Income statement

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Income Statement

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Agenda

1. Overview1. Introduction

2. About Income Statement

3. Why Income does not always equal cash?

2. Definitions1. Simple Step

2. Multiple Step

3. Simple Step vs Multiple Step

3. Methods & Principles1. General Principles

2. Inventory Costing Methods

4. Practicing

5. Conclusion

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Overview

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Overview

1. Introduction

This module is composed by:

Presentation is the skeleton of the course, with the main topics. (PPT) Readings are external files with additional content more complex than presentation.

(PDF)

Message for the reader

This course is very basic. My suggestion is to check the agenda before to start reading everything. The course is divided in: A theoretical part, how to present and report cash flow statements and finishes with a practical part. In the end there are some references and external readings.

If you are trying to develop an income statement or another financial statement and would like to discuss or ask any help in the development, feel free to contact me, it would be my pleasure help you and If you have suggestions, ideas, feedbacks or doubts send a mail, your message is very welcome.

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Overview

2. About Income StatementIncome statement is often called the PROFIT ANG LOSS STATEMENT (P&L), statement of

operations, statement of comprehensive income.

An income statement measures a section’s financial performance between balance sheet

dates. It is a representation of the operating and non-operating activities of a section.

A firm’s income statement indicates a great deal about the health of a section. Analysis of this

statement, in particular analysis of trends over time, provides a firm’s managers, creditors and

stockholders with important insights into the future potential of the section.

It is divided in two parts: Operating Items Sections & Non Operating Items Section

Operating IS: provides information about revenues and expenses that are a direct result

of regular organization operations

Non Operating IS: details any revenue and expense information about activities that are

not tied directly to these operations

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Overview

3. Income Statement & Cash Flow Statement

The income statement describes how the assets and liabilities were used in the stated

accounting period.

The cash flow statement explains cash inflows and outflows, and it will ultimately reveal the

amount of cash the company has on hand, which is also reported in the balance sheet.

Consequently how assets and liabilities are used can influence how inflows and outflows and

consequently the result of these interactions it will determine the final result, which means the

amount of resources available for the company. Which will be reported in the cash flow

statement.

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Overview

4. Why Income does not Always equal cash?

With the accrual method of accounting, sales are recorded on the income state when the

goods and/or services associated with those sales are delivered or shipped to a customer.

The cost of goods sold are recorded in the income statement at the same time the sales a

recorded. Sales and cost of goods are recorded regardless of when the business receives

cash for the goods delivered of when the business had to pay cash for the expense

associated with cost of goods sold.

There is a difference in the timing of when cash and income are recognized. Even though a

business may show a profit on the income statement, it cannot continue unless it has the cash

flow necessary to pay its bills.

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Example

Accrual Entry and Matching

PrincipleSituation: ESN Brera, to promote some

social events, decided to use a tool from

Facebook called “Promoter” and now is

time to pay the commission for this

service. The value to be paid is €500 in

January. But the treasurer just provided the

payment in February, how this is equated

according this principle?

The commission expense is charged

before the cash payment.

Matching PrincipleIn the next month, ESN Brera pays the

commission and records the following

entry:

Cash Basis AccountingThe same situation interpreted by Cash

Basis Accounting would lead ESN Brera to

entry in February, this:

The commission expense it would record

expense only when it pays the cash.

January Debit Credit

Commission Expense €500 -

Accrued Expenses - €500February Expenses

Commission Expense €500

February Debit Credit

Accrued Expenses €500 -

Cash - €500

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Definitions

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Simple Step

Under the accrual basis of accounting, revenues are shown in the period they earned,

not in the period when the cash is collected.

Revenues occur when money is earned.

Receipts occur when cash is received.

Revenues from Primary Activities - These are often referred to as operating revenues

and are only those revenues derived from the provision of sales or services. (es: Selling

of ESN Cards)

Revenues from Secondary Activities - These are often referred to as non-operating

revenue and are those that an organization earns outside of selling goods and services

(es: Sell of an old pc)

Gains - These are derived from the sale of long-term assets and are reported on the

income statement as the net of two amounts: The proceeds received from the sale of

long-term asset minus the amount listed for that item on the section’s book

Revenues

Primary Activities – Operating Expenses

Secondary Activities – Non Operating Revenues

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Simple Step

Expenses from Primary Activities - These are the costs that are incurred in order to

earn normal operating revenues. The Costs of Goods Sold is the costs that go into

creating the products that an organization sells, is considered the cost of the stock that

was sold during the period. (es: Cost to buy ESN Card)

Costs of Goods Sold = Beginning Inventory – Ending Inventory + Purchases

Expenses from Secondary Activities - These are often referred to as non-operating

expenses, like interest expense because involves the financial function of the

organization (es: Interest’s loan to pay)

Losses – These include things like the loss from the sale of long term assets or a

transaction that is outside of an organization’s primary activities. A loss is reported as the

net of two amounts: the amount listed for the item on the section’s books (book value)

minus the proceeds received from the sale. A loss occurs when the proceeds are less

than the book value.

Expenses

Primary Activities – Operating Revenues

Secondary Activities – Non Operating Expenses

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Multiple Step - Definitions

1. Net Sales (NS) - The total volume of all cash or credit sales less returns, allowances, discounts and rebates

2. Cost of Goods Sold (CGS) - For a retail or wholesale business it is the total price paid for the products sold

plus the cost of having them delivered to the store during the accounting period

3. Gross Profit (GP) - Profit before operating expenses and federal taxes have been deducted

4. Operating Expenses (OE) - The selling, general and administrative/overhead expenses to run the business.

Excludes cost of goods sold, interest and income tax expense. Examples of these costs are rent, utilities, administrative

department such as accounting, marketing human resources

5. Operating Income (OI) - The amount left over after subtracting operating expenses from gross profit

6.Income Before Taxes (IBT) - Operating Income plus other income

7. Net Income (NI) - Income before taxes minus income taxes. This is what the business earned in the period. It is

added to the balance sheet and increase net worth. Often called Net Profit or Net Earnings

8. Gross Margin (GM) – Gross profit margin indicates the percentage of revenue available to cover operating and

other expenditures. Higher gross profit margin indicates some combination of higher product pricing and lower product costs.

The ability to charge a higher price is constrained by competition, so gross profits are affected by (and usually inversely

related to) competition. If a product has a competitive advantage (e.g., superior branding, better quality, or exclusive

technology), the section is better able to charge more for it. On the cost side, higher gross profit margin can also indicate that

a section has a competitive advantage in product costs.

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(+) Sales €700,000.00

(-) Cost of Goods Sold €500,000.00

(=) Gross Profit €200,000.00

(-) Total Expenses €184,200.00

(=) Operating Income €15,800.00

(+) Other Income €500.00

(=) Income Before

Taxes€16,300.00

(-) Income Taxes €5,400.00

(=) Net Income €10,900.00

Multiple Step

Expenses

(+) Freight €7,000.00

(+) Debt €134,000.00

(+) Utilities €7,000.00

(+) Depreciation €4,000.00

(+) Insurance €7,000.00

(+) Taxes €11,000.00

(+) Interest €14,200.00

(=) Total Expenses €184,200.00

Simple Step

Revenues + Gains Expenses + Losses Net Incomes

Income Statement Simple Step vs Multiple Step

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Methods & Principles

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1. General Principles – Expense Recognition

An important concept concerning revenue recognition is that it can occur independently of

cash movements. For example, assume a section sells goods to a buyer on credit and so

does not actually receive cash until some later time.

A fundamental principle of accrual accounting is that revenue is recognized when it is earned,

so the section ’s financial records reflect the sale when it is made and a related accounts

receivable is created. Later, when cash changes hands, the section ’ s financial records

simply reflect that cash has been received to settle an account receivable.

Similarly, there are situations when a section receives cash upfront and actually delivers the

product or service later, perhaps over a period of time. In this case, the section would record

unearned revenue , which is then recognized as being earned over time.

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2. General Principles – Revenues Recognition

A general principle of expense recognition is the matching principle, also known as the

“matching of costs with revenues”. A section directly matches some expenses (e.g., cost of

goods sold) with associated revenues. Unlike the simple scenario in which a section

purchases inventory and sells all of the inventory within the same accounting period, in

practice, it is more likely that some of the current period ’s sales are made from inventory

purchased in a previous period. It is also more likely that some of the inventory purchased in

the current period will remain unsold at the end of the current period and so will be sold in the

following period. The matching principle requires that the section match the cost of goods sold

with the revenues of the period.

Period costs, expenditures that less directly match the timing of revenues, are reflected in the

period when a section makes the expenditure or incurs the liability to pay. Administrative

expenses are an example of period costs. Other expenditures that also less directly match the

timing of revenues relate more directly to future expected benefits; in this case, the

expenditures are allocated systematically with the passage of time.

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3. Inventory Costing Methods

Inventory Costing Methods are methods to evaluate the costs of products stocked. They can

be can be helpful to understand which method allows to reduce taxes expenditures for

example.

Method Description

Cost of Goods

Sold when Prices

are Rising, Relative

to Other Two

Methods

Ending Inventory

When Prices Are

Rising, Relative to

Other Two

Methods

FIFO (First in, First Out)

Assumes that

earliest items

purchased were

sold first

Lowest Highest

LIFO (Last in, First Out)

Assumes most

recent items

purchased were

sold first

Highest Lowest

Weighted Average Cost

Average total costs

over total units

availableMiddle Middle

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3. Inventory Costing Methods – Example (1)

ESN Brera purchases inventory items for resale. During 2006, it had the following

transactions:

Inventory sales during the year were 5,600 units at $50 per unit. ESN Brera determines that

there were 2,000 remaining units of inventory and specifically identifies that 1,900 were those

purchased in the fourth quarter and 100 were purchased in the third quarter.

What are the revenue and expense associated with these transactions during 2006?

Inventory Purchases

First Quarter 2000 units at €40/unit

Second Quarter 1500 units at €41/unit

Third Quarter 2200 units at €43/unit

Fourth Quarter 1900 unit at €45/unit

Total7600 unit at a total cost of

€321,600.00

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3. Inventory Costing Methods – Example (2)

Solution. The revenue for 2006 would be €280,000 (5,600 units x €50 per unit). Initially, the

total cost of the goods purchased would be recorded as inventory (an asset) in the amount of

$321,600. During2006, the cost of the 5,600 units sold would be expensed (matched against

the revenue) while the cost of the 2,000 remaining unsold units would remain in inventory as

follows:

To confirm that total costs are accounted for: €231,800 + €89,800 = €321,600

Cost of Goods Sold (1)

From the First

Quarter

2000 units at €40/unit =

€80,000.00

From the

Second

Quarter


€61,500.00

From the Third

Quarter


€90,300.00

Total cost of

goods sold

1900 unit at €45/unit =

€231,300.00


From the

Third Quarter


€4,300.00

From the

Fourth Quarter


€85,500.00

Total

Remaining (or

ending)

Inventory Cost

€89,800.00

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4. Alternative Inventory Costing Methods – Example (1)

In the previous example, ESN Brera was able to specifically identify which inventory items

were sold and which remained in inventory to be carried over to later periods. That method is

called the specific identification method. It is not always possible to specifically identify which

items were sold, so the accounting standards permit the assignment of inventory costs to

costs of goods sold and to ending inventory using cost flow assumptions.

Under both IFRS and U.S. GAAP, companies may use either of two methods to assign costs:

the first in, first out (FIFO) method, or the weighted average cost method. Under the FIFO

method, it is simply assumed that the earliest items purchased were sold first.

The weighted average cost method simply averages the total available costs over the total

available units.

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For ESN Brera:


Weighted Average Cost (WAC) €321,600/7,600 unit = 42.31 p/unit

Cost of Goods Sold with WAC 5,600 unit X €42,31 = €236,968

Ending inventory with WAC 2000 unit X €42,31 = €84,63

Total cost of goods sold 1900 unit at €45/unit = €231,300.00

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For ESN Brera:

Under the LIFO method, it is assumed that the most recent items purchased were sold first.

Although this may seem contrary to common sense, it is logical in certain circumstances.

Under the LIFO method, in the ESN Brera example, it would be assumed that the 2,000 units

remaining in ending inventory would have come from the first quarter’s purchases

Ending Inventory €40.00 p/unit X 2000 unit = €80.000

The remaining costs would be allocated to cost of goods under LIFO

Total Costs €321,600 - €80,000 = €241,600

Total cost of goods sold 1900 unit at €45/unit = €231,300.00

Alternatively, the cost of the last 5,600 units purchased is allocated to cost of

goods sold under LIFO:

1900 units X €45 p/unit + 2200 units X €43 p/unit + 1500 unit X €41 p/unit = €241,600.00

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Practicing

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Practicing

1. Exercises

1.1) Consider the following monthly data for ESN Brera, for January through June:

Assuming that the first quarter of 2003 includes the months of January, February and March,

1) What would ESN Brera report as revenue on its first quarter income statement?

2) What would ESN Brera report as expenses on its first quarter income statement?

3) What would ESN Brera report as profit (or loss) on its first quarter income statement?

Answers: €90,000.00 ; €65,000.00 ; €25,000.00

* Better visualize in Slide Show

Month Sales Expenses

January €20,000.00 €15,000.00

February €30,000.00 €20,000.00

March €40,000.00 €30,000.00

April €30,000.00 €20,000.00

May €50,000.00 €40,000.00

June €20,000.00 €15,000.00

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Practicing

1.2) Consider the following monthly data for ESN Brera, for January through June:

Assuming that the second quarter of 2003 includes the months of April, May and

June,

1) What would ESN Brera. report as revenue on its second quarter income statement?

2) What would ESN Brera report as expenses on its second quarter income statement?

3) What would ESN Brera report as profit (or loss) on its second quarter income statement?

4) What would ESN Brera report as profit (or loss) on its income statement covering the

period January through June?

Answers: €100,000.00 ; €75,000.00, €25,000.00, €50,000.00


Month Sales Expenses

January €20,000.00 €15,000.00

February €30,000.00 €20,000.00

March €40,000.00 €30,000.00

April €30,000.00 €20,000.00

May €50,000.00 €40,000.00

June €20,000.00 €15,000.00

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Practicing

CommentsIt is important to realize that profit on an income statement seldom corresponds with a section’s actual cash

flow. In fact, while all companies seek to maximize their cash flow (since cash is necessary to pay bills,

salaries, loans, dividends and so on), not all companies attempt to maximize reported earnings. In fact,

many companies actually try to minimize reported earnings in an attempt to reduce taxes.

The reason why income and cash flow seldom match is that most companies elect to prepare their income

statements (and thereby their balance sheets) using accrual accounting as opposed to cash accounting.

Accrual accounting recognizes revenues as earned when sales are transacted, regardless of when the

section actually receives payment. Likewise, expenses are recognized when they are incurred rather than

when the actual payment is made.

In contrast, cash accounting recognizes revenues as earned only when payment is received and recognizes

expenses as costs only when cash is actually paid out. One part of the statement of cash flows

(specifically, cash flows from operating activities) represents the conversion of an accrual accounting

income statement into a cash accounting income statement.

The basic structure of a multi-step income statement is outlined. The term multi-step means that four profit

measures are designated on the statement: gross profit, operating profit (sometimes referred to as

operating income, Earnings before Interest and Taxes, or EBIT), profit before taxes (sometimes referred to

as Earnings before Taxes or EBT), and net income (also referred to simply as earnings).

Note that these are not the only accounts that may appear on an income statement and some income

statements may utilize slightly different terminology. Some companies offer more detail on their statements

than others.

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Practicing

2.1) Consider this statement from ESN Brera

In 2003, ESN Brera, Inc. (a hardware retail section) sold 10,000 units of its product at an

average price of €400 per unit. The section reported estimated Returns and allowances in

2003 of €200,000. ESN Brera actually purchased 11,000 units of its product from its

manufacturer in 2003 at an average cost of €300 per unit. ESN Brera began 2003 with 900

units of its product in inventory (carried at an average cost of €300 per unit). Operating

expenses (excluding depreciation) for ESN Brera, Inc. in 2003 were €400,000 and

depreciation expense was €100,000. ESN Brera had €2,000,000 in debt outstanding

throughout all of 2003. This debt carried an average interest rate of 10 percent. Finally, ESN

Brera’s tax rate was 40 percent. ESN Brera’s fiscal year runs from January 1 through

December 31. Given this information, construct ESN Brera’s 2003 multi-step income

statement.

1) What was ESN Brera ending inventory balance (in both units and in euros)?


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Practicing

2.1) Answers

1) What was ESN Brera ending inventory balance (in both units and in euros)?

Answer: €570,000.00 and 1,900 units


(+) Sales €3,800,000.00

(-) Cost of Goods Sold €3,000,000.00

(=) Gross Profit €800,000.00



(-) Interest Expenses €200,000.00

(=) EBT €100,000.00

(-) Taxes €40,000.00

(=) Net Income €60,000.00

Net Sales =

Gross Sales - Returns and Allowances

(€10,000.00x€400) -

€200,000.00

Cost of Goods Sold =

unit x Cost/unit(10,000.00)x(€300)

Interest Expenses =

Debt x Average IR(€2,000.000)x(10%)

Taxes = (EBT) x (Tax Rate) (€100,000.00)x(40%)

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Practicing

Comments

A firm’s income statement indicates a great deal about the health of a section. Analysis of this statement, in

particular analysis of trends over time, provides a firm’s managers, creditors and stockholders with

important insights into the future potential of the section. Good analysis will also highlight areas where

changes need to be considered.

Hopefully, you now understand the basic structure and composition of an income statement. This

understanding is essential before any type of meaningful financial analysis or management can occur. To

verify the former, try to complete the following problem without looking back over this section of the book.

Be sure that you can properly define, identify and classify each item on this section’s income statement. If

you can do so, then you are ready to go on. If not, be sure that you carefully reread this section of the book.

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Practicing

3.1) Prepare a Multi Step Income Statement for ESN Brera

Advertising expenditures €68,000

Beginning inventory €256,000

Depreciation €78,000

Ending inventory €248,000

Gross Sales €3,210,000

Interest expense €64,000

Lease payments €52,000

Management salaries €240,000

Materials purchases €2,425,000

R&D expenditures €35,000

Repairs €22,000

Returns and allowances €48,000

Taxes €51,000


Answer

(+) Sales €3,162,000.00

(-) Cost of Goods Sold €2,433,000.00

(=) Gross Profit €729,000.00


(-) Depreciation €78,000.00


(-) Interest Expenses €64,000.00

(=) EBT €170,000.00

(-) Taxes €51,000.00

(=) Net Income €119,000.00

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Practicing

4.1) In 2003, ESN Brera had gross sales of €1,253,400. The section’s management

reported a Returns and Allowances estimate of €53,400 in 2003. What did ESN Brera report

as Net sales in 2003? (Answer: €1,200.000)


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Conclusion

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Conclusion

1. The income statement presents information on the financial results of a section ’s

activities over a period of time; it communicates how much revenue was generated

during a period and what costs it incurred in connection with generating that revenue.

2. The components of the income statement include: revenue; cost of sales; sales,

general, and administrative expenses; other operating expenses; non-operating income

and expenses; gains and losses; nonrecurring items; net income.

3. Revenue is recognized in the period it is earned, which may or may not be in the same

period as the related cash collection. Recognition of revenue when earned is a

fundamental principal of accrual accounting.

4. The general principles of expense recognition include the matching principle. Expenses

are matched either to revenue or to the time period in which the expenditure occurs

(period costs) or to the time period of expected benefits of the expenditures (e.g.

depreciation).

5. In expense recognition, choice of method (i.e., depreciation method and inventory cost

method), affect a section’ s reported income.

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References

1. Financial Statement Analysis, K.R. Subramanyam, John J.Wild, Tenth Edition, 2009

2. International Financial Statement Analysis, Thomas R. Robinson, Hennie van Greuning,

Elaine Henry, Michael A. Broihahn, CFA Institute, 2009

3. Financial Statement Analysis & Valuation, Peter D. Easton, Mary Lea McAnally, Gregory

A.Sommers, Xiao-Jun Zhang, Cambridge Business Publishers, Fourth Edition, 2015

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External Reading

Readings not related to ESN but to accounting.

1. Transparency in Central Banks Financial Statement Disclosures – IMF

2. Three Types of Accounting Policies Reflected in Financial Statements. Case Study for

Romania

3. Financial Accounting Manual for Federal Reserve Banks

4. Grants versus Loans for Development Banks

https://www.imf.org/external/pubs/ft/wp/2005/wp0580.pdf

http://www.globeco.ro/wp-content/uploads/vol/split/vol_2_no_1/geo_2014_vol2_no1_art_020.pdf

http://www.federalreserve.gov/monetarypolicy/files/BSTfinaccountingmanual.pdf

https://www.aeaweb.org/assa/2005/0107_1015_0703.pdf

Economy & Finance

Income statement