Considering the Benefits and Limitations of Income Statements
An income statement (US English) or profit and loss account (UK English) (also referred to as a profit and loss statement (P&L), revenue statement, statement of financial performance, earnings statement, operating statement or statement of operations) is one of the financial statements of a company and shows the company's revenues and expenses during a particular period. It indicates how the revenues (money received from the sale of products and services before expenses are taken out, also known as the "top line") are transformed into the net income (the result after all revenues and expenses have been accounted for, also known as "net profit" or the "bottom line"). It displays the revenues recognized for a specific period and the cost and expenses charged against these revenues, including write-offs (for example, depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.
The important thing to remember about an income statement is that it represents a period of time. This contrasts with the balance sheet, which represents a single moment in time. Charitable organizations that are required to publish financial statements do not produce an income statement. Instead, they produce a similar statement that reflects funding sources compared against program expenses, administrative costs, and other operating commitments. This statement is commonly referred to as the statement of activities. Revenues and expenses are further categorized in the statement of activities by the donor restrictions on the funds received and expended.
The income statement can be prepared in one of two methods.
- The Single Step income statement takes a simpler approach, totaling revenues and subtracting expenses to find the bottom line.
- The more complex Multi-Step income statement (as the name implies) takes several steps to find the bottom line, starting with the gross profit. It then calculates operating expenses and, when deducted from the gross profit, yields income from operations. Adding to income from operations is the difference of other revenues and other expenses. When combined with income from operations, this yields income before taxes. The final step is to deduct taxes, which finally produces the net income for the period measured.
Usefulness and limitations of Income Statement
Income statements should help investors and creditors determine the past financial performance of the enterprise, predict future performance and assess the capability of generating future cash flows through report of the income and expenses.
However, information of an income statement has several limitations:
- Items that might be relevant but cannot be reliably measured are not reported (e.g. brand recognition and loyalty).
- Some numbers depend on accounting methods used (e.g. using FIFO or LIFO accounting to measure inventory level).
- Some numbers depend on judgments and estimates (e.g. depreciation expense depends on estimated useful life and salvage value).
- Revenue - Cash inflows or other enhancements of assets of an entity during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major operations. It is usually presented as sales minus sales discounts, returns, and allowances. Every time a business sells a product or performs a service, it obtains revenue. This often is referred to as gross revenue or sales revenue.
- Expenses - Cash outflows or other using-up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major operations.
- Cost of Goods Sold (COGS) / Cost of Sales - represents the direct costs attributable to goods produced and sold by a business (manufacturing or merchandizing). It includes material costs, direct labor, and overhead costs (as in absorption costing), and excludes operating costs (period costs) such as selling, administrative, advertising or R&D etc.
- Selling, General and Administrative expenses (SG&A or SGA) - consist of the combined payroll costs. SGA is usually understood as a major portion of non-production related costs, in contrast to production costs such as direct labor.
- Selling expenses - represent expenses needed to sell products (for example, salaries of sales people, commissions and travel expenses, advertising, freight, shipping, depreciation of sales store buildings and equipment and more).
- General and Administrative (G&A) expenses - represent expenses to manage the business (salaries of officers / executives, legal and professional fees, utilities, insurance, depreciation of office building and equipment, office rents, office supplies and more).
- Depreciation / Amortization - the charge with respect to fixed assets / intangible assets that have been capitalized on the balance sheet for a specific (accounting) period. It is a systematic and rational allocation of cost rather than the recognition of market value decrement.
- Research & Development (R&D) expenses - represent expenses included in research and development.
Expenses recognized in the income statement should be analyzed either by nature (raw materials, transport costs, staffing costs, depreciation, employee benefit and so on) or by function (cost of sales, selling, administrative etc). If an entity categorizes by function, then additional information on the nature of expenses, at least, – depreciation, amortization and employee benefits expense – must be disclosed. The major exclusive of costs of goods sold, are classified as operating expenses. These represent the resources expended, except for inventory purchases, in generating the revenue for the period. Expenses often are divided into two broad sub classifications selling expenses and administrative expenses.
- Other revenues or gains - revenues and gains from other than primary business activities (for example, rent, income from patents, goodwill). It also includes unusual gains that are either unusual or infrequent, but not both (for example gain from sale of securities or gain from disposal of fixed assets)
- Other expenses or losses - expenses or losses not related to primary business operations, (for example, foreign exchange loss).
- Finance costs - costs of borrowing from various creditors (for example, interest expenses, bank charges).
- Income tax expense - sum of the amount of tax payable to tax authorities in the current reporting period (current tax liabilities/ tax payable) and the amount of deferred tax liabilities (or assets).
They are reported separately because this way users can better predict future cash flows - irregular items most likely will not recur. These are reported net of taxes.
- Discontinued operations: This is the most common type of irregular items. Shifting business location(s), stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations. Discontinued operations must be shown separately.
Cumulative effect of changes in accounting policies (principles) is the difference between the book value of the affected assets (or liabilities) under the old policy (principle) and what the book value would have been if the new principle had been applied in the prior periods. For example, valuation of inventories using LIFO instead of weighted average method. The changes should be applied retrospectively and shown as adjustments to the beginning balance of affected components in Equity. All comparative financial statements should be restated.
However, changes in estimates (for example, estimated useful life of a fixed asset) only require prospective changes.
No items may be presented in the income statement as extraordinary items under IFRS regulations, but are permissible under US GAAP. Extraordinary items are both unusual (abnormal) and infrequent, for example, unexpected natural disaster, expropriation, prohibitions under new regulations. Note: natural disaster might not qualify depending on location (for example, frost damage would not qualify in Canada but would in the tropics).
Additional items may be needed to fairly present the entity's results of operations.
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