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    CHAPTER 4FINANCIAL REPORTING STANDARDS

    Presenters namePresenters titledd Month yyyy

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    OVERVIEW

    Income statement components and formatAccounting issues

    - Revenue recognition

    - Expense recognition

    - Inventory

    - Depreciation

    - Nonrecurring items

    Earnings per share Income statement analysis

    Comprehensive income

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    INCOME STATEMENT COMPONENTS

    Also called the statement of earnings, statement ofoperations, and profit and loss statement (P&L)

    Presents results of operations for the accounting period

    RevenuesExpenses = Net income

    Revenue + Other Income + GainsExpensesLosses= Net income

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    INCOME STATEMENT FORMAT

    Subtotals

    - Gross profit (i.e., revenue less cost of sales)

    - Multistep format: Income statement shows gross profitsubtotal

    - Single-step format: Income statement excludes gross profitsubtotal

    - Operating profit (i.e., revenue less all operating expenses)

    - Profits before deducting taxes and interest expense andbefore any other nonoperating items

    - Operating profit and EBIT (earnings before interest andtaxes) are not necessarily the same

    Expense Grouping

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    INCOME STATEMENT FORMAT: EXAMPLE 1COLGATE-PALMOLIVE COMPANY

    Copyright 2013 CFA Institute 5

    Colgate Annual Report

    http://localhost/var/www/apps/conversion/tmp/scratch_8/Ch4_Colgate_2011_AR.pdfhttp://localhost/var/www/apps/conversion/tmp/scratch_8/Ch4_Colgate_2011_AR.pdf
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    INCOME STATEMENT FORMAT: EXAMPLE 2LOREAL GROUP

    Copyright 2013 CFA Institute 6

    L'Oreal's Annual Report

    http://localhost/var/www/apps/conversion/tmp/scratch_8/Ch4_LOREAL_Document-de-Reference-2011.pdfhttp://localhost/var/www/apps/conversion/tmp/scratch_8/Ch4_LOREAL_Document-de-Reference-2011.pdf
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    INCOME STATEMENT FORMAT: EXAMPLE 3PROCTER & GAMBLE

    Copyright 2013 CFA Institute 7

    Proctor & Gamble Report

    http://localhost/var/www/apps/conversion/tmp/scratch_8/Ch4_PG_2011_AnnualReport.pdfhttp://localhost/var/www/apps/conversion/tmp/scratch_8/Ch4_PG_2011_AnnualReport.pdf
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    GENERAL PRINCIPLES OF REVENUERECOGNITION AND ACCRUAL ACCOUNTING

    Revenue recognition can occur independently of cashmovementsfor example, in the case of the

    - sale of goods and services on credit or

    - receipt of cash in advance of providing goods andservices

    A fundamental principle of accrual accounting is thatrevenue is recognized (reported on the income statement)

    in the period in which it is earned.

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    WHEN TO RECOGNIZE REVENUE

    IFRS specify that revenue from the sale of goods is to berecognized when the following conditions are satisfied:

    - Entity has transferred to the buyer the significant risksand rewards of ownership of the goods;

    - Entity retains neither continuing managerial involvementwith 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.

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    WHEN TO RECOGNIZE REVENUE

    U.S. GAAP specify that revenue should be recognized whenit is realized or realizable and earned. The U.S. Securitiesand Exchange Commission (SEC) provides guidance onhow to apply the accounting principles. This guidance listsfour criteria to determine when revenue is realized or

    realizable and earned:

    1. There is evidence of an arrangement between buyer andseller.

    2. The product has been delivered, or the service has beenrendered.

    3. The price is determined or determinable.

    4. The seller is reasonably sure of collecting money.

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    SPECIFIC REVENUE RECOGNITIONAPPLICATIONS: LONG-TERM CONTRACTS

    Long-term contract:contract that spans a number ofaccounting periods.

    Percentage-of-completionmethod- 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 thatpercentage of the total contract revenue in its incomestatement.

    - Contract costs for the period are expensed against therevenue.- Net income or profit is reported each year as work is

    performed.

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    SPECIFIC REVENUE RECOGNITION APPLICATIONS:LONG-TERM CONTRACTS EXAMPLE

    Example that uses the percentage-of-completion method ofrevenue 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 mirrorsthe percentage complete)- Revenue?- Cost of revenue?

    - Year 2: Job is completed with costs of $1,000,000- Revenue?- Cost of revenue?

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    SPECIFIC REVENUE RECOGNITION APPLICATIONS:LONG-TERM CONTRACTS EXAMPLE

    Example that uses the percentage-of-completion method ofrevenue 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 thepercentage complete)- Revenue?- Cost of revenue?

    - Year 2: Job is completed with costs of $1,250,000 (a costoverrun)- Revenue?- Cost of revenue?

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    SPECIFIC REVENUE RECOGNITIONAPPLICATIONS: LONG-TERM CONTRACTS

    Percentage-of-completion is the preferred method under bothIFRS 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 costsincurred.

    - U.S. GAAP (but not IFRS) permit the completed contractmethod.

    Company does not report any income until the contract issubstantially finished. Completed contract method is also acceptable when the

    entity has primarily short-term contracts.

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    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), andincome would the company recognize each year under IFRS and,using the completed contract method, under U.S. GAAP?

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    SPECIFIC REVENUE RECOGNITION APPLICATIONS:LONG-TERM CONTRACTS EXAMPLE

    Question: How much revenue, expense (cost of construction), and incomewould the company recognize each year under IFRS and using the completedcontract method under U.S. GAAP?

    Answer: Under IFRS, recognize revenue to the extent of contract costsincurred. 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 nowmeasurable), 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

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    SPECIFIC REVENUE RECOGNITIONAPPLICATIONS: INSTALLMENT SALES

    Installment sales: Sales in which proceeds are to be paidin installments over an extended period.

    IFRS separate the installments into the sale price (presentvalue of the installment payments) and an interest

    component. Revenue attributable to the sale price is recognized atthe date of sale

    Revenue attributable to the interest component isrecognized over time.

    International standards note, however, that the guidancefor revenue recognition must be considered in light of locallaws regarding the sale of goods in a particular country.

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    SPECIFIC REVENUE RECOGNITIONAPPLICATIONS: INSTALLMENT SALES

    Sale of real estate under U.S. GAAPA sale of real estate is reported at time of sale using normal revenue

    recognition conditions when seller has completed the significantactivities in the earnings process and is either1) 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 profitrecognized in each period is determined by the percentage of thetotal sales price for which the seller has received cash, or

    - the cost recovery method, in which the seller does not report anyprofit until the cash amounts paid by the buyerincluding principaland interest on any financing from the sellerare greater than all thesellers costs of the property.

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    SPECIFIC REVENUE RECOGNITIONAPPLICATIONS: 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 thebuyer to complete all payments.

    - How much profit will be recognized attributable to the down payment if1) the installment method is used?2) the cost recovery method is used?

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    SPECIFIC REVENUE RECOGNITIONAPPLICATIONS: EXAMPLE

    How much profit will be recognized attributable to the down payment if theinstallment method is used?

    - Installment method apportions the cash receipt between cost recovered andprofit 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 costrecovery method is used?

    - Under the cost recovery method, do not recognize any profit until cashreceived from buyer exceeds all costs.

    - Here, $300,000 cash paid by the buyer is less than the sellers cost of$1,100,000.

    - Seller will recognize $0 profit attributable to the down payment.

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    SPECIFIC REVENUE RECOGNITIONAPPLICATIONS: GROSS VS. NET REPORTING

    Merchandising companies typically sell products that they purchasefrom 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 toship the products directly to the end customer. Should they recordrevenues 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 itssupplier, and has reasonable latitude to establish price.

    - Otherwise, report revenues net.

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    SPECIFIC REVENUE RECOGNITIONAPPLICATIONS: 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

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    SPECIFIC REVENUE RECOGNITIONAPPLICATIONS: EXAMPLE

    We evaluate whether it is appropriate to record the gross amountof 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 notall 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

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    GENERAL PRINCIPLES OF EXPENSERECOGNITION

    Fundamental principle: A company recognizes expenses inthe period in which it consumes (i.e., uses up) theeconomic 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

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    SPECIFIC EXPENSE RECOGNITIONAPPLICATIONS: INVENTORY

    Goods

    Purchased

    Beginning

    InventoryGoods

    Available

    for

    Sale

    Ending

    Inventory

    Cost of

    Goods Sold

    Balance Sheet Income Statement

    Inventory CostFlow

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    SPECIFIC EXPENSE RECOGNITIONAPPLICATIONS: EXAMPLE

    Inventory PurchasesFirst quarter 2,000 units at $40 per unitSecond quarter 1,500 units at $41 per unitThird quarter 2,200 units at $43 per unitFourth quarter 1,900 units at $45 per unitTotal 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 theyear?

    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.

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    SPECIFIC EXPENSE RECOGNITIONAPPLICATIONS: EXAMPLE SOLUTION

    Revenue = $280,000(5,600 units times $50 per unit)

    Cost of Goods SoldThe 5,600 units that were sold were specifically identified

    as follows:From 1st quarter: 2,000 units at $40 per unit $80,000From 2nd quarter: 1,500 units at $41 per unit $61,500From 3rd quarter: 2,100 units at $43 per unit $90,300Total cost of goods sold $231,800

    Ending inventoryFrom the 3rd quarter: 100 units at $43 per unit $4,300From the 4th quarter: 1,900 units at $45 per unit $85,500Total remaining (or ending) inventory cost $89,800

    Copyright 2013 CFA Institute 27

    Total availablefor sale

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    SPECIFIC EXPENSE RECOGNITIONAPPLICATIONS: EXAMPLE

    Inventory PurchasesFirst quarter 2,000 units at $40 per unitSecond quarter 1,500 units at $41 per unitThird quarter 2,200 units at $43 per unitFourth 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 insteaduses the weighted average cost method of inventory costing.

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    SPECIFIC EXPENSE RECOGNITIONAPPLICATIONS: EXAMPLE SOLUTION

    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

    Copyright 2013 CFA Institute 29

    Total availablefor sale

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    SPECIFIC EXPENSE RECOGNITIONAPPLICATIONS: EXAMPLE

    Inventory PurchasesFirst quarter 2,000 units at $40 per unitSecond quarter 1,500 units at $41 per unitThird quarter 2,200 units at $43 per unitFourth 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 insteaduses the FIFO (first in, first out) method of inventory costing.

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    SPECIFIC EXPENSE RECOGNITIONAPPLICATIONS: EXAMPLE SOLUTION

    Inventory PurchasesFirst quarter 2,000 units at $40 per unitSecond quarter 1,500 units at $41 per unitThird quarter 2,200 units at $43 per unitFourth 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:

    Copyright 2013 CFA Institute 31

    FIFO to determine COGS: 2,000 from 1st quarter at $40 perunit + 1,500 from 2nd quarter at $41 per unit + 2,100 from

    3rd quarter at $43 per unit

    COGS = $231,800

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    SPECIFIC EXPENSE RECOGNITIONAPPLICATIONS: EXAMPLE SOLUTION

    Inventory PurchasesFirst quarter 2,000 units at $40 per unitSecond quarter 1,500 units at $41 per unitThird quarter 2,200 units at $43 per unitFourth 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:

    Copyright 2013 CFA Institute 33

    LIFO to determine COGS: 1,900 from 4th quarter at $45 perunit + 2,200 units at $43 per unit + 1,500 units at $41 per unit

    COGS = $241,600

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    SUMMARY TABLE ON INVENTORYCOSTING METHODS

    Method Description

    COGS whenprices are risingrelative to theother twomethods

    Ending Inventorywhen prices arerising relative to theother two methods

    FIFO Assumes that earliest

    items purchased weresold first

    Lowest Highest

    LIFO Assumes most recentitems purchased weresold first

    Highest* Lowest*

    AverageCost

    Averages total costsover total units available

    Middle Middle

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    *Assumes no LIFO layer liquidation. LIFO layer liquidation occurs when the volume of sales exceeds thevolume of other purchases in the period so that some sales are assumed to be from existing, relatively low-pricedinventory rather than from more recent purchases.

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    INVENTORY METHOD: EXAMPLE DISCLOSURE

    Inventory Valuation Inventories are valued at the lower of costor 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

    Inventoriesare valued at the lower of cost or net realizable value.Cost is calculated using the weighted average cost method.

    LOreal Group (2011), Registration Document

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    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 onincome in 2011, 2010 and 2009.

    Colgate-Palmolive (2011), Annual Report (Note 16)

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    SPECIFIC EXPENSE RECOGNITIONAPPLICATIONS: DEPRECIATION

    Depreciation: Process of systematically allocating costs of long-livedassets over the period during which the assets are expected to provideeconomic 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

    DepreciationMethods:

    - Straight line

    - Accelerated (i.e., diminishing balance)

    - Units of production

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    SPECIFIC EXPENSE RECOGNITIONAPPLICATIONS: DEPRECIATION EXAMPLE

    Equipment cost = $9,000. Estimated residual = $0. Useful life = 3 years. Annual depreciation expense = (Cost Residual value)/Useful life.

    Copyright 2013 CFA Institute 38

    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

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    SPECIFIC EXPENSE RECOGNITIONAPPLICATIONS: DEPRECIATION EXAMPLE

    Judgments and estimates needed in depreciation:- estimated salvage value- estimated useful life

    For example, given a purchase price of $10,000, what isthe 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?

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    SPECIFIC EXPENSE RECOGNITIONAPPLICATIONS: 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: $11,000Estimated salvage value: $1,000Estimated useful life: 5 yearsAcceleration factor: 2

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    SPECIFIC EXPENSE RECOGNITION APPLICATIONS:DEPRECIATION EXAMPLE SOLUTION

    Year

    NBVBeginning of

    YearDepreciation

    ExpenseAccumulatedDepreciation

    NBV End ofYear

    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

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    NONRECURRING ITEMS AND CHANGES INACCOUNTING STANDARDS

    Separating nonrecurring from recurring items of incomeand expense can help an analyst assess a companysfuture earnings.

    Nonrecurring items:

    - discontinued operations

    - extraordinary items (not permitted under IFRS)

    - unusual or infrequent items

    Changes in accounting standards

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    EPS: EXAMPLE 1

    Basic EPS- Earnings available to common shareholders divided by weighted

    average number of shares outstanding

    Basic EPS = (Net incomePreferred 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 companys basic EPS?

    Copyright 2013 CFA Institute 44

    Colgate's Annual Report

    http://localhost/var/www/apps/conversion/tmp/scratch_8/Ch4_Colgate_2011_AR.pdfhttp://localhost/var/www/apps/conversion/tmp/scratch_8/Ch4_Colgate_2011_AR.pdf
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    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 companys Basic EPS?

    Basic EPS

    = (Net incomePreferred dividends)/Weighted average number of

    shares outstanding= ($2,431$0)/488.3

    = $4.98

    Copyright 2013 CFA Institute 45

    Colgate's Annual Report

    http://localhost/var/www/apps/conversion/tmp/scratch_8/Ch4_Colgate_2011_AR.pdfhttp://localhost/var/www/apps/conversion/tmp/scratch_8/Ch4_Colgate_2011_AR.pdf
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    EPS: EXAMPLE 2WEIGHTED AVERAGE NUMBER OF SHARES

    Calculate(1) the weighted average number of shares outstanding

    (2) the companys basic EPS

    Assume the following:Company had net income of $2,500,000 for the year and paid $200,000of 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

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    EPS: EXAMPLE 2 SOLUTIONWEIGHTED AVERAGE NUMBER OF SHARES

    Weighted average number of shares outstanding1,000,000 (3 months/12 months) Jan, Feb, Mar

    + 1,200,000 (6 months/12 months) AprilOct

    + 1,100,000 (3 months/12 months) Oct, Nov, Dec

    = 1,125,000 Weighted average number of shares outstanding

    Basic EPS

    = (Net incomePreferred dividends)/Weighted average numberof shares outstanding

    = ($2,500,000$200,000)/1,125,000

    = $2.04

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    EPS: EXAMPLE 3

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    EPS: EXAMPLE 3IF-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 securitiesEach share of preferred pays a dividend of $10 per share, and eachis convertible into five shares of the companys common stock.

    Calculate the companys basic and diluted EPS.

    Diluted EPS

    = Net income/(Weighted average number of shares outstanding+ New shares issued at conversion)

    Copyright 2013 CFA Institute 48

    EPS: EXAMPLE 3

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    EPS: EXAMPLE 3IF-CONVERTED METHOD FOR CONVERTIBLE

    PREFERRED STOCK SOLUTION

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    Basic EPSDiluted EPS Using

    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

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    EPS: EXAMPLE 4IF-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 atotal of 10,000 shares

    - no other potentially dilutive securities

    - An effective tax rate is 30%

    Calculate the companys basic and diluted EPS.

    Diluted EPS

    = (Net income + After-tax interest on convertible debtPreferreddividends)/(Weighted average number of shares outstanding + Additionalcommon shares that would have been issued at conversion)

    Copyright 2013 CFA Institute 50

    EPS: EXAMPLE 4

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    EPS: EXAMPLE 4IF-CONVERTED METHOD FOR CONVERTIBLE DEBT

    SOLUTION

    Copyright 2013 CFA Institute 51

    Basic EPS Diluted EPS UsingIf-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

    EPS EXAMPLE

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    EPS: EXAMPLE 5TREASURY 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 securitiesOver the year, its market price averaged $55 per share.

    Calculate the companys basic and diluted EPS.

    Diluted EPS

    = (Net IncomePreferred dividends)/(Weighted averagenumber of shares outstanding + New shares issued at optionexerciseShares that could have been purchased with cashreceived upon exercise)

    Copyright 2013 CFA Institute 52

    EPS: EXAMPLE 5

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    EPS: EXAMPLE 5TREASURY STOCK METHOD FOR STOCK OPTIONS

    SOLUTION

    800,000 Weighted average number of shares outstanding

    + 30,000 New shares issued at option exercise

    19,091

    Shares that could be purchased with cash receivedupon exercise, calculated as $1,050,000 ($35 foreach of the 30,000 options exercised) divided byaverage market price of $55 per share = 19,091shares

    = 810,909 Shares

    Copyright 2013 CFA Institute 53

    Calculate Denominator

    30,00019,091 = 10,909

    EPS: EXAMPLE 5

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    EPS: EXAMPLE 5TREASURY STOCK METHOD FOR STOCK OPTIONS

    SOLUTION

    Copyright 2013 CFA Institute 54

    Basic EPS

    Diluted EPS Using

    Treasury Stock

    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 10,909Denominator 800,000 810,909

    EPS $2.88 $2.84

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    COMMON-SIZE INCOME STATEMENTS

    Copyright 2013 CFA Institute 57

    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, andadministrative expenses 10 10 10

    Research and development 20 0 20

    Advertising 20 0 20Operating profit 20 15 20

    Each line item is expressed as a percentage of thecompanys sales.

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    COMPREHENSIVE INCOME

    Beginning Equity + or

    Change = Ending EquityRetained earnings + Net income

    DividendsRetained earnings

    Accumulated othercomprehensive income

    + Other comprehensiveincomeOther comprehensiveloss

    Accumulated othercomprehensive income

    Stock + IssuancesRepurchases

    Stock

    Copyright 2013 CFA Institute 59

    1. Foreign currency translation adjustments

    2. Unrealized gains or losses on derivatives contracts accounted for ashedges

    3. Unrealized holding gains and losses on available-for-sale securities4. Certain costs of a companys defined benefit post-retirement plans that

    are not recognized in the current period

    COMPREHENSIVE INCOME:

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    COMPREHENSIVE INCOME:EXAMPLE

    Copyright 2013 CFA Institute 60

    Assume the following about a company:- beginning shareholders equity is 200 million

    - net income for the year is20 million

    - cash dividends for the year are3 million

    - no issuance or repurchase of common stock.

    - actual ending shareholders equity is 227 million.

    What amount has bypassed the net income calculation bybeing classified as other comprehensive income?

    What is the companys comprehensive income?

    COMPREHENSIVE INCOME:

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    COMPREHENSIVE INCOME:EXAMPLE SOLUTION

    Copyright 2013 CFA Institute 61

    Assume the following about a company:

    - beginning shareholders equity is 200 million

    - net income for the year is20 million

    - cash dividends for the year are3 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 companys total comprehensive income?

    Answer:30 million

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    SUMMARY

    Income statement shows how much revenue the company

    generated during a period and what costs it incurred inconnection 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-sizeanalysis and profitability ratios.

    Comprehensive income includes net income and othercomprehensive income.


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