An income statement presents the results of a company's operations for a given reporting period. Along with the balance sheet, the statement of cash flows, and the statement of changes in owners' equity, the income statement is one of the primary means of financial reporting. It is prepared by accountants in accordance with accepted principles. The income statement presents the revenues and expenses incurred by an entity during a specific time period, culminating in a figure known as net income. A company's net income for an accounting period is measured as follows: Net income Revenues Expenses Gains Losses.
The income statement provides information concerning return on investment, risk, financial flexibility, and operating capabilities. Return on investment is a measure of a firm's overall performance. Risk is the uncertainty associated with the future of the enterprise. Financial flexibility is the firm's ability to adapt to problems and opportunities. Operating capability relates to the firm's ability to maintain a given level of operations.
The current view of the income statement is that income should reflect all items of profit and loss recognized during the accounting period, except for a few items that would be entered directly under retained earnings on the balance sheet, notably prior period adjustments (i.e., correction of errors). The main area of transaction that is not included in the income statement involves changes in the equity of owners.
TERMS ON THE INCOME STATEMENT
The Financial Accounting Standards Board provides broad definitions of revenues, expenses, gains, losses, and other terms that appear on the income statement in its Statement of Concepts No. 6. Revenues are inflows or other enhancements of assets of an entity or settlement of its liabilities (or both) during a period, based on production and delivery of goods, provisions of services, and other activities that constitute the entity's major operations. Examples of revenues are sales revenue, interest revenue, and rent revenue.
Expenses are outflows or other uses of assets or incurrence of liabilities (or both) during a period as a result of delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations. Examples are cost of goods sold, salaries expense, and interest expense.
Gains are increases in owners' equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and events affecting the entity during the accounting period, except those that result from revenues or investments by owners. Examples are a gain on the sale of a building and a gain on the early retirement of long-term debt.
Losses are decreases in owners' equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and events affecting the entity during the accounting period except those that result from expenses or distributions to owners. Examples are losses on the sale of investments and losses from litigations.
Discontinued operations are those operations of an enterprise that have been sold, abandoned, or otherwise disposed. The results of continuing operations must be reported separately in the income statement from discontinued operations, and any gain or loss from the disposal of a segment must be reported along with the operating results of the discontinued separate major line of business or class of customer. Results from discontinued operations are reported net of income taxes.
Extraordinary gains or losses are material events and transactions that are both unusual in nature and infrequent in occurrence. Both of these criteria must be met for an item to be classified as an extraordinary gain or loss. To be considered unusual in nature, the underlying event or transaction should possess a high degree of abnormality and be clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates. To be considered infrequent in occurrence, the underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates.
Extraordinary items could result if gains or losses were the direct result of any of the following events or circumstances: 1) a major casualty, such as an earthquake, 2) an expropriation of property by a foreign government, or 3) a prohibition under a new act or regulation. Extraordinary items are reported net of income taxes.
Gains and losses that are not extraordinary refer to material items which are unusual or infrequent, but not both. Such items must be disclosed separately and would be not be reported net of tax.
An accounting change refers to a change in accounting principle, accounting estimate, or reporting entity. Changes in accounting principles result when an accounting principle is adopted that is different from the one previously used. Changes in estimate involve revisions of estimates, such as the useful lives or residual value of depreciable assets, the loss for bad debts, and warranty costs. A change in reporting entity occurs when a company changes its composition from the prior period, as occurs when a new subsidiary is acquired.
Net income is the excess of all revenues and gains for a period over all expenses and losses of the period. Net loss is the excess of expenses and losses over revenues and gains for a period.
Generally accepted accounting principles require disclosing earnings per share amounts on the income statement of all public reporting entities. Earnings per share data provides a measure of the enterprise's management and past performance and enables users of financial statements to evaluate future prospects of the enterprise and assess dividend distributions to shareholders. Disclosure of earnings per share for effects of discontinued operations and extraordinary items is optional, but it is required for income from continuing operations, income before extraordinary items, cumulative effects of a change in accounting principles, and net income.
Primary earnings per share and fully diluted earnings per share may also be required. Primary earnings per share is a presentation based on the outstanding common shares and those securities that are in substance equivalent to common shares and have a diluting effect on earnings per share. Convertible bonds, convertible preferred stock, stock options, and warrants are examples of common stock equivalents. The fully diluted earnings per share presentation is a pro forma presentation that shows the dilution of earnings per share that would have occurred if all contingent issuances of common stock that would individually reduce earnings per share had taken place at the beginning of the period.
PRINCIPLES FOR RECOGNIZING REVENUES AND EXPENSES
The revenue recognition principle provides guidelines for reporting revenue in the income statement. The principle generally requires that revenue be recognized in the financial statements when: 1) realized or realizable, and 2) earned. Revenues are realized when products or other assets are exchanged for cash or claims to cash or when services are rendered. Revenues are realizable when assets received or held are readily convertible into cash or claims to cash. Revenues are considered earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. Recognition through sales or the providing (performance) of services provides a uniform and reasonable test of realization. Limited exceptions to the basic revenue principle include recognizing revenue during production (on long-term construction contracts), at the completion of production (for many commodities), and subsequent to the sale at the time of cash collection (on installment sales).
In recognizing expenses, accountants rely on the matching principle because it requires that efforts (expenses) be matched with accomplishments (revenues) whenever it is reasonable and practical to do so. For example, matching (associating) cost of goods sold with revenues from the interrelated sales that resulted directly and jointly from the same transaction as the expense is reasonable and practical. To recognize costs for which it is difficult to adopt some association with revenues, accountants use a rational and systematic allocation policy that assigns expenses to the periods during which the related assets are expected to provide benefits, such as depreciation, amortization, and insurance. Some costs are charged to the current period as expenses (or losses) merely because no future benefit is anticipated, no connection with revenue is apparent, or no allocation is rational and systematic under the circumstances, i.e., an immediate recognition principle.
The current operating concept of income would include only those value changes and events that are controllable by management and that are incurred in the current period from ordinary, normal, and recurring operations. Any unusual and nonrecurring items of income or loss would be recognized directly in the statement of retained earnings. Under this concept, investors are primarily interested in continuing income from operations.
The all-inclusive concept of income includes the total changes in equity recognized during a specific period, except for dividend distributions and capital transactions. Under this concept, unusual and nonrecurring income or loss items are part of the earning history of a company and should not be overlooked. Currently, the all-inclusive concept is generally recognized; however, certain material prior period adjustments should be reflected adjustments of the opening retained earnings balance.
FORMATS OF THE INCOME STATEMENT
The income statement can be prepared using either the single-step or the multiple-step format. The single-step format lists and totals all revenue and gain items at the beginning of the statement. All expense and loss items are then fixed and the total is deducted from the total revenue to give the net income. The multiple-step income statement presents operating revenue at the beginning of the statement and nonoperating gains, expenses, and losses near the end of the statement. However, various items of expenses are deducted throughout the statement at intermediate levels. The statement is arranged to show explicitly several important amounts, such as gross margin on sales, operating income, income before taxes, and net income. Extraordinary items, gains and losses, accounting changes, and discontinued operations are always shown separately at the bottom of the income statement ahead of net income, regardless of which format is used.
Each format of the income statement has its advantages. The advantage of the multiple-step income statement is that it explicitly displays important financial and managerial information that the user would have to calculate from a single-step income statement. The single-step format has the advantage of being relatively simple to prepare and to understand.