How Net Income Affects Stockholders’ Equity

A positive net income reported on a corporation’s income statement also increases the amount of the corporation’s retained earnings. Retained earnings is a separate item reported in the stockholders’ equity section of the balance sheet. Hence, the income statement and balance sheet are connected. (A net loss, or negative net income on the income statement decreases the amount of the corporation’s retained earnings.)

In the case of a sole proprietorship, the net income reported on the income statement will increase the owner’s capital account, which is part of owner’s equity. A net loss will decrease the owner’s capital account.

Statement of Comprehensive Income

The statement of comprehensive income contains a few amounts that are not reported on the income statement. These items are referred to as other comprehensive income.

The other component of comprehensive income is the net income reported on the company’s income statement. Therefore, the two major components of the the statement of comprehensive income are:

  • Net income (or net loss) from the income statement
  • Other comprehensive income

The specific items that comprise other comprehensive income will be listed on the statement of comprehensive income. Items that commonly appear as other comprehensive income include the following:

  • Foreign currency adjustments
  • Unrealized gains/losses on pension and other postretirement benefit plans
  • Unrealized gains/losses on hedging derivatives

How Other Comprehensive Income Affects Stockholders’ Equity

A corporation’s positive amount of other comprehensive income causes the corporation’s accumulated other comprehensive income to increase. (Other comprehensive losses cause the corporation’s accumulated other comprehensive income to decrease.)

Accumulated other comprehensive income is a separate item appearing in the stockholders’ equity section of the corporation’s balance sheet.

Here’s a Tip

  • A corporation’s net income increases its retained earnings
  • A corporation’s other comprehensive income increases its accumulated other comprehensive income
  • Net income + Other comprehensive income = Comprehensive income
  • Retained earnings and accumulated other comprehensive income are shown separately within stockholders’ equity

Additional Information Regarding the Income Statement

Owner’s compensation does not appear on a sole proprietorship income statement

The income statement of a sole proprietorship does not report an expense for the owner working in the business. The reason is that the owner of the sole proprietorship is not paid a salary. As a result, the net income of a sole proprietorship cannot be directly compared to the net income of a regular corporation where the owner is paid a salary.

For instance, assume that the income statement of a business organized as a sole proprietorship reported a net income of $100,000. The $100,000 reflects the combination of (1) the owner’s compensation for working in the business, and (2) the earnings of the business.

If the same business had been organized as a regular corporation and the owner/stockholder received a salary of $80,000, the income statement will report a net income of $20,000. The reason is that the $80,000 salary will be listed on the corporation’s income statement as salary expense.

Historical cost principle

The income statement amounts are generally based on the historical amounts at the time of the original transaction. (Changes in the fair value of marketable securities are an exception.)

To illustrate, assume that XXL Company’s office and warehouse building was constructed 20 years ago at a cost of $750,000 and was estimated to have a useful life of 25 years with no salvage value. Each year’s income statement will likely report depreciation expense of $30,000.

If the XXL Company or a competitor were to construct a similar building today, the cost might be $1,500,000 and the income statement will be reporting depreciation expense of $60,000.

What is the cost of using the facilities this year? Is it logical to match the costs from 20 years ago with the current year revenues? That’s what occurs because of the historical cost principle.

Average costs and opportunity costs

Some important costs are not shown in the income statement. Two examples are (1) the cost of making and selling one or more additional units of product, and (2) the cost of missing an opportunity.

To illustrate, assume that in a typical week Artisan Bread Company (ABC) produces 3,000 loaves of bread which will be sold for $7 a loaf. The cost of the ingredients is $1 per loaf and the other costs (bakers, rent, depreciation, etc.) are $6,000 every week regardless of the number of loaves produced. Therefore,

  • If 2,000 loaves are produced, the average cost is $4 per loaf ($2,000 for ingredients + $6,000 of fixed costs = $8,000/2,000 loaves)

  • If 4,000 loaves are produced, the average cost is $2.50 per loaf ($4,000 for ingredients + $6,000 of fixed costs = $10,000/4,000 loaves)

  • The cost of making one additional loaf is $1 since the cost of ingredients is the only cost that will change

Now assume that ABC decides to sell its breads at a special event but is unsure of the number of loaves to produce. To avoid baking loaves that will not sell and lose the average cost, ABC decides to bake 100 loaves. It ends up that the 100 loaves were sold within an hour, and it becomes clear that an additional 200 loaves could have been sold. What was the cost of not producing 200 additional loaves? In other words, what was the opportunity cost or opportunity lost?

The cost of missing the opportunity to sell 200 additional loaves will never be listed on ABC’s income statement. However, we can compute the opportunity cost of not producing the 200 additional loaves:

  • Additional revenues missed = $1,400 (200 loaves X $7 selling price)
  • Additional expenses avoided = $200 (200 loaves X $1 of ingredients)
  • Opportunity cost = $1,200 ($1,400 – $200)

Someone will say “Hindsight is 20/20! How would ABC have known?”

Well, ABC could have understood that the average costs of $2.50 to $4 per loaf were not relevant. In our example, the only relevant amount is the $1 per loaf cost of ingredients.

If ABC understood that by spending an additional $1 it could possibly earn $7, it may have produced more loaves. In other words, risking $200 in ingredients to potentially receive an additional $1,400 may have motivated ABC to produce more loaves. Looking at it another way, ABC would recover the additional $200 cost for ingredients by selling just 30 of the 200 additional loaves. After the 30 loaves are sold, ABC will be increasing its net income by $7 for each additional loaf sold.

Income Statements That Remain Inside the Company

The income statement format that we discussed and the requirement for issuing the set of five financial statements pertains to the financial statements that are distributed to people outside of the company, such as investors, lenders, financial analysts, etc. The financial statements that remain inside the company can be in a format different from those required by US GAAP.

More detailed and/or less complete

It is common for the internal income statements to contain schedules of expenses to support the amount of a company’s SG&A expenses. Some schedules will be limited to the expenses of a specific department such as IT, accounting, international marketing, human resources, etc. This allows each department’s manager to closely monitor its expenses without being distracted by the expenses of another department.

Income statements can also be prepared for a company’s major segments, such as the consumer products division and the industrial products division. Other formats are also possible.

Contribution Margin Format

An internal income statement can be prepared to emphasize the contribution margin of a company’s products and product lines. The contribution margin examines the amount of net sales remaining after deducting only the costs and expenses that will vary in total as volume changes. Here is the concept in the form of an equation:

Contribution margin = sales – all variable costs and variable expenses

A brief example using hypothetical amounts in an income statement arranged in the contribution margin format is shown here:

Income statement contribution margin format

After the contribution margin is shown, the $6,000 of fixed costs and fixed expenses that are directly traceable to each product line are subtracted.

The subtotal tells the reader the amount of profit that is available to cover the $20,000 of common fixed expenses. Common expenses means they have to be arbitrarily assigned to the product lines. Often the total amount of the common expenses will not decrease when a product line is eliminated.

The contribution margin format allows the company’s executives to see the relative profitability of its products or other segments. Seeing how profits will change when the volumes increase or decrease may be valuable.

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