Impact of the Operating Cycle on the Income Statement
The accrual method ensures proper reporting on the income statement because the operating cycle doesn’t coincide with the accounting cycle.
Differentiate between the accounting cycle and the operating cycle
- A company’s income statement shows profit (or loss) for a given period of time.
- A company’s operating cycle is the length of time necessary to convert inventory into a sale, plus the length of time to receive payment from receivables, plus the length of time to pay the accounts payable.
- The length of the operating cycle varies depending on how long inventory, receivable, and payable remain outstanding.
- The accounting cycle is a series of steps performed during the accounting period (some throughout the period, some only at the end of the period) for the purpose of creating financial statements.
- The accounting cycle is often different from the operating cycle.
- income statement: A calculation which shows the profit or loss of an accounting unit (company, municipality, foundation, etc.) during a specific period of time, providing a summary of how the profit or loss is calculated from gross revenue and expenses.
- profitability: The capacity to make a profit.
- operating cycle: The average time between purchasing or acquiring inventory and receiving cash proceeds from its sale.
The income statement is one component of the financial statements for a company. It can also be referred to as an earnings statement, profit and loss statement, or operating statement. The income statement reports the profitability of a business organization for a stated period, such as a month or a year. These time periods are usually of equal length so that statement users can make valid comparisons of a company’s performance from period to period. Profitability is measured by comparing the revenues earned with the expenses incurred to produce the revenue.
An example of revenue is cash received from the sale of products or services. Expenses are the costs involved in producing revenue, such as cash spent to purchase materials or pay bills or employees. If the revenues for a period exceed the expenses for the same period, net income results (Net income = Revenues – Expenses). If expenses exceed revenues for the period, then the result is a net loss.
Accounting Cycle vs. Operating Cycle
Information enters the income statement via the accounting cycle. The accounting cycle is a series of steps performed during the accounting period (some throughout the period, some only at the end of the period) for the purpose of creating the financial statements. This includes analyzing items to determine if they are a business transaction, as well as classifying and recording the transactions as journal entries in the proper journal. After that, the items are posted from the journals to the general ledger, which is used to prepare the financial statements. Companies choose the length of their accounting cycle by how long it takes to carry out the required accounting—not when the individual business transactions take place.
Often, companies have a separate operating cycle for their business. The operating cycle reflects the length of time it takes a company to convert its inventory purchase to sales revenue. A typical operating cycle includes the length of time to convert inventory into a sale, length of time to receive payment from receivables, and length of time to pay the accounts payable.
The length of the operating cycle varies depending on how long inventory, receivable, and payable remain outstanding and may occur several times in one period. It is very rare that the accounting cycle and operating cycle coincide with each other. That is why each business transaction during the operating cycle is analyzed to determine which accounting cycle to record it in. When companies fail to follow this procedure, the current accounting cycle records do not accurately reflect the business transactions in each of the operating cycles. In that case, the financial statements, including the income statement, will not be accurate.
Accrual Basis of Accounting
To allow for the fluctuations in the operating cycle, many companies choose to use the accrual basis of accounting. In accrual accounting, companies recognize revenues when the company makes a sale or performs a service, regardless of when the company receives the cash. However, the matching principle necessitates the preparation of adjusting entries. Adjusting entries are journal entries made at the end of an accounting period, or at any time financial statements are to be prepared, to bring about a proper matching of revenues and expenses.
The matching principle requires that expenses incurred in producing revenues be deducted from the revenues they generated during the accounting period. The matching principle is one of the underlying principles of accounting. This matching of expenses and revenues is necessary for the income statement to present an accurate picture of the profitability of a business.
Reporting Irregular Items
Irregular items are reported separately from the income statement proper so that users can better predict future cash flows.
Differentiate among discontinued operations, extraordinary items, and changes in accounting principles
- Irregular items are shown separately from the income statement proper because they are unlikely to recur. This helps the reader more accurately predict future cash flows
- There are three types of irregular items: discontinued operations, extraordinary items, and changes in accounting principles.
- Discontinued operations, the most common category of irregular items, are a component of an enterprise that either has been disposed of or is classified as “held for sale.”
- Extraordinary items are unexpected, abnormal, and infrequent occurrences—for example, sudden natural disaster or new regulations.
- Changes in accounting principles are when a company adopts a new accounting method that has an impact on the book value of the affected assets or liabilities.
- irregular item: An unusual occurrence reported separately from the standard income statement because it is unlikely to recur.
Irregular items, which are by definition unlikely to recur, are reported separately from the income statement proper so that users can better predict future cash flows. Irregular items are reported net of taxes.
Discontinued operations are the most common type of irregular items and must be shown separately. A discontinued operation is a component of an enterprise that either has been disposed of or is classified as “held for sale,” and:
- represents a separate major line of business or geographical area of operations; and
- is part of a single, co-ordinated plan to dispose of this separate major line of business or geographical area of operations; or
- is a subsidiary acquired exclusively with a view to resale.
Shifting business location(s), stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations. Any gain or loss from sale of assets should be recognized in the statement of comprehensive income.
Extraordinary items are unexpected, abnormal, and infrequent—for example, sudden natural disaster, expropriation, or new prohibitions due to changes in regulations.
Changes in Accounting Principles
The effect of changes in accounting principles is the difference between the book value of the affected assets (or liabilities) under the old policy (i.e. principle) vs. what the book value would have been had the new principle been applied. An example, if a company switched from using a weighted-average method to using a LIFO method of valuating inventories, both values for the same time period should be calculated and compared. These changes should be applied retrospectively and shown as adjustments to the beginning balance of affected components in Equity. All comparative financial statements should be restated.
Irregular items require special reporting procedures, and include discontinued operations, extraordinary items, and the reporting of the resultant EPS.
Summarize how a company reports extraordinary items, discontinued operations, intraperiod tax allocations, retained earnings and earnings per share.
- Discontinued operation pertains to the elimination of a significant portion of a firm’s business, such as the sale of a division.
- Extraordinary items are both unusual (abnormal) and infrequent — for example, unexpected natural disasters, expropriation, and prohibitions under new regulations.
- If a company reports any irregular items on its income statement, then it must report earnings per share for the irregular items.
- With intraperiod tax allocation, the specific item (or items) that generated the income tax expense are shown on the income statement with the applicable tax applied.
- dilute: To cause the value of individual shares to decrease by increasing the total number of shares.
- retained earnings: Retained earnings are the portion of net income that is retained by the corporation rather than distributed to its owners as dividends.
- income statement: Displays the revenues recognized for a specific period and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the reporting period.
Special Reporting Issues
Special, or irregular, items appear on single step or multi-step income statements, and require special reporting procedures. They are reported separately, and net of taxes, so that stakeholders can better predict future cash flows. Two examples of irregular items are discontinued operations and extraordinary expenses.
Discontinued operation is the most common type of irregular item. It pertains to the elimination of a significant portion of a firm’s business, such as the sale of a division. Shifting business location(s), 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 natural disasters, expropriation, and prohibitions under new regulations. If an item is unique, but does not fit the criteria of being unusual and infrequent, it must remain in the main section of the income statement. No items may be presented in the income statement as extraordinary items under IFRS regulations, but are permissible under US GAAP.
Other special reporting issues include Earnings per Share, Retained Earnings and Intraperiod Tax Allocation.
Earnings per Share: If a company reports any irregular items on its income statement, then it must report earnings per share for those items. The earnings per share can appear on the income statement or in the notes to the income statement. Earnings per share measures the dollars earned by each share of common stock. Earnings per share are calculated as net income, with preferred dividends /weighted number of shares outstanding. There are two forms of earnings per share that are reported: basic and diluted. For basic earnings per share, the weighted average of shares outstanding includes only actual stocks outstanding. In diluted, the 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. Diluted earnings per share are considered a more reliable way to measure earnings per share.
Retained Earnings: The statement of retained earnings explains the changes in a company’s retained earnings over the reporting period. It is required by the U.S. Generally Accepted Accounting Principles (U.S. GAAP) whenever comparative balance sheets and income statements are presented. It may appear in the balance sheet, in a combined income and changes in retained earnings statement, or as a separate schedule. In essence, the statement of retained earnings uses information from the income statement and provides information to the balance sheet. The statement breaks down changes in the owners’ interest in the organization, and also in the application of retained profit or surplus from one accounting period to the next. Line items typically include profits or losses from operations, dividends paid, the issue or redemption of stock, and any other items charged or credited to retained earnings.
Intraperiod Tax Allocation: With intraperiod tax allocation, the specific item (or items) that generated the income tax expense are shown on the income statement with the applicable tax amount applied. Income tax is allocated to income from continuing operations before tax, discontinued operations and extraordinary items.