Understanding Income

Statement

Presenter:
Ishter Mahal
Associate Professor
Department of Accounting & Information Systems
University of Dhaka
Learning Outcomes:
• Describe the components of income
statement and alternative presentation format
• General principles of revenue recognition
• General principles of expense recognition
• Reporting and treatment of non recurring
items
• Operating and non operating distinction
• EPS (Basic and Diluted)
• Common size income statement
• Comprehensive income and other
Comprehensive income.
Income Statement: Introduction
 Income statement represents information on
the financial result of a company’s business
activities over a period of time.
 It some times refer also “Statement of
Operations” , “Statement of Earnings”, or
“Profit and loss statements”.
 New name is called “Statement of
Comprehensive Income”.
 Basic equation: Revenue – Expenses=
Income
 Various needs of various users
 `
3
Income Statement: Introduction Con--d
An entity has to prepare (IAS 1):
 a STATEMENT OF COMPREHENSIVE INCOME
for the period (presented as either a single
statement or an income statement with a statement
of other comprehensive income);
along with
• a statement of financial position (balance sheet);
• a statement of changes in equity;
• a statement of cash flows (cash flow statement);
• Notes, including a summary of significant
accounting policies and other explanatory
information; and
 • a statement of financial position at the beginning of
the earliest comparative period when an entity applies
an accounting policy retrospectively or makes a
retrospective restatement of items in its financial
4
statements.
Income Statement: Components and Format
Consolidated Income Statement (Groupe Danone): For the year
ended 31 Dec
(A French Food Manufacturer) 2008 2009
Net revenue 15,220 14,982
Cost of goods sold (7172) (6749)
Selling expenses (4,197) (4,212)
General and administrative expense (1,297) (1,356)
Research and development expenses (198) (206)
Other revenue (expenses) (86) (165)
Trading operating income 2,270 2,294
Other operating income (expenses) (83) 217
Operating income 2,187 2,511
Interest revenue 58 76
Interest expenses (497) (340)
Other financial revenue (expenses) (145) (225)
5
Components and Format Con--d
2008 2009
Income before tax 1,603 2,022
Income tax (443) (424)
Income from fully consolidated 1,160 1,598
companies
Share of profit of association 62 (77)
Net income from continuing 1,222 1,521
operation
Net income from discontinued 269 -
operation
NET INCOME 1,491 1,521
Attributable to the Group 1,313 1,361
Attributable to the non controlling 178 160
interest/Minority interest
6
Income Statement: Components and Format
Consolidated Statement of earnings (Kraft Foods and
Subsidiaries): For the year ended 31 December (US
Food Manuf)
2009 2008 2007
Net revenues 40,386 41,932 35,858
Cost of sales 25,786 28,088 23,656
Gross profit 14,600 13,844 12,202
Marketing, Admin and Research 9,108 8,862 7,587
cost
Asset impairment and exist cost (64) 1,024 440
(Gains)/Losses on divestitures, 6 92 (14)
net
Amortizations of intangibles 26 23 13
Operating income 5,524 3,843 4,176
Interest and other expenses, net 1,237 1,240 604
Earnings from continuing 4,287 2,603 3,572
7
Components and Format Con--d
Consolidated Statement of earnings (Kraft Foods and
Subsidiaries): For the year ended 31 December
2009 2008 2007
Provision for income taxes 1,259 755 1080
Earnings from continuing 3,028 1,848 2,492
operations
Earnings and gain from - 1,045 232
discontinued operations, net of
income taxes
Net earnings 3,028 2,893 2,724
Non-Controlling interest 7 9 3
Net earnings attributable to 3,021 2,884 2,721
Krafts Foods

8
Analysis:
 Revenue: net, sales or Turnover
 Total sales revenue is shown net of
returns and allowances.
 A sales return is a cancellation of a
sale. A sales allowance is a deduction
from the original sales invoice price
 Increasing year from left to right for
GD
 Different orderings of chronological
information are common
 Difference in presentation of items
9
Analysis: Con---d
 Expenses may be grouped and reported in
different formats, R&D expenses in these
example.
 Indication of reduction mentioned in
parentheses, have a flexibility
 Use the word net income or Net earnings
 Net income referred to as the “bottom line”
 Income attributable to the company itself
and to minority interest or non-controlling
interests,

 10
Analysis: Con--d
 Net income also includes gains and losses.
 Income includes both revenue and gains
 Expenses encompasses both expenses and
losses
So, Net income:
Income –expenses, Or
Revenue + Other income + Gain-expenses, Or
Revenue + Other income + Gain-Expenses-Losses
 Finance cost, Tax expenses are required to
present separately
 Expenses may be grouped together either by-
 Its Nature- Depreciation, or
 Its Function- Cost of goods sold 11
Analysis: Con--d
 Multi step format or Single step format
 Concept of gross profit: Revenue- Cost of
goods sold
 GP is the amount of revenue available after
subtracting the cost of delivering goods or
services. Other expenses related to running the
businesses are subtracted after gross profit.
 Operating profit or Operating Income: GP-
Operating expenses (Admin. Selling, R&D
expenses)
 Operating profit reflects a company’s profit on
its usual business activities before deducting
taxes, financial expenses,
 Operating profit is also referred to as EBIT 12
IAS-1: Presentation of F/S
IAS 1 offers the choice of presenting
all items of income and expense
recognized in the period: either in a
single statement, or, in two statements.
The standard prescribes, as a minimum,
the following line items to be presented in
a statement of comprehensive income:
• Revenue, finance costs, share of profit
or loss from associates and joint ventures
accounted using the equity method, tax
expense, amounts required to be
disclosed under IFRS 5 relating 13to
IAS-1: Presentation of F/S
• Profit or loss for the reporting period;
• Each component of other comprehensive income
classified by nature;
• Share of other comprehensive income of associates
and joint ventures accounted using the equity
method; and
• Total comprehensive income.
Profit or loss for the reporting period as well as total
comprehensive income for the period attributable to
non controlling interests and owners of the parent are
required to be disclosed separately.

Since the IAS 1 prescribes minimum line item

disclosure, an entity is permitted to present
additional line items, headings and subtotals in the
statement of comprehensive income and the separate
14
Example: Single Statement Approach
Statement of Comprehensive Income
Revenue 780,000 710,000
Expenses (500,00 (550,00
0) 0)
Profit before tax 280,000
160,000
Income tax expense (50,000) (30,000)
Profit for the year from continuing 230,00 130,00
operations 0 0
Loss for the year from discontinued (61,000) -----
operations
Profit for the year 169,00 130,00
0 0
Other comprehensive income:
Exchange differences on translating 10,000 20,000
foreign operations
15
Available-for-sale financial assets 4,800 7,000
Example: Single Statement Approach Con--d
Statement of Comprehensive Income
Gains on property revaluation 16,000 14,000
Actuarial (losses)/gains on (1,334) 2,666
defined benefit pension plans
Share of other comprehensive 800 (1,400)
income of associates
Income tax relating to (8,000) (7,800)
components of other
comprehensive income
Other comprehensive income 24,666 38,866
for the year, net of tax

Total comprehensive income 193,666 168,866

for the year
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Example: Single Statement Approach Con---d
Statement of Comprehensive Income
Profit attributable to:
Owners of the parent 152,542 117,780
Minority interest 16,458 12,220
169,000 130,000

Total comprehensive income attributable to:

Owners of the parent 173,208 150,246

Minority interest 20,458 18,620
193,666 168,866

17
 Example: Two Statements Approach
1. Income Statement 20X9 20X8
Revenue 780,000 710,000
Expenses (500,000) (550,000)
Profit before tax 280,000 160,000
Income tax expense (50,000) (30,000)
Profit for the year from continuing operations 230,000 130,000
Loss for the year from discontinued operations (61,000) —
Profit for the year 169,000
130,000

Profit attributable to:

Owners of the parent 152,542 117,780
Noncontrolling interest 16,458 12,220
169,000 130,000
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 Example: Two Statements Approach Co--d
2. Statement of Comprehensive Income
Profit for the year 169,000
130,000
Other comprehensive income:
Exchange diff. on translating foreign operations 10,000 20,000
Available-for-sale financial assets 4,800
7,000
Cash flow hedges 2,400
4,400
Gains on property revaluation 16,000 14,000
Actuarial (losses)/gains on
defined benefit pension plans (1,334) 2,666
Share of other compre income of associates 800 (1,400)
Income tax relating to components of other comprehensive
income (8,000)
(7,800) 19
 Example: Two Statements Approach Co--d
Total comprehensive income attributable to:

Owners of the parent 173,208 150,246

Non-controlling interest 20,458 18,620
193,666 168,866

20
Basis of classification of expense
An example of a classification using the
nature of expense method:
Revenue x
Other income x
Changes in inventories of finished goods and work in progress
x
Raw materials and consumable used x
Employee benefits expenses x
Depreciation and amortization expense x
Other expenses x
Total expenses (x)
Profits before tax x

21
Basis of classification of expense con--d
An example of a classification using the
function of expense method:
Revenue x
Costs of sales
(x)
Gross profits x
Other income x
Distribution costs (x)
Administrative expenses (x)
Other expenses (x)
Profits before tax x

22
Revenue-Recognition & Expense-Recognition

Revenue Recognition Principle – This principle

dictates that revenue should be recognized in the
accounting period in which it is earned.

Matching (Expense Recognition) Principle –

Expense recognition is traditionally tied to
revenue recognition and referred to as the
matching principle. This principle dictates that
expenses be matched with revenues in the
period in which efforts are made to generate
revenues.

23
Revenue-Recognition & Expense-Recognition
C--d

When items of income or expense are material, an

entity shall disclose their nature and amount
separately (para 97 of IAS 1).

An entity shall not present any items of income or

expense as extraordinary items, in the statement of
comprehensive income or the separate income
statement (if presented), or in the notes (para 87 of
IAS 1).

24
 Revenue-Recognition
• Revenue- Arise from primary activities of the
business
•Income includes revenue and gain
•Gain arise from the secondary activities of the
business

•Gain/loss may be considered part of operating

activities such as – a loss due to decline in the value
of inventory or may be non operating activities such
as sale of non trading investment
•Industry Example:
Cement, Pharmaceutical, Telephone, Real
Estate, Textile, Bank, A Level College etc.
25
 Revenue-Recognition Con--d
General Principles:

1.Transfer of significant risk and rewards

2.Have no managerial involvement or control over
the goods
3.Revenue can be measured reliably and
4.Probable that the economic benefits associated
with the transaction will flow to the entity and
5.Cost can be measured reliably

26
 Revenue-Recognition Con--d
Special cases:
Before goods are At the time After goods are
fully delivered or goods are delivered Or
Services delivered Or Services
completely Services rendered
rendered rendered
For example, With Recognize For example,
long term contracts revenues with Real Estate
where the out comes using normal sales where there
can be reliably revenue is a doubt about
measured, The recognition the buyer’s
Percentage of criteria ability to
Completion complete
Method is used payment, the
installment
method and
27
cost recovery
Revenue-Recognition Con--d
Gross VS. Net Reporting:

What would be the reporting of revenue for an agent

who worked on behalf of the Principal?
Commission is their earnings. Freight Forwarder,

To report gross revenue, the following criteria are

relevant:
1. The company is the primary obligor under the
contract
2. Bears inventory risks and credit risks
3. Can choose its suppliers, and
4. Has reasonable latitude to establish price

If these criteria are not met, the company

should report revenues net.
28
Revenue-Recognition Con--d
Gross VS. Net Reporting: An Example
Haven Touch Tour & Travels (the Company) has
agreement with several major airlines to obtain
airline tickets at reduced rates. The company pays
only for tickets it sells to customers. In the most
recent period, the company sold airlines tickets to
customers over the internet for a total of Tk 1.1
million. The cost of these tickets to the company
was Tk 1 million. The company’s direct selling cost
was Tk 2000. Once the customers receive their
tickets, the airline is responsible for providing all
services associated with the customers’ flights.
Demonstrate the reporting of revenue under: a.
Gross reporting b. Net reporting
Determine and justify the appropriate method
for reporting revenues
29
Revenue-Recognition Con--d
Gross VS. Net Reporting: Solution:
1. Reporting under Gross and Net

Gross Net
Reportin Reportin
g Tk g Tk
Revenues 1,100,00 100,000
0
Cost of sales 1,002,00 2000
0
Gross margin 98,000 98,000
30
Revenue-Recognition Con--d
Gross VS. Net Reporting: Solution:
1.Appropirate method of Reporting

The company should report revenue on a net

basis. The company pays only for tickets it sells
to customers and thus does not bear inventory
risk. In addition, the airline- not the company-
is the primary obligor under the contract.
Revenue should be reported as Tk 100,000

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Accounting Manipulation
through Revenue-Recognition
Two Basic Strategies:

1. To inflate current period earnings

through overstating revenue and gain
or understating expenses

2. To reduce current period earnings by

understating revenues or over stating
expenses -Income smoothing

32
Manipulation Tricks of Income -
Four Categories
1. Recording questionable revenue, or
recording revenue prematurely:
 Recording revenue for services that

have yet to be performed

 Recording revenue prior to shipment

or before the customer acquires

control of the product
 Recording revenue for items for which

the customer is not required to pay

 Recording revenue for artificial sales

to affiliated parties

33
Manipulation Tricks of Income-
Four Categories
2. Recording Fictitious Revenue
 Recording revenue for sales that lacks
economic substance
 Recording revenue that is, in substance, a
loan
 Recording investment income as revenue
3. Recording one time gains to boost
income
 Deliberately undervaluing assets, resulting
in the recording of a gain on sale
 Recording investment gain as revenue
 Recording investment income or gains as a
reduction in expenses
4. Shifting revenue to34 future periods
Revenue-Recognition
Implications for Financial Analyst:
1. Whether a revenue recognition policy results
in recognition of revenue sooner rather than
later (sooner is less conservative)?
2. What extent a policy requires the company to
make estimates?
3. With in a same industry need to analyze
intercompany revenue recognition policies. It
will helpful to understand any differences in
their revenue recognition policies. It will help
to characterize the relative conservatism of a
company’s policies and to qualitatively assess
how differences in polices might affect
financial ratios. 35
Expense-Recognition
Expenses-its definition- Arises from ordinary course
of business
General principle: Matching Principle

IFRS do not refer to a “Matching Principle” but

rather to a “Matching concept” or to a process
resulting in “Matching of cost with revenues”.
Under matching, a company recognizes some
expenses when associated revenues are
recognized and thus, expenses and revenues are
matched.
Matching of Inventory as COGS with its Associated
revenue.
What about Period cost? Have no revenue what
would be happened? 36
Expense-Recognition
Issues in expense recognition:
Principle of expense recognition:
1. Doubtful Accounts
2. Warranties
3. Depreciation and Amortization

Doubtful Accounts
 Direct Write Off Method in case of bad debt is
not consistent with the GAAP
 Hence require an estimate of revenue which
will be uncollectable
 May have variety of basis for estimation such
as Past experience, Relationship, Time passes
37
i.e Aging etc.
Expense-Recognition
Doubtful Accounts
 The company records its estimate of uncollectable
accounts as an expense on the income statement,
not as a direct reduction of revenue.
Warranties
At the time of sale, the company does not know the
amount of future expense it will incur in
connection with its warranties.
Better to wait until actual expenses are incurred but
this will be against of matching principle.
As such a company is required to estimate the amount
of future expenses resulting from its warranties to
recognize an estimated warranties expenses in
the period of the sale, and to update the expense
as indicated by experience over the life of the
warranty. 38
Expense-Recognition
Depreciation and Amortization
Its concepts:
Cost Model: Depreciable amount is allocated on
a systematic basis over the remaining useful
life of the asset reported at its cost less
accumulated depreciation.
Revaluation Model: Assets is reported at its fair
value. It is not allowed in U.S GAAP.
Two Differences:
IFRS require each component of an asset to be
depreciated separately and US GAAP do not
require component depreciation; IFRS require
annual review of residual value and useful life
and US GAAP do not explicitly require such a
review. 39
Expense-Recognition
Depreciation and Amortization Co--d
IFRS do not prescribe any particular method for
computing depreciation but several methods are
commonly used. Straight line method,
Diminishing balance method, Unit of production
method etc. So you can do a research among
intercompany with in same industry on
Depreciation policy.

But annual depreciation expense is sensitive to

both the estimated useful life and to the
estimated residual value and have effect on
reported net income.

Goodwill and intangible assets with indefinite life

are not amortized instead they are under
40
impairment test at least annually.
Expense-Recognition
Implications for Financial Analyst:
1. Company’s choice of expense recognition can be
characterized by its relative conservatism.
2. What extent a policy requires the company to
make estimates.
3. With in a same industry analyst can analyze
intercompany estimation policy. It will helpful to
understand any differences in their difference in
estimates and to qualitatively assess how
differences in polices might affect financial ratios.
Say, significant change year to year in its estimates
of uncollectable accounts as a percentage of
sales, warranty expenses as a percentage of
sales, or estimated useful lives of assets, the
analyst should seek to know the underlying
reasons. 41
Expense-Recognition
Implications for Financial Analyst: Co--
d
Say, two companies in a same industry have
dramatically different estimates for
uncollectable accounts as a percentage of
their sales, Warranty expenses as a
percentage of a sales, estimated useful lives of
assets, it is important to understand the
underlying reasons.

Information about a company’s accounting

policies and significant estimates are describe
in the notes to the financial statements and in
the management discussion and analysis
section of a company’s annual report. 42
Non-recurring and Non-operating Items
 These two important items are useful to forecast
the company’s earnings for next year and in the
years after.
 Some items of prior years are clearly not expected
to continue in the future periods and are
separately disclosed in income statement.
“An entity shall present additional line items,
headings and subtotals when such presentation is
relevant to an understanding of the entity’s
financial performance.”- IAS-1, para-85.
 As per US GAAP two items must be disclosed
separately from continuing operation-
1. Discontinued operation 2. Extra-ordinary items
(unusual in nature or infrequent as per IFRS, 43
Judgment require )
Changes in Accounting Policies,
Estimates and Errors
 Change of accounting policies are permitted. When-
(Say change of inventory costing method)
 Change of accounting polices are reported through
Retrospective application unless it is impracticable
to do so.
 Details about the change along with justification to
be disclosed in notes to the financial statement
 Change of accounting g estimates are handled
through prospectively (Change of estimated useful
life of assets).
 Correction of an error for a prior period is handled
by restating the financial statements for the prior
periods presented in the current financial
statements. 44
Common-Size Income Statement
• Expresses each item on the INCOME
Statement as a percentage of sales
• Reveals the composition of expenses
• Form of ratio analysis allows comparison of
firms
• Useful for evaluating trends within a firm
and to make industry comparisons
• Facilitate internal or structural analysis
• Make industry comparisons
45
Net Earnings
 Also called the “bottom line”
 Representsprofit after consideration of all
revenue and expense
 Netprofit margin shows the percentage of
profit earned on every sales dollar.

Net profit margin is given by Net earnings

Net sales

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Earnings Per Share (EPS)
 EPS is the net earnings available to
common stockholders for the period
divided by the average number of
common stock shares outstanding.

 If a firm has “complex” capital structure, it

will report basic and diluted earnings per
common share.

47
Earnings Per Share (EPS)
Analysts should consider material changes
in the number of common stock shares
outstanding that will cause a change in
the computation of earnings per share.

 Basic EPS
 Diluted EPS
 Antidilutive EPS

48
Earnings Quality and Cash Flow
Other topics directly related to the income
statement
• Assessment of the quality of reported
earnings is an essential element of
income statement analysis.

• Cash flow from operations is a key

ingredient in analyzing operating
performance.

49
Other Comprehensive Income
According to paragraph 7 of IAS 1 Presentation of
Financial Statements, other comprehensive income
comprises items of income and expense (including
reclassification adjustments) that are not recognised in
profit or loss as required or permitted by other IFRSs.

The components of other comprehensive income

include:
(a) changes in revaluation surplus (see IAS 16
Property, Plant and Equipment and IAS 38 Intangible
Assets);
(b) actuarial gains and losses on defined benefit
plans recognised in accordance with paragraph 93A of
IAS 19 Employee Benefits; 50
Other Comprehensive Income
(c) gains and losses arising from translating the
financial statements of a foreign operation (see
IAS 21 The Effects of Changes in Foreign
Exchange Rates);
(d) gains and losses from investments in
equity instruments measured at fair value
through other comprehensive income in
accordance with paragraph 5.4.4 of IFRS 9
Financial Instruments;
(e) the effective portion of gains and losses
on hedging instruments in a cash flow hedge
(see IAS 39 Financial Instruments: Recognition
and Measurement). 51
THANKS