One of the primary purposes of a business is: Earning Profit or Making Revenues Or Generate Income
Profit earning is a basic purpose no matter which industry, scale, type, or form of business.
Every business entity closes its financial accounts at the end of a financial period and summarizes the results. Accordingly, the IAS 1 of IFRS has directed the business entities about preparing financial statements according to accepted accounting standards.
What is the first step of financial statement preparation?
There are five financial statements, and Income Statement is the first statement made by a company to close accounts. An income statement is the core financial statement that helps in the appropriation of a company’s profits or losses.
Out of five financial statements, three are used in both corporate finance and accounting. An income statement is a basic statement that is prepared for both fields.
This article is all about an income statement account. First, we will go through the types, formats, purpose, and parts of an income statement.
Income Statement Definition
An income statement is often called Profit & Loss Account. An income statement can be defined as,
It is a financial statement prepared by the data available in books of accounts to appropriate the profitability of a business. The income statement is prepared by subtracting all the expenses from the revenues. If the revenues exceed expenses, a firm or business entity is said to make a profit. Conversely, if the revenues are less than expenses, a company is at a loss.
The purpose of preparing an income statement is to summarize the profitability of a business. However, an income statement not only depicts the profitability of a business. It also shows how well a company is using the capital of shareholders for generating revenues. In addition, the income statement provides data for analysis to the investors for deciding their investment venture.
On the other hand, internal management uses the information to access discrepancies, make new strategies from lessons learned, and analyze their performance across different parameters. The income statement also unveils if a company can grow by capitalizing the future opportunities.
Types Of Income Statement
An income statement can be classified into different types based on the format and presentation of data. The most common types of income statements are single-step and multi-step income statements. There are other types of income statements too, which we’ve listed below.
Single Step Income Statement
The smaller organizations with fewer complex data or services businesses with no abundance of data mostly use single-step income statements. In this income statement, total revenues and expenses are subtotals, and the difference calculates the profit or loss.
Multi-Step Income Statement
A multi-step income statement is often called a classified income statement. Large organizations use the multi-step income statement to give more accurate information about each part of revenue and expenses. Multi-step income statements commonly have different steps or subtotals, including gross profit, operating expenses, and non-operating expenses.
Comparative Income Statement
When the companies prepare multi-year income statements with adjacent columns each year, it is called a comparative income statement. Mainly income statement is represented in this form when management wants to compare the year-over-year change of income.
Condensed Income Statement
A condensed income statement is like a summary of an income statement. First, the standard income statement is shrunk by picking classification of data. For instance, the cost of goods sold is subtracted from revenues. Afterward, operating expenses are subtracted from operating profit to get net profit. All done!
Parts Of Income Statement
Here are the parts of an income statement. There are three broader categories in an income statement. The three parts of the income statement are revenues & gains, Expenses, Profit & Loss.
The first section of an income statement for any industry is revenue. Revenues are the proceeds from the sales of goods and services, capital gains, or interest & dividend income. A Company might have more than one source of business. Based on it, revenues are further segregated into three types.
Direct revenues are the part of the company’s revenues & sales earned by routine business activities. For instance, if a company manufactures toys. The proceeds from the sales of toys will be reported under the head of direct revenues.
Indirect revenues are generated from sources other than the core business of a company. For example, a company might have multiple income streams, and revenues other than primary operations are treated as indirect revenues.
Let’s take the example of a toy manufacturing company again. If the management has invested in shares or bonds, the interest and dividend received on this investment is indirect revenue.
A capital gain is an increase in an asset’s value due to external factors. When a company disposes of an investment, the difference between book value and sales value is treated as capital gain or a capital loss.
Expenses correspond to the expenditures that are incurred by the management for running the company’s operations. The expenses are also sub-categorized into direct and indirect expenses. Additionally, these are also called operating and non-operating expenses.
Like direct revenues, direct expenses are the expenditures incurred for the operations of a company’s primary business. The difference in terminologies is due to the type of business. For example, for a manufacturing business, direct expenses are the cost of manufacturing and selling goods. Whereas, in the retail industry, inventory costs and other expenses of operations are called operating expenses.
Following expenses are generally recorded under the head of direct expenses:
- Cost of goods manufactured
- Inventory costs
- Marketing cost
- Insurance cost
- Rent of building
- Cost of depreciation
- Transportation cost
Non-operating expenses are the expenditures of a company for any purpose other than the primary operations of the business. An example of non-operating expense is currency exchange costs or interest payments.
Following items are recorded under the head of non-operating expenses:
- Interest expense
- Unusual costs arising from any accident
- Currency exchange costs
Profits are the net financial benefits earned by a company after paying all the direct and indirect costs incurred. A company’s profit is also sub-categorized according to the exclusion of expenses at each stage.
Gross profit is the difference between a business’s sales & revenues and the cost of goods sold/direct costs. Gross profit is the amount of income after paying the direct expenses or costs of goods sold.
Operating income is often called EBIT(Earnings before interest and tax). Operating income is calculated by subtracting all the operating costs from the gross profit. This is the income available to the company before deducting non-operating costs, interest, and tax.
Net profit is the residual income after deducting all kinds of expenses, non-operating costs, tax, interest, or any discontinued operations expenses.
There might be another step of EBT(Earnings before tax) or Pre-tax income. It is calculated by deducting interest from the operating income.
Earnings Per Share
Earnings per share are calculated by dividing the net income by the total number of shares available. Thus, earnings per share is an important measure often analyzed by investors for assessing the attractiveness of investment opportunities.
Format Of Income Statement According To Industry
The income statements are different across varying types of business industries and the nature of business. We have discussed the most common business types and how income statement differs in each of the classes.
A manufacturing business is involved in the manufacturing of a specific product or range of products. Therefore, a manufacturing company must deal with many inventories(raw material, unfinished goods, finished goods), direct labor, and factory overhead costs.
The profits of manufacturing companies are earned by converting raw materials into finished goods by incurring labor and FOH costs. The finished goods are sold at a price including profit margin and the cost of production.
In a manufacturing business, a multi-step income statement is prepared. Besides, the cost of goods sold is calculated before preparing the income statement for a manufacturing concern.
A retail or merchandising business operates in buying and selling finished goods. In the merchandising business, the retailer sells the goods at a price comprising purchase cost and markup. There is no cost of manufacturing involved in the retail industry. Therefore, a Profit and Loss Account is prepared for a merchandising business. The cost of goods sold comprises of:
- Purchase Price
- Octroi And Clearing Charges
In a retail business, there is a lot of competition. Therefore, you might observe the following things in an income statement of merchandising entity:
- Low gross profit
- Operating expenses are large
- Account receivables are high due to credit sales
Services are intangible, and there are no or deficient inventory requirements in a services business. Therefore, the income statement of a services firm is simple, and there are almost no complicated adjustments. Significant operating expenses include professional charges/consultancy costs, software expenses, stationery, traveling costs, etc.
In this article, we’ve discussed different parts and types of an income statement account. We also discussed how income statements vary across different business types.