The income
statement is a presentation of the results of a company's business
operations for a particular period of time. By reading the income
statement, you can determine the inflow of new assets into a business
and measure the consumption of assets that result from the production of
revenue.
As with most elements of financial statements, the key to quality
assessment of an income statement is looking for trends over time.
Compare the most recent statement with those of like periods in prior
years to gauge the direction and progress of a company's business
operations.
Revenues and expenses are recorded on an income statement at the time
they are earned or incurred, regardless of when actual assets change
hands.
We'll list each element of an income statement with a brief discussion
below
Sales or Operating Revenues:
Net sales or service revenues.
Cost of Goods Sold: The amount the company paid in the production
of goods it sold. Costs may include labor, materials, overhead, and
depreciation.
Gross Profit: Total revenue of a business less cost of goods sold
and selling and administrative expenses. Gross profit does not include
income from incidental sources.
Operating Expenses: The expenses incurred in running the
business. Operating expenses include selling and administrative expenses
but exclude interest, taxes, and cost of goods sold.
Operating Revenues: Revenues from any regular business source.
Operating Income: The difference between normal business revenue
and operating expenses. Excluded are expenses such as interest and
taxes, as well as any unusual income such as gains from selling a
subsidiary.
Other Revenues: Increases in assets resulting from transactions
not directly related to operations. Interest earned on investments is an
example of Other Revenues.
Other Expenses: Decreases in assets resulting from transactions
not directly related to operations. Debt interest is an example of Other
Expenses.
Income Before Taxes: Reported income before deducting income
taxes.
Income Tax Expense: Provision for taxes on pretax income.
Income From Continuing Operations: After-tax income from
operations that will continue.
Discontinued Operations: After-tax gain or loss on a portion of
the business that is intended to be sold.
Extraordinary Items: After-tax gains or losses on nonrecurring
transactions.
Net Income: The sum of all reported gains and losses.
Earnings Per Common Share: Net income divided by the average
number of shares outstanding.
Diluted Earnings Per Common Share: Net income divided by the
average number of shares of common stock that would be outstanding if
all convertible securities were converted into shares of common stock.
That wraps up the introduction to the income statement. Tune in next
week and we'll put each category under the electron microscope for a
much closer look.
Sales Revenue = Price x Quantity
Revenues are the proceeds a company receives for its merchandise or
services. They are usually recorded at the time of the sale or
completion of the service, providing the earnings process is
substantially complete and the collectibility of the revenue can be
estimated. Sales revenue equals the price of goods sold multiplied by
the quantity of goods sold minus returns.
Earnings Process
The earnings process is the sequence of events necessary to complete
the sale of goods or services in order to be recorded on the income
statement. The following criteria must be met to substantially fulfill
the earnings process:
- The buyer and seller have agreed on the price of the merchandise
or service.
- The buyer is not a middleman, withholding payment until a resale
occurs.
- The product or service is delivered in full.
- The buyer and seller are not related (such as a parent and
subsidiary).
Collectibility of Credit Sales
If the collectibility of a sale cannot be estimated, revenues are
recorded only as the customer makes payments. This deviates from the
accrual basis of accounting, recording sales when the cash is received,
rather than when it is earned. There are two methods used when recording
revenue as the customer makes payments: the installment method and the
cost-recovery method.
Installment Method
Under the installment method, revenues and, in turn, profits are
recognized in proportion to the percentage of the sale price collected
in a given accounting period.
For example, if Graney's Extra-Glossy Dental Floss sells Dr. Smiley one
thousand cases of shiny dentifrice with a total cost of $4,000 for a sum
$5,000, to be paid in five annual installments of $1,000 each, Graney's
would record annual revenues of $5,000/5, or $1,000 from this
transaction. Given annualized costs of $4,000/5, or $800, Graney's would
record annual profits of $1,000 - $800, or $200.
Cost-Recovery Method
The cost-recovery method matches revenues with costs until all of
the costs associated with those revenues have been recouped. After that
point, profits can be recorded on the income statement.
Using the example given above, Graney's Extra-Glossy Dental Floss would
need to collect $4,000 from Dr. Smiley before any profits could be
recorded. Annual revenues of $1,000 would match annual costs of $1,000
during the first four years. With the cost of the floss fully recovered
at the end of the fourth year, profits of $1,000 will hit the income
statement in the fifth year.
Long-Term Contracts Revenue
Companies that provide services on a long-term contract generally record
revenue under the installment method. If dependable estimates of selling
price, construction costs, and degree of completion are obtainable,
revenues will be recorded as the work is performed. This is known as the
percentage-of-completion method.
An example might be a three-year contract to construct a warehouse that
will house Graney's lustrous lace. The first year we estimate that
one-third of the project will be complete, therefore the contractor will
record one-third of the estimated total revenue from the contract in
year one. Years two and three would be treated likewise.
If dependable estimates of selling price, construction costs, or stage
of completion are not obtainable, revenue is not recorded until the
project is completed. This is known as the completed contract method.
Unearned Revenue
Unearned or deferred revenue is sales revenue for which the company
has not completed the earnings process.
For example, if Graney's Extra-Glossy Dental Floss has been paid to
train future Dr. Smiley employees on the finer points of polished floss
use and has received cash for this training up front, the company will
not record the sales until the time of service. However, Graney's will
create a liability account on the balance sheet, such as Advances from
Customers, to properly account for the cash that has been received.
Bad Debt
Uncollected credit sales are accounted for as bad debt on the income
statement, as well as a deduction of accounts receivable on the balance
sheet. The amount of bad debt is estimated out of necessity since it
must be recorded in the same year as the original sale. It will often be
another fiscal year before actual determination of un-collectible debt is
possible.
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