To present financial position for a period to public, companies prepare financial statements. It has four main parts: the balance sheet, income statement, cash flow and retained earnings / shareholder’s equity.
In this article, we will be looking at the income statement: what it is, how its prepared and what is its purpose.
Income statement is the first thing prepared by the company as all others are dependent on it. For instance, without net profit, you can’t prepare balance sheets, shareholders equity and cash flow.
Its also known as statement of operations or profit and loss account or P&L. Income statement of a company shows how much it earned or lost during the financial year by reporting total revenues and expenses for a period, generally a quarter or year. Its basically, summarizes the earnings generated by a company during a particular period of time. The bottom line is net profit or net loss for the period.
This means it reports profitability of the business by summarizing revenues and expenses of a business over a period of time, usually either for 3 months or one year. You can also define income statement as a summary report of the revenue, expenses and net profit of a business entity for a specific period of time.
It has two major sections: revenues and expenses. The basic equation to measure profit or loss of a business is as follows;
Net profit or loss = Total Revenues and gains – Total Expenses and losses
To find out net profit, first you have to list revenues, second list the expenses. Now subtract total expenses from total revenues to get net profit/loss. If the resulting figure is positive, it means your company earned profit. A negative number indicates that the company has earned loss, expenses exceeded revenues.
Instead of calculating net profit or loss by using above mathematical formula, companies prepare income statement in a summarized way to show how much revenue the company has generated during a period and what cost it has incurred in connection with generating that revenue.
In simple term, profit and loss account is an accounting statement that summarizes company’s sales, the cost of goods sold, indirect expenses incurred and profit or loss over an accounting period.
Net profit after paying dividend is transferred to retained earnings.
Income Statement or profit and loss account of a company answers three basic questions to all stakeholders:
- How much money came in? – Total Revenue
- Where did the money go? – Total outflow including direct and indirect expenses
- how much money left? – retained earnings
Components of Income Statement
A company publish its income statement according to the prescribed format of the country in which it operates. It shows all the incomes and expenses according to the applicable rules and regulations. However, in all of these, you will find following major heads;
Revenue or Gross Receipt from business
The first item you see in the income statement is the Revenue. Revenue means the total amount to be received from customers in return of selling goods and services. This means, if you are seeing total revenue in the income statement of an accounting year, then it means the company has incurred that much money in that accounting year by selling it’s products or services to customers. Revenues are inflows to the business from providing goods and services to customers.
Revenue is not always reported as “total revenue”. Depending on the type of business, it’s sometimes reported as net sales, income from business or gross receipts. It’s also called as top line by investors.
Expenses shown against revenues in an income statement are the costs incurred by the company to generate revenues. Costs or expenses can be categorized to three major type: cost of goods sold, general and administrative expenses and other items.
Cost of goods Sold
Cost of goods sold means the direct cost that a company has incurred in production to sale goods. It includes, cost of materials used for production, manufacturing overhead and direct labour cost.
Its shown in the Income statement of manufacturing, wholesaling and retailing company as these companies are buying raw material to either produce finished goods or for resell.
In case of service industries, such as information technology companies, financial services providers, you will not find cost of goods sold in P&L account.
It’s also termed as cost of sales or cost of goods consumed or COGS. Its deducted from the revenue recognized by the company to give you gross profit. Gross profit shows whether a company sold its goods and services for more than the cost they incur to produce it.
Operating expenses shows how much money a company has incurred to run it’s business this year or quarter. All indirect expenses such as selling, general and administrative expenses, travel, rent, interest on loan and depreciation are listed in this section.
Earning before tax
As the name indicates, this is the profit amount that a company has made before paying income tax to the government. Its also known as operating profit or Earnings before interest and tax (EBITA).
Net profit or loss
The difference between total revenues and total expenses is net profit or loss. If revenues are greater than expenses, the difference is net profit. Similarly, if expenses are greater than revenues, the difference is net loss.
Net profit or loss is always reported at the bottom of the income statement. It often referred as bottom line of the company.
Earning per share
The bottom line of a income statement is known as net income or loss for the period. Net profit or loss is calculated by deducting total expenses out of total revenue or gross receipts. If you divide net profit by the average number of outstanding shares, you will get EPS or earnings per share.
You will not find gross profit, which is sales minus cost of goods sold, in income statement as it’s generally not reported. If an organisation is following multi-step format for reporting, then they will show it in Income Statement. From gross profit if you deduct operating expenses and taxes, you will get net earnings.
Company in its income statement, matches the revenue earned from selling goods and services against all the costs incurred to operate it. It’s always published for a period. This means if you are preparing an annual report, the income statement in it should be for the whole year. Similarly, for a quarterly report, p&l account should be for the quarter.
Company for it’s internal purpose can also prepare income statement for a month or for some other period.
Please note, retained earnings in the income statement is the amount of earnings retained during the period, whereas in balance sheet its the record of accumulated earnings less dividend paid since inception of the company.