The income statement is one of the five financial statements that report and present an entity’s financial transactions or performance, including revenues, expenses, net profit, or loss, and other P&L Items for a specific period of time.
This is also known as the statement of financial performance because it shows how the entity financially performed during the period that the statement is presenting. And It is also known as a profit or loss statement.
All of these names refer to the same statement. However, the income statement is different from the balance sheet and other statements like cash flow and equity changes since it shows only financial transactions. In contrast, the balance sheet shows the balance of accounts at the end of the period.
The important financial transactions occurring every day are reported and presented in the income statement. For example, sales revenues, cost of goods sold, gross profits, administration expenses, salary expenses, interest expenses, tax expenses, and net profits.
The income statement is generally prepared at the same time along with other financial statements by complying with financial reporting frameworks such as GAAP and IFRS. To ensure that users could analyze the current financial performance, this statement must present the current period’s financial information with its comparative period, usually the previous period.
Changing the name of the statement:
An income statement is generally and officially called the Statement of Comprehensive Income. IASB had changed this name from Statement of Comprehensive Income to statement of profit or loss and other comprehensive income.
We can interpret the new name of this statement simply as it is provided. For example, this statement contains a Statement of Profit and Loss Plus Other Comprehensive Income.
Statement of Profit and Loss report the entity’s main revenues and expenses. It is the choices of entities to consider present them by nature or function. Other revenues and expenses like revaluation gain or loss, exchange difference, and so on are recorded in the Other Comprehensive income.
The entity could choices to prepare and present its revenues and expenses in two different formats either:
- In a single statement of profit or loss and other comprehensive income; or
- In two statements: a separate statement of profit or loss and a statement of other comprehensive income.
1) A single statement of profit or loss and other comprehensive income:
The entity could decide to present its income statement in the single statement of profit and loss and other comprehensive income allowed by IASB. This statement reports the Other comprehensive income in a single statement with the statement of profit and loss. As you could see in the example below, the entity reports its profit and loss statement for the year 2017 at the top of the statement. And Another comprehensive income section is reporting after profit or loss.
Operating incomes and expenses are recorded in the profits and loss section, which non-operating incomes and expenses are recorded in the Other Comprehensive Income section in only one statement. The following is the example of a single step statement of profit or loss and other comprehensive income:
2) Multi statement of profit and loss and other comprehensive income:
Multi statement of profit and loss and other comprehensive income reports and present the profit and loss statement in the difference statement from other comprehensive income statements.
All of the operating income and expenses that occur during the period are recorded in the profit and loss statement. This statement will show the profit for the year. This profit will be forwarded to the Others comprehensive statement, which reported and presented non-operating income and expenses during the period.
The following is the example of a multi-step statement of profit or loss and other comprehensive income:
An income statement is an important statement that reports and presents the entity’s financial transactions for a specific period. Revenues’ items are generally present at the time of the statement and follow by expenses items. Net income is shown in the bottom line. The following are the importance of financial information that you could find in the income statement:
1) Sales Revenues:
This is the total amount of revenues that the entity generates in the reporting period. This information is shown at the top of the statement. For example, if the entity is selling clothes, this line will show the total amount of clothes that the entity sells in monetary during the months, quarters, or annually. Standard requires revenues that an entity earns during the period shown on the face of the income statement. Total revenues here are both revenues from cash sales and revenues from credit sales.
Lines of income or revenues are sometimes shown in the face of the income statement, and sometimes, normally when there are many different lines of income, are shown in the notes to financial statements. You can see the Note’s reference number and review the sources of income that entity is earning and the major sources of income.
You probably could see the current year’s performance compared to the previous year’s performance. Increasing revenues prove that the entity’s sales performance is performing well. And if the revenues decline, it is proved that sales’ performance is not performing competitively.
2) Cost of Goods Sold:
The cost of goods sold is a direct cost related to the sold products. These costs are the variable cost that attributes to the goods sold during the period. These costs do not include the fixed and administrative expenses for the period, and they have to be recognized consistently with revenues that we recognize.
Cost of goods sold equal to the beginning of inventories plus purchase during the period less ending inventories. Costs of goods should be increasing or decreasing consistently with the revenues fluctuation. If the trend goes in a different direction, either costs or revenues are not correctly recorded or reported.
3) Gross Profits:
This is the gross operating profit that the entity generates for the period. This amount is equal to revenues less cost of goods sold. Gross profits are reporting below the costs of goods sold. It is important information for financial information users to assess how the entity’s profitability is compared to the same kind of entities in the market. If the gross profit margin is low compared to other companies, then we can assume that the entity’s production costs are higher than the competitors. In other words, the entity does not manage its production costs effectively.
4) Operating Expenses:
These expenses are different from the cost of goods sold. Operating Expenses are the general administrative expenses that occurred during the period to support the entity’s operating activities. Those expenses include the salary of administrative staff, including sales, admin, account, financial audit, and other staff, which is not directly related to productions. Other expenses included in this line include electricity, repair and maintenance, utilities, gasoline, the bank charged, and other operating expenses.
Noted: There is a debate among different publishers that operating costs include both the cost of goods sold and administrative expenses.
5) Operating Profits:
They are the profits after eliminating the operating expenses out of the gross profits. In the example above, operating profits are equal to Profits before tax. These profits are quite important for users of financial information. People mostly use these profits to figure out the remaining amount that the company could make before paying tax and financial costs.
Especially, banks normally assess how the company could pay back their debt by assessing this number. Operating profits are not included non-operating income and non-operating expenses.
6) Finance Costs:
Finance costs are mostly related to interest expenses. These expenses are different from bank charges, and they should report separately. Yet, sometimes we report them in one line in the Income Statement because one of them is immaterial. Finance Costs could also be charged from intercompany borrowing.
Finance Costs increasing mean that the entity’s debts are increasing, and these kinds of expenses will not make the shareholders happy. The high finance costs might mean the entity’s financial strategy favorite on debts rather than equity. The entity needs to leverage financial strategy between debt-equity.
7) Income Taxes:
It is the corporate tax expenses for the accounting period. These expenses are for the hold period, and they are the difference between tax payable and tax payments. Taxes payable are the remaining amounts that the company going to pay next time. Taxes payable are recorded in the balance sheet, while income taxes are recorded in the income statement.
Income Taxes normally stay after the interest expenses in the income statement. But, they are reporting before net income. The corporate tax rate is the difference from one country to another, and it might also differ from one industry to another in the same country.
8) Net Income:
This is sometimes called net income or Net Profit. This profit is what the company deliver to its shareholder or keep for reinvesting. Because of these reasons, net income becomes the most interesting figure for most stakeholders, including shareholders, investors, bankers, creditors, suppliers, customers, and employees as well. The positive net income means the entity generates profit, and the negative net income means the entity operating loss.
Net income can be calculated by less cost of goods sold, less operating expenses, taxes, and interest expenses from Sales Revenues. Net income stays in the bottom line of the income statement.
Limitation of Income Statement
Besides providing the entity’s useful financial information to users, the income statement also has its limitation, and the users should be aware of it. Here is the limitation:
- It provides the past data of the entity. As you know, that information is past data, and it might not help users much in their decision. Most decisions need current and further data and information to ensure that the decision is not being made in the wrong direction.
- It contains only a figure. As you can see, all of this information contains only financial data and figures. It does not contain the non-financial information that might be important to the users for their decision-making.
- Financial information could influence by accounting policies. This is probably the most important point. For example, the entity’s net income for the period might be significantly changed if there is a change in accounting policy for the depreciation of fixed assets.
- The income statement is also highly influenced by the demand of top executives whose performance is based on some figure in income statements like sales revenues, gross profits, or net profits. For example, management might try to manipulate the sales revenues for the period while the actual sales are not made to the goods or services. They might also try to influence accounting policies like LIFO and FIFO to ensure the cost of goods sold amounts are increased or decreased as they want.
Disclosure to income statement:
Disclosure to the income statement is part of disclosure to financial statements, which is the IAS 1 Presentation of Financial Statements requirement. As per requirement, the entity requires disclosing all necessary information in the financial statements that matter to the users of financial statements. Those include major accounting policies, significant accounting treatment, the major change in the business, and a major change in the key management team. These things could help the users of financial statements, especially investors and shareholders, better understand financial statements.
For the income statement, certain things should be disclosed to make sure that the users get the best benefit and comply with IAS 1. Here are those things:
- Accounting Policies: Accounting policies relevant to those significant items in the income statement like revenues, cost of goods sold, and other major expenses like depreciation.
- Accounting Classification and Measurement of the significant items in the income statement.
- Component of significant items in the income statement. For example, in the income statement, we have only one line of revenues like ” Sales Revenues.” Sales Revenues are the combination of many sublines of sales revenues. For example, revenues from hotels, restaurants, gaming, etc. These concepts should also apply to other significant items in the income statement—for example, the cost of goods sold and administrative expenses.
- Intercompany transactions related to the income statement. This is very important to ensure that users understand how many business transactions the entity has with its related parties. Those related parties could be the parent company, subsidiary, shareholders, the board of directors, management team, and employee.