UNDERSTANDING THE INCOME STATEMENT
LOS 32.k: State the accounting classification for items that are excluded
At the end of each accounting period, the net income of the firm is added to stockholders' equity through an account known as retained earnings. Therefore, any transaction that affects the income statement (net income) willalso affect stockholders' equity. However, not all accounting transactions are reported in the income statement.
For example, issuing stock and reacquiring stock are transactions that affect
stockholders' equity but not net income. Dividends paid reduce stockholders' equity, but they do not reduce in net income. Finally, transactions included in other
comprehemive income affect equity but not net income. Other comprehensive income includes:
1. Foreign currency translation gains and losses.
2. Adjustments for minimum pension liability.
3. Unrealized gains andlosses from cash flow hedging derivatives.
4. Unrealized gains and losses from available-far-sale securities.
AvtliLabLeIor-salt: semrities ~lre investment securities that are not expected ro be held to maturity or sold in (he near term. AV~lil~lble-rãor-.,alesecurities are reported on the balance sheet at f.lii value. The unrealized l!;ains :lnd losses (the changes in r:lir valuec ~ before the securities'~ltesold) are not reported in (he incol11e statement but are reported directly in stockholders' equity as ;1 cOl11f)onent or' ,)ther comprehensive income,
Stud)' Session ~
Cross-Reference to CFA Institute Assigned Reading #32 - Understanding the Income Statement
LOS .12.1: Descrihe and calculate comprehensive Income.
Comprehensive income is a measure that includes all changes.to equity other than owner contributions and distributions. That is. comprehensive income aggregates net income and other comprehensive income (foreign currency translation gains and losses, minimum pension liability adjustments. and unrealized gains and losses on cash flow hedging derivatives and available-for-sale securities).
Example: Calculating comprehensive income
Calculate comprehensive income for Triple C Corporation using the selected financial statement data found in the following table.
Triple CCorporation - Selected Financial Statement Data
$1,000 (15) 30
$1,000
Unrealizedgain from cash flow hedge
Unrealized loss from foreign currency translation
. ,-..-: '
Netinwrne Net income
Dividends received from available-for-sale securities
:_-----.-
Unrealized loss from available-for-sale securities Unrealized loss from foreign currency translation Dividend.spaid
ããããR~J~qJiie~()I!lmonstock
." Unrealized gain from cash flow hedge
U~ieillizedlossfrom avirilable-for-salesecurities
C6niIm:bensive income
The dividends received for available-foNale securities and: the realizc:d gainonthe saleofland are already included in net income. Dividends paid and the reacquisition of common srock are transactions with shareholders, so they are not included in comprehensive income.
Page 74 ©2008 Schweser
Study Session H Cross-Reference to CFA Institute Assigned Reading #32 - Understanding the Income Statement
1. Revenue is recognized when realized and earned. Revenue is realized when payment is reasonably assured and revenue is earned when the seller has fulfilled all its obligations to provide goods or services.
2. There are five differenr revenue recognition methods:
• At delivery - earnings process complete and payment is assured.
• Percenrage-of-completion - recognize revenue as work is performed.
• Completed-contract - recognize revenue when contract is complete.
• Installmenr method - recog.nize revenue as cash is collected.
• Cost recovery method - recognize revenue once collections exceed cost.
3. There are three special income statemenr items:
• Unusual or infrequenr items - reported before tax and above income from
. . .
contInuing operatIons.
• Extraordinary items - both unusual and infrequenr. Reported below income from conrinuing operations, net of tax.
• Disconrinued operations - reported below income from conrinuing operations, net of tax.
4. A change in accounring principle requires retrospective restatemenr (of prior financial statemenrs), while a change in an accounring estimate is a;-,plied prospectively (to subseq uenr periods).
5. The matching principle requires that firms match expenses incurred to generate revenues with the revenues. The matching principle also applies to invenrory (cost of goods sold) and long-lived assets (depreciation).
6. Under FIFO, invenrory purchased firstisassumed to be sold first. Under LIFO, invenrory purchased last is assumed to be sold first.
7. As compared to the straight-line method, accelerated depreciation methods will result in higher expenses in the early years and lower expenses in the later years of an asset's useful life.
8. A simple capital structure is one that contains no potentially dilutive securities, while a complex capital structure contains potentially dilutive securities such as options, warrants, or convertible securities.
9. The basic EPS calculation (the onlv EPS for firms with a simple capital structure) is:
b . EPS net income - preferred dividends
aSlc == - - - ' - - - - weighted average number of common shares outstanding 10. Calculating the weighted average number of common shares outstanding:
• Stock splits and dividends result in the additional shares being considered outstanding from the beginning of the vear.
• Shares issued enter into the computarion from the date of issuance.
• Reacquired shares are excluded from tl1e compuration from the date of reacquisitIOn.
11. Dilutive securities~lre stock options. W~lrLlnrs.convC[tible debt, or convertible preferred stock that decrease EPS ifexercised or converted to common srock.
12. Antidilutive securities .lte those that would increas<: EPS if exercised or converted to common srock.
Page 7'i
Stud," Scssi'"1 ~
Cross-Rd'crcl1n: toCFA Institute Assi~l1l'dReading #32 - Understanding thc Income Statement
13. Calculating diluted EPS with a complex capital structure:
I . -] rconverriblej [Converrible- net lI1come - preferred. . +l e dnrelt?ITe + d be t (1- r)
d"'ldends r. . .
L dtvldends tm erest
diIIIted EPS =---,,----;---,---=---;---'=----=----,--.,.---='---~
weigh ted: [" shares .fiãom : [Shares .from 1[. shares I
average + COl1\'erSlon of + conversion of + Issuable fromj
shares con\'. pfd. shares conv. debt) srock options 14. Warrants and options are pOtentiall~'dilutive. In the diluted EPS calculation, if
the average marker price is greater than tbe exercise price, tbe number of shares is adjusted by adding:
average market price - exercise price b f h
L X n urn er0 s ares
average market price
15. A company with a complex capital structure must repon both basic and diluted EPS.
16. A common-size income statement expresses each line item as a percentage of sales.
17. Gross profit margin and net profit margin are profitability ratios.
18. Comprehensive income includes all changes in equity other than from transactions with shareholders, such as gains and losses from foreign currency translation, cash flow hedging derivatives, and available-for-sale securities.
Pension obligation adjustments are also included.
StuJy Se"ion H Cross-Reference to CFA Institute Assigned Reading #32 - Understanding the Income Statement
1. For a nonfinancial firm, are depreciation expense and interest expense incl uded or excluded from operating expenses in the income statement?
Depreciation expense Interest expense
A. Included Included
B. Included Excluded
C. Excluded Included
D. Excluded Excluded
2. Are income taxes and cost of goods sold examples of expenses classified by nature or classified by function in the income statement?
Income taxes Cost of goods sold
A. Nature Nature
B. Nature Function
C. Function Nature
D. Function Function
3. Which of the following is least Likelya condition necessary for revenue recognition?
A. The price has been determined.
B. The goods have been delivered.
C. There is evidence of an arrangement between the buyer and seller.
D. Cash has been collected.
4. AAA has a contractto build a building for $100,000 with an estimated time to
completion of three years. A reliable cost estimate for the project is $60,000.
In the first year of the project, AAA incurred costs tOtaling $24,000. How much profit should AAA report at the end of the first year under the percentage-of-completion method and the completed-contract method'
Percen tage-o f-completion 'Completed-contract
A. $16,000 $0
B. $16,000 516,000
C. $40,000 SO
D. $40,000 $40,000
5. Which principle requires that cost of goods sold be recognized in the same period in which the sale of the related inventory is recorded?
A. Going concern.
B. Certainty.
C. Matching.
D. Economic.
6. Which0['the ['ollowing would Lei/st!ike~l' increase pret~lX income?
A. Decreasing the bad debt expense estinute.
B. Decreasing the residual value of~l depreciable tangible ~lsser.
C. Decreasing the warranty expense estimate.
D. Increasing the useful life of~ln inr~lngible ~lsser.
Stlld,' Scssi<'11 ~
Cross-Reference(0 eFAInstinlte Assignlãd Reading #32 - Understanding the Income St;l(Cl1ll'l1l
7. \X'hen ac(ounrin~for invenror~" arc the Erst-in. first-our (FIFO) and last-in, first-our (LIFO) cost flow aSSlll11ptions permitted under U.S. GAAP?
Fire) UFO
A. 't'cs Yes I',. Yes No
C. No Yc,
D. No No
8. Which of the following beN describes the impact of depreciating equipment with a useful life ofGyears using the declining balance method as compared to the straight-line method'
A. Total depreciation expense will be higher over the life of the equipment.
B. Depreciation expense will be higher in the first year.
C. Scrapping the equipment afrer Eve years will resulr in a larger loss.
D. Ner income will be higher over the life of rhe equipment.
9. CC Corporation reported rhe following inventory transactions (in chronological order) for the year:
Purchase 40 units at $30 20 units at $40 90 units at $50
Sale.r 13 units ar $35 35 units ar $45 60 units at $60
Page 7f!
10.
Assurr:ing inventory at the beginning of the year was zero, calculate the year- end inãentory using FIFO and LIFO.
Hã~D. LlEQ.
A. $5,220 $1,280 B. $5,220 51.040 C. $2.100 $1,280 D. $2.100 $1,040
Ar the beginning of the year, Triple W Corporation purchased a new piece of equipmem to be used in its manufacturing operation. The cost of the
equipment was S25,000. The equipment is expecredto be used for 4 years and then sold for $4,000. Depreciation expense tobe reponed for the second year using the double-declining-balance merhod is closest to:
A. $0.
B. $5,250.
C. $6,250.
D. S7.000.
Study Session 8 Cross-Reference to CFA Institute Assigned Reading #32 - Understanding the Income Statement 11. Which of the following is least likely considered a nonoperating transaction
from the perspective of a manufacturing firm)
A. Dividends received from available-for-sale securities.
B. Interest expense on subordinated debentures.
e. Accruing bad debt expense for goods sold on credit.
D. Recognizing an extraordinary loss from the destruction of a building.
12. Changing an accounting estimate:
A. is reported prospectively.
B. requires restatement of all prior-period statements presented in the current financial statements.
e. is ignored for purposes of income statement analysis.
D. is reponed by adj usting the beginning balance of retained earnings for the cumulative effect of the change.
13. Which of the following transactions would most likely be reported below income from continuing operations, net of tax?
A. Gain or loss from the sale of equipment used in a firm's manufacturing operatIOn.
B. A change from the accelerated method of depreciation to the straight-line method.
e. Impairment charges and restructuring costs.
D. The operating income of a physically and operationally distinct division that is currencly for sale, but not yet sold.
14. Which of the following statements about nonrecurring items is least accurate?
A. Gains from extraordinary items are reported net of taxes at the bottom of the income statement before net income.
B. Unusual or infrequent items are reported before taxes above net income from continuing operations.
e. A change in accounting principle is reported in the income statement net of taxes after extraordinarv items and before net income.
D. Losses from discontinued operations are reported net of taxes at the bottom of the income statement before net income.
15. The Hall Corporation had 100,000 shares of common stock outstanding at the beginning of the year. Hall issued .30, 000 shares of common stock on May 1.
On July 1, the companv issued a 10% stock dividend. On September 1, Hall issued 1,000, 10% bonds. each convertible into 21 shares of common stock.
What is the weighted average number of shares to be used in computing basic and diluted IPS. assuming the convertible bonds are dilutive?
Average shares, Aver~lgeshares .
.i:lli.lli:. dilutive
A. 1.30,000 132.000
B. 132,000 139.000
e. 1.32.000 1'-t6.000
D. 139,000 I~6.000
Stud\' Se""i,111 S
Cross-Reference to CFA Institute Assigned Reading#.12 - Understandingthe IncomeSt:llCI11CIll
16. Given the following information. how many shares should be used in computing diluted EPS>
.'100.000 shares outstanding.
100.000 warrants exercisable at $50 per share.
Average share price is $55.
Year-end share price is $60.
A. 9.091.
B. 90,')09.
C. 309,091.
D. 390,909.
17. An analyst gathered the following information about a company:
100,000 common shares outstanding from the beginning of the year.
Earnings of $125.000.
1,000, 7% $1,000 par bonds convertible into 25 shares each, outstanding .as of the beginning of the year.
The tax rate is 40%.
The company's diluted EPS is closest ro:
A. $1.22.
B. $1.25.
C. $1.34.
D. $1.42.
18. An analyst has gathered the following information about a company:
50,000 common shares outstanding from the beginning of the year.
Warrants outstanding all year on 50,000 shares, exercisable at $20 per share.
Srock is selling at year end for $25.
The average price of the company's stock for the year was $15.
How many shares should be used in calculating the company's diluted EPS?
A. 16,667.
B. 33,333.
C. 50,000.
D. 66,667.
Page 80
19.
20.
To study trends in a firm's COSt of goods sold (COGS), the analyst should standardize COSt of goods sold by dividing it by:
A. sales.
B. assets.
C. net mcome.
D. prior year COGS.
Which of the following ratios is a measure of profitability?
A. Current ratio.
B. Fixed asset turnover ratio.
C. Long-term debt-to-rotal capital ratio.
D. Pre-tax margin ratio.
©2008 Schweser
21.
StllJySCS;J"f] H Cross-Reference to CFA Institute Assigned Reading #32 - Understanding the Income Statement Which of the following transactions affects owners' equity but does not affect
net income?
A. Realized loss on sale of investment securi ties.
B. Foreign currency translation gain.
C. Repaying the face amount on a bond issued at par.
D. Dividends received from available-for-sale securities.
22. Which of the following is least likely to be included when calculating comprehensive income?
A. Unrealizedloss from cash flow hedging derivatives.
B. Unrealized gain from available-for-sale securities.
C. Minimum pension liability.
D. Dividends paid to common shareholders.
©2008 Schwc'scr
Study S"ssion I'
Cross- Reference to CFA I nSlitu(tã Assigned Read ingIf.12 - U nderst;lI1ding the Income 51a temenI
'ANSWERS - CONCEPT CHECKERs). , . , ' .< • •
, . ~
I. B [)cpreci;trion is incllided in rhe cOl11put;ltion 0['operating exp<:nses. Interest expense is
;1 financing ('ost. ThllS. it is ex,'luded (rom opnaring expcnses.
1 B Incol11c raxcs ;He l'XpeIlSCS groupcd IOgerher hI' rhcir narure. Cosr of goods sold includes a number of expenses relarcd ro rhe sal11e funcrion, rhc producrion of Inycl1[OI"\',
3, D In order to recognize revenue. rhe seller musr knOll' the sales price and be reasonably surr of collection, ;\ctual collection of cash is nor required.
4. A £24.000/$60.000:= 400;(, of the projecr completed. 40% of £ I 00,000:= $40.000 re\'t'llue. $40.000 re\'enue - 524.000 cosr := 5l6.000 proflr for rhe period. No proflr would be reponed in the first }'ear using the complered contract merhod.
5. C The matching principle requires thar the expenses incurred to generare the revenue be recognized in the same accounting period as rhe reven ue.
6. B Decreasing the residual (salvage) value of a depreciable long-lived asset will result in higher depreciation expense and. rhus, lower pretax income.
7 A LIFOandFIFOare borh permitted under U.S. GAi\P. LIFO is prohibired underIFRS.
8. B Accelerared depreciation will resulr in higher depreciation in the earl" years and lower depreciation in the larer years comparedtothe straight-line method. Total depreciation expense will be the same under both methods. The book "alue would be higher in the later years using straight-line depreciation. so the loss from scrapping the equipment would be less compared toan accelerated method like declining balance. Net income over the life of the equipment is the same under either method.
9. C 108 units were sold (13 +35 +(0) and 150 units were available for sale (beginning invenror\, of0 plus purchases of 40+ 20 +90). so there are 150 - 108 :=42 units in ending inventonã. CnderFIFO, units from rhe last barch purchased would remain in inventory; 42 x 550:= £2,100. UnderLIFO, the flrst 42 unirs purchased would be in inventory: (40 x 530) + (2 x 5401:= £1,280.
lO. C Year I: (2/4) x 25.000:= 512,500. Year 2: (2/4) x (25,000 - 12,500) := $6,250.
11. C Bad debt expense is an operating expense. All of the other choices are nonoperating from the perspective of a manufacturing flrm.
12. A A change in an accounting estimare is reponed prospecrively. No restatement of prior period sratements is necessary.
13. D A physically and operacionally distinct division thac is currently for sale is [[eared as a discontinued operarion. The income from the division is reponed net of rax below incom<: from continuing operations. Changing a depr<:ciation mechod is a change of accounting principle, which is al)plied retrospectively and will change operating Incom<:.
14. C Achange in ;lccoul1ling principle requir<:, rurospeClive applicarion; lhat is, all prior period financial "alcmcnts currel1lly presenled are restared 10 rcnecr rhe change.
Page82 ri)200H Slhwl'Sl'J
Srudy Session K Cross-Reference to CFA Institute Assigned Reading#32 - Understanding the Income Statement 15. B The new srock is weighted by8 / 12. The bonds are weighted by 4 / 12 and are not
affected by the stock dividend.
Basic shares= ([100,000 x (12 / 12)] +[30,000 x (8 / 12)]} x 1.10= 132,000 Diluted shares =132,000+ [21,000 x (4/ 12)] =139,000
16. C Since the exercise price of [he warrants is less than [he average share price, the warranrs are dilutive. Using [he treasury stock method to determine the denominator im pact:
$55-$50
----x100,000 shares=9,091 shares
$55
Thus, the denominator will increase by9,091 shares to 309,091 shares. The question asks for [he w[al, nor JUSt the impact of [he warrants.
17. BFirst, calculate basic EPS = 125,000 =$1.25
100,000
Nexl, check if [he convertible bonds are dilUIive:
numeraror impacl= (I,OOO x 1,000 x0.07) x (I - 0.4) =$42,000 denominator impacl=(I,OOO x 25) =25,000 shares
h ã $42,000 6
per s are ImpaCL= =$1. 8 25,000 shares
Since$1.68 is grealer than the basic EPS of $1.25, the bonds are anridilUIive. Thus, dilUIed EPS =basic EPS =$1.25.
18. C The war rams in this case are antidilUIive. The average price per share of$15 is less lhan rhe exercise price of$20. The year-end price per share is nor relevanr. The denominaror consiSlS of only rhe common SLack for basic EPS.
19. A In a common-size income stalemenr, each income sutemenr accounr is divided by sales. COGS is rhen production COStS as a percen rage of price.
20. D Pre-lax margin (pre-tax earnings / revenue) measures profitability.
21. B A foreign currency translation gain is not included in net income but the gain increases owners' equity. Dividends received are tepa ned in the income statemenr. The
repaYm.~nrof principal does not affect owners' equity.
22. D Comprehensive income includes aU changes in equity except transaCLions with shareholders. Therefore, dividends paidto common shareholders are not included in comprehensive income.
©200HSchwescr PageSJ
Thcr()llowin~is a revieworthe rinanci:11 Statemcnt Anal)'sis principlcs dcsigned 10:Iddrt'ss the leacning OlltCOllle SI,lIt'l1lents sel forth byCFA InslirutcQ<'. This topic is also covcred in: