Understanding Income Statement Components and Format | CFA Level I FSA

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

We now move on to an in-depth examination of the various financial statements, starting with the income statement.

The income statement is a crucial piece for an analyst to make forecasts of the future earnings of a firm. As such, an analyst should know the key components of an income statement, how they are prepared, and the techniques to analyse the statements.

Components of the Income Statement

The income statement communicates how much revenue a company generated during a period, and the expenses it incurred in connection with generating that revenue. The key outcome from the income statement is the net income, which is a key metric of the company’s profitability.

Under both IFRS and US GAAP, the income statement may be presented as a separate statement, followed by a statement of comprehensive income that begins with the profit or loss from the income statement.

Alternatively, the income statement can be combined with other comprehensive income and presented as a single statement of comprehensive income.

Investors examine a firm’s income statement for valuation purposes, while lenders examine it for information about the firm’s ability to make the promised interest and principal payments on its debt.

The basic equation underlying the income statement, ignoring gains and losses, is:

Net income = Revenue – Expenses

Revenues and Expenses

Revenues are the amounts reported from the sale of goods and services, in the normal course of business. So for a shoe retailer, revenue is recorded as the price of the shoes sold to a customer.

Revenue less adjustments for estimated returns and allowances is known as net revenue.

Expenses are the amounts incurred to generate revenue. It includes:

• Cost of goods sold – the direct costs attributable to the production of the goods.
• Depreciation expenses – the reduction in long-term assets value recorded during the period.
• The amount of interest paid to debt holders during the period.
• The amount of taxes recorded during the period.

What we have described so far are considered core operations of a company. Companies can make money outside their core operations.

Other Income, Other Expenses, Gains, and Losses

For example, a retailer may have unused warehouse space that is rented out for some side income. This revenue is classified under other income, and any expenses made outside of core operations is regarded as other expenses.

The income statement also includes economic gains and losses through investments. Gains and losses may also result from ordinary business activities. Taking the example of the unused warehouse, if the company decides to sell it off, the difference between the sales price and the book value is reported as a gain or loss on the income statement.

Net income = revenues – expenses + other income – other expense + gains – losses.

Minority Interest

If a firm has a controlling interest in a subsidiary, the entire net earnings of the subsidiary are reported in the income statement of the parent.

In cases where there are minority shareholders in the subsidiary, this portion of the net income should not be attributed to the parent.

This portion of the subsidiary’s earnings is known as the minority interest. It should be subtracted from the income statement of the parent.

Formats of the Income Statement

A firm can present its income statement using a single-step or multi-step format.

Single-Step Format

In a single-step statement, all revenues are grouped together and all expenses are grouped together. The single-step format uses only one subtraction to arrive at the net income.

Multi-Step Format

In contrast, a multi-step statement uses multiple subtraction steps to arrive at the net income.

It segregates the operating items from the non-operating items. The multi-step income statement also shows the gross profit, operating income, income before tax, and income from continuous operations. This allows an analyst to study the company’s gross profit margins and profits from core operations. It also allows the analyst to study the effects of finance costs and taxes on the company’s performance.

Conclusion

And that’s all for this lesson! Now that we have an overview of the income statement and the items that go into it, we shall go in-depth into each of the major items of the income statement. We shall begin with revenue in the next lesson.