Understanding Income Statements. In this reading
we talk about components and format of the income
statement the rules of revenue recognition and
expense recognition, non-recurring items and non-operating
items, the concept of earnings per share. We then conclude
the reading with a discussion on the analysis of
the income statement and the concept of comprehensive
income. The income statement has several names.
It is also referred to as the profit and loss statement,
the P&L, and the statement of earnings. The income
statement provides financial results of a company's
business activities over a period so you will always see
an income statement for a given quarter or a given
year. The basic formula for the income statement
is as follows; net income is equal to the revenue minus
expenses, and as you have probably figured out, the
income statement is an important input for valuation
models. It's not the only input but it is one of the
most important inputs. Components and Format of
the Income Statement. The top line on the income statement
is the revenue line shown right here. Other names for
revenue include sales and turnover. Next, we see
what's called net revenue or net sales. In certain situations
a company might sell but there can be returns, once
we subtract returns we have a net revenue number.
Certain companies might sell through agents and
those agents charge commissions. When we subtract
the commission then also we are left with net revenue
or net sale. The income statement will show both
cash expenses and non-cash expenses. So for example
here, we might say that cost of goods sold is mostly
cash expense. Sales, General and Administrative
expenses also might largely be cash expenses. Depreciation,
on the other hand, is a non-cash charge. We subtract
these expenses which are generally called operating
expenses and we are left with operating profit.
This is also referred to as EBIT or earnings before
interest and taxes, then we subtract interest and
we have earnings before taxes, subtract taxes and
we end up with net income. This is a really simple
income statement. Single step vs. Multi-step format,
that we will discuss on the next slide. What you see
on the left is a single step format and on the right,
we have a multi-step format. The subtle difference
is that in a multi-step format we subtract cost
of goods sold and come up with a gross profit number.
In this case that number is half a million. Whereas
in a single step format we do not have a number for
gross profit so you notice that on the left this
gross profit item is missing. Obviously, it can
be calculated easily by simply subtracting 500,000
from a million, but in terms of describing this format,
we say that this is a single-step format. Coming now
to Revenue Recognition which is a very important
topic. Just as a general point first of all, in IFRS the
term income includes both revenue and gains, and
gains generally refers to gains on the sale of equipment
or other long-term assets. So a company which is
in the business of selling laptops will report revenue
number based on the sale of laptops. The company
might also sell a piece of equipment and realize a gain
so an equipment with a book value of 100 might
be sold for 110, this gain of 10 would be shown on the income
statement as a gain and all this top bullet point
is saying is that the term 'income' applies to both
the core revenue of the company as well as gains.
Now, coming to the concept of Revenue Recognition.
When a company sells goods can it recognize revenue
in the period where it, quote unquote, sells. If a company
sells goods for 100, cash, in period 1 and has no refund policy,
can it recognize revenue in period one and the answer is
a unambiguous yes, because clearly the goods have
been sold, the customer cannot return the goods
and the customer has paid cash. So, clearly the company
can show revenue of 100 for period 1. Let's look
at the second scenario now. What if the company
sells goods on credit in period 1 and will receive cash
in period 2. Can revenue be recognized in period 1? So this is period
1, period 2. The goods are sold over here, but cash will
be received later. So where do we recognize revenue,
period 1 or period 2. Accounting rules say that you can recognize revenue in period
1 as long as you are sure that money will be received. So the
answer to this question is that revenue should be
recognized in period 1. There are more details, but we will
see them later. What if an advance payment is received
in period 1, but goods and services are to be delivered
in period 2. When will the revenue be recognized? So we have
a slightly different situation here. In period 1, we get
the cash, but the goods will actually be delivered
in the second period. Here we cannot recognize the revenue
in period 1 because the goods and services have not been
delivered. It's only in period 2 when goods and services
are delivered we can recognize revenue. As we've
seen over the last few slides, Revenue Recognition
rules are different under IFRS and US GAAP, this makes
it difficult to compare IFRS vs. US GAAP companies.
In 2014 IASB and FASB issued converged accounting
standards and here we are going to talk about the
key aspects of the revenue recognition aspect of
the new standards. Under IFRS standards these new standards take effect
for periods starting 1st, January 2018 and under
US GAAP the date is 15th December 2017. First, lets understand
the core principle of the converged standard. Now,
this is again with respect to revenue recognition
so the principal is this, revenue should be recognized
to depict the transfer of promised goods or services to
customers in an amount that reflects the consideration
to which the entity expects to be in entitled in an exchange
for those goods or services. So if you have a given
entity that sells goods or services to a customer,
the goods or services are delivered and the entity
either receives payment or expects to receive payment
for the goods and services rendered, then the company
can recognize revenue. So that's the principle,
but clearly more detail is needed. So let's understand
the five steps in Revenue Recognition. Step 1 is
to identify the contract or contracts with a customer.
A contract is an agreement and commitment with commercial
substance between two parties. It establishes
each parties' obligations and rights including payment
terms. A contract exists only if collectability
is probable. Step 2, identify the performance obligations
in the contract. The performance obligations with
in a contract represent promises to transfer distinct
goods or services. A good or service is distinct
if, number one, the customer can benefit from it on
its own or in combination with readily available
resources, and number two, if the promise to transfer
it can be separated from other promises in the contract.
Let's understand the application of this step through
an example. Let's say we have a company called Builder
Co. and this enters into a contract with another
company called Customer Co. The contract is to construct
a commercial building. Builder Co. identifies various
goods and services to be provided and these include
pre-construction engineering, construction of the
buildings individual components, plumbing, electrical
wiring, and interior finishes. So all these are given
as separate goods and services. Now here is the question,
with respect to identifying performance obligations,
can each of these items; pre-construction engineering,
the construction of individual components, plumbing,
and so on so can each of these items be treated as separate
performance obligations with respect to revenue
recognition? So let's go back to these two criteria
and this is an and condition. For a given good or service
to be distinct or to be a particular performance
obligation the customer should be able to benefit
from it on its own or along with other readily available
resources, and the promise to transfer this particular
good or service can be separated from other promises
in the contract. In the example that I just gave which
comes from the curriculum, this condition is not
met because the contract is to construct a commercial
building and if that is the contract then these specific
items like pre-construction engineering cannot
be separated from other promises in the contract,
therefore these items do not enough themselves
represent performance obligations. Steps 3
is to determine the transaction price. Step 4 is to
allocate the transaction price to the performance
obligations in the contract. Now in my earlier example,
there was only one performance obligation. Let's
take another scenario, say a software company sells
a product and a consulting service which are two
separate performance obligations then here in step
4 we allocate a price to each of these performance
obligations, and then in step 5, revenue is recognized
when the entity satisfies a performance obligation.
So let's say the product is delivered upfront then
the revenue can be recognized once this product
has been delivered. The service is rendered over
a one year period so for this service the revenue is recognized
as this performance obligation is fulfilled. Now,
I'll give another example related to revenue recognition.
Let's say we have a long-term contract and we go back
to Builder company which is let's say constructing a building
over a two-year period for Customer Company,And
in this case the overall contract price is 1 million,
and let's say that the expected total cost is 700,000.
If during the first year the cost incurred is 420,000 and
the cost incurred is a visible indication of the
percentage of completion then the amount of revenue
that can be recognized over the first year is 420,000
divided by 700,000 into 1,000,000. This gives us 600,000 which means that
600,000 can be recognized as revenue in the first
year. Notice that what we have actually done is essentially the percentage
of completion method and with this new standard
the term 'percentage of completion' is not used but
effectively we are doing the same thing. This new
converged standard also gives guidance on how to
deal with variable consideration so for example,
if the customer service says to the entity that if the
project is completed on time, then there will be
a performance bonus of 200,000. So how should this
be accounted? The existing standards do not give
sufficient guidance on how to deal with this variable
consideration. But according to the new standard
a company is allowed to recognize variable consideration
if it can conclude that it will not have to reverse
the cumulative revenue in the future. Next point
and this is something new in the converged standard.
Companies should capitalize incremental cost
of obtaining a contract. So let's say that a company
is pursuing a large government contract, and in
order to get that contract the company has to incur
an additional fee of 50,000. In the current
standard this 50,000 might be expensed, but according
to the new converge standard this 50,000 should
be capitalized, in other words, an asset needs to be
created. There are also certain other costs which
are incurred in order to fulfill a contract which
need to be capitalized. The curriculum doesn't
specify what costs exactly need to be capitalized, but you
just need to recognize that any cost incurred to
obtain the contract and certain other costs to fulfill
the contract have to be capitalized. The final couple
of points have to do with disclosure. The disclosure
requirements are more elaborate with the converged standard,
and here are a couple of points that you need to know.
So companies should disclose information about
contracts with customers disaggregated into different
categories of contracts. So these categories can
be based on customer types, on geography, on contract
types, or on pricing terms. Companies should disclose
balances of any contract related assets and liabilities
and significant changes in those balances, remaining
performance obligations and transaction price
allocated to those obligations, and any significant
judgments and changes in judgment related to revenue.
The curriculum doesn't spend much time on this, but
very briefly contract related assets so there might
be situations where a company has delivered a performance
obligation, has recognized revenue, but not created
an accounts receivable yet. So until the time that
the accounts receivable is created a contract related
asset can be created which eventually then gets converted
into an accounts receivable. Now, a detailed understanding
of contract related assets and liabilities are
not required under the learning outcomes, but the
but the comment that I gave you right now should be good enough.
The larger point is that the disclosure requirements are
more rigorous with the new converged standard.