The income statement reports a corporation's net income for the period of time indicated in its heading. The income statement is also known as the following:
- Statement of income
- Statement of earnings
- Statement of operations
- Profit and loss statement
*The period of time could be a year, quarter, month, 13 weeks, eight months, etc.
**The earnings per share must be reported if a corporation's shares of stock are traded on a stock exchange.
***Every financial statement should inform the reader that the notes are an integral part of the financial statements and should be read for important information.
Amounts on the Income Statement
The historical cost principle means that most of the amounts shown on the income statement reflect a corporation's vast number of actual transactions that occurred with parties outside of the corporation. Most of the transactions were routinely recorded by the accounting system, but some additional amounts were included through adjusting entries.
Revenues are the amounts earned by a corporation through its main activities such as:
- Selling products. These are reported as net sales, net product revenue, revenues from net sales, revenues, etc.
- Providing services. These are likely reported as net service revenues or revenues.
Under the accrual method of accounting, revenues are reported on the income statement in the accounting period in which they are earned (and there is a reasonable assurance that the amounts will be collected). The revenues (and the related assets) are likely captured at the time that the sales invoice is prepared. At the end of the accounting period, accountants will also prepare adjusting entries for revenues that were earned but were not yet fully processed through the accounting system.
(Keep in mind that under the accrual method of accounting the term revenues is different from cash receipts.)
Expenses are the historical costs that are associated with a corporation's main business activities, and are reported on the income statement. Examples of a retailer's expenses include:
- The cost of the merchandise (or goods) that it had sold
- Sales commissions that its employees and agents earned
- Ads that ran
- Store rent
- Other costs that had occurred or were used up during the accounting period
Under the accrual method of accounting, expenses will be reported on the income statement when they are best matched with 1) the revenues, or 2) the accounting period. The following are four ways in which costs will end up as expenses on the income statement:
When they best match revenues. The cost of goods sold and sales commission expense should be reported in the same period as the related sales are reported.
When they have expired or were used. The $400,000 cost of a building that is expected to be used for 40 years will often be reported as annual depreciation expense of $10,000.
When they have no future value which can be measured. The current year's $50,000 advertising campaign will be reported as an expense on the current year's income statement. The reason is that the future value of the current year's ads cannot be determined.
When costs are too small to justify allocating them to future periods. As an example, the entire $300 cost of a paper shredder will be expensed immediately even though it is expected to be used for several years.
Gains and Losses
If a corporation disposes of an asset that is no longer used in its business, the amount received should not be included in its sales revenues. Instead a gain or loss on the disposal is recorded.
For example, if a florist sells its old delivery van, the amount received is not included in its sales revenues. The reason is its main business activities involve buying and selling floral products (not buying and selling delivery vehicles).
Hence, if a florist receives $2,000 for its old delivery van and the accounting records show that the van has a carrying value of $1,500 the income statement will report a gain on sale of assets of $500. If the florist receives only $1,300 the income statement will report a loss on sale of assets of $200.
An important metric that is available from the income statement of a retailer or manufacturer is the gross profit. Gross profit is defined as net sales minus the cost of goods sold. Therefore, a corporation with net sales of $1,000,000 and cost of goods sold of $800,000 will have a gross profit of $200,000. Its gross margin or gross profit percentage is 20% of net sales ($200,000 divided by $1,000,000).
The gross margin or gross profit percentage is monitored by the readers of the financial statements to determine if the corporation was able to maintain the usual percentage during periods when its product costs had increased. This is important because the corporation's gross profit amount must be sufficient to cover its selling, general and administrative (SG&A) expenses and to provide a sufficient amount of net income.
A corporation's net income is often referred to as the bottom line of the income statement. In other words, net income is the amount remaining after all of the corporation's expenses, gains, and losses are considered. Depending on the industry, the net income as a percentage of net sales is often a very small percentage, such as 3% to 5% of net sales.
Net Income's Impact on Retained Earnings and Comprehensive Income
The positive net income reported on the income statement also causes an increase in the corporation's retained earnings (a component of stockholders' equity). A negative net income (a net loss) will cause a decrease in retained earnings. This provides a link between a corporation's income statement and its balance sheet.
Net income is also one component of a corporation's comprehensive income. The other component is other comprehensive income, which will be discussed shortly.
Earnings Per Share (EPS)
When a corporation's shares of stock are publicly traded, the income statement must display the earnings per share of common stock or EPS.
The number of shares of common stock is the weighted-average number of common shares that were outstanding during the accounting period. Therefore, if a corporation repurchases some of its shares of stock, the number of shares outstanding will decrease and the earnings per share will likely increase.
Income Statement Amounts are History
The historical cost principle means that most of the expenses reported on the income statement are the actual costs from past transactions. For instance, the expensing of building with an actual historical cost of $400,000 and a useful life of 40 years will mean that the annual depreciation expense will average $10,000 per year. It also means that the total of the depreciation expense over the asset's useful life cannot exceed $400,000. Thus the depreciation expense will be $0 after the cost of $400,000 has been expensed. This will be the case even if the building's market value increased to $2 million or more.
This also means that in the 41st year of the building's life the depreciation expense will be $0. However, if a competitor constructs a similar building close to the 41st year at a cost of $2,000,000 the competitor's annual depreciation expense will be $50,000 per year ($2,000,000/40 years). Hence, the depreciation expense for older assets is not indicative of the economic capacity being used. (This is why accountants say "depreciation is an allocation process, not a valuation process".)
Similarly, the sales revenues reported on the income statement reflect the past selling prices and past quantities. Current and future selling prices could be higher or lower than the past selling prices.
You will find more by reading our free Explanation of the Income Statement.