The Income Statement
Chapter 4
Introduction
• Four major types of items appear on
income statements.
–
–
–
–
Revenues
Expenses
Gains
Losses
Revenues
• Revenues are inflows of assets (or
reductions in liabilities) from
providing goods and services to
customers.
• Revenues arise from the firm's
ongoing, central operations.
Expenses
• Expenses arise from consuming
resources in order to generate
revenue.
• As is true for revenues, expenses arise
from the firm's ongoing, central
operations.
Gains
• Gains increase assets or decrease
liabilities.
– A gain differs from a revenue in that
gains arise from peripheral transactions
of the business.
Gains
• Gains increase assets or decrease
liabilities.
– A paper company earns revenues by
selling paper.
Gains
• Gains increase assets or decrease
liabilities.
– If it sells extra equipment from the
employee lounge for more than the
equipment's carrying value, then it will
have a gain, not revenue.
Losses
• Losses decrease assets or increase
liabilities.
– A loss differs from an expense, however,
in that losses arise from peripheral
transactions of the business.
Losses
• Losses decrease assets or increase
liabilities.
– Returning to the above example—if the
paper company sells that extra
equipment for less than its carrying
value, then it will have a loss, not an
expense.
The Materiality Principle
• The materiality principle states that
separate disclosure on a financial
statement is not required if an item is
so small that knowledge of it would
not affect the decision of a reasonable
financial statement reader.
Net Sales
• Net sales is the difference between
gross sales and certain items, such as
sales returns.
Gross Margin
• Gross margin is the difference
between net sales and cost of goods
sold.
Selling Expenses
• Selling expenses include any expenses
necessary for the sale of goods, such as
advertising and commissions.
Administrative Expenses
• Administrative expenses include
expenses related to the administration
of the business, such as management
salaries and legal and accounting fees.
Operating Income
• Operating income is the difference
between gross margin and selling and
administrative expenses.
Operating Income
• When interest and income tax expense
are deducted from operating income,
the result is net income.
Remember the following
important difference:
• Revenue refers to the total inflow of
assets or reduction in liabilities.
• Profit is the net increase in a firm's
recorded wealth after deducting
expenses.
Presenting the Income
Statement
• Income statements may be presented
in several different formats.
– The multiple-step income statement
shows various relationships.
– The single-step format adds up all
revenues and all expenses and does a
single step, a subtraction, with the totals.
Multi-Step Income Statement
Net Sales
Cost of sales
Gross profit
Selling, general and administrative
expenses
Income from operations
Other income
Interest expense
Income before provision for income taxes
Provision for income taxes
Net income
$ 172,428
134,373
38,055
14,844
23,211
1,503
31
24,683
10,016
$ 14,667
Single Step Income Statement
Revenues
Net sales
$172,428
Other income
1,503
Expenses
Cost of goods sold
$134,373
Selling, general and administrative
expenses
14,844
Interest expense
31
Provision for income taxes
10,016
Total expenses
159,264
Net income
$ 14,667
Uses of the Income
Statement
• A major purpose of the income
statement is to show a firm's
profitability.
• Investors, lenders, and company
management all use income statement
information for their assorted
purposes.
Revenue Recognition
• A firm’s earning process often takes
place over an extended period of time.
Revenue Recognition
Principle
• One of the generally accepted
accounting principles is the revenue
recognition principle.
Revenue Recognition
Principle
• The revenue recognition principle
states that revenue should be
recognized in the accounting records
when the earnings process is
substantially complete and the
amount to be collected is reasonably
determinable.
Revenue Recognition
Principle
• In most cases, revenue is recognized at
the point of sale.
Revenue Recognition
Principle
• Revenue is earned, and thus recorded,
whether or not cash is received.
Revenue Recognition
Principle
• Payment for a good or service may be
in the form of cash or an account
receivable.
Exceptions to the Revenue
Recognition Principle
• There are several exceptions to the
revenue recognition principle.
Exceptions to the Revenue
Recognition Principle
• If a seller is highly uncertain about the
collectibility of receivables, then he
should not recognize revenue until he
receives cash.
Exceptions to the Revenue
Recognition Principle
• With respect to long-term construction
contracts, a contractor may use the
percentage-of-completion method to
record revenues and profits
periodically.
Exceptions to the Revenue
Recognition Principle
• Another exception is certain service
contracts.
Revenue Recognition
• A company ought to disclose its
revenue recognition policies in the
notes to the financial statements.
Expense Recognition
• The matching principle drives expense
recognition.
Matching Principle
• It states that costs incurred to generate
revenue appearing on the income
statement in a given period should
appear on the income statement in
that same period.
Matching Principle
• The matching principle is
implemented in one of three ways.
Matching Principle
• First is associating cause and effect,
which implies that there is a clear and
direct relationship between an
expense and a revenue.
Matching Principle
• Second is systematic and rational
allocation, which is used when a cost
cannot be directly linked to specific
revenue transactions—the cost is
simply allocated over time.
Matching Principle
• Third is immediate recognition, used
when costs have no discernible future
benefit and thus are expensed
immediately.
A Closer Look at the Income
Statement
• Income statements summarize past
transactions and events.
• But many financial statement users are
concerned about the future, about
earnings sustainability.
A Closer Look at the Income
Statement
• GAAP requires that income
statements report certain items
separately from ongoing operations.
– Examples include discontinued
operations and extraordinary items.
Discontinued Operations
• Discontinued operations occur when a
firm ceases, or plans to cease,
operating, a major segment of its
business.
Discontinued Operations
• There are two line items.
– The results of operating the segment.
– The loss realized on the disposal.
– These items are shown net of income tax.
Discontinued Operations
• Since there is presumably a loss on
discontinued operations, the tax effect
is a tax benefit because losses lower
the taxes a firm must pay.
Discontinued Operations
• To make predictions about future
earnings, most analysts will add back
the losses to reported net earnings to
obtain adjusted net earnings because
the discontinued operations results
will not recur in the future.
Extraordinary Items
• Extraordinary items are events and
transactions that are unusual in nature
and infrequent in occurrence.
– Evaluating both of those characteristics
requires great judgment on the part of the
accountant who decides whether or not
an item is extraordinary.
Extraordinary Items
• These items, such as natural disasters
and a foreign government's
expropriation of a firm's assets, are
also shown net of income tax.
Extraordinary Items
• An extraordinary item may be either a
gain or a loss.
Earnings Per Share
• Earnings per share must be disclosed
on the face of the income statement.
Earnings Per Share
• Earnings per share is computed by
dividing net income by the average
number of shares of stock
outstanding.
Net income
EPS =
Shares outstanding
Earnings Per Share
• Earnings per share is computed by
dividing net income by the average
number of shares of stock
outstanding.
– If net income is $100,000, and there are
200,000 shares of stock outstanding, then
earnings per share is $ .50
($100,000/200,000).
Analyzing the Income
Statement
• The income statement contains a
number of measures related to a firm’s
ability to generate earnings.
• This helps analysts assess a firm’s
expected return.
Vertical Analysis
• Vertical analysis examines
relationships within a given year.
– This is accomplished by dividing each
line of the income statement by the first
item, which is net sales.
– This yields common-size income
statements in percentage terms.
Common-Size Income
Statements
• The top line will always be 100%
because net sales divided by itself
yields 100%.
Common-Size Income
Statements
• The second line—cost of products sold
divided by net sales—is referred to as
the cost of goods sold percentage.
Common-Size Income
Statements
• The third line—gross profit (or gross
margin) percentage—is calculated by
dividing gross profit by net sales or by
subtracting the cost of goods sold
percentage from 100%.
Common-Size Income
Statements
• The fourth line reflects the
relationship between selling, general,
and administrative expences.
Common-Size Income
Statements
• The operating income percentage is a
measure of management's success in
operating the firm.
Common-Size Income
Statements
• The net income percentage is a
measure of the firm's overall
profitability.
Common-Size Income
Statements
• A lower cost of goods sold percentage
and a higher gross profit percentage
are desirable.
Income Statements
Year Ended December 31,
1997
1996
Net Sales
Cost of products sold
Gross profit
Selling, general, & administrative expenses
Special charges and plant closings
Royalty income, net
Operating income (loss)
Interest expense
Other income
Income (loss) before taxes
Income taxes (benefit)
Net income
$395,196
250,815
144,381
115,439
$444,766
300,495
144,271
122,055
32,900
(7,945)
(6,100)
36,887
(4,584)
(305)
(1,088)
1,605
1,575
38,187
(4,097)
15,629
(5,216)
$ 22,558 $ 1,119
Common-Size Income Statements
Year Ended December 31,
1997
1996
Net Sales
Cost of products sold
Gross profit
Selling, general, & administrative expenses
Special charges and plant closings
Royalty income, net
Operating income (loss)
Interest expense
Other income
Income (loss) before taxes
Income taxes (benefit)
Net income
100.0%
63.5
36.5
29.2
(2.0)
9.3
(0.1)
0.5
9.7
4.0
5.7%
100.0%
67.6
32.4
27.4
7.4
(1.4)
(1.0)
(0.2)
0.3
(0.9)
(1.2)
0.3%
Trend Analysis
• Trend analysis involves comparing
financial statement numbers over a
period of time.
• One way to accomplish this is to
compare the common-size income
statement items over a period of time.
Horizontal Analysis
• Another form of trend analysis is
horizontal analysis.
Horizontal Analysis
• Horizontal analysis uses the figures
from a prior year's income statement
as the base year for calculating
percentage increases over a period of
time.
Horizontal Analysis
• Assume that net income for 1996 is
$100,000 and for 1997 is $110,000.
• Net income has thus increased by
$10,000.
– Dividing the $10,000 increase by the 1996
base year net income number of $100,000
shows that net income has increased by
10% from one year to the next.
The Return on
Shareholders' Equity Ratio
• The return on shareholders' equity
(ROE) ratio is computed by dividing
net income by average shareholders'
equity.
Net income
ROE =
Average shareholders' equity
The Return on
Shareholders' Equity Ratio
• Average shareholders' equity is
computed by adding the beginning-ofthe-year and the end-of-the-year
shareholders' equity balances and then
dividing the total by 2.
Return on Assets Ratio
• The return on assets (ROA) ratio
relates a firm's earnings to all assets
the firm has available to generate
those earnings.
Return on Assets Ratio
• It is computed by dividing average
total assets into the sum of net income
and interest expense (net of income
tax).
ROA =
Net income + Interest expense  (1 - tax rate)
Average total assets
Times Interest Earned
• The times interest earned ratio shows
how many times interest expense is
covered by resources generated from
operations and is very important to
creditors of a business.
Times Interest Earned
• It is computed by dividing earnings
before interest and taxes by interest
expense.
Times interest expense =
Earnings before interest and taxes
Interest expense
Times Interest Earned
• A creditor would certainly prefer a
high number instead of a low number
for this ratio.
Limitations of Accounting
Income
• For some assets, an increase in value is
recognized only at the disposal of the
asset.
• Financial statements often do not
reflect accomplishments of a firm, as
in the case of an executory contract.
Limitations of Accounting
Income
• The conservatism principle, one of the
generally accepted accounting
principles, also may limit the extent to
which accounting income reflects
changes in wealth.
Limitations of Accounting
Income
• The conservatism principle states that
when given a choice between or
among acceptable alternatives for
treatment for a transaction, the
accountant should choose the
alternative which least overstates
assets and income.
Accounting Income and
Economic Consequences
• Reported earnings have an affect on
managers' wealth and consequently,
on their accounting policy decisions.
– Bonuses can motivate a company's
managers to make accounting-related
decisions that do not affect the
underlying profitability of the company
but that do affect reported accounting
income.
Accounting Income and
Economic Consequences
• Reported earnings have an affect on
managers' wealth and consequently,
on their accounting policy decisions.
– Because managers' self-interests influence
their accounting policy judgments,
financial statements may not be an
unbiased reflection of the underlying
economic activities of a firm.
The Income Statement
End of Chapter 4