Definition:

Net income sometime called Net Profit, Bottom Line or Net Earning. It is the net earning from the operating activities and others income for the specific period of time. Net Income is the result of gross profits for the specific period less their corresponding expenses of the same period. Those expenses are Cost of Goods Sold, Operating Expenses, Interest Expenses and Taxes.

The net income is significantly affect by accounting policies and accounting framework as well as accounting principle that entity use to prepare its financial statements. For example, Incomes recognized for the period that using cash basis is different from incomes using in accrual basis. Different accounting policies or estimate could produce different results. For example, differentiation of depreciation rate could be result different bottom line.

This is the reason why people say Net Income is the accounting figure which could significantly affect by accounting policies, and judgement as the result of management bias.

Net Income Formula:

The following is the Formula of Net Income:

Revenue $XXX

Less Cost of Goods Sold $ (XXX)

Equal Gross Profit $XXX

Less Operating Expense ($XXX)

Equal Profit before interest and tax $XXX

Less Interest Expenses ($XXX)

Equal Profit Before Tax $XXX

Less Tax Expenses ($XXX)

Net Income $XXX

Another Net Income Formula:

Net Income = Total Profit – Total Expenses

This Net Income Formula, all of the expenses and incomes recorded here must be occurred or cut-off for the same period. As you could see here from the top to bottom before come to Net Income, we got five importance items:

  • Revenue or sometime called Sales Revenue
  • Cost of Goods Sold,
  • Operating Expenses,
  • Interest Expenses ( only if the company have debt or similar), and
  • Tax Expenses.
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Net Income is very importance for the company as it tell the shareholders, investors, managements, employees, banks, investors, creditors, customers and suppliers about the company’s performance. These stakeholders will use the Net Profit to make analysis based on their own purpose. For example, shareholders and investors will use bottom line to compare or benchmark with competitors as well as others investments portfolios so that they could assess if the current company could generate the return as their requirement or not.

Employees might use the bottom line to check if the company could have enough Net Income to continue its operation so that they could secure their job.

Disadvantages:

The disadvantage of net income is that it show only the short-term performance of the company.  If this figure is factor that use by Board as the performance measurement for management team or company, it is the big risks to the company. The reason is this figure could be manipulate by accounting policies and judgement. It also motivate management to focus on short-term by discouraging in investing new assets. It also  management encouraging on reducing training expenses , research as well as development.

Example:

ABC is the company operating in the manufacturing industry and it has the following transactions for the period of 31 December 2016. Assume that all figure are correct and correctly cut-off.

Revenue $ 1,000,000

Cost of Goods Sold $ (500,000)

Operating Expense ($20,000)

Interest Expenses ($5,000)

Tax Expenses ($10,000)

What is it Net Profit of ABC for the period of 31 December 2016?

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Answer:

Well, here is the answer. Let just pick up the figure provide into the framework provide above, and here is what we have:

Based on the Net Income Formula above,

Revenue $ 1,000,000

Cost of Goods Sold ($500,000)

Equal Gross Profit $$500,000

Operating Expense ($20,000)

Profit before interest and tax $480,000

Interest Expenses ($5,000)

Profit Before Tax $475,000

Tax Expenses ($10,000)

Net Income $465,000

The Bottom Line of ABC for the period of 31 December 2016 is $465,000.

Analysis:

As we discuss above, the bottom line is accounting profit could manipulate and affect by accounting policies and management’s bias. Therefore, for better analysis, we do need the detail information not just only financial data, but also financial information like management integrity, nature of each item in the income statements as well as reasons of going up and down for specific period of times. Theses are all the main factors that we need to know and express in our analytic report on Net Income section.

For example, as we can see in the example above, Cost of Goods Sold is 50% of Revenues or 100% of Gross Profit. Cost of Goods Sold here are significantly affect by the ending balance of inventories at the end of the period, do so the ending balance of the inventories are also significantly affect by the methods how they are value and measure. Another things that we need to consider and probably the most importance is depreciation policies. For the company that is newly operate, the most of fixed assets are new; therefor, the depreciation would be large at the first years in general. Yet, this different also depending on the policies the company are using.

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Example, if the company use the straight line depreciation method, the depreciation expenses high while the first years, the machine might not be use at their best optimal. Interest expenses also high compare to Net Income and its not because of operating lost. The interest expenses might be because of might debt or financial lease that the company invest for its assets.

This article is written by Sinra