OCW041: The Income Statement

Defining the Income Statement

Income statement is a company’s financial statement that indicates how the revenue is transformed into the net income.

Learning Objectives

Indicate the purpose of the income statement

Key Takeaways

Key Points

  • Income statement displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs and taxes.
  • The income statement can be prepared in two methods. The Single Step income statement takes a simpler approach, totaling revenues and subtracting expenses to find the bottom line. The Multi-Step income statement takes several steps to find the bottom line, starting with the gross profit.
  • Income statements should help investors and creditors determine the past financial performance of the enterprise, predict future performance, and assess the capability of generating future cash flows through report of the income and expenses.

Key Terms

  • FIFO: FIFO is an acronym for First In, First Out, which is an abstraction related to ways of organizing and manipulation of data relative to time and prioritization. This expression describes the principle of a queue processing technique or servicing conflicting demands by ordering process by first-come first-served (FCFS) behaviour: where the persons leave the queue in the order they arrive, or waiting one’s turn at a traffic control signal.

Income statement, also referred to as profit and loss statement (P&L), revenue statement, statement of financial performance, earnings statement, operating statement or statement of operations, is a company’s financial statement that indicates how the revenue (cash or credit sales of products and services before expenses are taken out) is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as Net Profit or “bottom line”). It 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.

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Example Income Statement: Income statement Green Harbor LLC

The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported. The important thing to remember about an income statement is that it represents a period of time. This contrasts with the balance sheet, which represents a single moment in time.

The income statement can be prepared in one of two methods. The Single Step income statement takes a simpler approach, totaling revenues and subtracting expenses to find the bottom line. The more complex Multi-Step income statement (as the name implies) takes several steps to find the bottom line, starting with the gross profit. It then calculates operating expenses and, when deducted from the gross profit, yields income from operations. Adding to income from operations is the difference of other revenues and other expenses. When combined with income from operations, this yields income before taxes. The final step is to deduct taxes, which finally produces the net income for the period measured.

In addition to the Single and Multi-step methods, the income statement can be reported on a cash or accrual basis. An income statement reported on a cash basis is typically used by smaller businesses that record transactions based on the exchange of cash; the revenues and expenses reported reflects cash received on sales and cash paid for expenses for the accounting period. Larger entities use the accrual basis, which is also the recommended method by the FASB. An income statement under accrual accounting reflects revenues “earned”, where an exchange in value among the parties has taken place, regardless of whether cash was received. Expenses on the statement have been “incurred”, where the business has received a benefit and has paid for it or has recorded a liability to pay it at a future date. As with revenues, the exchange of cash does not dictate the amount reported for the expense.

Income statements should help investors and creditors determine the past financial performance of the enterprise, predict future performance, and assess the capability of the business to generate future revenue streams through the reporting of income and expenses.

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 vary based on the 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).

Guidelines for statements of comprehensive income and income statements of business entities are formulated by the International Accounting Standards Board and numerous country-specific organizations, for example the FASB in the U.S.

Elements of the Income Statement

The income statement, or profit and loss statement (P&L), reports a company’s revenue, expenses, and net income over a period of time.

Learning Objectives

Construct a complete income statement

Key Takeaways

Key Points

  • The income statement consists of revenues and expenses along with the resulting net income or loss over a period of time due to earning activities. The income statement shows investors and management if the firm made money during the period reported.
  • The operating section of an income statement includes revenue and expenses. Revenue consists of cash inflows or other enhancements of assets of an entity, and expenses consist of cash outflows or other using-up of assets or incurring of liabilities.
  • The non-operating section includes revenues and gains from non-primary business activities, items that are either unusual or infrequent, finance costs like interest expense, and income tax expense.
  • The “bottom line” of an income statement is the net income that is calculated after subtracting the expenses from revenue. It is important to investors – also on a per share basis (as earnings per share, EPS) – as it represents the profit for the accounting period attributable to the shareholders.

Key Terms

  • income statement: a calculation which shows the profit or loss of an accounting unit during a specific period of time, providing a summary of how the profit or loss is calculated from gross revenue and expenses
  • gross profit: The difference between net sales and the cost of goods sold.
  • net income: Gross profit minus operating expenses and taxes.
  • income bond: a debt instrument where coupon payments are only made if the issuer can afford it
  • statement of cash flows: a financial document that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities

Elements of the Income Statement

The income statement is a financial statement that is used to help determine the past financial performance of the enterprise, predict future performance, and assess the capability of generating future cash flows. It is also known as the profit and loss statement (P&L), statement of operations, or statement of earnings.

A Sample Income Statement: Expenses are listed on a company’s income statement.

The income statement consists of revenues (money received from the sale of products and services, before expenses are taken out, also known as the “top line”) and expenses, along with the resulting net income or loss over a period of time due to earning activities. Net income (the “bottom line”) is the result after all revenues and expenses have been accounted for. The income statement reflects a company’s performance over a period of time. This is in contrast to the balance sheet, which represents a single moment in time.

Methods for Constructing the Income Statement

The income statement can be prepared in one of two methods: single or multi-step.

The Single Step income statement totals revenues, then subtracts all expenses to find the bottom line.

The more complex Multi-Step income statement (as the name implies) takes several steps to find the bottom line. First, operating expenses are subtracted from gross profit. This yields income from operations. Then other revenues are added and other expenses are subtracted. This yields income before taxes. The final step is to deduct taxes, which finally produces the net income for the period measured.

Operating Revenues and Expenses

The operating section includes revenue and expenses. Revenue consists of cash inflows or other enhancements of the assets of an entity. It is often referred to as gross revenue or sales revenue. Expenses consist of cash outflows or other using-up of assets or incurrence of liabilities.

Elements of expenses include:

  • Cost of Goods Sold (COGS): the direct costs attributable to goods produced and sold by a business. It includes items such as material costs and direct labor.
  • Selling, General and Administrative Expenses (SG&A): combined payroll costs, except for what has been included as direct labor.
  • Depreciation and amortization: charges with respect to fixed assets (depreciation) and intangible assets (amortization) that have been capitalized on the balance sheet for a specific accounting period.
  • Research & Development (R&D): expenses included in research and development of products.

Non-operating Revenues and Expenses

The non-operating section includes revenues and gains from non- primary business activities (such as rent or patent income); expenses or losses not related to primary business operations (such as foreign exchange losses); gains that are either unusual or infrequent, but not both; finance costs (costs of borrowing, such as interest expense); and income tax expense.

In essence, if an activity is not a part of making or selling the products or services, but still affects the income of the business, it is a non-operating revenue or expense.

Reading the Income Statement

Certain items must be disclosed separately in the notes if it is material (significant). This could include items such as restructurings, discontinued operations, and disposals of investments or of property, plant and equipment. Irregular items are reported separately so that users can better predict future cash flows.

The “bottom line” of an income statement—often, literally the last line of the statement—is the net income that is calculated after subtracting the expenses from revenue. It is important to investors as it represents the profit for the year attributable to the shareholders. For companies with shareholders, earnings per share (EPS) are also an important metric and are required to be disclosed on the income statement.

Noncash Items

Noncash items, such as depreciation and amortization, will affect differences between the income statement and cash flow statement.

Learning Objectives

Identify noncash items that can affect the income statement

Key Takeaways

Key Points

  • Noncash items should be added back in when analyzing income statements to determine cash flow because they do not contribute to the inflow or outflow of cash like other gains and expenses eventually do.
  • Depreciation refers to the decrease in value of assets and the allocation of the cost of assets to periods in which the assets are used–for tangible assets, such as machinery.
  • Amortization is a similar process to deprecation when applied to intangible assets, such as patents and trademarks.

Key Terms

  • depreciation: The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.
  • amortization: The distribution of the cost of an intangible asset, such as an intellectual property right, over the projected useful life of the asset.
  • obsolescence: The state of being obsolete—no longer in use; gone into disuse; disused or neglected.

Noncash Items

Noncash items that are reported on an income statement will cause differences between the income statement and cash flow statement. Common noncash items are related to the investing and financing of assets and liabilities, and depreciation and amortization. When analyzing income statements to determine the true cash flow of a business, these items should be added back in because they do not contribute to inflow or outflow of cash like other gains and expenses.

Fixed assets, also known as a non- current asset or as property, plant, and equipment (PP&E), is an accounting term for assets and property. Unlike current assets such as cash accounts receivable, PP&E are not very liquid. PP&E are often considered fixed assets: they are expected to have relatively long life, and are not easily changed into another asset. These often receive a more favorable tax treatment than short-term assets in the form of depreciation allowances.

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Machinery: Machinery is an example of a noncash asset.

Broadly speaking, depreciation is a way of accounting for the decreasing value of long-term assets over time. A machine bought in 2012, for example, will not be worth the same amount in 2022 because of things like wear-and-tear and obsolescence.

On a more detailed level, depreciation refers to two very different but related concepts: the decrease in the value of tangible assets (fair value depreciation) and the allocation of the cost of tangible assets to periods in which they are used (depreciation with the matching principle). The former affects values of businesses and entities. The latter affects net income.

In each period, long-term noncash assets accrue a depreciation expense that appears on the income statement. Depreciation expense does not require a current outlay of cash, but the cost of acquiring assets does. For example, an asset worth $100,000 in year 1 may have a depreciation expense of $10,000, so it appears as an asset worth $90,000 in year 2.

Amortization is a similar process to deprecation but is the term used when applied to intangible assets. Examples of intangible assets include copyrights, patents, and trademarks.

Uses of the Income Statement

The primary purpose of the income statement is to assess efficiency as revenues transform into profits/losses.

Learning Objectives

Utilize income statements to understand organizational efficiency

Key Takeaways

Key Points

  • Revenues are exposed to a number of expense types, and understanding the relationship between costs and revenues is the primary function of the income sheet.
  • When looking at profitability, dividing net profit by overall revenues provides insights as to the profitability of revenue from start to finish.
  • Another useful metric is the gross margin, which underlines the variable costs attached to adding new units of sales.
  • Operating margin provides insights as to how financing impacts overall profitability.

Key Terms

  • gross margin: A measurement of how the cost of goods sold per unit impact overall profitability.

Using the Income Statement

The primary purpose of the income statement is to demonstrate the profitability of an organization’s operations over a fixed period of time by illustrating how proceeds from operations (i.e. revenues) are transformed into net income (profits and losses).

Compared to the balance sheet and the cash flow statement, the income statement is primarily focused on the actual operational efficiency of the organization. The balance sheet discusses leverage, assets, funding, and other aspects of the organization’s existing infrastructure. The cash flow statement is primarily a description of liquidity. The income statement, however, is ultimately about how a given revenue input can be converted to profitability through assessing what is required to attain that revenue.

Assessing Efficiency

The income statement is relatively straight-forward. As an investor or a manager, the simplest way to view each section is by focusing on efficiency. An optimally efficient organization will have higher margins in the following areas:

Profit margin: A higher net profit as a proportion of sales indicates an overall higher capacity to capture returns on revenue. Profit margin is one of the first aspects of an organization a prospective investor will look at when considering the overall validity of a company as an investment. This is calculated as:

[latex]{displaystyle {frac {mbox{Net Profit}}{mbox{Net Sales}}}}[/latex]

Operating Margin: Another useful indicator of profitability is operating income over net sales. Operating income subtracts the cost of goods sold (COGS) alongside selling, general, and administrative expenses (SG&A), leaving the overall profit before taxes and interest on financial debt. Comparing this to the overall profit margin can give useful indications of reliance on debt. It’s calculated as:

[latex]{displaystyle {frac {mbox{Operating Income}}{mbox{Net Sales}}}}[/latex]

Another useful indicator is the gross margin. This essentially demonstrates the added value of each unit of sales, as it focuses exclusively on the impact of the cost of goods sold (COGS). COGS represents the costs incurred (directly) from materials, labor, and production of each individual unit. This can be a great indicator of how scalable an operation is, and the relative return an organization will see as they achieve growth.

[latex]{displaystyle {frac {mbox{Net Sales — COGS}}{mbox{Net Sales}}}}[/latex]

Income Statement Example: This is a simple example of the typical line items on an income statement.

Limitations of the Income Statement

Income statements have several limitations stemming from estimation difficulties, reporting error, and fraud.

Learning Objectives

Demonstrate how the limitations of the income statement can influence valuation

Key Takeaways

Key Points

  • Income statements include judgments and estimates, which mean that items that might be relevant but cannot be reliably measured are not reported and that some reported figures have a subjective component.
  • With respect to accounting methods, one of the limitations of the income statement is that income is reported based on accounting rules and often does not reflect cash changing hands.
  • Income statements can also be limited by fraud, such as earnings management, which occurs when managers use judgment in financial reporting to intentionally alter financial reports to show an artificial increase (or decrease) of revenues, profits, or earnings per share figures.

Key Terms

  • matching principle: According to the principle, expenses are recognized when obligations are (1) incurred (usually when goods are transferred or services rendered, e.g. sold), and (2) offset against recognized revenues, which were generated from those expenses, no matter when cash is paid out. In cash accounting—in contrast—expenses are recognized when cash is paid out.
  • FIFO: Method for for accounting for inventories. FIFO stands for first-in, first-out, and assumes that the oldest inventory items are recorded as sold first.
  • LIFO: Method for accounting for inventory. LIFO stands for last-in, first-out, and assumes that the most recently produced items are recorded as sold first.

Income statements are a key component to valuation but have several limitations: items that might be relevant but cannot be reliably measured are not reported (such as brand loyalty); some figures depend on accounting methods used (for example, use of FIFO or LIFO accounting); and some numbers depend on judgments and estimates. In addition to these limitations, there are limitations stemming from the intentional manipulation of finances.

One of the limitations of the income statement is that income is reported based on accounting rules and often does not reflect cash changing hands. This could be due to the matching principle, which is the accounting principle that requires expenses to be matched to revenues and reported at the same time. Expenses incurred to produce a product are not reported in the income statement until that product is sold. Another common difference across income statements is the method used to calculate inventory, either FIFO or LIFO.

Income statement: Accounting for inventory can be done in different ways, leading to differences in statements.

In addition to good faith differences in interpretations and reporting of financial data in income statements, these financial statements can be limited by intentional misrepresentation. One example of this is earnings management, which occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports in a way that usually involves the artificial increase (or decrease) of revenues, profits, or earnings per share figures.

The goal with earnings management is to influence views about the finances of the firm. Aggressive earnings management is a form of fraud and differs from reporting error. Managers could seek to manage earnings for a number of reasons. For example, if a manager earns his or her bonus based on revenue levels at the end of December, there is an incentive to try to represent more revenues in December so as to increase the size of the bonus.

While it is relatively easy for an auditor to detect error, part of the difficulty in determining whether an error was intentional or accidental lies in the accepted recognition that calculations are estimates. It is therefore possible for legitimate business practices to develop into unacceptable financial reporting.

Effects of GAAP on the Income Statement

GAAP’s assumptions, principles, and constraints can affect income statements through temporary (timing) and permanent differences.

Learning Objectives

Apply the four basic GAAP principles when preparing financial statements

Key Takeaways

Key Points

  • Items that create temporary differences due to the recording requirements of GAAP include rent or other revenue collected in advance, estimated expenses, and deferred tax liabilities and assets.
  • Also there are events, usually one-time events, which create “permanent differences,” such as GAAP recognizing as an expense an item that the IRS will not allow to be deducted.
  • The four basic principles of GAAP can affect items on the income statement. These principles include the historical cost principle, revenue recognition principle, matching principle, and full disclosure principle.

Key Terms

  • deferred: Of or pertaining to a value that is not realized until a future date, e.g. annuities, charges, taxes, income, either as an asset or liability.
  • fair market value: An estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. An estimate of fair market value may be founded either on precedent or extrapolation but is subjective. Fair market value differs from other ways of determining value, such as intrinsic and imposed value.

Although most of the information on a company’s income tax return comes from the income statement, there often is a difference between pretax income and taxable income. These differences are due to the recording requirements of GAAP for financial accounting (usually following the matching principle and allowing for accruals of revenue and expenses) and the requirements of the IRS’s tax regulations for tax accounting (which are more oriented to cash).

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Income statement: GAAP and IRS accounting can differ.

Such timing differences between financial accounting and tax accounting create temporary differences. For example, rent or other revenue collected in advance, estimated expenses, and deferred tax liabilities and assets may create timing differences. Also, there are events, usually one time, which create “permanent differences,” such as GAAP, which recognizes as an expense an item that the IRS will not allow to be deducted.

To achieve basic objectives and implement fundamental qualities, GAAP has four basic principles:

  • The historical cost principle: It requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities.
  • The revenue recognition principle. It requires companies to record when revenue is (1) realized or realizable and (2) earned, not when cash is received.
  • The matching principle. This governs the matching of expenses and revenues, where expenses are recognized, not when the work is performed or when a product is produced, but when the work or the product actually makes its contribution to revenue.
  • The full disclosure principle. This suggests that the amount and kinds of information disclosed should be decided based on a trade-off analysis, since a larger amount of information costs more to prepare and use. GAAP reporting also suggests that income statements should present financial figures that are objective, material, consistent, and conservative.


Source: Accounting