The Income Statement | Reviewing the Common Financial Statements

The Income Statement

Perhaps the most important financial statement that an accounting system produces is the income statement. The income statement is also known as a profit and loss statement. An income statement summarizes a firm's revenues and expenses for a particular period of time. Revenues represent amounts that a business earns by providing goods and services to its customers. Expenses represent amounts that a firm spends providing those goods and services. If a business can provide goods or services to customers for revenues that exceed its expenses, the firm earns a profit. If expenses exceed revenues, obviously, the firm suffers a loss.

To show you how this all works — and it's really pretty simple — take a look at Tables1-1 and 1-2. Table 1-1 summarizes the sales that an imaginary business enjoys. Table 1-2 summarizes the expenses that the same business incurs for the same period of time. These two tables provide all the information necessary to construct an income statement.

Table 1-1: A Sales Journal

Joe	$1,000
Bob	500
Frank	1,000
Abdul	2,000
Yoshio	2,750
Marie	2,250
Jeremy	1,000
Chang	2,500
Total sales	$13,000

Table 1-2: An Expenses Journal

Purchases of dogs and buns	$3,000
Rent	1,000
Wages	4,000
Supplies	1,000
Total supplies	$9,000

Using the information from Tables 1-1 and 1-2, you can construct the simple income statement shown in Table 1-3. Understanding the details of an income statement is key to your understanding of how accounting works and what accounting tries to do. Therefore, I want to go into some detail discussing this income statement.

Table 1-3: Simple Income Statement

Sales revenue	$13,000
Less: Cost of goods sold	3,000
Gross margin	$10,000
Operating expenses
Rent	$1,000
Wages	4,000
Supplies	1,000
Total operating expenses	6,000
Operating profit	$4,000

The first thing to note about the income statement shown in Table 1-3 is the sales revenue figure of $13,000. This sales revenue figure shows the sales generated for a particular period of time. The $13,000 figure shown in Table 1-3 comes directly from the Sales Journal shown in Table 1-1

One important thing to recognize about accounting for sales revenue is that revenue gets counted when goods or services are provided and not when a customer pays for the goods or services. If you look at the list of sales shown in Table 1-1, for example, Joe (the first customer listed) may have paid $1,000 in cash, but Bob, Frank, and Abdul (the second, third, and fourth customers) may have paid for their purchases with a credit card. Yoshio, Marie, and Jeremy (the fifth, sixth, and seventh customers listed) may not have even paid for their purchases at the time the goods or services were provided. These customers may have simply promised to pay for the purchases at some later date. However, this timing of the payment for goods or services doesn't matter. Accountants have figured out that you count revenue when goods or services are provided. Information about when customers pay for those goods or services, if you want that information, can come from lists of customer payments.

Cost of goods sold and gross margins are two other values that you commonly see on income statements. Before I discuss cost of goods sold and gross margins, however, let me add a little more detail to this example. Suppose, for example, that the financial information in Tables 1-1, 1-2, and 1-3 shows the financial results from your business: the hot dog stand that you operate for one day at the major sporting event in the city where you live. Table 1-1 describes sales to hungry customers. Table 1-2 summarizes the one-day expenses of operating your super-duper hot dog stand.

In this case, the actual items that you sell — hot dogs and buns — are shown separately on the income statement as cost of goods sold. By separately showing the cost of the goods sold, the income statement can show what is called a gross margin. The gross margin is the amount of revenue left over after paying for the cost of goods. In Table 1-3, the cost of goods sold equals $3,000 for purchases of dogs and buns. The difference between the $13,000 of sales revenue and the $3,000 of cost of goods sold equals $10,000, which is the gross margin.

Tip

Knowing how to calculate gross margin allows you to estimate firm breakeven points and also to perform profit, volume, and cost analyses. All these techniques are extremely useful for thinking about the financial affairs of your business.

The operating expenses portion of the simple income statement shown in Table 1-3 repeats the other information listed in the Expenses Journal. The $1,000 of rent, the $4,000 of wages, and the $1,000 of supplies get totaled. These operating expenses are then subtracted from the gross.

Do you see, then, what an income statement does? An income statement reports on the revenues that a firm has generated. It shows the cost of goods sold and calculates the gross margin. It identifies and shows operating expenses, and finally, shows the profits of the business.

One other important point: Income statements summarize revenues, expenses, and profits for a particular period of time. Some managers and entrepreneurs, for example, may want to prepare income statements on a daily basis. Public companies are required to prepare income statements on a quarterly and annual basis. And taxing authorities, such as the Internal Revenue Service, require tax return preparation both quarterly and annually.

Tip

Technically speaking, the quarterly statements required by the Internal Revenue Service don't need to report revenue. The Internal Revenue Service requires quarterly statements only of wages paid to employees. Only the annual income statements required by the Internal Revenue Service report both revenue and expenses. These are the income statements produced to prepare an annual income tax return.