Question

How can you be sure that accounting income number can be useful (in terms of research)

Answer 1

INCOME STATEMENT

An income statement is one of the three important financial statements used for reporting a company's financial performance over a specific accounting period, with the other two key statements being the balance sheet and the statement of cash flows. Also known as the profit and loss statement or the statement of revenue and expense, the income statement primarily focuses on the company’s revenues and expenses during a particular period. The income statement is an important part of a company’s performance reports that must be submitted to the Securities and Exchange Commission (SEC). While a balance sheet provides the snapshot of a company’s financials as of a particular date, the income statement reports income through a particular time period and its heading indicates the duration, example which may read as “For the (fiscal) year/quarter ended March 31 2020.”

• An income statement is one of the three (along with balance sheet and statement of cash flows) major financial statements that reports a company's financial performance over a specific accounting period.
• Net Income = (Total Revenue + Gains) – (Total Expenses + Losses)
• Total revenue is the sum of both operating and non-operating revenues while total expenses include those incurred by primary and secondary activities.
• Revenues are not receipts. Revenue is earned and reported on the income statement. Receipts (cash received or paid out) are not.
• An income statement provides valuable insights into a company’s operations, the efficiency of its management, under-performing sectors and its performance relative to industry peers.

Revenues and Gains

The following are covered in the income statement, though its format may vary depending upon the local regulatory requirements, the diversified scope of the business and the associated operating activities:

Operating Revenue

Revenue realized through primary activities is often referred to as operating revenue. For a company manufacturing a product, or for a wholesaler, distributor or retailer involved in the business of selling that product, the revenue from primary activities refers to revenue achieved from the sale of the product. Similarly, for a company (or its franchisees) in the business of offering services, revenue from primary activities refers to the revenue or fees earned in exchange of offering those services.

Non-Operating Revenue

Revenues realized through secondary, non-core business activities are often referred to as non-operating recurring revenues. These revenues are sourced from the earnings which are outside of the purchase and sale of goods and services and may include income from interest earned on business capital lying in the bank, rental income from business property, income from strategic partnerships like royalty payment receipts or income from an advertisement display placed on business property.

Gains

Also called other income, gains indicate the net money made from other activities, like the sale of long-term assets. These include the net income realized from one-time non-business activities, like a company selling its old transportation van, unused land, or a subsidiary company. Revenue should not be confused with receipts. Revenue is usually accounted for in the period when sales are made or services are delivered. Receipts are the cash received and are accounted for when the money is actually received. For instance, a customer may take goods/services from a company on 28 April, which will lead to the revenue being accounted for in the month of September. Owing to his good reputation, the customer may be given a 30-day payment window. It will give him time till 28 May to make the payment, which is when the receipts are accounted for.

Expenses and Losses:

The cost for a business to continue operation and turn a profit is known as an expense. Some of these expenses may be written off on a tax return if they meet the IRS guidelines.

Primary Activity Expenses

All expenses incurred for earning the normal operating revenue linked to the primary activity of the business. They include the cost of goods sold (COGS), selling, general and administrative expenses (SG&A), depreciation or amortization, and research and development (R&D) expenses. Typical items that make up the list are employee wages, sales commissions, and expenses for utilities like electricity and transportation.

Secondary Activity Expenses

All expenses linked to non-core business activities, like interest paid on loan money.

Losses as Expenses

All expenses that go towards a loss-making sale of long-term assets, one-time or any other unusual costs, or expenses towards lawsuits.

While primary revenue and expenses offer insights into how well the company’s core business is performing, the secondary revenue and expenses account for the company’s involvement and its expertise in managing the ad-hoc, non-core activities. Compared to the income from the sale of manufactured goods, a substantially high-interest income from money lying in the bank indicates that the business may not be utilizing the available cash to its full potential by expanding the production capacity, or it is facing challenges in increasing its market share amid competition. Recurring rental income gained by hosting billboards at the company factory situated along a highway indicates that the management is capitalizing upon the available resources and assets for additional profitability.

Mathematically, the Net Income is calculated based on the following:

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

Uses of Income Statements

Though the main purpose of an income statement is to convey details of profitability and business activities of the company to the stakeholders, it also provides detailed insights into the company’s internals for comparison across different businesses and sectors. Such statements are also prepared more frequently at the department- and segment-levels to gain deeper insights by the company management for checking the progress of various operations throughout the year, though such interim reports may remain internal to the company.

Based on income statements, management can make decisions like expanding to new geographies, pushing sales, increasing production capacity, increased utilization or outright sale of assets, or shutting down a department or product line. Competitors may also use them to gain insights about the success parameters of a company and focus areas as increasing R&D spends.

Creditors may find limited use of income statements as they are more concerned about a company’s future cash flows, instead of its past profitability. Research analysts use the income statement to compare year-on-year and quarter-on-quarter performance. One can infer whether a company's efforts in reducing the cost of sales helped it improve profits over time, or whether the management managed to keep a tab on operating expenses without compromising on profitability.

An income statement provides valuable insights into various aspects of a business. It includes a company’s operations, the efficiency of its management, the possible leaky areas that may be eroding profits, and whether the company is performing in line with industry peers.

• Revenues are exposed to a number of expense types, and understanding the relationship between costs and revenues is the primary function of the income sheet.
• When looking at profitability, dividing net profit by overall revenues provides insights as to the profitability of revenue from start to finish.
• Another useful metric is the gross margin, which underlines the variable costs attached to adding new units of sales.
• Operating margin provides insights as to how financing impacts overall profitability.

The primary purpose of the income statement is to demonstrate the profitability of an organization’s operations over a fixed period of time by illustrating how proceeds from operations (i.e. revenues) are transformed into net income (profits and losses).

Compared to the balance sheet and the cash flow statement, the income statement is primarily focused on the actual operational efficiency of the organization. The balance sheet discusses leverage, assets, funding, and other aspects of the organization’s existing infrastructure. The cash flow statement is primarily a description of liquidity. The income statement, however, is ultimately about how a given revenue input can be converted to profitability through assessing what is required to attain that revenue.

Assessing Efficiency

The income statement is relatively straight-forward. As an investor or a manager, the simplest way to view each section is by focusing on efficiency. An optimally efficient organization will have higher margins in the following areas:

Profit margin: A higher net profit as a proportion of sales indicates an overall higher capacity to capture returns on revenue. Profit margin is one of the first aspects of an organization a prospective investor will look at when considering the overall validity of a company as an investment.

This is calculated as: Net profit / Net sales

Operating Margin: Another useful indicator of profitability is operating income over net sales. Operating income subtracts the cost of goods sold (COGS) alongside selling, general, and administrative expenses (SG&A), leaving the overall profit before taxes and interest on financial debt. Comparing this to the overall profit margin can give useful indications of reliance on debt.

It’s calculated as: operating income / Net sales

Another useful indicator is the gross margin. This essentially demonstrates the added value of each unit of sales, as it focuses exclusively on the impact of the cost of goods sold (COGS). COGS represents the costs incurred (directly) from materials, labor, and production of each individual unit. This can be a great indicator of how scalable an operation is, and the relative return an organization will see as they achieve growth.

(Net sales - COGS) / Net sales

Limitations of the Income Statement

• Income statements include judgments and estimates, which mean that items that might be relevant but cannot be reliably measured are not reported and that some reported figures have a subjective component.
• With respect to accounting methods, one of the limitations of the income statement is that income is reported based on accounting rules and often does not reflect cash changing hands.
• Income statements can also be limited by fraud, such as earnings management, which occurs when managers use judgment in financial reporting to intentionally alter financial reports to show an artificial increase (or decrease) of revenues, profits, or earnings per share figures.

• matching principle: According to the principle, expenses are recognized when obligations are (1) incurred (usually when goods are transferred or services rendered, e.g. sold), and (2) offset against recognized revenues, which were generated from those expenses, no matter when cash is paid out. In cash accounting—in contrast—expenses are recognized when cash is paid out.
• FIFO: Method for for accounting for inventories. FIFO stands for first-in, first-out, and assumes that the oldest inventory items are recorded as sold first.
• LIFO: Method for accounting for inventory. LIFO stands for last-in, first-out, and assumes that the most recently produced items are recorded as sold first.

Income statements are a key component to valuation but have several limitations: items that might be relevant but cannot be reliably measured are not reported (such as brand loyalty); some figures depend on accounting methods used (for example, use of FIFO or LIFO accounting); and some numbers depend on judgments and estimates. In addition to these limitations, there are limitations stemming from the intentional manipulation of finances.

One of the limitations of the income statement is that income is reported based on accounting rules and often does not reflect cash changing hands. This could be due to the matching principle, which is the accounting principle that requires expenses to be matched to revenues and reported at the same time. Expenses incurred to produce a product are not reported in the income statement until that product is sold. Another common difference across income statements is the method used to calculate inventory, either FIFO or LIFO.

In addition to good faith differences in interpretations and reporting of financial data in income statements, these financial statements can be limited by intentional misrepresentation. One example of this is earnings management, which occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports in a way that usually involves the artificial increase (or decrease) of revenues, profits, or earnings per share figures.

The goal with earnings management is to influence views about the finances of the firm. Aggressive earnings management is a form of fraud and differs from reporting error. Managers could seek to manage earnings for a number of reasons. For example, if a manager earns his or her bonus based on revenue levels at the end of December, there is an incentive to try to represent more revenues in December so as to increase the size of the bonus.

While it is relatively easy for an auditor to detect error, part of the difficulty in determining whether an error was intentional or accidental lies in the accepted recognition that calculations are estimates. It is therefore possible for legitimate business practices to develop into unacceptable financial reporting.

Effects of GAAP on the Income Statement

GAAP’s assumptions, principles, and constraints can affect income statements through temporary (timing) and permanent differences.

Key Points

• Items that create temporary differences due to the recording requirements of GAAP include rent or other revenue collected in advance, estimated expenses, and deferred tax liabilities and assets.
• Also there are events, usually one-time events, which create “permanent differences,” such as GAAP recognizing as an expense an item that the IRS will not allow to be deducted.
• The four basic principles of GAAP can affect items on the income statement. These principles include the historical cost principle, revenue recognition principle, matching principle, and full disclosure principle.

Key Terms

• deferred: Of or pertaining to a value that is not realized until a future date, e.g. annuities, charges, taxes, income, either as an asset or liability.
• fair market value: An estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. An estimate of fair market value may be founded either on precedent or extrapolation but is subjective. Fair market value differs from other ways of determining value, such as intrinsic and imposed value.

Although most of the information on a company’s income tax return comes from the income statement, there often is a difference between pretax income and taxable income. These differences are due to the recording requirements of GAAP for financial accounting (usually following the matching principle and allowing for accruals of revenue and expenses) and the requirements of the IRS’s tax regulations for tax accounting (which are more oriented to cash).

Such timing differences between financial accounting and tax accounting create temporary differences. For example, rent or other revenue collected in advance, estimated expenses, and deferred tax liabilities and assets may create timing differences. Also, there are events, usually one time, which create “permanent differences,” such as GAAP, which recognizes as an expense an item that the IRS will not allow to be deducted.

To achieve basic objectives and implement fundamental qualities, GAAP has four basic principles:

• The historical cost principle: It requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities.
• The revenue recognition principle. It requires companies to record when revenue is (1) realized or realizable and (2) earned, not when cash is received.
• The matching principle. This governs the matching of expenses and revenues, where expenses are recognized, not when the work is performed or when a product is produced, but when the work or the product actually makes its contribution to revenue.
• The full disclosure principle. This suggests that the amount and kinds of information disclosed should be decided based on a trade-off analysis, since a larger amount of information costs more to prepare and use. GAAP reporting also suggests that income statements should present financial figures that are objective, material, consistent, and conservative.