LEARNING OUTCOMES

The candidate should be able to:

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

2. describe general principles of revenue recognition and accrual accounting, specific revenue recognition applications (including accounting for long-term contracts, installment sales, barter transactions, gross and net reporting of revenue), and implications of revenue recognition principles for financial analysis;

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

4. describe key aspects of the converged accounting standards issued by the International Accounting Standards Board and Financial Accounting Standards Board in May 2014;

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

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

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

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

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

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

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

12. describe, calculate, and interpret comprehensive income;

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

1. INTRODUCTION

The income statement presents information on the financial results of a company’s business activities over a period of time. The income statement communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. The basic equation underlying the income statement, ignoring gains and losses, is Revenue minus Expenses equals Net income. The income statement is also sometimes referred to as the “statement of operations,” “statement of earnings,” or “profit and loss (P&L) statement.” Under International Financial Reporting Standards (IFRS), the income statement may be presented as a separate statement followed by a statement of comprehensive income that begins with the profit or loss from the income statement or as a section of a single statement of comprehensive income.1 US generally accepted accounting principles (US GAAP) permit the same alternative presentation formats.2 This reading focuses on the income statement, but also discusses comprehensive income (profit or loss from the income statement plus other comprehensive income).

Investment analysts intensely scrutinize companies’ income statements.3 Equity analysts are interested in them because equity markets often reward relatively high- or low-earnings growth companies with above-average or below-average valuations, respectively, and because inputs into valuation models often include estimates of earnings. Fixed-income analysts examine the components of income statements, past and projected, for information on companies’ abilities to make promised payments on their debt over the course of the business cycle. Corporate financial announcements frequently emphasize information reported in income statements, particularly earnings, more than information reported in the other financial statements.

3. REVENUE RECOGNITION

Revenue is the top line in an income statement, so we begin the discussion of line items in the income statement with revenue recognition. We will first discuss revenue recognition under IFRS and US GAAP prior to the application of converged standards issued May 2014. In May 2014, the IASB and FASB each issued a new standard for revenue recognition. The nearly identical standards result from an effort to achieve convergence, consistency, and transparency in revenue recognition globally. The standards are effective for reporting periods beginning after 1 January 2017 under IFRS and after 15 December 2016 under US GAAP. Early adoption is permitted under IFRS. Key aspects and some implications of the standards are discussed at the end of this section.

A first task is to explain some relevant accounting terminology. The terms revenue, sales, gains, losses, and net income (profit, net earnings) have been briefly defined. The IASB Framework for the Preparation and Presentation of Financial Statements (referred to hereafter as “the Framework”) further defines and discusses these income statement items. The Framework explains that profit is a frequently used measure of performance and is composed of income and expenses.9 It defines income as follows:

Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.10

In IFRS, the term “income” includes revenue and gains. Gains are similar to revenue, but they typically arise from secondary or peripheral activities rather than from a company’s primary business activities. For example, for a restaurant, the sale of surplus restaurant equipment for more than its carrying value is referred to as a gain rather than as revenue. Similarly, a loss typically arises from secondary activities. Gains and losses may be considered part of operating activities (e.g., a loss due to a decline in the value of inventory) or may be considered part of non-operating activities (e.g., the sale of non-trading investments).

In the following simple hypothetical scenario, revenue recognition is straightforward: a company sells goods to a buyer for cash and does not allow returns, so the company recognizes revenue when the exchange of goods for cash takes place and measures revenue at the amount of cash received. In practice, however, determining when revenue should be recognized and at what amount is considerably more complex for reasons discussed in the following sections.

3.1. General Principles

An important aspect concerning revenue recognition is that it can occur independently of cash movements. For example, assume a company sells goods to a buyer on credit, so does not actually receive cash until some later time. A fundamental principle of accrual accounting is that revenue is recognized (reported on the income statement) when it is earned, so the company’s financial records reflect revenue from the sale when the risk and reward of ownership is transferred; this is often when the company delivers the goods or services. If the delivery was on credit, a related asset, such as trade or accounts receivable, is created. Later, when cash changes hands, the company’s financial records simply reflect that cash has been received to settle an account receivable. Similarly, there are situations when a company receives cash in advance and actually delivers the product or service later, perhaps over a period of time. In this case, the company would record a liability for unearned revenue when the cash is initially received, and revenue would be recognized as being earned over time as products and services are delivered. An example would be a subscription payment received for a publication that is to be delivered periodically over time.

When to recognize revenue (when to report revenue on the income statement) is a critical issue in accounting. IFRS specify that revenue from the sale of goods is to be recognized (reported on the income statement) when the following conditions are satisfied:11

• the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;

• the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;

• the amount of revenue can be measured reliably;

• it is probable that the economic benefits associated with the transaction will flow to the entity; and

• the costs incurred or to be incurred in respect of the transaction can be measured reliably.

In simple words, this basically says revenue is recognized when the seller no longer bears risks with respect to the goods (for example, if the goods were destroyed by fire, it would be a loss to the purchaser), the seller cannot tell the purchaser what to do with the goods, the seller knows what it expects to collect and is reasonably certain of collection, and the seller knows how much the goods cost.

IFRS note that the transfer of the risks and rewards of ownership normally occurs when goods are delivered to the buyer or when legal title to goods transfers. However, as noted by the above remaining conditions, physical transfer of goods will not always result in the recognition of revenue. For example, if goods are delivered to a retail store to be sold on consignment and title is not transferred, the revenue would not yet be recognized.12

IFRS specify similar criteria for recognizing revenue for the rendering of services.13 When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognized by reference to the stage of completion of the transaction at the balance sheet date. The outcome o