Income Statement Review

Provides performance overview for a specific period (year, quarter).
Helps assess operating risk by examining the stability of sales and operating income.

External Users:
- Investors (stockholders):
  - Concerned with profitability (drives value).
  - Focus on operating income, return on equity, and earnings per share.
- Lenders (short-term and long-term):
  - Concerned with creditworthiness.
  - Assess credit rating based on profit margin and EBIT (earnings before interest and tax).
  - The more EBIT, the higher the credit rating due to the ability to cover interest expenses.
Internal Users (managers):
- Concerned with return on assets for specific product lines.
All users are concerned with risk:
- Volatility in sales and operating income.
- Measured by standard deviation in sales and operating income.

Most revenues and expenses are from normal operating activities.
Revenue and expense items are shown separately (gross).
Exceptions:
- Interest revenue and interest expense (if not a bank) are non-operating.
- Other revenue and other expense are non-operating.

Cost: What you pay for something.
Expense: When a cost is recognized on the income statement.
Period Cost:
- Expensed immediately because it won't provide future benefit.
- Examples: recurring selling, general, administrative, research costs.
Capitalized Cost:
- Booked as an asset if it's expected to generate revenue in the future.
- Unexpired cost = asset (on the balance sheet).
- Expensed in future periods based on the matching principle.
- Examples:
  - Inventory costs are capitalized and expensed as cost of goods sold when sold.
  - Prepaid insurance is capitalized and expensed over the policy period.
  - PP&E (property, plant, and equipment) costs are capitalized and depreciated over their useful lives.
  - Intangibles (patents, copyrights, trademarks, franchises, licenses) are capitalized and amortized.
  - Natural resources are depleted.

Most revenues/expenses are core business (operating) vs. unusual/infrequent (non-operating).
Non-operating items:
- Selling something other than inventory (PP&E, investments).
- Write-downs or write-offs.
Extraordinary Items:
- Previously a separate line item but no longer exists.
- Now reported under non-operating, like losses from natural disasters.
Income from continuing operations:
- Sum of normal operating and non-operating items.
Disclosure Requirement:
- Unusual or infrequent items need to be disclosed in the financial statements or footnotes.

Report the net result of the transaction (gain or loss), not the gross selling price and cost.
Quantification:
- Selling price (if sold) or net realizable value (if impaired)
- Subtract book or carrying value to get net gain or loss.
Income from continuing operations:
- Operating revenues and expenses
- Plus or minus non-operating gains and losses, other revenue, other expenses.
Discontinued Operations:
- Reported separately after income from continuing operations, net of tax.

Single-Step Income Statement:
- Total revenues and gains minus total expenses and losses (except taxes) equals pre-tax income, then subtract income tax expense for net income.
- Alternatively, total revenues and gains minus all expenses and losses (including income tax expense) equals net income.
- Problem: Doesn't distinguish between core business and incidental activities.
Multiple-Step Income Statement:
- Enhances user information, separates operating and non-operating activities, aids in ratio analysis.
- Sales - Cost of Goods Sold = Gross Profit
- Gross Profit - Operating Expenses (SG&A, depreciation, amortization, R&D) = Operating Income
- Operating Income +/- Non-Operating Items (other revenues, other expenses, gains/losses from sale of non-inventory, write-downs/offs) = Pre-Tax Income
- If no discontinued operations: Pre-Tax Income - Tax Expense = Net Income
- If discontinued operations: Income from Continuing Operations Before Tax - Income Tax Expense = Income from Continuing Operations (after tax) +/- Discontinued Operation (net of tax) = Net Income
- Multiple-step format allows assessment of what's driving the bottom line.

Numbers are determined by accounting methods and estimates (accrual basis, not cash basis).
Accrual basis:
- Revenues and expenses are booked when earned/incurred, not when cash is received/paid.
Susceptible to management bias through assumptions and estimates (legal or illegal manipulation).
Aggressive vs. Conservative Accounting:
- Aggressive: Higher revenue now, lower expense now (higher profit today).
- Conservative: Lower revenue now, higher expense now (lower profit today).
- Examples:
  - Depreciation: Straight-line vs. double-declining balance (double-declining is more conservative initially).
  - Useful life and salvage value: Higher useful life/salvage value leads to lower expenses (aggressive).
  - Bad debts and warranty expense: Higher percentage/expense is more conservative.

Accrual basis and matching principle lead to income smoothing.
Better assessment of annual performance than cash basis.
Downside: Subjective and can be manipulated.
Example: Long-term construction contracts
- Without income smoothing: No revenue/expense recognized until project completion (volatile).
- With income smoothing: Revenue/expense recognized each year based on percentage of completion (stable).
Detriment: Management can disguise risk and alter performance.
Companies may defer revenue or shift classification to reduce volatility.

Companies want to put good news in operating income and bad news in non-operating.
Pushing up the good news and pushing down the bad news is a type of fraud