2.01 – Presenting Typical Income Statements
Understanding how income statements function is essential for tracking a business’s profit. Making a profit is the primary financial goal for businesses, although not-for-profit organizations and government entities aim to break even. Accountants play a crucial role in measuring this profit, which involves accurately determining revenue and expenses.
Among the three primary financial statements (balance sheet, income statement, and cash flow statement), the income statement is often the most scrutinized and sometimes manipulated. External parties frequently focus on it to assess performance metrics like sales growth and profitability. While businesses strive for accurate and reliable financial statements, it’s wise to be cautious when financial performance seems unusually high or low
The Role of Accountants
Accountants are responsible for generating accurate financial reports that summarize a business’s profit-making activities. They help managers analyze profit for decision-making and prepare profit forecasts. This lesson covers how these profit-making activities are reported in a business’s external financial reports to owners, investors, creditors, and lenders.
Presenting Typical Income Statements
Businesses typically generate profit in three ways:
- Selling Products: By controlling the cost of products sold and other operating costs.
- Selling Services: By managing the cost of providing services and other operating expenses.
- Investing in Assets: By generating investment income and controlling operating costs.
Income Statements for Different Business Types
Businesses that Sell Products
For a technology-based business that also sells software and services, the heading identifies the business, the statement title, and the time period summarized. The statement starts with sales revenue and proceeds through various expenses down to the net income, or “bottom line.”
Key terms include:
- Gross Profit: Sales revenue minus the cost of goods sold.
- Operating Earnings: Profit before interest, other expenses, and income tax.
- Profit Before Income Tax: Profit after interest and other expenses but before income tax.
- Net Income: Final profit after all expenses are deducted.
The statement also includes Earnings Per Share (EPS), a crucial metric for public corporations, showing net income divided by the number of shares held by shareholders.
Businesses that Sell Services
For a small consulting firm, service-based businesses often report direct expenses as costs of sales, reflecting expenses like salaries and travel directly tied to generating revenue. The statement shows:
- Gross Profit: Revenue minus direct costs of sales.
- Operating Earnings: Profit before other expenses and taxes.
- Net Income: Final profit after all deductions.
Note the presence of “other expenses” below operating income, often used to disclose unique or non-recurring expenses. Additionally, small service businesses might have low income tax expenses due to their structure as pass-through entities.
Investment Businesses
An income statement for an investment business shows three types of revenue: interest and dividends earned, gains from sales of investments, and unrealized gains in market value. Investment businesses may or may not have interest expenses. Public investment companies are heavily regulated and must report detailed investment returns.
Practical Tips for Understanding Income Statements
- Read from Top to Bottom: Start with sales revenue and proceed through each expense to the net income.
- Understand Key Metrics: Pay attention to gross profit, operating earnings, and net income.
- Compare Multiple Periods: Reviewing income statements over multiple periods can provide insights into trends and performance.
- Be Cautious of Anomalies: Unusually high or low performance should be scrutinized for potential misstatements.
By understanding and analyzing typical income statements, you gain insights into a business’s profitability and financial health, enabling better decision-making and financial management.
