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..
