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Income Statement

Income Statement: One of the Five Financial Statements

The income statement is one of the five financial statements issued by a business. It reports the amount a corporation has earned during the period between two balance sheet dates. For example, the income statement often reports the amounts occurring during a calendar year, such as the year 2023.

Income Statements Report on Various Periods of Time

In the U.S., many businesses have accounting years that do not end on December 31. For example, a corporation may decide to have a fiscal year, such as July 1, 2023 through June 30, 2024. Some retailers have fiscal years of 52 or 53 weeks that end on the Saturday closest to January 31.

Financial statements for shorter periods within the year are known as interim financial statements. For example, corporations’ income statements could report the earnings for a three-month period, a 13-week period, a six-month period, etc.

Note

The income statement covers a period of time such as a calendar year ending December 31, a fiscal year ending June 30, a 52-week year, and interim periods such as three months, 13 weeks, one month, etc.

Other Names for the Income Statement

The income statement is also known by the following names:

statement of operations
statement of income
statement of earnings
results of operations
profit and loss
P&L

We will use “income statement” throughout this tutorial.

Items Reported on the Income Statement

The following items are reported on the income statement:

  • Revenues
  • Expenses
  • Gains
  • Losses
  • Discontinued operations
  • Earnings per share (required if the corporation’s stock is publicly traded)

In addition to the above items, the notes to the financial statements are considered to be part of the income statement.

Common Rules: GAAP

The usefulness of income statements is enhanced when common rules are followed. In the U.S. the rules are known as generally accepted accounting principles, GAAP, or US GAAP.

GAAP includes some very complex and detailed rules, and also some basic underlying guidelines such as:

cost principle
matching principle
full disclosure principle
materiality
…and many more.

Accrual Method of Accounting

GAAP requires U.S. corporations’ financial statements to reflect the accrual method of accounting (as opposed to the cash method).

Under the accrual method of accounting, revenues are reported on the income statement in the period in which they are earned (not in the period in which the money is received).

The accrual method of accounting also requires that expenses be matched with revenues. If a cause and effect relationship does not exist, costs will be expensed when they expire or when a cost has no future value. As a result, the period in which an expense is reported on the income statement is often different from the period in which the corporation paid out cash.

Revenues: Operating and Nonoperating

On the income statement, revenues are considered to be one of two types:

  • operating revenues
  • nonoperating revenues

Operating revenues pertain to a corporation’s main activities. For example, a retailer’s main activities are buying and selling merchandise. Therefore, the retailer’s operating revenues will include its sales of merchandise. If a corporation’s main activity is the providing of services, its operating revenues are the fees it earns. Since a bank’s main activities include making loans, its operating revenues will include the interest it earns from the loans.

Nonoperating revenues result from the peripheral or secondary activities of the corporation. For example, the interest a retailer earns on its certificates of deposit is a nonoperating revenue because investing money is not a primary activity of a retailer.

Expenses: Operating and Nonoperating

On the income statement, expenses are also considered to be one of two types:

  • operating expenses
  • nonoperating expenses

Operating expenses involve a corporation’s main activities. For example, a retailer’s cost of goods sold, the rent for its retail space, sales staff wages, advertising, etc. are all part of the retailer’s main activities of purchasing and selling merchandise. A service corporation’s rent, salaries, and the depreciation of the equipment used in providing services are just a few of its operating expenses. Since receiving savings deposits is one of the main activities of a bank, the interest it pays to its depositors is an operating expense.

Nonoperating expenses result from the peripheral or secondary activities of the business. For example, the interest expense incurred by a retailer is a nonoperating expense.

Expenses are Based on Actual Costs

The cost principle requires that expenses be based on the actual costs incurred in past transactions. For instance, the cost of goods sold is normally the actual cost of the products sold (not the products’ replacement costs or current market values).

Likewise, the depreciation expense reported on the income statement is the current period’s share of an asset’s original cost. The depreciation expense is not the current economic value being used up. For example, the reported depreciation expense on a 20-year old electric power plant is much less than the cost to replace the capacity that is being used up.

Note

The cost principle requires that the expenses reported on the income statement be the actual costs based on previous transactions. As a result, the expenses reported on the income statement are often less than the expenses based on the current costs.

Matching Expenses with Revenues

The goal of the income statement is to measure a corporation’s earnings or net income during a period of time. To do this properly, accountants must match expenses and revenues. For example, this month’s cost of goods must be matched with this month’s sales of goods.

When such a cause and effect relationship is not present, expenses are reported on the income statement in the period in which the costs expire or have no future value.

Cost of Goods Sold

The largest expense on the income statement of a business that sells goods is the cost of goods sold (also known as the cost of sales).

With the cost of goods sold often amounting to 70% of sales, it is imperative that the matching be accurate in order to report the true results of operations. Here is one technique for computing the cost of goods sold:

Cost of Goods Sold (continued)

An alternate computation is to begin with the cost of the goods purchased and then adjust it for the change in inventory.

Using the amounts from the previous slide, the cost of the beginning inventory was $50,000 but at the end of the period the cost of the inventory was $55,000. This indicates that $5,000 of the cost of the goods purchased were not sold. In other words, $5,000 of the cost of goods purchased were instead added to the inventory, thereby making the cost of goods sold $295,000.

Example

*Or, “Subtract the increase in inventory”

Cost of Good Sold (continued) 

Again starting with the cost of goods purchased and then adjusting for the change in inventory…

If the corporation’s cost of goods purchased is $300,000 but its beginning inventory had a cost of $50,000 and its ending inventory had a cost of $43,000, the cost of goods sold will be $307,000. In other words, the cost of goods sold is the $300,000 of cost of goods purchased plus the $7,000 of costs removed from inventory and sold. 

*Or, “Add the decrease in inventory”

Gross Profit

Generally, the sales revenues and the cost of goods sold are the two largest amounts reported on the income statement. The difference between these two amounts is known as the gross profit or gross margin.

Example

Gross Profit (continued)

The gross profit percentage should be monitored to be certain that selling prices are being adjusted when the costs of goods purchased is increasing.

The dollar amount of gross profit must be sufficient to cover the many other expenses such as rent, wages, utilities, advertising, maintenance, interest, etc.

The amount of gross profit will be reported as a separate line on the multiple-step income statement.

On the single-step income statement the amount of the gross profit will not be shown on a separate line. However, the reader can compute the gross profit because the amounts of the sales and the cost of goods sold are presented.

Multiple-step Format

A corporation using the multiple-step format will first report its operating revenues, operating expenses (cost of goods sold; selling, general and administrative expenses), and the resulting operating income. Next, the income statement will present the nonoperating revenues and the nonoperating expenses.

The following income statement (heading not shown) illustrates the multiple-step format:

Single-step Format

The following income statement (with the heading omitted) uses the same amounts from the previous slide but presents them in the single-step format. Note that the operating and nonoperating expenses are shown in the same section and that the lines gross profit and operating income do not appear.

Recap of Accrual Accounting on Income Statement

Below are a few highlights about the income statement prepared under the accrual method of accounting.

The sales of $400,000 means that the main activity of selling goods has been completed and that the corporation has earned $400,000. It does not mean that the corporation received cash of $400,000.

The cost of goods sold of $295,000 means that the corporation has matched that amount of cost with the sales. It is possible that the goods that were sold had been in inventory for the past five months and that the corporation had paid for the goods three months ago.

The selling, general and administrative (SG&A) expenses and the interest expense are the amounts that expired or were used in the period covered by the income statement. The corporation may have paid for them prior to, during, or after the period of the income statement.

Gains and Losses on the Disposal of Plant Assets

The income statement will also report the gain or loss that occurs when a plant asset is sold for cash and the amount received is more or less than the asset’s book value.

Examples of plant assets include the buildings, machinery, office equipment, furniture, display counters, trucks, automobiles, etc. that are used in the business.

A plant asset’s book value is the asset’s cost minus its accumulated depreciation on the day the asset is sold.

The book value of an asset is also referred to as the carrying value of the asset.

Gain on the Disposal of a Plant Asset

If a corporation disposes of one of its plant assets for cash, and the amount received is more than the asset’s book value, the difference is a gain. The gain will be reported on the income statement with the nonoperating revenues.

Here is a calculation of a gain using hypothetical amounts:

Loss on the Disposal of a Plant Asset

If a corporation disposes of one of its plant assets for cash, and the amount received is less than the asset’s book value, the difference is a loss. The loss will be reported on the income statement with the nonoperating expenses.

Here is a calculation of a loss using hypothetical amounts:

Contingent Losses and Gains

Contingent loss. If a corporation is sued, it does not automatically have a loss and obligation. (Some lawsuits have no merit.) A lawsuit is referred to as a contingent loss because it is dependent upon a future event (such as losing the lawsuit). The rule for reporting contingent losses and liabilities is as follows. If it is 1) probable that the corporation will lose, and 2) the amount can be estimated, the income statement and balance sheet will report the loss. Without both conditions being met, a significant contingent loss and contingent liability will likely be described in the notes to the financial statements.

Contingent gain. The accountant’s concept of conservatism prevents contingent gains from being reported on the income statement unless the gain is absolutely certain.

Other Unique Items Reported on the Income Statement

If a corporation is eliminating an entire division (or major segment) of its business, the income statement will remove the division’s revenues and expenses from the ongoing revenues and expenses and will report the net amount as discontinued operations.

Notes to the Financial Statements

Another important part of the income statement is the notes to the financial statements. The notes include information that is relevant to the amounts reported or not reported on the income statement and other financial statements.

The notes will usually begin with the corporation’s accounting policies such as the use of estimates, the valuation of inventory including the cost flow assumptions, disclosures for leases, income taxes, research and development costs, pensions, contingent losses and liabilities, and many more.

Earnings per Share

When a corporation’s stock is publicly traded, the income statement must also report the net income as an amount per share of common stock. This is referred to as the earnings per share or EPS. (If there are discontinued operations, additional per share amounts are required.)

The earnings per share amounts are presented on the interim quarterly income statements as well as the annual income statement.

Related Financial Statements

When the net income/earnings reported on the income statement is a positive amount, it causes the corporation’s retained earnings (and therefore stockholders’ equity) to increase. A net loss will cause them to decrease.

The amount of a corporation’s net income is one of the two parts of the financial statement known as the statement of comprehensive income. The other part is other comprehensive income (which includes a limited number of items such as foreign currency translation adjustments). The amount of other comprehensive income causes the stockholders’ equity line accumulated other comprehensive income to change. 

To see all of the changes to retained earnings and stockholders’ equity you should also read the statement of stockholders’ equity.

Since the income statement is prepared under the accrual method of accounting, it is important to also read the statement of cash flows. This statement reports the major inflows and outflows of cash during the period of the income statement.

Internal Income Statements

Up to this point we assumed that the income statement was prepared for people outside of the corporation (stockholders, lenders, etc.). It is important to note that corporations also prepare more detailed income statements that will not be distributed outside of the corporation. These are referred to as internal income statements. For example, a merchant with four stores will likely prepare an internal income statement for each of the four stores in order to plan and control each store’s operations.

The internal income statement will likely have several columns for the revenue and expense amounts. The columns will likely have the following column headings:

Actual amounts for the period
Planned or budgeted amounts for the period
Previous year’s actual amounts for the similar period

Internal Income Statements (continued)

Internal income statements are also issued more frequently than the external income statements. For example, the internal income statements are likely to be prepared monthly (whereas the external income statements will usually be prepared quarterly and annually).

The internal income statements are also likely to report budgeted amounts and the amounts from the previous year. For example, the internal income statement for March 2024 might present revenues and expenses as follows:

Actual amounts for the month of March 2024
Actual amounts for the month of March 2023
Planned or budgeted amounts for the month of March 2024
Actual amounts for the three months ended March 2024
Actual amounts for the three months ended March 2023
Planned or budgeted amounts for the three months ended March 2024.

Internal income statements (continued)

For the internal income statements to be useful for management’s planning and control of the business, they will also contain many more lines of detail than the income statements distributed outside of the corporation.

For example, a corporation’s internal income statements will often report expenses by department (marketing, selling, procurement, human resources, accounting, etc.) as well as the revenues and expenses for each store, product line, territory, division, etc.

Percentages, Ratios, Industry Averages

It is helpful for the managers of a business to see key amounts also expressed as a percentage of sales. Hence, the internal income statement will not only report amounts, but will also report a percentage next to each amount. The percentage will be the amount divided by the amount of net sales. The managers can then compare the percentages to earlier periods, to industry averages, and perhaps to competitors (if their stock is publicly traded).

Lastly, some of the income statement amounts should be compared to their related balance sheet amounts. For example, a corporation’s annual cost of goods sold should be compared to the average inventory costs reported on the balance sheets during the year.

The End

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