The Income Statement
Defining the Income StatementThe income statements reports the revenues, expenses, and overall net profit or loss over a given reporting period.
Learning ObjectivesDefine the income statement in the broader context of financial accounting
- The income statement ultimately provides insights on profitability through tracking revenues and the expenses incurred to gain those revenues.
- The income statement starts with revenues, which represent the overall incoming proceeds from sales of products and/or services.
- The cost of the goods sold, alongside the selling and general administrative costs, depreciation, and R&D are subtracted from those revenues as expenses.
- Non-operating items such as taxes, cost of financing, and other sources of miscellaneous revenues or expenses are calculated after that.
- This results in the net income or loss over the given reporting period. Dividing the net income by overall sales will provide the organization's profit margin.
- depreciation: The decline in value of assets.
- Profitability: The capacity to produce capital, in this context through organizational operations.
What is an Income StatementThe income statement is one of the main financial statements all publicly traded organizations around the world generate on an regular basis as a reporting tool for stakeholders and the general public. The creation and maintenance of these statements is the primary responsibility of financial accountants.
The income statement (also referred to as a profit and loss account, or a profit and loss statement) answers some core questions regarding profitability and the overall utilization of raw materials to generate revenue exceeding the expenses involved. The income statement is therefore a linear assessment, starting with revenue and ending with net gains or losses, of the overall costs of a given production process. As a result, this statement is intrinsically describing a span of operational time, and the transformation of revenues into profits or losses over that given time period.
Why They Are UsefulThe income statement is a critically useful tool, particularly for product managers, strategists, operational specialists, and investors. In short, incomes statements are useful because they demonstrate an organization's ability to turn revenues into usable cash flows (which will then be inserted into a cash flow statement on an ongoing basis). Profitability of operations is the key concept here, and it is a critical component of organizational success.
How To Create an Income StatementAs a financial accountant, understanding the inputs of an income statement is key to developing accurate and useful reports. Incomes statements can loosely be divided into the following subcategories:
RevenueAt the top, an organization should report overall revenue. The primary input here will be overall proceeds from sales, though the appreciation of assets or the acquisition of accounts receivable owed from a previous reporting period may also add to this number.
ExpensesExpenses are the overall costs of acquiring the above revenues. This can be divided into a few categories:
- Cost of Goods Sold (COGS) - All costs in material, labor, and overhead that are directly required for the production and/or manufacturing of a given good.
- Selling and General Administration (SG&A) - These costs are support costs, such as the salaries of HR staff, management, legal, accounting, marketing, and other broader corporate expenses that benefit the sale of a particular good.
- Depreciation/Amortization - Over time, fixed assets will decrease in value. This depreciation of assets is allocated as an expense over the lifetime of the assets being recorded.
- Research and Development (R&D) - Investment in the research and development of revenue-generating products will also be a business expense for the income statement.
Non-Operating ItemsOther gains or losses, such as those from rent, income, patents, foreign exchange, goodwill, etc., should be included as unusual gains or losses. Financial costs from borrowing capital and taxes due will also be included in this section. An additional section of irregular items is added if necessary (though rarely), which could pertain to changing business locations (quite costly), discontinuing operations, or other unique scenarios that need to be reported but don't fit cleanly in any given line item.
Net IncomeAfter all of the items have been added or subtracted accordingly from the starting revenue, the income statement will display the overall net income or net loss. This is where investors and stakeholders derive profit margin: net income/revenue. This margin of profitability is a useful input for the overall value of an organization's operational efficiency.
RevenuesRevenue is cash inflows or other enhancements of assets derived by delivering or producing goods.
Learning ObjectivesExplain how revenue is used to determine the health of a company
- Revenue is a calculation or estimation of periodic income based on a particular standard accounting practice or the rules established by a government or government agency.
- In general usage, revenue is income received by an organization in the form of cash or cash equivalents. Sales revenue is income received from selling goods or services over a period of time. Tax revenue is income that a government receives from taxpayers.
- Revenue is a crucial part of financial statement analysis. A company's performance is measured by the extent to which its asset inflows (revenues) compare with its asset outflows ( expenses ).
- Revenue is used as an indication of earnings quality. There are several financial ratios attached, the most important being gross margin and profit margin. In addition, companies use revenue to determine bad debt expense using the income statement method.
- Cash inflows: Cash inflows are the movement of money into a business, project or financial product.
- cash budget: a prediction of future money receipts and expenditures for a particular time period
In business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. Every time a business sells a product or performs a service, it obtains revenue. This is referred to as gross revenue or sales revenue.
In the United Kingdom and other countries, revenue is referred to as turnover. Some companies receive revenue from interest, dividends or royalties paid to them by other companies. Revenue may refer to business income in general or the amount, in a monetary unit, received during a period of time. For example, "Last year, Company X had revenue of $42 million. "
Revenue is a crucial part of financial statement analysis, and the income statement in particular. A company's performance is measured to the extent to which its asset inflows (revenues) compare with its asset outflows (expenses). Net Income is the result of this equation. Consistent revenue growth, as well as net income growth, is considered essential for a company's publicly traded stock to be attractive to investors. Revenue is used as an indication of earnings quality. There are several financial ratios attached to it, the most important being gross margin and profit margin. In addition, companies use revenue to determine bad debt expense using the income statement method.
Cost of Goods SoldThe cost of goods sold, calculated and recorded in the income statement, is a useful indicator of overall production costs and efficiency.
Learning ObjectivesUnderstand how to calculate COGS under various recording methods, and recognize the value of this calculation strategically in terms of production efficiency
- Calculated and recorded on the income statement, the cost of goods sold ( COGS ) indicates the overall production efficiency on a unit to unit basis.
- COGS is a relevant indicator of potential profitability when used as a benchmark to the consumer willingness to pay and overall price point of the goods being sold.
- COGS includes the cost of sourcing raw materials, labor directly required for production, overhead applicable to production, warehousing, and shipping.
- Various approaches can be taken from an accounting perspective in order to record and report COGS. This includes LIFO, FIFO, average cost, and specific identification.
- overhead: The expense of a business not directly assigned to goods or services provided.
- homogeneous: Having the same composition throughout.
The Importance of COGSThe cost of goods sold (COGS) is a highly relevant indicator for the health of business operations, as it is a variable cost directly applied to each item sold on a per unit basis. This calculation allows the business to see just how much it costs to source, product, inventory, manage, and distribute organizational products and services. From a general strategic point of view, the COGS when compared to the consumer willingness to pay is the key indication of whether or not the production of a certain product (at a certain volume) will yield long-term sustainable profits.
How COGS is DerivedWhen viewing an income statement, it is useful to recall that the flow of information is top-down. At the top of the income statement is overall revenues, which are immediately applied to the cost of goods sold. This initial calculation will take into account the following costs of production:
- Sourcing of raw materials, parts and supplies used
- All labor directly involved in the production, manufacturing, and delivery of the product/service, including the benefits and payroll taxes
- All overhead directly applicable to the production process (i.e. electricity to run machines, rent for the manufacturing facility, rent for the warehouses, salaries of factory management, etc.)
- All storage and warehousing of products/services, alongside the distribution to consumers (i.e. shipping, storing, handling)
In short, COGS refers to the cost of producing the good from start to finish. This does NOT include support activities such as corporate marketing, corporate HR, senior management (unless they are actively on the production floor), IT infrastructure (unless directly integrated with manufacturing) and other sales, general, and administrative costs.
Recording MethodologiesWhen applying this information to the income statement, different accounting tactics are used depending upon the situation of the organization. A few key record keeping concepts to keep in mind when approaching COGS:
First-In, First-Out (FIFO) - Under this COGS tracking method, the first items to be produced are the ones that are sent off the shelves first. Picture a smartphone manufacturer, where the first 50 cost $200 to produce and the second 50 cost $300 to produce. After selling the first 50 phones, the COGS under FIFO would be $10,000 (50 x $200).
Last-In, First-Out (LIFO) - Under this COGS method, the last items produced are the ones that are sent off the shelves first. So, to use the above example, the sale of the first 50 phones would have a recorded COGS of $15,000 (50 x $300).
Average Cost - Under this COGS method, the overall per unit production cost is averaged across the entire recording period. That is to say that the total COGS per unit will simply be the overall cost of all operations (during reporting period)/production volume (during reporting period). This is particularly helpful for homogeneous goods.
Specific Identification - As an antithesis to average cost calculations, this method tracks each individual item and prices the COGS according to its individual production process. This can be valuable when producing specialized and differentiated goods, which don't always sell at the same price or compare cleanly to one another.
General and Administrative Expenses (G&A)General and administrative non-production related costs provide a good indication of overall operational efficiency.
Learning ObjectivesUnderstand SG&A expenses and what they indicate about an organization
- SG&A expenses are expressed on the income statement under operating expenses and refer to non-production related operating costs.
- SG&A costs are (relatively) fixed, and therefore they are a useful indication of efficiency when viewed as a percentage of overall revenues.
- Key items under SG&A include salary, rent, utilities, software, insurance, and a wide variety of other administrative and overhead-related costs.
- When viewing SG&A in the context of the organization and the competition, creating efficiency in spending relative to scale of production is a primary objective.
- expenditures: Costs to be paid out. From an accounting perspective, these are credited costs on a given line item.
Why SG&A Costs are RelevantIn reporting expenses on an income statement, there are various expenses incurred that are not directly related to production. The primary reason tracking these expenses separately is so important is because they are independent of variable production volume, and as a result, their overall impact on the organization is largely fixed (as opposed to variable, per unit cost). This has some strategic implications.
How SG&A Costs are CalculatedMost of these expenses tend to revolve around indirect aspects of production. One way to picture this is to consider the supporting infrastructure around the core process: the office space (and the associated utility costs), for example, or the salaries of support staff and management. While the potential list of expenditures for this line item is extensive, the following are some common expenses incurred that would be filed under SG&A:
- Salary/Payroll (i.e. salary not directly related to variable production)
What SG&A ImpliesBy separating these expenses from the production expenses, it provides investors, management, and other stakeholders with insights surrounding the efficiency of organizational operation. Organizations with an SG&A budget that represents a high percentage of their overall expense would be assumed to be less efficient than a similar organization producing a similar amount of revenue with a lower SG&A.
For example, company A has quite a few highly paid managers and executives on their team. They also use cutting edge software to manage the production process, which has a high annual cost. They produce slightly more revenue than their close competitor, company B (20% more revenue per annum). They create a net income of 2% on an annual basis.
Company B, on the other hand, has few managers and executives and relies on a slightly slower yet much cheaper software solution for managing operational output. As a result, they make 20% less than company A each year, but their expenses are 40% less than company. As a result, the produce a net income at almost 30% of revenue.
Company A is clearly producing more volume and making bigger strategic investments in IT, however company B is leveraging their resources better in terms of profitability by minimizing their SG&A and focusing more exclusive on investing in their production efficiency.
Net IncomeNet income in accounting is an entity's income minus expenses for an accounting period.
Learning ObjectivesDefine Net Income
- Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings.
- Net earnings and net profit are commonly found as synonyms for net income. Often, the term "income" is substituted for net income, yet this is not preferred due to the possible ambiguity.
- Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings.
- Common stock: Shares of an ownership interest in the equity of a corporation or other entity with limited liability entitled to dividends, with financial rights junior to preferred stock and liabilities.
- minority interest: In accounting, minority interest (or non-controlling interest) is the portion of a subsidiary corporation's stock that is not owned by the parent corporation.
Often, the term income is substituted for net income, yet this is not preferred due to the possible ambiguity. Net income is informally called the "bottom line," because it is typically found on the last line of a company's income statement (a related term is "top line," meaning revenue, which forms the first line of the account statement). The items deducted will typically include tax expense, financing expense ( interest expense), and minority interest.Likewise, preferred stock dividends will be subtracted too, though they are not an expense. For a merchandizing company, subtracted costs may be the cost of goods sold, sales discounts, and sales returns and allowances. For a product company advertising, manufacturing, and design and development costs are included.
Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings. As profit and earnings are used synonymously for income (also depending on United Kingdom and U.S. usage), net earnings and net profit are commonly found as synonyms for net income. Often, the term "income" is substituted for net income, yet this is not preferred due to the possible ambiguity.
An equation for net income:
Net sales (revenue) – Cost of goods sold = Gross profit – SG&A expenses (combined costs of operating the company) = EBITDA – Depreciation & amortization = EBIT – Interest expense (cost of borrowing money) = EBT – Tax expense = Net income (EAT)
Sample Income StatementThe income statement displays the revenues recognized for a specified period and the costs and expenses charged against these revenues.
Learning ObjectivesExplain the uses and components of an income statement
- The purpose of the income statement is to show managers and investors whether the company made or lost money during the reported period.
- An income statement differs from a balance sheet in that it represents a period of time as opposed to a single moment.
- Income statements should help investors and creditors determine the past financial performance of the enterprise, predict future performance, and assess the capability of generating future cash flows through reporting the income and expenses.
- goodwill: The value of a business entity not directly attributable to its tangible assets and liabilities. This value derives from factors such as consumer loyalty to the brand.
- depreciation: The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.
- income statement: a calculation which shows the profit or loss of an accounting unit during a specific period of time, providing a summary of how the profit or loss is calculated from gross revenue and expenses
Income StatementsThe income statement ( profit and loss statement), is a company's financial statement indicating how revenue becomes net income. 'Revenue' is money received from the sales of products and services before expenses are deducted, also called the 'top line. ' The net income is the result after all revenues and expenses have been accounted for, also known as the 'net profit' or the 'bottom line. ' The income statement displays the revenues recognized for a specified period and the expenses charged against these revenues, including write-offs ( depreciation and amortization of assets ) and taxes. The purpose of income statements is showing managers and investors whether companies made profits or losses during those periods. An income statement differs from a balance sheet because it represents a period of time, not a single moment.
Preparing the income statement involves two possible methods. The Single Step income statement takes a simpler approach, adding revenues and subtracting expenses to find the bottom line. The more complex Multi-Step income statement takes several steps to find the bottom line, starting with the gross profit. It then calculates operating expenses which, when deducted from the gross profit, yield 'income from operations. ' The difference of other revenues and expenses is then applied to the income from operations. When combined with 'income from operations,' this yields 'income before taxes. ' The final step is to deduct taxes, which finally produces the net income for the period measured.
Usefulness and LimitationsIncome statements should help investors and creditors determine the past financial performance of the enterprise, predict future performance, and assess the capability of generating future cash flows through income and expense reports. However, income statements have several limitations:
- Items that might be relevant but cannot be reliably measured are not reported (brand recognition and loyalty).
- Some numbers depend on the accounting methods used (using FIFO or LIFO accounting to measure inventory level).
- Some numbers depend on judgments and estimates (depreciation expense depends on estimated useful life and salvage value ).
Revenue: Cash inflows or other enhancements of an entity's assets during periods of delivering or producing goods, rendering services, or other activities constituting the ongoing major operations. It is usually presented as sales minus discounts, returns, and allowances. Every time a business sells a product or performs a service, it obtains revenue, which is often referred to as 'gross' or 'sales revenue. '
Expenses: Cash outflows, consumption of assets, or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities constituting the entity's ongoing major operations.
Cost of Goods Sold (COGS) / Cost of Sales: Represents the direct costs attributable to goods produced and sold by a business (manufacturing or merchandizing), including material costs, direct labour, and overhead costs. It excludes operating costs such as selling, administration, advertising, or R&D.
Selling, General and Administrative expenses (SG&A or SGA): Consists of the combined payroll costs. SGA is usually understood as a major portion of non-production costs, in contrast to production costs like direct labor.
Selling Expenses: Represents expenses needed to sell products (salaries of salespeople, commissions and travel expenses, advertising, freight, shipping, depreciation of sales, store buildings and equipment, et cetera).
General and Administrative (G&A) Expenses: Represents expenses necessary to manage the business (salaries of officers or executives, legal and professional fees, utilities, insurance, depreciation of office buildings and equipment, office rents, office supplies, et cetera).
Depreciation / Amortization: The charge with respect to fixed or intangible assets that have been capitalized on the balance sheet for a specific accounting period. It is a systematic and rational allocation of cost, not the recognition of market value decrement.
Expenses recognised in the income statement should be analysed either by nature (raw materials, transport costs, staffing costs, depreciation, employee benefit) or by function (cost of sales, selling, administrative).
Other revenues or gains: Revenues and gains from non-primary business activities (rent, patent income, goodwill). It also includes gains that are either unusual or infrequent, but not both (gain from sale of securities or gain from fixed asset disposal).
Other expenses or losses: Expenses or losses not related to primary business operations (foreign exchange loss).
Finance costs: Costs of borrowing from various creditors (interest expenses, bank charges).
Income tax expense: Sum of the amount of tax payable to tax authorities in the current reporting period (current tax liabilities/tax payable) and the amount of deferred tax liabilities or assets.
These are reported separately so that stakeholders can better predict future cash flows: irregular items probably won't recur. They are reported net of taxes. Discontinued operation is the most common type of irregular item. Shifting business locations, stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations, which must be shown separately.