Chapter 7
Using the Income Statement
In This Chapter
Getting acquainted with the income statement
Considering different types of revenue
Determining a company’s expenses
Analysing a company’s finances using profits and losses
Working out earnings per share
Businesspeople need to know how well their businesses have done over the past month, quarter, or year. Without that information, they have no idea where their businesses have come from and where they might go next. Even a small business that has no obligation to report to the public is likely to do income statements on at least a quarterly basis to find out whether the business is making a profit or a loss.
Introducing the Income Statement
The income statement is where you find out whether the company made a profit or a loss. You also find information about the company’s revenues, sales levels, the costs it incurred to make those sales, and the expenses it paid to operate the business. The key parts of the income statement are:
Sales or revenues: How much money the business took in from its sales to customers.
Cost of sales: What it cost the company to produce or purchase the goods it sold.
Expenses: How much the company spent on advertising, administration, rent, salaries, and everything else that’s involved in operating a business to support the sales process.
Profit or loss for the year: This is the bottom line that tells you whether the company made a profit or operated at a loss.
The IASB specifies that all items of income or expense recognised in a period should be included in the income statement except where an IAS or IFRS requires otherwise. Examples of items that affect equity but do not appear in the income statement of the current period are items relating to previous periods which have been adjusted in the current period – such as correction of errors or the effect of changes in accounting policies. Another example mentioned in Chapter 6 is a revaluation of a property which changes equity but is not shown in the income statement. In order that the financial statements reflect all changes during a period of time to the equity of a business IAS 1 requires a statement of changes in equity which include the profit or loss from the income statement but also gather together all other changes affecting equity.
When looking at an income statement, you can expect to find a report of either
Excess of revenues over expenses: This report means the company earned a profit, or
Excess of expenses over revenues: This report means the company faced a loss.
Digging into dates
Income statements reflect an operating period, which means that they show results for a specific length of time. At the top of an income statement, you see the phrase ‘Year Ended’ and the month the period ended for an annual financial statement. You may also see ‘Quarters Ended’ or ‘Months Ended’ for reports prepared based on shorter periods of time. Companies are required to show at least two periods of data on their income statements. So if you’re looking at a statement for Last Year, you’ll also find columns for the Previous Year.
Comparing formats
The UK format divides the income statement into several sections and gives the reader some critical subtotals to make analysing the data quicker and easier. Even though the UK and US income statements include the same revenue and expense information, they may group the information differently. Table 7–1 shows the format for a simple UK income statement.
| Revenue | 1,000 |
| Cost of sales | 500 |
| Gross profit | 500 |
| Marketing and distribution expenses | 200 |
| Administrative expenses | 150 |
| Other operating expenses | 50 |
| Operating profit | 100 |
| Financial income | 200 |
| Financial expenses | 50 |
| Profit before taxation | 250 |
| Taxation | 50 |
| Profit for the year | 200 |
The critical subtotals in the UK format are:
Gross profit: This reflects the profit generated from sales minus the cost of the goods sold.
Operating profit or loss: This reflects the income earned by the company after all its operating expenses have been subtracted.
Profit/Loss before taxation: This reflects all income earned – which can include gains on equipment sales, interest revenue, and other revenue not generated by sales – before taxes are subtracted.
Profit/Loss for the period: This reflects the bottom line – whether or not the company made a profit.
Many companies add even more profit lines, like earnings before interest, taxes, depreciation, and amortisation, known as EBITDA for short (see the section ‘EBITDA’ later in this chapter).
Some companies that have discontinued operations include those in the line item for continuing operations. But it’s better for the financial report reader if that information is on a separate line; otherwise, the reader won’t know what the actual profit or loss is from continuing operations. (You can find Tesco and Marks and Spencer financial reports in Appendix A.) We delve a bit deeper into these various profit lines in ‘Sorting Out the Profit and Loss Types’ later in this chapter.
There is more than one format for the Income Statement in the US. Table 7–2 shows an example of a simple US format:
| Revenues | |
|---|---|
| Sales | $1,000 |
| Interest income | 200 |
| Total Revenue | $1,200 |
| Expenses | |
| Cost of goods sold | $500 |
| Depreciation | 50 |
| Advertising | 50 |
| Salaries and wages | 100 |
| Insurance | 50 |
| Research and development | 100 |
| Supplies | 50 |
| Interest expense | 50 |
| Income taxes | 50 |
| Total expenses | $1,000 |
| Net income | $200 |
Delving into the Tricky Business of Revenues
You may think that deciding when to count something as revenue is a relatively simple procedure. Well, forget that. Revenue acknowledgement is one of the most complex issues on the income statement. In fact, you may have noticed that with the recent corporate scandals, a significant reason for companies getting into trouble has to do with the issue of misstated revenues.
In this section, we define revenue and explain the three line items that make up the revenue portion of the income statement: sales, cost of sales, and gross profit.
Defining revenue
When a company recognises something as revenue that doesn’t always mean that cash changed hands or that the product was delivered or even completed. Accrual accounting leaves room for deciding when revenue is actually recorded. A company recognises revenue when it earns it and recognises expenses when it incurs them, without regard to whether or not cash changes hands. You can find out more about accounting basics in Chapter 4.
Because accrual accounting allows a company to count something as revenue even if it doesn’t actually have the cash in hand, senior managers can play games to make the bottom line look the way they want it to look by counting or not counting income. Sometimes they acknowledge more income than they should to improve the financial reports; other times, they reduce income to reduce the tax bite. We talk more about these shenanigans in Chapter 22.
When a company wants to count something as revenue, several factors can make that decision rather muddy, leaving questions about whether or not a particular sale should be counted:
If the seller and buyer haven’t agreed on the final price for the merchandise and service, the seller can’t count the revenue collected. For example, when a company is in the middle of negotiating a contract for the sale of a major item, such as a car or appliance, it cannot include that sale as revenue until the final price has been set and a contract obligating the buyer is in place.
If the buyer doesn’t pay for the merchandise until the company resells it to a retail outlet (which may be the case for a company that works with a distributor) or to the customer, the company can’t count the revenue until the sale to the customer is final. For example, publishers frequently allow bookshops to return unsold books within a certain amount of time. If there’s a good chance that some portion of the product may be returned unsold, companies must take this into account when reporting revenues. For instance, a publisher uses historical data to estimate what percentage of books will be returned and adjusts sales downward to reflect those likely returns.
If the buyer and seller are related, then the company cannot ever count it as revenue. No, we’re not talking about blood relatives here. We’re talking about when the buyer is the parent company or subsidiary of the seller; in that case, revenue isn’t acknowledged in the same way. Instead, companies must handle it as an internal transfer of assets.
If the buyer isn’t obligated to pay for the merchandise because it’s stolen or physically destroyed before it’s delivered or sold, the company can’t acknowledge the revenue until the merchandise is actually sold. For example, a toy company works with a distributor or other middleman to get its toys into retail stores. If the distributor or middleman doesn’t have to pay for those toys until they’re delivered or sold to retailers, the manufacturer can’t count the toys it shipped to the middleman or distributor as revenue until the distributor or middleman completes the sale.
If the seller is obligated to provide significant services to the buyer or aid in reselling the product, the seller can’t count the sale of that product as revenue until the sale is actually completed with the final customer. For example, many manufacturers of technical products offer installation or follow-up services for a new product as part of the sales promotion. If those services are a significant part of the final sale, the manufacturer can’t count that sale as revenue until the installation or service has been completed with the customer. Items shipped for sale to local retailers under these conditions wouldn’t be considered sold, so they can’t be counted as revenue.
If the seller is providing a combination of products and services to the buyer which are bundled together into a single contract. For example, many sellers of IT equipment provide hardware, software and after-sales support and updates. In this case, the seller should try to separate the contracts into its constituent parts so that revenue can be recognised on the parts of the contract which have been delivered. For example, a contract for the sale of a computer may include a year’s ‘free’ support. The total revenue should be split between the two separate contracts. The revenue from the sale of the hardware and software should be recognised immediately and the revenue from the service contract should be recognised as the contract progresses.
Adjusting sales
Not all products sell for their list price. Companies frequently use discounts, returns, or allowances to reduce the prices of products or services. Sometimes, in order to make a sale, a company must sell the product at a discounted price. Whenever a company sells a product at a discount it should keep track of those discounts as well as its returns. That’s the only way a company can truly analyse how much money it’s making on the sale of its products and how accurately it’s pricing the products to sell in the marketplace.
As a financial-report reader, you won’t see the specifics about discounts offered in the income statement, but you may find some mention of significant discounting in the notes to the financial statements. The most common types of adjustments companies make to their sales are:
Volume discounts: To get more items in the marketplace manufacturers offer major retailers volume discounts, which means that these retailers agree to buy a large number of the manufacturer’s product in order to save a certain percentage of money off the price. One of the reasons you get such good prices at discount sellers like Asda and TKMaxx is because they buy products from the manufacturer at greatly discounted prices. Because they purchase for thousands of stores, they can buy a very large number of goods at one time. Volume discounts reduce the revenue of the company that gives them.
Notice that some volume discounts do not kick in until a certain level of sales is reached. This can cause a problem in establishing the correct revenue to recognise if a customer reaches a trigger point after the end of the accounting period.
Returns:
Returns are arrangements between the buyer and seller that allow the buyer to return goods for a number of reasons. I’m sure you’ve returned goods that you didn’t like, that didn’t fit, or that possibly didn’t even work. Returns are subtracted from a company’s revenue. At the period end, the company needs to make its best estimate of future returns of goods sold before the end of the period.
Allowances: Gift vouchers and similar types of accounts that a customer pays for upfront without taking merchandise are types of allowances. Allowances are actually liabilities for a store because the customer hasn’t yet selected the merchandise and the sale isn’t complete. Revenues are collected upfront, but at some point in the future, merchandise will be taken off the shelves and additional cash won’t be received.
Internally, managers see the detail about these adjustments in the sales area of the income statement, so they can track trends for discounts, returns, and allowances. Tracking such trends is a very important aspect of the managerial process. If a manager notices that any of these line items show a dramatic increase, he or she should investigate the reason for the increase. For example, an increase in discounts could mean that the company consistently has to offer its products for less money, which could mean the market is softening and fewer customers are buying fewer products. Or, if a manager notices a dramatic increase in returns, the products he or she is selling may have a defect that needs to be corrected.
Considering cost of sales
Like the sales line item, cost of sales (what it costs to manufacture or purchase the goods being sold) also has many different pieces that make up its calculation. You don’t see the detail for this line item unless you’re a manager of the company concerned. Few companies report their cost of sales in detail to the general public.
Items that make up the cost of sales vary depending on whether the company manufactures the goods in-house or purchases them. If the company manufactures them in-house, you track the costs all the way from the point of raw materials and include the cost of labour involved in building the product. A fair proportion of the manufacturing overheads of the company is added to the cost of each item manufactured. If a company purchases its goods, it tracks the purchases of the goods as they’re made.
In fact, a manufacturing firm tracks several levels of stock, including:
Raw materials: The materials used for manufacturing.
Work-in-progress: Products in the process of being constructed.
Finished goods: Products ready for sale.
Tracking begins from the time the raw materials are purchased, with adjustments based on discounts, returns, or allowances given. Companies also add freight charges, and any other costs involved directly in acquiring goods to be sold, to the cost-of-sales section of the income statement.
When a company finally sells the product, the product becomes a cost of sales line item. Managing costs during the production phase is critical for all manufacturing companies. Managers in this type of company receive regular reports that include this type of detail. Trends that show dramatically increasing costs must be investigated as quickly as possible, because the company must consider a price change to maintain its profit margin.
Even if a company is only a service company, it is likely to have costs for the services provided. In this case, the line item may be called ‘cost of services sold’ rather than ‘cost of goods sold’. You may even see a line item called ‘cost of goods or services sold’ if a company gets revenue from the sale of goods as well as from the sale of services. In this book, to keep it simple, we use the term ‘product’ to describe what the company sells. In every case ‘product’ implies the term ‘products and/or services’.
Gauging gross profit
The gross profit line item in the revenue section of the income statement is simply a calculation of net revenue or net sales minus the cost of sales. Basically, this number shows the difference between what a company pays for its products and services and the price at which the company sells them. This summary number tells you how much profit a company makes selling its products before deducting the expenses of the operation. If there’s no profit or not enough profit here, it’s not worth being in business.
Managers, investors, and other interested parties closely watch the trend of a company’s gross profit because it indicates the effectiveness of a company’s purchasing and pricing policies. Analysts frequently use this number not only to gauge how well a company manages its product costs internally, but also to gauge how well a company manages its product costs compared with other companies in the same business.
If gross profit is too low, a company can do one of two things – find a way to increase sales revenue or find a way to reduce the cost of the goods it’s selling.
To increase sales revenue, a company can raise or lower prices in order to increase the amount of money it’s bringing in. Raising the prices of its product brings in more revenue if the same number of items are sold, but it could bring in less revenue if the price hike turns away customers and fewer items are sold.
Lowering prices to bring in more revenue may sound strange to you, but if a company determines that a price is too high and is discouraging buyers, doing so may increase its volume of sales and, therefore, its gross profit. This scenario is especially true if the company has a lot of fixed costs (such as manufacturing facilities, equipment, and labour) that aren’t being used to full capacity. A company could use its manufacturing facilities more effectively and efficiently if it has the capability to produce more product without a significant increase in the variable costs (such as raw materials or other factors, like overtime).
A company can also consider using cost-control possibilities for manufacturing or purchasing if its gross profit is too low. The company may find a more efficient way to make the product or may negotiate a better contract for raw materials to reduce those costs. If the company purchases finished products for sale, it may be able to negotiate better contract terms to reduce its purchasing costs.
Acknowledging Expenses
Expenses include the items a company must pay for to operate the business that aren’t directly related to the sale and production of specific products. These differ from cost of sales, which can be directly traced to the actual sale of a product. Even when a company is making a sizable gross profit, if management doesn’t carefully watch the expenses, the gross profit can quickly turn into a net loss.
Advertising and promotion, administration, and research and development are all examples of expenses. Although many of these expenses impact the ability of a company to sell its products, they aren’t direct costs of the sales process for individual items. The following are details about the key items that fit into the expenses part of the income statement:
Distribution expenses: This category is a catch-all for any selling and distribution expenses, including salespeople’s and sales managers’ salaries, commissions, bonuses, and other compensation expenses. The costs of sales offices and any expenses related to those offices also fall into this category. It is sometimes referred to as Marketing Expenses.
For many companies, one of the largest expenses is advertising and promotion. Advertising includes TV and radio ads, print ads, and poster ads. Promotions include product giveaways, such as hats, T-shirts, pens with the company logo on it, or name identification on a sports stadium. If a company helps promote a charitable event and has its name on T-shirts or posters as part of the event, these expenses must be included in the advertising and promotion expense line item.
Administrative expenses: This category includes expenses such as administrative salaries, expenses for administrative offices and supplies, insurance, and anything else needed to run the general operations of a company. Expenses for human resources, management, accounting, and security also fall into this category.
Other operating expenses: If a company includes line-item detail in its financial reports, you usually find that detail in the notes to the financial statement. All operating expenses that aren’t directly connected to the sale of products or administrative expenses fall into the other- operating-expenses category, including:
• Royalties: Any royalties (payments made for the use of other peoples’ property) paid to individuals or other companies fall under this umbrella. Companies most commonly pay royalties for the use of patents or copyrights owned by another company or individual. Companies also pay royalties when they buy the rights to extract natural resources from another person’s property.
• Research and product development: Any costs for developing new products are listed in this line item. Most likely you’ll find details about research and product development in the notes to the financial statements or in the managers’ commentary. Any company that makes new products has research and development costs because, if it isn’t always looking for ways to improve its product or introduce new products, it’s at risk of losing out to a competitor. Note, however, that some development expenditure must be carried forward as an asset so that the costs of development are matched with the future expected revenues from the new products. The IASB have set out detailed rules in IAS 38 for when R&D expenditure should be listed and when it should be carried forward as an asset.
Finance income: This category includes interest from deposit accounts or bonds held by the company, or dividends received from another company.
Finance expenses: Expenses paid for interest on long- or short-term debt are shown in this line item. You usually find some explanation for the interest expenses in the notes to the financial statements.
Depreciation and amortisation expenses: Depreciation on buildings, machinery, or other items as well as amortisation on intangible items may be shown as a separate line item. However, in most income statements, depreciation and amortisation fall into the separate headings – cost of sales, distribution, and administrative – depending on the nature of the assets. If you look in the notes to the financial statements, you always find more details about depreciation and amortisation. To find out how these expenses are calculated, go to Chapter 4.
Taxes: All corporations have to pay tax on their income. In the taxes category, you find the amount of tax that the company needs to pay on its profits for the year. The standard rate of tax may be set at, say, 30 per cent but this does not mean that the tax charge is 30 per cent of the profit before tax. The reason for this is that the tax rules treat some items differently from accounting rules.
For example, some expenses like entertaining are not allowable for tax purposes so the tax is calculated on a higher profit figure. These differences are known as permanent differences. Depreciation is also not allowable for tax purposes but is replaced by capital allowances in the tax computation. This means that, in any particular period, the tax relief for the purchase of a fixed asset does not match the depreciation of the asset. Over the whole life of the asset, the total depreciation equals the total capital allowances received but the timing is different. Quite reasonably, these differences are known as timing differences.
Deferred tax is the device used by accountants to adjust the accounts for the effect of timing differences. Many companies and their investors complain that corporate income is taxed twice – once directly as a corporation and a second time on the dividends that the shareholders receive. In fact, the shareholder only pays tax on dividends if they are a higher rate tax payer since dividends are treated as though basic rate income tax has been deducted at source.
Sorting Out the Profit and Loss Types
When you hear earnings or profits reports on the news, most of the time the financial news reporters are discussing the net profit, net income, or net loss. For readers of financial statements, that bottom-line number doesn’t tell the entire story of how a company is doing. Relying solely on the bottom-line number is like reading the last few pages of a novel and thinking that you understand the entire story. All you really know is the end, not how the characters got to that ending.
Because companies have so many different charges or expenses unique to their operations, different profit lines are used for different types of analysis. We cover the types of analysis in Part III, but in this section, we review what each of these profit types includes or doesn’t include. For example, gross profit is the best number to use to analyse how well a company is managing its sales and the costs of producing those sales; however, you have no idea how well the company is managing the rest of its expenses. Using operating profit, which shows you how much money was made after considering all costs and expenses for operating the company, allows you to analyse how efficiently the company is managing its operating activities, but you don’t get enough detail to analyse product costs.
EBITDA
A commonly-used measure to compare companies is earnings before interest, taxes, depreciation, or amortisation, also known as EBITDA. With this number, analysts and investors can compare profitability among companies or industries because it eliminates the effects of the companies’ activities to raise cash outside their operating activities, such as by selling stock or bonds. EBITDA also eliminates any accounting decisions that could impact the bottom line, such as the companies’ policies relating to depreciation methods. Investors reading the financial report can use this figure to focus on the profitability of each company’s operations. If a company does include this term it is in the notes or, for example, the five-year record.
EBITDA gives financial report readers a quick view of how well a company is doing without considering its financial and accounting decisions. This number became very popular in the late 1990s to support companies that were pursuing an acquisition policy. It is also used to support decisions to make leveraged buyouts. A leveraged buyout takes place when an individual or company buys a controlling interest (which means more than 50 per cent) in a company using primarily debt. Many times, the individual or company pays 70 per cent or more of the purchase price using debt. This leaves many companies in a situation where investors have to carefully watch that the company earns enough from operations to pay its huge debt load.
Today, EBITDA is frequently touted by technology companies or other high-growth companies with large expenses for machinery and other equipment. In these situations, the companies like to discuss their earnings before the huge write-offs for depreciation, which can make the bottom line look pretty small. EBITDA can actually be used as an accounting gimmick to make a company’s earnings sound better to the general public or to investors who don’t take the time to read the fine print in the annual report.
Some commentators jokingly refer to this number as ‘earnings before all the bad stuff’.
Non-operating income or expense
If a company earns income from a source that isn’t part of its normal revenue-generating activities, it usually lists this income on the income statement as non-operating income. Amounts in this area are presented straight after the Operating Profit line. Finding a gain on the sale of a building, manufacturing facility, or division in this section of the income statement is common. Companies also group one-time expenses in the non-operating section of the income statement. For example, the severance and other costs of closing a division or factory are shown in this area of an income statement or, in some cases, a separate section on discontinuing operations is shown on the statement. Other types of expenses may include losses from theft, vandalism, or fire; loss from the sale or abandonment of property, plant, or equipment; and loss from employee or supplier strikes.
Whilst non-operating income or expense items are commonly shown in statements, IAS 1 does not actually include any reference to operating profit and therefore, by extension, does not consider it necessary to distinguish operating and non-operating items. What IAS 1 does indicate is that if an entity chooses to distinguish operating items from non-operating items then this should be done in such a way as would normally be considered to be appropriate.
You usually find explanations for income or expenses from non-operating activities in the notes to the financial statements. In our view, separating non-operating activities is helpful, otherwise, investors, analysts, and other interested parties can’t gauge how well a company is doing with its core operating activities. The core-operating-activities line item is where you find a company’s continuing income. If those core activities aren’t raising enough income, the company may be on the road to significant financial difficulties.
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Whether a gain or a loss, separating non-operating income from operating income and expenses helps to prevent sending the wrong signal to analysts and investors about a company’s future earnings and growth potential.
Net profit or loss
Calculating Earnings Per Share
In addition to profit for the year, the other number you hear almost as often about a company’s earnings results is earnings per share. Earnings per share is the amount of profit for the year the company made per share available on the market. For example, if you own 100 shares of stock in ABC company, and the company earned £1 per share, £100 of those earnings would be yours unless the company decided to reinvest them in the company for future growth. In reality, a company rarely pays out 100 per cent of its earnings; it usually pays out a very small fraction of those earnings.
You find the earnings-per-share after profit for the year on the income statement. The calculation for earnings per share is relatively simple: You take the number of outstanding shares (which you can find on the balance sheet or in the notes to the accounts) and divide it into the net earnings (which you find on the income statement).
Basically, earnings per share shows you how much money each shareholder made for each of their shares. In reality, this money doesn’t get paid back to the shareholder. Instead, most is reinvested in future operations of the company. The profit or loss for the year is added to the retained earnings number on the balance sheet.
At the bottom of an income statement, you see two numbers:
The basic earnings per share is a calculation based on the number of shares outstanding at the time the income statement was developed.
The diluted earnings per share includes other potential shares that could eventually be outstanding. This category includes shares designated for things like share options or warrants (financial instruments which give the holder a right to buy shares at a set price, usually below the share’s market value), and convertibles (shares promised to a holder of bonds or preference shares that are convertible to ordinary shares).
These numbers give you an idea of how much the company earned per share. You can use them to analyse the profitability of a company, which we show you how to do in Chapter 11.
Dividends declared per share are sometimes shown at the foot of the income statement under the earnings-per-share information. Otherwise these details are in the notes to the accounts. The company’s board of directors may declare dividends quarterly, biannually, or annually.