CHAPTER 2

Analyzing Income Statements

Comprehensive guide covering revenue recognition, expense analysis, EPS calculations, and income statement structure

1

INTRODUCTION TO THE INCOME STATEMENT

The Income Statement (I/S) is a financial report card showing a company's performance over a period (e.g., quarter or year). It answers: How much profit did the company earn?

WHY IT MATTERS

PERFORMANCE ASSESSMENT

Measures growth, profitability, and risk

INVESTMENT ANALYSIS

Helps decide whether to invest or lend

VALUATION

Core input for models like DCF and P/E

2

STRUCTURE OF THE INCOME STATEMENT

Income statements can be presented in a single-step format (Total Revenues - Total Expenses = Net Income) or a multi-step format. The multi-step format is more detailed and useful for analysis, providing key subtotals.

TYPICAL MULTI-STEP STRUCTURE

Component Description & Formula
Revenue (or Sales) Top-line earnings from selling goods or services.
(-) Cost of Goods Sold (COGS) Direct costs attributable to the production of goods sold.
= Gross Profit Revenue - COGS. Shows profit from core production/service activities before other expenses.
(-) Operating Expenses Costs not directly tied to production (e.g., Selling, General & Admin (SG&A), R&D, Depreciation).
= Operating Income (EBIT) Gross Profit - Operating Expenses. Profit from normal business operations. A key measure of core profitability.
(+/-) Non-Operating Items Income or expenses from outside the core business (e.g., Interest Expense, Interest Income, Gains/Losses on investments).
= Earnings Before Tax (EBT) Operating Income +/- Non-Operating Items. Profit before the effect of taxes.
(-) Income Tax Expense Provision for income taxes.
= Net Income EBT - Taxes. The "bottom line" profit attributable to all shareholders after all expenses.
3

REVENUE RECOGNITION

Under accrual accounting, revenue is recognized when earned — when goods/services are delivered — not when cash is received.

KEY SCENARIOS

SALE ON CREDIT

  • • Deliver product → recognize revenue
  • • Create Accounts Receivable (asset)

CASH IN ADVANCE

  • • Receive cash → create Deferred Revenue (liability)
  • • Recognize revenue over time as service is delivered

THE 5-STEP REVENUE RECOGNITION MODEL (IFRS & U.S. GAAP)

1

Identify the contract

Must have commercial substance and probable collectability

2

Identify performance obligations

Distinct promises to deliver goods/services

3

Determine transaction price

Total consideration expected

4

Allocate price

Based on standalone selling prices

5

Recognize revenue

When control is transferred

Phone + Service Plan

Customer pays $1,200 for a phone ($500 value) and 2-year service ($700 value).

  • • Two performance obligations
  • • $500 revenue recognized when phone is delivered
  • • $700 recognized over 24 months ($29.17/month)

CONTRACT MODIFICATIONS

NEW CONTRACT

Added goods/services are distinct and fairly priced

MODIFICATION

Not distinct → adjust existing contract

DISCLOSURE REQUIREMENTS

  • Revenue disaggregated by product, geography, customer type
  • Contract assets (e.g., receivables) and liabilities (e.g., deferred revenue)
  • Changes in these balances
4

EXPENSE RECOGNITION

THE MATCHING PRINCIPLE

Expenses should be recognized in the same period as the revenue they help generate.

PRODUCT COSTS (E.G., COGS)

Matched with sales

PERIOD COSTS (E.G., ADMIN SALARIES)

Expensed when incurred

INVENTORY COSTING METHODS

Method Description IFRS U.S. GAAP
Specific ID Track cost of each unique item
FIFO First in, first out. Ending inventory = newest costs
LIFO Last in, first out. COGS = newest costs
Weighted Avg Average cost applied to all units

IMPACT OF RISING PRICES (INFLATION)

Metric FIFO LIFO
COGS Lowest (old, cheap costs) Highest (new, expensive costs)
Ending Inventory Highest (recent costs) Lowest (old costs)
Net Income Highest Lowest
Taxes Highest Lowest (tax advantage)

CAPITALIZING VS. EXPENSING

Should a cost be expensed now or capitalized as an asset? The decision hinges on whether the cost provides future economic benefit beyond the current period.

Financial Item Capitalizing Expensing
Recognition Rule Future benefit > 1 period + reliably measurable cost → Capitalize Benefit consumed immediately or not reliably measurable → Expense
Year 1 Net Income Higher (only depreciation/amortization hits P&L) Lower (full expense recognized immediately)
Future Net Income Lower in subsequent periods (due to depreciation/amortization) No future impact
Balance Sheet (Assets) Higher initially; declines over time due to depreciation Lower (no asset created)
Operating Cash Flow (OCF) No immediate impact (non-cash expense later) Decreases immediately (cash outflow classified as operating)
Investing Cash Flow (ICF) Decreases (cash outflow classified as investing) No impact

Practical Example: $100,000 Capitalized Asset

Assume a $100,000 cost is capitalized and depreciated straight-line over 5 years ($20,000/year):

  • Year 1 Income Statement: -$20,000 (pre-tax)
  • Year 1 Cash Flow: OCF unchanged; ICF -$100,000
  • If Expensed: Year 1 Income Statement: -$100,000; OCF -$100,000; ICF unchanged

Capitalizing smooths earnings and shifts cash flow from investing to operating over time.

KEY CAPITALIZATION RULES

INTEREST COSTS

Capitalized during the construction of qualifying long-term assets (e.g., buildings, machinery)

DEVELOPMENT COSTS

  • Research: Always expensed (uncertain future benefit)
  • Development: May be capitalized under IFRS if technical feasibility established. Under U.S. GAAP, generally expensed unless software development criteria met
  • Software Development: Costs after technological feasibility can be capitalized under both IFRS and U.S. GAAP

Analyst Adjustment Example

If a company capitalizes $1M in R&D costs that should have been expensed:

  • Income Statement: Add $1M expense (adjust net income downward); remove related amortization
  • Balance Sheet: Reduce intangible assets and retained earnings (net of tax effect)
  • Cash Flow Statement: Reclassify $1M from Investing (CFI) to Operating (CFO)

This adjustment reveals lower profitability and higher operating cash outflow — critical for accurate comparability.

5

NON-RECURRING AND NON-OPERATING ITEMS

Analysts focus on core, recurring earnings. These items should be identified and often excluded.

TYPES OF SPECIAL ITEMS

DISCONTINUED OPERATIONS

  • • Reported separately, net of tax
  • Exclude from forecasts — not part of ongoing business

UNUSUAL OR INFREQUENT ITEMS

  • • Reported within continuing operations but disclosed
  • • Examples: restructuring, asset sale
  • • Often excluded from adjusted earnings

ACCOUNTING CHANGES

PRINCIPLE CHANGE (E.G., LIFO → FIFO)

Retrospective — restate prior years

ESTIMATE CHANGE (E.G., USEFUL LIFE)

Prospective — affects current/future

ERROR CORRECTION

Restate prior periods

NON-OPERATING ITEMS

IFRS

Flexible classification

U.S. GAAP

Operating = core business; Non-operating = investing/financing

6

EARNINGS PER SHARE (EPS)

EPS measures profit per common share. It's a key metric for investors and analysts.

SIMPLE VS. COMPLEX CAPITAL STRUCTURE

SIMPLE

Only common stock

COMPLEX

Has convertible securities (options, bonds) → must report Diluted EPS

BASIC EPS

Basic EPS = (Net Income - Preferred Dividends) / Weighted-Average Common Shares

Why? EPS is for common shareholders. Preferred dividends are subtracted.

DILUTED EPS

Diluted EPS ≤ Basic EPS. Shows worst-case EPS if all dilutive securities convert.

Anti-dilutive securities (those that would increase EPS) are excluded.

1. CONVERTIBLE PREFERRED STOCK:

Diluted EPS = Net Income / (Weighted Shares + New Shares from Conversion)

Why? Preferred dividends are eliminated upon conversion.

2. CONVERTIBLE DEBT:

Diluted EPS = (Net Income - Pref Div + After-Tax Interest) / (Weighted Shares + New Shares)

Why? Interest saved → added back (after tax).

3. STOCK OPTIONS (TREASURY STOCK METHOD):

Diluted EPS = (Net Income - Pref Div) / [Weighted Shares + (New Shares Issued - Shares Repurchased)]

Treasury Stock Method

1,000 options at $20. Avg stock price = $25.

  1. 1. Proceeds = 1,000 × $20 = $20,000
  2. 2. Shares repurchased = $20,000 / $25 = 800
  3. 3. Net new shares = 1,000 - 800 = 200

Add 200 to denominator.

7

ANALYZING THE INCOME STATEMENT

COMMON-SIZE ANALYSIS

VERTICAL ANALYSIS

Each item as % of revenue

  • • E.g., COGS = 60%, Net Income = 10%
  • • Great for comparing companies

HORIZONTAL ANALYSIS

Each item as % of base year

  • • E.g., Revenue grew from 100% to 120%
  • • Shows growth trends

KEY PROFITABILITY RATIOS

Gross Profit Margin

Gross Profit Margin = Gross Profit / Revenue

Operating Margin

Operating Margin = Operating Income / Revenue

Pre-Tax Margin

Pre-Tax Margin = EBT / Revenue

Net Profit Margin

Net Profit Margin = Net Income / Revenue

These help assess efficiency, cost control, and overall profitability.

8

KEY FORMULAS AND EXAM FOCUS

EXAM WEIGHT & CRITICAL AREAS

Income statement analysis accounts for 8-12% of Level I FSA weight. Master these areas:

  • • EPS calculations - Basic & Diluted (especially Treasury Stock Method)
  • • Revenue recognition - 5-step model and contract modifications
  • • LIFO vs. FIFO - Impact on financial statements during inflation
  • • Capitalizing vs. Expensing - Effects on all three financial statements
  • • Non-recurring items - How to adjust for normalized earnings

ESSENTIAL FORMULAS

Basic EPS:
Basic EPS = (Net Income - Preferred Dividends) / Weighted Average Common Shares
Treasury Stock Method (for options):
New Shares Added = Options Exercised - (Options × Exercise Price / Avg Market Price)
Diluted EPS - Convertible Debt:
Diluted EPS = (NI + Interest Saved × (1 - Tax Rate)) / (Wtd Avg Shares + New Shares from Conversion)
Gross Profit Margin:
Gross Profit Margin = (Revenue - COGS) / Revenue
Operating Profit Margin:
Operating Margin = Operating Income (EBIT) / Revenue
Net Profit Margin:
Net Profit Margin = Net Income / Revenue

COMMON PITFALLS

LIFO vs. FIFO in Inflation: LIFO results in higher COGS, lower net income, and lower taxes. Ending inventory is valued at older, cheaper costs.

Treasury Stock Method: Only add NET new shares (issued minus repurchased). Options are only dilutive if market price exceeds exercise price.

Capitalizing vs. Expensing: Capitalizing increases Year 1 net income, lowers operating cash flow, and increases investing cash outflow. Total cash is the same, just classified differently.

Revenue Recognition Timing: Revenue is recognized when control transfers and performance obligations are met, not necessarily when cash is received.

Anti-dilutive Securities: Only include securities that decrease EPS in diluted EPS calculation. If conversion would increase EPS, exclude it.