Understanding the Income Statement
Revenues - sales of goods and services. 'Sales' is not synonymous - might just be one component of revenues
Net revenue - revenue less allowance for returns/allowances
Expenses are amounts incurred to generate revenue, grouped together by the nature of their function
Gains/losses - incidentals, outside primary business activity
Single-step - all revenues grouped, all expenses grouped too. Multi-step - includes gross profit calc
If a firm has a controlling interest in a sub, prorata share of sub's income that the firm does not own is reported in parent co's income statement as minority owners' interest - you must subtract this because if a firm controls, it has to include the whole income in its income statement
Revenue recognition
- IASB - 'income' includes revenues and gains - increases in economic benefits during period in form of inflows or enhancements of assets or decreases of liability that result in increases in equity, other than those relating to contributions from equity participants
- FASB - recognize when realized and earned
- Evidence of arrangement between buyer/seller
- Product has been delivered/service rendered
- Price is determined or determinable
- Seller is reasonably sure of collecting money
- Percent completion method - divide cost to date by total cost
- Completed contract method - project cost can't be measured or project is short - only recognize when project is complete
- Under either, if a loss is expected, must recognize immediately
- IFRS - if can't reliably measure, bill revenue when costed, expense costs when incurred, and recognize profit only at completion
- Cash flow is same under both methods
- Percent method is slightly more aggressive and uses estimates, but also smooths earnings
- Firm finances transaction and receives payment over extended period
- If collection certain, then recognize rev right away
- If uncertain, use installment method
- Recognize profit as installments are received
- Cost recovery method
- Only recognize when cash collected > costs incurred
- IFRS defines when to use installment method - date when property is transferred and date buyer acquires vested interest may differ - risk and rewards of transfer may not be there right away - uncertainty of transaction completion
- Round trip transaction - exchange of almost identical goods - ex. internet companies buying ad space on each others' sites - should this be a sale?
- GAAP - only if firm has historically received cash payments for such goods/services, and record at fair value based on historical experience
- IFRS - revenue must be based on fair value of revenue from similar nonbarter transactions with nonrelated parties
Gross/Net Revenue Reporting
- Gross - report revenue and COGS separate
- Net - only report the difference
- GAAP - to report gross, you must be primary obligor, bear inventory and credit risk, be able to choose supplier, and have latitude to establish price
Analyst should consider:
- How conservative are revenue recognition policies (too soon is aggressive)
- Extent to which policies rely on judgment/estimates
Expense Recognition
Matching Principle - expenses to generate revenue are recognized in same period as said revenue
- Not all expenses are tied to revenue - period costs, like administrative, are expensed in the period incurred
- Depreciation of machines
- Warranty expenses and bad debt expenses - recognize in period of sale, not in future
Concerns
- Expenses contain estimates - delaying expenses inflates earnings
- Consider reasons for expense estimate changes
- Compare a firm's estimates to its peers
- Check footnotes!
Depreciation
- Straight-line: Depreciation = (cost - residual value) / useful life
- Accelerated: DDB - applies constant rate
- Note - does not explicitly use residual value, but ends once resid value is reached
- DDB depreciation = (2/useful life) * (cost - accumulated depreciation)
- If no residual, it will never reach it - so usually switch to straight line at some point
Break
6:15 pm
1 hour
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