Income Statements

The following are my notes about income statements as part of the financial statements series I am currently studying. After compiling these notes I thought I'd share them with anyone interested in learning more about income statements, how they are properly formatted, accounted, and finally turned into the useful profit and loss statements commonly used by managers, investors, and creditors.

 
Definition: An income statement, also called a Profit and Loss statement (P&L) indicates how Revenue (earnings received from the sale before expenses are taken out) is transformed into Net income (the result after all revenues and expenses have been accounted for).
 
The purpose of a P&L statement is to show if a company earned a net income or loss for the period being reported. This is useful information for managers and investors. The income statement represents a period of time, for example: a calendar or fiscal year.



The income statement contrasts with the balance sheet, which represents a single moment in time.

Basic formats of an income statement:


There are two basic formats for the income statement, the multi-step and the single-step.


Multi-Step format

• Net Sales
  
• Cost of Sales
  
• Gross Income
  
• Selling, General & Administrative Expenses
  
• Operating Income
  
• Other Income & Expenses
  
• Pretax Income
  
• Taxes
  
• Net Income

Single-Step format

• Net Sales
  
• Materials & Production
  
• Marketing & Administrative
  
• Research & Development (R&D) expenses
  
• Other Income & Expenses
  
• Pretax Income
  
• Taxes
  
• Net Income 

In the Multi-Step income statement, four measures of profitability are revealed at four critical junctions in a company's operations:

• Gross Income
  
• Operating Income
  
• Pretax Income
  
• Net Income 

In the Single-Step presentation, the gross and operating income figures are not stated, but can be calculated from the data provided.



In the Single-Step method, sales minus materials and production equal Gross income. By subtracting marketing, administrative costs and R&D expenses from Gross income, you get the operating income figure.
 
NOTE: The income statement recognizes revenues when they are realized (goods shipped, services rendered, expenses incurred).



With "accrual accounting", the flow of accounting events does not coincide with the actual receipt and disbursement of cash.
 
The income statement measures profitability, not cash flow.
 
Basic components of an income statement:
 
The following is for the Multi-Step format.

• 
  
  
  
  Net Sales (A.K.A. Sales or Revenues): Refers to the value of a company's sales to its customers.
  • Cost of Sales (A.K.A. cost of goods/products sold (COGS)):
    For a manufacturer, cost of sales are the expenses incurred for raw materials, labor, and manufacturing overhead, used in production of the goods. It may also be stated separately, but depreciation expense belongs in the cost of sales.
    
  • For wholesalers and retailers, cost of sales equals to the purchase cost of merchandise used for retail/resale.
    
  • For service-based businesses, cost of sales equals the cost of services rendered or cost of revenues.
    
• Gross Profit (A.K.A. gross income/gross margin): gross profit doesn't just represent the difference between net sales and cost of sales. It provides the resources to cover all of the company's expenses. The greater and more stable a company's gross profit margin, the greater potential there is for a positive bottom line (net income) results.
  
• Selling, General and Administrative Expenses (SG&A): comprises a company's operational expenses. Management exercises a great deal of control over this expense category. The trend of SG&A expenses, as a percentage of sales, watched closely to detect signs, both positive and negative.
  
• Operating Income: deducting SG&A from gross profit produces operating income. This figure represents a company's earnings from its normal operations before any so-called non-operating income and/or costs such as interest expenses, taxes, and special items. Income at the operating level is often viewed as more reliable, is often used by financial analysts rather than net income as a measure of profitability.
  
• Interest Expense: reflects the cost of a company's borrowings. Sometimes companies record a net figure here for interest expense and interest income from invested funds.
  
• Pretax Income: This is another carefully watched indicator of profitability, earnings garnered before the income tax expense as an important step in the income statement.
  There are numerous and diverse techniques available to companies to avoid and/or minimize taxes that affect their reported income. Because these actions are not part of a company's business operations, analysts may choose to use pretax income as a more accurate measure of corporate profitability.
  
• Income Taxes: this amount has not actually been paid. It is an estimate, or an account that has been created to cover what a company expects to pay.
  
• Special Items or Extraordinary Expenses: commonly identified as restructuring charges, unusual, or non-recurring items and discontinued operations. These write-offs are supposed to be one-time events. Investors need to take these special items, which can distort financial analysts, into account when making inter-annual profit comparisons.
  
• Net Income/Net Loss (A.K.A. net profit or net earnings): This is the bottom line, which is the most commonly used indicator of a company's profitability. If expenses exceed income, this would be called Net Loss. After payment of preferred-dividends, if any, net income becomes part of a company's equity position as retained earnings. Supplemental data is also presented for net income on the basis of shares outstanding (basic) and the potential conversion of stock options, warrants, etc. (diluted).
  
• Comprehensive Income: a relatively new concept (1998) takes into consideration such items as foreign currency translations adjustments, minimum pension liability adjustments, and unrealized gains/losses on certain investments in debt and equity. All of these items relate to volatile market and/or economic events that are out of the control of a company's management. Their impact is real when they occur, but they tend to even out over an extended period of time. 

Limitations of the income statements to users
 
Income statements should help investors and creditors determine the past performance of the enterprise, predict future performance, and assess the capability of generating future cash flows. However, there are several limitations:

• The items that might be relevant but cannot be reliably measured are not reported (brand recognition and loyalty)
  
• Some numbers depend on accounting methods used (using FIFO or LIFO accounting to measure inventory levels).
  
• Some numbers depend on judgments and estimates (depreciation expense depends on estimated useful life & salvage value). 

What are earnings per share?
 
The income statement reports earnings per share (EPS) numbers on the face of the income statement. At least one, and potentially two, EPS figures are reported: Basic and Diluted.

• Basic EPS: computed as (Net Income minus Dividends on preferred stock) divided by the weighted average number of common shares outstanding during the year. The subtraction of preferred stock dividends yields the income available for dividend payments to common shareholders.
  
• Diluted EPS: reflects the additional shares that would be issued if all stock options, warrants, and convertible securities had been converted into common shares at the beginning of the year. Diluted EPS never exceeds basic EPS.