In the last post we covered the bookkeeping principle of double entry accounting and the progress of entries from the Journal to the ledger to the trial balance and finally the financial statements. From this post we begin a series of posts which will cover each of the financial statements ,i.e. income statement, balance sheet and ‘statement of cash flows’ in detail. Let’s begin today with understanding the basics of the income statement.
Income statement, also as ‘Statement of earnings’ or ‘profit and loss statement’, records the revenues earned and expenses incurred during an accounting period.
Revenues are the income earned from sales of goods and services while expenses are the amounts incurred to generate revenue and include the cost of goods sold, operating expenses, depreciation expense, interest expense and tax expense. Cost of goods sold is all the costs that went into producing the good, such as cost of raw material, cost of labor, etc. They are called direct costs as they can be directly tied to the production of the good. Operating expenses, on the other hand, are called indirect costs as they cannot be directly tied to the production of the good. However they are expenses that directly emanate from the business operations.
Income statement also records the gains and losses on investments. The gains and losses may or may not have resulted from direct business activities.
The equation of an income statement is Revenues – expenses = net income
You will learn in further posts that revenue is recorded when it is earned irrespective of whether cash has been received or not. Similarly expenses are recorded when incurred irrespective of whether cash has been paid or not. This is called accrual accounting. As against this revenues and expenses are recorded on a cash flow statement when they are accompanied by cash flows. Therefore, cash flow statements are also called as cash based income statements.
Income statement example
Income statement can either be presented either by grouping all the revenues and expenses together or it can be presented in multiple steps where each type of expense is presented separately. Below is an income statement example of the later type.
ABC company Income Statement
For the year ended 31st March 2015
|(-) Cost of goods sold||(430,000.00)|
|Gross Profit / EBITDA||260,000.00|
|(-) Selling expenses||(50,000.00)|
|(-) General and Administrative expenses||(10,000.00)|
|Operating Income / EBIT||150,000.00|
|(-) Interest expense||(25,000.00)|
|(-) Tax expense||(37,500.00)|
|Income from continuing operations||162,500.00|
|Earnings or losses from discontinued operations net of tax||40,000.00|
|(-) Income distributed as dividends (40%)||(81,000.00)|
|Retained earnings (60%)||121,500.00|
From the above income statement example we can see that revenue minus the direct costs i.e. cost of producing the goods sold gives us the Gross Profit. The gross profit is also called EBITDA, i.e. earnings before (deducting) interest, tax, depreciation and amortization. From this gross profit/EBITDA we deduct the indirect costs, i.e operating expenses. Operating expenses are all expenses that cannot be directly tied to the production of the goods but they co-incidental to and directly emanate from the business operations and include depreciation expense, amortization expense, selling and administration expenses. After deducting the operating expenses from the gross profit/EBITDA we get the EBIT, i.e. earnings before interest and tax. From this we deduct the interest expense to arrive at EBT, i.e. earnings before tax. After deducting tax from EBT we are left with the net earnings which are called as ‘earnings from continuing business operations’. To this we add or deduct the earnings or losses from business operations that were discontinued during the accounting period to arrive at the Net Income for the accounting year.
A company usually distributes some percentage of the net income as dividends and the remaining amount is ploughed back into the company. The amount that is ploughed back into the company is called Retained Earnings on the income statement as it is the earnings retained back by the company and not distributed to shareholders as dividends. Retained earnings are carried to the balance sheet as Comprehensive Income which forms a part of the Owner’s Equity. Read here about owner’s equity
Thats all in this post folks…..hope you now have a basic understanding of what the income statement is all about and won’t forget to share the post :-)…i have attached a brief summary ppt of the post above for your reference….
in the next post we will take our discussion forward and look into revenue recognition on the income statement…further on in the series covering income statements we will discuss important concepts like earnings per share calculation under different capital structures and common size income statements……see you again then…
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For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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