CHAPTER 4

UNDERSTANDING INCOME
STATEMENTS
 OVERVIEW
Income statement components and format
Accounting issues
 Revenue recognition
 Expense recognition
 Inventory
 Depreciation
 Nonrecurring items
Earnings per share
Income statement analysis
Comprehensive income

2
 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

3
 INCOME STATEMENT
Subtotals
FORMAT
 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

4
 INCOME STATEMENT FORMAT:
EXAMPLE 1
COLGATE-PALMOLIVE COMPANY

Colgate Annual Report

5
INCOME STATEMENT FORMAT:
EXAMPLE 2
L’OREAL GROUP

L'Oreal's Annual Report

6
INCOME STATEMENT FORMAT:
EXAMPLE 3
PROCTER & GAMBLE

Proctor & Gamble Report

7
 GENERAL PRINCIPLES OF
REVENUE RECOGNITION AND
ACCRUAL ACCOUNTING

Revenue recognition can occur independently of cash movements

—for 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.

8
 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.

9
 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.

10
 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.

11
 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?

12
 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?

13
 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.

14
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?

15
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

16
 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.

17
 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 buyer—including principal and interest
on any financing from the seller—are greater than all the seller’s costs of
the property.

18
 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?

19
 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 seller’s cost of $1,100,000.
 Seller will recognize $0 profit attributable to the down payment.
20
 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.

21
 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 $100
 Cost of goods sold $90
 Gross Profit $10
Alternative B: Net
 Revenue $10

22
 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
23
 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

24
 SPECIFIC EXPENSE RECOGNITION
APPLICATIONS: INVENTORY
Inventory Cost Flow

Beginning Ending
Inventory Goods
Inventory
Available
Goods for
Sale Cost of
Purchased Goods Sold

Balance Sheet Income Statement

25
 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.
26
 SPECIFIC EXPENSE
RECOGNITION APPLICATIONS:
EXAMPLE SOLUTION
Total available
for sale
Revenue = $280,000
(5,600 units times $50 per unit)

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

27
 SPECIFIC EXPENSE
RECOGNITION
APPLICATIONS:
Inventory Purchases
EXAMPLE
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.

28
 SPECIFIC EXPENSE
RECOGNITION APPLICATIONS:
EXAMPLE SOLUTION
Total available
for sale
Revenue = $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 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

29
 SPECIFIC EXPENSE
RECOGNITION
APPLICATIONS:
Inventory Purchases
EXAMPLE
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.

30
 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
31
 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.

Assume
What are the
the company
revenue reports
and
LIFO notunder
expense
is forU.S.
allowed GAAP
these and usesduring
transactions
under IFRS. the LIFO
the (last
in, first out) method of inventory costing.
year?

Assume the company does not specifically identify the units, but
instead uses the LIFO method of inventory costing.
32
 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
33
 SUMMARY TABLE ON INVENTORY
COSTING METHODS
COGS when prices Ending Inventory
are rising relative when prices are rising
Method Description
to the other two relative to the other
methods two methods
FIFO Assumes that earliest
items purchased were sold Lowest Highest
first
LIFO Assumes most recent
items purchased were sold Highest* Lowest*
first
Average Averages total costs over
Middle Middle
Cost total units available

*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.

34
 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 Document

35
 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 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)
36
 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

37
 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 $0
38
 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?

39
 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×

40
SPECIFIC EXPENSE RECOGNITION
APPLICATIONS: DEPRECIATION
EXAMPLE SOLUTION
NBV
Beginning of Depreciation Accumulated NBV End of
Year Year Expense Depreciation Year

1 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

41
 NONRECURRING ITEMS AND
CHANGES IN ACCOUNTING
STANDARDS
Separating nonrecurring from recurring items of income and
expense can help an analyst assess a company’s future earnings.
Nonrecurring items:
 discontinued operations
 extraordinary items (not permitted under IFRS)
 unusual or infrequent items
Changes in accounting standards

42
 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.
Colgate's Annual Report
EPS is extensively used by analysts in evaluating a firm.
L'Oreal's Annual Report

43
 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 company’s basic EPS? Colgate's Annual Report
44
 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 company’s Basic EPS?

Basic EPS
= (Net income – Preferred dividends)/Weighted average number of shares outstanding
= ($2,431 – $0)/488.3
= $4.98 Colgate's Annual Report
45
 EPS: EXAMPLE 2
WEIGHTED AVERAGE
NUMBER OF SHARES
Calculate
(1) the weighted average number of shares outstanding
(2) the 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 20XX
1,100,000 Shares outstanding on 31 December 20XX

46
 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) April–Oct
+ 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

47
 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 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)
48
 EPS: EXAMPLE 3
IF-CONVERTED METHOD FOR
CONVERTIBLE PREFERRED STOCK
SOLUTION

Diluted EPS Using

Basic EPS If-Converted Method

Net income $1,750,000 $1,750,000

Preferred dividend – 200,000 0

Numerator $1,550,000 $1,750,000

Weighted average number of shares

outstanding 500,000 500,000
If converted 0 100,000
Denominator 500,000 600,000

EPS $3.10 $2.92

49
 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 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)

50
 EPS: EXAMPLE 4
IF-CONVERTED METHOD FOR CONVERTIBLE
DEBT SOLUTION
Diluted EPS Using
Basic EPS If-Converted Method
Net income $750,000 $750,000
After-tax cost of interest 0 2,100
Preferred dividend –0 0
Numerator $750,000 $752,100

Weighted average number of shares

outstanding 690,000 690,000
If converted 0 10,000
Denominator 690,000 700,000

Earnings per share (EPS) $1.09 $1.07

51
 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 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)
52
 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 each of the
– 19,091
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

53
 EPS: EXAMPLE 5
TREASURY STOCK METHOD
FOR STOCK OPTIONS SOLUTION
Diluted EPS Using
Treasury Stock
Basic EPS Method
Net income $2,300,000 $2,300,000
Numerator $ 2,300,000 $2,300,000

Weighted average number

of shares outstanding 800,000 800,000
If exercised and treasury
shares purchased 0 10,909
Denominator 800,000 810,909

EPS $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 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 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.

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 COMMON-SIZE INCOME
STATEMENTS
Panel A: Partial Income Statements for Companies A, B, and C
($) A B C

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 100% 100% 100%

Cost of sales 30 75 30
Gross profit 70 25 70
       
Selling, general, and
administrative expenses 10 10 10
Research and development 20 0 20
Advertising 20 0 20
Operating profit 20 15 20

Each line item is expressed as a percentage of the company’s

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 Colgate and L'Oreal Income Statements

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 COMPREHENSIVE
Beginning Equity
INCOME
+ or – Change = Ending Equity
Retained earnings + Net income Retained earnings
– Dividends
Accumulated other + Other comprehensive Accumulated other
comprehensive income income comprehensive income
– Other comprehensive
loss
Stock + Issuances Stock
– Repurchases

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 company’s defined benefit post-retirement plans that are not
recognized in the current period

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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 company’s comprehensive income?
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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 company’s total comprehensive income?
Answer: €30 million 61
 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.

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