ifsa_chapter4

Chapter 4: Understanding Income Statements

Chapter 4Financial Reporting StandardsNaveed Ahmad MughalAsst. ProfessorGBS

Customization noteS:Hyperlinks to the annual reports of companies used in this presentation are provided at the bottom of the slide. If the presenter saves the annual report to the same computer drive on which the PowerPoint presentation is saved, clicking the hyperlink will take the presenter to the annual report. Note also that the income statement and other relevant items are bookmarked in each annual report PDF. To navigate to the bookmarked pages, select the bookmark icon once the PDF is open (2nd down on far left of screen when PDF is opened).

This presentation contains numerous numerical examples. The presenter may wish to delete the solution slides from any handouts. In addition, the presenter may wish to shorten the presentation by eliminating some or all of the numerical examples.

LEARNING OUTCOMESDescribe the components of the income statement and alternative presentation formats of that statement.Describe the general principles of revenue recognition and accrual accounting, specific revenue recognition applications (including accounting for long-term contracts, installment sales, barter transactions, gross and net reporting of revenue), and the implications of revenue recognition principles for financial analysis.Calculate revenue given information that might influence the choice of revenue recognition method.Describe the general principles of expense recognition, specific expense recognition applications, and the implications of expense recognition choices for financial analysis.Describe the financial reporting treatment and analysis of nonrecurring items (including discontinued operations, extraordinary items, unusual, or infrequent items) and changes in accounting standards.Distinguish between the operating and nonoperating components of the income statement.Describe how earnings per share is calculated and calculate and interpret a companys earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures.Distinguish between dilutive and antidilutive securities, and describe the implications of each for the earnings per share calculation.Convert income statements to common-size income statements.Evaluate a companys financial performance using common-size income statements and financial ratios based on the income statement.Describe, calculate, and interpret comprehensive income.Describe other comprehensive income, and identify the major types of items included in it.1

OverviewIncome statement components and formatAccounting issuesRevenue recognitionExpense recognitionInventoryDepreciationNonrecurring itemsEarnings per shareIncome statement analysisComprehensive income

Copyright 2013 CFA Institute2

Income statement componentsAlso called the statement of earnings, statement of operations, and profit and loss statement (P&L)

Presents results of operations for the accounting period

Revenues Expenses = Net income

Revenue + Other Income + Gains Expenses Losses = Net income


LOS. Describe the components of the income statement and alternative presentation formats of that statement.Pages 135139

The income statement is also sometimes called the statement of earnings, statement of operations, and profit and loss (P&L) statement. Components of the income statement:Revenue generally refers to amounts charged (and expected to be received) for the delivery of goods or services in the ordinary activities of a business. The term net revenue means that the revenue number is reported after adjustments (e.g., for cash or volume discounts or for estimated returns). Revenue may be called sales or turnover.Sales is sometimes understood to refer to the sale of goods, whereas revenue can include the sale of goods or services; however, the terms are often used interchangeably. In some countries, such as the United Kingdom and South Africa, turnover may be used in place of revenue.Expenses reflect outflows, depletions of assets, and incurrences of liabilities in the course of the activities of a business.Net income also includes gains and losses, which are increases and decreases in economic benefits, respectively, which may or may not arise in the ordinary activities of the business. For example, when a manufacturing company sells its products, these transactions are reported as revenue and the costs incurred to generate these revenues are expenses and are presented separately. However, if a manufacturing company sells surplus land that is not needed, the transaction is reported as a gain or a loss. The amount of the gain or loss is the difference between the carrying value of the land and the price at which the land is sold. The definition of income encompasses both revenue and gains and the definition of expenses encompasses both expenses that arise in the ordinary activities of the business and losses. Thus, net income (profit or loss) can be defined as (a) income minus expenses, or equivalently, (b) revenue plus other income plus gains minus expenses, or equivalently, (c) revenue plus other income plus gains minus expenses in the ordinary activities of the business minus other expenses, and minus losses. At the bottom of the income statement, companies report net income (companies may use other terms such as net earnings or profit or loss). Where applicable, companies present another item below net income: information about how much of that net income is attributable to the company itself and how much of that income is attributable to minority interests, or noncontrolling interests. Companies consolidate subsidiaries over which they have control. Consolidation means that they include all of the revenues and expenses of the subsidiaries even if they own less than 100%. Minority interest represents the portion of income that belongs to minority shareholders of the consolidated subsidiaries, as opposed to the parent company itself.

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Income statement formatSubtotalsGross profit (i.e., revenue less cost of sales)Multistep format: Income statement shows gross profit subtotalSingle-step format: Income statement excludes gross profit subtotalOperating profit (i.e., revenue less all operating expenses)Profits before deducting taxes and interest expense and before any other nonoperating itemsOperating profit and EBIT (earnings before interest and taxes) are not necessarily the sameExpense GroupingCopyright 2013 CFA Institute4

LOS. Describe the components of the income statement and alternative presentation formats of that statement.LOS. Distinguish between the operating and nonoperating components of the income statement.Pages 135139, 168169

In addition to presenting the net income, income statements also present items, including subtotals, that are significant to users of financial statements. One subtotal often shown in an income statement is gross profit or gross margin (that is, revenue less cost of sales). When an income statement shows a gross profit subtotal, it is said to use a multistep format rather than a single-step format. Another important subtotal that may be shown on the income statement is operating profit (or, synonymously, operating income). Operating profit results from deducting operating expenses, such as selling, general, administrative, and research, and development expenses from gross profit. Operating profit reflects a companys profits on its usual business activities before deducting taxes and, for nonfinancial companies, before deducting interest expense. For financial companies, interest expense would be included in operating expenses and subtracted in arriving at operating profit because it relates to the operating activities for such companies. For some companies composed of a number of separate business segments, operating profit can be useful in evaluating the performance of the individual business segments, because interest and tax expenses may be more relevant at the level of the overall company rather than an individual segment level. The specific calculations of gross profit and operating profit may vary by company, and a reader of financial statements can consult the notes to the statements to identify significant variations across companies.Operating profit is sometimes referred to as EBIT (earnings before interest and taxes). However, operating profit and EBIT are not necessarily the same because interest and taxes do not represent the only differences between earnings (net income, net earnings) and operating income.

Expenses may be grouped and reported in different formats, subject to some specific requirements. Some of the items are specified by IFRS but other items are not specifiedCertain items, such as revenue, finance costs, and tax expense, are required to be presented separately on the face of the income statement. IFRS additionally require that line items, headings, and subtotals relevant to understanding the entitys financial performance should be presented even if not specified. Expenses may be grouped together either by their nature or function. Grouping together expenses, such as depreciation on manufacturing equipment and depreciation on administrative facilities, into a single line item called depreciation is an example of a grouping by nature of the expense. An example of grouping by function (sometimes referred to as the cost of sales method) would be grouping together expenses into a category, such as cost of goods sold, which may include labor and material costs, depreciation, some salaries (e.g., salespeoples), and other direct sales-related expenses. 4

Income statement format: example 1Colgate-Palmolive companyCopyright 2013 CFA Institute5

Colgate Annual Report


Colgates income statement is denominated in millions of U.S. dollars ($).The top line of Colgates income statement shows net sales.Colgates income statement shows gross profit (i.e., net sales less cost of sales) of $9.6 billion ($9,590 million) in 2011. When an income statement shows a gross profit subtotal, it is said to use a multistep format.Colgates income statement also shows operating profit (i.e., net sales less cost of sales and all other operating expenses) of $3.8 billion ($3,841 million) in 2011. Colgate includes operating items other than SG&A (selling, general, and administrative) expenses in a single line labeled Other (income) expense, net. The $(9) million in 2011 means that Colgate had other operating income of $9 million in 2011, compared with other operating expense of $301 million and $111 million in 2010 and 2009, respectively.The footnotes to the financial statements (shown on subsequent slides) provide additional information about each of these line items.Below operating profit, Colgate shows Interest expense, net of $52 million for 2011.The net means that interest expense is presented net of interest income and interest capitalized.After deducting interest, Colgates income statement shows pretax profit Income before income taxes of $3,789 million in 2011. After income taxes of $1,235 million, Colgates consolidated net income is $2,554.As noted earlier, where applicable, companies present another item below net income: Information about how much of that net income is attributable to the company itself and how much of that income is attributable to minority interests, or noncontrolling interests. For Colgate, $123 million of the consolidated net income is attributable to noncontrolling interests and $2,431 million is attributed to Colgate itself.Finally, the income statement shows earnings per share (EPS), both basic and diluted. A subsequent slide will discuss the computation of EPS.5

Income statement format: example 2LOreal GroupCopyright 2013 CFA Institute6L'Oreal's Annual Report


LOreals income statement is denominated in millions of euros ().The top line of LOreals income statement shows net sales.LOreals income statement shows expenses (e.g., cost of sales) as a negative number.LOreals income statement shows gross profit (i.e., net sales less cost of sales) of 14.5 billion in 2011. When an income statement shows a gross profit subtotal, it is said to use a multistep format.LOreals income statement shows R&D, advertising, and SG&A expense as three separate line items.LOreals income statement also shows operating profit (i.e., net sales less cost of sales and all other operating expenses) of 3.3 billion in 2011. LOreal defines operating profit in accordance with local regulations. As stated in the footnotes, Operating profit consists of gross profit less research and development expenses, advertising and promotion expenses, and selling, general, and administrative expenses. Operating profit corresponds to the definition of current operating profit provided by Conseil National de la Comptabilit (CNC) recommendation No. 2009-R-03 of July 2nd, 2009, regarding the presentation of financial statements for companies applying international accounting standards. It notably includes the entire charge relating to the Contribution conomique Territoriale (CET) tax collected in France, including its value added based component. The classification of the CET tax in operating expenses is, therefore, consistent with the classification of the former business tax (taxe professionelle) it replaces.LOreals 3,196.3 operational profit deducts 96.3 million of Other income and expenses, which, according to the footnotes, includes items such as capital gains and losses on disposals of property, plant, and equipment and intangible assets, impairment of assets, and restructuring costs.

Note: Operating profit and operational profit are not defined in IFRS or U.S. GAAP. Sometimes, operational profit is used as a synonym for operating profit. Another synonym for operating profit is operating income. For example, Danone, another French company, uses the terminology trading operating income and then operating income after deducting other operating income and expenses, such as restructuring costs.

Below operational profit, LOreal shows finance costs, finance income, and net finance costs. Amounts for 2011 are 48.1 million, 28.5 million, and 19.6 million, respectively.After deducting finance costs, LOreals income statement shows 5.6 million in other financial expenses and 295.6 million in dividends from its investment in Sanofi S.A. (a French health care company) to arrive at pretax profit, Profit before tax and non-controlling interests, of 3,466.7 million in 2011. After income taxes, LOreals 2011 net profit (i.e., net income) is 2,440.9.As noted, where applicable, companies present another item below net income: Information about how much of that net income is attributable to the company itself and how much of that income is attributable to minority interests, or noncontrolling interests. For LOreal, 2.5 million of the consolidated net profit is attributable to noncontrolling interests and 2,438.4 million is attributed to LOreal itself.Finally, the income statement shows EPS, both basic and diluted. A subsequent slide will discuss the computation of EPS.6

Income statement format: example 3Procter & GambleCopyright 2013 CFA Institute7Proctor & Gamble Report

LOS. Describe the components of the income statement and alternative presentation formats of that statement.LOS. Distinguish between the operating and nonoperating components of the income statement.LOS. Describe the financial reporting treatment and analysis of nonrecurring items (including discontinued operations, extraordinary items, unusual or infrequent items) and changes in accounting standards.Pages 135139, 163169

Proctor & Gambles (P&G) income statement is denominated in millions of U.S. dollars ($).Note that the year-end is 30 June.The top line of P&Gs income statement shows net sales.P&Gs income statement does not show gross profit. It is an example of the single-step format.P&Gs income statement shows operating income of $15,818 million in 2011. Below operating profit, P&G shows interest expense and then other nonoperating income (expense) to arrive at pretax earnings of $15,189 million in 2011. This amount is labeled Earnings from continuing operations before income taxes because in 2010 and 2009, P&G had some amounts of income related to discontinued operations.In the footnotes, the company discloses that it completed the divestiture of its global pharmaceuticals business to Warner Chilcott plc in October 2009 and the divestiture of its Folgers coffee business in November 2008.After income taxes, P&Gs 2011 net earnings (i.e., net income) is $11,797 million.P&G does not have minority interest.Finally, the income statement shows EPS, both basic and diluted. EPS is shown both for continuing operations and discontinued operations. A subsequent slide will discuss the computation of EPS. 7

general principles of revenue recognition and accrual accountingRevenue recognition can occur independently of cash movementsfor example, in the case of thesale of goods and services on credit or receipt of cash in advance of providing goods and services A fundamental principle of accrual accounting is that revenue is recognized (reported on the income statement) in the period in which it is earned.Copyright 2013 CFA Institute8

LOS. Describe the general principles of revenue recognition and accrual accounting, specific revenue recognition applications (including accounting for long-term contracts, installment sales, barter transactions, gross and net reporting of revenue), and the implications of revenue recognition principles for financial analysis.Pages 140152

Revenue is the top line in an income statement, so we begin the discussion of line items in the income statement with revenue recognition. An important aspect concerning revenue recognition is that it can occur independently of cash movements. A fundamental principle of accrual accounting is that revenue is recognized (reported on the income statement) when it is earned, so the companys financial records reflect revenue from the sale when the risk and reward of ownership is transferred; this is often when the company delivers the goods or services. If the sale was on credit, revenue is recognized and a related asset, such as trade or accounts receivable, is created. Later, when cash changes hands, the companys financial records simply reflect that cash has been received to settle an account receivable. If a company receives cash in advance and actually delivers the product or service later, the company would record a liability for unearned revenue when the cash is initially received. Later, as products and services are delivered, revenue would be recognized as being earned over time. An example would be a subscription payment received for a publication that is to be delivered periodically over time.

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When to recognize revenue

IFRS specify that revenue from the sale of goods is to be recognized when the following conditions are satisfied:Entity has transferred to the buyer the significant risks and rewards of ownership of the goods;Entity retains neither continuing managerial involvement with nor effective control over the goods sold;Amount of revenue can be measured reliably;It is probable that the economic benefits associated with the transaction will flow to the entity; andCosts incurred with respect to the transaction can be measured reliably.Copyright 2013 CFA Institute9


When to recognize revenue (when to report revenue on the income statement) is a critical issue in accounting. IFRS specify that revenue from the sale of goods is to be recognized (reported on the income statement) when the following conditions are satisfied:the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;the amount of revenue can be measured reliably;it is probable that the economic benefits associated with the transaction will flow to the entity; andthe costs incurred or to be incurred with respect to the transaction can be measured reliably.Simply put, revenue is recognized when the seller no longer bears risks with respect to the goods (for example, if the goods were destroyed by fire, it would be a loss to the purchaser), the seller cannot tell the purchaser what to do with the goods, the seller knows what it expects to collect and is reasonably certain of collection, and the seller knows how much the goods cost.IFRS note that the transfer of the risks and rewards of ownership normally occurs when goods are delivered to the buyer or when legal title to the goods transfers. However, as noted by the above remaining conditions, physical transfer of goods will not always result in the recognition of revenue. For example, if goods are delivered to a retail store to be sold on consignment and title is not transferred, the revenue would not yet be recognized. IFRS specify similar criteria for recognizing revenue for the rendering of services.9

When to recognize revenue

U.S. GAAP specify that revenue should be recognized when it is realized or realizable and earned. The U.S. Securities and Exchange Commission (SEC) provides guidance on how to apply the accounting principles. This guidance lists four criteria to determine when revenue is realized or realizable and earned:There is evidence of an arrangement between buyer and seller. The product has been delivered, or the service has been rendered. The price is determined or determinable.The seller is reasonably sure of collecting money. Copyright 2013 CFA Institute10


U.S. GAAP specify that revenue should be recognized when it is realized or realizable and earned. The U.S. SEC, motivated in part because of the frequency with which overstating revenue occurs in connection with fraud and/or misstatements, provides guidance on how to apply the accounting principles. This guidance lists four criteria to determine when revenue is realized or realizable and earned:There is evidence of an arrangement between buyer and seller. For instance, this would disallow the practice of recognizing revenue in a period by delivering the product just before the end of an accounting period and then completing a sales contract after the period end.The product has been delivered, or the service has been rendered. For instance, this would preclude revenue recognition when the product has been shipped but the risks and rewards of ownership have not actually passed to the buyer.The price is determined or determinable. For instance, this would preclude a company from recognizing revenue that is based on some contingency.The seller is reasonably sure of collecting money. For instance, this would preclude a company from recognizing revenue when the customer is unlikely to pay. This information is from FASB ASC Section 605-10-25 [Revenue RecognitionOverallRecognition]. The content of SEC Staff Accounting Bulletin 101 is contained in FASB ASC Section 605-10-S99 [Revenue RecognitionOverallSEC Materials].

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specific revenue recognition applications: long-term contractsLong-term contract: contract that spans a number of accounting periods.

Percentage-of-completion methodUse when the outcome of a contract can be measured reliably.In each accounting period, the company estimates what percentage of the contract is complete and then reports that percentage of the total contract revenue in its income statement. Contract costs for the period are expensed against the revenue.Net income or profit is reported each year as work is performed.Copyright 2013 CFA Institute11


A long-term contract is one that spans a number of accounting periods (e.g., a construction contract). Such contracts raise issues in determining when the earnings process has been completed and revenue recognition should occur. How should a company apportion the revenue earned under a long-term contract to each accounting period? When the outcome of a contract can be measured reliably, revenue and expenses should be recognized in reference to the stage of completion. Under the percentage-of-completion method, revenue is recognized based on the stage of completion of a transaction or contract and is thus recognized when the services are rendered. Construction contracts are examples of contracts that may span a number of accounting periods and that may use the percentage-of-completion method. Under the percentage-of-completion method, in each accounting period, the company estimates what percentage of the contract is complete and then reports that percentage of the total contract revenue in its income statement. Contract costs for the period are expensed against the revenue. Therefore, net income or profit is reported each year as work is performed.

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specific revenue recognition applications:long-term contracts exampleExample that uses the percentage-of-completion method of revenue recognition: Network Construction project: bid was $5,000,000 and estimated costs to complete were $4,000,000

Year 1: Costs incurred of $3,000,000 (assume this mirrors the percentage complete)Revenue?Cost of revenue?

Year 2: Job is completed with costs of $1,000,000Revenue?Cost of revenue?Copyright 2013 CFA Institute12

LOS. Describe the general principles of revenue recognition and accrual accounting, specific revenue recognition applications (including accounting for long-term contracts, installment sales, barter transactions, gross and net reporting of revenue), and the implications of revenue recognition principles for financial analysis.LOS. Calculate revenue given information that might influence the choice of revenue recognition method.Pages 140152

Under the percentage-of-completion method, in each accounting period the company estimates what percentage of the contract is complete and then reports that percentage of the total contract revenue in its income statement. Contract costs for the period are expensed against the revenue. Therefore, net income or profit is reported each year as work is performed.In Year 1, 75% of the estimated costs have been incurred. Therefore, the company will recognize 75% of the revenue, or $3,750,000. Gross profit on the contract for the year is $750,000.Revenue = $3,000,000/$4,000,000 = .75 $5,000,000 = $3,750,000Costs = $3,000,000Gross profit = $750,000In Year 2, the remaining $1,000,000 of costs are incurred. The company will recognize the remaining amount of the revenue, or $1,250,000. Gross profit on the contract for the year is $250,000.Revenue = $5,000,000 $3,750,000 = $1,250,000Costs = $1,000,000Gross profit = $250,000

What if the company had estimated costs inaccurately? (next slide)12

specific revenue recognition applications: long-term contracts exampleExample that uses the percentage-of-completion method of revenue recognition (continued):Network Construction project: bid was $5,000,000 and estimated costs to complete were $4,000,000.

Year 1: Costs incurred $3,000,000 (assume this mirrors the percentage complete)Revenue?Cost of revenue?

Year 2: Job is completed with costs of $1,250,000 (a cost overrun)Revenue?Cost of revenue?Copyright 2013 CFA Institute13


Under the percentage-of-completion method, in each accounting period, the company estimates what percentage of the contract is complete and then reports that percentage of the total contract revenue in its income statement. Contract costs for the period are expensed against the revenue. Therefore, net income or profit is reported each year as work is performed.In Year 1, 75% of the estimated costs have been incurred. Therefore, the company will recognize 75% of the revenue, or $3,750,000. Gross profit on the contract for the year is $750,000.Revenue = $3,000,000/$4,000,000 = .75 $5,000,000 = $3,750,000Costs = $3,000,000Gross profit = $750,000In Year 2, $1,250,000 of costs are incurred. The company will recognize the remaining amount of the revenue, or $1,250,000. However, gross profit on the contract for the year is $0.Revenue = $5,000,000 $3,750,000 = $1,250,000Costs = $1,250,000Gross profit = $0This example illustrates the importance of the estimates. The estimates affect when the revenue and profit will be recognized.Because the company underestimated the total cost of the project, all profits from the contract were reported in Year 1.A company might underestimate the total cost of the project if it mistakenly thought the project would cost less (i.e., did not expect a cost overrun).

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specific revenue recognition applications: long-term contractsPercentage-of-completion is the preferred method under both IFRS and U.S. GAAPWhen the outcome of a contract cannot be measured reliably, there are alternatives to the percentage-of-completion method Assuming it is probable that costs will be recovered, IFRS permit recognition of revenue up to the amount of costs incurred.U.S. GAAP (but not IFRS) permit the completed contract method. Company does not report any income until the contract is substantially finished.Completed contract method is also acceptable when the entity has primarily short-term contracts.



An advantage of the percentage-of-completion method is that it results in better matching of revenue recognition with the accounting period in which it was earned. The percentage-of-completion method is the preferred method of revenue recognition for long-term contracts and is required when the outcome can be measured reliably under both IFRS and U.S. GAAP. Under both IFRS and U.S. GAAP, if a loss is expected on the contract, the loss is reported immediately, not upon completion of the contract, regardless of the method used (e.g., percentage-of-completion or completed contract).Under IFRS, if the outcome of the contract cannot be measured reliably, then revenue may be recognized to the extent of contract costs incurred (but only if it is probable the costs will be recovered). Costs are expensed in the period incurred. Under this method, no profit is recognized until all the costs had been recovered. Under U.S. GAAP, but not under IFRS, a revenue recognition method used when the outcome cannot be measured reliably is the completed contract method. Under the completed contract method, the company does not report any income until the contract is substantially finished (the remaining costs and potential risks are insignificant in amount), although provision should be made for expected losses. Billings and costs are accumulated on the balance sheet rather than flowing through the income statement. Under U.S. GAAP, the completed contract method is also acceptable when the entity has primarily short-term contracts. Note that if a contract is started and completed in the same period, there is no difference between the percentage-of-completion and completed contract methods.

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specific revenue recognition applications: long-term contracts exampleAssume the following:A company has a contract to build a network for a customer for a total sales price of $10 million. Network will take an estimated three years to build. Considerable uncertainty surrounds total building costs because new technologies are involved. The outcome cannot be reliably measured, but it is probable that the costs up to the agreed-upon price will be recovered.Expenditures total $3 million, $5.4 million, and $6 million as of the end of Year 1,2, and 3, respectively.Question: How much revenue, expense (cost of construction), and income would the company recognize each year under IFRS and, using the completed contract method, under U.S. GAAP? Copyright 2013 CFA Institute15


This is Example 4-3 in the book.Long-Term Contract: Outcome Cannot Be Reliably MeasuredKolenda Technology Group has a contract to build a network for a customer for a total sales price of $10 million. This network will take an estimated three years to build, but considerable uncertainty surrounds total building costs because new technologies are involved. In other words, the outcome cannot be reliably measured, but it is probable that the costs up to the agreed-upon price will be recovered.Assuming the following expenditures, how much revenue, expense (cost of construction), and income would the company recognize each year under IFRS and using the completed contract method under U.S. GAAP? The amounts periodically billed to the customer and received from the customer are not necessarily equivalent to the amount of revenue being recognized in the period. For simplicity, assume Kolenda pays cash for all expenditures.At the end of Year 1, Kolenda has spent $3 million.At the end of Year 2, Kolenda has spent a total of $5.4 million.At the end of Year 3, the contract is complete. Kolenda spent a total of $6 million.

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specific revenue recognition applications: long-term contracts exampleQuestion: How much revenue, expense (cost of construction), and income would the company recognize each year under IFRS and using the completed contract method under U.S. GAAP?

Answer: Under IFRS, recognize revenue to the extent of contract costs incurred. Company would recognizeYear 1, $3 million construction cost, $3 million revenue, and thus, $0 incomeYear 2, $2.4 million construction cost, $2.4 million revenue, and thus, $0 incomeYear 3, $0.6 million construction cost, remaining $4.6 million revenue (because the contract has been completed and the outcome is now measurable), and thus, $4 million income. Answer: With the completed contract method under U.S. GAAP, no revenue will be recognized until the contract is complete.Year 1, $0 million construction cost, $0 million revenue, and thus, $0 incomeYear 2, $0 million construction cost, $0 million revenue, and thus, $0 incomeYear 3, $6 million construction cost, $10 million revenue (because the contract has been completed), and thus, $4 million incomeCopyright 2013 CFA Institute16


This is Example 4-3 in the book. It illustrates treatment for a long-term contract when the outcome cannot be reliably measured.Kolenda Technology Group has a contract to build a network for a customer for a total sales price of $10 million. This network will take an estimated three years to build, but considerable uncertainty surrounds total building costs because new technologies are involved. In other words, the outcome cannot be reliably measured, but it is probable that the costs up to the agreed-upon price will be recovered.Assuming the following expenditures, how much revenue, expense (cost of construction), and income would the company recognize each year under IFRS and using the completed contract method under U.S. GAAP? The amounts periodically billed to the customer and received from the customer are not necessarily equivalent to the amount of revenue being recognized in the period. For simplicity, assume Kolenda pays cash for all expenditures.At the end of Year 1, Kolenda has spent $3 million.At the end of Year 2, Kolenda has spent a total of $5.4 million.At the end of Year 3, the contract is complete. Kolenda spent a total of $6 million.

Solution. Under IFRS, revenue may be recognized to the extent of contract costs incurred if the outcome of the contract cannot be measured reliably and it is probable that costs will be recovered. In this example, the outcome is uncertain but it is probable that Kolenda will recover the costs up to $10 million. Under U.S. GAAP, the company would use the completed contract method. No revenue will be recognized until the contract is complete.Year 1. Under IFRS, Kolenda would recognize $3 million cost of construction, $3 million revenue, and thus, $0 income. Under U.S. GAAP, Kolenda would recognize $0 cost of construction, $0 revenue, and thus, $0 income. The $3 million expenditure would be reported as an increase in the inventory account construction in progress and a decrease in cash.Year 2. Under IFRS, Kolenda would recognize $2.4 million cost of construction, $2.4 million revenue, and thus, $0 income. Under U.S. GAAP, Kolenda would recognize $0 cost of construction, $0 revenue, and thus, $0 income. The $2.4 million expenditures would be reported as an increase in the inventory account construction in progress and a decrease in cash.Year 3. Under IFRS, Kolenda would recognize the $0.6 million cost of construction incurred in the period. Because the contract has been completed and the outcome is now measurable, the company would recognize the remaining $4.6 million revenue on the contract, and thus, $4 million income. Under U.S. GAAP, because the contract has been completed, Kolenda would recognize the total contract revenue (i.e., $10 million). Kolenda would recognize $6 million cost of construction and thus $4 million income. The inventory account construction in progress would be eliminated.16

specific revenue recognition applications: Installment Sales Installment sales: Sales in which proceeds are to be paid in installments over an extended period.IFRS separate the installments into the sale price (present value of the installment payments) and an interest component. Revenue attributable to the sale price is recognized at the date of sale Revenue attributable to the interest component is recognized over time. International standards note, however, that the guidance for revenue recognition must be considered in light of local laws regarding the sale of goods in a particular country. Copyright 2013 CFA Institute17


As noted earlier, revenue is normally reported when goods are delivered or services are rendered, independent of the period in which cash payments for those goods or services are received. This principle applies even to installment salessales in which proceeds are to be paid in installments over an extended period. For installment sales, IFRS separate the installments into the sale price, which is the discounted present value of the installment payments, and an interest component. Revenue attributable to the sale price is recognized at the date of sale, and revenue attributable to the interest component is recognized over time. International standards note, however, that the guidance for revenue recognition must be considered in light of local laws regarding the sale of goods in a particular country. Under limited circumstances, recognition of revenue or profit may be required to be deferred for some installment sales. An example of such deferral arises for certain sales of real estate on an installment basis. Revenue recognition for sales of real estate varies depending on specific aspects of the sale transaction. 17

specific revenue recognition applications: Installment Sales Sale of real estate under U.S. GAAPA sale of real estate is reported at time of sale using normal revenue recognition conditions when seller has completed the significant activities in the earnings process and is eitherassured of collecting the selling price or able to estimate amounts that will not be collected.Otherwise, defer some of the profit using the installment method, in which the portion of the total profit recognized in each period is determined by the percentage of the total sales price for which the seller has received cash, orthe cost recovery method, in which the seller does not report any profit until the cash amounts paid by the buyerincluding principal and interest on any financing from the sellerare greater than all the sellers costs of the property.



Under U.S. GAAP, when the seller has completed the significant activities in the earnings process, a sale of real estate is reported at the time of sale using the normal revenue recognition conditions if seller is eitherassured of collecting the selling price or able to estimate amounts that will not be collected. Otherwise, when those two conditions are not fully met, some of the profit is deferred under U.S. GAAP. Two of the methods may be appropriate in these limited circumstances and relate to the amount of profit to be recognized each year from the transaction: the installment method and the cost recovery method. Under the installment method, the portion of the total profit of the sale that is recognized in each period is determined by the percentage of the total sales price for which the seller has received cash. Under the cost recovery method, the seller does not report any profit until the cash amounts paid by the buyerincluding principal and interest on any financing from the sellerare greater than all the sellers costs of the property. Note that the cost recovery method is similar to the revenue recognition method under international standards, described earlier, when the outcome of a contract cannot be measured reliably (although the term cost recovery method is not used in the international standard).18

specific revenue recognition applications: example Assume the following:Sales price and cost of a property are $2,000,000 and $1,100,000, respectively, so that the total profit to be recognized is $900,000.Seller received a down payment of $300,000 cash, with the remainder of the sales price to be received over a 10-year period.There is significant doubt about the ability and commitment of the buyer to complete all payments.

How much profit will be recognized attributable to the down payment ifthe installment method is used?the cost recovery method is used?



This is Example 4-4 from the book. It illustrates the differences between the installment method and the cost recovery method. Installment sales and cost recovery treatment of revenue recognition are rare for financial reporting purposes, especially for assets other than real estate.

Installment and Cost Recovery Methods of Revenue RecognitionAssume the total sales price and cost of a property are $2,000,000 and $1,100,000, respectively, so that the total profit to be recognized is $900,000. The amount of cash received by the seller as a down payment is $300,000, with the remainder of the sales price to be received over a 10-year period. It has been determined that there is significant doubt about the ability and commitment of the buyer to complete all payments. How much profit will be recognized attributable to the down payment ifthe installment method is used?the cost recovery method is used?

Solution to 1. The installment method apportions the cash receipt between cost recovered and profit using the ratio of profit to sales value; here, this ratio equals $900,000/$2,000,000 = 0.45 or 45%. Therefore, the seller will recognize the following profit attributable to the down payment: 45% of $300,000 = $135,000.Solution to 2. Under the cost recovery method of revenue recognition, the company would not recognize any profit attributable to the down payment because the cash amounts paid by the buyer still do not exceed the cost of $1,100,000.

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specific revenue recognition applications: example How much profit will be recognized attributable to the down payment if the installment method is used?

Installment method apportions the cash receipt between cost recovered and profit using the ratio of profit to sales value.Here, the ratio of profit to sales value equals $900,000/$2,000,000 = 45%.Seller will recognize the following profit attributable to the down payment: 45% of $300,000 = $135,000.

How much profit will be recognized attributable to the down payment if the cost recovery method is used?Under the cost recovery method, do not recognize any profit until cash received from buyer exceeds all costs.Here, $300,000 cash paid by the buyer is less than the sellers cost of $1,100,000.Seller will recognize $0 profit attributable to the down payment.



This is Example 4-4 from the book. It illustrates the differences between the installment method and the cost recovery method. Installment sales and cost recovery treatment of revenue recognition are rare for financial reporting purposes, especially for assets other than real estate.

Installment and Cost Recovery Methods of Revenue RecognitionAssume the total sales price and cost of a property are $2,000,000 and $1,100,000, respectively, so that the total profit to be recognized is $900,000. The amount of cash received by the seller as a down payment is $300,000, with the remainder of the sales price to be received over a 10-year period. It has been determined that there is significant doubt about the ability and commitment of the buyer to complete all payments. How much profit will be recognized attributable to the down payment ifthe installment method is used?the cost recovery method is used?Solution to 1. The installment method apportions the cash receipt between cost recovered and profit using the ratio of profit to sales value; here, this ratio equals $900,000/$2,000,000 = 0.45 or 45%. Therefore, the seller will recognize the following profit attributable to the down payment: 45% of $300,000 = $135,000.Solution to 2. Under the cost recovery method of revenue recognition, the company would not recognize any profit attributable to the down payment because the cash amounts paid by the buyer still do not exceed the cost of $1,100,000. Also, no profit will be recognized until the cash amounts paid by the buyerincluding principal and interest on any financing from the sellerare greater than all the sellers costs of the property.

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specific revenue recognition applications: Gross vs. Net reporting Merchandising companies typically sell products that they purchase from a supplier. To account for the sales, they record the amount of the sale proceeds as sales revenue andrecord the cost of the products as the cost of goods sold.Some internet-based merchandising companies sell products that they never hold in inventory; they simply arrange for the supplier to ship the products directly to the end customer. Should they record revenues of the gross amount of sales proceeds received from their customers? the net difference between sales proceeds and their cost?U.S. GAAP guidanceReport revenues gross if the company is the primary obligor under the contract, bears inventory risk and credit risk, can choose its supplier, and has reasonable latitude to establish price. Otherwise, report revenues net.



Another revenue recognition issue that became particularly important with the emergence of e-commerce is the issue of gross versus net reporting. Merchandising companies typically sell products that they purchase from a supplier. In accounting for the sales, the company records the amount of the sale proceeds as sales revenue and the cost of the products as the cost of goods sold. As internet-based merchandising companies have developed, many companies sell products that they never hold in inventory; they simply arrange for the supplier to ship the products directly to the end customer. In effect, many such companies are agents of the supplier company, and the net difference between their sales proceeds and their costs is equivalent to a sales commission. What amount should these companies record as their revenuesthe gross amount of sales proceeds received from their customers or the net difference between sales proceeds and their cost?U.S. GAAP indicate that the approach should be based on the specific situation and provide guidance for determining when revenue should be reported gross versus net. To report gross revenues, the following criteria are relevant: The company is the primary obligor under the contract, bears inventory risk and credit risk, can choose its supplier, and has reasonable latitude to establish price. If these criteria are not met, the company should report revenues net.

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specific revenue recognition applications: ExampleCompany OLR, an online retailer, buys tickets (airline, concert, etc.), resells them for $100, and earns a 10% fee. What is the correct accounting?Alternative A: GrossRevenue$100Cost of goods sold $90Gross Profit $10Alternative B: NetRevenue $10



If the company does not bear inventory risk and does not have responsibility after, it should report net.Note that the decision does not affect net income.

So, why does this matter? Some companies (especially internet companies) are valued in part on salesfor example, price-to-sales ratios are taken into consideration by those establishing the value of companies.

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specific revenue recognition applications: ExampleWe evaluate whether it is appropriate to record the gross amount of product sales and related costs or the net amount earned as commissions. Generally, when we are primarily obligated in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators, revenue is recorded at the gross sales price. We generally record the net amounts as commissions earned if we are not primarily obligated and do not have latitude in establishing prices.Amazon Inc. (2011), 10-K Copyright 2013 CFA Institute23


This excerpt from Amazons 2011 10-K illustrates the gross versus net reporting of revenue.Apples 2011 10-K has similar revenue recognition disclosure:The Company sells software and peripheral products obtained from other companies. The Company generally establishes its own pricing and retains related inventory risk, is the primary obligor in sales transactions with its customers, and assumes the credit risk for amounts billed to its customers. Accordingly, the Company generally recognizes revenue for the sale of products obtained from other companies based on the gross amount billed. For sales of third-party software applications for iPhone, iPad, and iPod touch (iOS devices) and Macs made through the App Store and the Mac App Store, the Company is not the primary obligor to users of the software, and third-party developers determine the selling price of their software. Therefore, the Company accounts for such sales on a net basis by recognizing only the commission it retains from each sale and including that commission in net sales in the Consolidated Statements of Operations.

To analyze a companys financial statements, and particularly to compare one companys financial statements with those of another company, it is helpful for an analyst to understand any differences in revenue recognition policies. Although it may not be possible to calculate the monetary effect of differences between particular companies revenue recognition policies and estimates, it is generally possible to characterize the relative conservatism of a companys policies and to qualitatively assess how differences in policies might affect financial ratios.

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general principles of Expense recognitionFundamental principle: A company recognizes expenses in the period in which it consumes (i.e., uses up) the economic benefits associated with the expenditure.Matching principle: Costs are matched with revenues.As with revenue recognition, expense recognition can occur independently of cash movements.Inventory and cost of goods soldPlant, property, and equipment and depreciation


LOS. Describe the general principles of expense recognition, specific expense recognition applications, and the implications of expense recognition choices for financial analysis.Pages 152163

Under IFRS, the term expenses (defined as 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) encompasses losses as well as those expenses that arise in the course of the ordinary activities of the enterprise. Under U.S. GAAP, expenses (defined as outflows or other using up of assets or incurrences of liabilities [or a combination of both] from delivering or producing goods, rendering services, or carrying out other activities that constitute the entitys ongoing major or central operations) differ from losses (defined as decreases in equity [net assets] from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from expenses or distributions to owners).Similar to the issues with revenue recognition, in a simple hypothetical scenario, expense recognition would not be an issue. For instance, assume a company purchased inventory for cash and sold the entire inventory in the same period. When the company paid for the inventory, absent indications to the contrary, it is clear that the inventory cost has been incurred, and when that inventory is sold, it should be recognized as an expense (cost of goods sold) in the financial records. Assume also that the company paid all operating and administrative expenses in cash within each accounting period. In such a simple hypothetical scenario, no issues of expense recognition would arise. In practice, however, as with revenue recognition, determining when expenses should be recognized can be somewhat more complex.In general, a company recognizes expenses in the period that it consumes (i.e., uses up) the economic benefits associated with the expenditure or loses some previously recognized economic benefit.A general principle of expense recognition is the matching principle. Strictly speaking, IFRS do not refer to a matching principle but rather to a matching concept or to a process resulting in matching of costs with revenues. The distinction is relevant in certain standard-setting deliberations. Under matching, a company recognizes some expenses (e.g., cost of goods sold) when associated revenues are recognized and thus expenses and revenues are matched. Associated revenues and expenses are those that result directly and jointly from the same transactions or events. Unlike the simple scenario in which a company purchases inventory and sells all of the inventory within the same accounting period, in practice, it is more likely that some of the current periods sales are made from inventory purchased in a previous period or previous periods. It is also likely that some of the inventory purchased in the current period will remain unsold at the end of the current period and so will be sold in a following period or following periods. Matching requires that a company recognizes cost of goods sold in the same period as revenues from the sale of the goods.Period costs, expenditures that less directly match revenues, are reflected in the period when a company makes the expenditure or incurs the liability to pay. Administrative expenses are an example of period costs. Other expenditures create assets that will result in future benefits over a number of accounting periods (e.g., buildings, equipment, prepaid). In this case, the expenditures are allocated systematically with the passage of time. An example is depreciation expense.

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specific expense recognition applications: InventoryGoodsPurchasedBeginningInventoryGoodsAvailableforSaleEndingInventoryCost ofGoods SoldBalance SheetIncome StatementInventory Cost FlowCopyright 2013 CFA Institute25


This slide illustrates the cost flow of inventory for a company that purchases inventory items for resale (e.g., a wholesaler or retailer).During the period, the company purchases goods, which are added to its beginning inventory. Beginning inventory plus purchases equals goods available for sale.As the goods are sold and revenues are recognized, the cost of goods sold will be removed from inventory and recorded as an expense.Any items not sold during the period remain in ending inventory.

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specific expense recognition applications: ExampleInventory PurchasesFirst quarter2,000 units at $40 per unitSecond quarter1,500 units at $41 per unitThird quarter2,200 units at $43 per unitFourth quarter1,900 units at $45 per unitTotal7,600 units at a total cost of $321,600Inventory sales during the year: 5,600 units at $50 per unit

What are the revenue and expense for these transactions during the year?

Assume the company specifically identifies thatthe 5,600 units sold were those purchased in the 1st and 2nd quarter plus 2,100 of the units purchased in the 3rd quarter andthe 2,000 remaining units were 100 of those purchased in the 3rd quarter plus the 1,900 purchased in the 4th quarter. Copyright 2013 CFA Institute26


This is from Example 4-7 in the book.Assume this company purchases items for resale and had zero inventory at the beginning of the year.The company purchased 7,600 units during the year and sold 5,600, leaving 2,000 units in ending inventory at the beginning of the year.

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specific expense recognition applications: Example SolutionRevenue = $280,000 (5,600 units times $50 per unit)

Cost of Goods SoldThe 5,600 units that were sold were specifically identified as follows:From 1st quarter: 2,000 units at $40 per unit $80,000From 2nd quarter: 1,500 units at $41 per unit $61,500From 3rd quarter: 2,100 units at $43 per unit $90,300Total cost of goods sold$231,800

Ending inventoryFrom the 3rd quarter: 100 units at $43 per unit $4,300From the 4th quarter: 1,900 units at $45 per unit $85,500Total remaining (or ending) inventory cost$89,800Copyright 2013 CFA Institute27Total available for sale


The company specifically identified the units that were sold. The calculation of cost of goods sold (COGS) is shown on the slide.The company specifically identified the cost of units remaining in inventory. The calculation of ending inventory is shown on the slide.To confirm that total costs are accounted for: $231,800 + $89,800 = $321,600 = Amount of goods available for sale.Note that one could calculate COGS and derive ending inventory as amount of goods available for sale minus COGS = $321,600 $231,800 = $89,800.Similarly one could calculate ending inventory and derive COGS as amount of goods available for sale minus ending inventory = $321,600 $89,800 = $231,800.27

specific expense recognition applications: ExampleInventory PurchasesFirst quarter2,000 units at $40 per unitSecond quarter1,500 units at $41 per unitThird quarter2,200 units at $43 per unitFourth quarter1,900 units at $45 per unitTotal7,600 units at a total cost of $321,600

Inventory sales during the year 5,600 units at $50 per unit.

Revenue and expense for these transactions during the year?

Assume the company does not specifically identify the units, but instead uses the weighted average cost method of inventory costing. Copyright 2013 CFA Institute28



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specific expense recognition applications: Example solutionRevenue = $280,000 (5,600 units times $50 per unit)

Average cost per unit = Total cost of goods available divided by total units available = $321,600/7,600 units = $42.3158 per unit

Cost of goods sold =5,600 units at $42.3158 per unit $236,968

Ending inventory = 2,000 units at $42.3158 per unit $84,632Copyright 2013 CFA Institute29Total available for sale


Revenue is the same in each scenario. The method of costing inventory has no impact on revenue.The weighted average cost method assigns the average cost of goods available for sale to the units sold and remaining in inventory. The assignment is based on the average cost per unit (total cost of goods available for sale/total units available for sale), the number of units sold, and the number remaining in inventory.Calculations of average cost per unit, COGS, and ending inventory are shown on the slide.To confirm that total costs are accounted for: $236,968 + $84,632 = $321,600 = Amount of goods available for sale.Note that one could calculate COGS and derive ending inventory as amount of goods available for sale minus COGS.Similarly, one could calculate ending inventory and derive COGS as amount of goods available for sale minus ending inventory.29


Inventory sales during the year: 5,600 units at $50 per unit.


Assume the company does not specifically identify the units, but instead uses the FIFO (first in, first out) method of inventory costing. Copyright 2013 CFA Institute30



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specific expense recognition applications: Example solutionInventory PurchasesFirst quarter2,000 units at $40 per unitSecond quarter1,500 units at $41 per unitThird quarter2,200 units at $43 per unitFourth quarter1,900 units at $45 per unitTotal7,600 units at a total cost of $321,600

Using the FIFO method of inventory costing: Copyright 2013 CFA Institute31

FIFO to determine COGS: 2,000 from 1st quarter at $40 per unit + 1,500 from 2nd quarter at $41 per unit + 2,100 from 3rd quarter at $43 per unit

COGS = $231,800


This is from Example 4-8 in the book.Assume this company purchases items for resale and had zero inventory at the beginning of the year.The company purchased 7,600 units during the year and sold 5,600, leaving 2,000 units in ending inventory at the beginning of the year.Revenue is the same in each scenario. The method of costing inventory has no impact on revenue.

Using FIFO to determine COGS, the solution is

Goods sold:From the first quarter:2,000 units at $40 per unit = $80,000From the second quarter:1,500 units at $41 per unit = $61,500From the third quarter:2,100 units at $43 per unit = $90,300Total cost of goods sold $231,800Goods remaining in inventory:From the third quarter:100 units at $43 per unit = $4,300From the fourth quarter:1,900 units at $45 per unit = $85,500Total remaining inventory cost $89,800Total costs accounted for, $231,800 + $89,800 = $321,600 Because of the assumptions in the specific identification examplethe company specifically identified the earliest units purchased as the units that were soldthe solution is identical to the solution for the specific identification method example.

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Inventory sales during the year: 5,600 units at $50 per unit.


Assume the company does not specifically identify the units, but instead uses the LIFO method of inventory costing. Copyright 2013 CFA Institute32LIFO is not allowed under IFRS.Assume the company reports under U.S. GAAP and uses the LIFO (last in, first out) method of inventory costing.



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specific expense recognition applications: Example solutionInventory PurchasesFirst quarter2,000 units at $40 per unitSecond quarter1,500 units at $41 per unitThird quarter2,200 units at $43 per unitFourth quarter1,900 units at $45 per unitTotal7,600 units at a total cost of $321,600

Using the LIFO method of inventory costing:


LIFO to determine COGS: 1,900 from 4th quarter at $45 per unit + 2,200 units at $43 per unit + 1,500 units at $41 per unit

COGS = $241,600


This is from Example 4-8 in the book.Assume this company purchases items for resale and had zero inventory at the beginning of the year.The company purchased 7,600 units during the year and sold 5,600, leaving 2,000 units in ending inventory at the beginning of the year.Under LIFO, the cost of the last 5,600 units purchased is allocated to cost of goods sold: 1,900 units at $45 per unit + 2,200 units at $43 per unit + 1,500 units at $41 per unit = $241,600.Equivalently, under the LIFO method, it would be assumed that the 2,000 units remaining in ending inventory would have come from the first quarters purchases: Ending inventory 2,000 units at $40 per unit = $80,000.The remaining costs would be allocated to cost of goods sold. Total costs of $321,600 minus $80,000 remaining in ending inventory = $241,600 cost of goods sold.

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Summary Table on Inventory Costing MethodsMethodDescriptionCOGS when prices are rising relative to the other two methodsEnding Inventory when prices are rising relative to the other two methodsFIFOAssumes that earliest items purchased were sold firstLowestHighestLIFOAssumes most recent items purchased were sold firstHighest*Lowest*Average CostAverages total costs over total units availableMiddleMiddle

Copyright 2013 CFA Institute34*Assumes no LIFO layer liquidation. LIFO layer liquidation occurs when the volume of sales exceeds the volume of other purchases in the period so that some sales are assumed to be from existing, relatively low-priced inventory rather than from more recent purchases.


In periods of rising costs, FIFO will give the lowest COGS and highest ending inventory (compared with the other two methods) because the earlier, lower costs flow to COGS and the later, higher costs are in ending inventory.Similarly, in periods of rising costs, LIFO will give the highest COGS and lowest ending inventory (compared with the other two methods) because the later, higher costs flow to COGS and the earlier, lower costs are in ending inventory.This assumes no LIFO layer liquidation. LIFO layer liquidation occurs when the volume of sales exceeds the volume of purchases in a period so that some sales are assumed to be made from existing, relatively low-priced inventory rather than from more recent purchases.34

Inventory method: example disclosureInventory Valuation Inventories are valued at the lower of cost or market value. Product related inventories are primarily maintained on the first-in, first-out method. Minor amounts of product inventories, including certain cosmetics and commodities, are maintained on the last-in, first-out method. The cost of spare part inventories is maintained using the average cost method.Procter & Gamble (2011), Annual Report

Inventories are valued at the lower of cost or net realizable value. Cost is calculated using the weighted average cost method.LOreal Group (2011), Registration DocumentCopyright 2013 CFA Institute35


These excerpts from P&Gs and LOreals financial statement footnotes illustrate typical disclosure on inventory method.P&G primarily uses FIFO, whereas LOreal primarily uses average cost.35

Inventory method: example disclosureInventories. Inventories are stated at the lower of cost or market. The cost of approximately 80% of inventories is determined using the first-in, first-out (FIFO) method. The cost of all other inventories, predominantly in the U.S. and Mexico, is determined using the last-in, first-out (LIFO) method.Colgate-Palmolive (2011), Annual Report (Note 2)

Inventories valued under LIFO amounted to $271 and $263 at December 31, 2011 and 2010, respectively. The excess of current cost over LIFO cost at the end of each year was $30 and $52, respectively. The liquidations of LIFO inventory quantities had no material effect on income in 2011, 2010 and 2009.Colgate-Palmolive (2011), Annual Report (Note 16)



These excerpts from Colgates financial statement footnotes illustrate inventory-related disclosure.Companies that use LIFO must disclose what inventory would have been under FIFO. An analyst can use these disclosures to adjust the reported numbers, if desired (e.g., if comparing the company with one that reports using FIFO). 36

specific expense recognition applications: depreciationDepreciation: Process of systematically allocating costs of long-lived assets over the period during which the assets are expected to provide economic benefits. Depreciation: term commonly applied for physical long-lived assets, such as plant and equipment (NOT land)Amortization: Term commonly applied to this process for intangible long-lived assets with a finite useful lifeDepreciation Methods: Straight lineAccelerated (i.e., diminishing balance)Units of production



Companies commonly incur costs to obtain long-lived assets. Long-lived assets are assets expected to provide economic benefits over a future period of time greater than one year. Examples are land (property), plant, equipment, and intangible assets (assets lacking physical substance), such as trademarks. The costs of most long-lived assets are allocated over the period of time during which they provide economic benefits. The two main types of long-lived assets whose costs are not allocated over time are land and those intangible assets with indefinite useful lives.Depreciation is the process of systematically allocating costs of long-lived assets over the period during which the assets are expected to provide economic benefits. Depreciation is the term commonly applied to this process for physical long-lived assets, such as plant and equipment (land is not depreciated), and Amortization is the term commonly applied to this process for intangible long-lived assets with a finite useful life. Examples of intangible long-lived assets with a finite useful life include an acquired mailing list, an acquired patent with a set expiration date, and an acquired copyright with a set legal life. Intangible assets with indefinite life are not amortized. Instead, they are reviewed each period as to the reasonableness of continuing to assume an indefinite useful life and are tested at least annually for impairment (i.e., if the recoverable or fair value of an intangible asset is materially lower than its value in the companys books, the value of the asset is considered to be impaired and its value must be decreased). The method used to compute depreciation should reflect the pattern over which the economic benefits of the asset are expected to be consumed. The straight-line method allocates evenly the cost of long-lived assets less estimated residual value over the estimated useful life of an asset. The term straight line derives from the fact that the annual depreciation expense, if represented as a line graph over time, would be a straight line. In addition, a plot of the cost of the asset minus the cumulative amount of annual depreciation expense, if represented as a line graph over time, would be a straight line with a negative downward slope.Calculating depreciation and amortization requires two significant estimates: the estimated useful life of an asset and the estimated residual value (also known as salvage value) of an asset. Generally, alternatives to the straight-line method of depreciation are called accelerated methods of depreciation because they accelerate (i.e., speed up) the timing of depreciation. A commonly used accelerated method is the diminishing balance method, (also known as the declining balance method). With a units of production depreciation method, the amount of depreciation expense each period varies depending upon production or usage.37

specific expense recognition applications: depreciation exampleEquipment cost = $9,000. Estimated residual = $0. Useful life = 3 years.Annual depreciation expense = (Cost Residual value)/Useful life.

Copyright 2013 CFA Institute38Cost of equipment$9,000Less Year 1 depreciation expense 3,000Book value at end of Year 1 $6,000Less Year 2 depreciation expense 3,000Book value at end of Year 2$3,000Less Year 3 depreciation expense 3,000Book value at end of Year 3$0


Using the straight-line method of depreciation, annual depreciation expense is calculated as cost minus residual value divided by estimated useful life. Residual value is also referred to as salvage value.In this example, the annual depreciation expense is $9,000 cost minus $0 salvage value divided by three-year useful life, which equals $3,000 per year.The book value (cost net of accumulated depreciation): By the end of the useful life of the asset, the book value equals the estimated residual value.

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specific expense recognition applications: depreciation exampleJudgments and estimates needed in depreciation:estimated salvage valueestimated useful life

For example, given a purchase price of $10,000, what is the annual straight-line depreciation expenseif estimated salvage value = $5,000 and useful life = 10 years?if estimated salvage value = $0 and useful life = 2 years?



Using the straight-line method of depreciation, annual depreciation expense is calculated as cost minus residual value divided by estimated useful life.Calculating depreciation and amortization requires two significant estimates: the estimated useful life of an asset and the estimated residual value (also known as salvage value) of an asset. Annual depreciation expense is sensitive to both the estimated useful life and the estimated residual value.

Given a purchase price of $10,000, what is the annual straight-line depreciation expenseif estimated salvage value = $5,000 and useful life = 10 years? Annual depreciation expense would be ($10,000 $5,000)/10 years = $500 per year.if estimated salvage value = $0 and useful life = 2 years? Annual depreciation expense would be ($10,000 $0)/2 years = $5,000 per year.

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specific expense recognition applications: depreciation exampleDiminishing Balance DepreciationDetermine straight-line rate (100%/Useful life) Determine acceleration factor (e.g., 1.5 or 2)Depreciation rate = (Straight-line rate x acceleration factor)Depreciation expense = Net book value (NBV) x Depreciation rateDiscontinue depreciation when net book value = Salvage value

Example: What is the annual depreciation expense each year?Asset cost: $11,000Estimated salvage value: $1,000Estimated useful life: 5 yearsAcceleration factor: 2



Example is from Example 4-10 in book.Generally, alternatives to the straight-line method of depreciation are called accelerated methods of depreciation because they accelerate (i.e., speed up) the timing of depreciation. A commonly used accelerated method is the diminishing balance method (also known as the declining balance method). Steps in calculating depreciation expense using this method includedetermining the straight-line rate as 100% divided by the useful life and determining the acceleration factor (e.g., 1.5 or 2). When the acceleration factor is 2, the method is referred to as the double-declining balance method because it depreciates the asset at double the straight-line rate.The depreciation rate equals the straight-line rate times the acceleration factor. Each years depreciation expense equals the net book value (NBVi.e., the balance) times the depreciation rate.Discontinue depreciation when the net book value equals the salvage value.

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specific expense recognition applications: depreciation example solutionYearNBV Beginning of YearDepreciation Expense Accumulated DepreciationNBV End of Year1 11,000 4,400 4,400 6,600 2 6,600 2,640 7,040 3,960 3 3,960 1,584 8,624 2,376 4 2,376 950 9,574 1,426 5 1,426 426 10,000 1,000



Example is from Example 4-10 in book.Assume cost of equipment was $11,000, the estimated residual value is $1,000, and the estimated useful life is five years. Determine the straight-line rate, the rate at which the asset would be depreciated under the straight-line method. This rate is measured as 100% divided by the useful life, or 20% for a five-year useful life. Determine an acceleration factorhere given as 2, or 200%. Using this acceleration factor, the diminishing balance rate would be 40% (= 20% 2). Calculate depreciation expense by applying this rate to the remaining undepreciated balance of the asset each period.At the beginning of Year 1, the net book value is $11,000. Depreciation expense for the first full year of use of the asset would be 40% of $11,000, or $4,400. Under this method, the residual value, if any, is generally not used in the computation of the depreciation each period (the 40% is applied to $11,000 rather than to $11,000 minus residual value). However, the company will stop taking depreciation when the salvage value is reached.At the beginning of Year 2, the net book value is measured as asset cost of $11,000 minus accumulated depreciation of $ 4,400, which equals net book value of $ 6,600.For Year 2, depreciation expense would be $6,600 x 40%, or $2,640. At the end of Year 2 (i.e., beginning of Year 3), a total of $7,040 ($4,400 + $2,640) of depreciation would have been recorded. So, the remaining net book value at the beginning of Year 3 would be asset cost of $11,000 minus accumulated depreciation of $ 7,040, which equals net book value of $ 3,960.For Year 3, depreciation expense would be $3,960 x 40%, or $1,584. At the end of Year 3 (i.e., beginning of Year 4), a total of $8,624 ($4,400 + $2,640 + $1,584) of depreciation would have been recorded. So, the remaining net book value at the beginning of the Year 4 would be asset cost of $11,000 minus accumulated depreciation of $8,624, which equals the net book value of $2,376.For Year 4, depreciation would be $2,376 x 40%, or $950. At the end of Year 4 (i.e., beginning of Year 5), a total of $9,574 ($4,400 + $2,640 + $1,584 + $950) of depreciation would have been recorded.So, the remaining net book value at the beginning of the fifth year would be asset cost of $11,000 minus accumulated depreciation of $ 9,574, which equals net book value of $1,426.If Year 5 depreciation expense was determined as in previous years, it would amount to $570 ($1,426 x 40%). However, this would result in a remaining net book value of the asset below its estimated residual value of $1,000. So, instead, only $426 would be depreciated, leaving a $1,000 net book value at the end of the fifth year, calculated as asset cost of $11,000 minus accumulated depreciation of $10,000, which equals a net book value of $1,000.An estimated residual value of zero would create problems for diminishing balance depreciation because the asset would never fully depreciate.In order to fully depreciate the asset over the initially estimated useful life when a zero residual value is assumed, companies often adopt a depreciation policy that combines the diminishing balance and straight-line methods. An example would be a depreciation policy of using double-declining balance depreciation and switching to the straight-line method halfway through the useful life (or switching to the straight-line method at the point when that method would result in a higher depreciation expense than the diminishing balance method).

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nonrecurring items and changes in accounting standardsSeparating nonrecurring from recurring items of income and expense can help an analyst assess a companys future earnings.Nonrecurring items: discontinued operationsextraordinary items (not permitted under IFRS)unusual or infrequent itemsChanges in accounting standards

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