In general, an income statement summarizes revenues and expenses and gains and losses, and ends with the net income for a specific period. However, to comprehend and analyze profits, you need to understand income statement items that require special disclosure which I discuss in this post. The Income Statement below contains items that require special disclosure. These items are lettered to identify them for discussion. Note that some of these items are presented before tax and some are presented net of tax.
There are six common items of income statement requires disclosure, as follows:
- Unusual or Infrequent Item Disclosed Separately
- Equity in Earnings of Nonconsolidated Subsidiaries
- Discontinued Operations
- Extraordinary Items
- Cumulative Effect of Change in Accounting Principle
- Minority Share of Earnings
Before going to each of the items, to avoid any unnecessary confusion, let me, first, show you form of income statement briefly.
Basic Form of Income Statement
There are two forms of income statements:
1. Multiple-step Income Statement – It usually presents separately the gross profit, operating income, income before income taxes, and net income. A simplified multiple-step income statement might look as follows:
Net Sales (Revenues) $XXX
(-)Cost of Goods Sold (cost of sales) XXX
Gross Profit XXX
(selling and administrative) XXX
Operating Income XXX
(+/-) Other Income or Expense XXX
Income Before Income Taxes XXX
(-)Income Taxes XXX
Net Income $XXX
Earnings per Share $XXX
2. Single-step Income Statement – Many firms use a single-step income statement, which totals revenues and gains (sales, other income, etc.) and then deducts total expenses and losses (cost of goods sold, operating expenses, other expenses, etc.). A simplified single-step income statement might look as follows:
Net Sales $XXX
Other Income XXX
Total Revenue XXX
Cost of Goods Sold (cost of sales) XXX
(selling and administrative) XXX
Other Expense XXX
Income Tax Expense XXX
Total Expenses XXX
Net Income $XXX
Earnings per Share $XXX
A single-step income statement lists all revenues and gains (usually in order of amount), then lists all expenses and losses (usually in order of amount). Total expense and loss items deducted from total revenue and gain items determine the net income. Most firms that present a single-step income statement modify it in some way, such as presenting income tax expense as a separate item.
For firms that have cost of goods sold, cost of goods manufactured, or cost of services, a multiple-step income statement should be used for analysis. The multiple-step provides intermediate profit figures useful in analysis. You may need to construct the multiple-step format from the single-step.
Next, I describe each of the special items that require special disclosure. Read on…
A Unusual or Infrequent Item Disclosed Separately
Certain income statement items are either unusual or occur infrequently. They might include such items as a gain on sale of securities, write-downs of receivables, or write-downs of inventory.
These items are shown with normal, recurring revenues and expenses, and gains and losses. If material, they will be disclosed separately, before tax. Unusual or infrequent items are typically left in primary analysis because they relate to operations.
In supplementary analysis, unusual or infrequent items should be removed net after tax. Usually an estimate of the tax effect will be necessary. A reasonable estimate of the tax effect can be made by using the effective income tax rate, usually disclosed in a footnote, or by dividing income taxes by income before taxes.
Refer to next Gillette Company’s Income Statement, which illustrates unusual or infrequent item disclosed separately:
These items are reorganization and realignment expenses, and the merger-related costs. The income tax footnote discloses the effective tax rates to be 35.3% and 37.8%.
Equity in Earnings of Nonconsolidated Subsidiaries
When a firm accounts for its investments in stocks using the equity method (the investment is not consolidated), the investor reports equity earnings (losses). Equity earnings (losses) are the investor’s proportionate share of the investee’s earnings (losses).
If the investor owns 20% of the stock of the investee, for example, and the investee reports income of $100,000, then the investor reports $20,000 on its income statement. In this post, the term equity earnings will be used unless equity losses are specifically intended.
To the extent that equity earnings are not accompanied by cash dividends, the investor reports earnings greater than the cash flow from the investment. If an investor company reports material equity earnings, its net income could be much greater than its ability to pay dividends or cover maturing liabilities.
For purposes of analysis, the equity in the net income of nonconsolidated subsidiaries raises practical problems. For example, the equity earnings represent earnings of other companies, not earnings from the operations of the business.
Thus, equity earnings can distort the reported results of a business’ operations.
Refer to the next Honeywell’s Income Statement, which illustrates equity in earnings of nonconsolidated subsidiaries:
Leaving these accounts in the statements presents a problem for profitability analysis because most of the profitability measures relate income figures to other figures (usually balance sheet figures). Because these earnings are from nonconsolidated subsidiaries, an inconsistency can result between the numerator and the denominator when computing a ratio.
Some ratios are distorted more than others by equity earnings. For example, the ratio that relates income to sales can be distorted because of equity earnings. The numerator of the ratio includes the earnings of the operating company and the equity earnings of nonconsolidated subsidiaries. The denominator (sales) includes only the sales of the operating company. The sales of the unconsolidated subsidiaries will not appear on the investor’s income statement because the subsidiary was not consolidated. This causes the ratio to be distorted.
Equity in earnings of nonconsolidated subsidiaries (equity earnings) will be presented before tax. Any tax will be related to the dividend received, and it will typically be immaterial. When removing equity earnings for analysis, do not attempt a tax computation.
A common type of unusual item is the disposal of a business or product line. If the disposal meets the criteria of a discontinued operation, then a separate income statement category for the gain or loss from disposal of a segment of the business must be provided. In addition, the results of operations of the segment that has been or will be disposed of are reported in conjunction with the gain or loss on disposal. These effects appear as a separate category after continuing operations.
Discontinued operations pose a problem for profitability analysis. Ideally, income from continuing operations would be the better figure to use to project future income. Several practical problems associated with the removal of a gain or loss from the discontinued operations occur in the primary profitability analysis. These problems revolve around two points:
- An inadequate disclosure of data related to the discontinued operations, in order to remove the balance sheet amounts associated with the discontinued operations; and
- The lack of past profit and loss data associated with the discontinued operations.
The next exhibit illustrates the presentation of discontinued operations in net income:
The best analysis would remove the income statement items that relate to the discontinued operations.
The income statement items that relate to a discontinued operation are always presented net of applicable income taxes. Therefore, the items as presented on the income statement can be removed for primary analysis without further adjustment for income taxes. Supplementary analysis considers discontinued operations in order to avoid disregarding these items.
Ideally, the balance sheet accounts that relate to the discontinued operations should be removed for primary analysis. Consider these items on a supplemental basis because they will not contribute to future operating revenue. However, inadequate disclosure often makes it impossible to remove these items from your analysis.
The balance sheet items related to discontinued operations are frequently disposed of when the business or product line has been disposed of prior to the year-end balance sheet date. In this case, the balance sheet accounts related to discontinued operations do not present a problem for the current year.
Extraordinary items are material events and transactions distinguished by their unusual nature and by the infrequency of their occurrence. Examples include a major casualty (such as a fire), prohibition under a newly enacted law, or an expropriation.
These items, net of their tax effects, must be shown separately. Some pronouncements have specified items that must be considered extraordinary, including material tax loss carryovers and gains and losses from extinguishment of debt.
The effect of an extraordinary item on earnings per share must also be shown separately.
Below Income Statement presents an extraordinary gain on sale of lease assets.
In analysis of income for purposes of determining a trend, extraordinary items should be eliminated since the extraordinary item is not expected to recur. In supplementary analysis, these extraordinary items should be considered, as this approach avoids disregarding these items.
Extraordinary items are always presented net of applicable income taxes. Therefore, the items as presented on the income statement are removed without further adjustment for income taxes.
Cumulative Effect of Change in Accounting Principle
Some changes in accounting principles do not require retroactive adjustments to reflect the adoption of a new accounting principle. The new principle is used for the current year, while the prior years continue to be presented based on the prior accounting principle. This makes comparability a problem.
The comparability problem is compounded by the additional reporting guideline that directs that the income effect of the change on prior years be reported net of tax as a cumulative effect of a change in accounting principle on the income statement in the year of change.
The cumulative effect is shown separately on the income statement in the year of change. It is usually shown just above net income.
When there is a cumulative effect of a change in accounting principle, the reporting standards require that income before extraordinary items and net income, computed on a pro forma basis (as if the new principle had been in effect), should be shown on the face of the income statements for all periods as if the newly adopted accounting principle had been applied during all periods affected.
The pro forma presentation is an additional presentation at the bottom of the income statement. In practice, this pro forma material is often not presented or only partially presented.
The accounting standard of not changing the statements retroactively is the general case when an accounting principle changes.
APB Opinion No. 20, the basis of this reporting standard, provides for only a few exceptions. For most exceptions, the prior statements are retroactively changed using the new accounting principle. In the case when the cumulative effect cannot be determined, the firm should include a footnote explaining the change in accounting principle and the fact that the cumulative effect is not determinable.
The accounting standard of not changing the statements retroactively when there has been a change in accounting principle is not always followed in practice. APB opinions subsequent to No. 20 and later SFASs frequently directed that the new principles included in the respective pronouncement be handled retroactively by changing prior years’ statements.
The accounting standard of not changing the statements retroactively when there has been a change in accounting principle presents major problems for analysis. It is not good theory because it places on the income statement, in the year of change, a potentially material income or loss amount that has nothing to do with operations of that year.
Comparability with prior years (consistency) is also a problem. Statement of Financial Accounting Concepts No. 5 recommends that the cumulative effects of changes in accounting principles not be included in earnings in the year of change in principle. To date, this recommendation has not been the subject of a FASB statement.
No ideal way exists to handle the analysis problem when a change in accounting principle is not handled retroactively. The cumulative effect of a change in accounting principle should be removed from the income statement for primary analysis. This still leaves the comparability problem that the income in the year of change, and subsequent years, is based on the new principle; while the years prior to the change are based on the prior principle.
Tips: If, in your opinion, the income effect is so extreme that comparability is materially distorted, then do not use years prior to the change in comparability analysis. Also note the pro forma presentation, if provided, at the bottom of the income statement. The pro forma numbers will be comparable, but limited.
The next exhibit illustrates a cumulative effect of a change in accounting principle:
Minority Share of Earnings
If a firm consolidates subsidiaries not wholly owned, the total revenues and expenses of the subsidiaries are included with those of the parent.
However, to determine the income that would accrue to the parent, it is necessary to deduct the portion of income that would belong to the minority owners. This is labeled “minority share of earnings” OR “minority interest.”
Note that this item sometimes appears before and sometimes after the tax provision on the income statement. When presented before the tax provision, it is usually presented gross of tax. When presented after the tax provision, it is presented net of tax. In this post, assume net-of-tax treatment.
The next exhibit illustrates minority share of earnings:
Some ratios can be materially distorted because of a minority share of earnings. For each ratio influenced by a minority share of earnings, I can suggest a recommended approach that I may discuss in the coming post.