Components of the Income Statement
Below we will discuss each section of the income statement starting with the heading.
Heading of the income statement
In addition to the name of the company and the name of the financial statement, the heading of the income statement informs the reader of the period or time interval during which the reported amounts occurred. Typical periods of time are a year, year-to-date, three months, one month, 52 weeks, 13 weeks, 4 or 5 weeks, and others.
In the U.S., the annual time periods or time intervals could be:
A calendar year, which covers the 12 months from January 1 through December 31
A fiscal year, which covers the 12 months that ends on a date other than December 31. An example is the 12 months from July 1 through June 30.
A fiscal year, which covers a 52-week period (with a 53-week period every six years). An example is a retailer whose fiscal year ends on the Saturday closest to February 1. During the year, the retailer will have 4-week and 5-week periods instead of months and will have 13-week periods instead of quarters.
Net sales is the first amount shown on the income statement of a retailer, manufacturer, or other companies which sell products. In other words, sales are generally the main operating revenues for companies selling goods.
Net sales is the combination of the following amounts which occurred during the period shown in the income statement's heading:
- Sales of goods, products, merchandise, etc. originally billed to customers
- Reductions for goods that were returned by customers
- Reductions for allowances granted to customers
- Reductions for customers paying the amount owed during a discount period
Sales are reported (recognized) on the income statement when the ownership of the goods passes from the company to the customer. In many companies this occurs before the customer pays for the goods. For example, if goods are sold to a customer in December 2020, but the customer is allowed to pay in January 2021, the amount of the sale is reported on the December 2020 income statement (and a receivable is recorded on the balance sheet at the time of the sale). When the customer's money is received in January 2021, the receivable is removed.
Sales of goods, products, and merchandise are operating revenues for a company in the business of purchasing and selling goods. (If the merchant sells its old delivery truck, the amount received is not included in net sales since the merchant is not in the business of selling trucks.)
Cost of sales (cost of goods sold, cost of products sold)
The cost of sales, cost of goods sold, or cost of products sold is the company's cost for the products that it sold during the period indicated in the income statement's heading. The cost of the sales is the dominating operating expense for companies that sell products. No other operating expense will come close to a company's cost of sales since it is often 60-80% of the net sales. Therefore, it is critical for the cost of the items sold to be calculated accurately.
The cost of sales is related to the cost of the items in inventory. If an error is made in counting or calculating the cost of the ending inventory, it is likely to cause the cost of sales, gross profit and net income to be incorrect.
A retailer's cost of sales includes the cost paid to the supplier plus any other costs to get the items into the warehouse and ready for sale. For example, if a retailer purchases a product for $300 and pays an additional $20 of shipping costs to get the item into its warehouse, the cost of the product is $320.
A manufacturer's cost of sales is the cost of producing the goods that were sold. This includes the cost of raw materials, direct labor, and manufacturing overhead related to the items sold. Determining the manufacturer's cost of goods is complicated by the need to allocate the manufacturing overhead costs.
In the U.S., a company can select from several cost flow assumptions when calculating its cost of sales and ending inventory. However, the company cannot switch cost flow assumptions more than once.
You can learn more by visiting our topic Inventory and Cost of Goods Sold.
Gross profit (sometimes shown as gross margin) is the result of subtracting the cost of sales from net sales, as shown in Example Corporation's partial income statement:
For any company to be profitable (have a positive net income), its gross profit must be greater than its selling, general and administrative expenses and nonoperating items such as interest expense.
Some people use the term gross margin to mean the gross profit percentage, which is the amount of gross profit divided by net sales. Expressing the gross profit as a percentage of net sales allows the company's executives and financial analysts to see if the company was able to maintain its selling prices and gross profit percentages. The percentage also allows a company to compare its percentage to that of its competitors. Maintaining the gross profit percentages is often difficult because of pricing pressure from other companies, higher costs from suppliers, general inflation, and more.
The gross profit percentages (or gross margins) for Example Corporation have been improving as shown by the following calculations:
- Year 2020 was 22.1% = gross profit of $880 / net sales of $3,980
- Year 2019 was 21.3% = gross profit of $800 / net sales of $3,750
- Year 2018 was 20.6% = gross profit of $700 / net sales of $3,400
Selling, general and administrative expenses
The selling, general and administrative expenses are commonly referred to as SG&A.
For a retailer, SG&A include the salaries, wages, rents, utilities, depreciation of assets, advertising, insurance, and other expenses associated with the retailer's primary activities, which are the purchasing and selling of merchandise.
[The expenses associated with secondary activities (such as the interest expense associated with its financing activities) are not included in SG&A. The interest expense and other nonoperating expenses will be shown on the income statement after the operating income is presented.]
A manufacturer's main or primary activities include both the production and sale of its products. The costs in the production of the goods are included in the cost of sales (also known as the cost of goods sold). The manufacturer's selling and general administrative expenses are reported as SG&A expenses similar to those of a retailer.
Both the manufacturer's cost of sales and its SG&A expenses are operating expenses.
Operating income = operating revenues – operating expenses
Example Corporation's operating revenues are its net sales. Its operating expenses are its cost of sales and SG&A as shown in Example Corporation's partial income statement:
Recall that the operating revenues for retailers and manufacturers are the amounts earned from its main activities including its net sales. The operating revenues of a service business are the amounts earned from its main activity of providing services.
The operating expenses are the expenses associated with earning the operating revenues and maintaining its operations. Operating expenses for a retailer and manufacturer are the cost of sales and SG&A expenses. Operating expenses for a service business are the cost of services and SG&A expenses.
Interest expense is a nonoperating expense for most businesses since financing is outside of their main activities of purchasing/producing goods and selling goods and/or providing services.
[Interest expense for a bank would be an operating expense, since the bank's main activities involve paying interest to attract deposits that can be lent to borrowers to earn interest revenue.]
Since the interest expense incurred by retailers, distributors, and manufacturers is a nonoperating expense, it is presented after operating income as shown by hypothetical amounts in Example Corporation's partial income statement:
Loss on sale of equipment
When a company sells or scraps a long-term asset that had been used in the business, the asset's cost and accumulated depreciation must be removed from the company's accounts. In its place will be the cash received for the asset.
Since the company is not in the business of selling long-term assets, the amount received is not included in its operating revenues. Instead, only the gain or loss on the sale is shown on the income statement after the operating income.
To illustrate, assume a company had purchased equipment 8 years ago at a cost of $70,000 and its accumulated depreciation on the date of the sale was $55,000. The combination or net of these two amounts is $15,000, which is known as the equipment's book value or carrying value.
If the company receives less than the book value, the difference is reported as a loss on the company's income statement. If the asset had a book value of $15,000 and the company received $10,000 the company will report loss on sale of equipment of $5,000.
You can see from Example Corporation that the loss is listed after the operating income on the following partial income statement:
[If the company had received cash of $18,000 for the old equipment with a book value of $15,000, the company would report a $3,000 gain on sale of equipment.]
Income before income taxes
To arrive at the corporation's income before income taxes or earnings before income taxes, the corporation's nonoperating revenues and expenses, gains and losses on the sale of long-term assets, and "other" items are added/subtracted from the operating income as seen in the following partial income statement:
Income tax expense
Regular corporations (as opposed to other types of U.S. corporations and entities) must report on its income statement the amount of income tax expense that is associated with the items and amounts shown on the income statement. Typically there will be differences as to when the amounts will be reported on the income statement versus the corporation's income tax return. As a result, the income tax expense shown on the income statement will not be the amount paid by the corporation for that year.
(The amount of income taxes paid by the corporation is available in the corporation's statement of cash flows or notes to the financial statements.)
After subtracting the income tax expense, the resulting amount (referred to as the bottom line) is the corporation's net income or net earnings. The net income for Example Corporation can be see here: