Basically, an income statement prepared using the accrual basis of accounting reports revenues earned and expenses incurred during a period, based on the revenue recognition and matching principles. In other words, revenues do not necessarily equal the cash receipts, nor do the expenses necessarily equal the cash payments made by the business during that period. An income statement covers a specific period, generally one year, but also may be prepared for shorter periods. The income statement shows the revenues earned, the expenses incurred, and the resulting net income or net loss during a period of time.
Do I go back to basic? Yes firstly, I found many starters still need to learn the basic form and content of the income statement. So, in this post, I will discuss the very basic income statement format first. Later on, I am going to go to get deeper and more detail on each element of income statement for a sellers [a business that sells goods]. If you are looking for icome statement formats, how they are structured, you came to the right place, you will learn a lot here. Enjoy!
Basic Format of Income Statement
Her is an example of income statement in basic format:
Let’s overview each of the element.
Revenues are resources flowing into the business, primarily from providing services or selling purchased goods to customers. A company also can manufacture its own goods to sell to customers. Revenues generally provide cash or a future claim to cash, for example, with accounts receivable or a note receivable.
Assume you own your own house-cleaning business. You earn revenue every time one of your employees cleans a customer’s house. There are three ways a customer might pay you: (1) in advance, (2) as soon as your employee finishes performing the service, or (3) shortly after you bill the customer for the service. Let’s consider these three situations:
Situation 1: If the customer pays you in advance, your company will record the cash when you receive it, but it will be recorded as a liability or a debt (unearned revenue), which appears on the balance sheet. Why is this considered unearned revenue? If your business doesn’t fulfill its obligation to clean the house, your company will have to refund the customer’s money. However, once your employee has performed the cleaning service, you will remove the liability from your books and record it as earned revenue.
Situation 2: If the customer pays immediately upon the completion of the house cleaning, the cash you receive will also be recorded as revenue.
Situation 3: However, if the customer does not pay you immediately but asks that you send a bill, your company still has earned the revenue. Your business performed the agreed-upon service, and the customer owes your company money.
Thus, you will record the revenue as being earned, but you can’t record any cash as coming in. Instead, you will record this as an account receivable in your books. An account receivable is an asset, and like all assets, it will appear on the balance sheet. It represents money owed to your business by your customers for goods you already have sold to them or services your business already has performed. In other words, accounts receivable represents a claim to cash that your company has against someone, and you should receive the cash sometime in the future.
Note: All three situations, revenue is considered to be earned once your company has performed the service, regardless of when the cash is received. This approach is in accordance with the revenue recognition principle, which is also part of the accrual basis of accounting.
Expenses are costs associated with providing services or selling goods. Examples include:
- Salaries or wages paid to employees
- Rent paid for office space
- Utilities (e.g., electricity, telephone)
- Office supplies used
- The company’s cost of inventory sold to customers
According to the matching principle, costs are reported as expenses of the same period in which the revenue was earned or in the period in which the expenses were incurred, regardless of when those costs or expenses were paid in cash. In other words, we try to match the expenses, or costs of doing business, with the revenues that the expenses helped generate. This matching process helps develop a more accurate picture of the company’s operating success (or failure) during a period of time.
Let’s go back to the example in which you own your own house-cleaning business. Some of your expenses may be paid in advance [situation 1], whereas others may be paid after you incur them [situation 2].
Situation 1: If your company pays a cost of doing business in advance, such as the insurance, you must record the cash payment when you made it or your cash account will not reflect the actual amount of cash you have on hand. However, you have not incurred the expense yet because the time period for which you have paid has not passed. For example, if you decided to change insurance carriers, your old insurance company would have to refund you a prorated amount of the premium you had paid but for which you had not yet received coverage. Therefore, an expense that your company has paid for in advance is called a prepaid expense, which is an asset (and will appear on the balance sheet). However, as time passes, your prepaid expense no longer is prepaid but is actually an incurred expense. The insurance company provided you with insurance coverage during this period, and once the 12 months have passed, you must remove the balance from the prepaid insurance expense account and add it to the insurance expense account (which will appear on the income statement).
Situation 2: However, your company did not pay for a cost of doing business in advance but instead paid shortly after receiving the bill for the past month of service. Even though you have not paid your electric bill, you have incurred the expense. Your business used the electricity provided by the electric company, and even though you have not paid the bill yet, your company owes the money to the electric company. To reflect this transaction, you will record the expense, but there will be no cash going out until you actually make the payment. Instead, you will record this as an account payable in your books. An account payable is a liability or a debt (and will appear on the balance sheet). It represents money your business owes for goods or services another party already has provided to you. It is an account you must pay in the future.
Note that in both situations, an expense is recorded as incurred once the cost of doing business has happened, regardless of when the cash is paid. This approach is in accordance with the accrual basis of accounting.
According to the concepts of materiality and full disclosure, each significant revenue and expense should be shown separately in the income statement, but insignificant or immaterial items may be combined. The footnotes may provide additional information about items reported on the income statement.
Net Income [Or Loss]
Net income or net loss is the difference between revenues and expenses and reflects the results of all the income-producing activities of the business (see below).
Net Income (Loss) Formula:
Revenues – Expenses = Net Income (or Net Loss)
If revenues > expenses, your company has earned a net income
If expenses > revenues, your company has experienced a net loss
There are other terms for net income, all of which cover the same concept. These other terms include earnings, profit, and simply income.
Congratulation, you just learnt the basic format of income statement, using a very basic services business. Next, let’s see how income statement for sellers [a business that sells goods]
Income Statement Format for Sellers [A Business That Sells Goods]
The income statements presented previously were for simple service businesses. If a company purchases goods (products or inventory) for resale to customers or manufactures the goods that it sells to customers, additional items must be reported in the income statement. An example of an income statement for business that sells goods appears below:
Lie Dharma Putra Company purchases goods from other sources (or manufactures its goods) for resale to its customers. This basic income statement form may be used for both sole proprietorships and partnerships. The income statement for a corporation is similar and is discussed later.
Next’s let’s go to each element of the income statement
As we have discussed, sales revenue represents revenue earned from the sale of goods during the time period, whether the customers paid cash at the time of sale, paid in advance, or will pay in the future. Recall that the cash advances collected from customers, such as customer deposits and gift certificates that were not earned during the period will be shown on the balance sheet as a liability: unearned revenues. Revenues that were earned during the period but have not been collected in cash (such as sales on credit) will be shown on the balance sheet as an asset: accounts receivable.
More detailed reporting of sales revenue may be necessary when significant or material amounts of merchandise are returned by customers or when cash discounts are taken by customers for early payment on account. For example, the sales revenue for Lie Dharma Putra Company may appear as it does below:
In this example, gross sales revenue represents the total sales of the company for the year. However, some of those sales were returned by customers, and so it would be misleading to report only the gross sales revenue on the income statement. A separate account is created to record the sales returns: sales returns and allowances. Allowances also are recorded in this account, and they represent reductions in the amount owed by the customer. The company might agree to grant an allowance because the customer was not happy with the purchase for some reason (e.g., slightly inferior goods, wrong color). Since the original sale was recorded as part of the gross, or total, sales revenue, it would be misleading not to reduce the gross sales revenue by any allowances granted.
Sales discounts are reductions in the amount owed by the customer in return for prompt payment
For example: a company may offer terms of 2/10, n/30, which is read as “two ten, net thirty”. These terms mean that the seller will give the buyer 2 percent off the total sale if the buyer pays within 10 days of the invoice date, typically the date of the bill. Otherwise, the entire amount owed is due within 30 days of the invoice date, with no discount.
Why would a seller offer a sales discount? A company needs cash to pay its own bills. It can’t pay its bills with a sale it made on an account receivable even though that is an asset and represents cash the company should be receiving in the near future. Thus, the seller prefers to receive cash as soon as possible by offering discount.
Why would a buyer take advantage of a sales discount? Discounts are a great deal for the buyer. By paying the bill only 20 days early (since the entire amount is owed within 30 days with no discount) the buyer gets 2 percent off.
Interest rates typically are stated on an annual basis, such as the interest rate your bank pays you on your savings account. However, this discount interest rate pertains to a 20-day period only. To see how much interest the buyer would be paying to keep his or her cash for only an extra 20 days, convert the discount interest rate to an annual basis. For ease in computation, assume there are 360 days in a year, which translates to eighteen 20-day periods. Without considering compounding interest, this equals an annual interest rate of approximately 36 percent (18 periods times 2 percent), an astronomically high rate by most standards.
Why are separate accounts kept for sales discounts and sales returns and allowances?
It would be possible simply to reduce sales revenue for those items, but if that is done, this information is lost. Keeping separate accounts for these items allows management (and the readers of the financial statements) to determine, for example, if sales returns seem to be excessively high, which may indicate that the company is experiencing a problem with its products.
Cost Of Goods Sold [COGS]
Cost of goods sold sometimes is referred to as “cost of sales”, and the name of the account aptly describes what it represents. This account is an expense and includes the cost of the merchandise sold to customers during the year, not necessarily the amount of cash paid by the company for the merchandise. Some of this merchandise may have been purchased in a prior period, or the company still may owe money to its suppliers for some of the merchandise. Calculating cost of goods sold and reporting it on the income statement is another illustration of the matching principle.
Let’s consider 3 situations, again:
Situation 1: the accrual basis of accounting will result in the same reporting as the cash basis of accounting since the purchase, sale, and cash flows all occurred during the same period (year 1).
Situation 2: however, the company sold some merchandise that it had not paid for yet and for which it had not collected all the cash from its customers yet. Under the matching principle followed with the accrual basis of accounting, the revenue is to be recorded when it is earned (i.e., sold to the customers) and the expense is to be recorded in the same period as its related revenue (the sales of the merchandise).
Following the matching principle, situation 3: requires that the revenue be recorded when sold to the customers in years 1 and 2 (i.e., when earned) and the related expense be matched against that revenue (i.e., the goods sold in year 1 are expenses of year 1, and the goods sold in year 2 are expenses of year 2).
What happens to goods that are purchased but not yet sold? These goods are not shown on the income statement as part of cost of goods sold but rather are an asset called inventory that is shown on the balance sheet.
More detailed reporting of the cost of goods sold section of the income statement for Lie Dharma Putra Company appears below:
The formula shown in the figure makes logical sense. Essentially, what the formula for cost of goods sold states is that the inventory you have on hand at the beginning of the year plus the additional inventory you purchase during the year equals the inventory you have available to sell. Subtracting the inventory you still have on hand at the end of the year (it wasn’t sold if it is still on hand) from what was available to sell must equal the amount of inventory sold. Since all the components of the formula are stated in dollars, the end result is not the number of units sold but the cost of the inventory sold. Specifically, it is the cost to your company: what your business paid for the inventory, not what your company is selling it for to your customers.
Gross profit often is referred to as “gross margin” and represents the markup on the goods sold. This markup is the difference between what your company paid to purchase the inventory you will sell to your customers and the price you will charge your customers for the inventory they purchase from you. Your company should earn a gross profit. If not, it means you are selling your inventory for less than or exactly what it cost, and your company obviously won’t be in business for very long in this case.
The only expense we have placed on the income statement up to this point is the cost of goods sold. Before any income or loss is computed, the other operating expenses must be deducted from the gross profit. Operating expenses represent expenses arising from the primary business activity, which in this case is the sale of inventory to customers. These expenses are deducted from gross profit to determine operating income (or operating loss). Typical operating expenses may include the ones shown below:
Where do the owner’s personal expenses belong?
According to the business entity assumption, personal expenses of the owners that were paid by the business are not included in the income statement but instead are shown in the statement of owner’s equity as withdrawals. Similarly, salaries withdrawn by the owner or owners of a sole proprietorship or partnership usually are treated as withdrawals rather than expenses of the business because the owner is not considered an employee. Instead, the salary withdrawn by the owner is considered a distribution of the profits of the business to the owner.
Operating expenses often are categorized further as “selling expenses” and general and administrative expenses. Immaterial expenses may be combined rather than shown separately, particularly in financial statements used by parties other than management.
As with cost of goods sold, the matching principle applies to operating expenses. The salaries and wages expense consists of the salaries and wages earned by employees during the period even though the business may not pay the employees until a later time. For example, assume the income statement was for the calendar year, which ended on Tuesday, December 31, 2009, and the weekly pay period ends on Friday, January 3, 2010, which is in the next accounting period. Further, assume the business is closed on weekends. This year’s salaries and wages expense includes two days of wages expense incurred (Monday and Tuesday) even though the wages have not been paid (see below figure).
What happens with the liability for the two days of wages owed by the company to its employees as of December 31, 2009? That debt will appear on the balance sheet as salaries and wages payable. When it is paid on Friday, January 3, 2010, cash will be decreased and the liability will be decreased (since nothing more is owed), but there will be no impact on expense. This is an example of an accrued expense: one that is incurred but not yet paid.
Another example of the matching principle is the treatment of rent expense. Rent expense consists of the cost of renting space for the business that was incurred during the accounting period even though the rent may have been paid in advance. For example, assume the lease requires one year of rent to be paid on December 1, 2009 and the accounting time period ends on December 31.
How much rent expense will appear on the income statement for the year ending December 31, 2009? The income statement will include the cost of 1 month (or 1/12) of the lease as rent expense, and the remaining 11 months (11/12) will be shown on the balance sheet as an asset: prepaid rent. This is an example of a prepaid expense: one that is paid but not yet incurred.
Most other expenses are treated similarly; they are reported as expenses of the period in which they were incurred. As a practical matter, most operating expenses are both incurred and eventually paid in the same accounting period, except for those that fall close to the beginning or end of the accounting period. Consequently, accountants realize the importance of looking for and analyzing prepaid and accrued expenses at the end of the accounting period to make sure they are reported properly.
Although almost all operating expenses require cash payments at or near the time they are incurred, certain types of operating expenses do not require cash payments. “Depreciation expense” is a common example of an operating expense that does not use any of the business’s cash that is based on a different application of the matching principle. When a business purchases an asset that will be used in the company for a long time, such as office equipment, part of the cost of the asset is treated as an operating expense in each of the years in which it is used rather than treating its entire cost as an expense in the year in which it is purchased. The accounting profession considers this the proper treatment of these types of assets because the assets are used in the business for many years, helping the business generate revenues. In other words, it is another application of the matching principle.
Operating Income [Or Loss]
Operating income represents the profit earned by the business as a result of its primary business activity: revenues and expenses arising from the sale of goods. An operating loss is the opposite, representing the loss suffered by the business from its primary business activity. Other items affecting the overall profit of the business for the time period are shown in a separate category: other revenues and expenses.
Other Revenues and Expenses
This category of revenues and expenses sometimes is referred to as other income and expenses. It represents the activities affecting the profit or loss of a particular period which are not the result of the primary business activity (the sale of goods in the Example Company case). If material, the results of these activities should be separated from the normal operating activities, with each material item presented separately. Examples of what might be shown in this section of the income statement are listed below:
The gains and losses on sales of business assets which are included in the above list of examples are based on the difference between the selling price of an asset and its cost. If an asset sells for more than it cost, a gain results. Conversely, if an asset sells for less than it cost, the company has suffered a loss.
Net income (or net loss) is the last item on the income statement. It represents the net result of all revenues and other income earned during the period minus all costs and expenses incurred during the period, whether from the primary business activity or from other activities.
Pulling together all the components of the income statement that we have discussed, below figure shows a more detailed version of the income statement of Lie Dharma Putra Company:
Income Statement Format for Manufacturer [A Business That Manufactures Its Products]
When a business manufactures its goods for resale to its customers, additional information about “manufacturing costs“ incurred may be presented in a separate schedule that is referred to as the manufacturing statement. The “manufacturing statement” presents a summary of the principal manufacturing costs, as shown below:
What do each of these elements represent?
Goods in process at the beginning of the period represents the cost of raw materials, direct labor, and overhead incurred on goods in prior periods that have not been completed as of the beginning of the year. Additional materials, labor, and overhead costs are incurred during the year to finish manufacturing those goods as well as other goods started during the period. Goods in process at the end of the year represents the cost of materials, labor, and overhead on incomplete goods.
Raw materials used represents the cost of materials that become part of the finished product during the year. For example, in an automobile manufacturing plant, raw materials would include steel, glass, tires, and so on.
Direct labor is the cost of salaries and wages of employees directly involved in manufacturing goods. For example, the wages of employees who work on the assembly line in an automobile manufacturing plant installing windshields in the vehicles would be classified as direct labor. The salary of the company’s chief executive officer cannot be traced directly to the manufacture of vehicles, and so that amount would not be classified as direct labor.
Overhead represents all the indirect costs of production. Indirect costs cannot be traced directly to manufactured goods and include the salaries of supervisors, office supplies, depreciation of equipment or buildings, utilities, maintenance, marketing, advertising, salaries of company accountants and attorneys, and so forth. Each signi? cant type of overhead cost may be disclosed separately.
Cost of goods manufactured represents the cost of goods completed during the period that are ready for sale, similar to the cost of goods purchased by a business that purchases goods for resale.
The costs associated with manufactured goods would be shown as an expense of the accounting period in which the goods were sold because of the matching principle. The cost of unused raw materials on hand, the costs of partially completed goods, and the costs of unsold ? nished goods would be shown on the balance sheet as inventories. A manufacturer typically has three types of inventories: (1) raw materials, (2) goods in process or work in process, and (3) finished goods. The cost of these inventories will become part of cost of goods sold in future periods as the goods are completed and sold.
Variations in Income Statement Format
Income statements may be presented in different formats. Regardless of the format presented, you’ll notice that the basic content of the income statement has not changed: it contains the revenues, expenses, and any gains or losses experienced by the company for the period of time being reported.
Multiple-Step Versus Single-Step Income Statement
The most common variations in income statement format are multiple-step versus single-step income statements. Our earlier examples were generally multiple-step income statements with several categories before reaching the bottom-line net income figure. The multiple-step format emphasizes the relationship of sales and cost of goods sold (through the computation of gross pro? t) and the operating versus non-operating results.
The single-step format calculates the bottom-line net income figure in one single step by grouping all the revenues and other income together, and grouping the expenses and losses. The single-step format does not emphasize the distinction between the primary operating and non-operating status of each item.
The full disclosure and materiality concepts affect the amount of detail in the income statement and the number and depth of explanations or detailed schedules needed in the footnotes to the financial statements.
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