Statements of Net Income and Comprehensive Income

Overview and Terminology

The statement of net income and comprehensive income is a fundamental financial report that summarizes a company's financial performance over a period. It distinguishes between net income and comprehensive income, providing insights into both core earnings and other changes in equity not resulting from owner transactions.

• Net Income: The sum of revenues, expenses, gains, and losses not included in other comprehensive income. Also called net earnings.

• Comprehensive Income: The change in equity from transactions, events, and circumstances other than those with owners. Comprehensive Income = Net Income + Other Comprehensive Income (OCI).

• Other Comprehensive Income (OCI): Items excluded from net income by accounting standards, such as unrealized gains/losses, foreign currency translation, and pension adjustments.

Entities may report comprehensive income in one statement or in two consecutive statements (net income and comprehensive income).

Usefulness and Limitations of Income Statements

Income statements are valuable for:

• Evaluating past performance

• Predicting future performance

• Assessing risks or uncertainties of future cash flows

Limitations include:

• Exclusion of certain items

• Dependence on selected accounting methods

• Requirement for judgment and estimation

Earnings Quality and Management

Earnings Quality

Earnings quality refers to the usefulness of reported income for predicting future performance. It is influenced by the nature of earnings components and management's actions.

• Permanent earnings: Likely to continue in the future (e.g., sales revenue from regular customers).

• Transitory earnings: Unlikely to continue (e.g., gains/losses from asset sales).

• High earnings quality is associated with permanent earnings; low quality with transitory earnings.

Earnings Management

Managers may use discretion in accounting standards to manipulate earnings, aiming to meet benchmarks, avoid losses, or smooth trends. Extreme earnings management is fraudulent and illegal.

• Big bath: Increasing a net loss to show higher future income.

• Cookie jar reserves: Reducing current earnings to boost future earnings.

Statement of Net Income Elements and Classifications

Primary Elements

The statement of net income includes four primary elements:

• Revenues

• Expenses

• Gains

• Losses

Classification Approaches

• Nature: By source (e.g., payroll, raw materials, depreciation).

• Function: By use (e.g., manufacturing, selling, administrative).

Income Statement Formats

Multiple-Step vs. Single-Step

Two main formats exist:

• Multiple-step: Reports critical subtotals (gross profit, operating income, etc.) before net income.

• Single-step: Combines all revenues/gains and expenses/losses into single categories.

Key performance measures include:

• Gross profit

• Operating income

• Income before tax

• Income from continuing operations

• Net income

• Earnings per share

Drawbacks of single-step format: lacks classification, does not separate operating/non-operating items, and omits key performance measures.

IFRS Presentation

IFRS requires specific line items (revenue, finance costs, share of income/loss of associates, tax expense, after-tax profit/loss on discontinued operations, net income) and disclosures (write-downs, restructuring, disposals, litigation settlements, etc.).

Income from Continuing Operations

Components

Income from continuing operations is derived from business segments expected to persist. It includes:

• Operating income: Revenues and expenses from principal operations.

• Non-operating items: Gains/losses from peripheral activities, unusual or infrequent events.

• Income tax provision: Tax expense from all jurisdictions, deducted from income before taxes.

Discontinued Operations

Definition and Criteria

Discontinued operations are business segments disposed of or held for sale. A component must be operationally and financially distinguishable from the rest of the entity.

• Can be a reportable segment, operating segment, reporting unit, subsidiary, or asset group.

Reporting Requirements

• Report income from discontinued and continuing operations separately.

• Disclose pre-tax income/loss, major line items, reconciliation to after-tax profit/loss, carrying amounts of assets/liabilities, and cash flows.

• Report results of discontinued operations in comparative statements for prior periods.

Example: Discontinued Operations

For a division held for sale, report operating income/loss and remeasurement loss/gain, net of tax. For a division disposed of during the year, report operating loss and gain on disposal, net of tax.

IFRS Criteria

IFRS requires a discontinued operation to be a separate major line of business or geographical area, or a subsidiary acquired for resale, and part of a coordinated plan for disposal.

Net Income, Noncontrolling Interest, and Earnings per Share

Presentation

• Net income is the sum of income from continuing and discontinued operations.

• Separate net income attributable to stockholders and noncontrolling interests.

• Report earnings per share for continuing operations, discontinued operations, and net income (basic and diluted).

Statement of Comprehensive Income

Elements

• Unrealized gains/losses from available-for-sale securities and derivatives

• Foreign currency translation gains/losses

• Unrecognized pension costs/benefits

Items in OCI are typically transitory, have low probability of short-term cash realization, and are not part of normal operations.

IFRS Differences

IFRS allows revaluation of long-lived assets to be included in OCI.

Statement of Stockholders’ Equity

Components

• Contributed capital (common stock, preferred stock, additional paid-in capital)

• Retained earnings (net income/loss, dividends)

• Accumulated other comprehensive income (reserves under IFRS)

• Treasury stock

• Noncontrolling interests

Reporting Requirements

SEC requires the statement for U.S. public companies; non-public companies may include it voluntarily.

Changes in Accounts

• Net income increases retained earnings; losses and dividends decrease it.

• Positive OCI increases accumulated OCI; negative OCI decreases it.

• Share issuances and treasury sales increase contributed capital; repurchases decrease it.

Financial Statement Analysis

Horizontal and Vertical Analysis

• Horizontal analysis: Examines percentage change in items year-to-year.

• Vertical analysis: Expresses items as a proportion of a relevant total (e.g., sales or total assets).

• Common-size statements: Each item is measured relative to a key amount (e.g., sales).

Profitability Analysis

• Profit margin:

• Return on assets:

• Return on equity:

These ratios assess how well a company uses its resources and generates returns for shareholders.

Example: Johnson & Johnson Profitability

• Profit margin: 18.4% (2019), 18.8% (2018)

• Return on assets: 9.7% (2019), 9.9% (2018)

• Return on equity: 25.4% (2019), 25.5% (2018)

• All ratios positive, but slightly decreased from 2018 to 2019 due to lower net income.

Summary Table: Statement of Net Income Elements

Summary Table: Profitability Ratios