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Income Statement

The income statement, or statement of profits and losses, presents the current period installment of a firm's income. We typically break an income statement into several parts to make it more meaningful. The first part of the income statement relates to the profits and losses the firm incurrs over the period related to ordinary business activities. This is called operating income. The first part of our operating income section typically includes sales, the cost of goods sold related to these sales and gross profit: Revenue - COGS = Gross profit. (We typically do not use the term revenue on the income statement, ie. we abbreviate sales revenue to just sales). From gross profit we subtract other operating expenses such as selling, general and administrative expenses and overhead such as rent, insurance and depreciation in order to get net operating income.

In addition to operating income, a firm may have income or losses from other activities. This could result from items such as a gain or loss on the sale of an asset or a gain or a loss from changes in a foreign exchange rate that affects the business. After these profits and losses are included, we call this item earnings before interest and taxes (EBIT).

After this, we typically have a seperate line for interest expense. It is important for investors to be able to look at an income statement and see how much income the business generates in relation to the amount of fixed interest expense the firm must pay. Since taxes are determined on the amount of income left after interest is paid, we calculate this next. Our final line on a typical income statement is net income.

Today, many firms prepare a comprehensive income statement. In 1997, FASB issued FAS130 which requires that firm's either report comprehensive income on their income statement, or in a sperate statement. Other comprehensive income includes profits or losses that the firm has incurred but has not realized yet. For example, because we typically use a historical cost basis for recording the value of assets, a gain or a loss from investments in a firm's pension fund are not recognized under GAAP. However, a large loss in the amount of assets in a firm's pension fund will have a very material affect on the firm's future profitability. As a result, by including other comprehensive income we get a better picture of the firms overall profitability. Below is an example of a comprehensive income statement.

Often several companies are owned by a common group of shareholders, or one parent company owns several subsidiaries. When this is the case, companies are required to combine, or consolidate, all of their earnings on to one income statement. When this occurs, we call this a consolidated income statement. 

Shareholders get value from their investment in a firm when they receive dividends or the price of their share goes up, called capital gains. A firm can pay out dividends only when it earns an income. Similarly, income that is reinvested rather than paid out as dividends is what contributes to the growth of the firm, leading to capital gains. As a result, the value of a firm to its investors is inherintly tied to a firm's income - most importantly, a firm's future income. That is, the ability of the firm to generate income in the future is the key driver of the fundamental value of a firm. 

Because earnings are the key driver of shareholder value, significant attention is paid by investors to the firm's income statement. Net income is the single most important item in the financial statements. The idea is that if a firm that is profitable today, we can assume that it is likely to be similarly profitable in the future. This points to two major drawbacks to the income statement. For one, many projects that a company can invest in have high initial costs, and low initial profitability - that doesn't mean it won't be profitable over the long-term. In fact, you would not want to invest in a company that only invested in projects with short-term profitability, because chances are the firm is missing some highly valuable opportunities that could make money long-term. 

Similarly, the income statement is often subject to manipulation. Officers of a company have significant lattitude in determining when and how revenues and expenses are recorded within GAAP. Similarly, officers may bend or break the rules. For example, many people see the high-tech boom, and later bust, as a result of earnings that these firms were recognizing today, but were not reasonably assured. In fact, because of the latitude that GAAP allows for reporting revenue, errors in reporting revenue are the single most common cause of a company having to file restatements with the SEC.


1. Palmose and Scholz (2004)

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