Definition of the Income Statement
The basic objective of the income statement is to describe the income achieved by the reporting entity during a specific accounting period.
Objectives of the income statement
Experience has shown that the rules for measuring the amount of income are complex and far from
unanimously accepted among users and preparers. The complexity can be demonstrated by turning to economic theory for a definition of income. The widely acknowledged capital maintenance theory defines income in terms of wealth. It starts from the premise that there is a certain amount of wealth at the beginning of the period and that wealth can be increased and decreased during the year.
Income is defined as the amount of wealth that can be consumed during the period such that the wealth at the end will just equal the wealth at the beginning. While this concept may be helpful in identifying a relevant measure of income, it falls short of providing a model for accountants to apply in order to generate useful information. There are two major problems with this concept. First, “wealth” is so abstract and subject to personal interpretation that no reliable methods exist for measuring it.
The second weakness is that this approach does not provide detailed information about the events that produced the income. Because of these weaknesses, accounting has developed a more practical model.
First, instead of focusing on changes in wealth, accounting income is defined as changes in owners’ equity (except for contributions from and distributions to owners). Income is generally measured in terms of historical cost because of the relative unreliability of alternative measurement approaches.
In response to the second weakness, accountants gather and report information about the effects of the various types of changes in owners’ equity that occur throughout the year. This approach provides details about the causes of changes and their separate impacts in an income statement rather than merely reporting the net change.
Format of the Income statement
Example (How to prepare an income statement?)
The following data has been taken from ABC Industries limited for the month ended October 31, 2018.
Note: Income Tax is 40% on net profit. (Before Tax)
- Prepare ABC Industries schedule of cost of goods sold for the month ended October 31, 2018.
- Prepare ABC industries income statement for the month ended October 31, 2018.
Preparing the cost of goods sold statement:
Preparing Income Statement:
Working notes (W-1):
Elements of Income Statement:
In response to users’ needs for detailed information, income statement discloses a variety of items. The two primary elements of the income statement are operating and nonoperating income, as illustrated in this formula.
Net income = Operating income + Nonoperating income
There are several subelements of operating and nonoperating income, such that the formula can be restated as:
Net income = (Revenue — Expenses) + (Gains Losses)
In order to help readers evaluate the likelihood and amounts of future cash flows from the firm, accountants frequently identify and segregate the effects of the ongoing efforts exerted to produce income from the effects of other events that happened. In carrying out this refining process, one simple approach distinguishes operating events as those which are related to providing goods and services to customers. Current practice has modified this meaning slightly to include only those operating events occurring in the present year. This modification thus excludes corrections of errors made in measuring operating events of previous years. The two subelements within the operating category are revenues and expenses.
Accountants are concerned with two separate processes: revenue recognition and matching. Revenue recognition is the process of determining the time period in which revenues should be reported while matching is the process of associating expenses with the revenues that they produce.
The gross increases in owners’ equity caused by operating events are called revenues. The events either yield assets or result in the reduction of liabilities. In a qualitative sense, a revenue can be viewed as a reward obtained by providing goods or services to customers.
Accountants have developed several approaches for recognizing revenues. To understand these approaches, it is helpful to relate them to the legal concept of the contract. When a contract exists between two parties, each agrees to some specified performance. The seller agrees to provide goods or services, and the buyer agrees to make payment.
The four basic revenue recognition models can be distinguished
- by which party has performed its portion of the contract (when a contract exists)
- by the capability of the seller to provide goods when a contract does not exist.
1. Accrual accounting requires that a contract exist and that the selling entity perform its part before revenue can be recorded. For example, revenue can be recognized when a service is performed for a buyer, even if cash is not received at once. On the other hand, if the customer pays but the service is not performed, no revenue can be recognized. In this situation, a liability has been created that
must be satisfied either by services or by a refund.
In cases where the seller’s performance extends beyond the end of the present period, the percentage of completion approach recognizes revenue in proportion to the amount of effort exerted by the seller. Accrual accounting dominates current practice and should be used in the absence of strong evidence that one of the alternatives should be applied.
2. Cash accounting requires that a contract exist and that the buyer perform its part of the contract before revenue is recognized. For example, revenue is recorded by a service provider whenever cash is received from the customer, without regard to whether the service has been performed. This approach avoids the uncertainty associated with recording revenue before cash is received but misrepresents the liability that arises from a prepayment.
Cash accounting as a primary system is not generally accepted for financial reporting. Two variations of cash accounting are allowed in situations where the buyer’s performance encompasses a series of payments that will extend beyond the end of the present period and there is very high uncertainty as to that performance. The installment method allows revenue to be recognized as a part of each payment, whereas the cost recovery approach allows revenue to be recognized only after the sum of the cash received equals the seller’s costs.
For example, suppose that an asset with a cost of $90,000 is sold in exchange for a promise to pay $120,000 in the form of 12 $10,000 payments. The installment method would recognize 25 percent ($30,000 ÷ $120,000) of each payment, or $2,500, as gross margin, such that $30,000 would be recorded if all 12 are received. The cost recovery method would not record revenue until after the first nine payments ($90,000) are received, and then would treat each of the last three payments as revenue. Under Accounting Principles Board Opinion (APBO) 10, the installment method is acceptable only “when the collection of the sale price is not reasonably assured”. The cost recovery approach is allowed under similar circumstances where the probability of collection is extremely low.
Several variations of cash accounting (including the installment method) are acceptable for income tax returns and are thus frequently used by smaller firms for reporting to their owners and creditors. These reports, while common, are not in compliance with GAAP.
3. The production approach to the recognition of revenue does not require the existence of a contract or performance by either party. It holds that the mere production of a good is sufficient to recognize revenue, presumably because there is no doubt that the item can be sold. Under this approach, for example, a manufacturer would record revenue as each product is completed, without regard to the fact that a buyer had not yet offered to acquire it.
The approach lacks the reliability demanded elsewhere in generally accepted accounting and its use is therefore severely limited. It is allowed by ARB 43 in those few industries that produce interchangeable products for a well-organized market such as refined rare metals (for example, gold and silver) and agricultural products. In these situations, the measurement of the revenue is difficult when the market prices are not stable.
4. The capability approach has not been well received by accountants, and very rarely even discussed. It holds that revenue can be recognized whenever the seller is in the position of being able to earn revenue. Using this approach, the owner of a building could record rental revenue as soon as construction is completed without regard to occupancy.
Similarly, a manufacturer could record revenue as soon as materials and a workforce are available. The extreme uncertainty of this approach has made it totally unacceptable for practice. Nonetheless, in 1978, the SEC required supplemental disclosures based on a variation of it for the oil and gas industry. According to this method, known as reserve recognition accounting. a company would recognize revenue when an oil or gas field (that is, a reserve) is discovered, even if the firm is not immediately able to produce from it.
Revenue would not be recognized when the product is extracted from the well, in much the same way that the collection of a receivable is not considered to be revenue under accrual accounting. The SEC subsequently rescinded this requirement in February 1981. A variation of the capability approach is used in financial accounting when the current value method is applied.
The gross decreases in owners’ equity caused by operating events are called expenses. Generally, the events either reduce assets or create liabilities. In a qualitative sense, an expense can be viewed as an effort expended in the process of providing goods and services to customers.
The matching concept requires an offsetting of these efforts (expenses) against the rewards (revenues). Consequently, accountants attempt to discover if a causal relationship exists between revenue and some expenses. If causality can be determined, the expenses are reported in the period that the revenue is recognized.
This approach leads to the practice of adding production costs to inventory and deducting them as expenses (cost of goods sold) only when the product is actually sold.
If a causal relationship is likely but cannot be reliably determined, or no relationship is determinable, the expense is reported in the year in which it is incurred. For example, expenses incurred for research and development, advertising, and training are made for the purpose of increasing revenue. However, because there is no reliable way to associate the expenses directly with the revenue, the expenditure is deducted from revenues in the year it is made.
An expense may occur in a single period, or it may be spread over several periods. Recognition in the second case may involve allocation among the periods either on the basis of observed revenue generation or on a predetermined time-oriented basis. Some examples of these expenses are amortization and depreciation.
All events not properly classifiable as operating are classified as nonoperating. The two subelements, gains and losses, are defined as the net increases and decreases in owners’ equity resulting from nonoperating events. In this category are sales of noninventory assets, casualty losses, and other events. The amounts of gains and losses are recorded as the net change rather than the gross increase and decrease in owners’ equity.
For example, assume that a company sells an asset with a book value of $800 and receives $1,000. It is common to report only the gain of $200, rather than separately disclosing the selling price and the book value.
While there is general agreement on when to report gains and losses and the amount to be reported, two opposing positions have been taken with respect to the best method of presenting them to statement readers. The current operating concept holds that the income statement is more likely to be understood and used if it includes only the results of operating events.
On the other hand, the all-inclusive concept holds that the income statement is more likely to be comprehended and used if it is the only place in which the period’s operating and nonoperating events are disclosed. This approach would preclude the use of judgments about the classification of an event as operating or nonoperating as a means of distorting the reported results. Thus, a firm could not delete the effect of a nonoperating event from the income statement in order to present a better picture.
Ordinary and extraordinary items
Because of the above conflict, accounting practice concerning nonoperating items was unsettled and inconsistent. The Accounting Principles Board (APB) dealt with the situation by issuing two Opinions (9 and 30) that specified where particular events were to be disclosed. While these pronouncements did not resolve the theoretical question, they did bring much more uniformity to practice.
The fundamental approach used in the pronouncements is all inclusive in that gains and losses all appear on the income statement. However, the APB required the reporting of nonoperating items as either ordinary or extraordinary.
APBO 30 was issued in order to provide a more precise definition of “extraordinary”.
“Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their recurrence taking into account the environment in which the entity operates.”
The key point to recognize is that the event itself is neither ordinary nor extraordinary; rather, it is the context in which it occurs that determines whether it is one or the other. The authors interpret this Opinion to indicate that the accountant must consider the external and internal environments of the firm.
The firm’s external environment consists of its economic and physical surroundings and determines whether the event is usual or unusual. The APB said in Opinion 30:
“The environment of an entity includes such factors as the characteristics of the Industry or industries m which it operates, the geographical location of its operations, and the nature and extent of governmental regulation.”
The environment internal to the firm, on the other hand, is affected by such things as its history and management policies. The likelihood of the recurrence of a gain or loss from a particular type of event depends on the plans and decisions made by management.
The Company has agreed to settle all class-action antitrust suits in connection with alleged price fixing relating to folding cartons, milk cartons, and corrugated containers. The Company’s long-established policies requiring strict compliance with all laws in the conduct of its business apply to all segments of the Company’s operations, including the Hoerner Waldorf paper packaging business which was acquired in 2017. The Company has for many years emphasized these policies and will continue to take all actions it deems necessary to insure rigid compliance at all levels. It, therefore, believes significant antitrust litigation settlements to be unusual, nonrecurring, and extraordinary.
In some instances, a company’s management may initiate new policies to prevent the recurrence of actions that led to losses through litigation. Similarly, a decision to replace an earthquake damaged building with one designed to withstand another earthquake would reduce the likelihood of the recurrence of a loss.
This interpretation of APBO 30 is summarized in the above example. In order to be reported as extraordinary, an event must be considered to be both unusual for the external environment and nonrecurring in the firm’s internal environment.
Under this definition, such uncontrollable events as natural calamities or other accidents can be classified as ordinary if they are to be expected in the environment.
On the other hand, an event that the management can control completely, such as the sale of an unusual investment, can be classified as extraordinary. Because of overriding considerations, both the APB and the FASB have acted to require that certain special items be reported as extraordinary despite the fact that they do not fall within the criteria of APBO 30.
With this background, we can now turn to a more detailed description of the structure of the income statement.
Structure of Income Statement
In the process of actually preparing the income statement, a number of items are to be considered: heading, revenues and expenses, other ordinary items, discontinued operations, income taxes, extraordinary items, and earnings per share. The heading of the income statement identifies the entity, presents the title of the income statement, and shows the time period covered by the report.
Revenues and expenses
The revenues and expenses are presented in various ways, according to the preference of the issuer. Two general formats are the single step and the multiple step. The single-step format lists all the revenues and ordinary gains and then deducts all the expenses and ordinary losses in arriving at ordinary income. The multiple-step format contains a number of subgroupings of the revenues, then the expenses, and a separate section for reporting ordinary gains and losses. It should be noted that variations of these general forms are found in practice; for example, many companies report income tax expense as a separate item after ordinary income.
In the below example, the format selected by McDonald’s Corporation is an illustration of a single-step income statement where income taxes are reported separately. There is no conceptual issue involved in selecting the format. The choice is merely a matter of the preference of the firm presenting the statements. Once a format is selected, it generally should continue to be used from year to year to provide ease of comparison.
Other ordinary items
Other ordinary items include the results of events or situations that cannot be classified as operating or extraordinary. Whether each item is reported separately generally depends upon its materiality. APBO 30 requires separate disclosure of material events that are either unusual or nonrecurring, but not both. Following example presents an illustration of the reporting of an unusual gain which is expected to recur.
Note 2: The company sold at a net gain of $6 730 000 ($0.65 per share) a 20% interest in Canadian coal properties for $3 000 000 in cash and long-term notes having then the present value of $8 259 000. The company anticipates selling its remaining 16.75% interest for approximately $10 400 000 in interest-bearing notes.
In recognition of the usefulness of income statement information for assessing earning power, the APB called for the segregation on the statement of two income items related to the discontinuation of a particular line of activity. With this segregation, users can identify the income from continuing operations and thus make a more informed estimate of their future cash flows. In order to implement this separation, it is necessary to determine that a significant segment of the business has indeed been discontinued. APBO 30 provides this definition:
“For purposes of this Opinion, the term segment of a business refers to a component of an entity whose activities represent a separate major line of business or class of customer. A segment may be [any organizational unit whose] . . . assets, results of operations, and activities can be clearly distinguished physically and operationally, and for financial reporting purposes from the other assets, results of operations, and activities of the entity.”
This definition is broad and subject to judgment. In a subsequent interpretation, the AICPA provided a series of examples of situations to be included or excluded as discontinuances. The thrust of the Opinion and the interpretation is that the discontinued segment must have carried on a major set of separable activities or served a major set of customers who will not be served after the discontinuance.
For example, the disclosure requirements of the opinion would apply if a conglomerate disposes of a glass manufacturing division when it has no other division engaged in that activity. Similarly, if an electronics manufacturer decided to terminate its attempt to establish a chain of retail stores in shopping centers, the decision would result in discontinued operations because a major class of customers would no longer be served directly.
On the other hand, if an automobile manufacturer decided to stop producing four-wheel drive vehicles, the decision would not be considered a discontinuation as it only terminated a product line. Similarly, an airline’s decision to stop serving three cities would not be a discontinuation because the same general group of customers would still be served. Note that in these two cases, the affected productive assets (that is, the machinery to produce vehicles and the aircraft to serve customers) would not be separable and would still be available for other purposes.
In addition to knowing whether a discontinuation has taken place, the accountant also needs to know the effective date of the discontinuation in order to report its effects in the appropriate time period. The APB selected the date on commits itself to a formal plan to dispose of a segment of the business. The time period labeled in the following example as “Phaseout” begins with the date of the decision and extends until the completion of the process.
The Opinion requires that three items be disclosed in the income statement. Any other information that is needed must be provided in the footnotes. The three items are:
1. Income or loss that the discontinued segment generated in previous years, if the statements are
presented in a comparative format.
2. Income or loss in the current year from operating the discontinued segment prior to the discontinuation
3. Gain or loss from the discontinuation itself.
The first item involves a reclassification of amounts reported in earlier income statements, if those figures are being presented in comparative form together with the current year’s figures. The second item involves the determination of the income or loss earned through operating the discontinued segment from the beginning of the fiscal year up to the date that the decision to discontinue is finalized. The third item consists of two components: (1) The net disposal gain/loss, which is the gross disposal gain/ loss less the direct costs of the discontinuance (such as severance pay), and (2) the operating profit/loss from the phaseout period.
If phaseout is completed in the same year as the decision date, the discontinuation gain/loss is the sum of the two components. If it is not completed, the rules are more complex, as described in the below example. Operating losses expected to occur during phaseout are added to the net disposal gain/loss. Expected operating profits are not added to net disposal gains, but are offset against net disposal losses to the extent of those losses. The remainder is recognized as it is earned.
For example, consider these four cases:
Another item in the computation of ordinary income that receives special treatment is the amount of income taxes. The total amount in a year is allocated among and paired with the major categories of income that appear on the statement, such as extraordinary items and gains and losses from discontinued operations. The rationale behind this treatment is basically the same as the one used to support the disclosure of the components themselves; that is, predictions and evaluations are more likely to be helpful if
the primary causes of income are clearly identified.
The reasoning behind the use of the extraordinary category is explained earlier in this chapter. In a survey, it is reported that only 53 out of 600 of the surveyed companies disclosed this type of item. The restrictive impact of APBO 30 on practice is illustrated by the fact that the survey showed 204 disclosures of extraordinary items in 2018. Where appropriate, the firm should provide a footnote to explain the nature of the gain or loss.
Earnings per share
In response to an increase in the use of the earnings per share figure and to an apparently large variety of definitions, computations, and disclosure formats, the APB issued Opinion 15. The goal of the pronouncement was to bring uniformity to the computations and presentations of earnings per
share. There are five major requirements under APBO 15:
1. Earnings (or loss) per share figures are to be presented on the face of the income statement.
2. The earnings figure used in the calculation is computed as income attributable to common stockholders.
3. Earnings per share before and after extraordinary items are to be disclosed.
4. The earnings per share computation is based upon the existing common stock adjusted for securities
which are equivalent to common stock, such as convertible securities and options.
5. Earnings per share is to be computed also on a pro forma basis that would exist if all common shares issuable under existing agreements were indeed issued.