The need to provide information to help analysts predict future cash flows emphasizes the importance of properly reporting the amount of income from the entity's continuing operations. Clearly, it is the operating transactions that probably will continue into the future that are the best predictors of future cash flows. The components of income from continuing operations revenues, expenses (including income taxes), gain, and losses, excluding those related to discontinued operations and extraordinary items. are revenues, expenses (including income taxes), gains, and losses, excluding those related to discontinued operations and extraordinary items.1
Revenues, Expenses, Gains, and Losses
Revenues are inflows of resources resulting from providing goods or services to customers. For merchandising companies like Walmart, the main source of revenue is sales revenue derived from selling merchandise. Service firms such as FedEx and State Farm Insurance generate revenue by providing services.
Expenses are outflows of resources incurred while generating revenue. They represent the costs of providing goods and services. The matching principle is a key player in the way we measure expenses. We attempt to establish a causal relationship between revenues and expenses. If causality can be determined, expenses are reported in the same period that the related revenue is recognized. If a causal relationship cannot be established, we either relate the expense to a particular period, allocate it over several periods, or expense it as incurred.
Income from continuing operations includes the revenues, expenses, gains and losses that will probably continue in future periods.
Gains and losses are increases or decreases in equity from peripheral or incidental transactions of an entity. In general, these gains and losses are those changes in equity that do not result directly from operations but nonetheless are related to those activities. For example, gains and losses from the routine sale of equipment, buildings, or other operating assets and from the sale of investment assets normally would be included in income from continuing operations. Later in the chapter we discuss certain gains and losses that are excluded from continuing operations.
Income Tax Expense
Income taxes represent a major expense to a corporation, and accordingly, income tax expense is given special treatment in the income statement. Income taxes are levied on taxpayers in proportion to the amount of taxable income that is reported to taxing authorities. Like individuals, corporations are income-tax-paying entities.2 Because of the importance and size of income tax expense provision for income taxes; reported as a separate expense in corporate income statements. (sometimes called provision for income taxes), it always is reported as a separate expense in corporate income statements.
Income tax expense is shown as a separate expense in the income statement.
Federal, state, and sometimes local taxes are assessed annually and usually are determined by first applying a designated percentage (or percentages), the tax rate (or rates), to taxable income comprises revenues, expenses, gains, and losses as measured according to the regulations of the appropriate taxing authority.. Taxable income comprises revenues, expenses, gains, and losses as measured according to the regulations of the appropriate taxing authority.
Many of the components of taxable income and income reported in the income statement coincide. But sometimes tax rules and GAAP differ with respect to when and even whether a particular revenue or expense is included in income. When tax rules and GAAP differ regarding the timing of revenue or expense recognition, the actual payment of taxes may occur in a period different from when income tax expense is reported in the income statement. A common example is when a corporation takes advantage of tax laws by legally deducting more depreciation in the early years of an asset's life on its federal income tax return than it reports in its income statement. The amount of tax actually paid in the early years is less than the amount that is found by applying the tax rate to the reported GAAP income before taxes. We discuss this and other issues related to accounting for income taxes in Chapter 16. At this point, consider income tax expense to be simply a percentage of income before taxes.
While the actual measurement of income tax expense can be complex, at this point we can consider income tax expense to be a simple percentage of income before taxes.
Operating versus Nonoperating Income
Many corporate income statements distinguish between operating includes revenues and expenses directly related to the principal revenue-generating activities of the company. income and nonoperating includes gains and losses and revenues and expenses related to peripheral or incidental activities of the company. income. Operating income includes revenues and expenses directly related to the primary revenue-generating activities of the company. For example, operating income for a manufacturing company includes sales revenues from selling the products it manufactures as well as all expenses related to this activity. Similarly, operating income might also include gains and losses from selling equipment and other assets used in the manufacturing process.3
A distinction often is made between operating and nonoperating income.
Nonoperating income relates to peripheral or incidental activities of the company. For example, a manufacturer would include interest and dividend revenue, gains and losses from selling investments, and interest expense in nonoperating income. Other income (expense) often is the classification heading companies use in the income statement for nonoperating items. On the other hand, a financial institution like a bank would consider those items to be a part of operating income because they relate to the principal revenue-generating activities for that type of business.
Graphic 4-2 presents the 2009, 2008, and 2007 income statements for Dell Inc. Notice that Dell distinguishes between operating income and nonoperating income (labeled Investment and other income, net). Nonoperating revenues, expenses, gains and losses, and income tax expense (called Income tax provision) are added to or subtracted from operating income to arrive at net income. As Dell has no separately reported items, income from continuing operations equals net income.4
Now let's consider the formats used to report the components of net income.
Income Statement Formats
No specific standards dictate how income from continuing operations must be displayed, so companies have considerable latitude in how they present the components of income from continuing operations. This flexibility has resulted in a variety of income statement presentations. However, we can identify two general approaches, the single-step and the multiple-step formats, that might be considered the two extremes, with the income statements of most companies falling somewhere in between.
Income Statements—Dell Inc.
Real World Financials
The single-step income statement format that groups all revenues and gains together and all expenses and losses together. format first lists all the revenues and gains included in income from continuing operations. Then, expenses and losses are grouped, subtotaled, and subtracted—in a single step—from revenues and gains to derive income from continuing operations. Operating and nonoperating items are not separately classified. Illustration 4-1 shows an example of a single-step income statement for a hypothetical manufacturing company, Maxwell Gear Corporation.
A single-step income statement format groups all revenues and gains together and all expenses and losses together.
Single-Step Income Statement
The multiple-step income statement format that includes a number of intermediate subtotals before arriving at income from continuing operations. format reports a series of intermediate subtotals such as gross profit, operating income, and income before taxes. The overview income statements presented in Graphic 4-1 and the Dell Inc. income statements in Graphic 4-2 are variations of the multiple-step format. Illustration 4-2 presents a multiple-step income statement for the Maxwell Gear Corporation.
A multiple-step income statement format includes a number of intermediate subtotals before arriving at income from continuing operations.
Multiple-Step Income Statement
An advantage of the single-step format is its simplicity. Revenues and expenses are not classified or prioritized. A primary advantage of the multiple-step format is that, by separately classifying operating and nonoperating items, it provides information that might be useful in analyzing trends. Similarly, the classification of expenses by function also provides useful information. For example, reporting gross profit for merchandising companies highlights the important relationship between sales revenue and cost of goods sold. It is important to note that this issue is one of presentation. The bottom line, net income, is the same regardless of the format used. A recent survey of income statements of 500 large public companies indicates that the multiple-step format is used more than five times as often as the single-step format.5 We use the multiple-step format for illustration purposes throughout the remainder of this chapter.
In addition to net income, the components of the income statement and their presentation also are important to financial statement users in their assessment of earnings quality.
Before we investigate separately reported items, let's take a closer look at the components of both operating and nonoperating income and their relationship to earnings quality.
INTERNATIONAL FINANCIAL REPORTING STANDARDS
International standards allow expenses to be classified either by function (e.g., cost of goods sold, general and administrative, etc.), or by natural description (e.g., salaries, rent, etc.). SEC regulations require that expenses be classified by function.
In the United States, the “bottom line” of the income statement usually is called either net income or net loss. The descriptive term for the bottom line of the income statement prepared according to international standards is either profit or loss.
As we discuss later in the chapter, we report “extraordinary items” separately in an income statement prepared according to U.S. GAAP. International standards prohibit reporting “extraordinary items.”
1 These two separately reported items are addressed in a subsequent section.
2 Partnerships are not tax-paying entities. Their taxable income or loss is included in the taxable income of the individual partners.
3 FASB ASC 360–10–45–5: Property, plant, and equipment—Overall—Other Presentation Matters (previously “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,” Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001)).
4 In a later section we discuss items that are reported separately from continuing operations.
5Accounting Trends and Techniques—2009 (New York: AICPA, 2009), p. 321.