Income Statement Analysis

  1. INTRODUCTION

The income statement shows the calculation of a company’s profit over a period, such as a quarter or a year.  A company’s profit (also known as “net income”) is the difference between its revenue and expenses.  However, both revenue and expenses are calculated in accordance with given accounting guidelines (U.S. GAAP and IFRS), and often managerial judgement must be used in the profit calculation.

The typical income statement format will show sales, direct costs of delivering goods or services (known as “cost of sales” or “cost of goods sold”), gross profit (sales minus direct costs), operating expenses (known as “selling, general, and administrative” expenses), operating income (gross profit minus operating expenses), interest expense, and taxes.  A company may also have certain gains, losses, or expenses deemed “nonoperating” and “nonrecurring”, which will be shown net of tax below the tax expense line.  The difference between revenue and all expenses is the company’s net income, and is often referred to as the company’s “bottom line” due to its position on the last line of the income statement.  This income statement format just described is referred as a multi-step format, because its presents gross profit as a subcategory.

  1. REVENUE RECOGNITION

2.1.  General Guidelines

In May 2014, the FASB and the IASB issued nearly identical revenue recognition guidelines.  Since the implementation of these new standards is not required until January 1, 2018 (IFRS) and December 15, 2017 (U.S. GAAP), I will begin this section with a discussion of current U.S. GAAP and IFRS revenue recognition guidelines, followed by a discussion of the new standards.

Companies reporting revenue under U.S. GAAP can recognize revenue when that revenue is “realized or realizable” and earnedi.  Further guidance on revenue recognition from the SEC identifies four criteria which must be met before revenue can be recognized: (1) there must be evidence of an arrangement between the buyer and seller, (2) the product has been delivered or the service has been rendered, (3) the price is determined or determinable, and (4) payment for goods or services is reasonable assuredii.

Current IFRS provides different general guidelines for recognizing revenue from the sale of goods and recognizing revenue from providing servicesiii.  For the sale of goods, the following conditions are met: (1) the risks and rewards of ownership have been transferred to the buyer, (2) the seller retains neither involvement nor control over the goods being sold, (3) revenue can be reliably measured, (4) the seller expects to receive economic benefits from the transaction, and (5) the transaction’s costs can be reliably measured.  For the sale of services, the following conditions must be met: (1) revenue can be reliably measured, (2) the economic benefits of the transaction flowing to the entity are probable, (3) the transaction’s stage of completion can be reliably measured, and (4) the incurred costs of the transaction and the completion costs of the transaction can be reliably measured.

2.2.  Special Circumstances

In certain instances, revenue recognition can be ambiguous.  Three circumstances where revenue can be particularly difficult to determine are long-term service contracts, sales made in installments, and sales paid for via barter.

2.2.1.  Long-Term Contracts

Often a company will provide a service under a contract whose term exceeds one accounting period.  Such a contract is called a long-term contact and is considered a special case for revenue recognition purposes.

Under U.S. GAAP, a company may account for long-term contracts using either the percentage-of-completion method, or the completed contract method.  For IFRS, however, only the percentage-of-completion method is allowed.

When the outcome of a contract can be reliably measured, the company must use the percentage-of-completion method.  Under the percentage-of-completion method, a company recognizes revenue and profit in proportion to the company’s progress under the contract.  Although companies will have some discretion in how they estimate performance progress, most companies use the (contract’s) costs incurred-to-date relative to the total expected costs as the measure of progress.  Cumulative revenue is thus measured as: progress to date x total contract price.  Cumulative profit is measured as:  progress to date x total estimated contract profit.  For a given period, revenue or profit can be calculated by subtracting revenue or profit recognized in prior period from total cumulative revenue or profit.  This method utilizes two inventory accounts:  construction in process and progress billingsiv.  Costs and profits are initially recognized in the construction in process account (debit entry to construction in process and credit entry to construction expense or construction income), while customer billings are recognized in progress billings (debit entry to receivables or cash, credit entry to progress billings).  By the end of the contract, the balances of progress billings and construction in process will reflect the total revenue from the project.  At contract completion, the company would make an entry to close these accounts (debit progress billings and credit construction in process).

When the outcome of a contract cannot be reliably measured, U.S. GAAP allows for companies to utilize the completed-contract method of accounting.  Companies defer recognizing revenue, expenses, and profit until the project is fully complete.   Under this method, all costs incurred during the contract are recognized in the construction in process account and all billings are recognized in the progress billings account.  At contract completion, the progress billings and construction in process accounts are closed, and revenue, expenses, and profit are recognized at that point.  The completed contract method is not allowed under IFRS.  Rather, when a contract outcome cannot be reliably measured, IFRS requires companies to recognize revenue and costs but defer recognizing any profits until all costs have been incurred.

2.2.2.  Installment Sales

An installment sale is a sale in which the sales proceeds are paid in installments.  When the collection of the selling price cannot be reasonably estimated or assured, U.S. GAAP allows companies to use either the installment method or the cost recover method.

Under the installment method, a company recognizes revenue and cost of goods sold at the time of sale but will defer the recognition of profit until payments are received.  At the time of sale, the company defers profit through the use of an account called deferred gross profit (a contra account to accounts receivable).  The company will then apply the gross profit percentage established at the time of sale to each payment.  When payments are received, the company thus ratably “releases” profit from the deferred gross profit account.

U.S. GAAP permits the use of the cost recovery method only when there is a high degree of uncertainty of receivables collection.  Under this method, a seller fully defers the recognition of profit until the cash payments received exceed the seller’s cost.

The above methods are not allowed under IFRS.  Under IFRS, installment sales are recognized as a financing arrangement, and thus the seller must separate the sales price into two components: (1) the sales price, recognized as the discounted present value of the installment stream, and (2) the interest component.  The company recognizes the sales price at the time of sale and recognizes the interest

component over the installment period.

2.2.3.  Barter Sales

A company engages in a barter transaction when it provides a good or service and receives in exchange another good or service (instead of cash payment or the promise of future cash payment).  Under U.S. GAAP, companies engaging in barter can recognize revenue at the fair value of the goods or services received only when the company has a history of such transaction.  If no such history exists, the company must recognize revenue as the book value of the asset being surrendered.  Under IFRS, a company recognizes barter revenue based on the fair value of revenue of similar non-barter transactions with unrelated parties.

2.2.4.  New Revenue Recognition Standard Issued May 2014

The new revenue recognition pronouncements from the FASB and the IASB is the result of an ongoing effort at converging the two accounting standards.v  The joint guidelines require companies to take a “principles” based approach to revenue recognition.  The new framework was formulated with intent of being broad enough to apply to many types of revenue-generating activities, thus replacing the fractured revenue recognition guidelines under previous U.S. GAAP and IFRS.

Under the new guidelines, companies will follow a five-step process in recognizing revenue.  Companies must: (1) identify the contract(s) with a customer, (2) identify the performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contract, and (5) recognize revenue when (or as) the entity satisfies a performance obligation.

The new standards also require that certain costs which were previously expensed now be capitalizedvi.  In particular, incremental costs of obtaining a contract and certain costs incurred to fulfill a contract must be capitalized under the new standards.  The new standards also require greatly enhanced footnote disclosures.  This requirement is partially due to the increased use of discretion and managerial estimates inherent in the new standards.

  1. EXPENSE RECOGNITION

A company incurs an expense when it relinquishes value in a period of corresponding revenues.  The defining characteristic of expense recognition under both U.S. GAAP and IFRS is the matching principle, meaning expenses must be reported in the same period as the associated revenuevii.

3.1.  Managerial Estimates

The matching principle requires the use of managerial estimates in several key areas. For example, a company must estimate the amount of future uncollectible receivables by establishing an allowance for doubtful accounts (a contra-asset to accounts receivable).  Thus, the company will record accounts receivable at estimated realizable value (net of the allowance for doubtful accounts).  Another area requiring the use of managerial estimates is in the accounting for warranty expense.  Here the matching principle requires that companies estimate future warranty costs in the same period in which the sale is made.  Because this expense item is an estimate rather than an actual direct cost, the company sets up a corresponding liability (warranty reserve) on the balance sheet.  Future warranty costs would then be posted against this reserveviii.

3.2.  Depreciation and Amortization

Depreciation and amortization charges represent the systematic expensing of past capital expenditures.  Depreciation relates to the expensing of tangible assets (such as buildings and equipment), over the asset’s expected useful life.  Amortization is the periodic expensing of intangible assets (such as patents and brands) over the asset’s expected useful life.

Companies can choose from several methods in accounting for depreciation and amortization (I will discuss depreciation and amortization in greater depth in subsequent articles).  However, most company use the straight-line method for financial reporting purposes.  Under the straight-line method, depreciation expense is the asset’s cost minus its estimated salvage value, divided by its estimated useful life.  This method leads the company to recognize an asset’s depreciation in equal amounts.

  1. NON-RECURRING ITEMS AND NON-OPERATING ITEMS

Investors are concerned with a company’s sustainable earnings, i.e., those earnings which are likely to persist in the future.  As such, the income statement is structured to help investors identify those items which are likely aberrations.

4.1.  Discontinued Operations

Often a company will decide to exit a business segment.  When the given business is clearly distinct (separate both physical and operationally) from all other business operations, the company must disclose the income of the discontinued segment separately from the income from ongoing operations (known as income from continuing operations).  Because the discontinued operation will not contribute to future operating income, the segregation of this income allows the investor to better estimate a company’s sustainable earnings.

Under both U.S. GAAP and IFRS, discontinued operations are accounted for under a two-step processix.  First, the company must restate all items on the income statement excluding the effects of the discontinued operations.  Second, the effects of the discontinued operations must be reported, net of tax, below income from continuing operations.  Under U.S. GAAP, however, the company would separately report income (or loss) from discontinued operations and gains (or losses) on the disposition of the segment (or specific assets) within the discontinued segment.  Under IFRS, the total impact of discontinued operations is reported on the income statement in a single item.

Companies are only required to restate the income statement for three years (the current year and previous two years).  Income statements before the most recent three years will thus contain the results of these operations and likely the company will not have provided disclosures allowing the investor to segregate the impact of the operations.  For companies with substantial discontinued operations, past income statements may offer little basis of comparison with those after the discontinued operations.

4.2.  Extraordinary Items

Extraordinary items are an income statement category currently prohibited under both U.S. GAAP and IFRS.  However, this classification was permitted under U.S. GAAP for all periods before December 15, 2015.  Because investors may analyze financial statements prior to this period, a brief discussion of this now-defunct category is warranted.

For an item to be classified as extraordinary, the item had to be both unusual and infrequent.  Few items met both thresholds.  Extraordinary items were reported net of tax and appeared on the income statement below discontinued operations.  The separation and non-recurring nature of extraordinary items allowed investors to exclude these items from their calculations of sustainable earnings.

4.3.  Unusual or Infrequent Items

Current U.S. GAAP requires that companies separately disclose on the income statement items that are unusual, infrequent, or unusual and infrequent.  IFRS also requires separate disclosure of an item when the item is material and /or relevant to an understanding of a company’s financial performance, and items that are unusual or infrequent generally meet these criteria.  By separately presenting these items, investors are assisted in assessing the possibility that these items will recur and thus should be included in calculations of sustainable earnings.

4.4.  Changes in Accounting Policies

Companies may change accounting policies because of either a change in authoritative accounting standards or a choice by management.  Regardless of the cause, a change in accounting policy is recorded retroactively, typically requiring a restatement of the financials for the past two years in addition to the current year.  The company must disclose in the footnotes the specifics of and the justification for the accounting policy changex.

A company may also change certain accounting estimates.  For example, a company may change the estimated useful life of an asset when calculating depreciation.  Changes in accounting estimates could have a material impact on reported earnings, and thus management may have an incentive to abuse this discretion to inflate earnings.  These changes are particularly difficult for investors because these changes are not retroactively applied and the disclosures are made in the footnotes to the financial statements.

A company may also have to restate financial statements due to a past accounting error.  For accounting errors, the company must retroactively adjust the financial statements for all prior periods shown in the current financial statements.  Although honest accounting mistakes do occur, investors should be extra vigilant when analyzing the financial statements of companies with such errors.

  1. COMPREHENSIVE INCOME

5.1.  Other Comprehensive Income

Certain gains and losses are excluded from the income statement, but rather they are directly accounted for in a shareholder’s equity category known as other comprehensive income.

Under both U.S. GAAP and IFRS, four types of items are treated as other comprehensive income: (1) foreign currency translation adjustments, (2) unrealized gains and losses on hedge derivate contracts, (3) unrealized gains and losses on investments categorized as available-for-sale, and (4) certain costs related to a company’s defined-benefit post retirement plans.  Under IFRS (but not U.S. GAAP), companies may use other comprehensive income to revalue long-lived assets.

5.2.  Comprehensive Income

Comprehensive income (Total Comprehensive Income under IFRS) is the sum of net income and other comprehensive income.  This measure reflects the total impact of a company’s transactions with non-owners (it excludes investments and withdrawals by owners).

Under U.S. GAAP, a firm can report comprehensive income either at the bottom of the income statement, on a separate statement of comprehensive income, or as a separate column in the statement of shareholder’s equity.  Under IFRS, a firm can present total comprehensive income on a single statement of other comprehensive income or an income statement and a separate statement showing both income and other comprehensive income.

SOURCES

Revsine, Lawrence, Daniel W. Collins, W. Bruce Johnson, H. Fred Mittelstaedt, Leonard C. Soffer.

Financial Reporting & Analysis, 6th ed.  New York:  McGraw-Hill, 2015.

 

Robinson, Thomas R., Elaine Henry, Wendy L. Pirie, and Michael A. Broihahn.  International Financial  

                  Statement Analysis, 3rd ed.  Hoboken: Wiley, 2015.

 

i FASB Accounting Standards Codification (ASC) Section 605-10-25

ii SEC Staff Accounting Bulletin: No. 101

iii IAS No. 18

iv Progress billings is a contra account to construction in process, meaning that it is used to offset (reduce) that account.

v The new standards are set forth in IFRS No. 15 and FASB ASC Topic 606

vi An expenditure is capitalized when the expenditure is placed on the balance sheet as an asset, rather than initially placed on the income statement as an expense.

vii The matching principle is implicit in IFRS.

viii The actual journal entry for a direct warranty cost would be to debit warranty reserve and credit cash or accounts payable

ix Outlined in ASC 225 (U.S. GAAP) and IFRS 5 (IFRS)

x FASB ASC Topic 250 (U.S. GAAP) and IAS No. 8 (IFRS)

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

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