The income statement presents information on the financial results of a company’s business activities over a period of time. It is also known as the ‘statement of operations’, ‘statement of earnings’, or ‘profit and loss (P&L) statement’. The basic equation underlying the income statement is:
Income – Expenses = Net Income
Equity analysts carefully analyze a company’s income statements for use in valuation models while fixed-income analysts analyze income statements to measure a company’s debt servicing ability.
Components of the income statement
The components of an income statement are:
Revenues: Income generated from the sale of goods and services in the normal course of the business. Net revenue is the total revenue minus products that were returned and amounts that are unlikely to be collected.
Expenses: Costs incurred to generate revenues. Expenses may be grouped and reported in different formats, subject to some specific requirements.
Gains and losses: Amounts generated from non-operating activities.
Net income: Net income can be calculated as Net income = Revenues – Expenses + Gains – Losses.
Income statements can be presented in the following two formats:
The table below shows samples for both formats.
|Multi-step format||Single-step format|
|$ million||2018||2017||$ million||2018||2017|
|Cost of sales||10,300||9,060||Cost of sales||10,300||9,060|
|Gross Profit||25,010||22,540||Gain from sale of equipment||900||860|
|Gain from sale of equipment||900||860||Advertising expense||1,000||900|
|Advertising expense||1,000||900||Other expenses||6,500||6,100|
|Depreciation||960||850||Operating Income (EBIT)||14,050||12,650|
|Other expenses||6,500||6,100||Interest Expense||10||70|
|Operating Income (EBIT)||14,050||12,650||Profit before tax (EBT)||14,040||12,580|
|Interest Expense||10||70||Tax Expense||3,945||3,300|
|Profit before tax (EBT)||14,040||12,580|
|Tax Expense||3,945||3,300||Profit after tax||10,095||9,280|
|Profit after tax||10,095||9,280|
Under the accrual method of accounting, revenue should be recognized when earned and not necessarily when cash is received. Let us consider three simple examples to illustrate this point.
Companies must disclose their revenue recognition policies in the notes to their financial statements, and analysts should read these carefully to understand how and when a company recognizes revenue.
Accounting Standards for Revenue Recognition
In May 2014, the IASB and FASB issued converged standards for revenue recognition. The standards take a principles-based approach to revenue recognition issues. The core principle behind the converged standard is that revenue should be recognized to “depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in an exchange for those goods or services.”
According to the standard, the following five steps must be followed in order to recognize revenue:
When revenue is recognized, a contract asset is added to the balance sheet. If an advance is received but performance obligations have not been met, then a contract liability is added to the seller’s balance sheet.
Treatment of related costs
Specific accounting treatment for related costs is summarized below:
The converged standard mandates the following disclosure requirements: