Our Income Statement course is purely about helping you to present your company’s incomes and expenses for the period. As such we will start off with explaining the logic behind the statement and move onto different approaches there are present when it comes to forming the statement. What you’ll get is a simple structure with the key messages underlined and explained. To support the content, we’ve also prepared a template for easier following and to also be used as a base for your very own income statement.
The course itself is structured with the aim to have it easily follow able and understandable with examples to illustrate where possible. There will be just simple words and everything written in “down to earth” style for an easy and quick understanding.
So let’s kick off!
What’s an income statement?
An income statement is presented in a form of a table that shows your company’s incomes and expenses for the chosen reporting period. You may also recall more illustrative terms like “profit and loss statement”, “statement of financial performance”, “earnings statement” or “statement of operations” being used in some materials. An income statement is one of those basic financial statements alongside with the balance sheet which needs to be presented in the annual report and which usually is asked to be disclosed to management, investors etc. in various reporting.
What an income statement really is, is a summary of various transactions occurred over the reporting period. Note here that an income statement is for a period in time and not a specific moment at a date like a balance sheet is. It starts from the top with the main business inflows for the period, i.e. Income or Revenue and continues with related expenses as Cost of goods sold and services rendered. Those two groups result mathematically in Gross Profit.
To further continue, from Gross profit you then take off all operations related expenses like administrative, personnel and marketing expenses, depreciation etc. You may also have encountered expenses that aren’t exactly related to any of those characteristics, so there may also be a need for Other operating incomes and expenses. With that you’ve reached from Gross profit to Operating profit.
Now something that may also be present in your company, are financial incomes and expenses. They are always shown after Operating profit and as such, after those are added you reach to Profit before income tax. Please note that if corporate income tax applies in your country, this results in Income tax expense just before Profit for the year from continuing operations or simply put Net profit.
So as you see, an income statement is essentially a story about how the income is transformed into net profit for the year. Transformed in a way that we start by saying we earned this much and this is what we spent to achieve that. At the end of the day, our work was rewarded with what was left and that’s the profit at the very bottom of the table. It’s a story and it can say so many things about your company’s health to investors, employees, suppliers and to you yourself. We will talk about what and how to read in an income statement as a part of our course later on.
Now that we have covered the essentials about an income statement, namely what it is and how it looks like, we’re moving onto building one up.
Putting together an income statement
What goes where generally?
Revenue is something that’s fairly easily understandable by its nature. First, revenue is usually the main source of profits. Essentially revenue on the income statement represents cash inflows and receivable balances booked during a period from selling goods and / or rendering services. Since accounting in most countries and companies is made on accrual basis, recording revenue does not necessarily mean that the cash needs to be received. If all rights and obligations have passed from the company as a seller to its client, a sale can in most cases be booked into the accounts. Simplified accounting entry where we would book revenue and also recognize a receivable against our client for they have not paid yet would be as follows:
Cr Sales revenue
Note that all discounts, returns and allowances are deducted from sales and hence are disclosed on the income statement as part of revenue. Note also that in case a sales tax or VAT is charged on the sale, it is not presented as a part of revenue because this is not something the company has earned. This is a tax expense and should not increase company’s revenue. An accounting entry in case of VAT being charged (as an example, the VAT rate is 20% and the price of the product sold 120):
Db Receivable 120
Cr VAT payable 20
Cr Sales revenue 100
In case where you have to credit a sale made either due to misstatement on the invoice or similar (invoice sent to the client is for a bigger amount than it should have been and as such needs to be credited, i.e. decreased), your accounting entry would be as follows:
Db Sales revenue
What you essentially do, is just decrease the sales revenue cause the amount charged should have been smaller and you also take off the amount from the receivable balance as the client does not have to pay the extra amount.
Expenses represent all costs occurred during the reporting period. They may be done to buy materials, pay to employees, buy office supplies etc. We will go over presenting expenses in detail in a bit, but at this point let’s focus on accounting for expenses in general. In essence expenses represent an outflow of resources. The initial accounting entry would be as follows:
Cr Payable to supplier
If the amount has been paid right after, the entry is as follows:
Cr Cash and cash equivalents
Now something to pay attention to is the VAT. If your company is registered for VAT, it normally should not show paid VAT as part of its expenses. There are exceptions, but at this point we are not going to focus on them. The accounting entry in such case would be as follows (again pretending that the price paid was 120 and the VAT rate is 20%):
Db Expense 100
Db Prepaid VAT 20
Cr Payable to supplier 120
If those are the accounting entries done in case suppliers are involved, the payables to employees are in fact recognized with similar entries.
Cr Payable to employee
Note here that the debited expense account varies and depends really on the nature of the expense itself. For the purpose of the course we’ve just stated they’re expense accounts. However, note also that in case of expenses, the credit account usually refers to a balance sheet account. On those not so usual cases, where you would want to reclassify expenses from one account to another your entry would look like this:
Db New expense account
Cr Old expense account
With debit you place the expense amount to the proper account on the income statement and with credit you take it away from the wrong account where it was initially recognized on.
Now though, as promised, we will give you an overview of presenting expenses on the statement itself.
Expenses by function
One way of building up the income statement is to address expenses by their function. Revenue is still revenue, but it’s the expenses that can be shown differently. Now, when we talk about categorizing expenses by function, we mean dividing them by the function they serve.
Let me give you an example. Marketing department has ordered a campaign to advertise your new products. The goal of this expense is to market your business so it should be recognized under Marketing expenses. Now by function obviously the department costs themselves should also be grouped under the same line. Those costs include personnel expenses done for marketing people, depreciation, and office expenses etc. that are related to marketing function.
It’s the same with Cost of goods sold. Not only the expenses made to purchase materials, but also all related personnel, office, utilities expenses and depreciation etc. is categorized under Cost of goods sold. All expenses that are done to produce or render services and that are directly related to those activities are grouped under the relevant line.
Normally the groups used are as follows:
- Cost of goods sold / Cost of rendering services
- Sales costs / Marketing expenses / Distribution costs
- Administrative expenses
Note that the names vary and are dependent on the nature of the business. For an example, the company may be in the business of providing services and not selling goods or it’s not really distributing goods, but just focuses on marketing. The names of the groups really do depend on which best describes the function.
Expenses by nature
If one way of grouping expenses was analyzing their function, the other option is to group them by their nature. Nature is something that’s easily understandable and does not focus on processes.
You bought materials? It’s part of Cost of goods sold. You advertised something on the newspaper? It’s part of Operating expenses. You paid salaries? It’s part of Personnel expenses. Note here that our template is prepared by functions so the groups named may not be present there, but generally the groups used are as follows:
- Cost of goods sold / Cost of services rendered
- Operating expenses
- Personnel expenses
- Depreciation / Amortization
- Other operating expenses
Quite literally the grouping is done based on the very nature of the expense. If it’s materials you bought, they go under Cost of goods sold. The group does not include any other expenses like personnel charges, utilities, rent, depreciation etc. It purely comprises of expenses done to produce goods. If it’s service you provide, it consists of materials needed to provide the service and nothing more.
All payroll and other personnel related charges like bonuses, taxes etc. are grouped under Personnel expenses. Depreciation is also disclosed only under one group, namely Depreciation. It’s all about the very nature of the expense and not really the function it serves.
Now that we’ve covered also the building up an income statement, let’s discuss a bit about what the statement can say about your company.
What’s measured usually?
It’s obvious that one means of measuring is comparing current period results with prior year figures and make decisions based on the outcome. However, since it’s clear that in case the revenue has increased or expenses decreased, the company is generally doing well, we’re not going to focus on that.
What we’d like to focus on, are a couple of ratios usually noticed when the income statement is being analyzed.
First and obvious one is Gross profit and Gross margin (presented as a percentage) which can be calculated from the said gross profit (Gross Profit / Sales revenue). It’s generally expected for a company to have gross profit and not loss, yes, but something that’s also noted is the margin itself. Now although there isn’t a set rule of thumb of how big the margin should be generally, there are however certain levels which are expected from companies operating in specific industries. For an example, a company operating in retail market that’s selling groceries and essentials, expected margin would be around 10%. Now again, please note that this may vary in countries and economies, but it’s just to give you an example.
Another thing also noted is the Operating Profit. Generally only to an extent whether it’s a profit or a loss indicating if the business with its operations is able manage itself or not.
What’s more important however, is EBITDA. It’s quite literally earnings before interest, tax, depreciation and amortization, but what it also shows, is an estimation of cash flows the company is able to generate from its operations within the reporting period. Since it excludes interest and tax expenses, as well as depreciation charges, it makes companies comparable. If you think about it, interest expense is something that either is or isn’t there, tax expense depends on so many variables, depreciation charge is subject to management estimates and accounting treatments being used, it all ends up in not so comparable net profits whereas with EBITDA, you exclude all that and what remains is what’s similar for all companies. There are bound to be costs for materials, personnel etc. and they are less subject to estimations and less variable due to treatment differences.
We have now covered the meaning of an income statement, the logic behind it. To further help you, we also noted down the basic income statement related entries and explained different approaches there can be about grouping expenses. And just to add something, we also explained a bit the basic measured ratios from purely income statement.
We hope you our course was beneficial for you and helped you further with preparing your own income statement.