Income Statement

Session 6 & 7
 Learning Goals session 6 & 7 – Income
Statement
• Prepare an Income – Non Operating Income
Statement – Earnings before Interest
• Know the difference and Taxes
between Product Cost – Interest Expenses
versus Period Cost
– Earnings before Taxes
• Single Step vs. Multi Step
– Tax Expenses
• Understand and compute
following items: – Net Income
– Net Sales – Income for Equity holders
– Cost of Goods Sold – Basic and Diluted EPS (the
– Gross Profit number of shares needed
– Operating Expenses will be provided)
– Cost of Sales • I/S of Asian Paints &
– Operating Income Infosys.
• Know the format of the Statement of Profit & Loss as per
Schedule III (Division II) of the Companies Act, 2013. 1–2
 Preparation of Financial Statements
• Provides Guidance on Purpose and Contents of
Financial Statements
• Financial statements are summary of
accounting transactions & are presented in a
manner to enable users know the operating
performance of the organization and also its
impact on the overall value of the organization.
– Balance Sheet
– Profit & Loss A/c or Income Statement
– Cash Flow Statement
– Statement of Changes in Owner’s/Shareholder’s
Equity
– Notes to Financial Statements 1–3
 Recap…Preparation of Financial
Statements Indian Companies Act 2013
Sec 2(40)
• Financial Statement in relation to a company,
includes-
(i) Balance sheet as at the end of the financial year;
(ii) Profit & Loss account, or in case of company
carrying out activity not for profit, an Income &
Expenditure account for the financial year;
(iii) Cash flow statement for the financial year;
(iv) Statement of changes in Equity, if applicable; and
(v) any explanatory note annexed to, or forming part
of, any document referred to sub-clause (iv) stated
above.
1–4
Profit & Loss A/c or Income Statement
• Shows the operating results of the entity during
the period.
• Flow report.
• Focuses on earnings activities (or operating
activities).

Assets = Liabilities + Owner(s) Equity…(1)..(from the B/S)

Owner(s) Equity = Contributed Capital + Retained Earnings

Retained earnings = Revenue – Expenses … (2)

From (1)
Assets = Liabilities + Contributed Capital + Revenue - Expenses ... (3)

(2) is referred to as Profit & Loss A/c

1–5
 Service vs. Product (Manufacturing &
Merchandising) firms
Income Measurement Process

Not used in a Service

Less business, instead Cost
Revenue of Sales (COS) is used

Cost of Equals
Gross Less

Goods Sold Profit

Operating Equals Operating

Cost of goods sold is the total Income/Profit
cost of merchandise sold during Expenses
(Loss)
the period.
 Gains & Losses

• Gains are increases in Equity resulting from

transactions and economic events other than
those that either generate Revenue or are
investments by owners.

• Losses are decreases in Equity resulting from

transactions and economic events other than
those that either generate Expenses or are
distribution to owners.
 Gains
• Gains are Increases in Equity resulting from:
– an enterprise’s peripheral transactions (such as
sale of used equipments),
– economic events outside of the control of the
management (e.g. holding gains on securities), or
– non-reciprocal transactions (e.g. lawsuit
settlements, damages & compensations received)
• Gains are often described by their sources in
the financial statements:
– for example, Gains from Sale of Securities, Gains
from Sale of Equipment.
 Difference between Revenue & Gains
REVENUES
Result from a firm’s principal
activities or Central Operations.
Usually EARNED.
Reported GROSS.
i.e. Cost of the inventory sold and
expenses incurred to earn them are
not deducted. Expenses are reported
by function or nature separately in
I/S.
GAINS
Result from Entity’s Incidental or
Peripheral Activities and not from its
central operations.
Usually REALIZED
Reported NET.
i.e. Cost of the asset & expenses
incurred to realize the gain are
deducted from sales proceeds to
obtain Gains and this amount is
reported in I/S .
 Losses
• Losses are decreases in Equity resulting from
transactions and economic events other than those
that either generate Expenses or are distribution to
owners.
• They result from
– an enterprise’s peripheral transactions (such as sale
of used equipments),
– economic events outside of the control of the
management (e.g. holding loss on securities), or
– non-reciprocal transactions (e.g. lawsuit settlements,
damages & compensations payable)
• Losses are often described by their sources in the
financial statements, for example,
– Loss from Sale of Securities, Loss from Sale of
Equipment.
Difference between Expense & Losses

Expenses Losses
Result from a firm’s principal Result from Entity’s Incidental or
activities or Central Operations. Peripheral Activities and not from its
central operations.

Incurred during earning process Usually result from Non Reciprocal

Transactions or other Economic
Events not related to an Earnings
Process.

Reported GROSS. Reported NET.

 Net Income
Net Income is the change in equity that results
from the Operations of an entity during an
accounting period.
– net effect of Revenue, Expenses, Gains and
Losses for the period Net Income
• Net Income is Positive when
– (Revenue + Gains) is greater than (Expenses +
Losses
– This Increases the Equity of the Owners
• Net Income is Negative when
– (Revenue + Gains) is less than (Expenses +
Losses)
– This Decreases the Equity of the Owners
 Expenditure versus Expenses
• Expenditures are payments (or obligations to make future
payments) for assets & services. For example:
1) Capital expenditures = expansion by purchase of a long-term asset.
2) Revenue expenditures = repair & maintenance of long-term assets.
• Expenses are expenditures whose benefit has expired, i.e.
supplies have been consumed / services have been
received.
• Careful distinction between revenue & capital expenditures
is important for the proper application of the matching rule.
– Revenue expenditures are always expensed in the same year, while
capital expenditures are expensed over several years.
– Matching rule has an impact on the amount of capital expenditure,
which are expensed during the year.
Consequence of Inappropriate Matching
affects Earnings Quality
If
(1) matching rule is not applied properly, or
(2) revenue expenditure is incorrectly classified as capital
expenditure, or
(3) capital expenditure is not expensed,
– expenses are understated,
– income, equity & assets are overstated.
• Often such expensing is based on estimates &
management judgment. There have been times these
have been misused, resulting in financial shenanigans
and creating unreliability on the reported financial
results.
 Product & Period Costs

• Product costs are incurred to produce (or

acquire) the goods & have direct cause-and-
effect relationship to sales.
– Example, cost of goods purchased, cost of
material consumed, cost of goods manufactured,
etc.
– They are matched to revenue and expensed in the
year in which revenue is recognized.
– Until they are matched to revenue, they are
inventoried, i.e. they appear on the Balance Sheet
as a part of stock.
 Product & Period Costs
• Period costs are consumed during the period.
– Examples General, Administration, R&D,
Marketing & Advertising costs.
– No direct cause-and-effect relationship to specific
sales.
– Matched to the period in which they are incurred
or in which their benefit is consumed and not to
the year in which revenue is recognized.
– Therefore, capitalizing period cost is incorrect
and understates expenses and overstates
income/profits, assets and equity.
• Maintenance & Repair of Fixed Assets (PPE)
• Example, WorldCom wrongly capitalized operating
expenses (the cost of terminating calls) $3.85 Billion &
declared bankruptcy in 2002.
Income Statement or P&L A/c Multiple-Step

Illustration 5-8

Key
Line
Items
 Common Items in Income Statement
= Above the Line Items
• Revenue or Sales = TOP LINE ITEM
• Cost Of Goods Sold: The cost the company incurred to purchase
and convert material into the finished products sold to customers.
• Gross Profit/Margin: The difference between revenues and cost of
goods sold. Otherwise referred to as gross profit.
• Operating Expenses: Expenses of an operating nature, such as
general, marketing, administrative expenses, incurred in the generation
of revenues.
• Operating Profit/Income: gross margin less operating expenses
• PBIT/EBIT: Operating profit plus other income & Gains minus other
expense & Losses.
• Interest expenses/Finance Cost: Debt servicing charges
• PBT/EBT
• Income Taxes: tax as per books of accounts
• PAT / EAT: = On the Line Item
A Comparison of the Components of Multistep Income
Statements for Service and Merchandising or
Manufacturing Companies
 Determining Cost of Goods Sold
(COGS)
• Direct Material Cost (Raw material)
– Opening Balance + Net Purchases – Closing Balance
• Plus Conversion Cost
– Direct Labor Cost + Direct Expenses
– Manufacturing Overhead
o Manufacturing & Factory related expenses including
depreciation
= Manufacturing Cost Incurred
– + Opening Balance of WIP – Less Closing Balance of WIP
= Cost of Goods Manufactured

1–20
 Determining COGS & COS
Cost of Goods Manufactured
+ Opening Balance of FG
– Less Closing Balance of FG
= Cost of Goods Sold

+ Operating Expenses
– Research & Development Overhead
– Administration Overhead
– Selling & Marketing Overhead
– Distribution Overhead, etc.
= Cost of Sales (Indian context)

** Book – COGS is referred as COS by some companies

1–21
 Determination of Profit
Sales & Revenue
Less COGS (COGM +/- FG Inventory)
= GROSS PROFIT
Less Operating Expenses (R&D, Admin, S&D)
= Operating Profit
Add Other Income (not included in Sales
Revenue), Gains & Losses
= EBIT
Less Financial Cost or Interest Expenses
= EBT
Less Income Tax Expenses
= Net Income or EAT or PAT
1–22
Statements for Manufacturing and
Merchandising Firms

Insert Exhibit 3.15a

1–23
Income Statement for a Service Firm

Insert Exhibit 3.15b

1–24
 Profit & Loss Account: Single Step
• Sample format:
– INCOME
• Operating income
• Non-operating income
– EXPENDITURE
• Manufacturing expenses
• Administration expenses
• Selling & distribution expenses
• Depreciation
• Interest expenses
– Profit before tax (INCOME- EXPENDITURE)
• Provision for tax
– Profit after tax (Profit before tax – Provision for tax)
Key Points
• Under US GAAP, companies generally classify income
statement items by function.
• Classification by FUNCTION leads to descriptions like
administration, distribution, and manufacturing.
• Under IFRS, companies must classify expenses by either
nature or function.
• Classification by NATURE leads to descriptions such as the
following: salaries, depreciation expense, and utilities expense.
• If a company uses the functional-expense method on the
income statement, disclosure by nature is required in the notes
to the financial statements.
• How do Infosys and Asian Paints present their Income
Statements?
Hindalco

1–27
1–28
Asian Paints

1–29
Infosys 2020 I/S

1–30
ACC Ltd.
SINGLE STEP INCOME STATEMENT

1–31
Multiple Step Income Statement/P&L a/c
• Revenue or Sales = TOP LINE ITEM
• Cost Of Goods Sold: The cost the company incurred to
purchase and convert material into the finished products sold to
customers.
• Gross Profit / Margin: The difference between revenues and
cost of goods sold. Otherwise referred to as gross profit.
• Operating Expenses: Expenses of an operating nature, such
as general, marketing, administrative expenses, incurred in the
generation of revenues.
• Operating Profit / Income: gross margin less operating
expenses
• EBIT/PBIT: Operating income plus other income & Gains minus
other expense & Losses.
• Interest expenses: Debt servicing charges
• Income Taxes: tax as per books of accounts
• EAT / PAT: = On the Line Item 1–32
MULTI-STEP INCOME STATEMENT
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