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IFT Notes for Level I CFA® Program

R21 Understanding Income Statements

Part 1


 

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.

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.

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.


FRA Understanding Income Statements Part 1