Section 1.) Introduction to the Income Statement
The purpose of the income statement (sometimes referred to as the statement of operations, or informally as the profit/loss statement) is to report revenues and expenses that have occurred in a period of time, such as a year. The goal is to arrive at a final net income, showing the ultimate profitability of the company throughout the year. This allows users to compare one year’s profit to another. If the revenues exceed the expenses, then the company will have net income for the year. If the expenses exceed the revenues, then the company will have a net loss (i.e., negative net income) throughout the year.
The income statement records the revenues when they are earned and the expenses when they are incurred. This differs from the statement of cash flows that we will discuss next week. In that statement, everything is based on when the actual cash transaction takes place.
Revenue is something that is recorded over a period of time, whether it be a month, quarter, or year. It is one way of measuring the company’s performance over time.
Before being counted as revenues, they have to be realized/realizable and earned.
· The “Realization” criteria means that the transaction has taken place and there is cash or an expectation of future cash transaction. Important: This does not have to mean that cash has changed hands; it just has to mean that there is an expectation of cash being received in the future (e.g., Accounts Receivable). It can also mean that the person we originally owed money to has now reduced the amount we owe them as a result of this transaction. Even though there is a risk that we may not be paid in the future, we can still count it as revenue if it is a reasonable risk. If it is an unreasonable risk, we shouldn’t have made the transaction in the first place.
· The “Earned” criteria means that the company has done whatever they need to do to earn the money (e.g., providing the service, transferring the product, etc.) This criterion can be met a number of ways depending on the transaction. For example, rent and interest revenues are earned simply by time passing, sports ticket revenue is earned by the sports team playing the game, etc.)
Most revenues are reported under the “point of service” method. This means that all revenue for that transaction is recognized at one time when the delivery of the service or product is completed. In some cases, the earnings criteria are met in segments over a longer period of time, rather than all at once. There are a variety of methods used to recognize these long-term revenues. One example is the percentage of completion revenue recognition method. The best example of this is a large construction firm that completes a portion of a large project and gets paid in parts throughout the project. In these cases, they would not be able to wait until the very end (sometimes years down the road) for payment or revenue recognition. The details behind these longer-term revenue recognition methods are covered in more advanced accounting courses.
It is important to know that improper revenue recognition schemes make up a large share of the accounting fraud that occurs. This is because management must use judgment on when exactly the delivery of the product or service is completed. In some cases, false documentation (e.g., shipping records, etc.) are created to manipulate this number. This may be to report revenue too soon or delay it to another period. For this reason, auditors have to focus heavily on revenue recognition for most firms.
Depending on the firm, revenue may be called several different things:
· Earnings:
· Fees Earned
· Sales
Expense is also recorded over a period of time. The matching concept requires that we try to identify in what period the expenses helped to generate revenue. For example, if employees worked for us during the last week of December and helped us to generate revenue for that last week, it makes sense that we record the expense in that same period, even if we haven’t paid them by that time.
Another example of the matching principle is when we sell a product. Although we may have spent the money to purchase or build that product months or years ago, we do not record the expense (cost of goods sold) until the period in which we sell it. That way, both the revenue and expense are recorded in the same period.
Gains and losses will also show up in the income statement. Gains are similar to revenues, but the main difference is that they do not relate to the core, central, operations of the company. Instead, they are related to some peripheral transactions that may not occur very frequently. For example, when a piece of equipment is sold after the company has used it for years, any gain they make from this sale would be a one-time thing. Although it does indeed increase net income, it is reported separate from the normal revenues.
Losses, although similar to expenses, are not related to the core, central operations of the company. Like gains, these are one time type items and will be reported separate from the core expenses.
Use the below link from the Securities Exchange Commission (SEC) to access the full annual report (10-K) for Ford Motor Company. See if you can find the consolidated income statement. It starts on page 102, but feel free to look around for a bit first.
https://www.sec.gov/ix?doc=/Archives/edgar/data/0000037996/000003799621000012/f-20201231.htm
Now, use the below link to access the 10-K report for Southwest Airlines. It starts on page 84. Note that Ford is a manufacturer, whereas Southwest is a service firm. For this reason, the income statements will look different. Can you spot some of the differences?
https://www.sec.gov/ix?doc=/Archives/edgar/data/92380/000009238021000033/luv-20201231.htm
Section 2.) Components of the Income Statement
To understand the income statement, you first have to understand the various components. Below are terms that you will see on the statement. We will look at terms from a manufacturing firm’s income statement, as well as a service firm’s income statement. Although there are many similarities, there are also several differences.
Revenue Items
In a manufacturing firm, revenue is often referred to as sales. A service firm may have revenue accounts called fees earned or service revenues, etc. A service firm tends to be a simpler income statement, and some of the items noted below will not exist.
Sales = Revenue of firms that sell manufactured products. This sometimes referred to as “gross revenues.” In practice, this label is seldom on the face of the income statement. Instead, it is the “net sales” a few lines down that is usually the first line of the income statement. The gross sales and the reductions are generally only found in footnotes to the financial statements.
Sales returns = This reflects a reduction to sales when a customer returns a product that they previously purchased. This type of account offsets the total sales figure, however it is important to report these items separately for management and financial statement user information. This “offset” account is known as a “contra revenue account” and it has the opposite normal balance (debit) that the revenue account does (credit).
Sales Allowances = This reflects a reduction to sales when a customer has a defective product that they do not return. Instead, they negotiated with the store to have a reduced price in exchange for keeping the lightly defective product. This is also a contra revenue account.
Sales Discounts- These are discounts that are issued in exchange for prompt payment of the accounts receivable. You will often see credit terms such as 2/10 n/30. This means that the customer will get a 2% discount on any part of their balance that they pay within 10 days, and the “net” amount (the remainder) is due within 30 days without any discount given. This is also a contra revenue account.
This “sales discount” account DOES NOT include the normal discounts we see in everyday stores (i.e., 15% off, etc.) Those types of discounts are recorded as an immediate reduction to the overall sales account. In other words, if we paid $85 for a product that was originally priced at $100 with a 15% discount, we would not see the $100 anywhere. Instead, only the $85 would be reported as sales, with no need for any sales discount offset.
After taking sales less all of these contra sales accounts, you end up with the net sales figure that generally starts the income statement.
Sales
Less Sales Discounts
Less Sales Returns and Allowances
Equals Net Sales
FOB Terms
Sale of a product involves the passing of title (i.e., ownership rights) from seller to purchaser. This is very important when dealing with revenues that occur close to the end or beginning of a period.
Shipping Terms = (FOB- Free on Board)
FOB destination or FOB shipping point are two very common FOB terms.
These terms essentially mean that the product is “free on board” for the customer until it reaches the predetermined location. In other words, the seller pays the costs until the FOB point, when the buyer takes over.
In addition to determining shipping cost, the FOB terms also determine when title and risk of loss of the product passes. Once the risk of loss passes to the buyer, they will be responsible for any insurance. If they elect not to purchase insurance and the product is destroyed, the buyer will still owe the seller, even though the buyer never touched the product. They may have recourse against the shipping firm, but it will be up to the buyer to sue the shipper.
FOB terms do not mean that the other party cannot pay the shipping costs though.
For example, if the terms are FOB shipping point the buyer will owe the shipping costs. In some case the seller may pay the costs (known as Freight Prepaid), but they may just include the costs on their invoice to the buyer.
On the other hand, if it is FOB destination (the seller owes the costs) and the buyer happens to pay the shipping fees (known as Freight Collect) when they receive the product, they will generally reduce their payment to the seller by that amount.
In summary, the FOB terms are important because that determines when a company can recognize the sale, as well as who is responsible for the shipping costs.
Expense Items
Expenses are the outflow or other using up of assets or incurrence of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.
An important concept is remembering that expenses are incurred for the sole purpose of creating other revenues. A company would not pay to buy equipment if they didn’t think it was going to allow them to create a product that they could sell and earn revenues.
For this reason, expenses should generally be matched with the revenue they relate to whenever possible, although some expenses are known as “period” expenses and are recognized in the period in which they are incurred.
Cost of Goods Sold (sometimes called Cost of Sales) is one of the most significant expenses for manufacturing companies. It generally comes immediately after the revenue items. It will not exist for service firms, however. The “Inventory Cost Flow Assumption” (e.g., FIFO, LIFO, weighted average, etc.) that we discussed in previous sections determines when this cost is recorded and what amount.
Inventory shrinkage is the term used for recording stolen or obsolete merchandise. This is often included within Cost of Goods Sold, though in some cases may be separately reported if unusual and infrequent.
Periodic versus perpetual inventory systems (Refresher from Earlier Sections)
In a perpetual inventory system, the inventory counts for a company are updated after every transaction. This is often done by the use of bar code scanning. As soon as the salesclerk scans an item out, the computer updates the inventory account, and it also knows the exact cost of goods sold for that item. Most retailers now use this method.
Inventory is reduced and cost of goods sold is increased automatically after every transaction.
In a periodic inventory system, there is no way to know the current inventory after every single transaction. There is also no way to know the cost of goods sold. These two amounts can only be determined after performing a physical inventory and comparing it with the previous inventory and any recent purchases.
Cost of Goods Sold Calculation
Beginning Inventory Balance $xxx
+ Net Purchases (see calculation below) $xxx
= Cost of Goods Available for Sale $xxx ß This is what we could have sold
- Ending Inventory $xxx ß This is what was left (what we didn’t sell)
= Costs of Goods Sold $xxx ß This is the cost of what we did sell
Net Purchases Calculation (used in the COGS calculation above)
Cost of Purchases $xxx
+ Freight charges owed by buyer (FOB ship point) $xxx
- Purchase discounts (for quick credit payment) $xxx
- Purchase returns and allowances $xxx
= Net Purchases $xxx
Note that the purchase discounts and the purchase returns and allowances are the flip side of the sales discounts, etc. discussed earlier.
For a manufacturing term, the difference between sales revenue and costs of goods sold is “gross margin” or “gross profit”. This is the profit of the firm before taking all of the other costs into consideration. Gross Profit is important because companies often determine their price based on gross profit. Note that the gross profit subtotal will only exist in the “multi-step income statement” and not the “single step income statement. More on that later.
After the cost of goods sold (and gross profit if it is listed) you will find other operating expenses. Sometimes these are referred to as selling, general, and administrative expenses. Sometimes they are broken out into those categories on the income statement. The footnote and schedules will often contain a more detailed breakdown of what types of those expenses exist, though the face of the income statement itself will generally show only one or a few lines aggregating them together.
If the company has research and/or development expenses, you may also see those on a separate line.
The key thing is that all of the expenses listed up to this point are related to the core operations of the company, thus are referred to as operating expenses.
Gross profit minus all of the above expenses will give you “Income from Operations” or simply Operating Income. This is still not the bottom line, but it is key to investors, because it represents what can reasonably be expected to occur period after period.
Non-Operating Income Items (aka Other Income Items)
After the operating income, there may be a variety of other revenue and expense items listed out, known as “other income” and “other expenses”, or simply non-operating items. These are items that do not relate to the core operations of the company. Instead, they may relate to the financing or investing transactions.
“Income from Operations” you then add and subtract the “other income” and “other expenses” (such as interest, gains, losses, etc.) This then gives you “Income before Taxes.” Subtract any tax expenses and you get your final net income figure.
For a corporation, once Net Income is determined, you also need to determine how much of that Net income relates to every individual share of common stock. This is information the investors want to know.
Interest Income or Interest Expense – Although both of these can increase or decrease net income, they do not relate to the core operations of the company, thus must be separately reported.
Gains are like revenues, but they are for peripheral types of transactions. We don’t want the users of the financial statements to expect such transactions year after year, so we have to separate them out into their own category. In some cases, this could relate to selling fixed assets that the company is no longer using. If the sale is at a price higher than the current net book value of the asset, then a gain would be recognized. If it is at a lower price, then it would be a loss.
Losses are similar to expenses but are for peripheral items, not operating activities. These are reported separately for the same reasons as the gains above.
Provision for Income Taxes:
Income tax expense is generally reported separate from the other expenses. If the multi-step income statement is used, there will also be a subtotal before that amount. If the single step income statement is used, the tax will just be another line-item expense like everything else.
Net income and earnings per share
Net Income is the final aggregate subtotal, which is basically all of the revenues minus all of the expenses. Since had subtotals along the way, this is generally calculated by taking Operating Income minus all of the non-operating items. This is a very important number for a company and its investors, and it is ultimately the number that flows over to retained earnings and may be available for a dividend payment. It is often known as the “bottom line” though you will see additional informational calculations below it.
Basic earnings per share
This represents the portion of the earnings that could potentially be distributed out to stockholders as dividends (if 100% of all net income was always distributed. Although this is generally not the case, it is still an important figure for stockholders. It basically represents the value that was generated within the company due to the investments from owners.
This is calculated as:
Net Income Available for Common Stock/ Weighted Average Common Shares Outstanding
Net Income Available for Common Stock – This is net income less any preferred dividends. Although the preferred dividends are not actually expenses, they need to be used to reduce net income because that portion of the income is used to pay preferred stockholders, rather than common stockholders.
Weighted Average Common Shares Outstanding
This weighted average figure is simply an average of what number of shares have been outstanding throughout the month. For example, if one of the shares has only been outstanding for half of the period, it only has half of the weight of a share that has outstanding for all of the year.
Diluted Earnings Per Share
If the company has stock options or convertible stock, they may be converted to common stock shares at any time. Although this won’t affect the net income figure, this may affect the weighted average number of stocks outstanding. As such, we want to give the investors the “worst case scenario.” This topic is discussed further in advanced accounting courses.
Unusual Income Statement Items
Some companies may have situations that require special formatting. These can occur when they are making significant changes and terminating one or more divisions or product lines, etc. They may also exist when there is something so very unusual and infrequent that it deserves to be separately called out to as to very clearly inform users that this will very likely not occur again any time soon. If these items weren’t handled properly, investors may not be able to properly predict future results. Although these are briefly identified below, they are discussed in detail in more advanced accounting courses.
· Discontinued operations – If a portion of a company is discontinued, we must report this income (or loss) separately so that users don’t expect this income in future years.
· Extraordinary Items – These are items that do not occur during normal business years so again these are supposed to be reported separately so users don’t expect this type of activity in future years. To be extraordinary, they must be both unusual and infrequent. An earthquake in California that causes damage may not be that infrequent or unusual, but one in Nebraska that causes damage certainly would be.
· Cumulative Change in Accounting Principle- Although consistency in use of accounting principles is preferred, if a company does elect to change, it must show the user what difference that decision made in prior periods. This is so that companies do not simply change principles to manipulate income from one year to the next.
· Non-Controlling Interest in Earnings of Subsidiaries- When a parent company owns a subsidiary company, certain rules allow the parent to report all of the subsidiary’s activity in with their own activities. However, a portion of this does not belong with the parent company as there are other companies or investors that may own that small portion. This is referred to as the minority interest, or non-controlling interest. To do this, the activities related to the non-controlling interest are backed out in a separate section.
Section 3.) Different Income Statement Models
As alluded to earlier, there are two main types of income statements that can exist in a company. These are the single-step income statement and the multi-step income statement.
In a single step income statement, all of the revenues (operating or non-operating) will be included in one total revenue sum. All expenses (operating and non-operating), including the cost of goods sold, will be included under one expense column. There will not be a separate gross profit or gross margin figure. For a service firm, this format of the income statement may work well, since they have no cost of goods sold to create a gross profit to begin with.
The multi-step income statement will break out the operating and non-operating revenues and expenses. It will also give you a variety of other subtotals along the way, as shown in the examples below.
Single-Step Income Statement
Multi-Step Income Statement
Wrap-Up
This is a relatively light week, that just digs a bit deeper into the income statement that we already discussed in previous weeks. There are no separate videos for this material. Next week, we will head into the statement of cash flows.
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