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2023 Curriculum CFA Program Level I Financial Reporting and Analysis

Understanding Income Statements

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Introduction

The income statement presents information on the financial results of a company’s business activities over a period of time. The income statement communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. The basic equation underlying the income statement, ignoring gains and losses, is Revenue minus Expenses equals Net income. The income statement is also sometimes referred to as the “statement of operations,” “statement of earnings,” or “profit and loss (P&L) statement.” Under both International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP), the income statement may be presented as a separate statement followed by a statement of comprehensive income that begins with the profit or loss from the income statement or as a section of a single statement of comprehensive income. This reading focuses on the income statement, and the term income statement will be used to describe either the separate statement that reports profit or loss used for earnings per share calculations or that section of a statement of comprehensive income that reports the same profit or loss. The reading also includes a discussion of comprehensive income (profit or loss from the income statement plus other comprehensive income).

Investment analysts intensely scrutinize companies’ income statements. Equity analysts are interested in them because equity markets often reward relatively high- or low-earnings growth companies with above-average or below-average valuations, respectively, and because inputs into valuation models often include estimates of earnings. Fixed-income analysts examine the components of income statements, past and projected, for information on companies’ abilities to make promised payments on their debt over the course of the business cycle. Corporate financial announcements frequently emphasize information reported in income statements, particularly earnings, more than information reported in the other financial statements.

This reading is organized as follows: Section 2 describes the components of the income statement and its format. Section 3 describes basic principles and selected applications related to the recognition of revenue, and Section 4 describes basic principles and selected applications related to the recognition of expenses. Section 5 covers non-recurring items and non-operating items. Section 6 explains the calculation of earnings per share. Section 7 introduces income statement analysis, and Section 8 explains comprehensive income and its reporting. A summary of the key points and practice problems in the CFA Institute multiple choice format complete the reading.

Learning Outcomes

The member should be able to:

  1. describe the components of the income statement and alternative presentation formats of that statement;

  2. Describe general principles of revenue recognition and accounting standards for revenue recognition;

  3. calculate revenue given information that might influence the choice of revenue recognition method;

  4. describe general principles of expense recognition, specific expense recognition applications, and implications of expense recognition choices for financial analysis;

  5. describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, unusual or infrequent items) and changes in accounting policies;

  6. distinguish between the operating and non-operating components of the income statement;

  7. describe how earnings per share is calculated and calculate and interpret a company’s earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures;

  8. distinguish between dilutive and antidilutive securities and describe the implications of each for the earnings per share calculation;

  9. convert income statements to common-size income statements;

  10. evaluate a company’s financial performance using common-size income statements and financial ratios based on the income statement;

  11. describe, calculate, and interpret comprehensive income;

  12. describe other comprehensive income and identify major types of items included in it.

Summary

This reading has presented the elements of income statement analysis. The income statement presents information on the financial results of a company’s business activities over a period of time; it communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. A company’s net income and its components (e.g., gross margin, operating earnings, and pretax earnings) are critical inputs into both the equity and credit analysis processes. Equity analysts are interested in earnings because equity markets often reward relatively high- or low-earnings growth companies with above-average or below-average valuations, respectively. Fixed-income analysts examine the components of income statements, past and projected, for information on companies’ abilities to make promised payments on their debt over the course of the business cycle. Corporate financial announcements frequently emphasize income statements more than the other financial statements.

Key points to this reading include the following:

  • The income statement presents revenue, expenses, and net income.

  • The components of the income statement include: revenue; cost of sales; sales, general, and administrative expenses; other operating expenses; non-operating income and expenses; gains and losses; non-recurring items; net income; and EPS.

  • An income statement that presents a subtotal for gross profit (revenue minus cost of goods sold) is said to be presented in a multi-step format. One that does not present this subtotal is said to be presented in a single-step format.

  • Revenue is recognized in the period it is earned, which may or may not be in the same period as the related cash collection. Recognition of revenue when earned is a fundamental principal of accrual accounting.

  • An analyst should identify differences in companies’ revenue recognition methods and adjust reported revenue where possible to facilitate comparability. Where the available information does not permit adjustment, an analyst can characterize the revenue recognition as more or less conservative and thus qualitatively assess how differences in policies might affect financial ratios and judgments about profitability.

  • As of the beginning of 2018, revenue recognition standards have converged. The core principle of the converged standards 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.”

  • To achieve the core principle, the standard describes the application of five steps in recognizing revenue. The standard also specifies the treatment of some related contract costs and disclosure requirements.

  • The general principles of expense recognition include a process to match expenses either to revenue (such as, cost of goods sold) or to the time period in which the expenditure occurs (period costs such as, administrative salaries) or to the time period of expected benefits of the expenditures (such as, depreciation).

  • In expense recognition, choice of method (i.e., depreciation method and inventory cost method), as well as estimates (i.e., uncollectible accounts, warranty expenses, assets’ useful life, and salvage value) affect a company’s reported income. An analyst should identify differences in companies’ expense recognition methods and adjust reported financial statements where possible to facilitate comparability. Where the available information does not permit adjustment, an analyst can characterize the policies and estimates as more or less conservative and thus qualitatively assess how differences in policies might affect financial ratios and judgments about companies’ performance.

  • To assess a company’s future earnings, it is helpful to separate those prior years’ items of income and expense that are likely to continue in the future from those items that are less likely to continue.

  • Under IFRS, a company should present additional line items, headings, and subtotals beyond those specified when such presentation is relevant to an understanding of the entity’s financial performance. Some items from prior years clearly are not expected to continue in future periods and are separately disclosed on a company’s income statement. Under US GAAP, unusual and/or infrequently occurring items, which are material, are presented separately within income from continuing operations.

  • Non-operating items are reported separately from operating items on the income statement. Under both IFRS and US GAAP, the income statement reports separately the effect of the disposal of a component operation as a “discontinued” operation.

  • Basic EPS is the amount of income available to common shareholders divided by the weighted average number of common shares outstanding over a period. The amount of income available to common shareholders is the amount of net income remaining after preferred dividends (if any) have been paid.

  • If a company has a simple capital structure (i.e., one with no potentially dilutive securities), then its basic EPS is equal to its diluted EPS. If, however, a company has dilutive securities, its diluted EPS is lower than its basic EPS.

  • Diluted EPS is calculated using the if-converted method for convertible securities and the treasury stock method for options.

  • Common-size analysis of the income statement involves stating each line item on the income statement as a percentage of sales. Common-size statements facilitate comparison across time periods and across companies of different sizes.

  • Two income-statement-based indicators of profitability are net profit margin and gross profit margin.

  • Comprehensive income includes both net income and other revenue and expense items that are excluded from the net income calculation.