The Limitations of an Income Statement

As we know that financial news indicate the impact on the value of the enterprise. The statement of income called INCOME STATEMENT or STATEMENT of EARNINGS is the report that measures the success of enterprise operations for a given period of time. The business and community uses this report to determine

#   Profitability

#   Investment value

#   Credit worthiness

This report provides investors and creditors with information that helps them predict the amounts, timing and uncertainty of future cash flows.

The purposes of an income statement

The income statement helps users of the financial statement predict future cash flows in a number of different ways. Investors and creditors can use the information on the income statement to evaluate the past performance of the enterprise. Although success in the past does not mean success in the future but trends may be determined. If a reasonable correlation between past and future performance can be assumed, then predictions of future cash flows can be made.

Income statement helps users determine the risk concerned with level of uncertainty of not achieving particular cash flows among revenues, expenses, gains and losses. Operations are usually the major means by which revenues usually have greater significance then results from nonrecurring activities and events.

Suppose a manufacturing company that specializes in electronic spare-parts reported $20 million of income from continuing operations before taxes. A closer examination of this income revealed that

$8 million of income came from a gain on the sale of stock

$2.6 million represented a gain on the exchange of stock

$3.9 million came from a gain on the sale of stock in its investment portfolio

$3.4 million came from settlement of lawsuits related to patent infringements

The largest revenue $10.5 million comes from patent or royalties on its electronic spare-parts that might not continue because the patent was about to expire. Our point is that income does not tell the whole story because the derived income is at best a rough estimate, the reader of the statement should take care not to give it more significance than it deserves.

According to economists, income as the maximum value of an entity can consume during a period and still be as well off at the end as at the beginning. Any effort to measure how well an entity is at any point in time will prove fruitless unless certain assumptions are developed and applied. Income should measure not only monetary income but also physic income. Physic income is defined as a measure of increase in net wealth arising from quantitative factors. Accountants know that the recognition of such experiences might be useful but the problem of measurement has not been solved. Thus, items that cannot be reliable quantified have been discarded in determining income.

Income numbers are often affected by the accounting methods employed. For example, a company may choose to depreciate its plant assets on an accelerated basis while another company may choose a straight line basis. Assuming all factors are equal, the income of the first company will be lower than the second company event though the companies are same. Thus the quality of earnings of a given enterprise is important. Companies that use liberal or aggressive accounting policies report higher income in the short run. In such cases, we say the quality of the earnings is low. Other companies generate income in the short run as a result of a non-operating or nonrecurring event that is not sustainable over a period of time.

It is permissible to use smooth earnings by creating balance sheet reserves. This reserves are created by reducing income in good years however in less profitable years previous income is retrieved from the reserves to increase the income in the current year.  

There are two ways to calculate net income

I.  Capital Maintenance Approach or Change in Equity Approach

Ending net assets on the year minus beginning net assets on the same year plus dividend declared during the year then deduct with owner’s investments during the year, to get net income for the year.

It takes the net assets or capital values based on historical cost, discounted cash flows, current cost or fair market value and the difference in capital value at two points in time.

Suppose a corporation had beginning net assets $30,000 and $54,000 at the end of the year. During the same year additional owner’s investments $15,000 were made and $3,000 of dividends were declared. Calculation of net income for the period employing the capital maintenance approach is $12,000 ($54,000 - $30,000 + $3,000 - $15,000)

When using this capital maintenance approach, the composition of the income is not evident because the revenue and expense amounts are not presented to the financial statement reader.

II.  Transaction Approach

The alternative procedure measures the basic income related transactions that occur during a period and summarizes them in an income statement called TRANSACTION APPROACH. This approach focuses on the activities that have occurred during a given period. Instead of presenting only a net change, it discloses the components of the change. The transaction approach provides information on the elements of income. According to this approach, income may be classified by

#   Customer

#   Product line or function

#   Operating and nonoperating

#   Continuing and discontinued

#   Regular and irregular

 

It is called “IRREGULAR” if transactions and events are derived from developments outside the normal operations of the business. For example, the sale of investments by an insurance company is part of its irregular operations, whereas in a manufacturing enterprise it is not.

The transaction approach to income measurement requires the use of revenue, expense, loss and gain accounts, without which an income statement cannot be prepared. The distinction between revenues and gains and the distinction between expenses and losses depend to a great extent on the typical activities of the enterprise.

The sales of investments sold by an insurance company would generally be classified as revenue, whereas the sales price less book value on the sale of an investment by a manufacturing enterprise would be classified as gain or loss.

Single step income statement

In reporting revenues, gains, expenses and losses, many accountants prefer a format called the single step income statement. In the single step income statement, just using revenue and expenses groups. Expenses are deducted from revenue to arrive at net income or loss. Income tax is reported separately as the last item before net income to indicate their relationship to income before tax. This format of income statement is widely used in financial reporting. The primary advantage of this format lies in the simplicity of presentation and the absence of any implication that one type of revenue or expense item has priority over another.

In some cases, it is impossible to present in a single income statement of all the desired expense detail. This problem is solved by including only the totals of expense groups in the statement of income and preparing supplementary schedules of expense to support the totals. Readers who wish to study all the reported data must give their attention to the supporting schedules.

Multiple step income statement

Another format which called a multiple step income statement. Accountants use this format to describe other important revenue and expense data to make the income statement become more informative and useful. This statement is recommended because it recognizes a separation of operating transactions from non operating transactions and matches costs and expenses with related revenues. In arriving at net income, three subtotals are presented when you are using a multiple step income statement.

1. Net sales revenue
2. Gross profit
3. Income from operations

The disclosure of net sales revenue is useful because regular revenues are reported as a separated item. Irregular or incidental revenue are disclosed elsewhere in the income statement. As a result, revenue from continuing operations should be easier to understand and analyze.

Reporting of gross profit for evaluating performance and assessing future earnings. It shows how successfully a company uses its resources as a result of competitive pressure.

Disclosing income from operations highlights the difference between regular and irregular or incidental activities. This disclosure helps users recognize that incidental or irregular activities are unlikely. Disclosure of operating earnings may assist in comparing with different companies and to know operating efficiencies.

When you are using a multiple step income statement, you will find several sections and subsections there

A.  Operating section

Reporting the revenue and expenses of the company’s principal operations.

#   Sales or revenue

#   Cost of goods sole

#   Selling expenses

#   Administrative or general expenses

They are subsequents of operating section

B.  Non operating section

Reports revenues and expenses resulting from secondary or auxiliary activities of the company. Special gains and losses that are unusual or infrequent, but not both are normally reported in this section

#   Other revenue and gains from nonoperating transactions

#   Other expenses and losses

They are subsequents of nonoperating section

C.  Income tax section

A short section of reporting tax on income from continuing operations.

D.  Discontinued operations section

Material gains or losses resulting from the disposition of a segment of the business.

E.  Extraordinary items section

Unusual and infrequent material gains and losses.

F.  Earning per share section

Last section of an income statement.

The breakdown above is commonly used for manufacturing concerns and for merchandising companies in the wholesale trade. Usually financial statement that are provided to external users have less detail than internal management reports. However, whether a single step or multiple step income statement is used, irregular transactions such as

#   Discontinued operations

#   Extraordinary items

#   Cumulative effect of changes in accounting principles

They should be reported separately following income from continuing operations.

How much detail to include in the income statement is always a problem. On the one hand, we want to present a simple income statement so that a reader can discover important facts. On the other hand we want to disclose the results of all activities and to provide more than just a skeleton report. As we will see that they can be presented in various formats as long as certain basic elements are always included.

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