Question

What is the difference between net income and comprehensive income? Assess the usefulness and limitations of the income statements. What is meant by earnings quality? What are the four primary elements on the statement of net income? Describe the presentation of the statement of net income, including single-step and multi-step income statement formats. Compare and contrast income from continuing operations and discontinued operations. What is the statement of comprehensive income? Discuss in detail the components of and reporting requirements for the statement of stockholders' equity.

Answer 1

Net income is the financial gain or loss that a business has made in one single time period while comprehensive income is the change in equity in that same time period originating in non-owner sources.

Net income or net loss is equal to the sum of all revenues in the period minus the sum of all expenses in the period. If revenues exceed expenses, it is a net income and vice versa. Net income and net loss represent the change in the business's financial circumstances because of it running its revenue-producing operations for the period.

Comprehensive income is equal to net income plus other comprehensive income. Other comprehensive income is a catch-all term for changes in equity from non-owner sources, including unrealized gains and losses on investments because of changing market prices, on foreign exchange fluctuations, and the like. Because of the volatile nature of these items, comprehensive income is more susceptible to change than net income.

INCOME STATEMENT Usefulness and limitations:

Provides detailed information on revenues:The income statement provides detailed data on revenues. Besides the normal costs such as the cost of goods sold (COGS), employee expenses, operational expenses, it also accounts for additional costs like taxes applicable. Similarly, on the revenue front, it accounts not only for revenues earned from sales but also factors in for revenues gained from non operational components like interest accrued by different investments. Hence, the income statement is an ideal source for complete revenue information.
Database for Investor Analysis: It is an important document for investors who need detailed information before investing into any company. It provides all the data from sales to profits, operational efficiency to other non operational aspects. All this cumulatively helps investors get a clear picture of how the business is and expected to be. Thus, it is a single source to judge the condition of a company.
Other benefits: The income statement shows the profitability of the company over a period of time. The company can determine the major revenues it has earned. From an investment perspective, shareholders of a company are interested in the net income because the dividends are paid out of the total income. Moreover, income statement also helps the companies analyze their expenses and take into account the major streams of operating revenues of the company.

LIMITATIONS

Misrepresentation of data:The income statement includes not only current revenues gained from sales but also the money due from accounts receivable which the business has not paid yet, just as it includes liabilities as expenses that have not actually been paid yet. Also, the large one-time expenses or revenues can drive the income sharply up or down from what it actually should be. This leads to misrepresentation of the success of the company
Other factors:The income statement helps in gauging the earnings per share and other past financial data, but it does not provide with data on the expected future growth. It does not give any indication on how the revenue generation happens. Any investor looking into the income statement has to have these additional factors also in mind before taking any financial decision. One needs to remember that the income statement is considered as a fiction because it is based on accrual accounting and it does not provide cash transactions. Free cash cannot be calculated through income statement.

EARNINGS QUALITY

The quality of earnings refers to the proportion of income attributable to the core operating activities of a business. Thus, if a business reports an increase in profits due to improved sales or cost reductions, the quality of earnings is considered to be high. Conversely, an organization can have low-quality earnings if changes in its earnings relate to other issues.

4 ELEMENTS:

Revenue: Gross receipts earned by the company selling its goods or services

Expenses: The costs to the company to earn the gross receipts

Gains: Income from non-business-related transactions, such as selling a company asset

Losses: The flip side of gains, such as losing money when selling the company car

INCOME STATEMENT FORMAT

A single-step income statement gives a simple accounting of a business's net income, whereas a multi-step income statement follows a three-step process to calculate net income, separating operational from non-operational revenues and expenses.

The equation used in a single-step income statement is:

Net Income = (Revenues + Gains) – (Expenses + Losses)

The multi-step income statement uses three different accounting formulas to arrive at the net income:

1. GROSS PROFIT = NET SALES – COST OF GOODS SOLD

Cost of goods sold is subtracted from net sales. This gives the gross profit.

2. OPERATING INCOME = GROSS PROFIT – OPERATING EXPENSES

Operating expenses are subtracted from gross profit. This gives you the operating income.

3. NET INCOME = OPERATING INCOME + NON-OPERATING ITEMS

Operating income is added to the net non-operating revenues, gains, expenses and losses. This final figure gives the net income or net loss of the business for the reporting period.

Income from continuing operations and discontinued operations:

Continuing operations is the net income category found in the income statement that accounts for a company's regular, daily business activities, referring to the tasks required to make a product or service and deliver it to a customer.There are three formulas to calculate income from operations:

Operating income = Total Revenue – Direct Costs – Indirect Costs. OR.

Operating income = Gross Profit – Operating Expenses – Depreciation – Amortization. OR.

Operating income = Net Earnings + Interest Expense + Taxes.

Income (or Loss) from Discontinued Operations is a line item on an income statement of a company below Income from Continuing Operations and before Net Income. It represents the after tax gain or loss on sale of a segment of business and the after tax effect of the operations of the discontinued segment for the period.

STATEMENT OF COMPREHENSIVE INCOME

The statement of comprehensive income is one of the five financial statements required in a complete set of financial statements for distribution outside of a corporation.The statement of comprehensive income covers the same period of time as the income statement.

Comprehensive income is the variation in a company's net assets from non-owner sources during a specific period. Comprehensive income includes net income and unrealized income, such as unrealized gains or losses on hedge/derivative financial instruments and foreign currency transaction gains or losses.

COMPONENTS OF STATEMENT OF STOCKHOLDER EQUITY

Stockholders' equity is subdivided into components: (1) paid-in capital or contributed capital, (2) retained earnings, and (3) treasury stock, if any.

The paid-in capital component reports the amounts the corporation received when it issued its common and preferred (if any) stock. If the stock had a par value, the total par value of each class of stock is reported in a separate "par" account. Any amount received that was greater than the par amount is reported in an account such as Premium on Common or Paid-in Capital in Excess of Par—Common Stock.

Retained earnings reports the cumulative net income since the start of the corporation minus the dividends declared since the start of the corporation. In effect, the retained earnings are the profits that the stockholders have opted to reinvest in the business. The amounts are likely to be invested in various assets and are not likely to be in cash.

Treasury stock (cost method) reports the amount paid by the corporation to purchase its own shares of stock. This account will have a debit balance and therefore reduces the amount of stockholders' equity.

The total of stockholders' equity is the book value of the corporation. You should realize that the book value or stockholders' equity is not an indication of the market value of the corporation.