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Level I CFA: Understanding Income Statements Lecture 1 - YouTube
Channel: IFT
[1]
understanding income statements
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in this reading we talk about components
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and format of the income statement
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the rules of revenue recognition and
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expense recognition
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non-recurring items and non-operating
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items
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the concept of earnings per share
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we then conclude the reading with a
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discussion on the analysis of the income
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statement
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and the concept of comprehensive income
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the income statement has several names
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it is also referred to as the profit and
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loss statement
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the p l and the statement of earnings
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the income statement provides financial
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results
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of a company's business activities over
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a period so you will always see an
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income statement for a given quarter
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or a given year
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the basic formula for the income
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statement is as follows
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net income is equal to the revenue
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minus expenses and as you have probably
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figured out
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the income statement is an important
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input for
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valuation models it's not the only input
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but
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it is one of the more important inputs
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components and format of the income
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statement the top line on the income
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statement
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is the revenue line shown right here
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other names for revenue include sales
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and turnover next we see what's called
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net revenue on net
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sales in certain situations a company
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might
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sell but there can be returns
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once we subtract the returns we have a
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net revenue
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number certain companies might sell
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through agents and those agents charge
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commissions when we subtract the
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commission
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then also we are left with net revenue
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or net
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sale the income statement will show both
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cash expenses and non-cash expenses
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so for example here we might say that
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cost of goods sold
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is mostly uh cash expense sales
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general and administrative expenses also
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might largely
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be cash expenses depreciation
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on the other hand is a non-cash charge
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we subtract these expenses which are
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generally called
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operating expenses and we are left with
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operating profit
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this is also referred to as ebit or
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earnings
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before interest and taxes then we
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subtract
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interest and we have earnings before
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taxes
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subtract taxes and we end up with net
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income this is a really simple
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income statement single step versus
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multi-step format that we will discuss
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on the next slide what you see on the
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left is a single step format
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and on the right we have a multi-step
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format the subtle difference is that in
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a multi-step format we subtract
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cost of goods sold and come up with
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a gross profit number in this case
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that number is half a million whereas
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in a single step format we do not have
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a number for gross profit so you notice
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that on the left
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this gross profit item is missing
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obviously it can be calculated easily by
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simply subtracting 500 000
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from a million but in terms of
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describing this
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format we say that this is a single step
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format coming now to
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revenue recognition which is a very
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important
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topic just as a general point first of
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all
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in ifrs the term income includes
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both revenue and gains
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and gains generally refers to gains on
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the sale of
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equipment or other long-term assets
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so a company which is in the business of
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selling laptops
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will report a revenue number based on
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the sale of laptops
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the company might also sell a piece of
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equipment
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and realize again so an equipment with a
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book value of 100
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might be sold for 110. this
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gain of tin would be shown on the income
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statement
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as a gain and all this top bullet point
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is saying
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is that the term income applies to both
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the core
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revenue of the company as well as gains
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now coming to the concept of revenue
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recognition
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when a company sells goods can it
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recognize
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revenue in the period where it quote
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unquote sells
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if a company sells goods for 100
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cash in period one and has no refund
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policy
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can it recognize revenue in period one
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and the answer is a unambiguous yes
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because clearly the goods have been sold
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the customer cannot
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return the goods and the customer has
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paid cash
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so clearly the company can show revenue
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of hundred for period one let's look at
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the second scenario now
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what if the company sells goods on
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credit
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in period one and will receive cash in
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period two
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can revenue be recognized in period one
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so this is period one period two
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the goods are sold over here but cash
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will be received
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later so where do we recognize revenue
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period one or period two
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accounting rules say that you can
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recognize
[358]
revenue in period one as long as you are
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sure
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that money will be received so the
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answer
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to this question is that revenue
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should be recognized in period one there
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are more
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details but we will see them later
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what if an advanced payment is received
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in period one
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but goods and services are to be
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delivered in period two
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when will the revenue be recognized so
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we have a slightly different situation
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here
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in period one we get the cash
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but the goods will actually be delivered
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in the second period here
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we cannot recognize the revenue in
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period one because the goods and
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services have not been delivered
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it's only in period two when goods and
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services are delivered
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we can recognize revenue
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as we've seen over the last few slides
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revenue
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recognition rules are different under
[420]
ifrs
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and us cap this makes it difficult to
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compare ifrs versus us cap
[427]
companies in 2014
[431]
iasb and fazbee issued
[434]
converged accounting standards and here
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we are going to talk about the key
[440]
aspects
[441]
of the revenue recognition aspect of the
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new standards
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under ifrs these new standards take
[449]
effect for periods
[450]
starting first january 2018
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and under us gaap the date is 15th
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december 2017. first let's understand
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the core
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principle of the converged standard now
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this is again with respect to revenue
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recognition so the principle
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is this revenue should be recognized
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to depict the transfer of promised
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goods or services to customers in an
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amount that reflects the consideration
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to which the
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entity expects to be entitled
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in an exchange for those goods or
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services
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so if we have a given entity this sells
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goods or services to
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a customer the goods or services are
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delivered
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and the entity either receives payment
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or expects to receive
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payment for the goods and services
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rented
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then the company can recognize revenue
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so that's the principle but clearly more
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detail is needed
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so let's understand the five steps in
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revenue
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recognition step one is to identify
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the contract or contracts with a
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customer
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a contract is an agreement and
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commitment
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with commercial substance between two
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parties
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it establishes each party's obligations
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and rights including payment terms
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a contract exists only if collectibility
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is probable step two identify
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the performance obligations in the
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contract
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the performance obligations within a
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contract
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represent promises to transfer
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distinct goods or services a good or
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service is distinct
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if number one the customer can benefit
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from it
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on its own or in combination
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with readily available resources
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and number two if the promise to
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transfer
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it can be separated from other promises
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in the contract let's understand the
[583]
application of this step through
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an example let's say we have a company
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called builder co
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and this enters into a contract with
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another company called
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customer co the contract is to
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construct a commercial building builder
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co
[600]
identifies various goods and services to
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be provided
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and these include pre-construction
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engineering
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construction of the building's
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individual components
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plumbing electrical wiring and interior
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finishes
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so all these are given as separate goods
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and services
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now here is the question with respect to
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identifying performance obligations
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can each of these items pre-construction
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engineering
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the construction of individual
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components plumbing and so on
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so can each of these items be
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treated as separate performance
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obligations
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with respect to revenue recognition
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so let us go back to these two
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criteria and this is an and condition
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for a given good or service to be
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distinct
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or to be a particular performance
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obligation the customer
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should be able to benefit from it on its
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own
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or along with other readily available
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resources and the promise to transfer
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this particular good or service
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can be separated from other promises in
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the contract
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in the example that i just gave which
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comes from the curriculum
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this condition is not met because
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the contract is to construct a
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commercial building
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and if that is the contract then these
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specific items like pre-construction
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engineering
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cannot be separated from other promises
[697]
in the contract
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therefore these items do not enough
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themselves
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represent performance obligations
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step three is to determine the
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transaction price
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step four is to allocate the transaction
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price
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to the performance obligations in the
[714]
contract now in my earlier
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example there was only one performance
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obligation
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let's take another scenario say
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a software company sells a product
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and a consulting service which are two
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separate performance obligations then
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here
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in step four we allocate a price
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to each of these performance obligations
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and then in step five revenue is
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recognized
[744]
when the entity satisfies a performance
[748]
obligation
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so let's say the product is delivered up
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front
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then the revenue can be recognized once
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this product has been
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delivered let's say that the service is
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rendered over a one-year period
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so for this service the revenue is
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recognized as this performance
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obligation is
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fulfilled now i'll give
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another example related to revenue
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recognition
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let's say we have a long-term contract
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and we go back to build a company
[780]
which is let's say constructing
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a building over a two year period for
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customer company and in this case
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the overall contract price
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is one million and let's say that the
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expected total cost
[799]
is 700 000.
[802]
if during the first year the cost
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incurred
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is 420 000 and
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the cost incurred is a reasonable
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indication of the percentage of
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completion
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then the amount of revenue that can be
[818]
recognized over the first year
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is 420 000 divided by 700
[823]
000 into 1 million this gives us
[827]
600 000 which means that
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600 000 can be recognized
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as revenue in the first year notice that
[837]
what we have actually done
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is essentially the percentage of
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completion
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method and with this new standard
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the term percentage of completion is not
[847]
used
[848]
but effectively we are doing the same
[851]
thing
[852]
this new converged standard also gives
[854]
guidance
[855]
on how to deal with variable
[857]
consideration
[858]
so for example if the customer says to
[861]
the entity
[861]
that if the project is completed on time
[865]
then there will be a performance bonus
[867]
of two hundred thousand
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so how should this be accounted the
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existing standards do not give
[874]
sufficient guidance on how to deal with
[876]
this variable
[877]
consideration but according to the new
[880]
standard
[880]
a company is allowed to recognize
[883]
variable consideration
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if it can conclude that it will not have
[887]
to reverse
[888]
the cumulative revenue in the future
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next point and this is something new in
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the converged standard
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companies should capitalize incremental
[900]
costs of
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obtaining a contract so let's say that a
[904]
company is pursuing
[906]
a large government contract and in order
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to get that contract the company has to
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incur
[911]
an additional fee of 50 000 in the
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current standard
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this 50 000 might be expensed but
[918]
according to the new
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converged standard this 50 000
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should be capitalized in other words an
[925]
asset needs to be
[926]
created there are also certain other
[929]
costs which are incurred in order to
[931]
fulfill a contract
[933]
which need to be capitalized the
[935]
curriculum doesn't specify
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what costs exactly need to be
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capitalized but you just need to
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recognize that
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any cost incurred to obtain the contract
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and certain other costs
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to fulfill the contract have to be
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capitalized
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the final couple of points have to do
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with disclosure
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the disclosure requirements are more
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elaborate
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with the converged standard and here are
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a couple of points that you need to know
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so companies should disclose information
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about contracts with customers
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disaggregated
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into different categories of contracts
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so these categories can be based on
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customer types
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on geography on contract types or on
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pricing terms
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companies should disclose balances of
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any
[984]
contract related assets and liabilities
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and significant changes in those
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balances
[991]
remaining performance obligations and
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transaction price allocated to those
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obligations
[998]
and any significant judgments and
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changes
[1001]
in judgments related to revenue
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the curriculum doesn't spend much time
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on this but very briefly
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contract related assets so
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there might be situations where a
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company has delivered a performance
[1016]
obligation has recognized revenue
[1020]
but not created an accounts receivable
[1022]
yet
[1023]
so until the time that the accounts
[1026]
receivable is created
[1027]
a contract related asset can be created
[1030]
which eventually then gets converted
[1032]
into
[1032]
an accounts receivable now
[1035]
a detailed understanding of contract
[1037]
related assets and liabilities
[1040]
are not required under the learning
[1042]
outcomes but the brief comment that i
[1043]
gave you right now
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should be good enough the larger point
[1047]
is that
[1048]
the disclosure requirements are more
[1051]
rigorous with the new
[1052]
converged standard
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