The business entities prepare the financial statements to conclude their financial transactions of a complete period. The financial statements are prepared by the management of the company and have many uses. The external stakeholders use the financial statements to make decisions about investment in the company, giving credit, signing a contract, etc. The internal stakeholders of the financial statements are the managerial employees themselves.
The information in financial statements summarizes the company’s performance and helps implement different strategies to improve profitability and efficiency. There are five types of financial statements that most business entities prepare at the end of a financial period.
The four financial statements are as follow:
- Income statement
- Balance sheet
- Statement of cash flow
- Statement of change in equity/Statement of stockholder’s equity
The statements are prepared and publicly disclosed. The financial statements are also published in the annual report of the company.
In this article, we will discuss the first financial statement, the income statement. The income statement is the first statement that a business entity prepares to summarize the business operations and report the net income.
What Is An Income Statement?
An income statement can be defined as,
In accounting, the income statement is one of the primary financial statements that every business entity prepares for recording its net earnings. The income statement of a business entity summarizes the expenses and revenues to find the net profit or loss during a specific financial period. In other words, the income statement gives an overview of the company’s overall performance.
There are different names for income statements that are used across different types of business entities. In the retail companies, the trading and P & L accounts summarize the net income. The manufacturing concerns prepare costs of goods sold statement to find the expenses and summarize it in the income statement. Some business entities might prepare it with the name of ‘statement of earnings, statement of operations, profit and loss statement, etc.
Regardless of the name, an income statement reports the net income of the business entity. It reports the income after the payment of taxes and interest on the debt. If the revenues exceed the expenses, the result is net profit and vice versa.
Three Essential Elements Of Income Statement
If we analyze an income statement, there are three essential elements of the income statement: revenues, expenses, and net profit/loss. We will discuss each one in detail.
Revenues are the sales proceeds of the business entity during a financial period. The revenues can also be explained as the amount the business entity receives by selling the goods or services to the customers or clients. In the income statements, revenues are often recorded with the title sales or service revenues.
What Is Included?
The revenues of the business entity are recorded by making adjustments related to returns, volume, etc. Therefore, the following items are adjusted and included in the revenues of a business entity.
Gross Revenues: Gross revenues are recorded, showing the total amount received by selling the goods and services. The gross revenues are calculated by multiplying the number of units sold with the selling price per unit.
Returns/Defective Goods: Any business entity cannot claim all the sales made as to the company’s revenue. The reason is that a customer often might return the product due to a defect or change of decision. Any returns are also recorded and subtracted from the gross revenues.
Net revenues are recorded in the income statement as the balance of subtracting returns of defective goods from the gross revenues. The value of net revenues is used for further calculation of the net income or loss.
The expenses are subtracted from the revenues to determine the net income or profit. The expenses are the costs incurred by the business entity for continuing the business operations. In other words, expenses can be defined as the cost of business revenues. The business entity must pay expenses to keep the operations continuing.
The expenses can be sub-divided into different types based on nature. The most popular segregation of expenses is direct and indirect expenses. However, the expenses can also be sub-divided as operational expenses, manufacturing expenses, and administrative expenses.
Direct and Indirect Expenses
Direct expenses are the costs incurred by the company that is directly related to the core business operations. The direct expenses are usually related to the procurement of raw materials, manufacturing, labor, etc. The description of direct expenses varies from services
businesses to manufacturing companies and retail business entities.
On the other hand, indirect expenses are the costs that are not directly related to the core business operations of the business entity. The indirect expenses can vary from business to business. However, it does not mean that these expenses are not significant for the business entity.
The electricity bill of the manufacturing unit is the direct expense of the business entity. The raw materials, direct labor costs, etc., are also the direct expenses.
The salaries of administrative staff, telephone bills, printing and stationery, legal fees, accounting charges, carriage outwards, etc., are the indirect expenses of a business entity.
What Is Included?
The most common types of direct and indirect expenses recorded in the income statement of a business concern are as follow:
Cost of Goods Sold
The cost of goods sold sums up all the costs related to the goods sold. It can be recorded in the manufacturing concern or a retail store alike. Since the cost of goods sold is a line item in the income statement, the description of costs can vary from business to business.
For instance, the cost of goods sold for a manufacturing company will have direct material, labor, overhead costs, work in progress, etc. However, the cost of goods sold in a reselling or retail company will comprise purchases, purchases returns, transportation, taxes, imports, etc.
General And Administrative Expenses
General and administrative expenses comprise the indirect expenses that record the salaries of administrative staff, insurance expenses, traveling expenses, rents, wages, etc. Some entities might record the depreciation and amortization as a part of general and administrative expenses. However, many companies record the two expenses as separate line items.
Selling And Marketing Expenses
Selling and marketing expenses comprise the costs of the promotion of goods and services. It also includes marketing, advertising, and other costs incurred to sell the goods and services of the company.
Depreciation and Amortization
Depreciation and amortization are the non-cash expenses of the business entity that are subtracted from the non-current assets. The depreciation and amortization are recorded as expenses because the assets are used for more than one financial period.
The depreciation is calculated on the long-term tangible assets of the business entity. However, amortization is recorded on the intangible assets of the business entity.
Some companies record interest expense as a separate line item after calculation of the operating profit. The interest expense is recorded to show the interest paid by the business entity against its long-term debt and liabilities.
Taxes are the income taxes levied on the net income before the interest of a business entity. The income taxes are calculated as a percentage defined by the IRS, and it is calculated on the pre-tax income of the business entity. Taxes are deducted from the revenues of the company. Otherwise, the taxes are subtracted from EBT(income before taxes) to reach the net income.
The net income or loss of the company is the final result of a business entity’s operations. It is determined by subtracting all the expenses from the revenues of the company. If the revenues exceed the company’s expenses, the company will be in profit and report the net profit at the end of the income statement.
However, if the company’s revenues are less than its expenses, the net loss is recorded as the bottom line of the income statement. Whatever the case, the net income or loss is reported as the bottom line item of the income statement.
Example Of An Income Statement
Here is an example of an income statement to help you understand how all three elements combine to form the income statement of the business entity.
ABC Corporation Income Statement for the period ending on Dec 31st, 20XX
|(-)Sales Returns From Customers||Xxx|
|Cost of goods sold||Xxx|
|General and Administrative Expenses||Xxx|
|Income before income taxes||Xxx|
In this article, we have discussed the importance of the income statement as the primary financial statement of a business entity. Besides, the essential elements of the business entity’s income statement are also discussed. However, the description and details of each element may vary from entity to entity. The difference might be seen due to the difference in the nature of the business.
By looking at the example of the income statement, you can have a better idea of how an income statement looks.