An Illustrated Income Statement

Figure 3.1 contains the 1997 income statement for Altron Incorporated, a manufacturer of component parts used in advanced electronics equipment. The income statement is for the year ended January 3, 1998. Although most firms use a calendar yearend of December 31, Altron uses a 52-week year and prepares its financial statements as of the Saturday closest to December 31. A 52-week year enhances comparisons across quarterly reports because each quarter will have 13 weeks. Some firms use a natural year-end instead of a calendar year-end. That is, the financial statements are prepared shortly after the firm’s busy season. Wal-Mart, for example, prepares its annual financial statements on January 31, which is a good fiscal year-end for them because December is their busiest time of year. By the end of January, Wal-Mart has completed its busy season; it has made any exchanges or refunds, and its inventory levels are probably rather low. This is a good time to tally results.

Altron’s income statement, similar to the income statements of many corporations, is highly condensed. It contains two revenue items, four expense items, and no gains or losses. However, Altron almost certainly did experience gains and losses, but their relative sizes were probably so small that they were combined with other items on the income statement. This is an application of the materiality principle, which states that separate disclosure is not required if an item is so small that knowledge of it would not affect the decision of a reasonable financial statement reader. This principle can actually improve the usefulness of financial statements by eliminating the disclosure of inconsequential items, which helps analysts concentrate on items of importance.

The major revenue line on Altron’s income statement is labeled Net sales. Note that the terms sales and revenue are used interchangeably by many firms, while the term net implies that certain items have been deducted from the gross (or full) sales price. For example, most firms allow their customers to return merchandise within a specified period, and customers are usually offered a full refund upon returning the merchandise. The original sales amount is included in gross sales. The refund amount is termed a sales return, and it is subtracted from gross sales in calculating net sales. Even if the term net is omitted, reported sales on the income statement are usually net sales.

Cost of sales is often referred to as cost of goods sold. It reflects the cost to Altron of the goods sold to its customers. The difference between sales and cost of goods sold is called gross profit or gross margin.

Altron has elected to combine selling, general, and administrative expenses, although some companies report separate figures. Selling expenses include advertising costs, commissions to salespersons, depreciation of equipment used in the selling function, and a number of other items. General and administrative expenses consist
of senior managers’ salaries, accounting and auditing costs, insurance, depreciation of administrative offices, and so on.

Operating income equals sales minus all costs and expenses incurred by normal operations. Operating income is a primary indicator of how well a firm has managed its operations and, as you will see, serves as a basis for comparing firms within the same industry.

Altron’s income statement contains several other items. Other income can arise from a variety of sources, such as interest on investments. Interest expense reflects the firm’s cost of borrowing money from creditors. Income taxes are imposed by the federal government, state and local governments, and foreign jurisdictions. Neither interest nor income taxes directly relate to a firm’s operations. For example, interest expense is largely a function of how much the firm has borrowed to finance its operations. Differences in interest expense between firms are determined primarily by choices the firms have made in financing their businesses. Some firms elect to borrow heavily, which results in large interest charges. Other firms rely on investments by owners; Interest charges are not paid on these funds and, because of this, interest expense is deducted after operating income is calculated.

The bottom line of the income statement is called net income, earnings, or profit. Although interest and income tax expenses do not affect operating income, they are appropriate deductions in the calculation of overall profitability. Because net income reflects the increase in net assets from all profit-oriented activities, it is the focus of much scrutiny by analysts, investors, and other financial statement readers.

Keep in mind the difference between revenue and profit. Revenue refers to the total inflow of assets (or reduction in liabilities) from customers. Profit is the net increase in a firm’s recorded wealth after deducting expenses from revenue.

Altron’s income statement presented in Figure 3.1 is in the multiple-step format. Multiple-step income statements calculate certain subtotals for the reader. Altron’s statement contains subtotals for gross profit and operating income. In contrast, income statements using the single-step format summarize all revenues in one section and all expenses in another. Figure 3.2 in the section “Uses of the Income Statement” illustrates a single-step income statement. Whereas the single-step approach is simpler, the multiple-step approach provides more information.

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