Income Statements

Primary earnings per share and fully diluted earnings per share may also be required. Primary earnings per share is a presentation based on the outstanding common shares and those securities that are in substance equivalent to common shares and have a diluting effect on earnings per share. Convertible bonds, convertible preferred stock, stock options, and warrants are examples of common stock equivalents. The fully diluted earnings per share presentation is a pro forma presentation that shows the dilution of earnings per share that would have occurred if all contingent issuances of common stock that would individually reduce earnings per share had taken place at the beginning of the period.

RECOGNIZING REVENUES AND EXPENSES

There are two methods of accounting for revenues and expenses. The key difference between them has to do with how each records transactions—cash coming into and going out of the company.

Cash Basis

Accounting records and statements prepared using the cash basis recognize income and expenses according to real-time cash flow. Income is recorded upon receipt of funds, rather than based upon when it is actually earned; expenses are recorded as they are paid, rather than as they are actually incurred. Under this accounting method, therefore, it is possible to defer taxable income by delaying billing so that payment is not received in the current year. Likewise, it is possible to accelerate expenses by paying them as soon as the bills are received, in advance of the due date.

Accrual Basis

A company using an accrual basis for accounting recognizes both income and expenses at the time they are earned or incurred, regardless of when cash associated with those transactions changes hands. Under this system, revenue is recorded when it is earned rather than when payment is received; expenses are recorded when they are incurred rather than when payment is made. At any one point in time, a company's statements will look very different depending on which accounting method was used in their preparation. Over time, however, these differences diminish since all expenses and revenues are eventually recorded.

Companies using the generally preferred accrual method of accounting use what is called the revenue recognition principle. This Financial Accounting Standards Board principle generally requires that revenue be recognized in the financial statements when: 1) realized or realizable, and 2) earned. Revenues are realized when products or other assets are exchanged for cash or claims to cash or when services are rendered. Revenues are realizable when assets received or held are readily convertible into cash or claims to cash. Revenues are considered earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. Recognition through sales or the providing (performance) of services provides a uniform and reasonable test of realization. Limited exceptions to the basic revenue principle include recognizing revenue during production (on long-term construction contracts), at the completion of production (for many commodities), and subsequent to the sale at the time of cash collection (on installment sales).

In recognizing expenses, an effort must be made to match the costs with any revenues for which they are related. This is called the matching principle because expense and revenues are "matched." For example, matching, or associating, the cost of goods sold with the revenues that resulted directly and jointly from the same transaction is reasonable and practical. To recognize costs for which it is difficult to adopt some association with revenues, accountants use a rational and systematic allocation policy that assigns expenses to the periods during which the related assets are expected to provide benefits, such as depreciation, amortization, and insurance. Some costs are charged to the current period as expenses (or losses) merely because no future benefit is anticipated, no connection with revenue is apparent, or no allocation is rational and systematic under the circumstances, i.e., an immediate recognition principle.

The current operating concept of income would include only those value changes and events that are controllable by management and that are incurred in the current period from ordinary, normal, and recurring operations. Any unusual and nonrecurring items of income or loss would be recognized directly in the statement of retained earnings. Under this concept, investors are primarily interested in continuing income from operations.

The all-inclusive concept of income includes the total changes in equity recognized during a specific period, except for dividend distributions and capital transactions. Under this concept, unusual and nonrecurring income or loss items are part of the earning history of a company and should not be overlooked. Currently, the all-inclusive concept is generally recognized; however, certain material prior period adjustments should be reflected adjustments of the opening retained earnings balance.

FORMATS OF THE INCOME STATEMENT

The income statement can be prepared using either the single-step or the multiple-step format. The single-step format lists and totals all revenue and gain items at the beginning of the statement. All expense and loss items are then fixed and the total is deducted from the total revenue to give the net income. The multiple-step income statement presents operating revenue at the beginning of the statement and non-operating gains, expenses, and losses near the end of the statement. However, various items of expenses are deducted throughout the statement at intermediate levels. The statement is arranged to show explicitly several important amounts, such as gross margin on sales, operating income, income before taxes, and net income. Extraordinary items, gains and losses, accounting changes, and discontinued operations are always shown separately at the bottom of the income statement ahead of net income, regardless of which format is used.

Each format of the income statement has its advantages. The advantage of the multiple-step income statement is that it explicitly displays important financial and managerial information that the user would have to calculate from a single-step income statement. The single-step format has the advantage of being relatively simple to prepare and to understand.