The income statement presents the results of the operating activities of a firm for a specific period (i.e. one year, one quarter, etc.).
The basic equation of the income statement is total revenues (also called sales or the “top line”) less total expenses (or costs) equals net income (or earnings or the “bottom line”). Revenues measure the inflows of assets (or reductions in liabilities) from selling goods and services.
Expenses measure the outflow of assets (or increases in liabilities) used in generating revenues.
Net income is the difference between revenues and expenses (positive if the firm made a profit and negative if the firm made a loss).
There are two accounting approaches that a firm can use to measure operating performance: (1) cash basis or (2) accrual basis
· Under the cash basis, a firm recognizes revenue from selling goods or providing services in the period when it received cash from customers
· Similarly, the firm recognizes expenses in the period when it makes cash expenditures (i.e. pays) for merchandise, salaries, taxes, etc.
Unfortunately, there are some disadvantages of cash basis accounting. The cost of generating revenues is not adequately matched with the benefits of generating revenues. For example, if inventory is purchased at the end of a year, and that inventory is sold to customers at the beginning of the following year, the firm’s income statement will show an expense (but no revenue) the first year and revenue (but no expense) the following year.
This “mismatch” makes it difficult to compare operational performance from one year to the next. In other words, revenue recognition can be significantly delayed if the firm does not book revenues when goods are sold or services provided but when payment is received for those goods or services. Again, this can cause a timing “mismatch” from the difficult “work” of manufacturing and selling goods or providing services, and the recognition of revenues.
Operating performance can be easily manipulated. Because expenses are recognized only when a cash expenditure is made, firms have the ability to time payments to manipulate profits. For example, firms can delay payments until the next fiscal year to show a higher profit for the current year.
There are also many advantages to cash basis accounting. For example, bookkeeping is easier since only cash inflows and outflows need to be recognized and accounted for.
For firms with no inventories, few multi-period assets (such as buildings or equipment) and who usually receive payment for services shortly after providing services (e.g. professionals such as lawyers and accountants), cash basis accounting can be suitable.
Most firms, including all public firms, use the accrual basis of accounting which recognizes revenue when a firm sells goods or provides services.
The costs of assets used in producing the goods that were sold are recognized in the same period from which the associated revenue is recognized. The key factor (and advantage) of accrual accounting is that expenses are matched with associated revenues.
If the cost of assets used does not easily match up with particular revenues, then the expenses appear in the period in which the assets are used. An added benefit of the accrual method is that there are fewer opportunities for the firm to distort or manipulate earnings.
All of the analyses performed in this class will assume the accrual basis of accounting.
Under accrual accounting, revenue is recognized when the following two conditions have been met:
· A firm has performed all or most of the services it expects to provide
· The firm has received cash or another asset (such as a receivable) capable of measuring (reasonably precisely) the revenue to be recognized
If a firm recognizes revenue in a period before it collects cash, it may need to make adjustments to the agreed-upon price. These adjustments are made at the same time (or the same period) as the revenue is recognized. Such adjustments include:
· Uncollectible amounts or bad debts: the firm does not expect to collect the entire amount
· Sales discounts, allowances or returns: discounts off the purchase price or allowances for unsatisfactory merchandise or services or returned goods
· Delayed payments: payments longer than one-year from delivery of the goods or services require the revenue to be reduced by an implied interest charge
The gross revenue net of any adjustments is referred to as Net Revenue. Usually, only net revenue will be reported on a firm’s income statement but sometimes gross revenue and adjustments will also be shown.
Under accrual accounting, expenses are recognized as follows:
If an asset expiration (e.g. using inventory) can be associated directly with a particular revenue, that expiration becomes an expense when the firm recognizes revenue. This is known as the “matching principle” whereby costs are matched with revenues.
If an asset expiration does not clearly associate with a particular revenue, then that asset expiration becomes an expense in the period when the firm consumes or uses the benefit of that asset.
Costs that can be easily matched to revenues are known as direct costs or Cost of Goods Sold or COGS (also called the cost of sales, cost of revenue, cost of product). Examples include the cost of materials that comprise the goods being sold and the cost of labor directly responsible for making the goods being sold.
On the income statement, net revenues less COGS equals Gross Profit (also called Gross Margin).
Costs that cannot be directly matched to revenue are known as indirect costs. The largest category of indirect costs that almost always appears on an income statement is Selling, General and Administrative costs (SG&A) which is typically comprised of costs such as:
· Marketing and advertising
· Salaries of management
· Office expenses
· Travel and entertainment
· Professional services such as legal and accounting
Other indirect operating expenses may include research and development, depreciation (see the following page) as well as non-recurring or restructuring expenses.
Gross Profit less SG&A and other indirect operating expenses equal Operating Income or EBIT (Earnings Before Interest and Taxes). EBIT represents the profits of the company’s operations or equivalently, the profits of the company before taking out interest and taxes.
One additional and significant operating cost that has not been mentioned yet is depreciation. Accrual accounting stipulates that when assets such as factories and equipment are purchased, rather than have the entire amount expensed through the income statement when the property is purchased, the property gets “depreciated” over time. Because the asset will be used for a future benefit (e.g. used to generate future revenues), the cost of depreciating the asset is accounting’s attempt to “match” the benefit of the asset with the cost of the asset. The periodic (e.g. annual) cost of depreciating the assets becomes a cost on the income statement.
Depreciation is a process of cost allocation, and NOT meant to measure the decline in value of the asset.
There are various methods of depreciating assets (i.e. straight-line, accelerated) and because different assets have different useful lives, they can be depreciated over differing periods. However, land is not typically depreciated as it does not have a finite life.
The cost of depreciation can be considered a direct cost (Cost of Goods) or an indirect cost (SG&A or other expenses) depending on the type of asset and the type of company. For example, a manufacturing company that owns machinery that produces goods would consider the depreciation of that machinery a part of COGS. That same manufacturing company which also owns the building for its corporate headquarters would consider the depreciation of the headquarters building as an indirect cost (SG&A).
Depreciation (and amortization) is sometimes listed separately on the income statement as an operating expense but rarely broken out from COGS. The only way to ensure that the entire amount of depreciation and amortization is known is to consult the cash flow statement.
Amortization is similar to depreciation but is used for expensing over time intangible assets rather than tangible assets such as property and equipment.
Interest expense and interest income are shown below the operating income or EBIT line on the income statement. Sometimes interest expense and interest income are shown separately and sometimes only the net interest expense (interest expense less interest income) is shown.
Interest expense and interest income are not considered operating expenses or operating income for most companies (banks and other financial institutions are an exception) because the amount of interest expense is dependent on the amount of debt which is primarily a financing, rather than an operational decision.
Operating income (EBIT) less net interest expense equals Earnings Before Taxes (EBT). Occasionally, an income statement will also list non-operating income. This will come below operating income (typically below net interest expense) and before the line for taxes.
The income statement will also have a line item for taxes (often called “Provision for income taxes”). This represents the income taxes that the company owes based on financial accounting (book basis) but not necessarily the amount that will be paid to the government (see Advanced Topics for more information).
In the United States, the statutory rate for income taxes is 35% but the actual tax that a firm pays can vary significantly depending on many factors including state taxes, foreign taxes, previous operations and tax treatments (e.g. Net Operating Losses), etc.
Earnings Before Taxes (EBT) less the Income Tax Provision equals Net Income (also called Net Earnings or the “bottom line”).
On a public company’s income statement, Earnings Per Share (EPS) is typically listed directly below net income. It equates to the net income of the company divided by the number of common shares outstanding. Usually, two different metrics of earnings per share are shown: basic and diluted.
· Basic earnings per share equal net income divided by the number of common shares currently outstanding
· Diluted earnings equal the same net income divided by the number of common shares outstanding taking into account the effects of any company issued stock options outstanding. Stock options, when exercised have the effect of diluting the common ownership because new shares must be issued. That is, more shares (or more owners) have an ownership stake or claims on the same net income. Diluted shares are always greater than basic shares so diluted EPS is always less than basic EPS (assuming at least one option is exercisable and “in-the-money”).