Tuesday, November 18, 2008

Explaining The Income Statement

By Michael Russell

In layman’s terms, what is the income statement? We will look at the various components of the income statement: revenues, cost of goods sold, expenses and net income. Income statements are helpful, because they will give you some history of the business in order to budget for future operations and assess risk of future cash flows. An income statement is also known as a profit-and-loss statement.

The nature of the income statement is that it is a reflection of operations over a period of time, i.e., “for the month ended June 30, 2006”, or “for the year ended December 31, 2006”. This is different from the balance sheet, which reflects a certain point in time. Income statements contain what is known as “temporary” accounts and the balance sheet contains “permanent” accounts. Temporary accounts such as sales revenues and expenses are “closed out”, net income/loss is determined and this net amount ends up in an owner’s equity account. The accounts are closed at the end of one period, reopened and reused for the next period.

The income statement is revenues less cost of goods sold, less expenses, equals the net income or loss. Revenues are the sales of items normally sold in your business; what are you selling? Do you sell goods? Do you sell services? It is the selling price times the number of items sold. Sales are usually shown as net sales and some adjustment to sales would include sales discounts, sales returns and allowances.

If the business sells goods, the next part of the income statement would be the cost of goods sold section. If the business sells services, it won’t have this section. Because this is such a large part of expenses for a retail establishment, while it is an expense, it is broken out separately from other expenses. The business will need to know how much inventory it started with and how much inventory it had during the end of the period. Additionally, it will need to know how much inventory was purchased during the period. There are a number of ways to value inventory, such as Fifo (first in, first out), Lifo (last in, first out), average cost, specific identification, etc. Since we are taking a high-level glance at the income statement, it is just important at this time to note that, because of subjectivity of inventory methods, this can be more of an art than a science. Beginning inventory plus goods purchased equals goods available for sale; goods available for sale minus ending inventory will give you the cost of goods sold.

Expenses are outflows of cash necessary to the operation of the business. Some expenses are easily identified, such as rent or mortgage, utilities, office salaries, supplies, etc. and these are referred to as selling and administrative expenses. Selling expenses are costs related to selling goods, such as the salesperson’s salaries, shipping, freight, advertising, etc. Research and development costs are also valid expenses. If you own the building, vehicles, or equipment, there are depreciation costs. That just means if you own an asset that lasts for a couple of years, you can write off part of the cost of that asset as a depreciation expense for a certain number of years. Like inventory costs, there are a number of ways to subjectively determine depreciation, such as straight line, accelerated depreciation methods, etc. so there isn’t just one possible answer to determine depreciation costs.

To determine net income or loss, you take revenues minus cost of goods sold minus expenses. If this number is positive, it is net income. If this number is negative, it is net loss. This amount is closed to an equity account, such as an owner’s capital account for a sole proprietorship or stockholder’s equity for a corporation.

Expenses and/or income outside the realm of usual business operations should be included in its own separate section. For example, the business is a shoe store and they sell one of their buildings or part of their vacant lot, which creates an inflow of money. This is not what you would expect a shoe store to do. In order to make income statements comparable by year, this special income will need to be shown in a separate section above net income.

So, at a high level we’ve looked at the income statement, defined the components of revenue, cost of goods sold, expenses and net income. We’ve pointed out areas such as inventory valuation and depreciation where different methods can be used which will determine different financial amounts. Businesses need to select their methods carefully and stick with them for consistency. It is not totally impossible to change these valuation methods, but it would require special disclosures, etc. Once we understand the basics of the income statement, it will help us understand income statements from a number of different companies, regardless of the nature of their business.

Michael Russell Your Independent guide to Accounting

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