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The income statement is one of the major financial statements used by accountants and business owners. (The other major financial statements are the balance sheet, statement of cash flows, and the statement of stockholders' equity.) The income statement is sometimes referred to as the profit and loss statement (P&L), statement of operations, or statement of income. We will use income statement and profit and loss statement throughout this explanation. The income statement is important because it shows the profitability of a company during the time interval specified in its heading. The period of time that the statement covers is chosen by the business and will vary. For example, the heading may state:
"For the Three Months Ended December 31, 2011" (The period of October 1 through December 31, 2011.) "The Four Weeks Ended December 27, 2011" (The period of November 29 through December 27, 2011.) "The Fiscal Year Ended June 30, 2012" (The period of July 1, 2011 through June 30, 2012.)
Keep in mind that the income statement shows revenues, expenses, gains, and losses; it does not show cash receipts (money you receive) nor cash disbursements (money you pay out). People pay attention to the profitability of a company for many reasons. For example, if a company was not able to operate profitablythe bottom line of the income statement indicates a net lossa banker/lender/creditor may be hesitant to extend additional credit to the company. On the other hand, a company that has operated profitablythe bottom line of the income statement indicates a net income demonstrated its ability to use borrowed and invested funds in a successful manner. A company's ability to operate profitably is important to current lenders and investors, potential lenders and investors, company management, competitors, government agencies, labor unions, and others. The format of the income statement or the profit and loss statement will vary according to the complexity of the business activities. However, most companies will have the following elements in their income statements: A. Revenues and Gains 1. Revenues from primary activities 2. Revenues or income from secondary activities 3. Gains (e.g., gain on the sale of long-term assets, gain on lawsuits) B. Expenses and Losses 1. Expenses involved in primary activities 2. Expenses from secondary activities 3. Losses (e.g., loss on the sale of long-term assets, loss on lawsuits) If the net amount of revenues and gains minus expenses and losses is positive, the bottom line of the profit and loss statement is labeled as net income. If the net amount (or bottom line) is negative, there is a net loss.
On December 10, a new client asks your consulting company to provide a $2,500 service in January. You are uncertain as to whether or not this client is credit worthy, so to be on the safe side you ask for an immediate partial payment of $1,000 before you agree to schedule the work for January. Although your consulting company has a receipt of $1,000 in December, it does not have revenues in December. (In December your company will record a liability of $1,000.) Your consulting company will report the $1,000 of revenues when it performs $1,000 of services in January.
2. Revenues from secondary activities are often referred to as nonoperating revenues. These are the amounts a business earns outside of purchasing and selling goods and services. For example, when a retail business earns interest on some of its idle cash, or earns rent from some vacant space, these revenues result from an activity outside of buying and selling merchandise. As a result the revenues are reported on the income statement separate from its primary activity of sales or service revenues. As is true with operating revenues, nonoperating revenues are reported on the profit and loss statement during the period when they are earned, not when the cash is collected.
Don't confuse revenues with receipts Revenues (operating and nonoperating) occur when a sale is made or when they are earned. Revenues are frequently earned and reported on the income statement prior to receiving the cash. Receipts occur when cash is received/collected.
3. Gains such as the gain on the sale of long-term assets, or lawsuits result from a transaction that is outside of the primary activities of most businesses. A gain is reported on the income statement as the net of two amounts: the proceeds received from the sale of a long-term asset minus the amount listed for that item on the company's books (book value). A gain occurs when the proceeds are more than the book value. Consider this example: Assume that a clothing retailer decides to dispose of the company's car and sells it for $6,000. The $6,000 received for the car (the proceeds from the disposal of the car) will not be included with sales revenues since the account Sales is used only for the sale of merchandise. Since this retailer is not in the business of buying and selling cars, the sale of the car is outside of the retailer's primary activities. Over the years, the cost of the car was being depreciated on the company's accounting records and as a result, the money received for the car ($6,000) was greater than the net amount shown for the car on the accounting records ($3,500). This means that the company must report a gain equal to the amount of the differencein this case, the gain is reported as $2,500. This gain should not be reported as sales revenues, nor should it be shown as part of the merchandiser's primary activities. Instead, the gain will appear in a section on the income statement labeled as "nonoperating gains" or "other income". The gain is reported in the period when the disposal occurred.
Under the accrual basis of accounting, the cost of goods sold and expenses are matched to sales and/or the accounting period when they are used, not the period in which they are paid. The income statements or profit and loss statements of merchandisers and manufacturers will use a separate line for the cost of goods sold. The other expenses involved in their primary activities will either be grouped together as operating expenses or subdivided into the categories "selling" and "administrative."
2. Expenses from secondary activities are referred to as nonoperating expenses. For example, interest expense is a nonoperating expense because it involves the finance function of the business, rather than the primary activities of buying/producing and selling.
3. Losses such as the loss from the sale of long-term assets, or the loss on lawsuits result from a transaction that is outside of a business's primary activities. A loss is reported as the net of two amounts: the amount listed for the item on the company's books (book value) minus the proceeds received from the sale. A loss occurs when the proceeds are less than the book value. Let's assume that a clothing retailer decides to dispose of the company's car. The proceeds from the disposal are $2,800. This is less than the $3,500 amount shown in the company's accounting records. Since this retailer is not in the business of buying and selling cars (the sale of the car is outside of the operating activities of buying and selling clothing), the money received for the car will not be included in sales revenues, and the loss experienced on the sale of the car ($700) will not be included in operating expenses. Instead, the $700 loss will appear in a section on the income statement labeled "nonoperating gains or losses" or "other income or losses". The loss is reported in the time period when the disposal occurs.
The income statement or profit and loss statement shows revenues, expenses, gains, and losses. The income statement does not show cash receipts and cash disbursements.
Net Income = (Revenues + Gains) (Expenses + Losses) An extremely condensed income statement in the single-step format would look like this:
Sample Products Co. Income Statement For the Five Months Ended May 31, 2012 Revenues & Gains Expenses & Losses Net Income $108,000 90,000 $ 18,000
The heading of the income statement conveys critical information. The name of the company appears first, followed by the title "Income Statement." The third line tells the reader the time interval reported on the profit and loss statement. Since income statements can be prepared for any period of time, you must inform the reader of the precise period of time being covered. (For example, an income statement may cover any one of the following time periods: "Year Ended May 31," "Five Months Ended May 31," "Quarter Ended May 31," "Month Ended May 31, or "Five Weeks Ended May 31".) A sample income statement in the single-step format would look like this: Sample Products Co. Income Statement For the Five Months Ended May 31, 2012 Revenues & Gains Sales Revenues Interest Revenues Gain on Sale of Assets Total Revenue & Gains Expenses & Losses Cost of Goods Sold Commissions Expense Office Supplies Expense Office Equipment Expense Advertising Expense Interest Expense Loss from Lawsuit Total Expenses & Losses Net Income
An alternative to the single-step income statement is the multiple-step income statement, because it uses multiple subtractions in computing the net income shown on the bottom line. The multiple-step profit and loss statement segregates the operating revenues and operating expenses from the nonoperating revenues, nonoperating expenses, gains, and losses. The multiple-step income statement also shows the gross profit (net sales minus the cost of goods sold). Here is a sample income statement in the multiple-step format:
Sample Products Co. Income Statement For the Five Months Ended May 31, 2012 Sales Cost of Goods Sold Gross Profit Operating Expenses Selling Expenses Advertising Expense Commissions Expense Administrative Expenses Office Supplies Expense Office Equipment Expense Total Operating Expenses Operating Income Non-Operating or Other Interest Revenues Gain on Sale of Investments Interest Expense Loss from Lawsuit Total Non-Operating Net Income $100,000 75,000 25,000
7,000
Using the above multiple-step income statement as an example, we see that there are three steps needed to arrive at the bottom line Net Income:
Step 1.
Cost of goods sold is subtracted from net sales to arrive at the gross profit. Gross Profit Gross Profit Gross Profit = = = Net Sales $100,000 $25,000 Cost of Goods Sold $75,000
Step 2.
Operating expenses are subtracted from gross profit to arrive at operating income. Operating Income Operating Income Operating Income = = = Gross Profit $25,000 $12,000 Operating Expenses $13,000
Step 3.
The net amount of nonoperating revenues, gains, nonoperating expenses and losses is combined with the operating income to arrive at the net income or net loss. Net Income Net Income Net Income = = = Operating Income $12,000 $18,000 + + Non-Operating Items $6,000
There are three benefits to using a multiple-step income statement instead of a single-step income statement:
1. The multiple-step income statement clearly states the gross profit amount. Many readers of
financial statements monitor a company's gross margin (gross profit as a percentage of net sales). Readers may compare a company's gross margin to its past gross margins and to the gross margins of the industry. The multiple-step income statement presents the subtotal operating income, which indicates the profit earned from the company's primary activities of buying and selling merchandise. The bottom line of a multiple-step income statement reports the net amount for all the items on the income statement. If the net amount is positive, it is labeled as net income. If the net amount is negative, it is labeled as net loss.
2. 3.
Sometimes rare or extraordinary events will occur during the income statement's time interval along with the normally recurring events. It's helpful to the reader of the statement if these unique items are segregated into a special section near the bottom of either the single-step or multiple-step income statement. These unique or rare items are: 1. Discontinued Operations 2. Extraordinary Items When recording these items near the bottom of an income statement, it's required that you present them in the same order as they appear above. However, it is rare for a company to have either one of these items, and it is highly unlikely that a company will have both. 1. Discontinued operations pertains to the elimination of a significant part of a company's business, such as the sale of an entire division of the company. (Eliminating a small portion of product line does not qualify as a discontinued operation.)
2. Extraordinary items includes things that are unusual in nature and infrequent in occurrence. A loss due to an earthquake in Wisconsin would certainly be extraordinary. A loss due to a foreign country taking over a U.S. oil refinery in that country would be an extraordinary item. If an item is unique and significant but it does not meet the criteria for being both "unusual and infrequent," the item must remain in the main section of the income statement; it can however be shown as a separate line item. For example, if a company suffers a $40,000 loss due to a strike by its workers, the $40,000 cannot be shown as an extraordinary item since it is not unusual in nature for a strike to occur. The $40,000 may be shown as a separate line item, but it must be positioned in the main portion of the income statement. Two additional examples of situations that do not qualify as extraordinary items are (1) the loss from frost damage to a Florida citrus crop and (2) the write-down of inventory from cost to a lower amount. Apparently the frost in Florida is not unusual in nature and not infrequent. Similarly, it's not unusual for items in inventory to have a current value lower than its cost. Although these things maybe significant, unusual, and important, they do not belong in the section containing extraordinary items. Below is an example of a single-step income statement containing an extraordinary item. (If this were a corporation, income tax expenses would be part of the income statement and an extraordinary gain would be reduced by the income tax expense associated with the gain; an extraordinary loss would be reduced by the income tax savings associated with the loss.) See net of tax.
Sample Products Co. Income Statement For the Five Months Ended May 31, 2012 Revenues & Gains Sales Interest Revenues Gain on Sale of Assets Total Revenue & Gains Expenses & Losses Cost of Goods Sold Commissions Expense Office Supplies Expense Office Equipment Expense Advertising Expense Interest Expense Loss from Lawsuit Total Expenses & Gains Income Before Extraordinary Extraordinary Item - Gain Net Income
75,000 5,000 3,500 2,500 2,000 500 1,500 90,000 18,000 7,000 $ 25,000
Note that even in a single-step format shown above, the extraordinary item is separated out and added to the end of the income statement. The same would be true for discontinued operations. Below is a multiple-step income statement containing discontinued operations and an extraordinary item. (If this were a corporation, income tax expenses would be part of the income statement; the two unique items would be reduced by the income tax effect associated with each item.)
Sample Products Co. Income Statement For the Five Months Ended May 31, 2012 Sales Cost of Goods Sold Gross Profit Operating Expenses Selling Expenses Advertising Expense Commissions Expense Administrative Expenses Office Supplies Expense Office Equipment Expense Total Operating Expenses Operating Income Non-Operating or Other Interest Revenues Gain on Sale of Investments Interest Expense Loss from Lawsuit Total Non-Operating Income before Disc Op and Extraordinary Item Discontinued Operations Extraordinary Item Net Income $100,000 75,000 25,000
7,000
Note that the two unique items are shown near the bottom of the income statement. This is where the items should appear on both single-step and multiple-step statements.
If the business is a corporation with common stock that is publicly traded, it is required that the net income, discontinued operations, and extraordinary items be shown on the income statement on an aftertax, per-share basis.
Total Sales Variable Expenses Cost of Goods Sold Commissions Expense Total Variable Expenses Contribution Margin Fixed Expenses - Prod. Line Subtotal $100,000 75,000 5,000 80,000 20,000 6,000 14,000
2,000 $12,000
As you can see above, $2,000 of fixed expenses are common to both product lines. In other words they cannot be traced directly to Product Line 1 or Product Line 2. Rather than mislead someone, the expenses are not arbitrarily divided up between the product lines. Remember that this format is not acceptable for distribution outside of the companyits accessibility should be limited to the members of the company's management. In fact, this type of income statement is usually covered as part of managerial accounting, not financial accounting. It is shown here to let you know that income statement formats other than the single-step and multiple-step are permissible when they stay within a company, and may prove very useful to a company's managers.