrument individually and determine if it is dilutive or not. Only instruments
which are dilutive must be included in the diluted EPS calculation.
Changes in EPS
In general, an EPS can increase either due to an increase in net income, a decrease in the
number of shares outstanding, or a combination of both.
15. Common-Size Analysis of the Income Statement
Common-size income statement presents each line item on the income statement as a
percentage of revenue. This format standardizes the income statements and helps remove

the effects of company size. They are useful to comparisons across time periods and across
companies.
16. Income Statement Ratios
The income statement is used to calculate income statement ratios to evaluate a firm’s
profitability. The commonly used ratios are:
Gross profit margin = Gross profit / Revenue
Operating profit margin = Operating profit / Revenue
Net profit margin = Net profit / Revenue
High margin ratios are desirable. A firm can increase its margins by either increasing selling
price or by lowering costs, or both.
An example of a common size income statement is shown below.
2018 % 2017 %
Revenue $100,000 100% $110,000 100%
Cost of goods sold $60,000 60% $65,000 59%
Gross profit $40,000 40% $45,000 41%
SG&A $10,000 10% $11,000 10%
Depreciation expense $10,000 10% $11,000 10%
Operating profit $20,000 20% $23,000 21%
Interest expense $5,000 5% $5,500 5%
Earnings before taxes $15,000 15% $17,500 16%
Taxes (10%) $1,500 1.5% $1,750 1.6%
Net income $13,500 13.5% $15,750 14.3%
Looking at the above common-size statement, we can conclude that, the profitability margins
of this company have improved in 2018 as compared to 2017.
17. Comprehensive Income
Other comprehensive income
Other comprehensive income includes transactions that are not included in net income. Four
types of items treated as other comprehensive income under both IFRS and U.S. GAAP are:
• Unrealized gain/losses from available for sale securities.
• Foreign currency translation adjustments.
• Unrealized gains/losses on derivative contracts used for hedging.
• Adjustments for minimum pension liability.
Besides the items stated above, under IFRS, other comprehensive income includes certain
changes in the value of long-lived assets that are measured using the revaluation model
rather than the cost model. Further, under IFRS, reclassification of items from OCI to P&L is
not allowed.

Instructors Note: At Level I, you need to remember the above stated items; these are
explained in detail at level II.
Comprehensive income
Comprehensive income measures all changes to equity apart from those resulting from
transactions with shareholders (For example, dividends paid and stocks repurchased are not
included in comprehensive income.) Comprehensive income is conceptually same under
both IFRS and US GAAP. It is the sum of net income and other comprehensive income.
Example
Company ABC’s beginning shareholder equity was $100 million; its net income for the year
was $10 million. Cash dividends of $2million were paid to shareholders during the year. The
company's actual ending shareholder equity is $113 million. Calculate OCI.
Solution:
Amount that has bypassed the income statement = OCI = $113 – ($100+$10-$2) = $5 million.

Summary
LO.a: Describe the components of the income statement and alternative presentation
formats of that statement.
The components of an income statement are:
• Revenue
• Expenses
• Gains and Losses
• Net income
There are two ways of presenting an income statement:
• Single step format - All revenues and all expenses are grouped together.
• Multi-step format - It includes subtotals such as gross profit and operating profit.
LO.b: Describe general principles of revenue recognition and accounting standards for
revenue recognition.
According to the accrual method of accounting, revenue is recognized when earned and
expenses are recognized when incurred.
LO.c: Calculate revenue given information that might influence the choice of revenue
recognition method.
Firms can use any revenue recognition technique provided there is a rationale behind their
choice. Firms using an aggressive revenue recognition method will most likely inflate the
earnings of the current period and later periods. An analyst should consider the effects
different revenue recognition methods can have on the financial statements of a company.
LO.d: Describe general principles of expense recognition, specific expense recognition
applications, and implications of expense recognition choices for financial analysis.
The most important principle of expense recognition is the matching principle, under which
the expenses incurred to generate revenue are recognized in the same period as revenue.
Expenses that cannot be tied directly to generation of revenues are called periodic costs.
They are expensed in the period incurred.
Inventory methods: Accounting standards permit the use of the following methods to assign
inventory expenses:
• FIFO
• LIFO
• Weighted average cost
• Specific identification
Some issues in expense recognition are:
• Doubtful accounts: Record an estimate of credit losses (using historical data) at the
time of revenue recognition.

• Warranties: Expense an estimated amount at the time of revenue recognition.

• Depreciation: It is the process of systematically allocating costs of long-lived assets
over the period during which the assets are expected to provide economic benefits.
Depreciation methods include:
o Straight line method.
o Declining balance method.
Using the above mentioned accounts and information contained in the footnotes or
disclosures, an analyst can recognize whether a company’s expense recognition policy is
conservative or not.
LO.e: Describe the financial reporting treatment and analysis of non-recurring items
(including discontinued operations, unusual, or infrequent items) and changes in
accounting standards.
Net income from discontinued operations is shown net of tax after net income from
continuing operations.
Both IFRS and U.S. GAAP allow recognition of unusual or infrequent (but not both) items.
Changes in accounting policies can be adopted retrospectively (the financial statements for
all fiscal years are presented as if the newly adopted accounting principle had been used
throughout the period) or prospectively (only the financial statements for the period of
change and for future periods are changed).
LO.f: Contrast operating and non-operating components of the income statement.
Non-operating items are typically reported separately from operating income because they
are material and/or relevant to the understanding of the company’s financial performance.
Under IFRS, there is no definition of operating activities so judgment is required to
distinguish between operating and non-operating income. Under U.S. GAAP, operating
activities generally involve producing and delivering goods and providing services. All other
activities are non-operating.
LO.g: 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.
When a company has simple capital structure, basic EPS is calculated using the formula:
Net Income − Preferred dividends
Basic EPS =
Weighted Average Number of Shares Outstanding
When a company has complex capital structure, diluted EPS is calculated using the formula:
Net Income + After tax interest − Preferred dividend + convertible preferred dividends
Diluted EPS =
Weighted Average Shares + New shares if convertible debt is converted
LO.h: Contrast dilutive and antidilutive securities, and describe the implications of
each for the earnings per share calculation.

Dilutive securities are stock options, convertible debt, warrants, and convertible preferred
stock that decrease EPS when converted to common stock.
Antidilutive securities are stock options, convertible debt, warrants, and convertible
preferred stock that increase EPS when converted to common stock.
LO.i: Formulate income statements into common-size income statements.
Common-size analysis of the income statement can be performed by stating each line item
on the income statement as a percentage of revenue. Common-size statements facilitate
comparison across time periods as well as across companies because the standardization of
each line item removes the effect of size.
LO.j: Evaluate a company’s financial performance using common-size income
statements and financial ratios based on the income statement.
Net profit margin is calculated as: Net Income / Sales. This indicates how much income a
company was able to generate for each dollar of revenue.
Gross profit margin is calculated as: Gross Profit / Sales. Where gross profit is calculated as
revenue minus cost of goods sold.
Operating profit margin is calculated as: Operating Profit/ Sales.
Analysts can use these profit margins to compare over time and with industry peers.
LO.k: Describe, calculate, and interpret comprehensive income.
Comprehensive income = Net income + other comprehensive income (OCI)
It measures all changes in equity except for owner contributions and distributions.
LO.l: Describe other comprehensive income, and identify major types of items
included in it.
Other comprehensive income includes transactions that are not included in net income. Four
types of items treated as other comprehensive income under both IFRS and U.S. GAAP are:
• Unrealized gain/losses from available-for-sale securities.
• Foreign currency translation adjustments.
• Unrealized gains/losses on derivative contracts used for hedging.
• Certain costs of a company’s defined benefit post-retirement plans.

Practice Questions
1. The income statement least likely includes which of the following elements?
A. Depreciation.
B. Income tax payable.
C. Operating profit.
2. According to the converged accounting standards issued by IASB and FASB, which of the
following is the first step in the revenue recognition process ?
A. Determine the transaction price.
B. Identify the performance obligation.
C. Identify the contract.
3. ITminds has a five year license to provide fund accounting services to an asset
management company. The total amount of the IT accounting software fee that ITminds
will receive is USD 30,000. Revenue is recognized on a prorated basis as it is a long term
contract. What revenue would ITminds. recognize at the end of year 1?
A. USD 0.
B. USD 6,000.
C. USD 7,500.
4. Retrospective restatement of all prior period financial statements is least likely required
for a change from:
A. FIFO to LIFO inventory valuation.
B. Zero salvage value to positive salvage value.
C. Capitalization of borrowing costs to expensing borrowing costs.
5. For a nonfinancial firm, which of the following would most likely be included in operating
expenses in the income statement?
A. Interest expense.
B. Depreciation expense.
C. Both interest expense and depreciation expense.
6. An analyst has gathered the following information about a company:

• Net income: $250,000.
• Average number of shares outstanding: 100,000.
• 2,000, 8%, $1,000 face value bonds convertible into 15 shares each, outstanding at the
beginning of the year.
• The tax rate is 40%.
The company’s diluted EPS is closest to:
A. $2.2

B. $2.5
C. $2.8.
7. An analyst has gathered the following information about a company:

• 100,000 average shares outstanding during the year.
• 1,000 warrants outstanding with exercise price of $10
• The stock is selling at year end at $8.
• The average stock price during the year was $15.
How many shares should be used in calculating the company’s diluted EPS?
A. 100,000.
B. 100,333.
C. 101,000.
8. A company has earnings of 12 million for 2018. The preferred dividend for the year is 3
million and the common stock dividend is 2 million. The number of shares outstanding for
the year is 15 million. What is the basic EPS?
A. 0.60.
B. 0.67.
C. 0.75.
9. In a vertical common-size income statement, each category of the income statement is

expressed as a percentage of:
A. gross profit.
B. assets.
C. revenue.
10. Which of the following would be least likely included in comprehensive income?
A. Dividends paid to common shareholders.
B. Gains and loss from foreign currency translation.
C. Unrealized gains and losses from cash flow hedging derivatives.
11. The following information is from a company’s accounting records:

$ millions
Revenues for the year 5,500
Total expenses for the year 3,500
Gains from available-for-sale securities 425
Gain on foreign currency translation adjustments on a foreign subsidiary 655
Dividends paid 230
The company’s total comprehensive income (in USD millions) is closest to
A. 1,080.

B. 2,850.
C. 3,080.

Solutions
1. B is correct. Income tax payable is a balance sheet element. Both depreciation and
operating profit are included in the income statement.
2. C is correct. Under the converged standards, the five steps in the revenue recognition
process are:
• Identify the contract(s) with a customer
• Identify the performance obligations in the contract
• Determine the transaction price
• Allocate the transaction price to the performance obligations in the contract
• Recognize revenue when (or as) the entity satisfies a performance obligation
3. B is correct. The revenue recognized will be the total amount divided by the time period.
Therefore, USD 30,000 / 5 = USD 6,000. (The revenue for each period will be USD 6,000,
adding up to USD 30,000 over five years.)
4. B is correct. Changes in accounting principle require retrospective restatement of all prior-

period financial statements. A change in the salvage value of an asset is a change in
accounting estimate, which does not apply retrospectively.
5. B is correct. Depreciation expense is included in operating expenses. Interest expense is

excluded from operating expenses because it is a financing cost.
6. B is correct.
Net Income − Preferred dividends
Basic EPS =
weighted average number of common shares outstanding
Basic EPS = $250,000/100,000 = $2.5
Check if the convertible bonds are dilutive
(NI − Preferred dividends) + (converible debt interest)(1 − t)
Diluted EPS =
wt avg common shares + shares from conversion of conv. debt
convertible debt interest (1 − t)
convertible debt shares
Numerator impact = (2,000 x 1,000 x 0.08) x (1 – 0.4) = 96,000
Denominator impact = 2,000 x 15 = 30,000
Per share impact = 96,000 / 30,000 = $3.2
Since $3.2 is greater than the basic EPS of $2.5, the bonds are antidilutive. Thus, diluted
EPS = Basic EPS = $2.5.
7. B is correct. Since the exercise price of the warrants is less than the average stock price,
the warrants are dilutive. The year-end stock price is not relevant. With warrants, the

treasury stock method is used. Under this method the company would receive 1,000 x $10
= $10,000 and would repurchase $10,000/15 = 667 shares. Therefore, the number of
shares used in calculating the company’s EPS would be
Shares outstanding 100,000
Warrants exercised 1,000
Treasury shares purchased -667
Total 100,333
(Net Income – Preferred Dividend) 12−3

8. A is correct. Basic EPS = = = 0.60.
Number of shares outstanding 15
9. C is correct. In a vertical common-size income statement, each category of the income

statement is expressed as a percentage of revenue.
10. A is correct. Comprehensive income includes all changes to equity except transactions with
shareholders. Therefore, dividends paid to common shareholders are not included in it.
11. C is correct. Total comprehensive income = Net income + other comprehensive income
Net income = Revenues – Expenses
Other comprehensive income includes gains or losses on available-for-sale securities and
translations adjustments on foreign subsidiaries.
(Revenues – Expenses) + Gain on AFS + Gain on FX translation
(5500 – 3500) + 425 + 655 = 3,080.

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R17 Understanding Income Statements 2022 Level I Notes

R17 Understanding Income Statements

© IFT. All rights reserved 1

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Multi-step format Single-step format

Profit after tax 10,095 9,280

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• Antidilutive security: A potentially dilutive security that increases EPS when

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• Warranties: Expense an estimated amount at the time of revenue recognition.

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6. An analyst has gathered the following information about a company:

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7. An analyst has gathered the following information about a company:

9. In a vertical common-size income statement, each category of the income statement is

11. The following information is from a company’s accounting records:

© IFT. All rights reserved 18

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4. B is correct. Changes in accounting principle require retrospective restatement of all prior-

5. B is correct. Depreciation expense is included in operating expenses. Interest expense is

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(Net Income – Preferred Dividend) 12−3

9. C is correct. In a vertical common-size income statement, each category of the income

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