Income Statement
Hello and welcome to the topic Income Statement!
An income statement is more like a video of the firm’s operations for a specified period of time. A video
of a birthday celebration for example, captures the activities that happened during the whole
celebration from start to finish. Similarly, an income statement shows a picture of what a business sold
and what it spent over a period of time.
The sales made by a business in $ is what you call revenues and the money spent to earn those revenues
are called expenses. You generally report revenues first and then deduct any expenses for the period.
Revenue minus expenses gives you profit of loss.
When revenues exceed expenses, a business earns profits. If expenses exceed revenues, a business
earns losses. Revenues are called "Topline", while profit or loss is called "Bottomline".
Income Statement is constructed following two major accounting principles. They are matching
principle and accrual principle.
The matching principle directs a company to report an expense on its income statement in the same
period as the related revenues.
The accrual principle is the concept that you should record accounting transactions in the period in
which they actually occur, rather than the period in which the cash flows related to them occur.
Let me give you some examples for matching principle first to help you understand it better.
Big Appliance has sold kitchen appliances for 30 years in a small town. It purchases a large appliance
from wholesalers for $5,000 and resells it to a local restaurant for $8,000. At the end of the period, Big
Appliance should match the $5,000 cost with the $8,000 revenue. In essence, what you sell over a
period of time for which you are making the income statement, is recorded as revenue, and only those
expenses that you incur to earn that revenue are recorded in the income statement to calculate profits
or losses.
The second example of matching principle is, if a company purchases an elaborate office system for
$252,000 that will be useful for 7 years, the company will match $36,000 (i.e 252,000 / 7) of expense
each year to its yearly income statement.
Now let’s look at some examples of accrual principle.
Accrual Principle tracks promise and not settlement. What does that mean?
When a company makes sales and majority of it are against credit, record it irrespective of whether you
made the sales against cash or credit. For example if a customer receives delivery of goods or services
but promises to make the payment, say within 30 days. In accordance with accrual principle, revenue is
recognized when the delivery is made not when cash is received.
So, record sales when you invoice the customer, rather than when the customer pays you.
Similarly, record an expense when you incur it, rather than when you pay for it.
Record a commission in the period when the salesperson earns it, rather than the period in which he is
paid it.
Record wages in the period earned, rather than in the period paid.
So when you promise to pay for a good or service that you received, record it as an expense when you
received the good or service even if you pay for it at a later point in time.
Similarly, when someone promises to pay you for a good or service your delivered, record it as a
revenue when you sell the good or service even if you receive the payment later and not right away.
That’s why we say the income statement tracks promise and not settlement.
A typical income statement looks like this.
Sales on top. Then you deduct cost of goods sold in accordance with matching principle to arrive at
Gross Profit. Then deduct operating expenses and depreciation to get Earnings before interest and
taxes or EBIT. From EBIT, you deduct Interest to get Earnings before taxes or EBT. Deduct taxes to get
Net Income.
We know dividends are paid from profits and preference dividends are paid first and then common
stock holders are paid next.
So deduct preference dividends and common stock dividends from Net Income. What remains after
paying all dividends is retained earnings.
Here you see the income statement of DPH Tree Farm for 2015 and 2014.
Let’s do an example ourselves.
Andre's Bakery has sales of $687,000 with costs of $492,000. Interest expense is $26,000 and
depreciation is $42,000. The tax rate is 35 percent. What is the net income?
Income Statement
Sales
$687,000
Costs
Gross Profit
492,000
Depreciation
42,000
EBIT
Interest
EBT
$153,000
26,000
$127,000
Taxes (35%)
44,450
Net income
$82,550
Net income = ($687,000 - $492,000 - $26,000 - $42,000) (1 - .35) = $82,550