Topic 4- The Income Statement PDF

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Review of Key Points 1.

Net income is typically viewed as the fundamental measure of a company’s profitability, but there are also a variety of other measures of “income.” The best measure of sustainable profitability is income from continuing operations. Five key measures of income are as follows: o

Gross profit: the difference between the selling price of a product and the cost of the product.

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Operating income: gross profit minus all other expenses except for interest and taxes. Operating income measures the performance of the fundamental business operations conducted by a company.

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Income from continuing operations: operating income minus interest expense, minus income tax expense, and plus or minus other miscellaneous revenue and expense items, and gains and losses from peripheral transactions and events. Income from continuing operations is the best baseline from which to forecast a company’s income for the following year.

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Net income: income from continuing operations plus or minus the results of discontinued operations and extraordinary items, net of their respective income tax effects. Net income includes all revenues, expenses, gains, and losses.

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Comprehensive income: net income plus or minus adjustments for changes in company wealth stemming from changes in certain exchange rates, interest rates, or financial instruments’ values.

2.

The primary categories of income statement items are revenues, expenses, gains, and losses. Income statement items that do not relate to a company’s continuing operations are income from discontinued operations and extraordinary items. Some of the types of activities through which a company can generate revenue are: selling of goods, providing of services, and earning of interest through loaning money to others. The key expense items are cost of goods sold; selling, general, and administrative expense; depreciation expense; interest expense; and income tax expense. Gains and losses arise from activities that are peripheral to a company’s main operations. Income from

discontinued operations and extraordinary items are collectively referred to as the below-the-line items. Earnings per share (EPS) is the amount of net income associated with each share of stock. In addition to basic EPS, computation of diluted EPS adds information about the potential impact on EPS of the exercise of stock options and other rights to acquire shares. 3.

Income statements are prepared in a variety of formats. One useful format is the multiple-step income statement. A single-step income statement merely groups all of the revenues and all of the expenses, and reports the overall difference as net income. A multiple-step income statement emphasizes the presentation of gross profit and operating income.

4.

Revenue should be recognized when value has been delivered to customers which is typically only after the required work has been performed and after the collection of cash is reasonably assured. The matching concept has traditionally been used to decide when to recognize expenses. In order for revenue to be recognized, the promised work must be done and cash collection must be reasonably assured. A useful concept in recognizing expenses is that of matching, which states that an expense should be recognized in the same period in which the revenue it was used to generate is recognized. When direct matching is not possible, expenses are recognized using either systematic allocation or immediate expensing.

5.

Individual transactions impacting income can be analyzed using the expanded accounting equation which is: Assets = Liabilities + Paid-in Capital + (Revenues − Expenses − Dividends) The insight behind the expanded accounting equation is that equity can be decomposed into paid-in capital and retained earnings and that revenues, expenses, and dividends are just temporary subcategories of retained earnings. Revenues increase equity; and expenses and dividends represent a reduction in equity.

6.

An important use of an income statement is to forecast income in future periods. Good forecasting requires an understanding of what underlying factors determine the level of a revenue or an expense. Most financial statement forecasting exercises start with a forecast of sales, which establishes the expected scale of operations in future periods.

Some balance sheet items increase naturally as the level of sales increases; examples of such accounts are cash, accounts receivable, inventory, and accounts payable. Other balance sheet items, such as property, plant, and equipment, change in response to a company’s longterm strategic plans. Finally, the amounts of the balance sheet items associated with financing, such as long-term debt and paid-in capital, are determined by the financing decisions made by a company’s management. Some income statement items, such as cost of goods sold, maintain a constant relationship with sales. Depreciation expense is more likely to be related to the amount of a company’s property, plant, and equipment. Interest expense is tied to the balance in interest-bearing debt. Finally, income tax expense is typically a relatively constant percentage of income before taxes....