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Income Statement: Usefulness And Limitations Of Income Statement


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Usefulness And Limitations Of Income Statement

Income statements should help investors and creditors determine the past financial performance of the enterprise, predict future performance, and assess the capability of generating future cash flows through report of the income and expenses.

However, information of an income statement has several limitations:
  • Items that might be relevant but cannot be reliably measured are not reported e.g. brand recognition and loyalty.
  • Some numbers depend on accounting methods used e.g. using FIFO or LIFO accounting to measure inventory level.
  • Some numbers depend on judgments and estimates e.g. depreciation expense depends on estimated useful life and salvage value.

- INCOME STATEMENT GREENHARBOR LLC -

For the year ended DECEMBER 31 2010

GROSS REVENUES including INTEREST income 296,397

BANK & CREDIT CARD FEES 144

SUBCONTRACTORS 88,000

LEGAL & PROFESSIONAL SERVICES 1,575

PRINTING, POSTAGE & STATIONERY 320

TOTAL EXPENSES 195,512

Names and usage of different accounts in the income statement depend on the type of organization, industry practices and the requirements of different jurisdictions.

If applicable to the business, summary values for the following items should be included in the income statement:

Operating Section


  • Revenue - Cash inflows or other enhancements of assets of an entity during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major operations. It is usually presented as sales minus sales discounts, returns, and allowances. Every time a business sells a product or performs a service, it obtains revenue. This often is referred to as gross revenue or sales revenue.

  • Expenses - Cash outflows or other using-up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major operations.
  • Cost of Goods Sold COGS / Cost of Sales - represents the direct costs attributable to goods produced and sold by a business manufacturing or merchandizing. It includes material costs, direct labour, and overhead costs as in absorption costing, and excludes operating costs period costs such as selling, administrative, advertising or R&D, etc.
  • Selling, General and Administrative expenses SG&A or SGA - consist of the combined payroll costs. SGA is usually understood as a major portion of non-production related costs, in contrast to production costs such as direct labour.
  • Selling expenses - represent expenses needed to sell products e.g. salaries of sales people, commissions and travel expenses, advertising, freight, shipping, depreciation of sales store buildings and equipment, etc..
  • General and Administrative G&A expenses - represent expenses to manage the business salaries of officers / executives, legal and professional fees, utilities, insurance, depreciation of office building and equipment, office rents, office supplies, etc..
  • Depreciation / Amortization - the charge with respect to fixed assets / intangible assets that have been capitalised on the balance sheet for a specific accounting period. It is a systematic and rational allocation of cost rather than the recognition of market value decrement.
  • Research & Development R&D expenses - represent expenses included in research and development.

Expenses recognised in the income statement should be analysed either by nature raw materials, transport costs, staffing costs, depreciation, employee benefit etc. or by function cost of sales, selling, administrative, etc.. IAS 1.99 If an entity categorises by function, then additional information on the nature of expenses, at least, – depreciation, amortisation and employee benefits expense – must be disclosed. IAS 1.104

The major exclusive of costs of goods sold, are classified as operating expenses. These represent the resources expended, except for inventory purchases, in generating the revenue for the period. Expenses often are divided into two broad sub classicifications selling expenses and administrative expenses.

Non-operating Section


  • Other revenues or gains - revenues and gains from other than primary business activities e.g. rent, income from patents, goodwill. It also includes unusual gains that are either unusual or infrequent, but not both e.g. gain from sale of securities or gain from disposal of fixed assets

  • Other expenses or losses - expenses or losses not related to primary business operations, e.g. foreign exchange loss.

  • Finance costs - costs of borrowing from various creditors e.g. interest expenses, bank charges.

  • Income tax expense - sum of the amount of tax payable to tax authorities in the current reporting period current tax liabilities/ tax payable and the amount of deferred tax liabilities or assets.

Irregular Items

They are reported separately because this way users can better predict future cash flows - irregular items most likely will not recur. These are reported "net of taxes".
  • Discontinued operations is the most common type of irregular items. Shifting business locations, stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations. Discontinued operations must be shown separately.

However, "changes in estimates" e.g. estimated useful life of a fixed asset only requires prospective changes. IAS 8

No items may be presented in the income statement as extraordinary items under IFRS regulations, but are permissible under US GAAP. IAS 1.87 Extraordinary items are both unusual abnormal and infrequent, for example, unexpected natural disaster, expropriation, prohibitions under new regulations. Note: natural disaster might not qualify depending on location e.g. frost damage would not qualify in Canada but would in the tropics.

Additional items may be needed to fairly present the entity's results of operations. IAS 1.85

Disclosures


  • Write-downs of inventories to net realisable value or of property, plant and equipment to recoverable amount, as well as reversals of such write-downs
  • Restructurings of the activities of an entity and reversals of any provisions for the costs of restructuring
  • Disposals of items of property, plant and equipment
  • Disposals of investments
  • Discontinued operations
  • Litigation settlements
  • Other reversals of provisions

Earnings Per Share

There are two forms of EPS reported:
  • Basic: in this case “weighted average of shares outstanding” includes only actual stocks outstanding.
  • Diluted: in this case “weighted average of shares outstanding” is calculated as if all stock options, warrants, convertible bonds, and other securities that could be transformed into shares are transformed. This increases the number of shares and so EPS decreases. Diluted EPS is considered to be a more reliable way to measure EPS.

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