Income statement is useful for evaluating past performance, provide basis for future predictions, and help assess the risk or uncertainty of achieving future cash flow.
Eventhough, income statement also has its limitations. First, companies ignores items that they cannot measure reliably, such as unrealized gains or losses in some investments and brand recognitions, customer loyalty, etc. Second, numbers in income statements are affected by accounting method, e.g. depreciation rate. Third, income measurement involves judgement, e.g. bad debt rate, useful life of assets. Stakeholders has to understand this limitation to use it accordingly.
There are some case in these days that many companies do “earning management”, which planning timing of revenues, expenses, gains, and loses to smooth out bumps in earnings. This is happened currently with Dell company. For years, Dell is well known as expert in squeezing efficiency out of its supply chain and drive down cost. In July 2010, Security Exchange Commission (SEC) found out that Dell had manipulated its accounting over an extend period to project financial results. On July 22, Dell aggreed to pay 100 million dollars penalty to settle allegations by SEC.
The Dell case is about income statement. Prior to 2007, Dell had cooperated with Intel by exclusivity payments. Intel paid some amounts to Dell to use its chip exclusively in Dell’s computer. The amounts of payment reached 76% or Dell quarterly operating income in first quarter 2007.
In 2007, Dell decided to use AMD’s processors in its product, which is in competition with Intel’s processors. This made Intel stopped its exclusivity payments. After Intel cut its payments, Dell again misled investor my not disclosing the true reason behind company’s decreased profitability. Dell said that the main reason was too aggressive pricing in the face of slowing demand and component cost declined less than expected.
In multiple step of Income Statements, there should be a separation between operating income and non-operating income. In Dell case, operating income should come from selling computers and non-operating income should come from other than this activity, for example exclusivity payments from Intel. Failed to report this separation will mislead investor as we see from this case.
Therefore, income statement components include :
1. Operating sections
- Sales and revenue sections
- Cost of Good Sold (COGS)
- Selling expenses
- Admin & General expenses
2. Non-Operating sections
- Other revenue and gains, such as rental fee and dividents from investing in other company.
- Other expenses and losses, such as interest from payable
3. Income Tax
4. Discontinued operations
5. Extraordinary items
6. Earning per share (EPS)
In description above, companies have to report separately irregular items in componenents of income on income statements. These irregular items includes discontinued operations, extraordinary items, unusual gains and losses, changes in accounting principles, changes in estimates, and correction of errors. Each of these irregular items has different reporting method we have to understand.
Earning per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. Many beginner investors only see this number to decide their investment plan, which make the risk even higher. Therefore, accounting rule concluded that companies must disclose earnings per share on the face of income statement to lower this risk. Usually, we can see EPS in lower line of income statement.
Retained earning is the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. Retained earning statement reports this portion, separated from other part of financial statements.
Fail to report income statement accordingly will mislead stakeholders, such as managers, investors, and customers. As the result we can see from Dell’s case, the company has to pay $100 millions and Mr. Michael Dell as CEO has to pay $4 million.