Income statement is a financial statement that shows an entity’s financial performance during a particular period of time. Owners are often most concerned about the profitability of the business and this statement provides the information about profitability of a business during a particular period of time. This period can be monthly, quarterly, semi-annual, annual or any time period for which financial statements have been prepared.
Let’s see what information is reported in the income statement. In basics of accounting, we learnt that by nature, there are five (5) types/categories of accounts in which all business transactions are classified:
- Income and gains
- Expenses and losses
Balance sheet reports the amounts of assets, liabilities, and equity of an entity at any particular point in time, whereas income statement reports the amounts of income, gains, expenses and losses of an entity during a particular period of time.
Gains and losses are similar to income and expenses which, for simplification purposes, were intentionally not mentioned in the basics of accounting section. The difference between income/expenses and gains/losses is that income and expenses are measured at gross amounts, whereas gains and losses are measured at net amounts.
For instance, if a company makes cars and sells them, the amount earned by selling a car will be recorded as revenue (income), as the amount earned is from the company’s main business activities (see the definition of revenue below). Expenditure incurred to manufacture the car and sell it are recorded as expenses separately. Alternatively, if a bakery sells its old delivery van, its sales proceeds will be netted off with the carrying value of that van and any other selling expenses incurred, and the net amount will be recorded as gain or loss on disposal of van.
Some common examples of gains and losses include gain or loss on disposal of fixed assets, foreign currency exchange gain or loss etc.
Let’s briefly discuss income and expenses and their classification as these two items are the main elements of the income statement.
Income means amounts that are earned by the business during a particular period of time. It is important to understand the word “earned”. It is often considered that an entity’s receipts are its income. This is true if you are following “cash basis of accounting”, however this basis is now somewhat outdated, as it does not show a true picture of the performance of the business. The approach which is currently followed almost all over the world is the “accrual basis of accounting” and under this approach, income or revenues are defined as the amounts earned by the business.
For example, during year 20XX, Ricardo Garments Inc. sold premium quality dresses worth USD 100,000. Out of these sales, USD 20,000 were on credit and whose payment will be received in next year. What would be the income of Ricardo Garments Inc. during year 20XX? Yes, you guessed right! It should be USD 100,000 as we are following accrual basis of accounting and this is the amount that has been earned by the business during the year. Even though the entity has not received USD 20,000, it is entitled to this money as it has sold the dresses to customers and they have agreed to pay the credit amount in next year.
Income can be categorized into two types:
Income earned from the main business activities is classified as revenue. Here are some examples of revenue; a bakery selling bakery items and earning money, an educational institute getting earning fee from students, a car manufacturer earning income from sale of cars etc.
Any income earned from secondary sources i.e., sources other than an entity’s main business activities is classified as other income. For example, a bakery earning advertising income by displaying an ad in the bakery, an educational institute earning some income from fun fares or other similar functions, a car manufacturer earning income from selling some by-products or scrap steel etc.
Expenses mean expenses incurred by the business during a particular period of time regardless of when they are paid. It is important to understand the word “incurred”. Similar to income, it is often considered that an entity’s expenses are the amounts that are paid by the entity. This is true if you are following “cash basis of accounting”. However, “accrual basis of accounting” is the modern approach and under this approach, expenses are defined as the expenses incurred by the business.
Let’s look at how the accountant of Ricardo Garments Inc. prepares the income statement of the business for the year ended 31 December 20XX. Electricity, telephone and other utilities are used in the month of December 20XX, but these are billed in January of next year and are paid in next year as well. But he is taking the utility expense of December 20XX as well while preparing the income statement. Is he right or wrong? He’s right! as the utilities have been used by the business in December and their expense is actually incurred in December, even though it is paid in January next year. Similarly, December salaries of all the staff of Ricardo Garments Inc. are paid in January, but these are also included in expenses for the year as the staff has worked in December and the salary expense is incurred by the business regardless of timing of payment.
Expenses are categorized in two main types:
Cost of sales
All expenses that are directly related to earning revenue are classified as cost of revenue or cost of sales. For a manufacturing concern, this cost of sales is termed as cost of goods sold and it includes all production costs incurred for manufacturing the goods that are sold in a particular period.
All day-to-day operational expenses incurred by an entity in running the business operations, that do not fall in definition of cost of sales are classified as operating expenses. Further subclassifications may be used in operating expenses such as administrative expenses, selling expenses etc.
We have briefly explained the components of income statement. Now, let’s take a look at how the income statement looks like. Following is a sample income statement of XYZ Company for the year ended 31 December 2020.
Basic concepts of earnings per share disclosed in income statement is explained in our next post. Advanced concepts related to earnings per share will be discussed in our explanation of “IAS – 33 Earnings per share”.