What Every Real Estate Pro Needs To Know – Parts of The Income Statement

The first and most important part of an income statement is the line reporting sales revenue. Businesses need to be consistent regarding recording sales from year to year. For some businesses, the timing of recording sales revenue is a significant problem, primarily when the final acceptance by the customer depends on performance tests or other conditions that have to be satisfied. For example, when does an ad agency report the sales revenue for a campaign prepared for its client? When is the work completed and sent to the client for approval? When the client approves it? When do the ads appear in the media? Or when the billing is complete? These are issues a company must decide on for reporting sales revenue, and they must be consistent each year. The accountant should note the timing of reporting on the financial statement.

The following line in an income statement is the cost of goods sold. There are three methods of reporting the cost of goods sold expense. One is called the “first in-first out” (FIFO); another is the “last in-last out” (LIFO) method, and the last is the average cost method. Cost of goods sold expense is a huge item in an income statement, and how it’s reported can make a substantial impact on the reported bottom line.

Other items in an income statement include inventory write-downs. A business should regularly scrutinize its inventory to determine losses due to theft, damage, and deterioration and apply the lower cost or market (LCM) method. Bad debts are also a critical component of the income statement. Bad debts are those owed to a business by customers who bought on credit (accounts receivable) but are not paid. Again the timing of when bad debts are reported is crucial. Do you report it before or after any collection efforts are exhausted?

Of course, profit and cost of goods sold expense are the two most critical components of an income statement, or at least they’re what people will look at first. But an income statement is truly the sum of its parts, and they all need to be considered carefully, consistently, and accurately.

In reporting depreciation expense, a business can use a short-life method and load most of the expense over the first few years, or a longer-life method and spread the expense evenly over the years. Depreciation is a considerable expense for some businesses, and the method of reporting is especially critical for them.

One of the more complex elements of an income statement is the line reporting employee pensions and post-retirement benefits. The GAAP rule on this expense is complex. The business must make several vital estimates, such as the expected rate of return on the portfolio of funds set aside for these future obligations. This and other estimates affect the amount of expense recorded.

Many products are sold with expressed or implied warranties and guarantees. The business should estimate the cost of these future obligations and record this amount as an expense in the same period that the goods are sold and the cost of goods. It can’t wait until customers return products for repair or replacement; it should be forecast as a percent of the total products sold.

Other operating expenses reported in an income statement may also have timing or estimating considerations. Some expenses are also discretionary, which means that how much is spent during the year depends on the discretion of management.

Earnings before interest and tax (EBIT) measure the sales revenue less than all expenses above this line. It depends on all the decisions made for recording sales revenue and expenses and how the accounting methods are implemented.

While some lines of an income statement depend on estimates or forecasts, the interest expense line is a basic equation. However, when accounting for income tax expenses, a business can use different accounting methods for some of its expenses to calculate its taxable income. The hypothetical taxable income is calculated if the company uses the accounting methods used in the tax return. Then the income tax based on this hypothetical taxable income is figured. This is the income tax expense reported in the income statement. This amount is reconciled with the actual income tax owed based on the accounting methods used for income tax purposes. A reconciliation of the two income tax amounts is provided in a footnote on the income statement.

Net income is like earnings before interest and tax (EBIT) and can vary considerably depending on accounting methods used to report sales revenue and expenses. This is where profit smoothing can come into play to manipulate earnings. Profit smoothing crosses the line from choosing acceptable accounting methods from the list of GAAP and reasonably implementing these methods into the gray area of earnings management that involves accounting manipulation.

It’s incumbent on managers and business owners to decide which accounting methods measure profit and how those methods are implemented. A manager can be required to answer questions about the company’s financial reports on many occasions. It’s therefore critical that any officer or manager in a company be thoroughly familiar with how the company’s financial statements are prepared. Accounting methods and how they’re implemented vary from business to business. A company’s methods can fall anywhere on a continuum, either left or right of the center of GAAP.