1. INTRODUCTION

The income statement presents information on the financial results of a company’s business activities over a period of time. The income statement communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. The basic equation underlying the income statement, ignoring gains and losses, is Revenue minus Expenses equals Net income. The income statement is also sometimes referred to as the “statement of operations,” “statement of earnings,” or “profit and loss (P&L) statement.” Under International Financial Reporting Standards (IFRS), the income statement may be presented as a separate statement followed by a statement of comprehensive income that begins with the profit or loss from the income statement or as a section of a single statement of comprehensive income.1 US generally accepted accounting principles (US GAAP) permit the same alternative presentation formats.2 This reading focuses on the income statement, but also discusses comprehensive income (profit or loss from the income statement plus other comprehensive income).

Investment analysts intensely scrutinize companies’ income statements.3 Equity analysts are interested in them because equity markets often reward relatively high- or low-earnings growth companies with above-average or below-average valuations, respectively, and because inputs into valuation models often include estimates of earnings. Fixed-income analysts examine the components of income statements, past and projected, for information on companies’ abilities to make promised payments on their debt over the course of the business cycle. Corporate financial announcements frequently emphasize information reported in income statements, particularly earnings, more than information reported in the other financial statements.

4.2.1. Doubtful Accounts

When a company sells its products or services on credit, it is likely that some customers will ultimately default on their obligations (i.e., fail to pay). At the time of the sale, it is not known which customer will default. (If it were known that a particular customer would ultimately default, presumably a company would not sell on credit to that customer.) One possible approach to recognizing credit losses on customer receivables would be for the company to wait until such time as a customer defaulted and only then recognize the loss (direct write-off method). Such an approach would usually not be consistent with generally accepted accounting principles.

Under the matching principle, at the time revenue is recognized on a sale, a company is required to record an estimate of how much of the revenue will ultimately be uncollectible. Companies make such estimates based on previous experience with uncollectible accounts. Such estimates may be expressed as a proportion of the overall amount of sales, the overall amount of receivables, or the amount of receivables overdue by a specific amount of time. The company records its estimate of uncollectible amounts as an expense on the income statement, not as a direct reduction of revenues.

4.2.2. Warranties

At times, companies offer warranties on the products they sell. If the product proves deficient in some respect that is covered under the terms of the warranty, the company will incur an expense to repair or replace the product. At the time of sale, the company does not know the amount of future expenses it will incur in connection with its warranties. One possible approach would be for a company to wait until actual expenses are incurred under the warranty and to reflect the expense at that time. However, this would not result in a matching of the expense with the associated revenue.

Under the matching principle, a company is required to estimate the amount of future expenses resulting from its warranties, to recognize an estimated warranty expense in the period of the sale, and to update the expense as indicated by experience over the life of the warranty.

4.2.3. Depreciation and Amortisation

Companies commonly incur costs to obtain long-lived assets. Long-lived assets are assets expected to provide economic benefits over a future period of time greater than one year. Examples are land (property), plant, equipment, and intangible assets (assets lacking physical substance) such as trademarks. The costs of most long-lived assets are allocated over the period of time during which they provide economic benefits. The two main types of long-lived assets whose costs are not allocated over time are land and those intangible assets with indefinite useful lives.

Depreciation is the process of systematically allocating costs of long-lived assets over the period during which the assets are expected to provide economic benefits. “Depreciation” is the term commonly applied to this process for physical long-lived assets such as plant and equipment (land is not depreciated), and amortisation is the term commonly applied to this process for intangible long-lived assets with a finite useful life.32 Examples of intangible long-lived assets with a finite useful life include an acquired mailing list, an acquired patent with a set expiration date, and an acquired copyright with a set legal life. The term “amortisation” is also commonly applied to the systematic allocation of a premium or discount relative to the face value of a fixed-income security over the life of the security.

IFRS allow two alternative models for valuing property, plant, and equipment: the cost model and the revaluation model.33 Under the cost model, the depreciable amount of that asset (cost less residual value) is allocated on a systematic basis over the remaining useful life of the asset. Under the cost model, the asset is reported at its cost less any accumulated depreciation. Under the revaluation model, the asset is reported at its fair value. The revaluation model is not permitted under US GAAP. Here, we will focus only on the cost model. There are two other differences between IFRS and US GAAP to note: IFRS require each component of an asset to be depreciated separately and US GAAP do not require component depreciation; and IFRS require an annual review of residual value and useful life, and US GAAP do not explicitly require such a review.

The method used to compute depreciation should reflect the pattern over which the economic benefits of the asset are expected to be consumed. IFRS do not prescribe a particular method for computing depreciation but note that several methods are commonly used, such as the straight-line method, diminishing balance method (accelerated depreciation), and the units of production method (depreciation varies depending upon production or usage).

The straight-line method allocates evenly the cost of long-lived assets less estimated residual value over the estimate

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An Illustration of Diminishing Balance Depreciation

Assume the cost of computer equipment was $11,000, the estimated residual value is $1,000, and the estimated useful life is five years. Under the diminishing or declining balance method, the first step is to determine the straight-line rate, the rate at which the asset would be depreciated under the straight-line method. This rate is measured as 100 percent divided by the useful life or 20 percent for a five-year useful life. Under the straight-line method, 1/5 or 20 percent of the depreciable cost of the asset (here, $11,000 – $1,000 = $10,000) would be expensed each year for five years: The depreciation expense would be $2,000 per year.

The next step is to determine an acceleration factor that approximates the pattern of the asset’s wear. Common acceleration factors are 150 percent and 200 percent. The latter is known as double declining balance depreciation because it depreciates the asset at double the straight-line rate. Using the 200 percent acceleration factor, the diminishing balance rate would be 40 percent (20 percent × 2.0). This rate is then applied to the remaining undepreciated balance of the asset each period (known as the net book value).

At the beginning of the first year, the net book value is $11,000. Depreciation expense for the first full year of use of the asset would be 40 percent of $11,000, or $4,400. Under this method, the residual value, if any, is generally not used in the computation of the depreciation each period (the 40 percent is applied to $11,000 rather than to $11,000 minus residual value). However, the company will stop taking depreciation when the salvage value is reached.

At the beginning of Year 2, the net book value is measured as

Asset cost	$11,000
Less: Accumulated depreciation	(4,400)
Net book value	$ 6,600

For the second full year, depreciation expense would be $6,600 × 40 percent, or $2,640. At the end of the second year (i.e., beginning of the third year), a total of $7,040 ($4,400 + $2,640) of depreciation would have been recorded. So, the remaining net book value at the beginning of the third year would be

Asset cost	$11,000
Less: Accumulated depreciation	(7,040)
Net book value	$ 3,960

For the third full year, depreciation would be $3,960 × 40 percent, or $1,584. At the end of the third year, a total of $8,624 ($4,400 + $2,640 + $1,584) of depreciation would have been recorded. So, the remaining net book value at the beginning of the fourth year would be

Asset cost	$11,000
Less: Accumulated depreciation	(8,624)
Net book value	$ 2,376

For the fourth full year, depreciation would be $2,376 × 40 percent, or $950. At the end of the fourth year, a total of $9,574 ($4,400 + $2,640 + $1,584 + $950) of depreciation would have been recorded. So, the remaining net book value at the beginning of the fifth year would be

Asset cost	$11,000
Less: Accumulated depreciation	(9,574)
Net book value	$ 1,426

For the fifth year, if deprecation were determined as in previous years, it would amount to $570 ($1,426 × 40 percent). Ho

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For those intangible assets that must be amortised (those with an identifiable useful life), the process is the same as for depreciation; only the name of the expense is different. IFRS state that if a pattern cannot be determined over the useful life, then the straight-line method should be used.34 In most cases under IFRS and US GAAP, amortisable intangible assets are amortised using the straight-line method with no residual value. Goodwill35 and intangible assets with indefinite life are not amortised. Instead, they are tested at least annually for impairment (i.e., if the current value of an intangible asset or goodwill is materially lower than its value in the company’s books, the value of the asset is considered to be impaired and its value in the company’s books must be decreased).

NON-RECURRING ITEMS AND NON-OPERATING ITEMS

From a company’s income statements, we can see its earnings from last year and in the previous year. Looking forward, the question is: What will the company earn next year and in the years after?

To assess a company’s future earnings, it is helpful to separate those prior years’ items of income and expense that are likely to continue in the future from those items that are less likely to continue.36 Some items from prior years are clearly not expected to continue in the future periods and are separately disclosed on a company’s income statement. This is consistent with “An entity shall present additional line items, headings, and subtotals … when such presentation is relevant to an understanding of the entity’s financial performance.”37 IFRS describe considerations that enter into the decision to present information other than that explicitly specified by a standard. US GAAP specify some of the items that should be reported separately. Two such items are 1) discontinued operations, and 2) extraordinary items (the latter category is not permitted under IFRS). These two items, if applicable, must be reported separately from continuing operations under US GAAP.38 For other items on a company’s income statement, such as unusual items, accounting changes, and non-operating income, the likelihood of their continuing in the future is somewhat less clear and requires the analyst to make some judgments.

5.1. Discontinued Operations

When a company disposes of or establishes a plan to dispose of one of its component operations and will have no further involvement in the operation, the income statement reports separately the effect of this disposal as a “discontinued” operation under both IFRS and US GAAP. Financial standards provide various criteria for reporting the effect separately, which are generally that the discontinued component must be separable both physically and operationally.39

Because the discontinued operation will no longer provide earnings (or cash flow) to the company, an analyst can eliminate discontinued operations in formulating expectations about a company’s future financial performance.

In Exhibit 2, Kraft reported earnings and gains from discontinued operations of $1,045 million in 2008 and $232 million in 2007. In Note 2 of its financial statements, Kraft explains that it split off its Post Cereals business. The earnings and gains from discontinued operations of $1,045 million in 2008 and $232 million in 2007 refer to the amount of earnings of the cereal business in each of those years, up to the date it was split off.

5.2. Extraordinary Items

IFRS prohibit classification of any income or expense items as being “extraordinary.”40 Under US GAAP, an extraordinary item is one that is both unusual in nature and infrequent in occurrence. Extraordinary items are presented separately on the income statement and allow a reader of the statements to see that these items are not part of a company’s operating activities and are not expected to occur on an ongoing basis. Extraordinary items are shown net of tax and appear on the income statement below discontinued operations. An example of an extraordinary item is provided in Exhibit 10.

Exhibit 10. Extraordinary Gain on Debt Forgiveness

In its annual report, ForgeHouse, Inc. (OTCBB: FOHE) made the following disclosure describing an extraordinary gain on debt forgiveness:

On September 30, 2009, the Company entered into a Debt Forgiveness Agreement with Insurance Medical Group Limited (f/k/a After All Limited), Bryan Irving, and Ian Morl, pursuant to which $785,000 (plus accrued and unpaid interest and any penalties of $80,141) of the Company’s outstanding obligations in favor of Arngrove Group Holdings were forgiven and all $200,000 (plus accrued and unpaid interest and any penalties of $23,418) of the Company’s outstanding obligations in favor of After All Group, Limited, was forgiven. Gain on these two debt restructurings was a gross of $1,088,559 for the year ended December 31, 2009.

In December 2009, the Company entered into agreements with two of its vendors to reduce the amounts owed to the vendors in exchange for upfront payments. Gain on the restructure of amounts owed to the two vendors was $244,041.

These amounts are presented in the statement of operations net of income taxes of $453,084 for a net extraordinary gain on debt restructuring of $879,516.

Source: ForgeHouse, Inc. 10-K for fiscal year ended 31 December 2009, filed 14 May 2010: Note 6.

Companies apply judgment to determine whether an item is extraordinary based on guidance from accounting standards.41 Judgment on whether an item is unusual in nature requires consideration of the company’s environment, including its industry and geography. Determining whether an item is infrequent in occurrence is based on expectations of whether it will occur again in the near future. Standard setters offer specific guidance in some cases. For example, following Hurricanes Katrina and Rita in 2005, the American Institute of Certified Public Accountants issued Technical Practice Aid 5400.05, which states (the material in square brackets has been added): “A natural disaster [such as a hurricane, tornado, fire, or earthquake] of a type that is reasonably expected to re-occur would not meet both conditions [for classification as an extraordinary item].”

Given the requirements for classification of an item as extraordinary—unusual and infrequent—an analyst can generally eliminate extraordinary items from expectations about a company’s future financial performance unless there is some indication that such an extraordinary item may reoccur.

5.3. Unusual or Infrequent Items

IFRS require that items of income or expense that are material and/or relevant to the understanding of the entity’s financial performance should be disclosed separately. Unusual or infrequent items are likely to meet these criteria. Under US GAAP, which allow items to be shown as extraordinary, items that are unusual or infrequent—but not both—cannot be shown as extraordinary. Items that are unusual or infrequent are shown as part of a company’s continuing operations. For example, restructuring charges, such as costs to close plants and employee termination costs, are considered part of a company’s ordinary activities. As another example, gains and losses arising when a company sells an asset or part of a business, for more or less than its carrying value, are also disclosed separately on the income statement. These are not considered extraordinary under US GAAP because such sales are considered ordinary business activities.

Highlighting the unusual or infrequent nature of these items assists an analyst in judging the likelihood that such items will reoccur. This meets the IFRS criteria of disclosing items that are relevant to the understanding of an entity’s financial performance. Exhibit 11 shows such disclosure.

Exhibit 11. Highlighting Infrequent Nature of Items Excerpt from Roche Group Consolidated Income Statement (in millions of CHF, Year ended 31 December 2009)

[portions omitted]
Operating profit before exceptional items	15,012
Major legal cases	(320)
Changes in Group organisation	(2,415)
Operating profit	12,277
[portions omitted]

In Exhibit 11, Roche Group (SWX: ROG), a Swiss healthcare company, shows operating profit before and after exceptional items. The exceptional items relate to major legal cases and changes in the organization. The company’s notes explain both items further. The costs for changes in the organization relate to Roche’s acquisition of Genentech and major changes to certain manufacturing and commercial centers. Generally, in forecasting future operations, an analyst would assess whether the items reported are likely to reoccur and also possible implications for future earnings. It is generally not advisable simply to ignore all unusual items.

Under International Financial Reporting Standards (IFRS), the income statement may be presented as a separate statement followed by a statement of comprehensive income that begins with the profit or loss from the income statement or as a section of a single statement of comprehensive income.1 US generally accepted accounting principles (US GAAP) permit the same alternative presentation formats.2

Investment analysts intensely scrutinize companies’ income statements.3 Equity analysts are interested in them because equity markets often reward relatively high- or low-earnings growth companies with above-average or below-average valuations, respectively, and because inputs into valuation models often include estimates of earnings. Fixed-income analysts examine the components of income statements, past and projected, for information on companies’ abilities to make promised payments on their debt over the course of the business cycle. Corporate financial announcements frequently emphasize information reported in income statements, particularly earnings, more than information reported in the other financial statements.