The Income Statement

 

·         The Balance Sheet shows the current financial condition of the company. (Assets, Liabilities, Shareholder's Equity)

·         The Income Statement shows the profitability of the company. (Revenues, Cost of Sales, Expenses, Net Income)

 

The Income Statement can be an annual, quarterly, or monthly report. Shows revenues and expenses. The difference is net income (profit or loss).

 

Two formats for Income Statements:

·         Single step - Simple difference between revenues and expenses to arrive at net income.

·         Multi step - Separates basic revenues and expenses into groups, then takes the difference to arrive at net income. Reveals more information than the single step method; also allows ratios to be derived for further analysis.

 

Definitions on the Income Statement:

·        Revenue - Revenues are inflows of ash, promises of cash or other items of value received for goods or services rendered.

·         Cash Basis Accounting - Transactions are recognized when cash is received (revenues) or paid out (expenses). No cash received equals no revenue.

·         Accrual Basis Accounting - Revenues are recognized as goods are sold independent of when cash is received. Important: Expenses are recognized in the same accrual period. The Accrual Basis of accounting is a superior measure of performance because expenses and associated more closely with revenues. It also prevents manipulation of performance, profits and losses.

 

To recognize revenues on the accrual basis you have to be able to answer "yes" to the following three questions:

·         Is the earning process complete (was the good or service delivered)?

·         Was there an exchange between two parties?

·         Will you be able to collect the cash?

This process is called revenue realization.

 

Cost of Goods Sold (also called Cost of Sales):

·         Used by manufacturing businesses or retail establishments.

·         COGS for retail is the value of the beginning inventory and purchases totaled and then from that subtract the value of the ending inventory.

·         For a manufacturing company the COGS are calculated as follows: Sum the value of the beginning inventory with purchases of raw materials and subtract from that the value of the ending inventory plus labor.

 

When the COGS are subtracted from the net revenue (sales less discounts) the result is the Gross Margin.

 

The relationship between the gross margin and net sales is called the gross margin ratio.

 

Operating Expenses:

·         Administrative Expenses

·         Selling Expenses

·         General Expenses

 

Selling expenses include the cost of advertising, printing, salaries, commissions, taxes on salaries, etc.

 

General and Administrative expenses include officers and office worker salaries and payroll taxes, benefits, office supplies, telephone expenses, professional fees and legal services, insurance, property tax, entertainment, depreciation, rent, heat, lights.

 

When reading income statements, check to see the reporting period.

 

The total operating expenses are subtracted from the gross margin to give the operating profit/loss for the accounting period. The operating profit represents the gross profit on sales.

 

Interest expense and other non-operating expenses are listed next on the income statement. They are separate because they relate more to finance or investing than merchandising.

 

Net income before taxes is so stated because federal, state, and local taxes vary in how they are applied to the bottom line. Payroll taxes, withholding, social security taxes are covered in operating expenses.

 

The bottom line is the net income (after taxes), which is all expenses subtracted from the revenue.

 

Questions:

  1. What are the two basic elements of any income statement?

  2. Revenues and expenses may be recognized on the cash basis and what other basis?

  3. Matching expenses to revenue is a principle of what recognition basis?

  4. The original cost of raw materials that are later sold is an example of what?

  5. How is gross margin calculated?

  6. What type of expenses are selling, administrative, and general expenses?

  7. True or False: Interest expense is classified with selling expenses.

  8. True or False: Income tax expense is stated separately, while payroll taxes are included in operating expenses?

 

Answers:

1. Revenues and Expenses 2. Accrual 3. Accrual 4. Cost of Goods Sold 5. Net sales minus cost of goods sold 6.Operataing expenses 7. False 8. True

 

Copyright 1988 Greatapes

Financial Video Series