Classification and Format in the Income Statement
Investors commonly assess a firm’s value based on the firm’s expected future sustainable earnings stream. As Chapter 10 discusses more fully, analysts predict future earnings, or net income, of a firm by projecting future business activities that will drive future revenues, expenses, profits, and cash flows. To inform analysts and other financial statement users about sustainable earnings, firms often report income from recurring business activities separately from income effects from unusual or nonrecurring activities (such as asset impairments, restructuring, discontinued business segments, and extraordinary events). To provide more useful information for prediction, U.S. GAAP requires that the income statement include some or all of the following sections or categories depending on the nature of the firm’s income for a period:
Investors commonly assess a firm’s value based on the firm’s expected future sustainable earnings stream. As Chapter 10 discusses more fully, analysts predict future earnings, or net income, of a firm by projecting future business activities that will drive future revenues, expenses, profits, and cash flows. To inform analysts and other financial statement users about sustainable earnings, firms often report income from recurring business activities separately from income effects from unusual or nonrecurring activities (such as asset impairments, restructuring, discontinued business segments, and extraordinary events). To provide more useful information for prediction, U.S. GAAP requires that the income statement include some or all of the following sections or categories depending on the nature of the firm’s income for a period:
- Income from continuing operations
- Income, gains, and losses from discontinued operations
Income from Continuing Operations
This first section reports the revenues and expenses of activities in which a firm anticipates an ongoing involvement. When a firm does not have discontinued segments in a particular year, all of its income items are related to continuing operations; so it does not need to use the continuing operations label. Firms report their expenses in various ways. Most firms in the United States report expenses by their function: cost of goods sold for manufacturing, selling expenses for marketing, administrative expenses for administrative management, and interest expense for financing. Other firms, particularly those in the European community, tend to report expenses by their nature: raw materials, compensation, advertising, andresearch and development.
Many variations in income statement format appear in corporate annual reports. Most commonly, firms list various sources of revenues from selling their goods and services and then list the cost of goods sold. Some firms (Coca-Cola but not PepsiCo) choose to report a subtotal of gross profit (sales revenues minus cost of goods sold), which is an important measure of the inherent profitability of a firm’s principal products and services. Firmsthen list subtractions for the various operating expenses (for example, selling, general, and administrative expenses). This format reports a subtotal for operating income. The income statement then reports income amounts from investments (interest income and equity income), expenses associated with financing (interest expense), and nonoperating gains and losses. Firms commonly aggregate operating income with the nonoperating income items to report income before income taxes. Firms then subtract the provision for income taxes to compute and report the bottom-line net income.
Many firms, including PepsiCo, report restructuring charges and impairment losses in their income statements. Such items often reflect the write-down of assets or the recognition of liabilities arising from changes in economic conditions and corporate strategies. Because restructuring charges and impairment losses do not satisfy the criteria for discontinued operations, firms often report them in the continuing operations section of the income statement. If the amounts are material, they appear on a separate line to distinguish them from recurring income items. Chapters 4 and 6 discuss the benefits and possible pitfalls of segregating such amounts when analyzing profitability.
Income from Discontinued Operations
A firm that intends to remain in a line of business but decides to sell or close down some portion of that line (such as closing a single plant or dropping a line of products) generally will report any income, gain, or loss from such an action under continuing operations. On the other hand, if a firm decides to terminate its involvement in a line of business (such as selling or shutting down an entire division or subsidiary), it will report the income, gain, or loss from operating that line of business in the second section of the income statement, labeled ‘‘Income, Gains, and Losses from Discontinued Operations.’’ Income, gains, and losses from discontinued operations appear on the income statement net of any income tax effects. Firms must report the results of discontinued operations separately from continuing operations so financials statement users can assess the portion of earnings that are likely to persist in the future.
Income from Discontinued Operations
A firm that intends to remain in a line of business but decides to sell or close down some portion of that line (such as closing a single plant or dropping a line of products) generally will report any income, gain, or loss from such an action under continuing operations. On the other hand, if a firm decides to terminate its involvement in a line of business (such as selling or shutting down an entire division or subsidiary), it will report the income, gain, or loss from operating that line of business in the second section of the income statement, labeled ‘‘Income, Gains, and Losses from Discontinued Operations.’’ Income, gains, and losses from discontinued operations appear on the income statement net of any income tax effects. Firms must report the results of discontinued operations separately from continuing operations so financials statement users can assess the portion of earnings that are likely to persist in the future.
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