Income statement, its elements, usefulness and limitations
Income statement
The income statement focuses on the four key items - revenue, expenses, gains, and losses. It
does not cover receipts (money received by the business) or the cash payments/disbursements
(money paid by the business). It starts with the details of sales, and then works down to
compute the net income and eventually the earnings per share (EPS). Essentially, it gives an
account of how the net revenue realized by the company gets transformed into net earnings
(profit or loss).
Key notes:
An income statement is one of the three (along with balance sheet and statement of cash
flows) major financial statements that reports a company's financial performance over a
specific accounting period.
Net Income = (Total Revenue + Gains) – (Total Expenses + Losses)
Total revenue is the sum of both operating and non-operating revenues while total
expenses include those incurred by primary and secondary activities.
Revenues are not receipts. Revenue is earned and reported on the income statement.
Receipts (cash received or paid out) are not.
An income statement provides valuable insights into a company’s operations, the
efficiency of its management, under-performing sectors and its performance relative to
industry peers.
Income Statement Structure
Mathematically, the Net Income is calculated based on the following:
Net Income = (Revenue + Gains) – (Expenses + Losses)
Elements of Income Statement
Revenues and Gains
The following are covered in the income statement, though its format may vary depending upon
the local regulatory requirements, the diversified scope of the business and the associated
operating activities:
Operating Revenue
Revenue realized through primary activities is often referred to as operating revenue. For a
company manufacturing a product, or for a wholesaler, distributor or retailer involved in the
business of selling that product, the revenue from primary activities refers to revenue achieved
from the sale of the product. Similarly, for a company (or its franchisees) in the business of
offering services, revenue from primary activities refers to the revenue or fees earned in
exchange of offering those services.
Non-Operating Revenue
Revenues realized through secondary, non-core business activities are often referred to as non-
operating recurring revenues. These revenues are sourced from the earnings which are outside of
the purchase and sale of goods and services and may include income from interest earned on
business capital lying in the bank, rental income from business property, income from strategic
partnerships like royalty payment receipts or income from an advertisement display placed on
business property.
Gains
Also called other income, gains indicate the net money made from other activities, like the sale
of long-term assets. These include the net income realized from one-time non-business activities,
like a company selling its old transportation van, unused land, or a subsidiary company.
Revenue should not be confused with receipts. Revenue is usually accounted for in the period
when sales are made or services are delivered. Receipts are the cash received and are accounted
for when the money is actually received. For instance, a customer may take goods/services from
a company on 28 September, which will lead to the revenue being accounted for in the month of
September. Owing to his good reputation, the customer may be given a 30-day payment window.
It will give him time till 28 October to make the payment, which is when the receipts are
accounted for.
Expenses and Losses:
The cost for a business to continue operation and turn a profit is known as an expense. Some of
these expenses may be written off on a tax return if they meet the IRS guidelines.
Primary Activity Expenses
All expenses incurred for earning the normal operating revenue linked to the primary activity of
the business. They include the cost of goods sold (COGS), selling, general and administrative
expenses (SG&A), depreciation or amortization, and research and development (R&D) expenses.
Typical items that make up the list are employee wages, sales commissions, and expenses for
utilities like electricity and transportation.
Secondary Activity Expenses
All expenses linked to non-core business activities, like interest paid on loan money.
Losses as Expenses
All expenses that go towards a loss-making sale of long-term assets, one-time or any other
unusual costs, or expenses towards lawsuits.
While primary revenue and expenses offer insights into how well the company’s core business is
performing, the secondary revenue and expenses account for the company’s involvement and its
expertise in managing the ad-hoc, non-core activities. Compared to the income from the sale of
manufactured goods, a substantially high-interest income from money lying in the bank indicates
that the business may not be utilizing the available cash to its full potential by expanding the
production capacity, or it is facing challenges in increasing its market share amid competition.
Recurring rental income gained by hosting billboards at the company factory situated along a
highway indicates that the management is capitalizing upon the available resources and assets for
additional profitability.
Uses of Income Statements
Though the main purpose of an income statement is to convey details of profitability and
business activities of the company to the stakeholders, it also provides detailed insights into the
company’s internals for comparison across different businesses and sectors. Such statements are
also prepared more frequently at the department- and segment-levels to gain deeper insights by
the company management for checking the progress of various operations throughout the year,
though such interim reports may remain internal to the company.
Based on income statements, management can make decisions like expanding to new
geographies, pushing sales, increasing production capacity, increased utilization or outright sale
of assets, or shutting down a department or product line. Competitors may also use them to gain
insights about the success parameters of a company and focus areas as increasing R&D spends.
Creditors may find limited use of income statements as they are more concerned about a
company’s future cash flows, instead of its past profitability. Research analysts use the income
statement to compare year-on-year and quarter-on-quarter performance. One can infer whether a
company's efforts in reducing the cost of sales helped it improve profits over time, or whether the
management managed to keep a tab on operating expenses without compromising on
profitability.
The following are the limitation (Disadvantages) of the income statement:
1. Provides Confirmatory Value: The first limitation of Income statement is that it is
prepared after auditing all the financial data recorded by the business. Hence, there is room for
data manipulation or management by individuals with ill intentions. In such instances, the
establishment of internal control is necessary and also the financial statement which contains
income statement needs to be audited by the external and reputed auditors.
2. Provides Predictive Value: The second limitation of Income Statement is it is prepared
using various accounting policies and methods. These are subject to bias from the management
or the business owners. The forecasts are also judgmental in nature. If the accounting methods
are regularly changed or accounting policies are implemented differently as per different cases,
the income statement is bound to give predictive value and deviate a lot from the true values.
Hence, accounting policies that are adopted by the business forecast the future in predictive style
based on bias and changing policies.
3. Profit is an Opinion: Despite income statement being called as the gospel to test the
business health, it is widely called in investors’ community as mere opinion. Investors therefore
also place emphasis on cash flow statements and in some cases, they rely more on cash flow
rather than the auditors’ opinion on profit. Hence, Profit is an opinion, while cash is always real.
Cash also needs to be certified in physical by the auditors which provide more credibility than
the profit and loss statement.
4. Ignores non-revenue factors: Income statement is all about the data that impacts the
revenue and wages. Qualitative factors such as how the wages are determined, how the company
earns from its customers and its sales policy are not accounted for in the income statements as
they are not in monetary terms.
5. Does not provide actual cost: Imagine buying an asset. Although the asset is shown in the
balance sheet and depreciation forms part of the income statement, the life of the asset must be
estimated well in advance. The asset may last longer than estimated. However, the costs are
already debited to the income statement as depreciated. This shows that the costs are actually
concentrated in a few accounting periods rather it should have been distributed over the actual
use. Hence, the application of the income statement does not provide actual costs of the asset,
rather it provides a fair estimation of expenses. Hence, it is said that the auditors express the
opinion of financial statements and emphasizes that it reflects true and fair view.
