Income Statement Presentation
The objective of studying the format and presentation of the income statement is to gain an understanding of the different ways that certain economic events can be presented. Sometimes, the type of presentation depends upon management's intent regarding the future. Needless to say, there is a lot of room for the application of judgment when choosing amongst various acceptable income statement formats. Interpreting the income statement requires users to have an appreciation for where this judgment has the potential to affect their decision. At the most rudimentary level, we expect the income statement to portray revenues and expenses, and to report the difference between these two numbers as the resulting income or loss. Expenses may be broken out between those that are inventoried (e.g., direct materials, direct labor, manufacturing overhead), and those that are recognized as incurred (e.g., selling, general and administrative costs). An example of a simple income statement for a single year would be as follows: Sales revenue: Cost of goods sold: Gross margin Less: Selling, general and administrative expenses Tax expense Net income $ 32,000 28,000 4,000 2,750 500 $ 750
Often, much more detail is provided regarding the sources of revenues and the types of expenses. This presentation is appropriate for assessing the performance of the period covered by the income statement, but our interest in knowing income extends beyond simply assessing the past period's performance. Another important use of the income number is to help predict a firm's future performance. In apparent acknowledgment of this fact, the accounting rules require three types of transactions to be presented differently than in the simple example above. The three types of transactions that are presented differently are extraordinary items, discontinued operations, and changes in accounting policy. The events that necessitate these types of transactions are supposed to be nonrecuring in their nature and, as such, are not relevant for predicting what might occur in future periods. In general, these items are presented after a subtotal "income from continuing operations" (or some equivalent title) is reported. This treatment is often referred to as reporting the item "below the line," where the line is defined to be the continuing operations subtotal. Removing the effects of these types of transactions can have dramatic effects on the communicated performance of the firm. Sales revenue: Cost of goods sold: Gross margin Less: Selling, general and administrative expenses Tax expense Income from continuing operations Results of discontinued operations (net of tax effects) Effects of extraordinary items (net of tax effects) Effects of changes in accounting policy (net of tax effects) Net income $ 31,000 22,000 9,000 1,083 3,167 4,750 (1,000) (2,000) (1,000) $ 750
This presentation now offers the user two different income numbers to choose between. Income from continuing operations may well be considered a better proxy for expectations of future performance, while net income is the allinclusive performance of the corporation for the period. The predictive aspect of the continuing operations number makes it tempting to emphasize that number to the exclusion of net income. Income from continuing operations seems to be the number that the market focuses on when interpreting the information contained in corporate earnings announcements. If users of financial information are more interested in income from continuing operations and do not pay much attention to net income, management may perceive an incentive to report unfavorable results "below the line"
Note: Income Statement Format
whenever possible. There is evidence to suggest that some management bonus plans are based on earnings from continuing operations, instead of net income. This creates a...