How to Evaluate an Income Statement as an Effective Financial Tool

How to Evaluate an Income Statement as an Effective Financial Tool
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The Main Characteristics of Income Statements Prepared According to GAAP Rules

If you’re in the process of evaluating your Income Statement and how it measures to the GAAP Rules for standards of reporting, be informed that there are four fundamental principles that every Income Statement should possess: relevance, reliability, consistency and comparability of financial information presented.

Relevance – The matter of relevance may refer not only to the usefulness of the information provided but also to the manner of organizing the data according to its most significant value, as a tool for making informed decisions. Data will be organized in such a way that costs can be readily matched against the revenue generated, wherein financial figures used for ratios can be easily extracted.

Reliability – It used to be that an auditor’s certification about the fairness of presentation was the main gauge of reliability. As trading became more sophisticated and complex, the true test of reliability is when the financial reports, particularly the Income Statement, will pass the scrutiny and evaluation of the IRS and SEC. Both are concerned about the income reported by a business entity, wherein the focus of the IRS is the reliability of information to ensure tax propriety as source of federal funds. The SEC on the other hand, ensures the investment worthiness of the business as source of income for the investing public.

Consistency in application of rules and policies whether internal or external will produce sound financial reports. Lack of consistency usually arises if rules are made to conform to the business objectives. If for example, a company uses LIFO in inventory costing because the cost of the latest purchases are higher, then it follows that LIFO will be used all throughout even if the prices of the latest purchases decreased.

While some contend that the basis of consistency is not about the valuation method but the observance of high price value, this is still contestable since price is not a good basis for consistency. Price as gauge of consistency lacks the quality of being stable and constant. There is the matter of misleading the user into believing that his investment decisions will be based on something that is not volatile and unstable.

Comparability of financial reports, particularly the Income Statement can be achieved if all three previously mentioned qualities are present. Degree of comparisons may be between businesses engaged in similar trade or industry, or of performance results from year to year, or of business sizes in terms of net worth as against the ability to generate income. Evaluate an Income Statement as part of financial reports that contain information that can be compared in all aspects and angles, to serve as the most useful tool when making important business decisions.

What Information Can Be Derived from an Income Statement?

Evaluate an Income statement according to its content. Keep it in mind that an Income Statement is a measure of business performance. Its bottom line figure, which is the Net Income or (Net Loss), reveals the effectiveness of the company’s marketing and cost-efficiency strategies.

Others prefer to label this financial report with a more explanatory title, Statement of Income and Expenses, wherein equal weight is placed in the importance of its components. It will readily impress the user that this is where he can find details about the business entity’s income generating activity, whether it’s into selling, manufacturing or both manufacturing and selling, or it’s into leasing or renting, or in providing services as a contractor or on a retainer basis.

In providing details about the related expenses, the financial statement user will know what resources and how much of it were utilized by the business. Does the company pay commissions or just salaries? Does it provide for travelling expenses or even pay for Social Security or Health Care Benefits? Is the company using a business-owned facility or renting? These are only a few of the information that can be gathered from the Income Statement, if all accounts used are properly itemized and labeled.

For more details on what should be included in the income and expense accounts, readers may refer to the guidelines provided in two other articles: Income Statements: Free Template and Example and Examples of Multiple-Step Income Statements.

Income Statement Formats

Part of evaluating the Income Statement is determining if the proper format was used to present the income generating activities of the business. There are two formats being used in preparing a statement about the income and expenses of a company: (1) Single-Step and (2) Multiple-Step.

Proper formatting is important in as much as users would prefer to read an Income Statement that can serve as ready reference for analysis with just a quick glance.

Users of Single-Step Format

A company engaged in a simple business activity of buying and selling commodities has fewer accounts to contend with, in order to present an Income Statement that is intelligible, albeit brief. The same is true with a business that gains income from providing commercial/residential spaces for lease or for rent, as well as businesses engaged in providing services through their profession like architects, accountants, engineers and the likes. Hence, the use of the Single-Step Income Statement can serve their purposes well enough.

Kindly click on the images for a larger view of a Single-Step Income Statement and Multiple-Step Income Statement.

Net Income after Operating Expenses Section

Gross Profit Section in a Multiple-Step Income Statement

Users of Multiple-Step Format

Multifaceted businesses, engaged in two or more types of income generating activities make use of several descriptive accounts, partly for monitoring purposes. The business operations can be broad and wide-ranged especially if the activities involved include manufacturing, selling, distributing, consigning and all other methods of gaining income from their manufactured goods.

In some cases, the business’s management may desire to have an Income Statement that provides a segment for the income generated by each product line that the company manufactures. The objective is to have a financial report that will present income and expenses in the most all-inclusive structure possible; thus, the Multiple-Step format was introduced as means to attain this objective.

Evaluating an Income Statement will be more effective if you can compare it with a concrete example. You may find Income Statements in template forms at Bright Hub’s Media Gallery; the samples provide the structural features of a Single-Step or the Gross Profit Section and Net Income after Operating Expenses Section of a Multiple-Step Income Statement as shown in the images above.

Reference Materials and Image Credit Section

Reference Materials:

Images Credit:

  • Created for the Income Statement articles by author CS Cantoria