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The income statement is one of the three major financial statements that all publicly held firms are required to prepare annually. It provides a record of a company's revenues and expenses for a given period of time, and thus serves as the basic measuring stick of profitability. In fact, the income statement is often referred to as the profit-and-loss statement, with the bottom line literally revealing which result a company achieved. Along with the balance sheet and cash flow statement, the income statement provides important financial information to business managers, investors, lenders, and analysts.
"The income statement is simply a scorecard that summarizes the revenues and expenses of an organization for a specific period of time," Jayson Orr wrote in CMA Management. "It reveals critical information about the operations and profitability of a business unit. It also reveals little secrets that may not be so obvious. In short, the income statement tells how successfully a business unit is fulfilling its prime directive—to generate profit."
Preparing an income statement is one of the basic responsibilities of the accounting function. Accounting is the process of recording and disclosing the financial information for a company so that operating results can be known and comparisons between different years and different companies can be made. Accounting has been described as the language of business. Because managers of all organizations use accounting information, perhaps on a daily basis, it is critical that they understand the language. One of the obstacles to the best use of accounting information is that its terminology is confusing, especially when some of the terms used in accounting have alternate meanings in other business settings.
One of the purposes of this essay is to provide logical definitions for key business terms from an accounting perspective; thus avoiding misunderstandings from applying an inappropriate definition. A second purpose is to describe the contents of the typical income statement prepared for a profit-seeking corporation.
ACCRUAL ACCOUNTING VS.
CASH BASIS ACCOUNTING
An area of confusion for many people is the concept known as accrual accounting. When individuals and small companies spend money, the expenditure is generally considered to be an expense. This is what accountants refer as the cash basis of accounting. But larger companies, particularly publicly held corporations, are required to use the accrual basis of accounting. From the accrual accounting perspective, the purpose of the expenditure determines whether or not the expenditure is an expense at the time of payment. For example, if a business expends cash for office supplies, no expense occurs until the office supplies are used in business operations. The spending of cash is not the critical event. Thus, when a business buys postage stamps, it has purchased an asset, that is, an item that has a future potential to benefit the company. If the stamps are used to mail an invoice to a customer or supplier, then the expense occurs because the stamp (asset) has no further benefit for the company.
The same logic would apply to other expenditures wherein a company acquires an asset that offers future benefits on a long-term basis, such as a delivery truck. Identifying when the benefit occurs, and therefore when the expense occurs, is a more difficult task in this instance, and the point will be discussed later as the concept of depreciation. One unique aspect of an expense is that expenses are incurred in order to produce revenues.
The concept of revenues also proves confusing to some people. Revenues can be defined as the amount charged to customers for the services and products that are provided to them. When employees receive paychecks, they consider that they have earned their pay at that time. The paycheck represents the completion of labor for the previous work period. For a company that uses accrual accounting, however, the receipt of payment is not the critical event for determining when revenues have been earned. From an accrual accounting perspective, a company generally earns revenues at the time when a product or service is provided to the customer. Thus, whether a customer pays for the purchase of a product or service with cash (or check) or charges the purchase on a credit card, the company earns revenue when the product or service is provided. This concept is complicated because revenue is earned, and yet no cash might be paid to the company at the time that accounting says that revenue is earned. Using the paycheck example, employees
actually earn their pay on a daily basis as they perform services for their company, but they do not receive payment until payday.
To merge the two concepts of revenues and expenses together, consider a rule accountants refer to as the matching principle. This rule can be summarized as follows: revenues are recorded in the time period when earned and expenses are matched (offset) against the revenues in the same time period that they cause revenues to be earned. More formal definitions can be summarized as follows: revenues can be defined as the total amount earned from providing goods and services to customers. Revenues are equal to (measured by) the amount of cash or legal claim to receive cash or other items of value to be received at a later date in payment from the customer. The receipt of payment might occur immediately or it might occur, say, 30 days after the invoice's date. In either case, the revenues are earned when the service or product is provided, not necessarily when the cash is received.
Expenses can be viewed as representing the use of the benefits that an employee or asset provides; the payment for the asset or services might or might not occur at the same time that the benefits are used. The important thing to remember is that expenses are incurred, and therefore matched with revenues, in the period in which the company earns the revenues.
THE INCOME STATEMENT
The income statement is considered by many to be a company's most important financial statement. It discloses the dollar amount of the profitability for a company during a specific period of time. Since published annual financial statements usually cover a 12-month period, which will be the assumption here.
The heading of the income statement should contain three crucial elements of information: the name of the company involved, the title of the statement identifying it as an income statement, and the specific 12-month period during which the income was earned. The basic format of the income statement is represented by the following equation: revenues minus expenses equal net income.
The income statement discloses total revenue and total expenses for the period in question. The amount of the revenues in excess of the expenses is the net income, or profit, earned by the company for the year covered by the statement. Notice that revenues are considered as a total or gross concept, whereas profit is considered a net concept, as in net income. Revenues represent the total amount that products and services are worth; expenses represent the amount that products or services cost the company; and the excess of the revenues over the expenses is the profit.
Consider a simple example: say that a company sells automobiles for profit. The company buys a car for a cost of $20,000 and sells it for $30,000 in revenue. Ignoring expenses other than the cost of the car, the profit can be determined by taking the $30,000 in revenue minus the $20,000 in expenses (the cost of the car), giving a figure of $10,000. If the total of all such sales for a year are shown and all related expenses incurred in that same year to produce the sales are deducted, the result is an income statement.
There are two basic formats of the income statement. The one summarized above is known as the single-step income statement, used by many service companies. All revenues are disclosed at the top of the statement, followed by all expenses of the company for the same time period. Some companies prefer to disclose their income tax expense after having deducted all other expenses from the revenues, since it doesn't relate directly to operations of the company, as do the other expenses. Net income is the bottom line, just as the expression says. However, for a company that is a corporation, an amount that is roughly the net income earned per share of corporate voting stock is disclosed last. This figure is entitled earnings per share, and when tracked over time it is used widely as an indicator of corporate performance from period to period.
The other format for the income statement is known as the multiple-step income statement. Its form is somewhat more complex; its purpose is to disclose in more detail certain relationships that many users of financial statements consider important. An abbreviated version of the multiple-step income statement is shown in Table 1.