Income Statement This module provides an introduction to the income statement, one of the essential financial statements in accounting. In addition, some

Income Statement

This module provides an introduction to the income statement, one of the essential financial statements in accounting. In addition, some simple percentage of revenues calculations, basic transactions, and debits and credits are covered. We suggest doing the balance sheet module prior to working on this module.

Author: Stu James

© 2014 Stu James and Management by the Numbers, Inc.

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• The income statement is one of the essential financial statements (reports) for a company and is a required filing for all public companies.

• Understanding how to read and interpret an income statement is an important skill for a business person or investor.

• The income statement provides important information about the financial health of a company over a certain period of time (usually a year or a quarter). This information includes:

• Revenues (sales of product/services)• Expenses (costs of doing business)

INTRODUCTIO

N TO THE INCO

ME STATEM

ENTIntroduction to the Income Statement

MBTN | Management by the Numbers

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SAMPLE INCO

ME STATEM

ENTSample Income Statement


Facebook, Inc.Quarter ending Sept 30, 2013

$millions

Revenues 2,015

Expenses 1,593

Net Income 422

Here is a (very) simplified income statement for Facebook, Inc. for the 3 month period ending Sept 30, 2013. What can we say about this income statement?

First, note that Revenues – Expenses

= Net Income(2,015 - 1,593 = 422)

Second, note that the reporting period is for 3 months (July 1-

Sept 30, 2013)

We can also say that Facebook is a profitable company during this period, because revenues exceed total expenses, leaving net income of $422 million. Now let’s look at these areas in more detail.

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TOTAL REVENUE

Total Revenue


Facebook, Inc. Inc. Statement $MillionsTotal Revenue 2,015 Cost of Revenue 506Gross Profit 1,509 Research and Development 369 Selling, General and Admin. 403Operating Income or Loss 737 Interest Expense 21 Net Non-Recurring Events 0 Income Taxes 294Net Income 422

Total Revenue is the combined total for all sales in a period.

Total revenue is all sales from products and services for the company (aka the “top line” of the business – as opposed to the “bottom line” or net income.). Publically, only a single line will be shown for revenue, but internally to the company, revenue will be reported in a very detailed fashion – broken out by product line, geographic region, etc.

Definition: Total Revenue = Net sales of all products and services.

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GRO

SS PROFIT

Gross Profit


Facebook, Inc. Inc. Statement $MillionsTotal Revenue 2,015 Cost of Revenue 506Gross Profit 1,509 Research and Development 369 Selling, General and Admin. 403Operating Income or Loss 737 Interest Expense 21 Net Non-Recurring Events 0 Income Taxes 294Net Income 422

Subtracting the Cost of Revenue leaves Gross Profit.

Gross Profit is what is left after subtracting cost of revenue. Cost of Revenue (or Cost of Sales) includes any direct expenses (cost of goods / services sold) associated with revenues. Gross profit (as a percent) varies widely by business type. Both gross profit and cost of revenue are often expressed as % of total revenue for comparisons.

Definition: Gross Profit = Total Revenue – Cost of Revenue

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GRO

SS PROFIT

Gross Profit


Sept 2013 (3 months) $Mil As %Total Revenue 2,015 100% Cost of Revenue 506 25%Gross Profit 1,509 75%

Percentages help analysts compare data. For example, how is Facebook doing compared to the previous year?

Facebook is growing rapidly (2,015 vs. 1,262 previous year, 60% growth). But analysts also want to see how that growth has affected their margin. Expressed as a % of total revenue, we can see that the percentage is stable and even improved some (75% vs. 74%).

Definitions: Gross Profit % = Gross Profit /Total Revenue

Cost of Revenue % = Cost of Revenue / Total Revenue

Sept 2012 (3 months) $Mil As %

Total Revenue 1,262 100%

Cost of Revenue 322 26%

Gross Profit 940 74%

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OPERATING

INCOM

EOperating Income


Facebook, Inc. Inc. Statement $MillionsTotal Revenue 2,015 Cost of Revenue 506Gross Profit 1,509 Research & Development (R&D) 369Selling, General & Admin. (SGA) 403Operating Income or Loss 737 Interest Expense 21 Net Non-Recurring Events 0 Income Taxes 294Net Income 422

Now let’s look at the next section of the Income Statement.

Operating Income (or EBIT – Earnings before Interest and Taxes) represents a company's earnings from its normal operations (not including interest expense, taxes and one-time costs). It is calculated by subtracting other on-going operating expenses from Gross Profit. Operating income is often used by analysts rather than net income as a measure of profitability.

Definition: Operating Income = Gross Profit – (SGA + R&D)

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GRO

SS PROFIT

Operating Income


Sept 2013 (3 months) $Mil As %Gross Profit 1,509 75% Research + Develop. 369 18% Sell. Gen. + Admin. 403 20%Operating Income 737 35%

Let’s Compare Operating Income (%) for 2012 vs. 2013

While Facebook is spending more on R&D and SGA than in 2012, as a percent of total revenue, these expenses are less than in 2012. This means that operating income is growing at a faster rate than revenue (95% vs. 60%). This bodes well for future profitability presuming revenue continues to grow.

Definitions: Operating Income % = Operating Income / Total Revenue

Sept 2012 (3 months) $Mil As %

Gross Profit 940 74%

Research + Develop. 244 19%

Sell. Gen. + Admin. 319 25%

Operating Income 377 30%

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NET INCOM

ENet Income


Facebook, Inc. Inc. Statement $MillionsTotal Revenue 2,015 Cost of Revenue 506Gross Profit 1,509 Research and Development 369 General, Selling and Admin. 403Operating Income or Loss 737 Interest Expense 21 Net Non-Recurring Events 0 Income Taxes 294Net Income 422

Net Income is the “bottom line” of the Income Statement

Definition:

Net Income = Oper. Income - Interest - Taxes - Non Recurring Items

To calculate Net Income, or the “bottom line” of a business, we subtract remaining expenses from operating income. For various reasons, analysts separate out interest expense (financing costs), net non-recurring events (special situations) and income taxes from the normal operating costs of a business.

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TRANSACTIONS

Transactions


Since we’ve already introduced transactions, debits, credits and T-accounts in the balance sheet, we’ll focus here on how revenue and expense items are handled.

Two important points. First, generally a transaction that impacts revenue or expense accounts will also impact the balance sheet. Second, for the most part, revenue accounts are usually credited (increased) and expense accounts are usually debited (also increased). So, throughout the accounting period, the revenue and expense accounts are accumulating balances that indicate whether the business is profitable or not (revenues > expenses).

Account Category Debit / Credit Account BalanceRevenue Credit IncreaseExpenses Debit Increase

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TRANSACTIONS

Transactions


Let’s walk through a few examples. Consider the following transactions:

• A customer purchasing an item for $1,000 cash

• Recognizing the $600 cost of the $1,000 item

• Loan payment of $3,000 ($2,000 is interest and $1,000 is principal)

• The business purchasing a marketing list for $2,500 to be paid later

• A customer receiving $500 of services (invoiced to be paid later)

Definition:

Assets = Liabilities + Shareholder Equity + (Revenues – Expenses)*

Now we can now extend our basic accounting equation to include expenses and revenues by showing the revenues and expenses of the current accounting period as below:

*Note – this is simplified a bit so as not to get bogged down in some details until later.

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SAMPLE TRANSACTIO

NSSample Transactions


• A customer purchasing an item for $1,000 cash

Assets = Liab. + SE + (Revenues – Expenses)Cash Revenues

Debits Credits Debits Credits$1000

= $1000

Increase Increase

The cash account is debited (increases) by $1,000, reflecting the receipt of cash, and the revenue account is credited (also increases) by $1,000.

• Debits and credits are equal ($1,000 = $1,000) • Assets = Liabilities + SH Equity + (Revenues – Expenses)

($1,000 + $0 = $0 + $0 + $1,000 - $0)

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SAMPLE TRANSACTIO



• Recognizing the $600 cost of the $1,000 item

Assets = Liab. + SE + (Revenues – Expenses)Inventory (Asset) Cost of Revenue (Expense)

Debits Credits Debits Credits$600 = $600

Decrease Expense account increases, but this side of the equation decreases (b/c negative)

• Debits and credits are equal ($600 = $600) • Assets = Liabilities + SH Equity + (Revenues – Expenses)

-$600 = $0 + $0 + $0 + ($0 - $600)

InsightThe net of these first two transactions is a $400 improvement to the “bottom line” or net income (Rev-Exp=Net Inc: $1,000 - $600 = $400).

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SAMPLE TRANSACTIO



• Loan payment of $3,000 ($2,000 interest / $1,000 principal)

Assets = Liab. + SE + (Revenues – Expenses)

Cash (Asset) Loan (Liability)

Debits Credits Debits Credits

$3000 = $1000

Interest (Expense)

Debits Credits Debits Credits= $2000

Assets decrease by $3000 Liabilities decrease by $1,000, Expenses

increase by $2,000 (total decrease of $3,000 b/c expense is negative)


-$3,000 = -$1,000 + $0 + ($0 - $2,000)

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SAMPLE TRANSACTIO



• The business purchasing a marketing list for $2,500 to be paid later


Accounts Payable (Liability)


SG&A (Expense)


No net changeLiabilities increase by $2,500,

Expenses increase by $2,500. Net change = 0


$0= $2,500 + $0 + ($0 - $2,500)

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SAMPLE TRANSACTIO



• A customer receiving $500 of services (invoiced to be paid later)


Accounts Receivable Revenues


= $500

Increase Increase

Accounts Receivable is debited (increases) by $500 reflecting the purchase of services and the revenue account is credited (also increases) by $500. This is similar to the first transaction except that the asset is a promise from the customer to pay at a later time (Accounts Receivable). An important point that applies to the last two transactions is to note when a sale or expense is recognized. This depends on the accounting system being used.

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CASH VS. ACCRUAL ACCOUNTING

SYSTEMS

Cash vs. Accrual Accounting Systems


The determination of when revenues or expenses are recognized (entered) on the Income Statement depends primarily on what type of accounting system, Cash or Accrual, is being used. The focus of this module is to compare how transactions are entered in cash or accrual systems. Accrual systems have additional guidelines for determining how and when transactions are recorded, which is not addressed here.

Definitions:

In a cash-based accounting system, revenues and expenses are

recognized when cash is received for the transaction.

In an accrual-based accounting system, revenues and expenses are

recognized when the economic transaction occurs (not necessarily when

cash is exchanged), with the goal to match revenues with their

associated expenses.

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SYSTEMS



The cash-based accounting system is easier to understand and simpler (as it reduces the number and complexity of transactions), but is generally allowable for use only by smaller businesses. Let’s use the last transaction to demonstrate the difference between the two systems. But we’ll add a few more details to highlight the difference between the two systems.

• On Aug 15th, a customer receives services for $500 (this is the economic transaction - when services were rendered and the obligation to pay is initiated.

• On Sept 15th, the customer is invoiced.

• On Oct 15th, the customer pays the invoice in full.

How and when would these transactions be recorded under a cash and an accrual based accounting system?

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CASH SYSTEM EXAM

PLECash System Example


In a cash-based accounting system, there is a single transaction that takes place when the payment is received (on Oct 15th). Cash increases, as does revenues, as shown below.


Cash Revenues


= $500

Increase Increase

Easy. Single step. Now let’s see how this works under an accrual accounting system.

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ACCRUAL SYSTEM EXAM

PLEAccrual System Example


In an accrual system, the event is a multi-part accounting transaction consisting of the revenue recognition and the payment of the invoice.


Accounts Receivable Revenues


= $500

Increase Increase

On Aug 15th, according to generally accepted principles, one would recognize the revenues at that time with an off-setting debit to accounts receivable (promise by the customer to pay later).

On Sep 15th, the customer is invoiced. Technically, this would not be an accounting event since the revenue has already been recognized in Aug. Practically speaking, however, most accounting systems link the creation of the invoice with the accounting transaction.

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ACCRUAL SYSTEM EXAM

PLEAccrual System Example


Finally, on Oct 15th, the customer pays the invoice, resulting in the transaction that closes the loop. In addition, in most computerized accounting systems, this will clear the customer’s statement showing that they no longer owe any money.


Cash


=

Accounts Receivable

Debits Credits Debits Credits

$500 =

Cash increases. Accounts Receivable decreases. No net

change to overall assets.No change

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SYSTEMS



Let’s spend a moment talking about two important timing distinctions that could easily be glossed over here, but that should be highlighted.

First is that the business should invoice the customer at the time the services are rendered. This is so that the timing of the revenues (invoice for services) match the expenses (presumably the salaries paid for the people performing those services) and that they are in the same month.

Second is that the accrual system will show the revenues in the Sept 30th income statement, whereas the cash system will show them on the Dec 31st statement. These types of timing differences can have significant implications, especially with regard to tax liabilities.

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BUILDING AN INCO

ME STATEM

ENTBuilding an Income Statement


The last example we’ll show is to create an Income Statement from scratch for a start-up coffee shop. While this is obviously a very simplified exercise, it will help you understand how the transactions build together to create the Income Statement.

On the next page, there are 6 transactions that you can use to test your comprehension. Try to build it yourself before checking the answer key. We’ve also provided the detail on all the individual transactions so you can follow how the accounts were updated.

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BUILDING AN INCO

ME STATEM



Create an income statement for the month of January from the following transactions – use a cash system:

• The coffee shop sells $8,000 of coffee (all cash purchases).

• The coffee shop pays $4,500 in barista wages.

• The coffee shop purchases $2,500 of coffee and milk for cash.

• The coffee shop purchases an advertisement running January-June in the local paper for $1,200 (pays in advance).

• The coffee shop receives a request for a special order of $2,500 of fair trade Guatemalan coffee.

• The coffee shop makes a loan payment of $600, of which $400 is interest and $200 is principal.

Ready, set, go – don’t advance until you’ve tried it!

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BUILDING AN INCO

ME STATEM



Coffee Shop Income Statement $Total Revenue 8,000 Cost of Revenue 7,000Gross Profit 1,000 Research and Development 0 Selling, General and Admin. 1,200Operating Income or Loss -200 Interest Expense 400 Net Non-Recurring Events 0 Income Taxes 0Net Income -600

Cash system – Income Statement for January

Though very simple, this exercise provides a good sense of how the income statement accumulates values over time. Note that the balance sheet is also affected by these transactions.

The detail of the transactions and T accounts are shown on the following pages for reference.

Follow-up question: What would be different if using an accrual system instead of cash?

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BUILDING AN INCO

ME STATEM



Assets = Liab. + SE + (Revenues – Expenses)Cash Revenues


= $8000

Increase Increase

Assets = Liab. + SE + (Revenues – Expenses)Cash Cost of Revenues


Decrease Expenses Increase, but remember, negative

Assets = Liab. + SE + (Revenues – Expenses)Cash Cost of Revenues



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BUILDING AN INCO

ME STATEM



Assets = Liab. + SE + (Revenues – Expenses)Cash Selling, General & Admin.



If the coffee shop had used an accrual system, $200 would have been an expense (as above) but the remainder of $1,000 (Feb-June advertising) would have been an asset of a pre-paid expense.

The special order for Guatemalan coffee is tricky. It isn’t clear from the description if this is a binding order or not. Generally, this type of order would not be recognized until delivery was made. So, there is no accounting transaction necessary for this special order yet and no difference (yet) between cash and accrual systems.

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BUILDING AN INCO

ME STATEM



Assets = Liab. + SE + (Revenues – Expenses)Cash Interest


Cash Loan (Liabilities)Debits Credits Debits Credits

= $200

Decrease Liabilities decrease. Expenses Increase, but remember, negative

The loan payment transaction impacts both the income statement (interest expense) and two accounts of the balance sheet – an asset account (cash) and a liability account (loans).

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CASH VS. ACCRUAL INCOM

E STATEMENT

Cash vs. Accrual Income Statement


Cash System $Total Revenue 8,000 Cost of Revenue 7,000Gross Profit 1,000 Research and Development 0 Selling, General and Admin. 1,200Operating Income or Loss -200 Interest Expense 400 Net Non-Recurring Events 0 Income Taxes 0Net Income -600

Accrual System $Total Revenue 8,000 Cost of Revenue 7,000Gross Profit 1,000 Research and Development 0 Selling, General and Admin. 200Operating Income or Loss 800 Interest Expense 400 Net Non-Recurring Events 0 Income Taxes 0Net Income 400

InsightNow we can see how the two different systems can lead to significantly different results. The cash system shows a loss for January, whereas the accrual system shows a profit!

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The MBTN Balance Sheet module introduces the Balance Sheet financial statement, at a similar level to that used in the Income Statement module. It is recommended to start with the balance sheet module and then cover the income statement.

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EFinancial Statements - Further Reference


Documents

Income Statement This module provides an introduction to the income statement, one of the essential financial statements in accounting. In addition, some