Any business has 5 main financial statements. These are the Balance Sheet (Statement of Financial Position), the Income Statement (Statement of Profit or Loss), the Statement of Owner’s Equity (also known as the Statement of Changes in Equity), the Cash Flow Statement (Statement of Cash Flows) and the Notes to the Financial Statements.
These key financial statements are required to be produced by businesses under the financial reporting standards, although, sometimes exemptions may apply.
The income statement is one of the most important financial reports that show the users a key entity’s financial performance for a period of time including sales revenue, cost of goods sold, gross profits, administrative expenses, interest expense, tax expenses, etc.
Entity has the option to prepare its income statement in either by present it in the form as function or nature.
In this article, we will discuss the presentation or preparation of income statement by function.
Before we discuss the detail of the income statement by function, let us discuss what is the income statement and what is the information that the income statement shows to the users.
Income Statement (Statement of Profit or Loss)
The Income Statement of a business shows the financial performance of a business for a period, usually produced quarterly, semi-annually, or annually.
The Income Statement of a business shows the owners and other important users how the business has performed in its activities for that period. This performance is judged through two key figures, the Gross Profit and the Net Profit.
The Income Statement of a business takes all the expenses of the business and subtracts them from the revenues and other incomes of the business for the period to reach the profits of the business.
When only expenses that are directly attributable to the revenues of the business, also known as the Cost of Sales, are subtracted from the revenues, the profit calculated is known as the Gross Profit of the business.
When all the expenses of the business are subtracted from the revenues of the business, it is known as the Net Profit of the business.
The Gross Profit of the business is the total profit after deducting all the expenses directly related to the revenues of the business from its revenues. The formula to calculate the Gross Profit of a business can be written as:
Gross Profit = Revenues – Cost of Sales
The net profit of the business is the total profit after deducting all expenses, whether they are directly attributable to the revenues of the business or not, from the revenues of the business. The formula to calculate the Net Profit of a business can be written as:
Net Profit = Revenues – All Expenses (Cost of Sales + Other expenses)
The Net Profit of a business can also be calculated using the Gross Profit of the business. Instead of deducting all expenses of the business from the revenues of the business, all expenses that are not directly attributable to the revenues of the business (All expenses less Cost of Sales) are subtracted from the Gross Profit.
This can be written as:
Net Profit = Gross Profit – Other Expenses (Expenses that are not Cost of Sales)
As demonstrated above, the expenses of the business must be deducted from its revenues to reach its Gross Profit and Net Profit. Businesses have different size of expenses.
For smaller businesses, these expenses are usually in thousands while for bigger business these expenses can be in millions. Furthermore, businesses may have various types of expenses.
example, all businesses have salary expenses for their employees, repair and maintenance expenses, depreciation expenses, utilities expenses, etc. All of these expenses are aggregated at the end of the year and subtracted from the revenues of the business to reach its profits for the year.
The above expenses are classified by their nature. These expenses can also be grouped together based on the function of the business where the expenses occur. When grouped by the function of the expense, the presentation is known as functional presentation.
Presenting Expenses in the Income Statement
The main reason a business prepares financial statements is to report its activities for a period or at a specific period to its stakeholders.
The main stakeholders of any business are its owners. Other stakeholders may include the business’ management, employees, customers, suppliers, government or the general public.
These financial statements are prepared for the stakeholders to provide them with useful information on the basis of which they can make decisions.
For instance, the owners of the business use the financial statements of the business to make decisions regarding their investments in the business. The management might use financial statements to develop strategies for the business, etc.
While some of a business’ stakeholders may have financial knowledge to interpret the data provided in the financial statements of the business, the majority of stakeholders do not.
It is, therefore, the duty of the management of the business to present data in the financial statements of the business in a way that it is relevant and understandable by the stakeholders.
For the Income Statement of the business, this is achieved by presenting the expense of the business in one of two ways, as required by the standard.
The expenses of the business can either be presented by their function or by their nature.
The choice to choose either lies with the management of the business. According to the standard, the management can choose among the two options based on reliability and relevance of the presentation.
The management of a business usually take different factors when choosing between the two presentations. These factors may include, but are not limited to, historical and industrial factors and the nature of the business.
Presentation by Function
Most businesses around the world choose the option to present expenses in their Income Statements by their function.
However, the standard requires that if the expenses of the business are presented by their function in the Income Statement, the Notes to the Financial Statements should provide information about the nature of these expenses.
For nonprofit organizations, the standards dictate that expenses must be presented by their function. These expenses are reported in the Statement of Functional Expenses and Statement of Activities, two unique Financial Statements in nonprofit organizations.
These expenses are presented by their functions, usually Program Costs and Operating Costs. A breakup of the functional expenses by their nature is then provided in the Statement of Functional Expenses of the organization.
When expenses of a business are presented by their function, they are grouped together according to the activity of the business where the expenses are incurred.
Expenses that can be directly associated with a function are allocated to the function without any further calculations. However, some expenses may have to be apportioned according to the proportion of the function they are incurred in.
For example, the depreciation of a building used by the business can be split into different activities and apportioned to the related functions, such as administrative, marketing, production, etc.
Once apportioned, they are grouped together and presented in the Income Statement of the business.
This presentation of expenses allows businesses to easily calculate the Gross Profit and Net Profit for the period. This is because expenses are split according to the function of the business and, therefore, expenses directly attributable to the revenues of the business can easily be identified from other expenses.
As a minimum, this presentation requires the Cost of Sales of the business to be separately presented from other expenses of the business. This is due to the Cost of Sales being the main element necessary to calculate the Gross Profit of the business.
Furthermore, as expenses are grouped together by their function, businesses can easily trace any business functions with high expenses. This allows businesses to better control expenses by allowing them to narrow the expense down to the activity where the expense is being incurred in.
This also allows businesses to easily make budgets and check for any variances in those budgets with actual data because budgets are usually made departmentally.
This method can be easier to understand for the stakeholders of the business as this presentation is widely used.
However, the management of the business might need to make some judgements to apportion expenses to different functions.
For example, as mentioned above, depreciation may need to be apportioned between different functions. This apportionment is usually based on judgement.
A business ABC Ltd. has revenues of $2 million in the year 2019. The expenses, directly attributable to the functions are as follows:
|Raw material consumed||1,200,000|
|Production staff salaries||80,000|
|Machinery repair and maintenance||10,000|
|Administrative staff salaries||50,000|
|Marketing staff salaries||50,000|
The following are expenses that are have to be apportioned to each function:
ABC Ltd. also calculated tax expenses for the year as $35,000.
The Income Statement of the business can be presented functionally as follows:
|For the year ended 2019|
|Less: Cost of Sales||(1,470,000)|
The Income Statement of a business shows the Gross Profit and Net Profit of the business. These are calculated by subtracting the expenses of the business from the revenues of the business.
These expenses can be either presented according to their function or nature. When expenses are presented according to their function, any expenses directly attributable to the function is allocated directly to the function.
Any expenses that cannot be directly attributable to the function are apportioned to different functions based on judgment.