Chapter 3 discusses the organization, components, purpose and limitations of
the Income Statement. After completing Chapter 3 you should be able to: explain
how the multiple step income statement is organized, describe the accrual basis
of accounting, revenue recognition, and the matching principle. Compute and
interpret profitability ratios, Interpret trends in income statement, revenues
expenses, subtotals, and totals. And prepare and interpret trend and common
size analysis. This statement is also called "Statement of Income", "Statement of
Earnings", "Statement of Operations" or "Profit and Loss statement" or simply "P&L".
The Income Statement helps users of financial statements to evaluate past
performance, how much was the revenue, has grown from previous years, has
management operated in an efficient manner that is with the use of fewer
resources. An analysis of revenues and expenses and how they change can help us
determine that. If sales have grown but expenses haven't at the same rate that
would be a sign of efficiency. We can predict future performance based on past
performance and we can determine the risk or uncertainty of achieving future
cash flows. Information about the various components of income is helpful for
assessing the likelihood of achieving a particular level of cash flows in the
future. It would be a favorable sign if sales increased because they result from
an on going operations. if there are no significant changes in the economy or
company's operations we can expect to see them next period as well. However, if
these increases are from "gains" (as non recurring transactions) we should be
worried because we may never see them again. In the case of the second scenario
there will be no income to cover the expenses incurred. As we analyzed Income
Statement we should be aware of its limitations. One of them is that items that
cannot be measured reliably are omitted from the income statement.
For example the value of brand recognition, customer service and product
quality are not part of the financial accounting. Another flaw is that income
numbers are affected by the accounting methods employed. For example company's
results will be different if the company adopts FIFO instead of LIFO for
inventory valuation. When comparing companies you should make a note of any
differences in major accounting methods and make adjustments for better
comparability. Another flaw is that income measurement involves judgment.
Some companies tend to be more aggressive than others and this will lead to different results.
The major elements of income are: Revenues, Expenses, Gains and
Losses as previously discussed in Chapter 1. The distinction between
Revenues, Gains, Expenses and Losses depends to a great extent on the
typical activities of a business enterprise. When the income results from
a typical business activities, generally the activities the entity is in business
to perform or its primary operations, revenues will result. Likewise outflows,
or the use of assets resulting from typical business activities, will cause
increase in expenses. Here are the definitions: Revenues is income received
from the entity's ongoing major or central operations. Some names for
revenue accounts are: "sales", "service revenue", "fees earned".
Expenses are used up resources in the effort to generate revenue. Some example for expense
accounts are: "cost of goods sold", "salary expense", "rent expense", "utilities expense", "depreciation expense".
Non-typical business activities resulting in flows
or outflows of assets will generate gains or losses. Gains and losses result
from peripheral transactions. For example a CPAs firm's revenue and expenses
will result from its principal activities. Revenues for services
provided such as consultations, audits tax returns etc. and expenses would be
resources used such as: salary, rent, utilities, supplies expense. If the CPA
firm sells one of its old computers and sells it for more than its Book value,
this transaction will result in a gain. If it sells it for less than its Book
value then it will result in a loss. This is a peripheral transaction since the
firm is not in a business to sell computers. The income statement may be
presented in single step format or multiple step format. Single step income
statement derives its name from the fact that total cost and expenses are
subtracted from total revenues in a single step to arrive at net income.
Income taxes are normally shown as a separate item among the expenses - usually
last to indicate their relationship to Income. So what we will see on the
statement - will see a list of all of the revenues, will add to them all the gains,
then we'll subtract all expenses and will subtract all losses. This math will
give us the bottom line for the figure for Net Income. The multiple step format
separates results achieved by regular operations of the entity from those
obtained by non operating activities. Expenses are also classified by
functions such as: cost of sales, selling, administrative. The multiple step format
provides more information to financial statement users than does the single
step format, however both are found in actual practice.
Thank you for watching!