To many, the Income Statement is the most important member of the Financial Statement triumvirate, due mainly to the fact that the income statement shows whether a company is profitable or not. Many analysts and observers are drawn first to the income statement, paying close attention to the revenue, expenses and profit and deciding on the financial condition of a company based on the level of these values. Unlike the Balance Sheet, the Income Statement is a “flow report”, providing a report (so to speak) on the performance of a company over a given period of time. By law, all publicly traded companies in the US (and a number of other countries) are required to publish financial statements (including the income statement) on a quarterly basis (for the three-month period ending that quarter) and also on an annual basis, for the 12-month period ending at the end of the fiscal year. As an example of the “flow” concept, the income statement for the quarter January 1 to March 31 will include trading activities for that period of time. Revenue for instance, will be the revenue for the three months, and not just for the last day of the month. This is fundamentally different from a balance sheet, which show values as at a particular date. The typical Income Statement is divided into three main categories: Revenue Expenses Income Revenue is at the top of the list and is the first category shown on the typical income statement. This category lists the revenue generated by the company in the period under consideration. Although most companies will show sales as the only item in this category, the category may be extended to include the following: Sales of tangible items Sales of services Sales by product category Sales by geographical regions Revenue represents the beginning of the income earning process and is an area of great interest to most businesses. In most cases, it is through the revenue generating process that the company comes in contact with its customers, and making the customers happy is usually priority number one. Gross income/profit is the difference between total revenue and the cost of goods sold (COGS) or the cost of the services provided. Cost of goods sold represents the excess of selling price (sp) over cost price (cp) (Markup on cost). For companies trading in tangible goods, cost of goods sold usually represents the value of the inventory sold to generate revenue, while for companies providing services, the cost of the service is usually the value of the labor and other expenses incurred as a direct result of the revenue generating process. For a manufacturing company, cost of goods sold is more comprehensively defined as the cost of goods produced and includes charges such as manufacturing wages, stock of raw materials and royalties. Operating Income is the difference between gross income and net operating expenses, and represents the actual “operating” result of the company. “Operating” is used here to denote the combination of revenue generating activities for which the company was formed and the expenses associated with those activities. Operating income is therefore the true value that indicates the company’s performance according to its business mandate. Not all revenue generated by the company will be operating revenue, and not all expenses will be operating expense. A company may “earn” income from an insurance claim or from the sale of fixed assets. While these activities will add to the company’s net income, they will not influence operating income. Net income (the bottom-line) represents the total income (revenue and other income less all expenses) earned by the company, and includes all non-operating revenue and expenses. The calculation of net income will therefore include operating income and non-operating income, and will be net of all non-operating expenses. In its strictest sense, net income is gross income minus corporate taxes, and represents the income of the company that is available to common stockholders. In preparing the income statement, it is important to know and understand the major principles of accounting as such knowledge is needed to ensure accuracy and consistency in preparation. An example of this is the accrual principle, which is applied in the recognition of revenue and the booking of expenses. Revenue is therefore recorded when it is earned, and not necessarily when it is paid for. Expenses are charged against revenue during the period that the expense was incurred, and not necessarily when the expense is paid. Revenue recognition has become more and more important as the economic world become more complex, and business executives seek to maximize revenue by methods that distort accuracy. When you think of revenue, you must realize that it is more than just the selling of goods over the counter at the corner grocery, or the sale of football tickets at the entrance to the stadium. Revenue is a complex accounting line item that merits serious consideration and analysis. As stated by the SEC’s chief accountant (Lynn Turner) in 2001, "The fundamental revenue recognition concept is that revenues should not be recognized by a company until realized or realizable and earned by the company." In that same speech, Lynn Turner went on to say that revenue recognition is the largest issue involved in the restatement of financial statements today. The SEC has released a number of statements on revenue recognition and will more than likely continue to discuss the subject well into the future. A second principle that is important to the preparation of the income statement is the Matching principle which states that all costs and expenses associated with the revenue of a particular period are recognized in the period the revenue is recognized. The best-known example of the matching principle at work is the provision of depreciation. Provision for depreciation is a charge against revenue for the period based on the assets used to generate the revenue. Because the asset will exist for more than one accounting period, the accountant will calculate a percentage of the value of the asset to charge against the revenue. The assumption is that the percentage value calculated is an accurate reflection of the contribution of that asset to the revenue earned in the period. The importance of a well-rounded knowledge of accounting in the preparation of the income statement cannot be understated. In today’s complex business environment, the average income statement will be more than just the balancing entries on the general ledger accounts, but the application of a number of accounting principles. ----- ----- ----- ----- ----- See our Income Statement example