CFA – Financial Reporting and Analysis – Understanding the Income Statement

LOS 32d

An accelerated depreciation method is appropriate if a long term asset generates proportionally more of its economic benefits in the early years of its life. Straight line depreciation is appropriate when an assets economic value decreases at an approximately decreases at approximately constant rate over time.

 

Inventory that can be tracked by individual unit can be valued by specific identification.

FIFO valuation is appropriate for goods with a limited shelf life.

LIFO is widely used in the US because of its tax advantages but is not allowed under IFRS.  The weighted average cost method averages the cost of all units purchased or manufactured and currently available for sale.

Intangible assets with limited lives should be amortized using a method that reflects the flow over time of their economic benefits. Intangible assets with indefinite lives (e.g. goodwill) are not amortized.

 

LOS 32e

Depreciation methods:

  • Straight line: Equal amount of depreciation expense in each year of the assets useful life.
  • Declining balance: Apply a constant rate of depreciation to the declining book value until book value equals residual value.

Inventory valuation methods:

  • FIFO: Inventory reflects cost of most recent purchases. COGS reflects cost of oldest purchases.
  • LIFO: COGS reflect cost of recent purchases, inventory reflects cost of oldest purchases.
  • Average cost: Unit cost equals cost of goods available for sale divided by total units available and is used for both COGS and inventory
  • Average cost: Unit cost equals cost of goods available for sale divided by total units available and is used for both COGS and inventory.
  • Specific identification: each item in inventory is identified and its historical cost is used for calculating COGS when the item is sold e.g. Ferarri

Amortization methods for identifiable intangible assets should also approximate the pattern of decrease in their economic values, but intangible assets with indefinite lives are not amortized.

 

LOS 32f

Operating income is generated from the firms normal business operations. For a nonfinancial firm, income that results from investing or financing transactions is classified as non-operating income, while it is operating income for a financial firm since its business operations include investing in and financing securities.

 

LOS 32g  –p78

Results of discontinued operations are reported below income from continuing operations, net of tax, from the date the decision to dispose of the operations is made.

 

Results of discontinued operations are reported below income from continuing operations, net tax, from the date the decision to dispose the operations is made.  These results are segregated because they likely are non-recurring and do not affect future net income.

 

Unusual or infrequent items are reported before tax and above income from continuing operations.  An analyst should determine how ‘unusual’ or ‘infrequent’  these items really are for the company when estimating future earnings and/or firm value.

 

Extraordinary items (both unusual and infrequent) are reported below income from continuing operations, net of tax under US GAPP, but this treatment is not allowed under IFRS, Extraordinary items are not expected to continue in future periods.

 

Changes in accounting standards, changes in accounting methods applied, and corrections of accounting errors require retrospective restatement of all prior period financial statements included in the current statement.a change in accounting estimate, however is applied prospectively (to subsequent periods) with no restatement of prior period results.

 

LOS 32h

 

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LOS 32i

A dilutive security is one that, if converted to its common equivalent, would decrease EPS.  An  anti dilutive security is one that would not reduce EPS if converted to its common stock equivalent.

 

LOS 32 j

A vertical common size income statement expresses each line item as a % of sales.

Gross profit margin and net profit margin are profitability ratios that can be read directly from a vertical common size income statement.    An analyst should examine changes in items on a vertical common size income statement over time and compare values to those for peer companies or to industry averages.

 

LOS 32k

Transactions with shareholders, such as dividends paid and shares issued or repurchased, are not reported on the income statement.

“Other comprehensive income” includes other transactions that affect equity but do not affect income including:

 

  1. Gains and losses from foreign currency translation
  2. Pension obligation adjustments
  3. Unrealized gains and losses from cash flow hedging derivatives
  4. Unrealised gains and losses on available for sale securities

 

LOS 32 l

Comprehensive income is the sum of net income and other comprehensive income

 

 

Key Points

  • The matching principle requires that the expenses incurred to generate the revenue be recognised in the same accounting period as the revenue
  • LIFO not allowed under IFRS
  • Bad debt expense is an operating expense
  • Change in accounting principle require retrospective application
  • Pre-tax margin measures profitablity
  • Foreign currency translation is not included in net income