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CHAPTER 4

UNDERSTANDING INCOME STATEMENTS


Presenters name
Presenters title
dd Month yyyy

OVERVIEW
Income statement components and format
Accounting issues
- Revenue recognition
- Expense recognition
- Inventory
- Depreciation
- Nonrecurring items
Earnings per share
Income statement analysis
Comprehensive income
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INCOME STATEMENT COMPONENTS


Also called the statement of earnings, statement of
operations, and profit and loss statement (P&L)
Presents results of operations for the accounting period
Revenues Expenses = Net income
Revenue + Other Income + Gains Expenses Losses
= Net income

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INCOME STATEMENT FORMAT


Subtotals
- Gross profit (i.e., revenue less cost of sales)
- Multistep format: Income statement shows gross profit
subtotal
- Single-step format: Income statement excludes gross profit
subtotal
- Operating profit (i.e., revenue less all operating expenses)
- Profits before deducting taxes and interest expense and
before any other nonoperating items
- Operating profit and EBIT (earnings before interest and
taxes) are not necessarily the same
Expense Grouping
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INCOME STATEMENT FORMAT: EXAMPLE 1


COLGATE-PALMOLIVE COMPANY

Colgate Annual Report


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INCOME STATEMENT FORMAT: EXAMPLE 2


LOREAL GROUP

L'Oreal's Annual Report


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INCOME STATEMENT FORMAT: EXAMPLE 3


PROCTER & GAMBLE

Proctor & Gamble Report


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GENERAL PRINCIPLES OF REVENUE


RECOGNITION AND ACCRUAL ACCOUNTING
Revenue recognition can occur independently of cash
movementsfor example, in the case of the
- sale 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.

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WHEN TO RECOGNIZE REVENUE


IFRS 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; and
- Costs incurred with respect to the transaction can be
measured reliably.

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WHEN TO RECOGNIZE REVENUE


U.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:
1. There is evidence of an arrangement between buyer and
seller.
2. The product has been delivered, or the service has been
rendered.
3. The price is determined or determinable.
4. The seller is reasonably sure of collecting money.
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SPECIFIC REVENUE RECOGNITION


APPLICATIONS: LONG-TERM CONTRACTS
Long-term contract: contract that spans a number of
accounting periods.
Percentage-of-completion method
- Use 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.
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SPECIFIC REVENUE RECOGNITION APPLICATIONS:


LONG-TERM CONTRACTS EXAMPLE
Example that uses the percentage-of-completion method of
revenue recognition:
Network Construction project: bid was $5,000,000 and
estimated costs to complete were $4,000,000
- Year 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 $1,000,000
- Revenue?
- Cost of revenue?
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SPECIFIC REVENUE RECOGNITION APPLICATIONS:


LONG-TERM CONTRACTS EXAMPLE
Example 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?
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SPECIFIC REVENUE RECOGNITION


APPLICATIONS: LONG-TERM CONTRACTS
Percentage-of-completion is the preferred method under both
IFRS and U.S. GAAP
When 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.

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SPECIFIC REVENUE RECOGNITION APPLICATIONS:


LONG-TERM CONTRACTS EXAMPLE
Assume 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?

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SPECIFIC REVENUE RECOGNITION APPLICATIONS:


LONG-TERM CONTRACTS EXAMPLE
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?
Answer: Under IFRS, recognize revenue to the extent of contract costs incurred.
Company would recognize
- Year 1, $3 million construction cost, $3 million revenue, and thus, $0 income
- Year 2, $2.4 million construction cost, $2.4 million revenue, and thus, $0 income
- Year 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 income
- Year 2, $0 million construction cost, $0 million revenue, and thus, $0 income
- Year 3, $6 million construction cost, $10 million revenue (because the contract
has been completed), and thus, $4 million income

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SPECIFIC 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.
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SPECIFIC REVENUE RECOGNITION


APPLICATIONS: INSTALLMENT SALES
Sale of real estate under U.S. GAAP
A 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 either
1) assured of collecting the selling price or
2) 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, or
-)the cost recovery method, in which the seller does not report any
profit until the cash amounts paid by the buyerincluding principal
and interest on any financing from the sellerare greater than all the
sellers costs of the property.
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SPECIFIC 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 if
1) the installment method is used?
2) the cost recovery method is used?

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SPECIFIC 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 sellers cost of
$1,100,000.
- Seller will recognize $0 profit attributable to the down payment.
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SPECIFIC 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 and
- record 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 guidance
- Report 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.
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SPECIFIC REVENUE RECOGNITION


APPLICATIONS: EXAMPLE
Company 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: Gross
- Revenue
- Cost of goods sold

$100
$90

- Gross Profit

$10

Alternative B: Net
- Revenue

$10

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SPECIFIC 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

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GENERAL PRINCIPLES OF EXPENSE


RECOGNITION
Fundamental 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 sold
- Plant, property, and equipment and depreciation

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SPECIFIC EXPENSE RECOGNITION


APPLICATIONS: INVENTORY
Inventory Cost Flow
Beginning
Inventory
Goods
Purchased

Balance Sheet

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Goods
Available
for
Sale

Ending
Inventory
Cost of
Goods Sold

Income Statement

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SPECIFIC EXPENSE RECOGNITION


APPLICATIONS: EXAMPLE
Inventory Purchases
First quarter 2,000 units at $40 per unit
Second quarter 1,500 units at $41 per unit
Third quarter 2,200 units at $43 per unit
Fourth quarter
1,900 units at $45 per unit
Total
7,600 units at a total cost of $321,600
Inventory 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 specifically identifies that
- the 5,600 units sold were those purchased in the 1st and 2nd quarter
plus 2,100 of the units purchased in the 3rd quarter and
- the 2,000 remaining units were 100 of those purchased in the 3rd
quarter plus the 1,900 purchased in the 4th quarter.
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SPECIFIC EXPENSE RECOGNITION


APPLICATIONS: EXAMPLE SOLUTION
Revenue = $280,000
(5,600 units times $50 per unit)

Total available
for sale

Cost of Goods Sold


The 5,600 units that were sold were specifically identified
as follows:
From 1st quarter: 2,000 units at $40 per unit
$80,000
From 2nd quarter: 1,500 units at $41 per unit $61,500
From 3rd quarter: 2,100 units at $43 per unit $90,300
Total cost of goods sold
$231,800
Ending inventory
From the 3rd quarter: 100 units at $43 per unit
$4,300
From the 4th quarter: 1,900 units at $45 per unit $85,500
Total remaining (or ending) inventory cost $89,800
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SPECIFIC EXPENSE RECOGNITION


APPLICATIONS: EXAMPLE
Inventory Purchases
First quarter 2,000 units at $40 per unit
Second quarter 1,500 units at $41 per unit
Third quarter 2,200 units at $43 per unit
Fourth quarter
1,900 units at $45 per unit
Total
7,600 units at a total cost of $321,600
Inventory 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.

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SPECIFIC EXPENSE RECOGNITION


APPLICATIONS: EXAMPLE SOLUTION
Revenue = $280,000
(5,600 units times $50 per unit)

Total available
for sale

Average cost per unit =


Total cost of goods available divided by total units available =
$321,600/7,600 units = $42.3158 per unit
Cost of goods sold =
5,600 units at $42.3158 per unit

$236,968

Ending inventory =
2,000 units at $42.3158 per unit

$84,632

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SPECIFIC EXPENSE RECOGNITION


APPLICATIONS: EXAMPLE
Inventory Purchases
First quarter 2,000 units at $40 per unit
Second quarter 1,500 units at $41 per unit
Third quarter 2,200 units at $43 per unit
Fourth quarter
1,900 units at $45 per unit
Total
7,600 units at a total cost of $321,600
Inventory 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.

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SPECIFIC EXPENSE RECOGNITION


APPLICATIONS: EXAMPLE SOLUTION
Inventory Purchases
First quarter 2,000 units at $40 per unit
Second quarter 1,500 units at $41 per unit
Third quarter 2,200 units at $43 per unit
Fourth quarter
1,900 units at $45 per unit
Total
7,600 units at a total cost of $321,600
Using the FIFO method of inventory costing:
FIFO 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 = $231,800

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SPECIFIC EXPENSE RECOGNITION


APPLICATIONS: EXAMPLE
Inventory Purchases
First quarter 2,000 units at $40 per unit
Second quarter 1,500 units at $41 per unit
Third quarter 2,200 units at $43 per unit
Fourth quarter
1,900 units at $45 per unit
Total
7,600 units at a total cost of $321,600
Inventory 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
reports
under under
U.S. GAAP
LIFO is
not allowed
IFRS.and uses the LIFO
Assume
company
does notofspecifically
identify the units, but instead
(last the
in, first
out) method
inventory costing.
uses the LIFO method of inventory costing.

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SPECIFIC EXPENSE RECOGNITION


APPLICATIONS: EXAMPLE SOLUTION
Inventory Purchases
First quarter 2,000 units at $40 per unit
Second quarter 1,500 units at $41 per unit
Third quarter 2,200 units at $43 per unit
Fourth quarter
1,900 units at $45 per unit
Total
7,600 units at a total cost of $321,600
Using the LIFO method of inventory costing:
LIFO 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 = $241,600

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SUMMARY TABLE ON INVENTORY


COSTING METHODS
COGS when
prices are rising
relative to the
other two
methods

Method

Description

FIFO

Assumes that earliest


items purchased were
Lowest
sold first
Assumes most recent
items purchased were
Highest*
sold first
Averages total costs
Middle
over total units available

LIFO
Average
Cost

Ending Inventory
when prices are
rising relative to the
other two methods
Highest
Lowest*
Middle

*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.

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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.
LOreal Group (2011), Registration Document

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INVENTORY 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 firstin, 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)

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SPECIFIC EXPENSE RECOGNITION


APPLICATIONS: DEPRECIATION
Depreciation: 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 life
Depreciation Methods:
- Straight line
- Accelerated (i.e., diminishing balance)
- Units of production

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SPECIFIC EXPENSE RECOGNITION


APPLICATIONS: DEPRECIATION EXAMPLE
Equipment cost = $9,000. Estimated residual = $0. Useful life = 3 years.
Annual depreciation expense = (Cost Residual value)/Useful life.

Cost of equipment

$9,000

Less Year 1 depreciation expense

3,000

Book value at end of Year 1

$6,000

Less Year 2 depreciation expense

3,000

Book value at end of Year 2

$3,000

Less Year 3 depreciation expense

3,000

Book value at end of Year 3


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$0
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SPECIFIC EXPENSE RECOGNITION


APPLICATIONS: DEPRECIATION EXAMPLE
Judgments and estimates needed in depreciation:
- estimated salvage value
- estimated useful life
For example, given a purchase price of $10,000, what is
the annual straight-line depreciation expense
- if estimated salvage value = $5,000 and useful life = 10
years?
- if estimated salvage value = $0 and useful life = 2 years?

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SPECIFIC EXPENSE RECOGNITION


APPLICATIONS: DEPRECIATION EXAMPLE
Diminishing Balance Depreciation
Determine 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
rate
Discontinue depreciation when net book value = Salvage value
Example: What is the annual depreciation expense each year?
Asset cost: $11,000
Estimated salvage value: $1,000
Estimated useful life: 5 years
Acceleration factor: 2
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SPECIFIC EXPENSE RECOGNITION APPLICATIONS:


DEPRECIATION EXAMPLE SOLUTION

Year

NBV
Beginning of
Year

Depreciation
Expense

Accumulated
Depreciation

NBV End of
Year

11,000

4,400

4,400

6,600

6,600

2,640

7,040

3,960

3,960

1,584

8,624

2,376

2,376

950

9,574

1,426

1,426

426

10,000

1,000

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NONRECURRING ITEMS AND CHANGES IN


ACCOUNTING STANDARDS
Separating nonrecurring from recurring items of income
and expense can help an analyst assess a companys
future earnings.
Nonrecurring items:
- discontinued operations
- extraordinary items (not permitted under IFRS)
- unusual or infrequent items
Changes in accounting standards

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EARNINGS PER SHARE


Earnings per share (EPS) is the net earnings available to
common stockholders for the period divided by the
weighted average number of common stock shares
outstanding
If firm has a complex capital structure, it will report basic
and diluted EPS.
EPS is extensively used by analysts in evaluating a firm.
Colgate's Annual Report
L'Oreal's Annual Report

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EPS: EXAMPLE 1
Basic EPS
- Earnings available to common shareholders divided by weighted
average number of shares outstanding
Basic EPS =
(Net income Preferred dividends)
Weighted average number of shares outstanding
Assume the following:
- Company had net income of $2,431 million for the year,
- 488.3 million weighted average number of common shares outstanding
- No preferred stock, no convertible securities, no options
What was the companys basic EPS?
Colgate's Annual Report
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EPS: EXAMPLE 1 SOLUTION


Assume the following:
- Company had net income of $2,431 million for the year
- 488.3 million weighted average number of common shares outstanding
- No preferred stock, no convertible securities, no options
What was the companys Basic EPS?
Basic EPS
= (Net income Preferred dividends)/Weighted average number of
shares outstanding
= ($2,431 $0)/488.3
= $4.98
Copyright 2013 CFA Institute

Colgate's Annual Report


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EPS: EXAMPLE 2
WEIGHTED AVERAGE NUMBER OF SHARES
Calculate
(1) the weighted average number of shares outstanding
(2) the companys 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
200,000

Shares outstanding on 1 January 20XX


Shares issued on 1 April 20XX

(100,000)

Shares repurchased on 1 October 20XX

1,100,000

Shares outstanding on 31 December 20XX

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EPS: EXAMPLE 2 SOLUTION


WEIGHTED AVERAGE NUMBER OF SHARES
Weighted average number of shares outstanding
1,000,000 (3 months/12 months) Jan, Feb, Mar
+ 1,200,000 (6 months/12 months) AprilOct
+ 1,100,000

(3 months/12 months) Oct, Nov, Dec

= 1,125,000

Weighted average number of shares outstanding

Basic EPS
= (Net income Preferred dividends)/Weighted average number
of shares outstanding
= ($2,500,000 $200,000)/1,125,000
= $2.04
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EPS: EXAMPLE 3
IF-CONVERTED METHOD FOR CONVERTIBLE PREFERRED
STOCK
Assume a company has the following:
- net income of $1,750,000
- an average of 500,000 shares of common stock outstanding
- 20,000 shares of convertible preferred outstanding
- no other potentially dilutive securities
Each share of preferred pays a dividend of $10 per share, and each is
convertible into five shares of the companys common stock.
Calculate the companys basic and diluted EPS.
Diluted EPS
= Net income/(Weighted average number of shares outstanding
+ New shares issued at conversion)
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EPS: EXAMPLE 3
IF-CONVERTED METHOD FOR CONVERTIBLE PREFERRED
STOCK SOLUTION
Basic EPS

Diluted EPS Using


If-Converted Method

Net income
Preferred dividend

$1,750,000
200,000

$1,750,000
0

Numerator

$1,550,000

$1,750,000

500,000
0
500,000

500,000
100,000
600,000

$3.10

$2.92

Weighted average number of shares


outstanding
If converted
Denominator
EPS
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EPS: EXAMPLE 4
IF-CONVERTED METHOD FOR CONVERTIBLE
DEBT
Assume a company has the following:
- net income of $750,000
- an 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 shares
- no other potentially dilutive securities
- An effective tax rate is 30%
Calculate the companys 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)
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EPS: EXAMPLE 4
IF-CONVERTED METHOD FOR CONVERTIBLE DEBT
SOLUTION
Diluted EPS Using
Basic EPS If-Converted Method
Net income
After-tax cost of interest
Preferred dividend

$750,000
0
0

$750,000
2,100
0

Numerator

$750,000

$752,100

690,000
0
690,000

690,000
10,000
700,000

$1.09

$1.07

Weighted average number of shares


outstanding
If converted
Denominator
Earnings per share (EPS)
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EPS: EXAMPLE 5
TREASURY STOCK METHOD FOR STOCK OPTIONS
Assume 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 outstanding
- 30,000 options with an exercise price of $35 outstanding
- no other potentially dilutive securities
Over the year, its market price averaged $55 per share.
Calculate the companys 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)
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EPS: EXAMPLE 5
TREASURY STOCK METHOD FOR STOCK OPTIONS
SOLUTION

Calculate Denominator
800,000 Weighted average number of shares outstanding
+ 30,000 New shares issued at option exercise
Shares that could be purchased with cash received
upon exercise, calculated as $1,050,000 ($35 for
19,091 each of the 30,000 options exercised) divided by
average market price of $55 per share = 19,091
shares
= 810,909 Shares
30,000 19,091 = 10,909

Copyright 2013 CFA Institute

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EPS: EXAMPLE 5
TREASURY STOCK METHOD FOR STOCK OPTIONS
SOLUTION

Net income
Numerator
Weighted average number
of shares outstanding
If exercised and treasury
shares purchased
Denominator
EPS
Copyright 2013 CFA Institute

Diluted EPS Using


Treasury Stock
Basic EPS
Method
$2,300,000
$2,300,000
$ 2,300,000
$2,300,000

800,000

800,000

0
800,000

10,909
810,909

$2.88

$2.84
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DILUTIVE VS. ANTIDILUTIVE SECURITIES


Dilutive securities: securities that, if included in a diluted EPS
calculation, result in an EPS lower than the companys basic EPS
Antidilutive securities: securities that, if included in a diluted EPS
calculation, would result in an EPS higher than the companys
basic EPS
- Antidilutive 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 Institute

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COMMON-SIZE INCOME STATEMENTS


Panel A: Partial Income Statements for Companies A, B, and C
($)
A
B
Sales

$10,000,000

$10,000,000

$2,000,000

Cost of sales

3,000,000

7,500,000

600,000

Gross profit

7,000,000

2,500,000

1,400,000

Selling, general, and


administrative expenses

1,000,000

1,000,000

200,000

Research and development

2,000,000

400,000

Advertising

2,000,000

400,000

Operating profit

2,000,000

1,500,000

400,000

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COMMON-SIZE INCOME STATEMENTS


Panel B: Common-Size Income Statements for Companies A, B, and C
A
B
C
Sales
Cost of sales
Gross profit
Selling, general, and
administrative expenses
Research and development
Advertising
Operating profit

100%
30
70

100%
75
25

100%
30
70

10
20
20
20

10
0
0
15

10
20
20
20

Each line item is expressed as a percentage of the


companys sales.
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INCOME STATEMENT RATIOS


Net profit margin = Net income/Revenue
- Net 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/Revenue
- Pretax profit margin = Pretax profit/Revenue
- Net profit margin
Copyright 2013 CFA Institute

Colgate and L'Oreal Income Statements


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COMPREHENSIVE INCOME
Beginning Equity

+ or Change

= Ending Equity

Retained earnings

+ Net income
Dividends

Retained earnings

Accumulated other
comprehensive income

+ Other comprehensive
income
Other comprehensive
loss

Accumulated other
comprehensive income

Stock

+ Issuances
Repurchases

Stock

1. Foreign currency translation adjustments


2. Unrealized gains or losses on derivatives contracts accounted for as
hedges
3. Unrealized holding gains and losses on available-for-sale securities
4. Certain costs of a companys defined benefit post-retirement plans that
are not recognized in the current period
Copyright 2013 CFA Institute

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COMPREHENSIVE INCOME:
EXAMPLE
Assume the following about a company:
- beginning shareholders equity is 200 million
- net income for the year is 20 million
- cash dividends for the year are 3 million
- no 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 companys comprehensive income?
Copyright 2013 CFA Institute

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COMPREHENSIVE INCOME:
EXAMPLE SOLUTION
Assume the following about a company:
- beginning shareholders equity is 200 million
- net income for the year is 20 million
- cash dividends for the year are 3 million
- no 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?
Answer: 10 million.
What is the companys total comprehensive income?
Answer: 30 million
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SUMMARY
Income 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 Institute

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