Small Business Doctor

What is the Income Statement?

The Income Statement, which is sometimes referred to as the Profit and Loss Statement for small businesses, is a document that shows the financial performance of a company over a specific period of time. The Income Statement is used by investors, the company itself, and business analysts.

What Is the Format for the Income Statement?

There are two formats for the Income Statement. The traditional format is known as the Multi-Step Income Statement. The Single-Step format is a simplified version of this traditional Income Statement format.

Single-Step Income Statement

The Single-Step format of the Income Statement is so-named, because it uses a single subtraction to arrive at Net Income. All revenues and gains are added together. All expenses are losses are added together. Subtract the expenses subtotal from the revenues subtotal to arrive at Net Income.

A Single-Step Income Statement looks like this.

Multi-Step Income Statement

In contrast to the Single-Step Income Statement, the Multi-Step Income Statement is more detailed. There are more categories. Operating revenues and expenses are separated from non-operating ones to yield deeper insight into a business’s profitability.

A Multi-Step Income Statement looks like this.

What Are the Components of the Income Statement?

Net Revenues

Net Revenues, sometimes referred to as Net Sales, are total revenue from a company’s primary operations minus any returns, allowances, and discounts. Net Revenues are therefore the actual revenue a company earns from selling products and services.

Revenue recognition for long-term contracts follows these five steps:

1. Identify the contract with the customer.
2. Identify the performance obligations in the contract.
3. Determine the amount of the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue as the business satisfies the performance obligations.

Net Revenues often appear in an Income Statement like this:

Cost of Goods Sold aka Cost of Sales

Cost of Goods Sold (COGS) or Cost of Sales is the direct costs from producing or purchasing the products a business sells during a specified period. These costs include direct materials, direct labor, and manufacturing overhead.

I debate the legitimacy and usefulness of including direct labor and manufacturing overhead within Cost of Goods Sold in this essay.

You calculate Cost of Goods Sold or Cost of Sales like this:

Gross Profit

Gross Profit is defined as Net Revenue minus Cost of Goods Sold. Gross Profit is the profit left after deducting the direct costs associated with producing or purchasing the products a business sells.

Operating Expenses

Operating expenses are those costs associated with the ordinary operation of a business that are not included within the Cost of Goods Sold.

There are three categories for operating expenses. Oftentimes, the Selling and General & Administrative Expenses are combined as Selling, General & Administrative Expenses (SG&A).

A fourth category for Impairment Losses is available for SEC registrants (big businesses).

I debate the legitimacy and usefulness of including direct labor and manufacturing overhead within Inventory and COGS in this essay. I think these are actually operating expenses that should be included here instead.

Operating Profit

Operating Profit is the profit a business earns from its core business operations. Operating Profit is also sometimes known as Operating Income or Earnings Before Interest and Taxes (EBIT). We calculate Operating Profit by subtracting Cost of Goods Sold and Operating Expenses from Net Revenue. Equivalently, Operating Profit is Gross Profit minus Operating Expenses.

Non-Operating Items

Non-Operating Items are any gains, losses, revenues or expenses that are not related to a company’s ordinary operations. These items should be infrequent and unusual, like the following:

For non-SEC registrants (small and mid-sized companies), this is where Impairment Losses go.

Income or Loss from Continuing Operations, Gross of Taxes

The pretax profit or loss generated by a business including the infrequent and unusual Non-Operating Items mentioned above is Income or Loss from Continuing Operations, Gross of Taxes. This is the company’s profitability from its main business activities. It doesn’t include temporary or non-recurring activities.

You calculate Income or Loss from Continuing Operations, Gross of Taxes by subtracting Non-Operating Items from Operating Profit.

Income Taxes

Income Tax Expense, which is sometimes referred to as Provision for Income Taxes, is subtracted from pretax Income from Continuing Operations, Gross of Taxes. Businesses calculate their Income Tax Expense by following the many rules of the federal Internal Revenue Code as well as applicable state and local tax codes.

Permanent Differences Between US GAAP and the IRS

Because the IRS doesn’t follow US GAAP, there are differences between the two standards regarding the timing and recognition of revenues and expenses. Mostly, these differences are temporary, but some differences between US GAAP and the IRS are permanent. The following table shows the different treatment of forms of business income by US GAAP and the IRS that will lead to a permanent difference between US GAAP and the IRS.

Temporary Differences Between US GAAP and the IRS

When these differences between US GAAP and the IRS are temporary, Deferred Tax Assets and Deferred Tax Liabilities are created. These temporary differences occur whenever deductions or income are recognized at different times by the two standards.

If, as a result of these timing differences, a company’s GAAP income is greater than their IRS income, then a Deferred Tax Liability is created. On the other hand, whenever a company’s GAAP income is less than their IRS income, then a Deferred Tax Asset is created.

In either case, the Deferred Tax Asset or Liability will equal the difference between the two income amounts multiplied by the Future Enacted Tax Rate. The Future Enacted Tax Rate is simply the tax rate that Congress has set for the next year.

Income Tax Expense

The Income Tax Expense for the Income Statement will be the company’s Current Tax Liability, which is the actual amount due to the IRS for this period, plus or minus the Deferred Tax Liability or Asset.

Income or Loss from Continuing Operations, Net of Taxes

Income or Loss from Continuing Operations, Net of Taxes is the profit or loss from the business’s ongoing activities after accounting for income taxes. It only excludes Discontinued Operations.

Income or Loss from Discontinued Operations, Net of Taxes

A Discontinued Operation is a section of a business whose operations and cash flows are now clearly distinguished from the rest of the business. This must be true both operationally and for financial reporting purposes.

When Does a Business Segment Get Classified as a Discontinued Operation?

Whenever one of these three criteria are met, a business unit is classified as a Discontinued Operation.

1. The business component is classified as held for sale, which requires all of the following:
   • Management, with board approval, commits to a plan to sell it.
   • The business component is available for immediate sale subject only to standard terms that are usual and customary for such things.
   • An active buyer search has begun.
   • The sale is probable and expected to be completed within one year.
   • The business component is being actively marketed for a sale price that is reasonable compared to its current fair value.
   • Actions required to complete the sale plan show that it’s unlikely the sale plan will be significantly changed or withdrawn.
2. The business component is disposed of by sale.
3. The business component is disposed of other than by sale, like being spun off or abandoned.

How Is a Discontinued Operation Presented on the Income Statement and Balance Sheet?

Income Statement

On the Income Statement, the results of Discontinued Operations, after adjusting for applicable income taxes are reported separately from ongoing operations. This is to avoid confusion about the ongoing business’s profitability.

If there’s a loss, it offsets the income from the rest of the business, resulting in a tax benefit. If there’s a gain, there will be an income tax expense.

Balance Sheet

On the Balance Sheet, the assets and liabilities of the Discontinued Operation are also reported separately in the asset and liability sections. The equity valuation of a Discontinued Operation is at current fair value less the cost to sell it.

How Do You Calculate Income or Loss from Discontinued Operations, Net of Taxes?

Impairment Loss

An Impairment Loss is the difference between the Current Value, as per the accounting books, and the Net Realizable Value it will likely sell for. Costs of selling the business component are deducted from the expected sale price to arrive at Net Realizable Value. Impairment Loss presumes that the business component has not yet sold. Note there is no such thing as an Impairment Gain!

Gain or Loss on Disposal

This presumes that the business component has been sold. It is the difference between the Current Value, as per the accounting books, and the actual proceeds from the sale.

The full calculation of Income or Loss from Discontinued Operations looks like this:

Net Income

Net Income is also known as Net Profit or the good ol’ Bottom Line. Net Income is the total profit a company earns after subtracting all expenses and all obligations have been met.