INCOME STATEMENT
Introduction
The income statement provides investors and creditors with information about the performance of a business. In its basic format, the income statement provides information about revenues, expenses, gains, and losses of a business.
Net income usually does not equal the cash flows generated from the operations of the business. Statement of Financial Accounting Concepts No. 1 states that “information about earnings and its components... generally provides a better indication of enterprise performance than information about current cash receipts and payments.”
Businesses pay income taxes based on their income. However, the income number calculated for tax purposes is usually different from that calculated using the generally accepted accounting principles (GAAP) for financial reporting purposes. This is so because tax rules are based on laws enacted by Congress, which do not necessarily follow GAAP.
Income Statement Format
The income statement may be prepared in single-step or multiple-step format. In the single-step income statement, all operating revenues and gains are listed first, followed by all operating expenses and losses. The differences between revenues/gains and expenses/losses represent income from continuing operations. An example of a single-step income statement follows:
RevenuesSales revenue / $10,000
Interest revenue / 500
Gain on sale of land / 1,200
Other income / 300
Total revenue / $12,000
Expenses
Cost of goods sold / $ 7,000
Selling and administrative expenses / 2,500
Other operating expenses / 200
Loss on sale of equipment / 800
Income tax expense / 600
Total expenses / $11,100
Income from continuing operations / $ 900
Loss on discontinued operations (net of tax) / (200)
Income before extraordinary items and cumulative effect of change in accounting principle / 700
Extraordinary gain (net of tax) / 250
Cumulative effect of change in accounting principle (net of tax) / 300
Net income / $ 1,250
Note:
1. In the single-step format, revenues and gains are combined and shown as a single category (similarly, expenses and losses are combined).
2. Discontinued operations, extraordinary items, and the cumulative effect of accounting principle change are presented net of tax.
In the multiple-step income statement, operating revenues are listed first, followed by operating expenses. The difference between the two gives operating income. To this number, gains are added and losses are subtracted giving income from continuing operations. An example of a multiple-step income statement follows:
Sales revenue / $10,000Cost of goods sold / (7,000)
Gross profit / $3,000
Operating expenses
Selling and administrative expenses / 2,500
Other expenses / 200 / (2,700)
Income from operations / $ 300
Other revenue and gains
Interest revenue / 500
Gain on sale of land / 1,200
Other income / 300 / 2,000
Other expenses and losses
Loss on sale of equipment / (800)
Net income before taxes / 1,500
Income tax expense / (600)
Income from continuing operations / $ 900
Loss on Discontinued operations (net of tax) / (200)
Income before extraordinary item and cumulative effect of change in accounting principle / 700
Extraordinary gain (net of tax) / 250
Cumulative effect of change in accounting principle (net of tax) / 300
Net income / $1,250
Note:
1. In the multiple-step format, information is divided into operating and other (nonoperating) sections.
2. Income from operations is different from income from continuing operations.
3. The items after income from continuing operations are presented similarly in the single- and multiple-step formats.
The order of appearance of the items is important. Use this acronym to memorize the order.
I = Income from continuing operations
D = Discontinued operations
E = Extraordinary items
A = Accounting principle change
Discontinued Operations
A company may decide to discontinue the operations of a business segment for a variety of reasons. The segment could be a product line, a division, or a subsidiary. To qualify for special treatment as a discontinued operation, the assets and liabilities of the segment should be clearly distinguishable from other activities of the company.
Information about discontinued operations is required to be presented separately from other operations. For such measurement and reporting, it is important to identify the measurement date and the disposal date. The Measurement date is the date on which the management decides on a plan to dispose of a segment of the business. The Disposal date is the date on which the segment is actually disposed of, either by closing a sale or by stopping the operations. The Phase-out period is the period between the measurement date and the disposal date.
Sometimes management may decide to discontinue a segment, but the actual process of phasing it out may take some time. For example, it is possible that management of a company with a December 31 fiscal year-end decided on October 1, 2002 to discontinue a segment, but the actual liquidation process of the segment is not completed until March 15, 2003. In such instances, there are three relevant periods, and each of these three periods has an associated income or loss. They are as follows:
A. Income (or loss) related to the operations of the segment from the beginning of the period to the measurement date (in our example, this is the period from January 1, 2002 to September 30, 2002).
B. Realized gains (or losses) of the segment from the measurement date to the end of period (in our example, this is the period from October 1, 2002 to December 31, 2002). This period in turn includes two components: the operating income or loss from continuing to operate the segment as it is being phased out and the gain or loss on disposal of segment as the process of disposing of it proceeds from the measurement date to the end of the period.
C. Unrealized gains (or losses) of the segment from the beginning of the next period until the date the disposal is complete (in our example, this is the period from January 1, 2003 to March 15, 2003). Since these are future numbers as of December 31, 2002, they must be estimated because under certain circumstances unrealized gains (or losses) may have to be included in the income statement for the period ending December 31, 2002. As with item B, the estimated gains or losses for this period also include two components: estimated operating income or loss and estimated gain or loss on the disposal of the segment, both from the end of the current period to the date of disposal.
The rules for the recognition of gains or losses related to disposal of a segment, when the measurement date is in the first year and disposal is completed in the second year, are as follows:
· Income or loss related to the period before the measurement date is always recognized in year 1.
· Income or loss related to the period from the measurement date to the end of the period are always recognized in the first year.
Thus, measurement and recognition related to two of the three relevant periods is straightforward. However, measurement and recognition related to the estimated future costs (in year 2) are more difficult. The rules related to the estimated future amount from the operation and disposal of the segment (these two numbers must be added together) are as follows:
· If the combined amount is a loss, the estimated loss amount must be recognized in the first year (in our example, if the results of operation and disposal from January 1, 2003 to March 15, 2003 together lead to an estimated loss, that amount must be recognized in the income statement for the period ending December 31, 2002).
· If the combined amount is a gain, the estimated gain amount can be recognized only to offset losses, if any, from the operations and disposal of the segment in the first year. The remainder of the gains are recognized only in year 2, after the actual disposal.
Extraordinary Items
Extraordinary items are both unusual in nature and infrequent in occurrence.
Unusual means the event must be highly abnormal and must be clearly unrelated to the ordinary activities of the entity. Infrequent means that the event would not reasonably be expected to occur again in the foreseeable future. However, the environment in which an entity functions must be considered when applying these definitions. This means that what may be considered extraordinary for one company may not be extraordinary for another company. (For example, an earthquake may be infrequent in New York but not in California.)
The following items do not qualify as extraordinary (because they are not unusual or may be expected to occur regularly):
1. Write-downs or write-offs of receivables, inventories, or intangible assets.
2. Gains or losses from foreign currency translations.
3. Gains or losses from disposal of a segment of a business.
4. Gains or losses from sale or abandonment of property, plant, or equipment.
5. Effects of a strike.
However, material gains and losses from extinguishment of debt are considered to be extraordinary.
Extraordinary items are reported net of tax. For example, assume that a firm has an extraordinary loss of $100,000. If the tax rate is 30%, the extraordinary loss reduces the taxable income by $100,000, which in turn means that the income tax is reduced by $30,000. Hence, the after-tax loss is only $70,000, and the extraordinary item is reported on the income statement as a net of tax loss of $70,000.
What if an item is unusual but not infrequent, or infrequent but not unusual? Such items are reported separately but are included before calculating income from continuing operations. Note that such items cannot be reported net of tax but must be shown at their gross amount.
Change in Accounting Principles and Estimates
A company may adopt an accounting method that is different from the one it previously used. This may occur for two reasons. First, a standard-setting body (for example, the Financial Accounting Standard Board, FASB) may issue a new pronouncement that requires a change in principle. Second, circumstances may change and the company may want to change accounting principles so that financial reporting is more representative of the new conditions in which it operates. For example, a company may change from FIFO to LIFO for inventory accounting or from the straight-line method to the double-declining balance method for depreciation of plant assets.
When there is a change in accounting principle, the cumulative effect of the change must be considered. The cumulative effect is the difference between the value of an asset or liability on the balance sheet when using the old principle and the value of the same asset or liability when using the new principle. The cumulative effect of adopting the new principle on net income is reported, net of tax, on the income statement. In addition, for all periods for which comparative data are presented in the income statement, pro forma net income and earnings per share under the new method must be reported. That is, for such prior periods, the net income and earnings per share must be calculated and reported according to the new principle.
In some special cases, prior period financial statements need to be restated. In addition, if the change in accounting principle is required (because of a new FASB standard), the FASB specifies the method to use to report the cumulative effect of the change in accounting principle.
Changes in accounting estimates are different from changes in accounting principle. For example, the estimated useful lives of machines may be changed during the period. This has an impact on the depreciation expense calculated during the current and future periods, but the previously reported numbers are not changed. Another example of a change in accounting estimate is the percentage used to estimate the allowance for doubtful accounts or the estimated warranty expenses.
Earnings per share (EPS)
Basic earnings per share are calculated as follows:
Basic EPS = (Net income – Preferred dividends) / Weighted average number of common shares outstanding
Per share numbers are disclosed in the income statement for the following separate amounts:
· Income from continuing operations.
· Income related to special situations (such as discontinued operations, extraordinary items, and the cumulative effect of changes in accounting principle).
· Net income.
Statement of Changes in Retained Earnings
Many companies include a statement of changes in retained earnings. The format of this statement follows:
Beginning retained earnings
+ or – Prior period adjustment
+ net income
+ or – Adjustments due to certain types of changes in accounting principles
– Dividends declared during the period
= Ending retained earnings.
Prior period adjustments usually occur when errors from prior periods are discovered (for example, an inventory overstatement). In this situation, the beginning balance of retained earnings is adjusted for the amount of the discovered error. Prior period adjustments are reported net of tax on the retained earnings statement.
Certain types of changes in accounting principles made during the current year require a direct adjustment to the (ending) balance of retained earnings.
Note that dividends declared (not dividends paid, which may or may not equal the dividends declared during a specific period) are subtracted to calculate the ending retained earnings. Dividends declared for both preferred stock and common stock must be subtracted.