income statement managerial accounting

income statement managerial accounting

The Importance and Analysis of Income Statements in Managerial Accounting

1. Introduction to Income Statements

An income statement represents a measure of performance of a business organization during some specific period of time. It contains summarized information that reflects operations communicated to external parties such as taxing authorities, shareholders, creditors, and others interested in a firm’s ability to make periodic distributions. In the hands of owners or management, the results are used in evaluating probable future performance, as demonstrated by the relationship of profits to sales or some other measure of operations. If the firm is absorbing an excessive amount of capital for the volume of sales within the industry, it may be compelled to change its corporate objectives in order to reduce risks or justify the rate of return. This relationship between profits and some measure of activity can also be used in comparing the operating efficiency of physically separated profit centers.

Managerial accounting presents a complex design subjecting the information requirements. On the practical level, five main areas can be distinguished: financial planning, product pricing, projections, cost reduction, and control of operations. The income statement provides an important part of the data involved in each of these areas of managerial accounting. As was noted in the previous chapter, financial accounting reports have little meaning unless they are related to some specific business decision. This is also true of income statements and other managerial accounting reports for there is no sense in the development of data simply because it is possible to assemble them. Hence, the accountant must be fully conscious of the reasons for income statement preparation in order to derive the maximum usefulness from the reports. And, with equal force, management must understand the report design to evaluate financial responses to programs set up to correct the situations.

2. Key Components of an Income Statement

Nature of business operations or relationships: Given the variety of corporate activities, the income statement needs to identify the categories of revenues and expenses that will best predict future performance. To do so, these revenues and expenses are classified into distinct categories. The categories selected are closely associated with the categories listed in the following sections. In general, those revenues and expenses that should flow from the company’s daily operations sparkle the interest of stockholders, creditors, managers, and others. Such revenues and expenses affect all business relationships not addressed by the criteria for reporting nonoperating revenues and expenses. Accordingly, companies should accent the identification of operating revenues, gains, expenses, and losses on the face of the income statement. Moreover, these categories should depict and predict future operating results.

Key components of an income statement: The balance sheet describes the financial condition of a corporation at a single point in time. The income statement, on the other hand, measures the performance of a corporation over some interval of time. Such a report serves to evaluate several significant aspects of the corporation’s operations. For a business that is organized as a corporation, the income statement reports the following: (a) overall performance of the enterprise over a certain period of time, (b) changes in the corporation’s shareholders’ equity over a certain time period, (c) performance of the company’s operations by product line, (d) probable dividends that will be paid, and (e) market prospects. Given the wide range of decisions assisted by income statement data, executives and managers rely on income statements to evaluate the economic aspects of business operations. These elements have raised several related questions. Specifically, what definitions are associated with an income? Should income exclude or include any special items? What should be highlighted in income statements – uncertain items, management’s performance, unusual events, or transitional activities? Although no universally accepted answers for these questions have been agreed, the following.

State the major components of an income statement and define operating income.

Required:

Income statement: A report of the revenues, expenses, and net income or loss of an accounting period for a corporation and earnings per share data for a corporation with publicly traded common stock. An income statement is normally presented in two parts: (1) operating section and (2) nonoperating section. Typically, the operating section reports (a) sales, (b) cost of merchandise sold, and (c) selling, general, and administrative expenses. The nonoperating section normally reports revenues, gains, expenses, and losses that are either unusual or unrelated to the company’s main line of operation. To understand the needs and structure of income statements, the following key concepts must be defined: (a) The basic components of an income statement, (b) the matching concept and income statement preparation, (c) the limitations of an income statement, (d) quality of earnings, and (e) the relationship of quality of income to earnings management. In this chapter, to highlight the importance of the income statement in management decision making, the section on ‘Key components of an income statement’ is presented next.

3. Analyzing and Interpreting Income Statements

The operating income or profit of a company is generally considered important because the income statement reflects the results of an entity’s principal or central activities. For this reason, income statements frequently organize information in a format resembling the following: 1. revenues or sales; 2. cost of goods sold. The difference between revenues or sales and the cost of goods sold is often termed gross profit. Revenues and costs that are not considered to be part of a principal operation are termed nonoperating gains and expenses. Nonoperating items may include gains or losses from the sale or exchange of long-term assets, interest and dividend revenue, interest expense, and income taxes. The important thing is to segregate items that are associated with normal operations from those items that are incidental to normal operations.

Analyzing and interpreting financial information are crucial tasks of managers if they are to succeed in the business world. The most typical and traditional financial reports provided to managers for this purpose are the income statement, the balance sheet, and the statement of cash flows. Because the income statement provides information on the past performance or results of an entity, it helps users identify potential problems and risks. By using this information in combination with other pieces of financial data, managers are better able to make informed decisions about the future. The income statement is also useful for comparing actual performance to previously set standards or budgets.

4. Using Income Statements for Decision Making

The different results should appear in the financial statements and other reports used to judge performance. However, if indivisible income measures are used properly, subjective performance evaluations and accounting numbers provide similar performance assessments. Also, high-powered incentive devices may motivate managers to work harder and more effectively, but incentive devices cannot change the economic values created by organizations. Nor can incentive devices affect the internal and external unplanned actions that will help or hinder performance as reflected in financial reports. Therefore, similar economic relationships may be used to predict income measures reported by organizations operating within different incentive structures. If differences in economic relationships are explained to decision makers, accounting measures can help to shape the performance of organizations whose outcomes are being evaluated based on the principle, “Reasonable people will not take actions unless they believe that their goal-relevant benefits exceed all of their goal-relevant costs.” In business and many other institutional settings, the goal is to maximize profits. If the organization that conducts the evaluation does not maximize profits, the goal becomes to achieve a budgeted income amount.

To make decisions that have internal and external effects, managers must acquire knowledge about the different income measures and about the conditions under which accounting data will lead to decisions that optimize objectives relevant decisions. We believe that, even in the presence of major institutional deficiencies in some countries, income statements could and should be used to improve the performance of many types of organizations. The income measures that we use can be computed and would be useful to many decision makers. Their effect on decisions is topic or control-structure specific. Knowledge of the economic theory underlying managerial accounting income measures could help to reduce the existing controversy and to improve general understanding of the forces that affect decisions. Since managers will be more effective in any organization if they make decisions that are optimal with respect to this organizational goals, other things being constant, we would expect managers of organizations operating within different incentive structures and with different goals to manage their respective organizations to achieve different economic results.

5. Conclusion and Future Trends in Income Statement Analysis

5.2. Future Trends in Income Statement Analysis Accounting curricula will provide students with knowledge about contemporary accounting practices and the ability to analyze complex problem situations. Recently, more and more companies have been reorganizing their businesses around the concept of the Value Chain. This holistic approach to analyzing strategic business performance and creating shareholder value through internal and external measurement. These trends, operating results, and economic data help shareholders develop a greater understanding of what is really going on throughout the company from top to bottom in terms of financial performance. This allows shareholders to independently monitor corporate performance and long-term progress through financial oversight. Companies alone cannot create economic value; they can, at best, merely invite its creation. The recovery of costs, let alone the charging of above-average returns on investment, is principally a question of the external competitiveness of any company. Hence, shareholders should be kept abreast of the economic results and indicators surrounding economic value creation at their companies.

5.1. Conclusion The three fundamental financial statements – the income statement, the balance sheet, and the cash provided and used statement – summarize a company’s operating, financing, and investing activities. The income statement reflects the efforts and results of the company’s management and is fundamentally devoid of estimation of market value. The income statement can be thought of as the heartbeat of a corporation. It not only measures performance, but it assesses how management has addressed the major economic issues that impact an organization’s success. Although an income statement changes continuously throughout the year, it is principally a report at a point in time.