Ask yourself: Exactly how are my products and services affecting my business? How much money am I actually making because of those products and services? An income statement answers these and other financial questions. An income statement tells you and any stockholders how your net assets have increased or decreased. On an income statement, the total inflow of net assets resulting from the delivery of services and products to your customers is measured in revenue accounts, which in turn tells you what caused the net assets to increase or decrease.
In addition, you can use a statement of income as a tool to compare the most recent year with past trends, thus forming a reasonable forecast for the future. The statement also helps you locate problem areas regarding sales, margins and expenses, and provides a method for you to investigate problem areas within a reasonable amount of time. When an income statement is prepared properly, the net increase or decrease in your net assets, or the difference between revenue and expense, is designated as net income or net loss. A net increase in net assets or net income is then added to your equity on your balance sheet.
This tool examines the process of developing an income statement and explains the meaning of the components of an income statement. When you are finished with this article, your understanding of income statements will give you greater insight into your company's growth and financial health.
The elements of income are generally divided into four categories: revenues, expenses, gains and losses. Revenues are inflows or other enhancements of financial assets of your business. They may also be settlements of your liabilities from delivering or producing goods and services, or engaging in other activities that constitute your company's ongoing major or central operation. Expenses, on the other hand, are outflows of assets or incurrences of liabilities from delivering or producing goods and services, or carrying out other activities that constitute your company's ongoing major or central operations. When gains are reported, they represent increases in net assets from peripheral or incidental transactions and from all other transactions, events and circumstances affecting your company, except those resulting from revenues or investments by owners. Losses report decreases in your company's net assets.
Your income is measured as the difference between resource inflows (revenue and gains) and resource outflows (expenses and losses) over a period of time. There are a number of general methods for determining your income. The most basic is the transaction approach, which compares the amounts used in revenue expenses, gains and losses. This method requires a clear definition of when the income elements should be recognized or recorded in the financial statement. In other words, you must know beforehand when your company will gain net assets and when to list them on your statement to provide the most beneficial use of those assets. Other methods include:
Revenue and Gain Recognition
Under the generally accepted accounting principle of accrual, revenue recognition does not necessarily occur when cash is received. Generally, service organizations such as accounting firms, use the cash basis of accounting and only recognize income when they are paid by a client (not when the client was billed). On the other hand, the recognition of a sale for businesses that sell products and carry inventory occurs when the product is sold, not when payment is received.
Expense and Loss Recognition
In order to determine your income, you must establish criteria for revenue recognition and the principles for recognizing expenses and losses must be clearly defined. Some expenses are directly associated with revenues. These expenses can be recognized in the same period as the related revenues. Other expenses are not associated with specific revenues. These expenses are recognized in the time period when they are paid or they are incurred. Still, other expenses are not recognized currently as expenses because they relate to future revenues; therefore, these expenses are reported as assets. Expense recognition, then, can be divided into three sub-categories: direct matching, systematic and rational allocation, and immediate recognition.
In order to perform direct matching, you must relate your expenses to specific revenues. This is referred to as the "matching" process, in which your revenues that are produced by the sale of goods and reported in the same time period are recognized. Similarly, shipping costs and sales commissions are usually directly related to revenues. Your direct expenses include not only those expenses that have been incurred, but also anticipated expenses that are related to revenues of the current period. After the delivery of goods to your customers, there are still costs of collection, bad debt losses from uncollectable receivables, and possible warranty costs (for product deficiencies). These expenses are directly related to your revenues and should be estimated and matched against recognized revenues for the accounting period.
Systematic and Rational Allocation
The second general expense recognition category involves assets that benefit more than one accounting period. The cost of assets, such as buildings, equipment, patents, and prepaid insurance, need to be spread across the periods of expected benefit in some systematic and rational way. Generally, it is difficult to relate these expenses directly to specific revenues or to specific periods; however, these expenses are necessary if your revenue is to be earned. Examples of expenses included in this category are depreciation and amortization.
Many expenses are not related to specific revenues, but are incurred to obtain goods and services that indirectly help to generate revenues. Because these goods and services are used almost immediately, their costs are recognized as expenses in the period of acquisition. Examples of immediate recognition items include most administrative costs, such as office salaries, utilities, and general advertising and selling expenses. You will find immediate recognition appropriate when your future benefits are highly uncertain. For example, your expenditures for research and development may provide significant future benefits, but they are usually so uncertain that the costs can be written off in the period in which they are incurred. Most losses also fit in the immediate recognition category. Because they arise from peripheral or incidental transactions, your losses do not relate directly to revenues. Examples of losses in the immediate recognition category include losses from disposition of used equipment, natural catastrophes (i.e., earthquakes or tornadoes), and losses from disposition of investments.
The methods you adopt for recognizing expenses and losses should appear reasonable to an unbiased observer and should be followed consistently unless the underlying conditions surrounding the assets change. Some expenses are related to the goods your company produces. These expenses may be deferred in inventory values if the goods are unsold at the end of an accounting period. Examples of expenses deferred in inventory values include depreciation on production machinery and plant insurance. Other expenses are related to accounting periods and should be allocated directly as an expense of the immediate time period. Examples of this include depreciation of delivery trucks and amortization of bond discount.
When reporting periodic revenues and attempting to properly match those expenses incurred to generate current period revenues, you must continually make judgments. The numbers you report in the financial statements reflect these judgments and are based on estimates of factors such as the number of years of useful life for depreciable assets, the amount of uncollectable accounts expected, or the amount of warranty liability to be recorded on the books. These and other estimates should be made using the best available information at the statement date. However, conditions may subsequently change and the estimates may need to be revised. Naturally, if either revenue or expense amounts are changed, the income statement is affected.
Note: A question to consider is whether previously reported income measures should be revised or whether the changes should impact only current and future periods.
The income statement traditionally has been prepared in either single-step form or multiple-step form. Under the single-step form, you should place all of your revenues and gains that are identified as operating items first on the income statement, followed by all expenses and losses identified as operating items. The difference between total revenues and total expenses represents income from your operations. If there are no non-operating, irregular, or extraordinary items, this difference is also equal to your net income. A Single-Step Income Statement is generally used by service organizations. When using the Multiple-Step Form, your income statement is divided into separate sections, and various subtotals are reported that reflect different levels of profitability. Some of those sections, especially those reported after operating income, are specified by the Financial Accounting Standards Board (FASB) pronouncements. Others have become standardized by wide usage.
Sample Single-Step Income Statement
Note: Using titles such as Income Statement or Statement of Income alerts the reader that the report is not in accordance with generally accepted accounting principles.
First Line: On the first line at the top of the Income Statement, the name of the business appears.
Second Line: The second line should read Income Statement or Statement of Income.
Last Line: The last line tells the reader the period of time covered by the Income Statement. This period covered can be a month, a quarter, six months or a year. This is different than a balance sheet because it specifies a date, not a period of time.
Sample Multiple-Step Income Statement
Net Sales Revenue from net sales shows your total sales for the income statement period less any sales discounts or returns and allowances. This total should not include additions to billings for sales tax that you are required to collect. These billing increases are properly recognized as current liabilities. Sales returns and allowances and sales discounts should be subtracted from gross sales in arriving at net sales revenue. When the sales price is increased to cover the cost of freight to the customer and the customer is billed accordingly, freight charges paid by the company should also be subtracted from sales in arriving at net sales. Freight charges not passed to the buyer are recognized as selling expenses.
You can use the following table as a model for creating a multi-step income statement for your company
Whether you're a merchandising or manufacturing enterprise, you must determine the cost of goods relating to sales for the period. This is the sum of your beginning inventory, net purchases, and all other buying, freight, and storage costs relating to the acquisition of goods. Your net purchases balance is developed by subtracting purchase returns and allowances and purchase discounts from gross purchases. Your cost of sold goods can then be calculated by subtracting your ending inventory from your cost of goods available for sale. When you manufacture your goods, additional elements enter into the cost. Aside from material costs, you will incur labor and overhead costs to convert raw material to a finished good. A manufacturing company has three inventories rather than one: raw materials, goods in process, and finished goods.
Operating expenses may be reported in two parts: selling expenses as well as general and administrative expenses. Your selling expenses include items such as sales salaries and commissions as well as related payroll taxes, advertising and store displays, store supplies used, depreciation of store furniture and equipment, and delivery expenses. Your general and administrative expenses include officers' and office salaries as well as related payroll taxes, office supplies used, depreciation of office furniture and fixtures, telephone, postage, business licenses and fees, legal and accounting services, and contributions.
Note: For manufacturing companies, charges related jointly to both production and administrative functions should be allocated in some equitable manner between manufacturing overhead and operating expenses.
This section usually includes items identified with the peripheral activities of your company. Examples include revenue from financial activities (i.e., rents, interest and dividends) and gains from the sale of assets (i.e., equipment or investments).
This section parallels other revenues and gains; however, the items result in deductions from, rather than increases to, your operating income. Examples include interest expense and losses from the sale of assets.
Your total income tax expense for a period is allocated to various components of your income. One amount is computed for income from your continuing operations, and separate computations are made for any irregular or extraordinary items you may find.
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