While a balance sheet is a stock-based static statement
that presents a company's financial position at a point in
time, an income statement is a flow-based dynamic statement
that describes a company's operating performance over a
period of time. The period covered by an income statement
must be clearly specified. The phrase "Income Statement of
30 June 1997" is meaningless unless it is intended to show
the revenues and expenses for the single day 30 June 1997.
Historically, the income statement used to be a supporting
statement to the balance sheet. Without the income
statement, we would record revenue as an increase, and
expense as a decrease, of the equity account Retained
Earnings. Such transactions are numerous. To simplify the
bookkeeping, as well as to provide more useful information,
the income statement was born.
Depending on how revenues and expenses are presented,
there are roughly two formats of the income statement, the
traditional multi-step format and the relatively new
two-step format. The former has a few steps: Sales - Cost
of Goods Sold = Gross Profit; Gross Profit - Operating
Expenses = Operating Income; Operating Income ±
Non-Operating Items = EBT (Earnings Before Tax); EBT -
Income Tax = Net Income.
Of course whether an item is operating or not depends on
the nature of the business. For instance, while Interest
Expense may be a non-operating expense for many companies,
it is the most important operating expense for banks.
When a company has losses rather than earnings, it does
not have to pay income tax. It may also be allowed to carry
the loss backward and/or forward, depending on the tax
environment the company is in.
Different users of financial statements often have
different needs. The multi-step format of the income
statement is unlikely to suit all needs. Some American
companies took the lead to use the two-step format. In this
format, the income statement contains basically two parts.
The first part lists all sources of revenues while the
second lists all kinds of expenses. A reader can prepare
the income statement in any form to suit his purpose.
It must be pointed out that the net income shown in the
income statement is an accounting profit, not cash flow. In
the computation of accounting profit, cash receipts from
selling farecards are not recognised as revenue. Rather,
they are "Unearned Revenue" classified under Current
Liabilities. Revenue is considered realised only after the
bus service is provided and consumed. Similarly, insurance
premium paid for any part of the next financial year will
not go to the expense in the income statement. Rather, it
will appear as Prepaid Expense, an item under Current
Assets.
In accounting terminology, the income statement is
prepared using the "accrual basis", not the outdated "cash
basis". When China in 1994 proclaimed the adoption of the
Western accounting system, the switch from the cash basis to
the accrual basis was the heart of the change.
(The writer is a resource panellist of SPH's Chinese
Newspapers.)
