• Home
• 2.1 Introduction
• 2.2 SEC Interactive Data
• 2.3 Accessing SEC Data
• 2.4 Additional Information
• 2.5 Touring the 10-K
• 2.6 Primary Statements
• 2.7 M D&A
• 2.8 Item 6 Selected Data
• 2.9 Mini Case Studies
• 2.10 Summary
• A.1 Balance Sheet
• A.2 Income Statement
• A.3 Cash Flow Statement
• A.4 Stockholders' Equity
• A.5 Statement Linkages
• A.6 Common Size Analysis
• 2.11 Questions

A.2 The Consolidated Income Statement

This financial statement attracts the most attention in the media.  This attention is reinforced by the results from a survey of managers in the field that found:

This attention by managers is further reinforced from the results of a study regarding the incentives faced by CEO�s in the field.  This study concluded:

So what is the Consolidated Statement of Income?

Simply it measures the performance of a firm in terms of the income it generates over a given period of time.  The form of presentation for an income varies across firms and in particular across industries.  However, in its basic form the following components typically appear:

Top Line:  What revenues are recognized (e.g., what was sold)?

Less

What did it cost to generate those revenues?

Gross Margin

Less

Period expenses (SG&A, Research and Development)

Income from Operations

Less

tax expenses (period expenses)

Bottom Line:  Net Income

Remarks: 

The mode of presentation for the income statement varies in practice.  For example, under US GAAP both single-step and multiple-step income statement formats are acceptable.  The multiple-step format provides intermediate measures of net income such as gross profit, operating profit, profit before taxes and so on.  The single-step format groups categories of revenue and categories of expenses together, before arriving at the net income number.  In practice statements can be in part single and in part multiple steps.  This is an important distinction to be aware of when working with the real world statements because you will usually find it useful to recast a single step or partial single step statement into a multiple-step statement for comparison and other purposes.

US GAAP requires some items to be reported separately in the income statement, such as extraordinary items and discontinued operations.  Extraordinary items are prohibited under IFRS.  Discontinued operations, on the other hand, is highlighted under both systems for assets held for sale or to be disposed of, provided that no significant future continuing cash flows will be generated.

In summary this statement provides the primary source of information relevant to assessing the profitability of a company.  

Understanding the Income Statement with Valuation Tutor

By selecting the Consolidated Statement of Operations for Amazon from the 2011 10-K reveals the following:

First, observe that Amazon reports in a partial single step income statement format.  The gross margin for example is not reported even though the cost of sales is provided.  As a result, an analyst would likely immediately recast Amazon�s statement into the following generic format:

Net Sales

Less Cost of Sales

Gross Profit

Less Selling and General Administration Expenses

Less Other Expenses

Net Income Before Interest and Taxes (Equivalently EBIT)

Interest Expense

Net Income Before Taxes (Equivalently EBT)

Tax Expense

Net Income After Taxes

You can observe that Amazon already classifies on the basis of Income from Operations (EBIT (Earnings Before Interest and Taxes)) and then Income Before Taxes (EBT) and finally Net Income (NI).

The Consolidated Income Statement represents a flow concept in the sense of providing important insights into how a company has performed between two points in time. The 10-K for additional comparison purposes requires three years of income statements are presented for comparison purposes.

Elements of the Income Statement

Net Sales

This contains the aggregate of sales revenue given the revenue recognition criteria which is usually discussed in the critical accounting judgments section of the 10-K.  The net part refers to sales revenue net of an allowance for bad and doubtful debts. 

Sales Revenue is a difficult area in general for accounting.  The major difficulty is in applying revenue recognition criteria. 

That is, when does revenue become earned?

Loosely the answer to this question is when goods are transferred or services rendered irrespective of cash payments under accrual accounting.  Formally, there are two models for revenue recognition, the Merchant Model and the Agent Model.  These models will directly impact the format of income statement reporting in relation to whether cost of goods sold is formally recognized or not.  In practice it is not uncommon for a firm today to measure some sales revenue under both models and an alert analyst will read the 10-K closes to identify what combination of models is actually being used. 

We describe these models briefly next.

 

Merchant Model:  Under this model the merchant bears all of the risk of the inventory and therefore books the selling price as revenue when sold (Gross Revenue Recognition) and the cost of the inventory as COGS.  This is often referred to as the �gross revenue reporting method� because COGS is itemized separately.  For example, Coca-Cola uses this model in its 10-K and itemizes Gross Profit as follows:

Agent Model:  an agent provides a service to a customer (facilitating the purchase of a ticker but not providing the actual product/service) and under this model the agent is permitted to book the agent�s fee or brokerage fee as revenue (Net Revenue Recognition).  Under this method there is no COGS.  An example of the Agent Model is provided by Live Nation Entertainment:

Observe there is no Cost of Goods Sold when selling tickets for entertainment.

Cost of Revenue (Cost of Goods Sold) Summary

These items include the costs associated with selling or providing the goods and services that generate the net revenue.  Cost of Revenue largely consists of direct or variable costs associated with generating sales.

Cost of Revenues is defined relative to the firm�s business model.  For example, consider a traditional example of cost of goods sold, Walmart versus a new economy example of cost of sales, Google.

Cost of Sales Walmart

Walmart buys and sells inventory.  Cost of sales includes actual product cost, the cost of transportation to the company�s warehouses, stores and clubs from suppliers, the cost of transportation from the company�s warehouses to the stores and clubs and the cost of warehousing for our Sam�s Club segment.

Cost of Revenues Google

Google�s revenues consist primarily of traffic acquisition costs. Cost of revenues are traffic acquisition costs.  These consist of amounts ultimately paid to our Google Network members under AdSense arrangements, certain other partners (our distribution partners) who distribute our toolbar and other products (collectively referred to as access points), and otherwise direct search queries to our website (collectively referred to as distribution arrangements). These amounts are primarily based on the revenue share and fixed fee arrangements with our Google Network Members and distribution partners.

Gross Profit (a component of a multiple-step income statement)

This measures the difference between net revenues and the cost of sales.  If Gross Profit is reported it is calculated prior to accounting for operating expenses such as selling and administration.  Under segment reporting this is provided by functional lines of business.

Sales less Cost of Sales determines the Gross Profit or Gross Margin

A Non US GAAP Popular Variation

A further adjustment made by most analysts in a multiple-step income statement is to measure EBIT (Earnings Before Interest and Taxes) to keep the investment and financing decisions for the firm whereas US GAAP treats interest expense as part of operations.  The impact from the investment and financing decision is separated as follows:

Gross Margin

Less Operating Expenses (not including any financing expenses)

EBIT (Earnings Before Interest and Taxes)

Less Financing expenses

EBT (Earnings Before Taxes)

We next summarize the above structure.

Operating Expense and EBIT

Accrual Accounting Income applies the matching expenses to revenue test to identify operating expenses.  The matching principle imposes a hierarchical test as follows:

�      Test 1:  Match expenses to revenue (product expense)

�      Test 2:  Match expenses to the period (period expenses)

That is, if the expense cannot be related to the revenue recognized then it is matched to the period of time that the revenue is recognized in under this principle.  Most operating expenses are period expenses although some such as selling can be product expenses.  Today, fair value accounting further extends the matching principle to impairments of operating assets (current (e.g., inventory) and non-current (Property Plant and Equipment, Capital Leases, Intangibles).  This generates additional sources of operating expenses because an impairment is an unrealized loss.

Formally, SFAS 144 defines an impairment loss to be recognized if the carrying amount of a long-lived asset is not recoverable (e.g., via a sale) and exceeds its fair value.  That is, the fair value of the asset is below the existing book value so that impairment results in writing down the asset to its fair value on the books.

In turn another important standard, SFAS 157 formally defines fair value as the �price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.�  That is, the transaction cannot be within a consolidated group but instead be what is often referred to as an �arms-length� transaction. 

Some specific items in operating expenses are listed below.  These include selling, administration and related expenses.  Related expenses are the indirect costs associated with generating revenue such as depreciation and amortizations and lease expenses. 

Selling, General and Administration Expenses (largely period expense)

Depreciation and amortization  (period expense)

• Includes capital lease adjustments (today is subject to an impairment test)
• Amortization of intangibles is based on impairment tests

Research and Development Expenses (period expense)

Lease Expenses (period expense)

Repairs and Maintenance (period expense)

Combined in a multi-step format this results in operating profit or EBIT (Earnings Before Interest and Taxes) as it is often referred to.

Operating Profit (EBIT)

This item measures the profit from the company�s operations.  It reflects how well the company is implementing its investment decision ignoring how it has financed its assets.

Some Practical Notes

In practice there are large differences in the external reporting of operating expenses.  For example, consider three well-known companies:  Wal-Mart, Apple and Amazon.

For the case of Wal-Mart operating expenses is a single line item:

And for the case of Apple two line items as follows:

This is because Research and Development is a more significant item for Apple relative to Wal-Mart.  Amazon on the other hand provides the most detailed reporting of this category by providing five sub-categories as follows:

For technology firms operating expense categories provide useful information and in particular in relation to their Research and Development Expenditure is US GAAP requires expensing (with the exception of software).  To put this into perspective it is informative to compare the average R&D per employee for some technology firms:

That is, Amazon spends more than Apple but both are less than Google on a per employee basis.

Another practical note is that depreciation expense can be included in both cost of revenues as a product cost and operating expenses.  However, it is always disclosed separately in the consolidated statement of cash flows.  As a result, you may always find a finer breakdown of operating expenses in the cash flow statement than the actual income statement which provides more aggregated disclosures.

For example, for the case of Apple additional details are provided:

Other Income or Expenses

This item includes revenues and expenses from other sources that are not the firm�s operations.  This can include dividends or interest expenses associated with other investments.  This can also include items arising when the company accounts for its investments using the equity method.

These items can sometimes be very large.  For example, consider the case of Google.  In 2011 they were the subject of a Justice Department probe and it was conjectured that they may have to pay $500 million in fines.

It turned out that the $500 million was correct and in their 2012 10-K Google accounted for this transparently as follows:

Finally, Fair Value Accounting is having an increasing influence upon the income statement.  In particular, SFAS 159 (actually now ASC 825-10) gives entities the option to account for some assets at fair value that otherwise would be accounted for under the equity method (for the case of a 20-50% ownership).  This was the case for intangibles with Coca-Cola�s acquisition of bottling plants.  By electing this fair value option Coca-Cola accounted for the gain from their purchase as follows:

Earnings Before Taxes (EBT)

This measures the earnings before income tax expenses are accounted for.  It is relevant to analysts to assess what the company’s effective tax rate is.  This ratio is calculated by dividing income tax expense by the earnings before taxes.  Effective tax rates can vary significantly from corporate tax rates for a variety of reasons including the result of operations in foreign countries.  Many corporations will provide additional details in relation to taxes paid in their footnotes to the accounts.

Special Items

Under US GAAP extraordinary items are permitted and are disclosed as a separate category.  The common special items are:

Extraordinary Items (US GAAP not IFRS)

These are unusual items plus items that are not expected to re-occur including one time adjustments from accounting changes.  A major difference between US GAAP and the International Financial Reporting Standards (IFRS) is that the latter does not separately itemize extraordinary items.

Discontinued Operations

Other (accounting standard changes and other items)

Net Earnings or Net Income or Net Profit

This is referred to as the “bottom line” which is the major focal point of an income statement.

Additional Categories

There is a variety of additional information provided in an income statement.  First, is the major ratio EPS (earnings per share).

Earnings Per Share

This is the net income available to the weighted average number of common shares outstanding over the year. US GAAP requires that if a company has a complex financial structure that includes embedded derivatives such as convertible securities then the earnings per share needs to be expressed in two forms.

EPS Basic versus Diluted

Basic uses the common stock outstanding whereas Diluted assumes that convertible securities are exercised so that the number of issued shares would increase.

Additional line items provided by companies filing under US GAAP provide this EPS information broken up into Continuing and Discontinuing operations.