Comprehensive guide covering revenue recognition, expense analysis, EPS calculations, and income statement structure
The Income Statement (I/S) is a financial report card showing a company's performance over a period (e.g., quarter or year). It answers: How much profit did the company earn?
Measures growth, profitability, and risk
Helps decide whether to invest or lend
Core input for models like DCF and P/E
Income statements can be presented in a single-step format (Total Revenues - Total Expenses = Net Income) or a multi-step format. The multi-step format is more detailed and useful for analysis, providing key subtotals.
| Component | Description & Formula |
|---|---|
| Revenue (or Sales) | Top-line earnings from selling goods or services. |
| (-) Cost of Goods Sold (COGS) | Direct costs attributable to the production of goods sold. |
| = Gross Profit | Revenue - COGS. Shows profit from core production/service activities before other expenses. |
| (-) Operating Expenses | Costs not directly tied to production (e.g., Selling, General & Admin (SG&A), R&D, Depreciation). |
| = Operating Income (EBIT) | Gross Profit - Operating Expenses. Profit from normal business operations. A key measure of core profitability. |
| (+/-) Non-Operating Items | Income or expenses from outside the core business (e.g., Interest Expense, Interest Income, Gains/Losses on investments). |
| = Earnings Before Tax (EBT) | Operating Income +/- Non-Operating Items. Profit before the effect of taxes. |
| (-) Income Tax Expense | Provision for income taxes. |
| = Net Income | EBT - Taxes. The "bottom line" profit attributable to all shareholders after all expenses. |
Under accrual accounting, revenue is recognized when earned — when goods/services are delivered — not when cash is received.
Must have commercial substance and probable collectability
Distinct promises to deliver goods/services
Total consideration expected
Based on standalone selling prices
When control is transferred
Customer pays $1,200 for a phone ($500 value) and 2-year service ($700 value).
Added goods/services are distinct and fairly priced
Not distinct → adjust existing contract
Expenses should be recognized in the same period as the revenue they help generate.
Matched with sales
Expensed when incurred
| Method | Description | IFRS | U.S. GAAP |
|---|---|---|---|
| Specific ID | Track cost of each unique item | ✅ | ✅ |
| FIFO | First in, first out. Ending inventory = newest costs | ✅ | ✅ |
| LIFO | Last in, first out. COGS = newest costs | ❌ | ✅ |
| Weighted Avg | Average cost applied to all units | ✅ | ✅ |
| Metric | FIFO | LIFO |
|---|---|---|
| COGS | Lowest (old, cheap costs) | Highest (new, expensive costs) |
| Ending Inventory | Highest (recent costs) | Lowest (old costs) |
| Net Income | Highest | Lowest |
| Taxes | Highest | Lowest (tax advantage) |
Should a cost be expensed now or capitalized as an asset? The decision hinges on whether the cost provides future economic benefit beyond the current period.
| Financial Item | Capitalizing | Expensing |
|---|---|---|
| Recognition Rule | Future benefit > 1 period + reliably measurable cost → Capitalize | Benefit consumed immediately or not reliably measurable → Expense |
| Year 1 Net Income | Higher (only depreciation/amortization hits P&L) | Lower (full expense recognized immediately) |
| Future Net Income | Lower in subsequent periods (due to depreciation/amortization) | No future impact |
| Balance Sheet (Assets) | Higher initially; declines over time due to depreciation | Lower (no asset created) |
| Operating Cash Flow (OCF) | No immediate impact (non-cash expense later) | Decreases immediately (cash outflow classified as operating) |
| Investing Cash Flow (ICF) | Decreases (cash outflow classified as investing) | No impact |
Assume a $100,000 cost is capitalized and depreciated straight-line over 5 years ($20,000/year):
Capitalizing smooths earnings and shifts cash flow from investing to operating over time.
Capitalized during the construction of qualifying long-term assets (e.g., buildings, machinery)
If a company capitalizes $1M in R&D costs that should have been expensed:
This adjustment reveals lower profitability and higher operating cash outflow — critical for accurate comparability.
Analysts focus on core, recurring earnings. These items should be identified and often excluded.
Retrospective — restate prior years
Prospective — affects current/future
Restate prior periods
Flexible classification
Operating = core business; Non-operating = investing/financing
EPS measures profit per common share. It's a key metric for investors and analysts.
Only common stock
Has convertible securities (options, bonds) → must report Diluted EPS
Why? EPS is for common shareholders. Preferred dividends are subtracted.
Diluted EPS ≤ Basic EPS. Shows worst-case EPS if all dilutive securities convert.
Anti-dilutive securities (those that would increase EPS) are excluded.
Why? Preferred dividends are eliminated upon conversion.
Why? Interest saved → added back (after tax).
1,000 options at $20. Avg stock price = $25.
Add 200 to denominator.
Each item as % of revenue
Each item as % of base year
These help assess efficiency, cost control, and overall profitability.
Income statement analysis accounts for 8-12% of Level I FSA weight. Master these areas:
LIFO vs. FIFO in Inflation: LIFO results in higher COGS, lower net income, and lower taxes. Ending inventory is valued at older, cheaper costs.
Treasury Stock Method: Only add NET new shares (issued minus repurchased). Options are only dilutive if market price exceeds exercise price.
Capitalizing vs. Expensing: Capitalizing increases Year 1 net income, lowers operating cash flow, and increases investing cash outflow. Total cash is the same, just classified differently.
Revenue Recognition Timing: Revenue is recognized when control transfers and performance obligations are met, not necessarily when cash is received.
Anti-dilutive Securities: Only include securities that decrease EPS in diluted EPS calculation. If conversion would increase EPS, exclude it.