The income statement converts a year of activity into a single net income number, but the path matters more than the destination for an analyst. Same sales, same customers, and different revenue policies, different expense choices, or different treatment of one-off items can produce wildly different earnings.
International Financial Reporting Standards (IFRS) 15 and Accounting Standards Codification (ASC) 606 share converged guidance. Revenue is recognized when a performance obligation is satisfied. The five steps below describe the general principles of revenue recognition:
- Identify the contract with a customer.
- Identify the performance obligations (distinct promises) in the contract.
- Determine the transaction price (consideration expected, including variable consideration).
- Allocate the price to each performance obligation based on standalone selling price.
- Recognize revenue when (or as) each obligation is satisfied.
KEY: "Satisfied" means control transfers to the customer, either at a point in time or over time. Revenue is recognized over time only if one test is met: the customer consumes the benefit as you perform (most services), the customer controls the asset as you build it, or...
Common mistakes
- Treating discontinued operations as part of continuing operations. The $2,100,000 after-tax gain must be stripped to below the line, net of tax, and excluded from EPS from continuing operations. Trap: using $8,400,000 gives basic EPS of $3.37 instead of $2.48 from continuing operations.
- Including antidilutive securities in diluted EPS. If exercise price exceeds average market price, options are out-of-the-money and antidilutive. In-the-money options are also antidilutive when continuing-operations earnings after preferred dividends are negative. The same applies to a convertible whose incremental EPS beats the running EPS after more dilutive securities are included.
- Adding back pretax interest on convertible debt. The company deducted the interest for tax, so only $375,000 comes back. Trap: adding the full $500,000 gives $2.38 instead of $2.34.
Bottom line
- Revenue is recognized when control of goods or services transfers (five-step model under IFRS 15 / ASC 606), not when cash is received
- Capitalize only costs that meet asset-recognition criteria (future benefit beyond one period, measurable cost, not a must-expense item such as research); expense the rest
- Discontinued operations: below the line, net of tax. Unusual or infrequent items: above the line in continuing operations with disclosure
- Changes in accounting policy: retrospective. Changes in estimate: prospective. Error correction: restate
Exam shortcut
For revenue recognition, anchor on "control." When control transfers, revenue is recognized, regardless of cash timing. For capitalize-versus-expense, ask "Does this benefit a future period, and does the standard let it be an asset?" Research fails the second test. For diluted EPS, start with continuing-operations earnings after preferred dividends. Rank securities by incremental EPS (add-back divided by new shares), lowest first. Include each only if it lowers the running EPS.
The full lesson (about 4,966 words, 33 min read) adds 10 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- analyzing income statements
Browse all free CFA Level I lessons or jump into free CFA Level I practice questions.