Net Income – Definition

Cite this article as:"Net Income – Definition," in The Business Professor, updated December 13, 2018, last accessed October 21, 2020, https://thebusinessprofessor.com/lesson/net-income-defined/.

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Net Income Definition

Net income of a business is calculated by deducting all expenses incurred in an accounting period from the total revenue earned in that same period.

A Little More on What is Net Income

The operating costs, interests, depreciation, taxes and all other expenses are deducted from the total revenue to get the net income of a business. As the net income is written at the bottom of an income statement, it is also called the bottom line.

Net income is an indicator to measure a company’s profitability and performance. If the income taxes and interests are not deducted from the revenue, then it is called operating profit.

When accounting for an individual’s net income, taxes and other deductions are to be considered. Net income is used for calculating a business’s earning per share.

At first, the business’s expenses and operating costs are to be taken away from the business’s earnings before tax.

Then the tax amounts are to be deducted from this figure to get the net income.

Net income of a company may be calculated by hiding expenses or using aggressive revenue recognition. Thus, the quality of the numbers used for calculating taxable income and net income needs to be inspected thoroughly before taking an investment decision.

Gross income of an individual is the total pre-tax earnings and net income is calculated by deducting the taxes from the gross income.

Taxable income minus income tax is one’s net income. Taxable income is calculated by removing the deduction from the gross income. The IRS calculates the tax based on this amount.

For example, suppose an individual’s gross income is $50,000 and he or she qualifies for $10,000 tax deductions. Then, the taxable income of that individual stands at $50,000-$10,000= $40,000. Now, if his or her payable income tax is $5,000 then the net income of that individual would be $40,000-$5,000=$35,000.

At the end of a financial year, the taxpayers need to submit Form 1040 to the Internal Revenue Services. This form doesn’t record the net income, rather it records the gross income, adjusted gross income, and taxable income.

Paycheck stubs generally mention the net income of the employee. The net income mentioned is paycheck is calculated by subtracting the taxes and retirement contributions from the gross income.

References for Net Income

Academic Research on Net Income

Relative valuation roles of equity book value and net income as a function of financial health, Barth, M. E., Beaver, W. H., & Landsman, W. R. (1998). Journal of Accounting and Economics, 25(1), 1-34. In this study, predictions that pricing multiplies on an incremental explanatory power of equity book value (net income) increase (decrease) as there’s a decrease in financial health. A test was conducted using a sample of 396 bankrupt firms, and the test was based on using a larger pooled sample both that results in inferences consistent with predictions. With inclusions of controls for size, industry, return-on-equity and the volatility of equity returns, findings are robust. There are increment and multiplicity in equity book value and net income. Also, there’s variation in explanatory power across three illustrative industries, and the selection is based on the likely extent of unrecognized intangible assets.

Is comprehensive income superior to net income as a measure of firm performance? 1, Dhaliwal, D., Subramanyam, K. R., & Trezevant, R. (1999). Journal of Accounting and Economics, 26(1-3), 43-67. There is no evidence that comprehensive income is more highly associated with returns/market value; except financial firms, or better assume future cash flows oder than net income. Marketable securities adjustment is the only component of comprehensive income that improves the association between income and returns. The result does not support the assertion that comprehensive income, about firm performance, is a better measure than net income. Questions are raised based on our result about the appropriateness of items included in SFAS 130 comprehensive income and also the need for making mandatory income disclosures for all industries.

On the usefulness of operating income, net income and comprehensive income in explaining security returns, Agnes Cheng, C. S., Cheung, J. K., & Gopalakrishnan, V. (1993). Accounting and Business Research, 23(91), 195-203. The usefulness of three earnings definitions relating to operating income, comprehensive income, net income, is evaluated by this study and also reviewing residual security returns. Usefulness can be measured in the form of relative information content and increased information content. Previously, the return’s goodness-of-fit earnings relationship is in comparison to each earnings definition. The increase in goodness-of-fit recently, due to more earnings component is measured. Based on a sample run in 18 years, and averages 922 firms, the analysis explains that operating weak income dominates net income. Also, both net income and operating income dominate comprehensive income in terms of information content.

Accelerated Depreciation: Tax Expenditure or Proper Allowance for Measuring Net Income?, Kahn, D. A. (1979). Michigan Law Review, 78(1), 1-58. Attacking various provisions of the Internal Revenue Code has become fashionable since the 1950s. They have achieved this by calling them subsidies instead of proper means of measuring taxable income. Through Code provisions, these subsidies are now referred to as tax expenditures. This term was coined by Professor Stanley Surrey. The extent to which accelerated depreciation accurately reflects net income is what this paper studies.  It is done by reference to The traditional criteria against which all cost recovery method must be scrutinized. Measuring an individual’s capacity to pay government costs and the constraint that is accepted is important to our tax system

How well does net income measure firm performance? A discussion of two studies1, Skinner, D. J. (1999). Journal of Accounting and Economics, 26(1-3), 105-111.

Net income and capital depletion, Pigou, A. C. (1935). The Economic Journal, 45(178), 235-241.

Relevance of differences between net income based on IFRS and domestic standards for European firms, Barth, M. E., Landsman, W. R., Young, D., & Zhuang, Z. (2014Journal of Business Finance & Accounting, 41(3-4), 297-327. Values relevant for financial and non-financial firms are net income adjustments that result from mandatory 2005 IFRS adoption in Europe. Differences in the importance of the aggregate adjustments and also adjustments related to several IFRS standards, applicable to financial and non-financial firms across groups in the country, suggests the differences in domestic standards and institutions affect investor’s assessment of the importance of IFRS accounting amounts. In spite of these differences, investors look at net income measured using IAS except for French/German non-financial firms.

Accelerated Depreciation: A Proper Allowance for Measuring Net Income, Blum, W. J. (1979). Mich. L. Rev., 78, 1172.

The trend toward equality in the distribution of net income, Browning, E. K. (1976). Southern Economic Journal, 912-923. Data limitations as earlier mentioned, prevented making adjustments for all forms of income excluded in the Census Bureau’s definition of money income. Most probably, farm income-in-kind is far more important of these items which include fringe benefits (including imputed revenue of pension plans), and imputed revenue of housing occupied by the owner. Some capital gains and some important taxes were also ignored for this same reason. Also, there was no attempt made to allocate general government expenditures, for example, outlays on defense, police, and highways.  (The expenditures of the government that were allocated were those categorized as “social welfare expenditures” by the Social Security Administration. [11])

An investigation of the effect of differing accounting frameworks on the prediction of net income, Simmons, J. K., & Gray, J. (1969). The Accounting Review, 44(4), 757-776.

Comprehensive income and net income as measures of firm performance: some evidence for scale effect, Dastgir, M., & Velashani, A. S. (2008). European Journal of Economics, Finance and Administrative Sciences, 12(1), 123-133. This study investigates the relative ability of comprehensive income and net income. This is to summarize firm performance as shown in stock returns. The comprehensive income adjustments that improve the income ability to summarize the performance of the firm is also examined. Companies listed in Tehran’s (Iran) stock exchange is where this study is chosen from. Comprehensive income, as unsupported by the results, is superior to net income for accessing the performance of the firm based on both stock return and price. Better results were found for the state companies which shows that the performance of the firm evaluation on cash flow prediction basis using comprehensive income is higher than net income.

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