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INCOME STATEMENT

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The income statement measures the success ofenterprise operations for a given period of time.

Economist J.R.Hicks' income definition: the

maximum value an entity can consume duringa period and still be as well-off at the end as at

the beginning.

What was your income for last Year?

Suppose that you worked in the summer andearned $4,200.

Because you paid taxes and incurred tuitionand living expenses for the school, yourincome statement may show a loss for the year.

But have you sustained a loss?

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How do you value the education obtainedduring this year?

One interpretation of Hicks's definition statesthat you would measure not only monetaryincome but also psychic income("well-offiress").

Psychic income is a measure of increase in netwealth arising from qualitative factors.Inspite of the usefulness of the recognition ofpsychic income, it has been discarded byaccountants in determining net income due tomeasurement problems.

ltems that cannot be quantified with anydegree of reliability are discarded from

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oeterTnlnlng lncome.

On the other hand, income totals are notuniform and precrse.

Income totals are affected by the accountmg

rr.itt"Ot employed (stralght-line vs'

accelerated meihods of depreciation) '

Companies that use liberal (aggressive)

"'*"i"iing policies report higher income

numbers in the short run'

In such cases, the quallty of earnings is low'

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Is income sustainable?

X corp reported earnings of $4.77 per share,supposedly a 20 % increase over the prioryear's $3.99 per share earnings.

However,

- $2.2 per share was earned from the salesof certain lines of business.

- S0.17 per share resulted from anonoperating tax forgiveness granted toencourage exports.

- An additional $0.19 per share of incomeresulted from a nonrecurring transaction.

So, how real was the 20oh increase?

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The past decade has witnessed an exceptionaldegree of attention on subtotals that make upthe income statement.

The opportunistic use of income statement toalter earnings performance is also important.

Earnings management can be performed byaccelerating or decelerating the recognition ofrevenue or gains and expenses or losses.

Earnings can be shifted among differentperi ods(interperiod version).

Different classification or disclosure of itemswithin the income statement of a single periodmay also lead to earnings management.

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If earnings perfonnance were assesed by netincome- the bottom line of the incomestatement, intra-income statement creativitywould be fruitless.

However, in the past decade, there has been astrong shift away from a primary emphasis onthe bottom line of the income statement.

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Usefulness of the Income Statement

I ) Evaluate the past performance of theenterprise.

By examining revenues and expenses, youcan tell how the company performed andcompare its perfoffnance to its competitors.

2)Provide a basis for predicting futureperformance.

Information about past performance can beused to determine imporlanl trends that, ifcontinued, provide information aboutfuture performance.

3)Information about various components ofincome - revenues, expenses, gains andlosses-highlights the relationship amongthem and can be used to assess the risk ofnot achieving a particular level of cashflows in the future.

The results from continuing operationsusually have greater significance forpredicting future performance than do theresults from non-recurring events.

Limitations of the fncome Statement

I ) Items that cannot be measured reliabl y arenot reported in the income statement.

Ex: increases in value due to brandrecognition, customer service, and productquality.

2) Income numbers are affected by theaccounting methods employed.

3) Income measurement involves judgement.

Ex: determination of useful lives of fixedassets can change between companies.Similarly, companies may make overlyoptimistic estimate of bad-debt write-offs.

Reporting lrregular Items

- What should be included in net income?

- What should be done with irregular gains

and losses and corrections of revenues

and expenses of prior Years?

- Should they be closed directlY toRetained Earnings (not reported in net

income)

Or

- Should they be first presented in the

income statement and then carried to

Retained Earnings along with the net

income or loss for the Period.

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Carrent operating performonce concept:

- net income should show only the regular,recurring earnings.

- irregular gains and losses do not reflectan enterprise's fufure earnings power.

- irregular gains and losses should not beincluded in computing net income.

- irregular gains and losses should becarried directly to Retained Earnings as

special items.

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All-inclusive concept:

- irregular items must be included in netincome.

- irregular items contribute to the long-runprofitability of the business entity.

- irregular items can be separated from theresults of regular operations to arrive atincome from operations.

- However, net income should include alltransactions.

I - When judgement is allowed to determineirregular items, a danger of manipulatingincome dataarises.

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Ex: At one time, American Standardwrote-off directly to Retained Earnings

$17.9 million of losses from discontinuedoperations.

This enabled the company to reportearnings per share of $1.01.

If the write-off had been charged toexpense, American Standard would have

reported a loss of 78 cents per share.

It could be to the advantage of the firm to runone time losses through Retained Earnings ,

but gains through income which leads to poorfinancial reporting practices.