A Roadmap to Income Statement Standardization

Imagine you are planning a road trip across the country. To ensure a smooth and successful journey, you need a detailed map that shows all the important routes, landmarks and destinations. This map allows you to understand where you have been, where you are, and where you are going. Without this map, you are more likely to go off track, lose your way, or even quit the road trip altogether. Without this map, no one will want to accompany you on a journey with no plan.

Just as a good map is crucial to any road trip, a good income statement helps business owners, investors, and other stakeholders make informed decisions about a business, giving them a path to follow and a plan into the future. A well-prepared income statement provides a clear picture of the business’s financial performance, showing how much money it has made, how much it has spent, and how profitable it is.

Financial statements are essential to a company’s financial reporting. They provide investors, analysts, and the general public with crucial information about a firm’s performance and financial health. Among these statements, the income statement stands out as a critical document that requires careful consideration. Recently, the Financial Accounting Standards Board (FASB) has been working on how best to present and break down financial performance information. This includes deciding on the right format, the amount of detail needed, and how standardized these presentations should be.

Professor Kristian Allee from the Walton College of Business says, “Determining the information presented in the performance report (i.e., income statement) and the format of this statement have long been complex issues for financial accounting standard setters.”

Allee and fellow researchers, Devon Erickson (Utah State University), Adam Esplin (The University of Texas at El Paso), and Teri Lombardi Yohn (Emory University) bring to light the real thoughts and preferences of investment professionals regarding income statement presentation. In their article, “Investment Professionals’ Preferences Regarding Income Statement Presentation,” the authors seek to understand these preferences to shed light on future income statement standardization.

Understanding the Income Statement

The income statement, or profit and loss statement, is a report that summarizes a company’s revenues, expenses and ultimately, the net income or profit. It provides an overview of a firm’s financial performance over a period of time, typically a quarter or a year. This information helps stakeholders make informed decisions regarding the company’s financial health and operational efficiency.

While income statements help provide information, sometimes it can be difficult to compare that information across differing businesses. Without a level of standardization, businesses are free to organize their income statements however they see fit. In the past, the lack of uniformity has, on some levels, allowed businesses to hide behind tricky data and numbers, whereas a universal format might enhance transparency and comparability by ensuring that everyone has the same data and standards.

How Should We Split This? 

One key question for creating a universal format would be how to separate and organize the statement, and there are many different schools of thought on this issue. Some suggest that the information should be organized based on the earnings persistence of items (revenue, gross profit, operating income, etc.). The idea behind this type of organization is that it allows investors to see more clearly how profitable the business might be in the future; and, if you separate the temporary earnings from persistent earnings, it will improve market efficiency.

Other professionals suggest that statements organized based on manager discretion are useful for forecasting and valuation. The level of importance of each bit of information is relative to every person. While one person might think comprehensive income is highly important in an income statement, others might find that information obscure and unimportant and report it on a separate statement to keep it distinct from the “traditional” income statement. Another common example, separating accruals and cash flows, indicates that each earnings component has a different level of confidence or importance. This type of organization allows a better understanding of a company’s future cash flows and how sustainable current earning levels are. This point of view suggests that managers should be able to organize their income statements based on what they think is most important.  

Each level of organization allows a different viewpoint and understanding of the data in an income statement. In this way, investors could be looking at two almost identical companies, with similar financial standings. However, if both companies have their information separated in differing ways, investors could get completely different views of the companies. Allee and his coauthors’ research provides some insight into which format professionals think would provide the most transparency and precision.

One of the biggest advantages of standardization of financial information would be a greater level of transparency and disclosure. However, this research suggests that transparency and disclosure might not be the most pressing issue for investment professionals right now. Allee and his coauthors’ research finds that investment professionals, who play a crucial role in financial markets, generally feel that the current level of disclosure in income statements is adequate. They find all the disaggregation approaches discussed by regulators to be useful, but they rate disaggregation by management discretion and by operating, investing, and financing activities as less useful.

Ask The Professionals

While the topic of standardization is at large with standard setters, a lack of consensus among everyday professionals might make it difficult to know what is best for the future of accounting. Allee and his coauthors surveyed 235 investment professionals to better understand investment professionals’ preferences of standardization versus flexibility. While there was not a resounding answer one way or the other, there were a few issues that came to the researchers’ attention that might shed some light on how the standardization process should continue.

In this article, the researchers also found a preference from professionals for line-item label standardization. This preference suggests that the labels used for various items in financial statements such as revenues, expenses, gains, losses, etc., should be consistent across different companies and industries. Consistent labels would make comparing numbers across different companies easier by providing clarity on what each number represents.

In the same vein, the professionals in this study also showed a desire for clear definitions for operating and nonoperating items. Operating items are typically those directly related to a company’s core business activities, like sales revenue and cost of goods sold. On the other hand, nonoperating items are usually related to peripheral activities, such as interest income, investment revenue, or unusual charges. Clear definitions would make it easier to accurately distinguish between the categories and decide whether items should be classified as operating or nonoperating.

Allee and his coauthors also found large support for the inclusion of non-GAAP measures in the income statement. GAAP (Generally Accepted Accounting Principles) measures are the standard rules and guidelines for financial reporting in the United States, essentially like a rulebook that everyone agrees to follow so that everything is as clear as possible. While professionals understand the need for and importance of including GAAP measures in an income statement, those in this study believe that non-GAAP measures might be able to provide additional insights into a company’s financial performance that GAAP might not fully capture.

Financial professionals are currently required to present their company’s earnings per share (EPS) on the face of the income statement. When asked whether this should continue, the group of respondents were clear about their desire to keep this standard, with over 40% of respondents saying that they “strongly agree” that EPS should continue to be required up front. One analyst said that “removing EPS from the income statement would be like removing the stars from the American flag. People are sort of used to it. It’s what they expect.”

Despite conducting this research, Allee still believes that it will always be hard to find the “right answer” to the standard setting issue. “The old (Lincoln) adage is quite apropos here:” he said. “’You can please some of the people some of the time, all of the people some of the time, some of the people all of the time, but you can never please all of the people all of the time.’”

Despite not having a universal answer, standard setters should consider the information found in Allee’s work moving forward. To ensure that standardizing income statements is beneficial to as many as possible, standard setters should consider the needs and desires of those who will eventually use these statements, as well as those who must abide by these rules to prepare them. By doing so, they can create a more effective and inclusive financial reporting framework that balances regulatory requirements with practical usability for companies and their stakeholders.