You are tested about the income statement on the FAR test of the CPA exam. You need an understanding of earnings per share, an important measure of profitability, extraordinary items, and comprehensive income.
Earnings per share
One important indicator of profitability is earnings per share (EPS). EPS is defined as net income available for common shareholders divided by average common stock shares outstanding. EPS tells a financial-statement reader how much a company earns for each share of stock outstanding. The more a business can earn per common stock share, the more valuable a share of stock becomes.
Average common stock shares outstanding refers to the average number of shares during the period, usually a year. The average is computed as follows:
Note that the basic EPS formula is calculated using common stock outstanding. Shares outstanding refers to shares held by the public. The basic formula does not include preferred stock shares in the denominator. Preferred stock is “preferred” or “better” than common stock for two reasons:
If the company generates earnings, preferred shareholders receive a dividend before any dividend payments to common shareholders.
Preferred shareholders can make a claim on the assets of the company before common shareholders. If the company liquidates, creditors and owners stand in line to make a claim of ownership for the assets that remain. Preferred shareholders have a claim on assets before common shareholders.
When net income is calculated for basic EPS, any dividends paid to preferred shareholders are subtracted. Here’s how the basic EPS formula looks, given any preferred dividends:
Companies that use basic EPS have a simple capital structure. A simple capital structure means that the company hasn’t issued any securities that are potentially dilutive. Dilutive securities are securities that can be converted into shares of common stock. Dilutive securities have the potential to increase the number of common shares outstanding.
Take a look at the basic EPS formula. Suppose that net income less preferred stock dividends is $10,000. If 5,000 common stock shares are outstanding, basic EPS is $10,000 / 5,000 shares = $2 per share. If dilutive securities are converted into 5,000 additional common stock shares, EPS would be $10,000 / 10,000 shares = $1 per share. The numerator ($10,000) didn’t change, but the denominator (common shares outstanding) doubled. Dilutive securities can reduce EPS.
To fully inform financial-statement readers, businesses with dilutive securities also present dilutive EPS. The numerator for dilutive EPS is the same as in basic EPS. In each case, you use Net income – Preferred stock dividends. The denominator of the formula, however, is different. Dilutive EPS assumes that any securities that can be converted into common stock are converted. Those common stock conversions have the impact of increasing common stock shares outstanding.
Here are some potentially dilutive securities that you may see on the FAR test:
Convertible bonds and convertible preferred stock
Rights and warrants
If any of these securities are converted to common stock, they lower earnings per share. This assumes that net income for the year is unchanged and that total common stock shares outstanding increases.
FAR test questions normally list several types of dilutive securities and ask you to convert the number of additional shares of common stock outstanding. When you know the new number of common stock shares, you can compute dilutive EPS.
Operations are the day-to-day activities you perform to run your business. For example, to make blue jeans, your business may buy denim as a raw material, pay payroll, and collect payments from blue jean sales. Those are your normal business operations. However, if you issue stock or sell a building, those activities aren’t directly related to selling blue jeans. In other words, those transactions are not due to normal operations.
A multi-step income statement is divided into two main parts: an operating section and a non-operating section. In some cases, a third section of the income statement lists discontinued operations and extraordinary items.
Discontinued operations and extraordinary events: The third section of the income statement starts with non-operating income. You then adjust non-operating income for rare, extraordinary events that occur in the business. Here are two main categories that are tested:
Discontinued operations: Discontinued operations are the costs incurred to eliminate a company division or department. They might include severance pay to workers or the cost of selling division assets at a loss.
Extraordinary items: Extraordinary items are transactions that are both unusual and infrequent. A loss due to a rare weather occurrence would be considered an extraordinary item. If a factory were damaged due to a tornado in an area of the country where tornados are rare, that event would be considered extraordinary.
Non-operating income is adjusted for discontinued operations and extraordinary items to arrive at net income.
Nailing down comprehensive income
Comprehensive income adjusts net income for some additional gain and loss activity. Companies that report both net income and comprehensive income must provide a schedule that reconciles the differences between those two amounts. Other comprehensive income is the difference between net income and comprehensive income.
Here are the two most common gains and losses that are included in comprehensive income (and excluded from net income):
Change in market value of securities held as available for sale. Available for sale (AFS) securities are purchased with the intent of selling them in the short term. At the end of each accounting period, the value of AFS securities is adjusted to the current fair market value. The unrealized gain or loss is recorded as other comprehensive income.
Gains and losses from foreign currency exchange rates. Assume your U.S.-based company owns a subsidiary that does business in Britain, using the British pound as the currency. You’re required to convert the activity for all your overseas operations into U.S. dollars. When you translate the British financial results into U.S. dollars, you may have a gain or a loss, depending on the exchange rate for dollars versus pounds. That gain or loss is included in comprehensive income.
FAR test questions typically provide gains and losses for one or both of these situations. The question asks you to compute net income, comprehensive income, or the difference between the two (other comprehensive income).