Taking a Look at the Income Statement – Part Three

While some lines of an income statement depend on estimates or forecasts, the interest expense line is a basic equation. When accounting for income tax expense, however, a business can use different accounting methods for some of its expenses than those which it uses for calculating its taxable income. The hypothetical amount of taxable income, if the accounting methods used were used in the tax return is calculated.

Then the income tax based on this hypothetical taxable income is figured. This is the income tax expense reported in the income statement. This amount is reconciled with the actual amount of income tax owed based on the accounting methods used for income tax purposes.

A reconciliation of the two different income tax figures is then provided in a footnote on the income statement. Under the same scenario, net income is like earnings before interest and tax (EBIT) and can vary considerably depending on which accounting methods are used to report sales revenue and expenses. This is where profit smoothing can come into play to manipulate earnings.

Profit smoothing crosses the line from choosing acceptable accounting methods from the list of GAAP and implementing these methods in a reasonable manner, into the gray area of earnings management that involves accounting manipulation. It’s incumbent on managers and business owners to be involved in the decisions about which accounting methods are used to measure profit and how those methods are actually implemented.

A manager can be requires to answer questions about the company’s financial reports on many occasions. It’s therefore critical that any officer or manager in a company be thoroughly familiar with how the company’s financial statements are prepared. Accounting methods and how they’re implemented vary from business to business. A company’s methods can fall anywhere on a continuum that’s either left or right of center of GAAP.

Taking a Look at the Income Statement – Part One

The first and most important part of an income statement is the line reporting sales revenue. Businesses need to be consistent from year to year regarding when they record sales. For some business, the timing of recording sales revenue is a major problem, especially when the final acceptance by the customer depends on performance tests or other conditions that have to be satisfied.

For example, when does an ad agency report the sales revenue for a campaign it’s prepared for its client? When the work is completed and sent to the client for approval? When the client approves it? When the ads appear in the media? Or when the billing is complete? These are issues a company must decide on for reporting sales revenue, and they must be consistent each year, and the timing of reporting should be noted on the financial statement.

The next line in an income statement is the cost of goods sold expense. There are three methods of reporting cost of goods sold expense. One is called “first in-first out” (FIFO); another is the “last in-last out” (LIFO) method and the last is the average cost method. Cost of goods sold expense is a huge item in an income statement and how it’s reported can make a substantial impact on the reported bottom line.

Other items in an income statement include inventory write-downs. A business should regularly inspect its inventory carefully to determine any losses due to theft, damage and deterioration, and to apply the lower of cost or market (LCM) method.

Bad debts are also an important component of the income statement. Bad debts are those owed to a business by customers who bought on credit (accounts receivable) but are not going to be paid. Again the timing of when bad debts are reported is crucial. Do you report it before or after any collection efforts are exhausted? The answer to this question may well be found in your accountant’s reporting approach.