Income Statement

Quick Summary of Income Statement

Financial statement presenting revenues, expenses, and profit. Also called profit and loss account.

An Income statement is a financial statement that appraises the financial performance of a specific company over a particular accounting period. The income statement describes how revenue is converted into net income. Revenue or ‘top line’ is money received from the sale of services and products before expenses. Net income or ‘bottom line’ is obtained after deducting all expenses from revenues. The income statement constitutes a definite time period,-in contrast with a balance sheet representing a single moment in time. The income statement is also known as ‘statement of revenue and expense’ or ‘profit and loss statement’.

Sections Of An Income Statement

The income statement is divided into two parts: the operating section and the non-operating section. The operating section discloses information about revenues and expenses relating to regular business operations of the company. This section is particularly read by business analysts and investors who are interested to acquire a stake or already own shares in a company. The non-operating section exposes revenue and expense information that is indirectly related to a company’s core activities. An example of a non-operating section is the selling of a factory by the company.

Items On The Income Statement

Operating Section

• Revenue – Cash inflows or other enhancements of assets of an entity during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major operations. Usually presented as sales minus sales discounts, returns, and allowances.
• Expenses – Cash outflows or other using-up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major operations.
  • General and administrative expenses (G & A) – represent expenses to manage the business (officer salaries, legal and professional fees, utilities, insurance, depreciation of office building and equipment, stationery, supplies)
  • Selling expenses – represent expenses needed to sell products (e.g., sales salaries and commissions, advertising, freight, shipping, depreciation of sales equipment)
  • R & D expenses – represent expenses included in research and development
  • Depreciation – is the charge for the year with respect to fixed assets that have been capitalised on the Balance Sheet.

Non-Operating Section

• Other revenues or gains – revenues and gains from other than primary business activities (e.g. rent, patents). It also includes unusual gains and losses that are either unusual or infrequent, but not both (e.g. sale of securities or fixed assets).
• Other expenses or losses – expenses or losses not related to primary business operations.

Irregular Items

They are reported separately because this way users can better predict future cash flows – irregular items most likely won’t happen next year. These are reported net of taxes.

• Discontinued operations is the most common type of irregular items. Shifting business location, stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations.
• Extraordinary items are both unusual (abnormal) and infrequent, for example, unexpected nature disaster, expropriation, prohibitions under new regulations. Note: natural disaster might not qualify depending on location (e.g. frost damage would not qualify in Canada but would in the tropics).
• Changes in accounting principle is, for example, deciding to depreciate an investment property that has previously not been depreciated. However, changes in estimates (e.g. estimated useful life of a fixed asset) do not qualify.

Earnings Per Share

Because of its importance, earnings per share (EPS) are required to be disclosed on the face of the income statement. A company which reports any of the irregular items must also report EPS for these items either in the statement or in the notes.

There are two forms of EPS reported:

• Basic: in this case “weighted average of shares outstanding” includes only actual stocks outstanding.
• Diluted: in this case “weighted average of shares outstanding” is calculated as if all stock options, warrants, convertible bonds, and other securities that could be transformed into shares are transformed. This increases the number of shares and so EPS decreases. Diluted EPS is considered to be a more reliable way to measure EPS.

Uses

An income statement assists creditors and investors to ascertain a company’s past performance, anticipate future performance and evaluate the company’s capability to bring forth cash flows in the future.

Usefulness And Limitations Of Income Statement

Income statements should help investors and creditors determine the past performance of the enterprise, predict future performance, and assess the capability of generating future cash flows.

However, information of an income statement has several limitations:

• items that might be relevant but cannot be reliably measured are not reported (e.g. brand recognition and loyalty)
• some numbers depend on accounting methods used (e.g. using FIFO or LIFO accounting to measure inventory level)
• some numbers depend on judgments and estimates (e.g. depreciation expense depends on estimated useful life and salvage value).

Drawbacks

The income statement has some glaring drawbacks. The major limitations of an income statement include:

• Income statement may vary depending on the accounting methodologies employed.
• Some numbers in the income statement are approximate. For example, depreciation expense is an approximation.
• Brand recognition and other intangible details are not accurately measured in the income statement.

Top Line

The term “top line” refers to the total revenues or sales mentioned in the income statement. This refers to the fact that the total revenues collected by a company appear at the top of the income statement.

Bottom Line

“Bottom line” is the net profit that is calculated after subtracting the expenses from revenue. Since this forms the last line of the income statement, it is generally referred to as the bottom line. It is important to investors as it represents the profit for the year attributable to the shareholders.

Annual Report

It is a yearly publication that public corporations compulsorily provide to shareholders. The annual statement describes the company’s financial condition. The operations of the company are also comprehensively described. The mutual fund annual report informs about the financial entity’s performance and contains data to support the claim. The information is predominantly quantitative rather than qualitative.

Things to note

Almost all financial statements use the accrual basis accounting method. That is, revenue is recognized if the company meets one of several definitions for being able to state that a good or service has been “sold” (see the footnotes for when this might be), even though it actually hasn’t received the cash payment yet. The difference between what it has sold and what it has not been paid for at the end of the period would show up in the accounts receivable line on the balance sheet.

Similarly, expenses are “recognized” before the company actually pays for them. For instance, employees are owed salary or wages, even though they might not have been paid by the time the reporting period has ended. These expenses would be part of the selling, general & administrative expenses as a non-cash expense and the amount owed would show up as a liability on the balance sheet under wages payable or, more probably, part of “other current liabilities.”

Depreciation and amortization is another non-cash expense, which spreads out the expense of purchasing some equipment over its useful lifetime as it is used to generate revenue.

All these non-cash expenses and incomes are reconciled through the cash flow statement.

Further, management has a certain amount of latitude in when it recognizes and how it classifies these various expenses and incomes. As a result, GAAP net income can be and often is manipulated by the company to present the best favorable face to investors.

One reason to do this is to “make the numbers.” That is, the company meets Wall Street analyst expectations for revenue or income. Another reason is to “take a bath.” In this case, the company shoves all the bad results into one period so as to get it out of the way, suffer the pain of one bad reporting period only to come out clean afterwards. Not coincidentally, after taking a bath, the following year often shows up as being quite good, as it is easier to “beat” bad results.

Examples of Income Statement in a sentence

The corporation’s income statement for the last fiscal year shows a 50% increase in sales.
A typical quarterly report to shareholders includes a summary of the company’s income statement.

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