CFA Level 1 (2009) - 3

Study Session H

Cross-Refcrencc to CFA lnstirutc Assigned Reading #.12 - Understanding the Income Statelllcll!

Example 3: EPS with stock options

During 20X6, ZZZ rcporrcJ nc[ income of $ll5,600 and had 200,000 shares of

COm111011 srock ou[standing for the entire year. ZZZ also had l ,000 shares of lO<)1),

$100 par, preferred stock outstanding during 20X6. ZZZ has 10,000 srock options (or warrants) outstanding the 1'I1tire year. Each option allows its holder to purchase one share of COl111110n srock ar $15 per sh:Jre. The average marker price of ZZZ's C0I111110n stock during 20XG is $20 per share. COl11pute the diluted EPS.

Answer:

diluted EPS = $115,600 - $10,000 = $0.52 200,000 + 2,500

A quick way ro calculate the net increase in common shares fr0111 [he potential exercise of srock options or warrants when the exercise price is less [han the average market price is:

AMP-EP]XN [ AMP

where:

AMP = average market price over the year

EP = exercise price of [he options or warrants

N = number of common shares that the options and warrants can be converted into

$20 - $15

For ZZZ: xl 0,000 shares = 2,500 shares $20

Study Session 8

Cross-Rcfercnce to CFA Institute Assigned Reading #32 - Understanding the Incomc Statement

Exam.rle 4: EPS with convertible bonds, convertible preferred, and options

During 20X6, ZZZ reported nct income of $115,600 and had 200,000 shares of C0111mon stock outstanding for the entirc year. ZZZ had 1,000 shares of 10%, $100 par convertible preferred stock, convertible inLO 40 shares eJch, outstanding for the entire year. ZZZ also had 600, 7%, $1,000 par valuc convertible bonds, convertible into 100 shares each, outstanding for the entire year. Finally, ZZZ had 10,000 srock

options outstanding during the year. Each option is convertible into one share of stock at $15 per share. The average market price of the srock for the year was $20. What arc ZZZ's basic and diluted EPS? (Assume a 40% tax rate.)

Answer:

Step 1: From Examples 1,2, and 3, we know that the convertible preferred srock,

convertible bonds, and srock options are all dilutive. Recall that basic EPS was calculated as:

Step 2: Review the number of shares created by converting the convertible securities

and options (the denominator):

Step 3: Review the adjustments to net income (the numerator):

Step 4: Compute ZZZ's diluted EPS:

diluted EPS = 115,600 -10,000 +10,000 + 25,200 = $0.47 200,000 + 40,000 + 60,000 + 2,500

Common-size statemenrs and ratios are tools used to facilitate analysis of the financial statemen [So

A common-size income statement expresses each income statement item as a percentage of sales. This format is known as l)ertica! common-size analysis and allows the analyst to

Study Session 8

Cross-Reference to CFA Institute Assigned Reading #32 - Understanding the Income StatemelH

t:valuatc firm pnformance over time (tinK-series), as wt:ll as compare performance across firms, InJllstrit:s, or sectors (cross-sectional).

Example: Common-size income statements

The table below presents the income statements for Company A, Company B, and Company C. Also presented are the income statements in (vertical) common-size format. All three companies are involved in the same industry. Evaluate the financial performance of the three firms.

Income Statements - In Dollars alld Common Size

As compared to Company B, Company A is smaller in terms of sales and net income when stated in dollars. However, in common-size terms, Company A's net income is higher than Company B's net income (18% versus 15%). By presenting the income statements in common-size format, the analyst is able to compare the firms without regard to size.

Common size analysis also provides information about a firm's business strategies. Revenues are the same at Company B and Company C. However, Company C reports higher gross profit, higher operating profit, and higher net income. The higher profit can be traced to lower cost of goods sold. Notice that Company C spends more on production research and development (R&D) than Company B. As a result, Company C has been able to lower its production costs.

Presenting income tax expense as an effective rate is usually more meaningful than the common-size percentage. The effective rate is equal to income tax expense divided by pre-tax income. In the above example, the effective tax rate for all three companies is

40%.

5mdy Scssion 8

Cross-Rclcn:ncc to CfA Instillitc Assigned Reading #32 - Understanding thc Incomc StatcllH:nt

Financial Ratios Based on the Income Statement

})rojitalJility ratio) examine how good man3.gement is at turtling theil efforts into profits. Ratios such as gmss pmfit malgin, oper3.ting profit margin, and net prof11 margin l'ompare the first value ~\t the top of the income statemelll (sales) to various profil measures. The dilTnent ralios arc designcd to isolate specillc costs and identify specific measures of perCortlullce. Centrally, higher margin ralios arc more desirahle,

Gross profit margin is the ratio of gross proht (sales less cost oC goods sold) (() sales:

, . Cross proht (]ross proht margm = -----

Re venue

Cross prof1t margin can be increased hy raising sales prices or lowering per-unit cost.

Net profit margin is the ratio of net income [0 sales:

, . Net incollle Net proht margm :..= -----

Revenue

Any subtotal presented in the income statemenr cm be expressed in terms of a margin ratio. For example, operating profil margin is equal to operating income dividco by leVenue. Pre-tax margin is equal (0 pre-tax earnings divided by n:venuc,

0\ ProfeS5or~.Not~: Rat~~J'are discussed in detail in the topic review 011 "Filla1/cia!

,<:c~ Anlllysts f eclmuJlfl's.

LOS .:n.k: State the accounting classification for Items lhal are excluded from the income statement but affect owners' equity, and list the major types of items receiving that treatment.

At rile end of each accounting period, the net income of the hrm is added to stockholders' equity through an account known as retained earnings. Therefore, any transaction that affects the income statement (net income) will also affect stockholders' equity. However, not all accounting transactions are reported in the income statement. For example, issuing srock and reacquiring stock are transactions that afFect stockholders' eq uity but not net income. Dividends paid reduce stockholders' equity, but they do not reduce in net income. Finally, transactions included in other comprehensive income affect equity but not Ilet income. Other comprehensive income includes:

J.Foreign currency translation gains and losses.

2.Adjustments for minimum pension liability.

3.Unrealized gains and losses from cash flow hedging derivatives.

4.Unrealized gains and losses from available-for-sale securities.

Study Session 8

Cross-Reference to CFA Institute Assigned Reading #32 - Understanding the Income Statement

Availablc-for-stLIe sewrities arc investment securities that are not expeLlcd to be held to maruriry or sold in the ncar term. Available-for-sale securiries arc reported on the balance sheer ar rair value. The unrealized gains ~1l1d losses (the c1unges in fair value

before the securiries are sold) arc not reponed in the income statelllelll but arc reported directly in stockholders' equity as a componelll of other comprehensivc income.

-~------- ------------------------ --- -----------------

Comprehensive income is a measure that includes all changes to equity other than owner contributions and distributions. That is, comprehensive income aggregates net incomc and other comprehensive income (foreign currency translation gains and losses, minimum l)cnsion liability adjustmelHs, and unrealized gains and losses on cash How hedging derivatives and available-for-sale securities).

Example: Calculating comprehensive income

Calculate comprehensive income for Triple C Corporation using rhe selected financial statement data found in the following table.

Triple C CO/jJortltioll - Selected Fir/tll/cial Statement Dattl

The dividends received for available-for-sale securities and the realized gain on the sale of land are already included in net income. Dividends paid and the reacquisition of common stock are transactions with shareholders, so they are not included in comprehensive income.

Study S~ssion 8

Cross-Refcrcnce to CrA Institute Assigned Reading #32 -- Understanding the Incomc Statcment

lOS P.:l

The income slatemeIlt shows an entity's revenues, expenses, gains and losses during a reporting pniod.

A multi-step income statcment provides a subwtal for gross profit and a single step income stalemcnr does nor. Expenses on the income statemenr can be grouped by the nature of the expense items or by their function, such as with expenses grouped into cost of goods sold.

1 '\"!) ,!)

, {, . ") . I .:,.

Revenue is recognizcJ when earned and expenses are recognized when incurred.

Ivlcthods for :lccounting for long-terlll clliltracts include:

•Percen rage-of.-com p!ction--recogn izcs reven ue in proporrion LO costs incLl rn:d. ComplereJ-conrraer--recognizes revenue only when the contract is complete.

Revenue recognition methoJs for insrallment sales are:

•Cost recovery method if collectability is highly uncertain.

Revenue from barrer transactions can only be recognized if its fair value can be estimated from historical data on similar non-barter transactions.

Gross revenue reponing shows sales and COSt of goods sold, while net revenue reporting shows only the difference between sales and cost of goods sold and should be used when the firm is acting essentially as a selling agent and does not stock inventory, take credit risk, or have control over supplier and price.

A firm using a revenue recognition method that is aggressive will inflate current period earnings at a minimum and perhaps inflate overall earnings.

LOS 32.c

The matching principle requires that firms match revenues recognized in a period with the expenses required to generate them. One application of the matching principle is seen in accounting for inventory, with cost of goods sold as the cost of units sold from inventory that are included in current-period revenue. Other costs, such as straight-line depreciation of fixed assets or administrative overhead, are period costs and are taken without regard to revenues generated during the period.

Users of financial data should analyze the reasons for any changes in estimates of expenses and compare these estimates with those of peer companies.

Study Session;

Cross-Reference to CFA Institute Assigned Reading #32 - Underst;\llding the Income Statemt:n

LOS 32.d

An acceleratcd depreciation mcthod is appropriate if a long.ttrm asset gencrates proportionally more of its economic beIlefits in the carly years of its life. Straight.linc depreciation is appropriate whcn an asset's economic value dccreases at an approximately constant rate over time.

IIlvemory that CIl\ bc trackcd by individll:ll unit Cln be v;llucd hy specific identif1cation. First·in-hrst-out inventory valuation is appropriate for goods with a limited shelf lifc. Last-in-hrst-out is widely uscd in the U.S. becausc of its tax advantages blll is nOt allowed under IFRS. Thc weighted average cost method averages thc COSt of all units purchased or manufactured and currently available for sale.

Illtangible aSsets with limited lives should be amortized Ilsing a mcthod tint reHeers the How over time of their economic bcnefits. Illtangible asscts with indcfinite lives (e.g., goodwill) are not amortized.

LOS 32.e

Deprccia tion mcthods:

Straight·line: Equal amoullt 01 depreciation expcnse in each year oC the asset's uscful lifc.

•Declining balance: Apply a CO!1Stanr rate of depreciation to the declining book value umit book value equals residual value.

Inventory valuation methods:

•FIFO: Inventory rcRects cost of most reccnt purchases. COGS rd1ccts cost uf oldest purchases.

•U 1:0: COGS reHecrs cust of most recent purchases, in\'Cnror)' rcJkcrs cost 0['ulJeSt purchases.

A\'Cragc cust: Unit COSt equals cost of goods available for sale di\'ided lw t()tal units available and is uscd for both COGS and inventory.

•Specific identification: each irem in invcntory is identified and itS historical COSt is used for calculating COGS whcn the item is sold.

Amortization methods for idcnti!1ablc intangible Jssets should also Jf1[HOxirnatc the p;J([crn ()f decrease in their economic nlues, but intangible ~1Ssets with indefinitc \iws are not amortized.

L.OS 32.1'

Operating income is gener;Jted from the firm's normal business operations. for a nonfinancial firm, income that results from investing or financing rransaClions is classified as non-operating incollle, while it is operating income for a {1nJI1ci;J1 firm since its busincss operations include investing in Jnd financing securities.

Study Sessio/1 ~

Cross-Refaence to CFA Institute Assigned Reading #31 - Understanding the Income Statement

LOS 32.g

Resulrs of discontinued operarions _Ire reponed below income from conrinuing operarions, net or I;IX, from [he datc thc decision [0 dispose of rhe operariollS is mack. These resulrs arc segregarcd beGlUSe [he)' likely arc nOll-recurring ;ll1d do no[ affeer future nel income.

Unusual or infrequelH irems arr rrpul"led bd"orc (;IX ~1l1l1 abovc incomc From continuing operarions. An analyst should dcrermine how "unusual" or "infrequen[" rhese irems really arc for the company when esrimating furure earnings and/or firm vaille.

Extraordinary i[ems (borh [lnuSllal ~lnd infrequenr) arc reported below income from continuing operariollS, net of [ax under U.S. CAAP, bu[ [his trcatnll'nt is nor ;tllowcd uIHlcr IFRS. Ex[ral1rdinary i[cms arc no[ cxpeCled [ll con[inuc in fUlllre periods.

Ch~lng('s in :ll'lollnring sLlndards, ch~lnses in accounting methods applied, and correCtions of .lCCOllnrIng l'lTOLS rl'\jllirl" rClrospCClil'l' rl'SLHCl\lCnt I)"~ :111 prior-period fin:lllli:tl Sl~ltL'll1l'lllS includl'd in [hL' c"llrrl'nt sl:HcmCIH. (\ lhange in an :In:olln[ing es[inLIlc, II00I·c'l·l'r. is ~lppliCtI pll"peCllI'r!I' (ll) SUbSl'ljUCnl [)eriods) with no rCSlalCmL:lll of prior-period results.

For an)' convertihle preferred srock, cO!lI"(:rriblc deht, \V~Hranr" or ,LOck options rhar arc

LOS 32.i

A dilurive security is one thar, if' convened ro irs cOl11mon srock equivalent, would decrease EllS. An anridiluti\'c security is one [hat would nor reduce EPS if convened ro irs comlllon srock equivalent.

LOS 52.)

A verrical conllTIon-size income starcmcll( expresses each linc irem ;\s a percentage of sales. Gross profil margin and ncr I)ro/lr margin arc proFitabiliry ratios rhat can be read directly (10m ;t \'ertical common-size income sraremcnt. An analysr should examine changes in irems on a venical coml1lon-size income Sl;UCJ1lelll o\'er rime ;tnd compare \';llues to those for peer romp.lnies or to industry averages.

SI ud)' Session H

Cross-Reference to CFA Institute Assigned Reading #32 - Understanding the Income Statement

LOS 52.k

Transacrions with shareholders, such as dividcnds paid and sh~res issued or repurchased, ;ll'e not reponed on the incomc statement.

"Other comprehensive income" includes othn transactions that affect equity hut do not a ITeet net income, i ncl Lid ing:

Cains and losses (rom foreign currency translation.

Pcnsion obligation ad j ustmen ts.

Unrealizcd gains and losses from cash Row hedging derivatives.

Unrcalized gains and losses on available-far-sale securities.

! (lS LU

Comprehensive income is the sum of' net income and other comprehensive income.

Study Session 8

Cross-Rclcrence to CFA Institute Assigned Reading #32 - Understanding the Income Statement

1.h)r a nonJinancial firm, arc depreciation expense and interest expcnse included or excluded from operating cxpcnses in the income statement?

2.Arc income taxes and cost of goods sold examples of expenses classified by

nature or classified by function in the income statcment? Income taxes sQld

A. N atu re

B. Function

C. Function

5.Which principle requires that cost of goods sold be recognized in the same

period in which the sale of the relatcd inventory is recordcd?

A.Going concern.

B.Certainty.

C.Matching.

6.Which of the following would least likely increase pretax income?

A.Decreasing the bad debt expense estimate.

B.Increasing the useful life of an intangible asset.

C.Decreasing the residual value of a depreciable tangible asset.

7.When accounting for inventory, are the first-in, first-out (FIFO) and last-in, first-out (LIFO) cost flow assumptions permitted under U.S. GAAP?