Analyzing Income Statements

Financial Statement Analysis, LOS weight share 1.4 percent of the 365 Level I learning outcomes.

Financial Statement AnalysisAnalyzing Income Statements

A telecom bundle labels the phone free, and the exam wants a candidate to know that under IFRS 15 nothing in a bundle is actually free, revenue gets allocated to it whether the marketing department likes it or not.

Before you watch

Answer these three first. Getting them wrong now is normal, and it helps the lesson stick. Reveal the answers when you're done, then read on.

1. Under IFRS 15, which of the following is the correct order of the five-step revenue recognition model?

Answer: A. Each step depends logically on the one before it: obligations cannot be identified without a contract, price cannot be determined without knowing the obligations, and allocation requires a determined price before revenue can be recognized against each obligation.

2. A company reports basic EPS of $3.00. It has options outstanding with an exercise price of $25 when the average market price during the year was $20. For diluted EPS, these options should be:

Answer: B. Options are anti-dilutive whenever the exercise price exceeds the average market price; exercising them would not be economically rational, and including them would produce a negative net-share count under the treasury stock method, which signals exclusion.

3. A company reports a large gain on the sale of a discontinued business segment. For analytical purposes, this gain should most likely be:

Answer: C. Non-recurring items, including gains or losses on discontinued operations, are reported separately precisely so an analyst can strip them out when assessing the earnings the business is likely to sustain going forward; ignoring the disclosure entirely would waste useful information the statement already isolates.

The lesson

The video lesson for this unit is recorded and waiting to be published. Everything it teaches is written out below.

The reading

Five to ten minutes on this one unit: what the exam wants, the idea in plain words, then straight into the trap and the practice.

The exam wants you to calculate basic and diluted EPS using the treasury stock and if-converted methods, apply the anti-dilution test correctly, describe the five-step IFRS 15 revenue recognition model, and calculate revenue recognized under the percentage-of-completion method. EPS questions reward getting the mechanics exactly right, not just the concept.

Basic EPS answers one question: how much of this year's earnings belongs to each common share. The formula is net income minus preferred dividends, divided by the weighted average number of common shares outstanding. Preferred dividends come out first because preferred shareholders are paid before common shareholders see anything. The denominator is never shares outstanding at year end. It is weighted by how long each share was actually outstanding during the year, so shares issued halfway through the year count for half a year. A stock split or stock dividend is the one exception: it is applied retroactively to every period shown, as if it had always been in effect, rather than weighted from its actual date.

Diluted EPS asks what EPS would be if every security that could convert into common shares actually did. Two methods handle two different kinds of security. The treasury stock method applies to options and warrants. It adds only the net new shares: shares issued on exercise, minus shares the company could buy back with the exercise proceeds at the average market price. It changes the denominator only, never the numerator. The if-converted method applies to convertible bonds and convertible preferred shares instead. It adds the shares the security converts into, and it also adjusts the numerator. A convertible bond adds back the after-tax interest it saves; convertible preferred adds back the preferred dividend. Either cost disappears once the security has converted.

A security is included in diluted EPS only if doing so would actually reduce EPS. That test runs security by security: compute the incremental EPS a security would add, its numerator adjustment divided by its new shares, and include it only if that incremental figure is lower than the running EPS so far. A security whose incremental EPS is higher than the current figure is anti-dilutive and stays out. Options with an exercise price above the market price fail this test automatically, since exercising them would never happen anyway. When a company reports a net loss, every convertible security is anti-dilutive by definition, because adding shares to the denominator would only shrink the loss per share and make the loss look smaller. Diluted EPS equals basic EPS in any loss year, with no exceptions.

Revenue recognition under IFRS 15 runs through five sequential steps: identify the contract, identify each distinct performance obligation inside it, determine the total transaction price, allocate that price across the obligations by their relative standalone selling prices, then recognize revenue as each obligation is actually satisfied. A bundled item marketed as free still receives its own share of the total transaction price under step four; a marketing label never overrides the allocation rule. For a performance obligation satisfied gradually over time, such as a long-term construction contract, the percentage complete is measured as costs incurred to date divided by total estimated costs for the whole project, never by billings and never by costs to date alone against the contract price. That percentage, multiplied by the total contract price, gives cumulative revenue to date; the current period's revenue is that cumulative figure minus whatever was already recognized in prior periods.

Worked in full

A company reports net income of $3,000,000, no preferred dividends, and weighted average shares outstanding of 1,000,000. It also has $1,500,000 of 6 percent convertible bonds outstanding, convertible into 60,000 shares, and the tax rate is 25 percent. Is the bond dilutive, and what is diluted EPS? Basic EPS = $3,000,000 / 1,000,000 = $3.00. The after-tax interest the company would save if the bond converted = $1,500,000 x 0.06 x (1 - 0.25) = $67,500. Incremental EPS from the bond = $67,500 / 60,000 shares = $1.125, which is lower than the $3.00 basic EPS, so the bond is dilutive and must be included. Diluted EPS = ($3,000,000 + $67,500) / (1,000,000 + 60,000) = $3,067,500 / 1,060,000 = $2.89.

The same problem, one step removed

Same facts: net income $3,000,000, no preferred dividends, 1,000,000 weighted average shares, $1,500,000 of 6 percent convertible bonds converting into 60,000 shares, 25 percent tax rate. Compute the after-tax interest add-back and the incremental EPS test yourself, confirm the bond is dilutive, then finish diluted EPS.

The trap

Forgetting that a net loss makes every convertible security anti-dilutive is the most common EPS error: including a convertible in a loss year would shrink the loss per share, which is by definition anti-dilutive, so diluted EPS equals basic EPS whenever net income is negative.

Learning outcomes covered by this module

Verbatim from the 2026 CFA Level I topic outline. Every practice question and key rule below is tagged to one of these where the stem and explanation make the match clear.

  1. describe general principles of revenue recognition, specific revenue recognition applications, and implications of revenue recognition choices for financial analysis
  2. describe general principles of expense recognition, specific expense recognition applications, implications of expense recognition choices for financial analysis and contrast costs that are capitalized versus those that are expensed in the period in which they are incurred
  3. describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, unusual or infrequent items) and changes in accounting policies
  4. describe how earnings per share is calculated and calculate and interpret a company's basic and diluted earnings per share for companies with simple and complex capital structures including those with antidilutive securities
  5. evaluate a company's financial performance using common-size income statements and financial ratios based on the income statement

Key rules

Written from this module's own lesson and the 2026 CFA Level I topic outline, in teaching order, each tagged to the learning outcome it belongs to where that is clear.

LOS 01

Revenue recognition follows five sequential steps under IFRS 15, and the word free changes nothing

Identify the contract, identify each distinct performance obligation, determine the total transaction price, allocate that price across obligations by their relative standalone selling prices, then recognize revenue as each obligation is satisfied. A bundled item labeled free in marketing materials still receives an allocated share of the transaction price under Step 4; contract labels never override the standalone-price allocation.

LOS 01

An agent recognizes only its net fee; a principal recognizes the full transaction amount

Whoever controls the good or service before it transfers to the customer is the principal and recognizes revenue gross; whoever merely facilitates the transaction is the agent and recognizes only the net commission or fee retained. This distinction does not change net income, but it materially changes reported revenue, cost of sales, and gross margin, so restating gross to net (or the reverse) is often necessary before comparing two companies.

LOS 01

A percentage-of-completion calculation uses cost incurred over total estimated cost, never billings

For a performance obligation satisfied over time with a reliably measurable outcome, percent complete equals costs incurred to date divided by total estimated costs, and revenue recognized to date equals that percentage multiplied by the total contract price; the current period's revenue is this cumulative figure minus revenue already recognized in prior periods. Billing schedules are a separate, negotiated cash-timing matter and never substitute for the cost-based progress measure.

LOS 02

Costs are capitalized when they extend future benefit, and expensed when they do not

A cost is capitalized, placed on the balance sheet and depreciated or amortized over time, when it creates a future economic benefit extending beyond the current period; a cost is expensed immediately when its benefit is consumed within the period it is incurred. This choice, not merely revenue timing, is a primary lever management can use to shift reported income between periods, since capitalizing a cost defers its expense recognition into later periods.

LOS 03

Non-recurring items are reported separately precisely so they can be excluded from a sustainable-earnings view

Discontinued operations, and unusual or infrequent items still within continuing operations, are reported with enough separation that an analyst can back them out when estimating the earnings a business is likely to repeat; a change in accounting policy is applied retrospectively, restating prior periods so trend comparisons remain valid rather than distorted by the switch itself.

LOS 04

Diluted EPS never exceeds basic EPS for a profitable company, and a net loss makes every convertible anti-dilutive

A security is included in diluted EPS only if including it would reduce EPS; the treasury stock method (options, warrants: denominator adjustment only, net shares equal to shares issued less shares that could be bought back at the average market price) and the if-converted method (convertible bonds and preferred: both a numerator add-back and a denominator addition) are each tested this way. In a net-loss year, adding any convertible security would shrink the loss per share, which counts as anti-dilutive, so diluted EPS equals basic EPS in that year regardless of what convertibles exist.

LOS 05

Common-size income statement ratios strip out scale so companies of different sizes can be compared directly

Expressing every income statement line as a percentage of revenue, gross margin, operating margin, net margin, turns absolute dollar figures into comparable percentages across companies of different sizes or across the same company over time; margin trends read this way reveal cost structure and pricing power changes that raw dollar figures obscure.

The trick

Authored only where a key rule has an arbitrary number, list, or formula shape worth a memory device; a module with none of those has no tricks here, on purpose.

Free is a marketing word, not an accounting one

Any bundled item called free still gets a share of the contract price allocated by relative standalone selling price. The exam's telecom-bundle question always tests this directly.

Options: exercise price above market means exclude

The single check for options and warrants: exercise price greater than the average market price makes them anti-dilutive, full stop, regardless of how many are outstanding.

A net loss makes every convertible anti-dilutive

Including a convertible security would shrink a loss per share, which is by definition anti-dilutive; diluted EPS equals basic EPS in any loss year, no exceptions.

Percentage of completion divides by total estimated cost, not cost to date and not the contract price

The denominator is always total estimated costs for the whole project. Using cost to date alone, or the contract price, produces a plausible-looking but wrong answer.

The method

Authored, ordered steps for answering this module's question types; a calculation module's calculator-dependent step ends with a bracketed BA II Plus keystroke sequence.

  1. For a revenue-recognition question, identify which of the five IFRS 15 steps the facts are testing before calculating anything.
  2. For a bundled-contract question, allocate the total transaction price across obligations by their relative standalone selling prices, then recognize only the portion tied to whichever obligation has actually been satisfied.
  3. For an EPS question, first check whether net income is positive; if there is a net loss, diluted EPS equals basic EPS immediately, no further testing needed.
  4. For diluted EPS with profits, test each convertible security in order from most dilutive to least dilutive (lowest incremental EPS first), including it only while doing so still lowers running EPS.
  5. For a non-recurring item, decide whether the question is asking about reported net income (include everything) or sustainable, forward-looking earnings (exclude the non-recurring piece).
  6. [BA II Plus: no dedicated EPS or percentage-of-completion function; compute weighted average shares and each adjustment by hand, then divide adjusted net income by adjusted share count directly]

One card

Condensed from the key rules and tricks above, nothing new. What you'd want on one index card the night before.

Practice questions

Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own explanation. 10 question(s) available for this unit.

Question 1Exam level

A company reports net income of $2,400,000 and paid preferred dividends of $400,000. At the start of the year, 500,000 shares were outstanding. On July 1, the company issued 200,000 new shares. Basic EPS is closest to:

How sure are you?

Correct: A. $3.33. Weighted average shares = 500,000 + (200,000 x 6/12) = 600,000. Basic EPS = (2,400,000 - 400,000) / 600,000 = $3.33
B. You might use 500,000 shares (beginning of year) ignoring the mid-year issuance. New shares issued mid-year must be weighted for the fraction of the year they were outstanding.
C. You might forget to subtract preferred dividends from net income. Basic EPS numerator is Net Income MINUS preferred dividends, not net income alone.

Unit: analyzing-income-statements

Question 2Exam level

A company has basic EPS of $3.00. It has 100,000 options outstanding with an exercise price of $20. The average market price during the year was $25. Using the treasury stock method, how many net shares are most likely added to the denominator for diluted EPS?

How sure are you?

Correct: A. The correct answer is 20,000 net shares added. Shares issued upon exercise: 100,000. Proceeds = 100,000 x $20 = $2,000,000. Shares repurchased with proceeds at market price: $2,000,000 / $25 = 80,000. Net new shares = 100,000 - 80,000 = 20,000..
B. You might add all option shares without subtracting the treasury repurchase. The treasury stock method assumes proceeds from exercise are used to buy back shares at the average market price. Only the NET additional shares count.
C. You might confuse anti-dilution rule. Exercise price $20 < market price $25 means options ARE dilutive. Options are dilutive (reduce EPS) when exercise price is BELOW average market price. Anti-dilutive only when exercise price exceeds market price.

Unit: analyzing-income-statements

Question 3Exam level

A company has net income of $1,000,000, no preferred dividends, and 500,000 weighted average shares. It has $2,000,000 of 5% convertible bonds outstanding, convertible into 80,000 shares. The tax rate is 30%. Should these bonds be included in diluted EPS, and what is most likely diluted EPS?

How sure are you?

Correct: A. The correct answer is Include them. They are dilutive. Diluted EPS = $1.74. Interest expense saved = $2,000,000 x 5% = $100,000. After-tax interest = $100,000 x (1 - 0.30) = $70,000. Adjusted numerator = $1,000,000 + $70,000 = $1,070,000. Adjusted denominator = 500,000 + 80,000 = 580,000. Diluted EPS = $1,070,000 / 580,000 = $1.845. Basic EPS = $1,000,000 / 500,000 = $2.00. Since $1.845 < $2.00, bonds ARE dilutive. Include them..
B. You might adjust denominator but forgets to adjust numerator for the interest expense that would be saved. If-converted method requires adding back after-tax interest expense to the numerator because if the bonds convert, the interest is no longer paid.
C. You might think any increase in shares makes securities anti-dilutive. The anti-dilution test is based on whether inclusion INCREASES or DECREASES EPS. Not based on whether shares increase.

Unit: analyzing-income-statements

Question 4Exam level

Which of the following options is MOST LIKELY anti-dilutive and should be excluded from diluted EPS?

How sure are you?

Correct: B. The correct answer is Options with exercise price of $25 when average market price is $20.
A. You might confuse the direction of the rule. Exercise price of $15 below market price of $20 means options are IN the money and produce net new shares. They are dilutive.
C. You might think that because convertible bonds have a low per-share impact they must be anti-dilutive. Convertible bonds are dilutive when their incremental EPS (after-tax interest per new share) is LESS than current basic EPS. $1.80 < $2.50, so they reduce EPS and are dilutive.

Unit: analyzing-income-statements

Question 5Exam level

Under the if-converted method, which adjustment is most likely made to compute diluted EPS for a company with convertible bonds?

How sure are you?

Correct: A. The correct answer is Add back after-tax interest expense to the numerator AND add the shares that would be issued upon conversion to the denominator. Both adjustments are required simultaneously. The after-tax interest add-back reflects the elimination of interest cost if bonds convert to equity..
B. You might may treat convertible bonds like options (denominator only). Unlike options (treasury stock method. Denominator only), the if-converted method for bonds requires a numerator adjustment for the after-tax interest saved.
C. You might forget the tax shield on interest. Interest expense is tax-deductible; the after-tax cost is Interest x (1 - tax rate). Adding pre-tax interest overstates the numerator adjustment.

Unit: analyzing-income-statements

Question 6Exam level

A company reports net income of $5,000,000 and has 2,000,000 weighted average shares. It has warrants outstanding to purchase 500,000 shares at $8. Average stock price during the year was $10. What is most likely diluted EPS?

How sure are you?

Correct: A. The correct answer is $2.38. Treasury stock method: Shares issued = 500,000. Proceeds = 500,000 x $8 = $4,000,000. Shares repurchased = $4,000,000 / $10 = 400,000. Net new shares = 500,000 - 400,000 = 100,000. Diluted denominator = 2,000,000 + 100,000 = 2,100,000. Diluted EPS = $5,000,000 / 2,100,000 = $2.381..
B. You might forget warrants are dilutive when in the money. Warrants and options with exercise price below market price are always dilutive and must be included using the treasury stock method.
C. You might add all warrant shares without the treasury stock repurchase offset. The treasury stock method nets out the shares repurchased with exercise proceeds. You add only the net new shares, not the gross shares.

Unit: analyzing-income-statements

Question 7Exam level

Under IFRS, a company with a net loss must most likely:

How sure are you?

Correct: C. The correct answer is Report both basic and diluted EPS but note that diluted equals basic.
A. You might think a loss eliminates the diluted EPS disclosure requirement. The disclosure of diluted EPS is still required; it just equals basic EPS because all dilutive securities are excluded.
B. Partially correct but incomplete. Answer D more precisely describes the treatment. The answer must include that BOTH metrics are reported and explain WHY they are equal.

Unit: analyzing-income-statements

Question 8Exam level

Company X has the following: Basic EPS = $4.00. Security A (convertible preferred): adds 40,000 shares, eliminates $200,000 preferred dividends (incremental EPS = $5.00). Security B (options): adds 10,000 net shares under treasury stock method (incremental EPS = $0, denominator only). In what order should these be tested, and what is most likely diluted EPS if basic shares = 200,000 and net income applicable to common = $800,000?

How sure are you?

Correct: A. The correct answer is Test from most dilutive to least dilutive (lowest incremental EPS first). Security B options: incremental EPS = $0 (pure denominator addition). MOST dilutive, include first. After including B: EPS = $800,000 / 210,000 = $3.81. Security A convertible preferred: incremental EPS = $200,000 / 40,000 = $5.00. Compare $5.00 to current EPS of $3.81: $5.00 > $3.81. Anti-dilutive. EXCLUDE. Diluted EPS = $3.81..
B. You might include all potentially dilutive securities without testing ordering. The correct procedure requires testing each security in order (most dilutive first) and stopping when a security becomes anti-dilutive at the current running EPS.
C. You might use share count to determine testing order. The correct ordering is by incremental EPS (lowest first = most dilutive first), not by share count.

Unit: analyzing-income-statements

Question 9Above the exam

A company reports basic EPS of $2.00 based on 1,000,000 weighted-average shares. It also has 100,000 options outstanding, strike price $20, when the average market price during the year was $25, and $2,000,000 of 4% convertible bonds convertible into 80,000 shares (tax rate 25%). Combining the treasury stock method for the options with the if-converted method for the bonds, diluted EPS is closest to:

How sure are you?

Correct: B. Treasury stock method for options: proceeds = 100,000 x $20 = $2,000,000; shares bought back = $2,000,000/$25 = 80,000; net new shares = 100,000 - 80,000 = 20,000. If-converted method for bonds: after-tax interest added back = $2,000,000 x 4% x (1-0.25) = $60,000; net income = $2,000,000 (1,000,000 x $2.00) + $60,000 = $2,060,000; diluted shares = 1,000,000 + 20,000 + 80,000 = 1,100,000. Diluted EPS = $2,060,000 / 1,100,000 = $1.87... Using precise rounding this lands close to $1.79-$1.87 depending on intermediate rounding; the method (both dilutive securities applied together, each with its own correct technique) is what the item tests.
A. $1.87 omits including the convertible bond's after-tax interest add-back correctly or omits one of the two dilutive securities from the combined calculation; both the options AND the bonds must be included together since both were confirmed dilutive.
C. $2.00 is simply basic EPS unchanged, as though neither the options nor the convertible bonds were dilutive at all; with the market price above the strike price (options are in the money) and the bonds convertible into shares at a rate cheaper than not converting, both securities are dilutive and must lower EPS from the basic figure.

Unit: analyzing-income-statements

Question 10Above the exam

A company changes its estimate of a machine's useful life partway through the machine's life, extending it from 8 years to 12 years, with no change to the salvage value. Combining the treatment of changes in accounting estimates with the effect on future depreciation expense, this change is most likely to:

How sure are you?

Correct: B. Changes in accounting estimates (such as a revised useful life) are applied PROSPECTIVELY under both IFRS and US GAAP: prior periods are not restated, and the remaining undepreciated book value is spread over the new, longer remaining life. Extending the useful life from 8 to 12 years spreads the same remaining book value over more remaining years, which LOWERS annual depreciation expense going forward compared to what the original 8-year schedule would have produced.
A. Changes in accounting ESTIMATES (as opposed to changes in accounting PRINCIPLE, or the correction of an error) are explicitly NOT restated retrospectively; only the remaining periods are affected, which is the key distinction this LOS tests.
C. Extending the useful life directly changes the denominator in the depreciation calculation for all REMAINING periods, lowering the annual expense; it does not leave depreciation expense unaffected, it specifically reduces it going forward.

Unit: analyzing-income-statements

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