The income statement of a business, also known as the statement of profit or loss. It is among the five key financial statements for businesses. The other four are the balance sheet (also known as the statement of financial position), the statement of owners’ equity (also known as the statement of changes in equity), the cash flow statement (also known as the statement of cash flows) and the Notes to the financial statements.
Each of the key financial statements of business gives different information about the business. The Balance Sheet of the Business shows the financial position of a business at any time.
It represents the total assets, owners’ equity (or shareholders’ equity), and total liabilities of a business.
The statement of owners’ equity gives information about the changes in the capital of owners of the business and any profits or losses of the business.
The cash flows statement gives an overview of the cash position and movements during the period of the business. Notes to the Financial Statements give extra information about the business and the other financial statements.
The financial statement that gives the main information about the performance of the business is the Income Statement.
The company could has option to income statement either using nature or by function template.
In this article, we will discuss about preparation of income statement using nature template.
But, before moving the detail of this, let talk about the key information that income statement show to the user first.
Income Statement
The Income Statement of a business, also referred to as Statement of Financial Performance, is the main indicator of the performance of a business.
The Income Statement is used by the owners and any other stakeholders of the business to determine whether the business is profitable or not.
The performance of a business in its Income Statement is demonstrated by two key figures. The Gross Profit and the Net Profit.
The Income Statement of the business is prepared for a specified period. It is prepared either quarterly, semi-annually or annually.
Unlike the Balance Sheet and Statement of Owners’ Equity of a business, the Income Statement does not carry over any balances from previous years or carry forward any balances to next year’s Income Statement.
The Net Profit (or Loss) calculated in the Income Statement is carried over to the Accumulated Profits (or Losses) in the Equity portion of the Balance Sheet of the business.
1) Gross Profit
The Gross Profit of the business is the profit that the business makes purely due to its business operations.
It is the profit that the business makes on the sale of goods or services without taking into account any additional overheads. Therefore, the Gross Profit is a key indicator of the performance of the business.
To calculate the Gross Profit of a business, its total production expenses are subtracted from its total revenues for the specified period.
The production expenses of the business are all expenses of the business that are directly attributable to the generated revenues of the business for that period. This is also known as the Cost of Sales or Cost of Goods Sold of the business.
The Gross Profit of a business can be calculated using the formula below:
Gross Profit = Revenue – Cost of Sales (or Cost of Goods Sold) In the Income Statement of a business, the gross profit is often presented as following:
2) Net Profit
The Net Profit is the overall profit of the business. This is calculated by taking all the expenses of the business and subtracting them from the revenues for the period. The Net Profit shows the overall profitability of the business.
The Net Profit of a business can be calculated using the following formula:
Net Profit = Revenues – All expenses (Cost of Sales + Other Expenses)
The Net Profit of a business is calculated after the Gross Profit of the business is calculated. Therefore, the Net Profit of a business can also be calculated using the following formula:
Net Profit = Gross Profit – Other Expenses (All expenses – Cost of Sales) The Net Profit of a business is presented as following in the Income Statement of the business:
3) Expenses
The expenses of a business must be calculated after every specified period to calculate the Gross Profit and Net Profit of the business.
The types of expenses incurred in business differ according to the nature of the business. For example, machinery repair expenses will not be borne by a services-based business like schools.
When presenting expenses in the Income Statement of a business, they are generally grouped together. This is because a typical business can have many types of expenses.
This is done to present a better Income Statement for stakeholders to easily understand. For example, all expenses related to labor costs may be grouped together under one heading “Salaries”.
When it comes to grouping together expenses, there are two methods to choose from for businesses. Businesses may choose to group together their expenses in the Income Statement either by the nature of the expense or the function of the expenses.
Presenting Expenses in Income Statement
The financial statements of a business are prepared to satisfy the needs of different stakeholders for information regarding the activities of the business.
These stakeholders may range from the owners of the business, who are the main stakeholders of any business, to the management, employees, customers, or suppliers of the business. The stakeholders of a business may also include the government or the general public.
To satisfy the needs of these stakeholders, information about the business is provided in the form of financial statements.
The stakeholders then use the information provided in these financial statements to make different decisions about the business. For example, the owners of the business may use the information to make decisions about further investments in the business.
Since a variety of stakeholders make decisions based on the information provided in the financial statements of the business, it is important that the information is provided in an understandable way.
That is why standards exist to provide guidelines about how the information should be presented.
When it comes to expenses in the Income Statement, the standard dictates that expenses should be grouped together.
Furthermore, it dictates that these expenses should be grouped either by the nature of the expenses or their function.
The standard does not specify which method should be used by businesses but rather gives them the option to choose based on the business’ management decision.
The standard dictates that the management can choose any method they deem will provide the most reliable and relevant information to the business’ stakeholders.
The management of the business also take other factors into mind when deciding on which method to use.
These include the historical factors of the business, industrial factors of the industry the business operates in, and the nature of the business itself.
Presentation by Nature
Grouping expenses and presenting by nature isn’t common practice among businesses globally. However, in some European countries such as France, it is common to present expenses in the Income Statement of business by their nature.
For example, instead of presenting expenses as Cost of Sales, Administrative Expenses, Marketing Expenses, etc. (presentation by function), they are presented as Utilities, Repair and Maintenance, Depreciation, Salaries, etc.
Presenting expenses by their nature eliminates any judgement on the management’s part. In functional presentation, expenses that are not attributable to a specific function are split and apportioned based on the judgement of the management.
This judgment can easily be manipulated by the management to show better performance in certain areas of the business.
For example, since Depreciation is no longer presented by function, the need to apportion it to different functions is eliminated.
The presentation of expenses by their nature is also easier to prepare for businesses. Therefore, many small businesses prefer this method over the functional presentation of expenses as it is cost beneficial.
This presentation is also the basis for the preparation of single-step income statements. In the single-step income statement, instead of calculating Gross Profit and Net Profit, all expenses are subtracted from the revenues of the business directly to reach the Net Profit of the business.
This presentation can also have many other uses for businesses. For example, presenting and grouping expenses by their nature can be useful forecasting future cashflows of the business.
Example
A business, ABC Ltd. has generated revenues of $2 million for the year ending 2019. It’s expenses, by nature are as follows:
The tax expense calculated by the management of ABC Ltd. is $35,000.
The Income Statement of ABC Ltd. can be prepared as follows:
Conclusion
Income Statement is one of the five key financial statements for businesses. The Income Statement of a business is an indicator of the financial performance of the business for a period.
This performance is demonstrated in the form of calculation of profit of the business in the Income Statement.
The profit of the business is calculated by subtracting the expenses of the business from its revenues for a period.
The expenses in Income Statement can be presented by their nature or their function. Unlike functional representation, the natural presentation of expenses does not require expenses to be allocated and apportioned between different functions.
