The 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 Limitations
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 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).
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.