Financial Reporting and Analysis II

Reading 21. Understanding Income Statements

Learning Outcome Statements

a. describe the components of the income statement and alternative presentation formats of that statement;

CFA Curriculum, 2020, Volume 3

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Subject 1. Components and Format of the Income Statement

The income statement presents information on the financial results of a company's activities over a period of time. The format of the income statement is not specified by U.S. GAAP and the actual format varies across companies.

Here are common components:

  • Sales or revenue: amount charged for the delivery of goods or services.

    • Follows the revenue recognition rule: Revenue is recognized even though cash may not be collected until the following accounting period.
    • Net sales = gross sales - sales returns and allowances - discounts.
    • Amount of sales and trends in net sales over time are used to analyze a company's progress.

  • Cost of goods sold is the amount paid for merchandise sold, or the cost to manufacture products that were sold, during an accounting period.

  • Gross margin = net sales - costs of goods sold. Also called gross profit.

    Management is interested in both:

    • The amount of gross margin; and
    • The percentage of gross margin (gross margin/net sales).

    Both are useful in planning business operations.

  • Operating expenses are expenses other than the cost of goods sold that are incurred in running a business.

    • These expenses are grouped into categories: selling expenses, general and administrative expenses, and other revenues and expenses.
    • Careful planning and control of operating expenses can improve a company's profitability.

  • Income from operations (also called operating income) is the difference between gross margin and operating expenses. It represents the income from a company's normal, or main, business. It is used to compare the profitability of companies or divisions within a company.

  • Other revenues and expenses are not part of a company's operating activities. These include:

    • Revenues or expenses from investments (e.g., dividends and interest).
    • Interest and other expenses from borrowing.
    • Any other revenue or expense not related to the company's normal business operations.

    They are also called non-operating revenues and expenses.

  • Income before income taxes is the amount a company has earned from all activities - operating and non-operating - before taking into account the amount of income taxes the company incurred.

    This is used to compare the profitability of two or more companies or divisions within a company. Comparisons are made before income taxes are deducted because companies may be subject to different income tax rates.

  • Income taxes (also called provision for income taxes) represent the expense for federal, state, and local taxes on corporate income.

    The income taxes account is shown as a separate item on the income statement. Tax rates are substantial (usually 15-38%) and have a significant effect on business decisions. Most other types of taxes are shown among operating expenses.

  • Net income is what remains of the gross margin after operating expenses are deducted, other revenues and expenses are added or deducted, and income taxes are deducted. It is the final figure, or "bottom line," of the income statement.

    Net income = Income before income taxes - income taxes

    Net income is an important performance measure.

    • It represents the amount of business earnings that accrue to stockholders.
    • It is the amount transferred to retained earnings from all income generating activities during the year.
    • It is often used to determine whether a business has been operating successfully.

The following is a sample income statement for company XYZ for fiscal years ending 2006 and 2007 (expenses are in parentheses).

Income Statement For Company XYZ FY 2006 and 2007
(Figures USD) 2006 2007
Net Sales 1,500,000 2,000,000
Cost of Sales (350,000) (375,000)
Gross Income 1,150,000 1,625,000
Operating Expenses (SG&A) (235,000) (260,000)
Operating Income 915,000 1,365,000
Other Income (Expense) 40,000 60,000
Extraordinary Gain (Loss) - (15,000)
Interest Expense (50,000) (50,000)
Net Profit Before Taxes (Pretax Income) 905,000 1,360,000
Taxes (300,000) (475,000)
Net Income 605,000 885,000

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User Contributed Comments 22

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totsaso

good

olagbami

i say good too.

purepunjabi

clear

wundac

I like it.

demonita

It is easy to understand

ndachie

simple, concise and easy to comprehend. thanks

SpyAli

not bad

tamanma

it is simple and concise

gill15

not knowing accounting at all that cleared up a lot...

oneashok

clear, but whether this is comprehensive?

Yfj211

Isn't extraordinary items after income from ops, net of tax

fgt124

very good to understand

gill15

I hate accounting. That was a great simple first lesson.

nab3a123

Yeah isn't extraordinary items after income from operations???
Net of taxes !!

emmaejehu

what is the meaning of exraordinary items

ruiyong

cool

cy166099

So Net sales could also = allowances - discounts? and where do you find allowances and discounts?

cy166099

nevermind.

cy166099

emmaejhu, extraordinary items are rare and infrequent gains and losses

idzani

Gorgeous

mycfa2016

well explained and made simple to understand

792721018

Easy to understand