Reading a financial statement: The income statement

A set of financial statements is comprised of several key statements. This article explains the income statement. Related articles contain details on the balance sheet and the cash flow statement (and more).

In a set of financial statements, the income statement shows revenues less expenses. In this way, the company’s net income for the period can be calculated. Depending on the type of business, an income statement can be formatted in different ways and may show gross profit (sales less cost of goods sold) or it may show revenues grouped together and all expenses grouped together.

Revenues and expenses can be grouped either by function (such as retail group, manufacturing division and administrative department) or by nature (such as salaries and benefits, rent, and insurance).

Generally Acceptable Accounting Principles (GAAP) requires income and expenses to be recorded when they are incurred (rather than when they are actually paid). As a result, when reporting under GAAP there are usually timing differences. Specifically, there are often significant differences in the areas such as deferred revenues and prepaid expenses (such as insurance, which is discussed below).

Income statement: Revenues

Revenues are the inflows (cash or other benefits) that generally result from the sale of goods and services. Revenues can also result from the gain on sale of long-term assets such as land or equipment.

As noted above, sometimes revenue must be deferred. This happens when the criteria that must be met in order to record an amount as revenue have not yet been fulfilled. This means that the revenue will have to be shown as a liability until those criteria have been met. A key example of this would be where a deposit is received before you complete and deliver the actual product or service.

Income statement: Expenses

Expenses are the costs incurred in the running of the business throughout a period of time.

Where the cost of goods sold is presented, the gross revenue divided by sales, or the gross margin, is often used as a measure of as a measure of pricing and profit.

Prepaid expenses are those such as insurance, where you are required to pay upfront, but you continue to receive the benefit over a period of time. Accordingly, the expense is recorded over this period.

What is net income?

Net income (or loss) is the difference between the revenues and expenses for the period.

Retained earnings: Part of the income statement?

In a set of financial statements, the statement of retained earnings is sometimes presented separately or it can be included at the bottom of the income statement. IFRS requires it to be presented separately, but in many other cases it is included as part of the income statement. When this is the case, the statement will usually be referred to as the statement of income and retained earnings.

The statement of retained earnings calculates the retained earnings balance at the end of the period (which is reported on the balance sheet). The statement shows the opening balance of retained earnings, adds the net income (or subtracts the net loss) for the period, subtracts any dividends paid out in the period and adjusts for any items that are to go directly to retained earnings.

In this way, the closing retained earnings is a cumulative tally of all previous years’ income, less any dividends paid out of the earnings and any adjustments, since the inception of the company—hence its name.

[download url=”” type=”pdf”]Sample income statement[/download]