Income Statement

Introduction to Income Statement
Types of accounts used to prepare the Income Statement
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Introduction to Income Statement

Income StatementThe Income Statement is a formal financial statement that summarizes a company's operations (revenues and expenses) for a specific period of time usually a month or year.

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.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.

A fiscal year is the period used for calculating annual (yearly) financial statements. While a large number of businesses use the calendar year as their fiscal year, a business can elect to use any other twelve month period such as June-May as their fiscal year.

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.

Usefulness and limitations of income statement

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.

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 depend on 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).

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Types of accounts used to prepare the Income Statement

The following types of accounts are used to prepare the Income Statement.

Operating section

  • Revenue - Cash inflows or other enhancements of assets of an entity during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major operations. It is usually presented as sales minus sales discounts, returns, and allowances.Every time a business sells a product or performs a service, it obtains revenue. This often is referred to as gross revenue or sales revenue.
  • Expenses - Cash outflows or other using-up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major operations.
    • Cost of Goods Sold (COGS) / Cost of Sales - represents the direct costs attributable to goods produced and sold by a business (manufacturing or merchandizing). It includes material costs, direct labour, and overhead costs (as in absorption costing), and excludes operating costs (period costs) such as selling, administrative, advertising or R&D, etc.
    • Selling, General and Administrative expenses (SG&A or SGA) - consist of the combined payroll costs. SGA is usually understood as a major portion of non-production related costs, in contrast to production costs such as direct labour.
      • Selling expenses - represent expenses needed to sell products (e.g. salaries of sales people, commissions and travel expenses, advertising, freight, shipping, depreciation of sales store buildings and equipment, etc.).
      • General and Administrative (G&A) expenses - represent expenses to manage the business (salaries of officers / executives, legal and professional fees, utilities, insurance, depreciation of office building and equipment, office rents, office supplies, etc.).
    • Depreciation / Amortization - the charge with respect to fixed assets / intangible assets that have been capitalised on the balance sheet for a specific (accounting) period. It is a systematic and rational allocation of cost rather than the recognition of market value decrement.
    • Research & Development (R&D) expenses - represent expenses included in research and development.

Expenses recognised in the income statement should be analysed either by nature (raw materials, transport costs, staffing costs, depreciation, employee benefit etc.) or by function (cost of sales, selling, administrative, etc.). If an entity categorises by function, then additional information on the nature of expenses, at least, depreciation, amortisation and employee benefits expense must be disclosed. The major exclusive of costs of goods sold, are classified as operating expenses. These represent the resources expended, except for inventory purchases, in generating the revenue for the period. Expenses often are divided into two broad sub classicifications selling expenses and administrative expenses.

Non-operating section

  • Other revenues or gains - revenues and gains from other than primary business activities (e.g. rent, income from patents). It also includes unusual gains that are either unusual or infrequent, but not both (e.g. gain from sale of securities or gain from disposal of fixed assets)
  • Other expenses or losses - expenses or losses not related to primary business operations, (e.g. foreign exchange loss).
  • Finance costs - costs of borrowing from various creditors (e.g. interest expenses , bank charges).
  • Income tax expense - sum of the amount of tax payable to tax authorities in the current reporting period (current tax liabilities/ tax payable) and the amount of deferred tax liabilities (or assets).

Irregular items

They are reported separately because this way users can better predict future cash flows - irregular items most likely will not recur. These are reported net of taxes.

  • Discontinued operations is the most common type of irregular items. Shifting business location(s), stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations. Discontinued operations must be shown separately.

Cumulative effect of changes in accounting policies (principles) is the difference between the book value of the affected assets (or liabilities) under the old policy (principle) and what the book value would have been if the new principle had been applied in the prior periods. For example, valuation of inventories using LIFO instead of weighted average method. The 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.

However, changes in estimates (e.g. estimated useful life of a fixed asset) only requires prospective changes.

Disclosures

Certain items must be disclosed separately in the notes (or the statement of comprehensive income), if material, including:

  • Write-downs of inventories to net realisable value or of property, plant and equipment to recoverable amount, as well as reversals of such write-downs
  • Restructurings of the activities of an entity and reversals of any provisions for the costs of restructuring
  • Disposals of items of property, plant and equipment
  • Disposals of investments
  • Discontinued operations
  • Litigation settlements
  • Other reversals of provisions

Earnings per share

Because of its importance, earnings per share(EPS) are required to be disclosed on the face of the income statement. A company which reports any of the irregular items must also report EPS for these items either in the statement or in the notes.


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