CFA Program Level I for November 2024 $ & '

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r Practice INTRODUCTION
v Mock Exams Income statements and analytical measures derived from them, such as sales growth, operating margin,
and earnings per share (EPS), are critical for equity and credit analysis. Investors analyze income
j Game Center
statements to evaluate companies’ growth, profitability, and risks, and often use income statement figures in
e Discussions valuation. Corporate financial announcements frequently emphasize information reported in income
statements, particularly earnings, more than information reported in the other financial statements.
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Learning Module Overview

Revenue is recognized in the period it is earned, which may or may not be in the same period as the
related cash collection.
An analyst should identify differences in companies’ revenue recognition methods and adjust reported
revenue where possible to facilitate comparability. In cases in which the available information does not
permit adjustment, an analyst can characterize the revenue recognition as more or less conservative
and thus qualitatively assess how differences in policies might affect financial ratios and judgments
about profitability.
As of the beginning of 2018, revenue recognition standards have converged across US GAAP and
International Financial Reporting Standards (IFRS). The core principle of the converged standards 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.”
To achieve the core principle, the standard describes the application of five steps in recognizing
revenue. The standard also specifies the treatment of some related contract costs and disclosure
requirements.
The general principles of expense recognition include a process to match expenses to revenue (e.g.,
cost of goods sold), to the period in which the expenditure occurs (e.g., administrative costs), or to the
period of expected benefits of the expenditures (e.g., depreciation and amortization).
In expense recognition, choice of method (i.e., depreciation method and inventory cost method), as
well as estimates (i.e., uncollectible accounts, warranty expenses, assets’ useful life, and salvage
value) affect a company’s reported income. An analyst should identify differences in companies’
expense recognition methods and adjust reported financial statements where possible to facilitate
comparability. In cases in which the available information does not permit adjustment, an analyst can
characterize the policies and estimates as more or less conservative and thus qualitatively assess
how differences in policies might affect financial ratios and judgments about companies’ performance.
To assess a company’s future earnings, it is helpful to separate those prior years’ items of income and
expense that are likely to continue in the future from those items that are less likely to continue.
Under IFRS, a company should present additional line items, headings, and subtotals beyond those
specified when such presentation is relevant to an understanding of the entity’s financial performance.
Some items from prior years clearly are not expected to continue in future periods and are separately
disclosed on a company’s income statement. Under US GAAP, unusual or infrequently occurring
items, which are material, are presented separately within income from continuing operations.
Non-operating items are reported separately from operating items on the income statement. Under
both IFRS and US GAAP, the income statement reports separately the effect of the disposal of a
component operation as a “discontinued” operation, net of income taxes.
Basic EPS is the amount of income available to common shareholders divided by the weighted
Rate Your Confidence
average number of common shares outstanding over a period. The amount of income available to
common shareholders is the amount of net income remaining after preferred dividends (if any) have High
been paid.
If a company has a simple capital structure (i.e., one with no potentially dilutive securities), then its Medium

basic EPS is equal to its diluted EPS. If, however, a company has dilutive securities, its diluted EPS is
Low
no greater than its basic EPS.
Diluted EPS is calculated using the if-converted method for convertible securities and the treasury
stock method for options. Continue !
Common-size analysis of the income statement involves stating each line item on the income
statement as a percentage of sales. Common-size statements facilitate comparison across time Category

periods and across companies of different sizes. Analyzing Income Statements

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