Level 1 CFA® Exam:
Income Statement - Basics
Income Statement – Definitions & Equations for Level 1 CFA Candidates
star content check off when doneWelcome to the first lesson on the income statement. In this lesson we will discuss:
- definitions and equations,
- principles of revenue recognition,
- principles of expense recognition, and
- statement of comprehensive income.
Definitions
However, we should begin with the very basics. Remember that the income statement, which is also called the statement of operations or profit and loss statement:
- shows items that are used to calculate net income,
- contains information about the financial performance of the company over a period of time,
- indicates how much revenue and other income the company earned,
- indicates what expenses the company incurred.
To be able to talk about the income statement, we should also know how revenue, income and costs are defined:
- Revenue is the amount received for the supply of goods or services in the ordinary course of business.
- “Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.” (IASB framework)
- “Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.” (IASB framework)
Equations
Have a look at some equations related to the income statement. The basic equation tells us that:
net income = income - expenses
We can expand the equation and get a more complex one:
net income = revenue + other income + gains - expenses - losses
A company will generate a gain or incur a loss for example if it sells a real estate, and the selling price is different than the carrying amount of this real estate. We will speak of gain if the company sells the real estate for a price higher than the carrying amount, and of loss – if the selling price is lower than the carrying amount. Of course, we assume here that the company’s primary activity is not trading real estates.
We should also mention here that both gains and losses can result from both operating and non-operating activities.
Remember: net income is also called net earnings or bottom line.
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A company recognizes an expense in the period in which it uses up the economic benefits associated with the expenditure. This process is called matching principle. According to it, costs are matched with revenues.
An example of expenses that directly match revenue are cost of goods sold applicable to inventories.
There are also period costs which are not directly matched to revenues and are expensed in the period they were incurred in. Examples of such costs are selling costs, administrative costs, advertising expenses, and so on.
Cost of Goods Sold (COGS)
Cost of goods sold (COGS) relates to inventory. Here are some formulas to know for your level 1 CFA exam:
goods available for sale = beginning inventory + purchases of inventory in the period
ending inventory = beginning inventory + purchases of inventory in the period – COGS
ending inventory = goods available for sale – COGS
Inventory Valuation Methods
You should remember that there are different inventory valuation methods, the choice of which affects both COGS and ending inventory. Thus, the applied inventory valuation method impacts the income statement and the balance sheet. Inventory valuation methods are called cost formulas under IFRS and cost flow assumptions under U.S. GAAP.
Cost formulas allowed under IFRS:
- specific identification,
- weighted average cost, and
- FIFO (first-in, first-out).
Cost flow assumptions allowed under U.S. GAAP:
- specific identification,
- weighted average cost,
- FIFO, and
- LIFO (last-in, first-out).
Specific identification is an inventory accounting method according to which the cost of goods acquired or produced is reported at its purchase or production cost.
FIFO reports inventory beginning with those units that were stored first.
LIFO reports inventory beginning with those units that were stored last.
Weighted average cost takes into account the weighted average cost of acquired or produced inventories.
COGS & Ending Inventory vs Prices of Inventory
| Prices of Inventories in Period are Rising | ||
|---|---|---|
| COGS | Ending Inventory | |
| FIFO | Lowest | Highest |
| LIFO | Highest | Lowest |
(...)
Depreciation
Depreciation is the allocation of the purchase price or production cost throughout the useful life of a long-lived tangible asset. Amortization is generally the same, however the term 'amortization' is used to describe the cost of long-lived intangible assets.
Expected useful life of a long-lived asset is an estimated period of time in which the asset is going to bring an economic benefit to the company.
Expected residual value is the value of a long-lived asset when its useful life is over.
There are 3 basic methods of depreciation and amortization:
- the straight-line method,
- accelerated methods, and
- the units of production method.
According to the straight-line method, all depreciation expenses have the same value:
According to accelerated methods, depreciation expenses are lower from period to period. Remember! When calculating a depreciation expense by means of accelerated methods, don’t take the expected residual value into account!
According to the units of production method, a depreciation expense in a given period relates to the estimated amount of the productivity of the long-lived asset in this period.
If the company chooses accelerated methods, the costs related to PP&E or intangibles in a given period are higher than in the case of the straight-line method and the company reports lower net income. Using accelerated methods is very popular for tax purposes. Thanks to it tax base and taxable income are lower in a current period than in the case of the straight-line method.
total comprehensive income = net income from the income statement + other comprehensive income
Other comprehensive income (OCI) includes items that affect owners’ equity but are not included in the net income and don’t result from transactions with shareowners.
According to both U.S. GAAP and IFRS, in the other comprehensive income you will find items like:
- foreign currency translation adjustments,
- unrealized gains or losses on hedging instruments,
- unrealized holding gains and losses on available-for-sale securities,
- part of costs related to an entity’s defined benefit pension plan.
IFRS also include in OCI revaluation surplus for companies that measure long-lived assets using the revaluation model.
In accordance with IFRS and U.S. GAAP, the statement of comprehensive income may be presented as:
- a single statement of comprehensive income, or
- in two statements: a) the income statement, and b) the statement of comprehensive income that begins with profit or loss from the income statement.
U.S. GAAP allow also to present comprehensive income in the statement of shareholder’s equity.
- An income statement contains information about the financial performance of the company over a period of time.
- Revenue is the amount received for the supply of goods or services in the ordinary course of business.
- An income statement is also called the statement of operations or profit and loss statement.
- Net income is also called net earnings or bottom line.
- Revenue recognition may occur independently of cash movements.
- A company recognizes an expense in the period in which it uses up the economic benefits associated with the expenditure. This process is called matching principle. According to it, costs are matched with revenues.
- Inventory valuation methods are called cost formulas under IFRS and cost flow assumptions under U.S. GAAP.
- Cost formulas allowed under IFRS include specific identification, weighted average cost, and FIFO.
- Cost flow assumptions allowed under U.S. GAAP include specific identification, weighted average cost, FIFO, and LIFO.
- Specific identification is an inventory accounting method according to which the cost of goods acquired or produced is reported at its purchase or production cost.
- FIFO reports inventory beginning with those units that were stored first.
- LIFO reports inventory beginning with those units that were stored last.
- Weighted average cost takes into account the weighted average cost of acquired or produced inventories.
- If prices of inventories in a given period are rising, assuming the FIFO method we will get the lowest value of COGS and the highest value of ending inventory.
- If prices are declining, the FIFO method means the highest COGS and the lowest ending inventory and the LIFO method results in the lowest COGS and the highest ending inventory.
- Depreciation is the allocation of the purchase price or production cost throughout the useful life of a long-lived tangible asset.
- Amortization is the same as depreciation, however the term 'amortization' is used to describe the cost of long-lived intangible assets.
- There are 3 basic methods of depreciation and amortization the straight-line method, accelerated methods, and the units of production method.
- Other comprehensive income (OCI) includes items that affect owners' equity but are not included in the net income and don’t result from transactions with shareowners.