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Financial Statements, Taxes, and Cash Flow > The Income Statement
The Income Statement
• Elements of the Income Statement
• Limitations of the Income Statement
• Effects of GAAP on the Income Statement
• Noncash Items
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Financial Statements, Taxes, and Cash Flow > The Income Statement
Elements of the Income Statement
• 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
A Sample Income Statement
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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.
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Financial Statements, Taxes, and Cash Flow > The Income Statement
Limitations of the Income Statement
• 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.
Income statement
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Financial Statements, Taxes, and Cash Flow > The Income Statement
Effects of GAAP on the Income Statement
• 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.
Income statement
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Financial Statements, Taxes, and Cash Flow > The Income Statement
Noncash Items
• 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.
Machinery
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Appendix
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Financial Statements, Taxes, and Cash Flow
Key terms
• amortization The distribution of the cost of an intangible asset, such as an intellectual property right, over the projected useful
life of the asset.
• 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.
• 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.
• 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.
• 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.
• gross profit The difference between net sales and the cost of goods sold.
• income bond a debt instrument where coupon payments are only made if the issuer can afford it
• 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
• 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.
• 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.
• net income Gross profit minus operating expenses and taxes.
• obsolescence The state of being obsolete—no longer in use; gone into disuse; disused or neglected.
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Financial Statements, Taxes, and Cash Flow
• 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
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Financial Statements, Taxes, and Cash Flow
Machinery
Machinery is an example of a noncash asset.
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Financial Statements, Taxes, and Cash Flow
A Sample Income Statement
Expenses are listed on a company's income statement.
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Financial Statements, Taxes, and Cash Flow
Income statement
GAAP and IRS accounting can differ.
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Financial Statements, Taxes, and Cash Flow
Income statement
Accounting for inventory can be done in different ways, leading to differences in statements.
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Financial Statements, Taxes, and Cash Flow
Which of the following is NOT a step in constructing a multi-step
income statement?
A) Add all revenues, then subtract all expenses.
B) Subtract operating expenses from gross profit to determine income
from operations.
C) Subtract non-operating expenses from income from operations.
D) Subtract income tax expense from income before taxes.
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Financial Statements, Taxes, and Cash Flow
Which of the following is NOT a step in constructing a multi-step
income statement?
A) Add all revenues, then subtract all expenses.
B) Subtract operating expenses from gross profit to determine income
from operations.
C) Subtract non-operating expenses from income from operations.
D) Subtract income tax expense from income before taxes.
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Financial Statements, Taxes, and Cash Flow
Which of the following is a non-operating expense?
A) Depreciation and Amortization
B) Research & Development expenses
C) Selling, General and Administrative Expenses
D) Interest expense
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Financial Statements, Taxes, and Cash Flow
Which of the following is a non-operating expense?
A) Depreciation and Amortization
B) Research & Development expenses
C) Selling, General and Administrative Expenses
D) Interest expense
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Financial Statements, Taxes, and Cash Flow
Which of the following is a limitation associated with income
statements?
A) Items that might be relevant to a company's value cannot be reliably
measured and are not reported.
B) Some figures are based on differing accounting methods.
C) All of these answers
D) Some values are based on judgments and estimates.
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Financial Statements, Taxes, and Cash Flow
Which of the following is a limitation associated with income
statements?
A) Items that might be relevant to a company's value cannot be reliably
measured and are not reported.
B) Some figures are based on differing accounting methods.
C) All of these answers
D) Some values are based on judgments and estimates.
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Financial Statements, Taxes, and Cash Flow
Which of the following is NOT one of the four basic GAAP
principles?
A) Assets and liabilities should be reported based on acquisition cost.
B) Revenue should be recorded when realized or realizable and when
cash is received.
C) Deciding which information to disclose should be based on a trade-off
analysis.
D) Expenses should be recognized when the product it is associated with
generates recognized revenue.
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Financial Statements, Taxes, and Cash Flow
Which of the following is NOT one of the four basic GAAP
principles?
A) Assets and liabilities should be reported based on acquisition cost.
B) Revenue should be recorded when realized or realizable and when
cash is received.
C) Deciding which information to disclose should be based on a trade-off
analysis.
D) Expenses should be recognized when the product it is associated with
generates recognized revenue.
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Financial Statements, Taxes, and Cash Flow
Which of the following best summarizes why there may be a
difference between a company's pretax income and taxable
income?
A) The tax code requires full disclosure, GAAP does not.
B) Pretax income is based on revenue recognition; taxable income is
based on the company's cashflow.
C) GAAP requires that companies use historical costs, while the tax code
does not.
D) All of these answers
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Financial Statements, Taxes, and Cash Flow
Which of the following best summarizes why there may be a
difference between a company's pretax income and taxable
income?
A) The tax code requires full disclosure, GAAP does not.
B) Pretax income is based on revenue recognition; taxable income is
based on the company's cashflow.
C) GAAP requires that companies use historical costs, while the tax code
does not.
D) All of these answers
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Financial Statements, Taxes, and Cash Flow
Which of the following is a noncash item that would be included
on the income statement?
A) Depreciation and Amortization
B) Unrealized losses from investments
C) All of these answers.
D) Write down of inventory.
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Financial Statements, Taxes, and Cash Flow
Which of the following is a noncash item that would be included
on the income statement?
A) Depreciation and Amortization
B) Unrealized losses from investments
C) All of these answers.
D) Write down of inventory.
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Financial Statements, Taxes, and Cash Flow
Attribution
• Wiktionary. "deferred." CC BY-SA 3.0 http://en.wiktionary.org/wiki/deferred
• Wiktionary. "fair market value." CC BY-SA 3.0 http://en.wiktionary.org/wiki/fair+market+value
• Wikibooks. "Accountancy/Non-current assets." CC BY-SA 3.0 http://en.wikibooks.org/wiki/Accountancy/Non-current_assets
• Wikipedia. "Asset." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Asset
• Wikipedia. "Fixed asset." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Fixed_asset
• Wikipedia. "Intangible asset." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Intangible_asset
• Wikibooks. "Intermediate Accounting/Preparation of Financial Statements." CC BY-SA 3.0
http://en.wikibooks.org/wiki/Intermediate_Accounting/Preparation_of_Financial_Statements
• Wikipedia. "Income statement." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Income_statement
• Wikipedia. "Amortization." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Amortization
• Wikipedia. "Depreciation." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Depreciation
• Wiktionary. "obsolescence." CC BY-SA 3.0 http://en.wiktionary.org/wiki/obsolescence
• Wiktionary. "amortization." CC BY-SA 3.0 http://en.wiktionary.org/wiki/amortization
• Wiktionary. "depreciation." CC BY-SA 3.0 http://en.wiktionary.org/wiki/depreciation
• Wikibooks. "Getting Started as an Entrepreneur/Plan/Measuring Your Success." CC BY-SA 3.0
http://en.wikibooks.org/wiki/Getting_Started_as_an_Entrepreneur/Plan/Measuring_Your_Success
• Wikipedia. "Creative accounting." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Creative_accounting
• Wikipedia. "Valuation (finance)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Valuation_%2528finance%2529
• Wikipedia. "Matching principle." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Matching_principle
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Financial Statements, Taxes, and Cash Flow
• Wikipedia. "Depreciation." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Depreciation
• Wikipedia. "Income statement." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Income_statement
• Wikipedia. "LIFO." CC BY-SA 3.0 http://en.wikipedia.org/wiki/LIFO
• Wikipedia. "FIFO." CC BY-SA 3.0 http://en.wikipedia.org/wiki/FIFO
• Boundless Learning. "Boundless." CC BY-SA 3.0 http://www.boundless.com//finance/definition/matching-principle
• Wikipedia. "FIFO and LIFO accounting." CC BY-SA 3.0 http://en.wikipedia.org/wiki/FIFO_and_LIFO_accounting
• Wikibooks. "Intermediate Accounting/Preparation of Financial Statements." CC BY-SA 3.0
http://en.wikibooks.org/wiki/Intermediate_Accounting/Preparation_of_Financial_Statements
• Wikipedia. "Income statement." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Income_statement
• Boundless Learning. "Boundless." CC BY-SA 3.0 http://www.boundless.com//finance/definition/income-bond
• Wikipedia. "Statement of cash flows." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Statement_of_cash_flows
• Wiktionary. "income statement." CC BY-SA 3.0 http://en.wiktionary.org/wiki/income+statement
• Wiktionary. "gross profit." CC BY-SA 3.0 http://en.wiktionary.org/wiki/gross+profit
• Wiktionary. "net income." CC BY-SA 3.0 http://en.wiktionary.org/wiki/net+income
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