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 profitability of the business needs to be evaluated.
Let’s see what information is reported in the income statement. By nature, there are five (5) types/categories of accounts in which all business transactions are classified:
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 and expenses of an entity during a particular period of time.
Let’s briefly go through each type of account which is reported in the income statement.
Income (or revenue)
Income or revenues are the 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 This is true if you are following “cash basis of accounting”, however this basis is now somewhat outdated, as it does not show a true picture of the performance of the business.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.
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 expenses 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.
We have briefly explained both components of income statement. Let’s take a look at how the income statement looks like. Following is a sample income statement of Ricardo Garments Inc. for the year ended 31 December 20xx.
Ricardo Garments Inc.
For the year ended 31 December 20xx
|Selling and administrative expenses||5,500|