Tài chính doanh nghiệp - Chapter 4: Understanding income statements

Chapter 4Understanding income statementsPresenter’s namePresenter’s titledd Month yyyyOverviewIncome statement components and formatAccounting issuesRevenue recognitionExpense recognitionInventoryDepreciationNonrecurring itemsEarnings per shareIncome statement analysisComprehensive incomeCopyright © 2013 CFA Institute2Income statement componentsAlso called the “statement of earnings,” “statement of operations,” and “profit and loss statement (P&L)”Presents results of operations for the accounting periodRevenues – Expenses = Net incomeRevenue + Other Income + Gains – Expenses – Losses = Net incomeCopyright © 2013 CFA Institute3Income statement formatSubtotalsGross profit (i.e., revenue less cost of sales)Multistep format: Income statement shows gross profit subtotalSingle-step format: Income statement excludes gross profit subtotalOperating profit (i.e., revenue less all operating expenses)Profits before deducting taxes and interest expense and before any other nonoperating itemsOperating profit and EBIT (earnings before interest and taxes) are not necessarily the sameExpense GroupingCopyright © 2013 CFA Institute4Income statement format: example 1Colgate-Palmolive companyCopyright © 2013 CFA Institute5Colgate Annual ReportIncome statement format: example 2L’Oreal GroupCopyright © 2013 CFA Institute6L'Oreal's Annual ReportIncome statement format: example 3Procter & GambleCopyright © 2013 CFA Institute7Proctor & Gamble Reportgeneral principles of revenue recognition and accrual accountingRevenue recognition can occur independently of cash movements—for example, in the case of thesale of goods and services on credit or receipt of cash in advance of providing goods and services A fundamental principle of accrual accounting is that revenue is recognized (reported on the income statement) in the period in which it is earned.Copyright © 2013 CFA Institute8When to recognize revenueIFRS specify that revenue from the sale of goods is to be recognized when the following conditions are satisfied:Entity has transferred to the buyer the significant risks and rewards of ownership of the goods;Entity retains neither continuing managerial involvement with nor effective control over the goods sold;Amount of revenue can be measured reliably;It is probable that the economic benefits associated with the transaction will flow to the entity; andCosts incurred with respect to the transaction can be measured reliably.Copyright © 2013 CFA Institute9When to recognize revenueU.S. GAAP specify that revenue should be recognized when it is “realized or realizable and earned.” The U.S. Securities and Exchange Commission (SEC) provides guidance on how to apply the accounting principles. This guidance lists four criteria to determine when revenue is realized or realizable and earned:There is evidence of an arrangement between buyer and seller. The product has been delivered, or the service has been rendered. The price is determined or determinable.The seller is reasonably sure of collecting money. Copyright © 2013 CFA Institute10specific revenue recognition applications: long-term contractsLong-term contract: contract that spans a number of accounting periods.Percentage-of-completion methodUse when the outcome of a contract can be measured reliably.In each accounting period, the company estimates what percentage of the contract is complete and then reports that percentage of the total contract revenue in its income statement. Contract costs for the period are expensed against the revenue.Net income or profit is reported each year as work is performed.Copyright © 2013 CFA Institute11specific revenue recognition applications:long-term contracts exampleExample that uses the percentage-of-completion method of revenue recognition: Network Construction project: bid was $5,000,000 and estimated costs to complete were $4,000,000Year 1: Costs incurred of $3,000,000 (assume this mirrors the percentage complete)Revenue?Cost of revenue?Year 2: Job is completed with costs of $1,000,000Revenue?Cost of revenue?Copyright © 2013 CFA Institute12specific revenue recognition applications: long-term contracts exampleExample that uses the percentage-of-completion method of revenue recognition (continued):Network Construction project: bid was $5,000,000 and estimated costs to complete were $4,000,000.Year 1: Costs incurred $3,000,000 (assume this mirrors the percentage complete)Revenue?Cost of revenue?Year 2: Job is completed with costs of $1,250,000 (a cost overrun)Revenue?Cost of revenue?Copyright © 2013 CFA Institute13specific revenue recognition applications: long-term contractsPercentage-of-completion is the preferred method under both IFRS and U.S. GAAPWhen the outcome of a contract cannot be measured reliably, there are alternatives to the percentage-of-completion method Assuming it is probable that costs will be recovered, IFRS permit recognition of revenue up to the amount of costs incurred.U.S. GAAP (but not IFRS) permit the completed contract method. Company does not report any income until the contract is substantially finished.Completed contract method is also acceptable when the entity has primarily short-term contracts. Copyright © 2013 CFA Institute14specific revenue recognition applications: long-term contracts exampleAssume the following:A company has a contract to build a network for a customer for a total sales price of $10 million. Network will take an estimated three years to build. Considerable uncertainty surrounds total building costs because new technologies are involved. The outcome cannot be reliably measured, but it is probable that the costs up to the agreed-upon price will be recovered.Expenditures total $3 million, $5.4 million, and $6 million as of the end of Year 1,2, and 3, respectively.Question: How much revenue, expense (cost of construction), and income would the company recognize each year under IFRS and, using the completed contract method, under U.S. GAAP? Copyright © 2013 CFA Institute15specific revenue recognition applications: long-term contracts exampleQuestion: How much revenue, expense (cost of construction), and income would the company recognize each year under IFRS and using the completed contract method under U.S. GAAP? Answer: Under IFRS, recognize revenue to the extent of contract costs incurred. Company would recognizeYear 1, $3 million construction cost, $3 million revenue, and thus, $0 incomeYear 2, $2.4 million construction cost, $2.4 million revenue, and thus, $0 incomeYear 3, $0.6 million construction cost, remaining $4.6 million revenue (because the contract has been completed and the outcome is now measurable), and thus, $4 million income. Answer: With the completed contract method under U.S. GAAP, no revenue will be recognized until the contract is complete.Year 1, $0 million construction cost, $0 million revenue, and thus, $0 incomeYear 2, $0 million construction cost, $0 million revenue, and thus, $0 incomeYear 3, $6 million construction cost, $10 million revenue (because the contract has been completed), and thus, $4 million incomeCopyright © 2013 CFA Institute16specific revenue recognition applications: Installment Sales Installment sales: Sales in which proceeds are to be paid in installments over an extended period.IFRS separate the installments into the sale price (present value of the installment payments) and an interest component. Revenue attributable to the sale price is recognized at the date of sale Revenue attributable to the interest component is recognized over time. International standards note, however, that the guidance for revenue recognition must be considered in light of local laws regarding the sale of goods in a particular country. Copyright © 2013 CFA Institute17specific revenue recognition applications: Installment Sales Sale of real estate under U.S. GAAPA sale of real estate is reported at time of sale using normal revenue recognition conditions when seller has completed the significant activities in the earnings process and is eitherassured of collecting the selling price or able to estimate amounts that will not be collected.Otherwise, defer some of the profit using the installment method, in which the portion of the total profit recognized in each period is determined by the percentage of the total sales price for which the seller has received cash, orthe cost recovery method, in which the seller does not report any profit until the cash amounts paid by the buyer—including principal and interest on any financing from the seller—are greater than all the seller’s costs of the property. Copyright © 2013 CFA Institute18specific revenue recognition applications: example Assume the following:Sales price and cost of a property are $2,000,000 and $1,100,000, respectively, so that the total profit to be recognized is $900,000.Seller received a down payment of $300,000 cash, with the remainder of the sales price to be received over a 10-year period.There is significant doubt about the ability and commitment of the buyer to complete all payments.How much profit will be recognized attributable to the down payment ifthe installment method is used?the cost recovery method is used?Copyright © 2013 CFA Institute19specific revenue recognition applications: example How much profit will be recognized attributable to the down payment if the installment method is used?Installment method apportions the cash receipt between cost recovered and profit using the ratio of profit to sales value.Here, the ratio of profit to sales value equals $900,000/$2,000,000 = 45%.Seller will recognize the following profit attributable to the down payment: 45% of $300,000 = $135,000.How much profit will be recognized attributable to the down payment if the cost recovery method is used? Under the cost recovery method, do not recognize any profit until cash received from buyer exceeds all costs.Here, $300,000 cash paid by the buyer is less than the seller’s cost of $1,100,000.Seller will recognize $0 profit attributable to the down payment.Copyright © 2013 CFA Institute20specific revenue recognition applications: Gross vs. Net reporting Merchandising companies typically sell products that they purchase from a supplier. To account for the sales, they record the amount of the sale proceeds as sales revenue andrecord the cost of the products as the cost of goods sold.Some internet-based merchandising companies sell products that they never hold in inventory; they simply arrange for the supplier to ship the products directly to the end customer. Should they record revenues of the gross amount of sales proceeds received from their customers? the net difference between sales proceeds and their cost?U.S. GAAP guidanceReport revenues gross if the company is the primary obligor under the contract, bears inventory risk and credit risk, can choose its supplier, and has reasonable latitude to establish price. Otherwise, report revenues net. Copyright © 2013 CFA Institute21specific revenue recognition applications: ExampleCompany OLR, an online retailer, buys tickets (airline, concert, etc.), resells them for $100, and earns a 10% fee. What is the correct accounting?Alternative A: GrossRevenue $100Cost of goods sold $90Gross Profit $10Alternative B: NetRevenue $10Copyright © 2013 CFA Institute22specific revenue recognition applications: Example“We evaluate whether it is appropriate to record the gross amount of product sales and related costs or the net amount earned as commissions. Generally, when we are primarily obligated in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators, revenue is recorded at the gross sales price. We generally record the net amounts as commissions earned if we are not primarily obligated and do not have latitude in establishing prices.”Amazon Inc. (2011), 10-K Copyright © 2013 CFA Institute23general principles of Expense recognitionFundamental principle: A company recognizes expenses in the period in which it consumes (i.e., uses up) the economic benefits associated with the expenditure.Matching principle: Costs are matched with revenues.As with revenue recognition, expense recognition can occur independently of cash movements.Inventory and cost of goods soldPlant, property, and equipment and depreciationCopyright © 2013 CFA Institute24specific expense recognition applications: InventoryGoodsPurchasedBeginningInventoryGoodsAvailableforSaleEndingInventoryCost ofGoods SoldBalance SheetIncome StatementInventory Cost FlowCopyright © 2013 CFA Institute25specific expense recognition applications: ExampleInventory PurchasesFirst quarter 2,000 units at $40 per unitSecond quarter 1,500 units at $41 per unitThird quarter 2,200 units at $43 per unitFourth quarter 1,900 units at $45 per unitTotal 7,600 units at a total cost of $321,600Inventory sales during the year: 5,600 units at $50 per unitWhat are the revenue and expense for these transactions during the year?Assume the company specifically identifies thatthe 5,600 units sold were those purchased in the 1st and 2nd quarter plus 2,100 of the units purchased in the 3rd quarter andthe 2,000 remaining units were 100 of those purchased in the 3rd quarter plus the 1,900 purchased in the 4th quarter. Copyright © 2013 CFA Institute26specific expense recognition applications: Example SolutionRevenue = $280,000 (5,600 units times $50 per unit)Cost of Goods SoldThe 5,600 units that were sold were specifically identified as follows:From 1st quarter: 2,000 units at $40 per unit $80,000From 2nd quarter: 1,500 units at $41 per unit $61,500From 3rd quarter: 2,100 units at $43 per unit $90,300Total cost of goods sold $231,800Ending inventoryFrom the 3rd quarter: 100 units at $43 per unit $4,300From the 4th quarter: 1,900 units at $45 per unit $85,500Total remaining (or ending) inventory cost $89,800Copyright © 2013 CFA Institute27Total available for salespecific expense recognition applications: ExampleInventory PurchasesFirst quarter 2,000 units at $40 per unitSecond quarter 1,500 units at $41 per unitThird quarter 2,200 units at $43 per unitFourth quarter 1,900 units at $45 per unitTotal 7,600 units at a total cost of $321,600Inventory sales during the year 5,600 units at $50 per unit. Revenue and expense for these transactions during the year?Assume the company does not specifically identify the units, but instead uses the weighted average cost method of inventory costing. Copyright © 2013 CFA Institute28specific expense recognition applications: Example solutionRevenue = $280,000 (5,600 units times $50 per unit)Average cost per unit = Total cost of goods available divided by total units available = $321,600/7,600 units = $42.3158 per unitCost of goods sold =5,600 units at $42.3158 per unit $236,968Ending inventory = 2,000 units at $42.3158 per unit $84,632Copyright © 2013 CFA Institute29Total available for salespecific expense recognition applications: ExampleInventory PurchasesFirst quarter 2,000 units at $40 per unitSecond quarter 1,500 units at $41 per unitThird quarter 2,200 units at $43 per unitFourth quarter 1,900 units at $45 per unitTotal 7,600 units at a total cost of $321,600Inventory sales during the year: 5,600 units at $50 per unit. What are the revenue and expense for these transactions during the year?Assume the company does not specifically identify the units, but instead uses the FIFO (first in, first out) method of inventory costing. Copyright © 2013 CFA Institute30specific expense recognition applications: Example solutionInventory PurchasesFirst quarter 2,000 units at $40 per unitSecond quarter 1,500 units at $41 per unitThird quarter 2,200 units at $43 per unitFourth quarter 1,900 units at $45 per unitTotal 7,600 units at a total cost of $321,600Using the FIFO method of inventory costing: Copyright © 2013 CFA Institute31FIFO to determine COGS: 2,000 from 1st quarter at $40 per unit + 1,500 from 2nd quarter at $41 per unit + 2,100 from 3rd quarter at $43 per unit COGS = $231,800specific expense recognition applications: ExampleInventory PurchasesFirst quarter 2,000 units at $40 per unitSecond quarter 1,500 units at $41 per unitThird quarter 2,200 units at $43 per unitFourth quarter 1,900 units at $45 per unitTotal 7,600 units at a total cost of $321,600Inventory sales during the year: 5,600 units at $50 per unit. What are the revenue and expense for these transactions during the year?Assume the company does not specifically identify the units, but instead uses the LIFO method of inventory costing. Copyright © 2013 CFA Institute32LIFO is not allowed under IFRS.Assume the company reports under U.S. GAAP and uses the LIFO (last in, first out) method of inventory costing.specific expense recognition applications: Example solutionInventory PurchasesFirst quarter 2,000 units at $40 per unitSecond quarter 1,500 units at $41 per unitThird quarter 2,200 units at $43 per unitFourth quarter 1,900 units at $45 per unitTotal 7,600 units at a total cost of $321,600Using the LIFO method of inventory costing:Copyright © 2013 CFA Institute33LIFO to determine COGS: 1,900 from 4th quarter at $45 per unit + 2,200 units at $43 per unit + 1,500 units at $41 per unit COGS = $241,600Summary Table on Inventory Costing MethodsMethodDescriptionCOGS when prices are rising relative to the other two methodsEnding Inventory when prices are rising relative to the other two methodsFIFOAssumes that earliest items purchased were sold firstLowestHighestLIFOAssumes most recent items purchased were sold firstHighest*Lowest*Average CostAverages total costs over total units availableMiddleMiddleCopyright © 2013 CFA Institute34*Assumes no LIFO layer liquidation. LIFO layer liquidation occurs when the volume of sales exceeds the volume of other purchases in the period so that some sales are assumed to be from existing, relatively low-priced inventory rather than from more recent purchases.Inventory method: example disclosure“Inventory Valuation Inventories are valued at the lower of cost or market value. Product related inventories are primarily maintained on the first-in, first-out method. Minor amounts of product inventories, including certain cosmetics and commodities, are maintained on the last-in, first-out method. The cost of spare part inventories is maintained using the average cost method.Procter & Gamble (2011), Annual Report“Inventories are valued at the lower of cost or net realizable value. Cost is calculated using the weighted average cost method.”L’Oreal Group (2011), Registration DocumentCopyright © 2013 CFA Institute35Inventory method: example disclosure“Inventories. Inventories are stated at the lower of cost or market. The cost of approximately 80% of inventories is determined using the first-in, first-out (FIFO) method. The cost of all other inventories, predominantly in the U.S. and Mexico, is determined using the last-in, first-out (LIFO) method.”Colgate-Palmolive (2011), Annual Report (Note 2) “Inventories valued under LIFO amounted to $271 and $263 at December 31, 2011 and 2010, respectively. The excess of current cost over LIFO cost at the end of each year was $30 and $52, respectively. The liquidations of LIFO inventory quantities had no material effect on income in 2011, 2010 and 2009.”Colgate-Palmolive (2011), Annual Report (Note 16) Copyright © 2013 CFA Institute36specific expense recognition applications: depreciationDepreciation: Process of systematically allocating costs of long-lived assets over the period during which the assets are expected to provide economic benefits. Depreciation: term commonly applied for physical long-lived assets, such as plant and equipment (NOT land)Amortization: Term commonly applied to this process for intangible long-lived assets with a finite useful lifeDepreciation Methods: Straight lineAccelerated (i.e., diminishing balance)Units of productionCopyright © 2013 CFA Institute37specific expense recognition applications: depreciation exampleEquipment cost = $9,000. Estimated residual = $0. Useful life = 3 years.Annual depreciation expense = (Cost – Residual value)/Useful life. Copyright © 2013 CFA Institute38Cost of equipment$9,000Less Year 1 depreciation expense– 3,000Book value at end of Year 1 $6,000Less Year 2 depreciation expense– 3,000Book value at end of Year 2$3,000Less Year 3 depreciation expense– 3,000Book value at end of Year 3$0specific expense recognition applications: depreciation exampleJudgments and estimates needed in depreciation:estimated salvage valueestimated useful lifeFor example, given a purchase price of $10,000, what is the annual straight-line depreciation expenseif estimated salvage value = $5,000 and useful life = 10 years?if estimated salvage value = $0 and useful life = 2 years? Copyright © 2013 CFA Institute39specific expense recognition applications: depreciation exampleDiminishing Balance DepreciationDetermine straight-line rate (100%/Useful life) Determine acceleration factor (e.g., 1.5× or 2×)Depreciation rate = (Straight-line rate x acceleration factor)Depreciation expense = Net book value (NBV) x Depreciation rateDiscontinue depreciation when net book value = Salvage valueExample: What is the annual depreciation expense each year?Asset cost: $11,000Estimated salvage value: $1,000Estimated useful life: 5 yearsAcceleration factor: 2×Copyright © 2013 CFA Institute40specific expense recognition applications: depreciation example solutionYearNBV Beginning of YearDepreciation Expense Accumulated DepreciationNBV End of Year1 11,000 4,400 4,400 6,600 2 6,600 2,640 7,040 3,960 3 3,960 1,584 8,624 2,376 4 2,376 950 9,574 1,426 5 1,426 426 10,000 1,000 Copyright © 2013 CFA Institute41nonrecurring items and changes in accounting standardsSeparating nonrecurring from recurring items of income and expense can help an analyst assess a company’s future earnings.Nonrecurring items: discontinued operationsextraordinary items (not permitted under IFRS)unusual or infrequent itemsChanges in accounting standardsCopyright © 2013 CFA Institute42Earnings per shareEarnings per share (EPS) is the net earnings available to common stockholders for the period divided by the weighted average number of common stock shares outstandingIf firm has a “complex” capital structure, it will report basic and diluted EPS.EPS is extensively used by analysts in evaluating a firm.Copyright © 2013 CFA Institute43Colgate's Annual ReportL'Oreal's Annual ReportEPS: Example 1Basic EPS Earnings available to common shareholders divided by weighted average number of shares outstandingBasic EPS = (Net income – Preferred dividends)  Weighted average number of shares outstandingAssume the following: Company had net income of $2,431 million for the year,488.3 million weighted average number of common shares outstandingNo preferred stock, no convertible securities, no optionsWhat was the company’s basic EPS?Copyright © 2013 CFA Institute44Colgate's Annual ReportEPS: Example 1 SolutionAssume the following: Company had net income of $2,431 million for the year488.3 million weighted average number of common shares outstandingNo preferred stock, no convertible securities, no optionsWhat was the company’s Basic EPS?Basic EPS = (Net income – Preferred dividends)/Weighted average number of shares outstanding= ($2,431 – $0)/488.3 = $4.98Copyright © 2013 CFA Institute45Colgate's Annual ReportEPS: Example 2 Weighted Average Number of SharesCalculate the weighted average number of shares outstandingthe company’s basic EPS Assume the following:Company had net income of $2,500,000 for the year and paid $200,000 of preferred dividends.1,000,000 Shares outstanding on 1 January 20XX 200,000 Shares issued on 1 April 20XX (100,000) Shares repurchased on 1 October 20XX1,100,000 Shares outstanding on 31 December 20XXCopyright © 2013 CFA Institute46EPS: Example 2 SolutionWeighted Average Number of SharesWeighted average number of shares outstanding 1,000,000 × (3 months/12 months) Jan, Feb, Mar + 1,200,000 × (6 months/12 months) April–Oct+ 1,100,000 × (3 months/12 months) Oct, Nov, Dec= 1,125,000 Weighted average number of shares outstandingBasic EPS = (Net income – Preferred dividends)/Weighted average number of shares outstanding= ($2,500,000 – $200,000)/1,125,000 = $2.04Copyright © 2013 CFA Institute47EPS: Example 3 If-converted method for Convertible Preferred StockAssume a company has the following:net income of $1,750,000an average of 500,000 shares of common stock outstanding20,000 shares of convertible preferred outstandingno other potentially dilutive securitiesEach share of preferred pays a dividend of $10 per share, and each is convertible into five shares of the company’s common stock. Calculate the company’s basic and diluted EPS.Diluted EPS = Net income/(Weighted average number of shares outstanding + New shares issued at conversion)Copyright © 2013 CFA Institute48EPS: Example 3 If-converted method for Convertible Preferred Stock solutionCopyright © 2013 CFA Institute49Basic EPSDiluted EPS UsingIf-Converted MethodNet income$1,750,000$1,750,000Preferred dividend– 200,000 0Numerator$1,550,000$1,750,000Weighted average number of shares outstanding500,000500,000If converted 0100,000Denominator500,000600,000EPS$3.10$2.92 EPS: Example 4 If-converted method for Convertible debtAssume a company has the following:net income of $750,000an average of 690,000 shares of common stock outstanding$50,000 of 6% convertible bonds outstanding that are convertible into a total of 10,000 sharesno other potentially dilutive securitiesAn effective tax rate is 30%Calculate the company’s basic and diluted EPS.Diluted EPS = (Net income + After-tax interest on convertible debt – Preferred dividends)/(Weighted average number of shares outstanding + Additional common shares that would have been issued at conversion)Copyright © 2013 CFA Institute50EPS: Example 4 If-converted method for Convertible debt solutionCopyright © 2013 CFA Institute51Basic EPSDiluted EPS UsingIf-Converted MethodNet income$750,000$750,000After-tax cost of interest02,100Preferred dividend– 0 0Numerator$750,000$752,100Weighted average number of shares outstanding690,000690,000If converted 010,000Denominator690,000700,000Earnings per share (EPS)$1.09$1.07 EPS: Example 5 Treasury Stock Method for Stock OptionsAssume a company reported net income of $2.3 million for the year ended 30 June 2005 and has the following:an average of 800,000 common shares outstanding30,000 options with an exercise price of $35 outstandingno other potentially dilutive securitiesOver the year, its market price averaged $55 per share. Calculate the company’s basic and diluted EPS.Diluted EPS = (Net Income – Preferred dividends)/(Weighted average number of shares outstanding + New shares issued at option exercise – Shares that could have been purchased with cash received upon exercise)Copyright © 2013 CFA Institute52EPS: Example 5 Treasury Stock Method for Stock Options solution800,000Weighted average number of shares outstanding + 30,000New shares issued at option exercise – 19,091Shares that could be purchased with cash received upon exercise, calculated as $1,050,000 ($35 for each of the 30,000 options exercised) divided by average market price of $55 per share = 19,091 shares = 810,909SharesCopyright © 2013 CFA Institute53Calculate Denominator30,000 – 19,091 = 10,909EPS: Example 5 Treasury Stock Method for Stock Options solutionCopyright © 2013 CFA Institute54Basic EPSDiluted EPS Using Treasury Stock MethodNet income$2,300,000$2,300,000Numerator$ 2,300,000$2,300,000Weighted average number of shares outstanding800,000800,000If exercised and treasury shares purchased 0 10,909Denominator800,000810,909EPS$2.88$2.84dilutive vs. antidilutive securitiesDilutive securities: securities that, if included in a diluted EPS calculation, result in an EPS lower than the company’s basic EPS Antidilutive securities: securities that, if included in a diluted EPS calculation, would result in an EPS higher than the company’s basic EPSAntidilutive securities are not included in the calculation of diluted EPS.Diluted EPS should reflect the maximum potential dilution from conversion or exercise of potentially dilutive financial instruments. By definition, diluted EPS will always be less than or equal to basic EPS. Copyright © 2013 CFA Institute55common-size income statementsPanel A: Partial Income Statements for Companies A, B, and C($)ABCSales$10,000,000$10,000,000$2,000,000Cost of sales3,000,0007,500,000600,000Gross profit7,000,0002,500,0001,400,000    Selling, general, and administrative expenses1,000,0001,000,000200,000Research and development2,000,000—400,000Advertising2,000,000—400,000Operating profit2,000,0001,500,000400,000Copyright © 2013 CFA Institute56common-size income statementsCopyright © 2013 CFA Institute57Panel B: Common-Size Income Statements for Companies A, B, and CABCSales100%100%100%Cost of sales307530Gross profit702570    Selling, general, and administrative expenses101010Research and development20020Advertising20020Operating profit201520Each line item is expressed as a percentage of the company’s sales.Income Statement RatiosNet profit margin = Net income/RevenueNet profit margin measures the amount of income that a company was able to generate for each dollar of revenue. Higher level of net profit margin indicates higher profitability (generally more desirable). Net profit margin can also be found directly on the common-size income statements.Also referred to as “return on sales.”Profitability ratios found directly on the common-size income statement.Gross profit margin = Gross profit/Revenue.Operating profit margin = Operating profit/RevenuePretax profit margin = Pretax profit/RevenueNet profit marginCopyright © 2013 CFA Institute58Colgate and L'Oreal Income StatementsComprehensive income Beginning Equity+ or – Change= Ending EquityRetained earnings+ Net income– DividendsRetained earningsAccumulated other comprehensive income+ Other comprehensive income– Other comprehensive lossAccumulated other comprehensive incomeStock+ Issuances – RepurchasesStockCopyright © 2013 CFA Institute59Foreign currency translation adjustmentsUnrealized gains or losses on derivatives contracts accounted for as hedgesUnrealized holding gains and losses on available-for-sale securitiesCertain costs of a company’s defined benefit post-retirement plans that are not recognized in the current periodComprehensive income: example Copyright © 2013 CFA Institute60Assume the following about a company:beginning shareholders’ equity is €200 millionnet income for the year is €20 millioncash dividends for the year are €3 millionno issuance or repurchase of common stock. actual ending shareholders’ equity is €227 million.What amount has bypassed the net income calculation by being classified as other comprehensive income?What is the company’s comprehensive income?Comprehensive income: example solution Copyright © 2013 CFA Institute61Assume the following about a company:beginning shareholders’ equity is €200 millionnet income for the year is €20 millioncash dividends for the year are €3 millionno issuance or repurchase of common stockactual ending shareholders’ equity is €227 millionWhat amount has bypassed the net income calculation by being classified as Other comprehensive income?Answer: €10 million.What is the company’s total comprehensive income?Answer: €30 millionsummaryIncome statement shows how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue.Accounting issues relate primarily to timing (revenue recognition, expense recognition, nonrecurring items).The income statement also presents EPS (earnings per share), an important metric.Tools for income statement analysis include common-size analysis and profitability ratios.Comprehensive income includes net income and other comprehensive income.Copyright © 2013 CFA Institute62