Title LM02 Analyzing Income Statements IFT Notes.pdf ✅

LM02 Analyzing Income Statements 2025 Level I Notes © IFT. All rights reserved 1 LM02 Analyzing Income Statements 1. Introduction ........................................................................................................................................................... 2 2. Revenue Recognition .......................................................................................................................................... 3 3. Expense Recognition .......................................................................................................................................... 8 4. Non-Recurring Items .......................................................................................................................................11 5. Earnings Per Share ...........................................................................................................................................13 6. Income Statement Ratios and Common-Size Analysis .......................................................................16 Summary ...................................................................................................................................................................18 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM02 Analyzing Income Statements 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction The income statement presents information on the financial results of a company’s business activities over a period of time. It is also known as the ‘statement of operations’, ‘statement of earnings’, or ‘profit and loss (P&L) statement’. The basic equation underlying the income statement is: Income - Expenses = Net Income Equity analysts carefully analyze a company’s income statements for use in valuation models while fixed-income analysts analyze income statements to measure a company’s debt servicing ability. Components of the income statement The components of an income statement are: Revenues: Income generated from the sale of goods and services in the normal course of the business. Net revenue is the total revenue minus products that were returned and amounts that are unlikely to be collected. Expenses: Costs incurred to generate revenues. Expenses may be grouped and reported in different formats, subject to some specific requirements. Gains and losses: Amounts generated from non-operating activities. Net income: Net income can be calculated as Net income = Revenues – Expenses + Gains – Losses. A sample income statement is shown below: Multi-step format $ million 2018 2017 Sales 35,310 31,600 Cost of sales 10,300 9,060 Gross Profit 25,010 22,540 Gain from sale of equipment 900 860 Administrative expenses 3,400 2,900 Advertising expense 1,000 900 Depreciation 960 850 Other expenses 6,500 6,100 Operating Income (EBIT) 14,050 12,650 Interest Expense 10 70 Profit before tax (EBT) 14,040 12,580 Tax Expense 3,945 3,300 Profit after tax 10,095 9,280
LM02 Analyzing Income Statements 2025 Level I Notes © IFT. All rights reserved 3 2. Revenue Recognition General Principles Under the accrual method of accounting, revenue should be recognized when earned and not necessarily when cash is received. Let us consider three simple examples to illustrate this point.  If a company sells goods for $100 cash in Period 1, can it recognize revenue in Period 1? The answer is yes. Revenue is recorded in the period it is earned, i.e., when goods or services are delivered.  What if the company sells goods on credit in Period 1 and expects to receive cash in Period 2? Can revenue be recognized in Period 1? The answer is that revenue is recorded in Period 1. In addition, since the goods are sold on credit, an asset called accounts receivable is created.  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? The revenue will be recognized in Period 2 because that is when delivery of goods will take place. In this case, the company will record a liability called unearned revenue when the advance payment is received. Companies must disclose their revenue recognition policies in the notes to their financial statements, and analysts should read these carefully to understand how and when a company recognizes revenue. Accounting Standards for Revenue Recognition In May 2014, the IASB and FASB issued converged standards for revenue recognition. The standards take a principles-based approach to revenue recognition issues. The core principle behind the converged standard is that 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 entitled in an exchange for those goods or services.” According to the standard, the following five steps must be followed in order to recognize revenue: 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. 5. Recognize revenue when (or as) the entity satisfies a performance obligation. When revenue is recognized, a contract asset is added to the balance sheet. If an advance is received but performance obligations have not been met, then a contract liability is added to the seller’s balance sheet. The entity will recognize revenue when it is able to satisfy performance obligation by
LM02 Analyzing Income Statements 2025 Level I Notes © IFT. All rights reserved 4 transferring control of the goods or service to the customer. The following factors can be considered to determine whether the customer has gained control:  Entity has a present right to payment  Customer has legal title  Customer has physical possession  Customer has the significant risks and rewards of ownership  Customer has accepted the good or service Analysts can encounter many companies with complex revenue recognition policies. Several examples adapted from real companies are presented in the example below. Instructor’s Note: Understand the core concepts covered in this example. On the exam you will probably be tested on a short mini-scenario resembling the scenarios below. Example: Applying the Converged Revenue Recognition Standards (This is Example 1 from the curriculum.) Principal Versus Agent MegaDigital is an online marketplace that sells goods and delivers them quickly to customers. For some sales, MegaDigital acts as a principal in which it controls the product before the goods are transferred to the customer. In other sales, MegaDigital acts as an agent in which it arranges for the transfer of a product controlled by a third-party seller. In transactions in which MegaDigital is the principal, revenue is recorded as the total amount of considerations received for the transfer of the product. In transactions in which MegaDigital is the agent, it records revenue only for the portion of the considerations, which amounts to its fee or commission. This can have a significant impact on common size and ratio analysis. Revenue is lower but profit margins are higher for sales for which MegaDigital is an agent. Assume MegaDigital sells a particular product as a principal for USD100 that it purchased for USD70. Additionally, there are USD10 of other selling, general, and administrative costs. The margins would be: Sales USD100 100% Cost of Sales 70 70% Gross Profit 30 30% SG&A 10 10% Net Profit 20 20% If MegaDigital acts an agent for the same item with the same retail price, MegaDigital would receive a commission of USD30 and still incurs USD10 of other costs. Margins would be: Sales USD30 100% Cost of Sales 0 0%