The income statement is one of the three major financial statements that all publicly held firms are required to prepare annually. It provides a record of a company's revenues and expenses for a given period of time, and thus serves as the basic measuring stick of profitability. In fact, the income statement is often referred to as the profit-and-loss statement, with the bottom line literally revealing which result a company achieved. Along with the balance sheet and cash flow statement, the income statement provides important financial information to business managers, investors, lenders, and analysts.
"The income statement is simply a scorecard that summarizes the revenues and expenses of an organization for a specific period of time," Jayson Orr wrote in CMA Management. "It reveals critical information about the operations and profitability of a business unit. It also reveals little secrets that may not be so obvious. In short, the income statement tells how successfully a business unit is fulfilling its prime directive—to generate profit."
Preparing an income statement is one of the basic responsibilities of the accounting function. Accounting is the process of recording and disclosing the financial information for a company so that operating results can be known and comparisons between different years and different companies can be made. Accounting has been described as the language of business. Because managers of all organizations use accounting information, perhaps on a daily basis, it is critical that they understand the language. One of the obstacles to the best use of accounting information is that its terminology is confusing, especially when some of the terms used in accounting have alternate meanings in other business settings.
One of the purposes of this essay is to provide logical definitions for key business terms from an accounting perspective; thus avoiding misunderstandings from applying an inappropriate definition. A second purpose is to describe the contents of the typical income statement prepared for a profit-seeking corporation.
ACCRUAL ACCOUNTING VS.
CASH BASIS ACCOUNTING
An area of confusion for many people is the concept known as accrual accounting. When individuals and small companies spend money, the expenditure is generally considered to be an expense. This is what accountants refer as the cash basis of accounting. But larger companies, particularly publicly held Page 368 | Top of Article corporations, are required to use the accrual basis of accounting. From the accrual accounting perspective, the purpose of the expenditure determines whether or not the expenditure is an expense at the time of payment. For example, if a business expends cash for office supplies, no expense occurs until the office supplies are used in business operations. The spending of cash is not the critical event. Thus, when a business buys postage stamps, it has purchased an asset, that is, an item that has a future potential to benefit the company. If the stamps are used to mail an invoice to a customer or supplier, then the expense occurs because the stamp (asset) has no further benefit for the company.
The same logic would apply to other expenditures wherein a company acquires an asset that offers future benefits on a long-term basis, such as a delivery truck. Identifying when the benefit occurs, and therefore when the expense occurs, is a more difficult task in this instance, and the point will be discussed later as the concept of depreciation. One unique aspect of an expense is that expenses are incurred in order to produce revenues.
The concept of revenues also proves confusing to some people. Revenues can be defined as the amount charged to customers for the services and products that are provided to them. When employees receive paychecks, they consider that they have earned their pay at that time. The paycheck represents the completion of labor for the previous work period. For a company that uses accrual accounting, however, the receipt of payment is not the critical event for determining when revenues have been earned. From an accrual accounting perspective, a company generally earns revenues at the time when a product or service is provided to the customer. Thus, whether a customer pays for the purchase of a product or service with cash (or check) or charges the purchase on a credit card, the company earns revenue when the product or service is provided. This concept is complicated because revenue is earned, and yet no cash might be paid to the company at the time that accounting says that revenue is earned. Using the paycheck example, employees actually earn their pay on a daily basis as they perform services for their company, but they do not receive payment until payday.
To merge the two concepts of revenues and expenses together, consider a rule accountants refer to as the matching principle. This rule can be summarized as follows: revenues are recorded in the time period when earned and expenses are matched (offset) against the revenues in the same time period that they cause revenues to be earned. More formal definitions can be summarized as follows: revenues can be defined as the total amount earned from providing goods and services to customers. Revenues are equal to (measured by) the amount of cash or legal claim to receive cash or other items of value to be received at a later date in payment from the customer. The receipt of payment might occur immediately or it might occur, say, 30 days after the invoice's date. In either case, the revenues are earned when the service or product is provided, not necessarily when the cash is received.
Expenses can be viewed as representing the use of the benefits that an employee or asset provides; the payment for the asset or services might or might not occur at the same time that the benefits are used. The important thing to remember is that expenses are incurred, and therefore matched with revenues, in the period in which the company earns the revenues.
THE INCOME STATEMENT
The income statement is considered by many to be a company's most important financial statement. It discloses the dollar amount of the profitability for a company during a specific period of time. Since published annual financial statements usually cover a 12-month period, which will be the assumption here.
The heading of the income statement should contain three crucial elements of information: the name of the company involved, the title of the statement identifying it as an income statement, and the specific 12-month period during which the income was earned. The basic format of the income statement is represented by the following equation: revenues minus expenses equal net income.
The income statement discloses total revenue and total expenses for the period in question. The amount of the revenues in excess of the expenses is the net income, or profit, earned by the company for the year covered by the statement. Notice that revenues are considered as a total or gross concept, whereas profit is considered a net concept, as in net income. Revenues represent the total amount that products and services are worth; expenses represent the amount that products or services cost the company; and the excess of the revenues over the expenses is the profit.
Consider a simple example: say that a company sells automobiles for profit. The company buys a car for a cost of $20,000 and sells it for $30,000 in revenue. Ignoring expenses other than the cost of the car, the profit can be determined by taking the $30,000 in revenue minus the $20,000 in expenses (the cost of the car), giving a figure of $10,000. If the total of all such sales for a year are shown and all related expenses incurred in that same year to produce the sales are deducted, the result is an income statement.
There are two basic formats of the income statement. The one summarized above is known as the single-step income statement, used by many service companies. All revenues are disclosed at the top of the statement, followed by all expenses of the company Page 369 | Top of Article for the same time period. Some companies prefer to disclose their income tax expense after having deducted all other expenses from the revenues, since it doesn't relate directly to operations of the company, as do the other expenses. Net income is the bottom line, just as the expression says. However, for a company that is a corporation, an amount that is roughly the net income earned per share of corporate voting stock is disclosed last. This figure is entitled earnings per share, and when tracked over time it is used widely as an indicator of corporate performance from period to period.
The other format for the income statement is known as the multiple-step income statement. Its form is somewhat more complex; its purpose is to disclose in more detail certain relationships that many users of financial statements consider important. An abbreviated version of the multiple-step income statement is shown in Table 1.
|Less Cost of Goods Sold||-600,000|
|Gross Profit on Sales||400,000|
|Less Operating Expenses||-250,000|
|Income Before Income Taxes||150,000|
|Less Income Tax Expense||-50,000|
|Earnings Per Share||$1.00|
The following paragraphs examine each line in this hypothetical income statement. To begin with, revenues would follow the general description presented earlier; in other words, they would be recorded on an accrual basis as customers take delivery of products. Thus, in this sample the sales revenue refers to the revenue earned from providing products to the customer. Note, however, that a bank would not have sales revenue but, instead, would have interest revenue, while a car rental company would have rental revenue. The nature of the revenue would determine the adjective used to describe the source of the revenue. There are other points in time that revenue may be recorded as being earned, but point of sale is the dominant usage.
COST OF GOODS SOLD.
Cost of goods sold (often abbreviated COGS) is the expense representing the cost that a company expends to manufacture a product, if it is a manufacturing firm, or to acquire a product for resale, if a wholesaler or retailer. This represents only the direct cost of providing the product to the customer; other costs of operating the business, such as management and sales staff salaries, are deducted as expenses in other locations of the income statement. Of course, a company that provides a service instead of a product would not have a COGS expense to be deducted on its income statement.
GROSS PROFIT ON SALES.
Gross profit on sales (or simply gross profit or gross margin) represents the total profit on the sales, if only the cost of the product itself is considered. This amount is used in calculating numerous financial ratios, such as the gross margin percent; thus it is provided for the financial statement user's benefit to analyze operating performance and make comparisons with other firms in the same line of business.
Operating expenses are deducted next. Sometimes this category is divided into two major components: selling (marketing) expenses and general and administrative (G&A) expenses (or both together, SG&A). Selling expenses include any expense incurred in an attempt to sell the products. Expenses such as advertising, salaries of sales personnel, and sales commissions would be included. G&A expenses include all other expenses; these relate to the general administration activities needed to run the business for the current year covered by the income statement. Examples of G&A expenses include rent expense, insurance expense, and other expenses related to the general administration of the company.
A few special expenses in this category require added discussion. Based on the accrual accounting definition of expenses presented above, expenses are deducted when incurred to earn revenue, and this may not correspond with the point in time that cash is spent to pay for the expense. For example, one of the operating expenses might be warranty expense. A product might be sold with a two-year warranty to cover labor and parts needed for repairs. In the year that the product is sold and the revenue from the sale is recorded, the future two years of warranty expense must also be recorded. This might seem illogical except for two important reasons. First, accrual accounting requires that expenses be matched with related revenues when the revenues are earned. Second, the warranty expense was incurred to create the sale in the first place. The sale might not have occurred without the warranty made available to the customer. This means that the accountant, with management's approval, must estimate and currently deduct what the future sacrifice will be during the subsequent two-year period, long before any cash expenditures are made.
Another example of an estimated expense is an uncollectible accounts expense or bad debt expense. Any company that offers credit terms to its customers will experience a few instances when customers are unable to pay the balance of an account when it comes due. Since accrual accounting requires the disclosure of revenue when it is earned, even when on a credit basis, the company must deduct at the time the revenue Page 370 | Top of Article is recorded an estimate of the total of the accounts that may prove to be uncollectible in the future.
The next example of an expense that must be estimated, but one that is common to many income statements, is depreciation expense. If a company owns a long-lived asset, such as a building, delivery truck, machine, or computer equipment, the company should not (and often cannot for tax purposes) deduct the total cost of the item in the year it is acquired and placed into service. Since the asset has potential benefit to the company in future years, the asset's cost must be allocated over the years of its estimated life as the company receives its benefits. When a long-lived asset is first acquired for use, therefore, management must make some good-faith estimates concerning the asset. The accountant can then calculate, by one of a number of mathematical formulas, the amount of the asset's cost that will be recorded as an expense each year of the asset's life. If, after a few years, it becomes clear that the original estimate was incorrect, an updated estimate is then used to calculate the new depreciation for the asset's remaining life. The total of all depreciation expensed over an asset's life should be equal to its cost less any amount for which it can be sold at the end of its useful life.
The final estimated expense that will be covered here is a pension expense. The nature of the pension expense is somewhat similar to the warranty expense. Pension expenses are also deducted before they are paid in cash. The main distinction is that a pension expense is much more difficult to estimate. Nonetheless, management must make a good-faith effort to determine the expense to be deducted each year. What makes the amount so difficult to estimate is that the actual payment to the employee might not occur for decades into the future. Meanwhile, management, with the assistance of actuaries, must make assumptions as to how long the employee will work for the company, how much the employee will earn in future years, how long the employee will live after retirement, and other such seemingly insurmountable hurdles. It will sound repetitive, but accrual accounting requires that expenses be deducted in the year that they are incurred to earn revenue. Since the employee is working currently to help the company earn revenues, the cost of all post-employment benefits must be deducted while the employee is currently employed. This is true for medical and dental benefits, just as it is for pension benefits.
INCOME BEFORE INCOME TAXES.
Income before income taxes is the result of subtracting operating expenses from gross profit on sales. This amount is shown separately so that the profit from regular operations—before the impact of income taxes—can be seen easily.
INCOME TAX EXPENSE.
The final expense normally shown as a deduction on the income statement is the income tax expense. The amount of the expense is the result of accrual accounting rules, which differ from rules required for filing tax returns. In other words, the income tax expense is matched to the revenues that give rise to that expense, regardless of the amount computed on the tax return or paid to the IRS.
This is the "bottom line" amount that shows the excess of the revenue over all the expenses. It does not reflect the amount of cash left over at year-end. Because revenues are recorded when they are earned (and not necessarily when they are collected), and expenses are deducted from revenues when the expenses are incurred (and not necessarily when they are paid), net income is not correlated directly to cash left over at year-end. In the long run, however, all revenues should be collected in the form of cash and all expenses should be paid in the form of cash. In the short run, accrual accounting provides a more meaningful measurement of the profitability of the company than do mere cash receipts and expenditures.
EARNINGS PER SHARE.
The final presentation on the income statement for a publicly held corporation is the amount of earnings per share of stock outstanding. In effect, this is the entire income statement condensed to show the amount of net income that each share of common voting stock earned for the income statement time period. If a stockholder owns 100 shares, the stockholder's investment earned 100 times this amount. This amount should not be confused with dividends per share. Dividends per share represents the amount of cash that the board of directors, as representatives of all stockholders, chooses to pay to the stockholders as a return on their investment in the company for the current period. Again, earnings and cash received do not mean the same thing.
OTHER SPECIAL ISSUES
A few other issues deserve some explanation. In the lower portion of many income statements (following operating expenses), there may be a different caption from income before income taxes. The caption income from operations is substituted when a company has experienced gains and losses. Gains and losses usually occur whenever a company sells an asset (other than inventory for which it is in business to sell) for more or less than the value of the asset in its records. The accounting concept here is to separate the disclosure of normal sales activities from the unusual disposal of other assets. (See also the discussion of extraordinary items below.)
There may also be up to three unique items that follow income tax expense at the end of the income statement. These items are discontinued operations, extraordinary items, and cumulative effect of accounting changes.
A company would include discontinued operations if it had disposed of a significant segment of its operations. This event would be of such a magnitude (usually defined in percentage terms) that the information on the income statement would be misleading if it were not separately disclosed from what the reader could consider to be regular recurring operations of the company.
Extraordinary items are major gains or losses that are defined to be both highly unusual in nature and infrequent in occurrence, such as expenses stemming from a natural disaster or the restructuring of long-term debt. These extremely rare gains and losses are disclosed apart from regular operations, including normal gains and losses as discussed above, so that the user of the income statement can better judge the results of normal recurring operations.
The last item disclosed as part of the income statement before the earnings per share data can be the cumulative effect of accounting changes. This caption is used only when the management of a company has decided that changing from one generally accepted accounting principle (as defined by independent standards organizations for the accounting profession) to a different generally accepted accounting principle will better disclose the results of operations for the users of the statements. This change is based on management's judgment, and the accounting firm that audits the company's financial statements reviews this change. Generally, any previous years' accounting data will be restated to use the new accounting rule so that comparisons of current and previous data will be made on the same basis.
A relatively new concept that may be included at the end of the income statement is comprehensive income. Comprehensive income results from changes in certain assets and liabilities on the balance sheet (a financial statement of corporate assets and liabilities). These unique gains and losses are not included in calculating net income, but they may be added after net income is shown. They are excluded from net income itself because they would distort the basic purpose of the income statement: to disclose the results of operations. These particular gains and losses result, instead, from two main sources not related to operations. First, comprehensive income results from market value changes of certain investment securities that are reported in the financial statements at their current trading values. Second, these gains and losses also result from foreign exchange rate changes used to report the values of assets and liabilities in foreign subsidiaries. These items may be also be shown on other financial statements rather than as an addition to the income statement.
PROBLEMS WITH THE
Studying a company's income statement can help managers, investors, creditors, and analysts to form an understanding of the business's performance and profitability. Yet the income statement has come under criticism in recent years because the two main figures—income and expenses—are often obscured by accounting adjustments and subjective estimates. In the wake of accounting scandals at several major corporations, many analysts began pushing for expanded reporting standards that would limit companies' ability to overstate revenue or understate expenses. In any case, rather than relying on the income statement alone, users should examine all three major financial statements to gain further information about a company's results.
John M. Alvis
Revised by Laurie Hillstrom
"Analyzing Company Reports: Understanding Income Statements." Ameritrade.com. Available from <http://www.ameri-trade.com/educationv2/fhtml/learning/uincomestates.fhtml >.
"Income Statements." Inc.com. Available from <http://pf.inc.com/articles/2000/05/18739.html >.
Orr, Jayson. "Making Your Numbers Talk." CMA Management, November 2000.
Rappaport, Alfred. "Show Me the Cash Flow! The Income Statement Badly Needs an Overhaul. Here's a Way to Fix It." Fortune, 16 September 2002.