Earlier, I used to wonder why Financial Reporting and Analysis (FRA) was given the highest weightage for the Level I CFA exam. However, as I understood various terms of the financial statements and their implications on key decisions over time, I must admit that the weightage given is worth it. The Level I CFA exam is easy to crack if you have the concepts in place and FRA is one topic where proper understanding will help you score marks very easily.
When I started my CFA Program preparation, I started with FRA mainly because it carries the highest weightage and one of the first topics that I studied in FRA was “Income Statement”. In this blog, I will focus on this topic and will try to cover all the concepts related to it. Through this blog, I hope to simplify your CFA Program level 1 FRA Preparation. I expect you people to be able to directly solve any CFA Program Level 1 question related to this topic after going through this blog.
So, where do we start? I guess we should first know why these financial statements are important and why we have to understand them. The answer is quite simple- they help investors (normal people like us who buy shares in a company) and creditors (banks and other financial institutions who give loans) to take decisions such as whether to invest in a company or not, whether to give debt to a company or not, etc. Obviously, we would want to buy shares of a company with good prospects so that we can make money. Financial statements help us to do just that- know about the company’s ability to generate cash flows and earn profits in the future. Income statement, in particular, examines the company’s ability.
Introduction to Income statement:
Let us now understand the components of Income statement. This is also called “Statement of Earnings” or “Profit and Loss statement”. The table below shows the income statement of a sample company. It basically reports the revenues and expenses of a company over a period of time. The period can be quarterly, semi-annual or annual. The equation that governs this financial statement is
Revenues- Expenses = Net Income
Revenues or sales are the amounts obtained through sale of goods and services. Expenses are the amounts incurred to generate these revenues. The main expense is Cost of Goods Sold (COGS) which represents the cost of manufacturing the goods (raw materials, labour, etc.). Other expenses are related to administration, depreciation, interest etc. Gross profit is the revenue minus the direct costs of production (COGS). Subtracting operating expenses from this gives operating profit. Finally, interest expense and income taxes are subtracted to get “Net Income”.
Principles of Revenue recognition:
Let’s now see how the first component of the income statement, revenue, is calculated. Under accrual method of accounting, revenue is recognized when “Earned”. This means that it need not necessarily be recognized at the time of cash exchange. IASB has set some standards to recognize revenue. The important things to note are:
1. The risk and reward of ownership should be transferred.
2. There is a reasonable probability of future economic flows.
3. Revenue can be reliably measured
For example, if you give full cost as advance to buy a laptop today which you will receive after 2 months then the shop keeper should recognize your revenue after 2 months and not today. (Risk transfer after 2 months!)
There are three methods to value inventory and COGS depending on which method we are using. Look at the table below to understand each of them.
For example, if you buy 5 items @ Rs. 10 today and 10 items tomorrow @ Rs. 15 and sell 12 items later, then:
According to FIFO, COGS= 5X10 + 7X15 = 155 and Ending Inventory= 3X15 = 45
According to LIFO, COGS= 10X15 + 2X10 = 170 and Ending Inventory= 3X10 = 30
According to Weighted Average, Average unit cost= (5X10 + 10X15)/ (5+10) = 200/15 = 13.33
Therefore, COGS = 12X13.33 = 160 and Ending Inventory = 3X13.33 = 40
In general, most firms use the straight line depreciation method in which there is an equal amount of depreciation expense each period. This is calculated using:
Another method is declining balance method in which a constant rate of depreciation is used with respect to the asset’s book value. The most common declining balance method used is double-declining balance method (DDB). This is calculated using:
EPS and Diluted EPS:
Earnings Per Share (EPS) is one of the very commonly used measures of performance of a publicly traded firm and it is found using the income statement. If a company has a simple capital structure (meaning that there are no convertible securities or warrants or options), basic EPS is enough to know the per share income available to shareholders. However, if it has a complex structure, it will have some potentially dilutive securities and hence, both basic and diluted EPS should be looked at. These metrics are calculated as follows:
The concept behind this is to use the income available to “Common” stockholders in the numerator and the average number of outstanding shares in the denominator to get Earnings per share for a common shareholder.
P.S. In case of any queries feel free to drop in as a comment. Go through the QUIZ on this topic to gauge your understanding of the topic.
on “Understanding Income Statement”:
Date: Fri, 12 Apr 2013
Time: 9 AM 10 AM EDT (See time in your Zone)
Topics to be dealt with:
- Introduction to various components of I/S
- Principles of Revenue Recognition
- Inventory, Depreciation and other Expense Recognitions
- EPS and Diluted EPS Calculations