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Reading 21: Understanding Income Statements. (Revenue recognition and…
Reading 21: Understanding Income Statements.
Components of Income Statement
Revenue
Sale of G&S
Net revenues = Revenues - allowance - returns of G&S
Expense
Amounts incurred to generate revenue
Non-operating expenses
must be disclosed separately (e.g., interest expense, income tax expense)
Operating Expenses
can be grouped by
Nature (depreciation, materials)
Ex: Depreciation of manufacturing equipment and of admin facility can be summarized as "Depreciation" only
Function (cost of good sold)
Ex: Cost of good sold can include (depreciation of goods, materials cost, commission for sale people, transportation cost, etc)
Gains and losses
typically from disposal of long-term assets
Gains: Asset Proceeds > Asset Carrying Value
Losses
: Proceeds < Carrying Value
Presentation format
Multi-step Income statement
: operating expense component is shown in income statement (Common)
Single-step income statement
: 1 figure for operating expense. Footnote is necessary
Revenue recognition and accrual accounting
Accrual accounting
Revenue is recognized when earned and expenses are recognized when incurred.
Specific revenue recognition applications.
For contracts
Percentage of completion
Recognize revenue in proportion to cost incurred.
Used for projects under contract with reliable estimates of revenues, costs, and completion time
% of completion is % of estimated total costs
Calculation
Profit recognized in period = Cumulative Revenue - Revenue recognized in prior year - Cost incurred in current period
Cumulative revenue
= \( \frac{Cost_{ToDate}}{TotalProject Cost}\times SalesPrice \)
Complete-contract
Recognize revenue (and thus expenses and profit) only when the contract is complete.
US GAAP
: project with
NO CONTRACT
or
unreliable estimates of revenue or costs
IFRS
Revenue and Expense are recognized over project's life (cost = revenue), but NO PROFIT until
project is completed
Comparison between POC and CC
Net income
POC has higher income because CC doesn't recognize revenue until completion
Income Volatility
CC has more volatility, because POC recognizes some revenue and income each year
Cash flow
is the same because CF is not affected by revenue recgonition method
For installment-sales
Normal revenue recognition at time of sale if collectibility is reasonably estimated.
Installment sales method if collectibility cannot be reasonable estimated.
Cost recovery method if collectibility is highly uncertain.
For barter transaction
Revenue can be recognized if its fair value can be estimated from historical data on similar non-barter transaction.
Sale-basis method
Used when G&S is provided at time of sale, cash, or credit with high payment probability
Gross revenue vs net revenue reporting
Gross revenue
Shows sales and cost of goods sold.
Net revenue reporting
Shows only the difference between Sales and Cost of Goods Sold.
Should only been used if the firm is a selling agent and does not stock inventory, take credit risk or have control over supplier and price.
5-step process for recognizing revenue.
S1: Identify the contract with a customer
S2: Identify the performance obligation in the contract
S3: Determine the transaction price
S4: Allocate the transaction price to the performance obligation in the contract
S5: Recognize revenue when the entity satisfies a performance obligation.
IASB Requirements for Revenue Recognition for Goods
For Goods
No continuing control or management over the good sold
Reliable revenue measurement
Probable flow of economic benefits
Cost can be measured reliably
Risk and reward of ownership transferred
For Services
Outcome can be measured reliably if:
Amount of revenue can be measured
Probable flow of economic benefits (clients pay you)
Stage of completion can be measured
Cost incurred and remaining cost to complete can be measured
When Outcome (profitability) can be reliably measured, Revenue will be recognized according to Stage of Completion
SEC Requirements for Revenue Recognition
FASB
: Revenue is recognized when it is reliazable and earned
SEC
Evidence of an arrangement between buyer and seller
Completion of earning process, firm has delivered G&S
Price are determined
Assurance of payment, able to estimate probability of payment
General principles of expense regonition
Depreciation Methods
Straight-line
Equal amount of depreciation expense in each year of the asset's useful life.
Depreciation Value = \( \frac{Cost - Salvage}{UsefulLive}\)
Declining-balance
Apply a constant rate of depreciation to the declining book value, until book value = residual value.
Double-declining: Decline at the rate = straight-line rate x 2
Accelerated depreciation
More depreciation at earlier year, less at later year
Inventory Valuation Methods.
FIFO
:
Inventory reflects costs of most recent purchases, COGS reflects costs of oldest purchases.
LIFO (US GAAP only):
CoGS reflects cost of most recent purchase, Inventory reflect cost of oldest purchase
Average Cost:
Unit cost equal cost of goods available for sale divided by total unit available, and is used for both CoGS and Inventory.
Specific identification (high-value item)
Each item in inventory is identified, and its historical cost is used for calculating CoGS when the item is sold.
CoGS should be matched with items sold and recorded as revenue over the period
Amortization Methods
Intangible assets with limited lives
should be amortized using method that reflects the flow of their economic benefits overtimes.
Intangible assets with unlimited lives
(ex: goodwill) are not amortized but checked for loss periodically
If earnings pattern cannot be established, use straight line (IFRS and GAAP usually use straight-line with no residual value)
Expense Recognition
Accrual basis - matching principle
Match costs against related revenues
Examples: Inventory, depreciation/ amortization, warranty expense, doubtful debt expense
Period expenses
Expenditures that less directly match the timing of revenue (e.g. admin costs)
Warranty Expense
estimated based on past experience
Non-recurring items
Discontinued operations
are reported net of taxes after (net income from continuing operation)
Operations that management has decided to dispose of, but (1) has not done so yet or (2) did so in current year after it generated profit or loss
Unusual or infrequent item
Reported pretax before (net income from continuing operations)(above the line)
Include
Gain (loss) from disposal of business segment or assets
Gain (loss) from sale of investment in subsidiary
Provisions for environmental remediation
Impairments, write-offs, write-downs (when Net Realizable Value is smaller than cost), restructuring
Integration expense for recently acquired business
Changes in Accounting standards, methods and estimates.
Changes in accounting standards or methods
Require retrospective restatement
of all prior-period financial statements.
Changes in estimates
Does not require restatement of prior-period results.
Changes from Straight-line to Accelerated Depreciation
Prior-period Adjustments
Correcting errors or changing from
Incorrect accounting method
to acceptable one
Retrospective application needed
Restate prior years' principal financial statement
Must disclose the nature of the error and its effect on net income
Operating vs. Non-operating components
Operating income
:
Generated from firm's normal business operations.
Non-operating income
Accidental to firm's normal business operations
Earning per share (EPS)
Formulas
Diluted
Then \(EPS_{diluted}= \frac{Income_{net} - Dividend_{pref}+Dividend_{pref, conv}+Interest_{debt,conv}\times (1-t)}{No.Shares_{Weighted Avg}+Share_{conv, pref share}+ Share_{Conv, debt}+Share_{StockOption}}\)
First, check whether each component is dilutive or anti-dilutive (only dilutive components are include in calculation)
Basic
\(EPS_{basic}= \frac{Income_{net} - Dividend_{preferred}}{WeightedAverageNo.Shares}\)
Dilutive vs. Antidilutive Securities
Definition
Anti-dilutive security
If converted, will not reduce EPS
Dilutive security
If converted into common stock, will decrease EPS
Potentially dilutive securities
Can be converted into common shares
Stock options
Warrants
Convertible debt
Convertible preferred stock
Checking for Dilution
Convertible Preferred Stock
if \( \frac{Dividend}{NewShares}< Basic \)
Convertible Debt
if \(\frac{Interest \times (1-t))}{NewShares} < Basic\)
Options and Warrants
if Avg. Price > Exercise Price
Dilutive Stock Options
: Treasury Stock Method
Warrants and Stock Option
Calculate number of common shares created if options are exercised
Calculate cash that the company receives from exercise
Calculate number of shares that can be purchased at average market price with exercise proceeds
Calculate net increase in common shares outstanding (2 -3)
Calculating Weighted-Average No. Shares Outstanding
) Adjust for stock dividend and stock-split, only retrospectively
2) Calculate Weighted-Average based on the No. Months that stocks are outstanding
\(No.Shares \times \frac{No.Months_{outstanding}}{12}\)
Sum them up
Simple vs. Complex Capital Structures
Simple Capital Structure
Contains no potentially dilutive securities
Firm report only Basic EPS
Complex Capital Structure
Contains potentially dilutive securities
Firm report both
Basic EPS
and
Diluted EPS
Common-size Income Statement
Each item is expressed as % of total revenue
Profitability ratio
Gross profit margin
=\( \frac{Profit_{gross}}{revenue}\)
Net Profit Margin
=\( \frac{Profit_{net}}{revenue}\)
Comprehensive income
Comprehensive income
= net income + other comprehensive income
Measures all changes to equity, other than those from transactions with shareholders.
Other comprehensive income
Net changes in figures shown in Balance Sheet
Gains/ losses from foreign currency translation
Pension obligation adjustment
Unrealized gains / losses from cash flow hedging derivatives.
Unrealized gains / losses from available-for-sale securities (changes in fair value of such securities in Balance Sheet over year)