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Key Takeaways
- The Income Statement is a financial statement that shows information about the company’s income and expense items and its financial performance over a period of time.
- A favorable financial performance during a period results in a net income where total income exceeds total expenses. On the other hand, an unfavorable financial performance results in a net loss where total income is less than total expenses.
- Information in the income statement can be presented in either the nature of expense method or the function of expense method.
Introduction to the Income Statement
The Income Statement, also called a Profit or Loss Statement, is a financial statement that gives a detailed information about the financial performance of an entity over a period of time.
The Income Statement, also called the Profit or Loss Statement, is one of the main financial statements that you’ll need to prepare for your company on a regular basis. This is a report that summarizes your company’s income and expenses over a period of time.
Below is an example of an income statement.
To put into perspective, the income statement can be compared to a video clip of the financial performance of your company, captured over a certain period of time. This period of time can be an accounting period of one year, six months, three months, or one month.
What is Financial Performance? It refers to the results of your company’s operations and profitability during a period. It is a measurement of how your company has efficiently and effectively used its resources for its operations. Operations are the activities of your company that encompass the purchasing, producing, selling, delivering, servicing, and administrating activities.
The income statement will show if your company performed well financially during a period. Financial performance will result in either a net income or a net loss.
Net Income is a favorable financial performance where total income exceeds total expenses. Net Loss is an unfavorable financial performance where total income is less than total expenses.
Budget and Income Statement
What is a budget and how does it differ with an income statement?
A Budget is a report that you can prepare at the beginning of a period that contains estimated amounts of income and expense items that are found in your income statement. It is used to forecast the income and expense items that your company intends to generate and incur over the course of an accounting period.
Think of the budget report as an important planning tool you could use to set goals and commit resources to achieve those goals. You’ll usually prepare it before the start of an accounting period and then subsequently review it when the period ends to determine if there are variances between actual and budgeted amounts.
When setting up a budget, you can use information about your company’s past financial performances and incorporate your company’s expectations of future performance. Previous financial statements such as your income statement is a good basis in the preparation of a budget.
To make your budget preparation less overwhelming, you can break down the budgeted into smaller periods such as by month or by quarter. Then as the accounting period progresses and actual revenues and expenses are earned and incurred, you can track them down and make any necessary adjustments in your budget.
At the end of the period, you will then compare your budget report with your income statement to determine and analyze any difference between actual amounts and budgeted amounts of each income and expense item. Analyzing these variances can give you important information that could help in making decisions such as whether to increase or decrease the budget amounts of a specific income or expense item in the next budget report.
Analyzing your budget report and comparing it with actual results can also help you reallocate resources in areas that can improve your company’s operations and profitability.
Income
The income statement shows two important elements that measures the company’s financial performance. These elements are income and expenses.
Income will always be the first element that you’ll see in an income statement.
Income are increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity.
To understand this definition that was set out in the Conceptual Framework for Financial Reporting, you need to have a basic understanding of the accounting equation, Assets = Liabilities + Equity. This equation is the most fundamental concept in accounting and will guide you as you record financial transactions and prepare financial statements.
The accounting equation shows the asset on the left side while the liabilities and equity on the right side. The equilibrium between both sides should always be maintained as you continue to record transactions.
As your company earns income, either your assets will increase or your liabilities will decrease. Either way, the result will always be an increase in equity.
Equity, which is also referred to as Net Assets, is the portion of assets that is owned by the owners of a business. On the other hand, liabilities are the portion of assets that are claimable by the creditors and lenders of a business.
Every time your company earns income, the amount of equity also increases. This is manifested at the end of the accounting period when income items are absorbed by equity during the closing process of the accounting cycle.
To summarize, income can result in either an increase in assets and equity, or a decrease in liabilities and an increase in equity. However, keep in mind that the increase in equity does not include transactions related to additional investments or contributions made by the owners or holders of equity shares.
Income can be produced either by the ordinary operating activities of your business or by incidental transactions that are outside these operating activities. The difference between these two producers of income lie on regularity and frequency of occurrence.
Income that arise in the course of the ordinary operating activities of your company usually occur regularly and frequently. A common example is the revenue earned from the sale of goods and services. Other examples are interests, dividends and royalties.
Sale of goods
If your company is in the merchandising or manufacturing business, its main source of income are revenues earned by selling tangible goods or products to customers. Merchandisers buy goods and sell them at a price higher than the costs of acquiring those goods. Manufacturers, on the other hand, produce a product and sell them for more than their manufacturing costs.
The common account title used by companies that sell goods is Sales or Sales Revenue.
Rendering of services
If your company is a service-based business, your main source of income are revenues earned when you perform and render services to a customer or client. Some examples of businesses that provide services for a fee are financial institutions that sell financial services, hotels that provide lodging services, and SaaS platforms that provide software as their service.
Professional firms such as law, engineering and accounting firms are also considered as service-based businesses. Their earn professional fees from services that they offer to their clients.
The common account titles used by service providers are Service Revenue and Professional Fees.
Interests, dividends and royalties
Interests and dividends are revenues earned from debt and equity instruments. If your company mainly invests in these instruments, then your main source of operations involves interest and/or dividend income.
Businesses can also earn royalty income which are revenues earned from the use of assets such as patents and copyrighted works by others. If you’re a patent holder or a musical composer, your main source of revenues are probably royalties.
Other activities that can produce income for your company are incidental activities that are not associated with the ordinary operating activities of the business. The keyword here is incidental.
The income related to incidental transactions can be categorized as other income since they don’t recur regularly as opposed to the revenue-producing activities that we discussed above. Other income include gains earned as a result of the sale of a company asset, such as a fixed asset, for an amount that is more than the asset’s recorded value in the accounting books.
Expense
Below the income items are expenses that are deducted from revenues.
Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity.
Similar to income, the expenses that are incurred by your company also affect equity. However, instead of increasing the amount of equity like income does, expenses have the opposite effect of decreasing equity as they are absorbed at the end of the accounting period.
Expenses are necessary for your company to produce and sell goods and services. Whether you’re in a high profit margin business or not, there’s always a form of expense that you’ll have to incur every time you sell goods and services.
To summarize, expenses can result to either a decrease in assets and equity, or an increase in liabilities and a decrease in equity. Keep in mind though that a decrease in equity does not include transactions related to distribution of resources to the owners, such as in the case of dividends.
The company’s expenses are either connected to the ordinary operating activities of the business or to incidental transactions that are outside those operating activities.
Expenses that arise in the course of the ordinary operating activities of your company occur regularly and frequently. Some common examples of operating expenses are cost of sales, utilities, wages, rent, depreciation, and advertising.
Operating expenses are costs that are usually incurred by a business to sell goods or services and earn revenue in the process. In other words, for the business to operate and generate revenue, it must utilize or consume its own resources in the form of expenses.
Any expense resulting from incidental activities that are not associated with the ordinary operating activities of your business can be categorized as other expense. They are only incidental and are not incurred regularly.
Other expenses include losses as a result of selling a fixed asset for an amount that is less than the asset’s recorded value. Another example is casualty loss resulting from disasters such as fire and flood.
Presentation of Income Statement Items
When preparing an income statement, you can use either the Nature of Expense Method or the Function of Expense Method to present information. Your choice between these two methods depends on historical and industry factors and the nature of your company.
However, the International Accounting Standards (IAS 1) does not prescribe any method of presenting the income statement items for as long as the selected form will make the presentation of your company’s financial performance reliable and more relevant.
Nature of Expense Method
The Nature of Expense method can also be referred to as the Single-Step Income Statement. Under this form, you aggregate expenses according to their nature rather than to their functions within your company.
If your company has simple operations that don’t require the preparation of detailed income statements, then you can use the nature of expense method. This form of income statement is also used by many service-based businesses because their income statements do not have cost of sales.
This method is simpler to apply because the allocation of expenses according to functions is not necessary. Managers use this format for internal purposes because of the ease of preparing and analyzing it.
Below is an example of an income statement prepared using the nature of expense method.
The natural form lists all revenue items together under the heading Revenues, or Revenues and Gains. Expense items are grouped together under the heading Expenses, Expenses and Losses, or Costs and Expenses.
In the above income statement, observe that it shows a single step of deducting the total expenses from the total revenues to arrive at the net income or net loss. This results to only one line of income at the bottom.
Function of Expense Method
The Function of Expense method can also be referred to as the Cost of Sales method or the Multi-Step Income Statement. Under this method, you’ll need to classify your company’s expenses according to their function as part of cost of sales, distribution costs, administrative costs, and other expenses.
- Cost of Sales (Cost of Goods Sold) – the cost of the merchandise or finished goods that are sold by a merchandiser or manufacturer, respectively during an accounting period. This is deducted from the net sales to compute for the gross income.
- Distribution Costs (Selling Expenses) – costs incurred for the marketing, selling and delivery of goods and services. Some examples of distribution costs are sales commissions, advertising expenses, delivery fees, and marketing expenses.
- Administrative Costs – costs incurred to support the administration and proper functioning of the business. They include overhead costs and operating expenses that are not directly related to the production and distribution of goods and services. Some examples are salaries of office personnel, depreciation of office fixed assets, bad debts or doubtful accounts expense, office utilities, and professional fees.
- Other Expenses – expenses that could not be classified as cost of sales, distribution costs or administrative costs. These are the incidental expenses that are not associated with the regular activities of the company. Some examples are loss on sale of a fixed asset, loss on sale of an investment, and casualty losses.
The function of expense method can provide more relevant information as compared to the nature of expense method. However, allocating costs according to functions also involves additional work and considerable judgment.
If your company is in the merchandising and manufacturing business, the functional form is more appropriate because the gross income, which is an important line of income for businesses that sell products, is presented separately. Public companies also use this form of income statement to give external users such as investors and creditors more information about the company’s operations.
Below is an example of an income statement prepared using the function of expense method.
You may notice that the income statement prepared under the function of expense method presents three lines of income: Gross Income, Operating Income and Net Income. In contrast, the income statement prepared under the nature of expense method only shows a single subtraction to arrive at the net income.
- Gross Income – computed by deducting cost of sales from net sales.
- Operating Income – computed by deducting operating expenses such as distribution costs and administrative costs from gross income.
- Net Income – computed by adding or deducting the net of other income and expenses from operating income.
IAS 1 states that companies that are using the function of expense method are required to disclose additional information on the nature of expenses, including depreciation expense, amortization expense and employee benefits expense.
Statement of Comprehensive Income
The Statement of Comprehensive Income, as mentioned in IAS 1, provides for a more complete picture of the financial performance of a company compared to the income statement alone. According to the standard, a company shall present all items of income and expense recognized in a period as follows:
- In a single Statement of Comprehensive Income, or
- In two separate statements as follows:
- Income statement – a statement displaying components of profit or loss, and
- Statement of Comprehensive Income – a second statement beginning with profit or loss and then presenting components of other comprehensive income next. Other comprehensive income are income and expense items that are not included in the income statement.
If you’re preparing the financial statements of a smaller company with simple operations that doesn’t have other comprehensive income items, the income statement is sufficient enough to provide information about your company’s financial performance.
Review Questions
- What information about the company does the income statement provide?
- What is financial performance?
- How do you compute net income for both the nature of expense method and function of expense method?
- Why do investors, lenders and regulators favor the function of expense method of presenting information in the financial statements?
- What are the differences between revenue, expense, gains, and losses?
