Income Statement

Purposes of income statement

An income statement is useful to investors and creditors for evaluating economic performance of a firm so it presents the success of a company’s operations during an accounting period.

The results of operations during a period of time are reported in the income statement (statement of earnings) on the accrual basis.

Reporting income reflects the all-inclusive approach.

Revenues, expenses, gains and losses accounts are nominal (temporary) accounts. They are zeroed out (closed) periodically and their net balance transferred to real (permanent) accounts on the balance sheet (through R.E). The accountant need not close each revenue and expense transaction directly to capital.

Revenues and expenses stem from a firm’s central and ongoing operations

Gains and losses report the results of peripheral or incidental transactions.

All transactions affecting the net change in equity during the period are included in income statement under the all-inclusive approach except:

• Transactions with owners
• Prior-period adjustments
• Items reported initially in other comprehensive income
• Transfers to and from appropriated retained earnings
• Adjustments made in quasi-reorganization, quasi-reorganization eliminates a deficit in retained earnings through reductions in other capital accounts. It accomplishes in a simpler way the same purpose as a legal reorganization. Elimination of the deficit permits a company to pay dividends.

Income statement formats

Three formats are commonly used for presentation of income or loss from continuing operations:

The Single-step income statement

provides one grouping for revenue items and one for expense items.

The single step is the one subtraction necessary to arrive at net income from continuing operations prior to the effect of income taxes.

The multiple-step income statement

matches operating revenues and expenses in a section separate from non-operating items, this format enhances disclosure by presenting intermediary totals rather than one net income figure

The multiple-step income statement matches operating revenues and expenses separately from non-operating items this presentation enhances disclosure by presenting intermediary totals rather than one net income from continuing operations figure. This format emphasizes subtotals; the intermediary totals include gross margin, operating income (EBIT), and EBT, within presentation of income from continuing operations.

Because of inexact estimates of the service life and the residual value of a plant asset, if a fully depreciated asset was sold at a material gain, this gain should be reported in the other revenues and gains section of the income statement.

The major distinction between the multiple-step and single-step income statement formats is the separation of operating and non-operating data Within the income from continuing operations category.

Condensed income statement

includes only the section totals of the multiple- step format.

Reporting irregular items

When an enterprise reports discontinued operations (that result from disposal of a business segment) or extraordinary items, these must be presented in a separate section after income from continuing operations and reported net of tax.

To be classified as an extraordinary item, the item should be material in amount, unusual in nature in the environment in which the entity operates and infrequent in occurrence.

An unusual or infrequent event considered to be material that does not qualify as an extraordinary item is Placed as part of income from continuing operations (Shown in operating revenues or expenses) after normal recurring revenues and expenses preferably as a single line item ,such items should not be shown net of income taxes.

Extraordinary items are presented after the discontinued operation category, when reporting extraordinary items, each item (net of tax) is preferably presented on the face of the income statement separately (individually) as a component of net income for the period. Otherwise, disclosure in related notes is acceptable.

Certain items ordinarily are not treated as extraordinary gains or loss, rather they are included in the determination of income from continuing operations, these gains and losses include those from write -downs of receivables and inventories, gains or losses from foreign currency transactions, sale of productive assets, losses from strikes, accruals on long term contracts, and gains or losses from early extinguishment of debt.

Separating recurring items from non- recurring items enhances earning quality analysis.

Basic and diluted EPS amounts must be disclosed, either on the face of the income statement or in the accompanying notes.

If the firm prepared its income statement under the current operating performance concept (narrow concept and is not consistent with GAAP) it would include only the recurring earnings from its normal operations and no other items, because inclusion of extraordinary items and non-recurring items is believed to impair the significance of net income.

The limitations of income statement include the following

The income statement does not always show all items of income and expense. For example, some items of “other comprehensive income,” such as foreign exchange translation adjustments, are not reported in the calculation of net income. Instead these items are reported on a statement of Other Comprehensive Income, which is usually effectively hidden on the statement of shareholders’ equity.