Complete Guide To Corporate Finance

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Financial Statements - The Income Statement

The income statement measures a company's financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses through both operating and non-operating activities. It also shows the net profit or loss incurred over a specific accounting period, typically over a fiscal quarter or year. The income statement is also known as the "profit and loss statement" or "statement of revenue and expense."

The income statement is divided into two parts: the operating items section and the non-operating items section.

The operating items section discloses information about revenues and expenses that are a direct result of the regular business operations. For example, if a business creates sports equipment, then the operating items section would talk about the revenues and expenses involved with the production of sports equipment.

The non-operating items section discloses revenue and expense information about activities that are not tied directly to a company's regular operations. For example, if the sport equipment company sold a factory and some old plant equipment, then this information would be in the non-operating items section.
Income statements can be presented in one of two ways: multi-step and single-step. Both single and multi-step formats conform to GAAP standards. Both yield the same net income figure; the main difference is how they are formatted, not how figures are calculated. The two formats are illustrated below in two simplistic examples:

Multi-Step Format
Single-Step Format
Net Sales
Net Sales
Cost of Sales
Materials and Production
Gross Income*
Marketing and Administrative
Selling, General and Administrative Expenses (SG&A)
Research and Development Expenses (R&D)
Operating Income*
Other Income & Expenses
Other Income & Expenses
Pretax Income
Pretax Income*
Taxes
Taxes
Net Income
Net Income (after tax)*
--



Sample Income Statement
Now let's take a look at a sample income statement for company XYZ for Fiscal Year (FY) ending 2008 and 2009. Expenses are in parentheses.

Income Statement For Company XYZ FY 2008 and 2009


(Figures USD)
2008
2009
Net Sales
1,500,000
2,000,000
Cost of Sales
(350,000)
(375,000)
Gross Income
1,150,000
1,625,000
Operating Expenses (SG&A)
(235,000)
(260,000)
Operating Income
915,000
1,365,000
Other Income (Expense)
40,000
60,000
Extraordinary Gain (Loss)
-
(15,000)
Interest Expense
(50,000)
(50,000)
Net Profit Before Taxes (Pretax Income)
905,000
1,360,000
Taxes
(300,000)
(475,000)
Net Income
605,000
885,000




Here are some of the different entries that may be found on the income statement and what each one means.

  • Sales - These are defined as total sales (revenues) during the accounting period. Remember these sales are net of returns, allowances and discounts.
  • Cost of Goods Sold (COGS) - These are all the direct costs that are related to the product or rendered service sold and recorded during the accounting period. (Reminder: matching principle.)
  • Operating expenses - These include all other expenses that are not included in COGS but are related to the operation of the business during the specified accounting period. This account is most commonly referred to as "SG&A" (sales general and administrative) and includes expenses such as selling, marketing, administrative salaries, sales salaries, maintenance, administrative office expenses (rent, computers, accounting fees, legal fees), research and development (R&D), depreciation and amortization, etc.
  • Other revenues & expenses - These are all non-operating expenses such as interest earned on cash or interest paid on loans.
  • Income taxes - This account is a provision for income taxes for reporting purposes.

The Components of Net Income:

  • Operating income from continuing operations - This comprises all revenues net of returns, allowances and discounts, less the cost and expenses related to the generation of these revenues. The costs deducted from revenues are typically the COGS and SG&A expenses.

  • Recurring income before interest and taxes from continuing operations - In addition to operating income from continuing operations, this component includes all other income, such as investment income from unconsolidated subsidiaries and/or other investments and gains (or losses) from the sale of assets. To be included in this category, these items must be recurring in nature. This component is generally considered to be the best predictor of future earnings. However, non-cash expenses such as depreciation and amortization are not assumed to be good indicators of future capital expenditures. Since this component does not take into account the capital structure of the company (use of debt), it is also used to value similar companies.

  • Recurring (pre-tax) income from continuing operations - This component takes the company's financial structure into consideration as it deducts interest expenses.

  • Pre-tax earnings from continuing operations - Included in this category are items that are either unusual or infrequent in nature but cannot be both. Examples are an employee-separation cost, plant shutdown, impairments, write-offs, write-downs, integration expenses, etc.

  • Net income from continuing operations - This component takes into account the impact of taxes from continuing operations.

Non-Recurring Items
Discontinued operations, extraordinary items and accounting changes are all reported as separate items in the income statement. They are all reported net of taxes and below the tax line, and are not included in income from continuing operations. In some cases, earlier income statements and balance sheets have to be adjusted to reflect changes.

  • Income (or expense) from discontinued operations - This component is related to income (or expense) generated due to the shutdown of one or more divisions or operations (plants). These events need to be isolated so they do not inflate or deflate the company's future earning potential. This type of nonrecurring occurrence also has a nonrecurring tax implication and, as a result of the tax implication, should not be included in the income tax expense used to calculate net income from continuing operations. That is why this income (or expense) is always reported net of taxes. The same is true for extraordinary items and cumulative effect of accounting changes (see below).

  • Extraordinary items - This component relates to items that are both unusual and infrequent in nature. That means it is a one-time gain or loss that is not expected to occur in the future. An example is environmental remediation.

  • Cumulative effect of accounting changes - This item is generally related to changes in accounting policies or estimations. In most cases, these are non cash-related expenses but could have an effect on taxes.
  • Unusual or Infrequent Items
    Included in this category are items that are either unusual or infrequent in nature but they cannot be both.

Examples of unusual or infrequent items:

  • Gains (or losses) as a result of the disposition of a company's business segment including:
    • Plant shutdown costs
    • Lease-breaking fees
    • Employee-separation costs
  • Gains (or losses) as a result of the disposition of a company's assets or investments (including investments in subsidiary segments) including:
    • Plant shut-down costs
    • Lease-breaking fees
  • Gains (or losses) as a result of a lawsuit
  • Losses of operations due to an earthquake
  • Impairments, write-offs, write-downs and restructuring costs
  • Integration expenses related to the acquisition of a business


  • Extraordinary Items
    Events that are both unusual and infrequent in nature are qualified as extraordinary expenses.

Example of extraordinary items:

  • Losses from expropriation of assets
  • Gain (or losses) from early retirement of debt

Discontinued Operations
Sometimes management decides to dispose of certain business operations but either has not yet done so or did it in the current year after it had generated income or losses. To be accounted for as a discontinued operation, the business must be physically and operationally distinct from the rest of the firm. Keep in mind these basic definitions:

  • Measurement date – This is the date when the company develops a formal plan for disposing.
  • Phase-out period – This is the time between the measurement date and the actual disposal date.


The income or loss from discontinued operations is reported separately, and past income statements must be restated, separating the income or loss from discontinued operations.
On the measurement date, the company will accrue any estimated loss during the phase-out period and estimated loss on the sale of the disposal. Any expected gain on the disposal cannot be reported until after the sale is completed (the same rule applies to the sale of a portion of a business segment).

Accounting Changes
Accounting changes occur for two reasons:

  1. As a result of a change in an accounting principle.
  2. As a result of a change in an accounting estimate.

The most common form of a change in accounting principle is the switch from the LIFO inventory accounting method to another method such FIFO or average cost basis.

The most common form of a change in accounting estimates is a change in depreciation method for new assets or change in depreciable lives/salvage values, which is considered a change in accounting estimates and not a change in accounting principle. Note that past income does not need to be restated from the LIFO inventory accounting method to another method such FIFO or average cost basis.

In general, prior years' financial statements do not need to be restated unless it is a change in:

  • Inventory accounting methods (LIFO to FIFO)
  • Change to or from full-cost method (This is used in oil and gas exploration. The successful-efforts method capitalizes only the costs associated with successful activities while the full-cost method capitalizes all the costs associated with all activities.)
  • Change from or to percentage-of-completion method (see revenue-recognition methods)
  • All changes just prior to a company's IPO

Prior Period Adjustments
These adjustments are related to accounting errors. These errors are typically not reported in the income statement but are reported in retained earnings (found in changes in retained earnings). These errors are disclosed as footnotes explaining the nature of the error and its effect on net income.

For further reading about income statements, see Understanding The Income Statement and Fundamental Analysis: The Income Statement.

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