Here I will be covering the concept of Income Statement and providing explanations on what items you can find on this financial statement and also present Sample Income Statement for a better understanding how to compose it and what information is necessary for its preparation.
The Essence Of Income Statement
Coming back to the essence of Income Statement remember that it is one of the three main financial statements, which include:
1. Balance Sheet / 2. Income Statement / 3. Cash Flow Statement.
Income Statement reflects result of business operations for the particular period of time (i.e. for month, quarter, year) and includes net result, i.e. net income (profit) or loss from these operations, and also details how this result was achieved, i.e. revenue, cost of goods sold or services provided, selling, administrative, operating, financial and other expenses.
There might be two results on the income statement, i.e.:
In case there is an excess in revenue over the expenses incurred during the period such excess is called net income or net profit.
If expenses for the period exceed revenue, such excess is called net loss.
From practical perspective it is impossible to estimate exact expenses for each separate transaction, so Income Statement provide a summary of all revenue earned and all expenses incurred during the period to earn this revenue.
While preparing Income Statement or analyzing sample Income Statement it is important to remember matching principle, i.e. revenue in the Income Statement is recognized at the moment the sale occurs despite the fact that cash is not received yet.
Expenses recognized in the Income Statement are only those which relate to the revenue earned for the period, i.e. they are matched against the revenue.
Items On The Income Statement
Generally we can say that Income Statement will include 2 main parts:
I. Revenue – gross revenue in owners’ equity as a result of sale of goods or provision of services, sale or rent of assets, lending money and other business transactions performed with the purposes to earn income. On the Income Statement the following items can be found:
Sales Revenue – revenue from the main business activities like sale of goods or provision of services;
Other Income – revenue from other activities, which are not major ones. For example rent or sale of assets if the business is not involved in asset trading or renting business
II. Expenses – costs incurred in the process of earning sales revenue or other revenue. As mentioned above matching principle applies here and only those expenses which are related to earning of revenue are recognized in the income statement. Expenses in the Income Statement are classified in the following groups:
Cost of goods sold or services provided – these expenses represent direct cost incurred while selling goods or providing services, i.e. these expenses can be directly linked to the items of goods sold or type of services provided;
Selling expenses – these expenses represent costs related to the sale of goods or provision of services. Best example can be salaries of sales force who are responsible for selling. These expenses cannot be directly linked to a particular item of goods sold or type of services provided, therefore they are included into a separate category
Administrative Expenses – these expenses represent costs incurred to earn revenue, however which cannot be directly linked to revenue and which do not represent selling activities. Examples can be salaries to accountants, office space rent and other.
Quite often you can find only one category of expenses on the Income Statement, i.e. Operating Expenses, which include both selling and administrative expenses.
Interest expenses – these expenses represent cost of financing, i.e. interest paid by the business for the borrowed money. These expenses are separated for decision making and financial analysis, since it is very important whether the business is able to earn enough profit to cover interest expenses.
Tax – in case the business is profitable it is liable to pay corporate income tax on the profit earned and this amount is included into the Income Statement.
III. Resulting Items – these items are presented for the purpose of analysis of Income Statement and represent difference between certain captions of this financial statement. The following resulting items can be found on the Income Statement:
Gross profit – difference between Sales Revenue and Cost of Goods Sold (Services provided).
Operating profit – amount which we get deducting from Gross Profit selling and administrative expenses. For financial management this figure is called Earnings Before Interest And Tax (EBIT).
Profit Before Tax – this is a difference between Operating Profit and Interest Expenses. For financial management purposes usually is called Earning Before Tax (EBT).
Net income (Net profit) – this is the final result of the Income Statement, which is the difference between all the revenue and all the expenses.
Relation Between Income Statement and Balance Sheet
In the Sample Income Statement above you can see that there is Net Income for the period. All the amount of Net Income or part of it can be distributed to the shareholders in the form of dividends. The remaining amount is transferred to the Balance Sheet Retained Earnings account, where profit not distributed to the shareholders or loss not covered by the shareholders is being accumulated. If we assume that Net Income from the above Sample Income Statement is not distributed to the shareholders, in the picture below you can how it is transferred to the Balance Sheet.