What is an Income Statement?

The income statement focuses on the four key items – revenue, expenses, gains, and losses. It does not cover receipts (money received by the business) or the cash payments/disbursements (money paid by the business). It starts with the details of sales, and then works down to compute the net income and eventually the earnings per share (EPS). Essentially, it gives an account of how the net revenue realized by the company gets transformed into net earnings (profit or loss).

The following are covered in the income statement, though its format may vary depending upon the local regulatory requirements, the diversified scope of the business and the associated operating activities:

Revenue realized through primary activities is often referred to as operating revenue. For a company manufacturing a product, or for a wholesaler, distributor or retailer involved in the business of selling that product, the revenue from primary activities refers to revenue achieved from the sale of the product. Similarly, for a company (or its franchisees) in the business of offering services, revenue from primary activities refers to the revenue or fees earned in exchange of offering those services.

Revenues realized through secondary, non-core business activities are often referred to as non-operating recurring revenues. These revenues are sourced from the earnings which are outside of the purchase and sale of goods and services and may include income from interest earned on business capital lying in the bank, rental income from business property, income from strategic partnerships like royalty payment receipts or income from an advertisement display placed on business property.

Also called other income, gains indicate the net money made from other activities, like the sale of long-term assets. These include the net income realized from one-time non-business activities, like a company selling its old transportation van, unused land, or a subsidiary company.

Revenue should not be confused with receipts. Revenue is usually accounted for in the period when sales are made or services are delivered. Receipts are the cash received and are accounted for when the money is actually received. For instance, a customer may take goods/services from a company on 28 September, which will lead to the revenue being accounted for in the month of September. Owing to his good reputation, the customer may be given a 30-day payment window. It will give him time till 28 October to make the payment, which is when the receipts are accounted for.

The cost for a business to continue operation and turn a profit is known as an expense. Some of these expenses may be written off on a tax return if they meet the IRS guidelines.

All expenses incurred for earning the normal operating revenue linked to the primary activity of the business. They include the cost of goods sold (COGS), selling, general and administrative expenses (SG&A), depreciation or amortization, and research and development (R&D) expenses. Typical items that make up the list are employee wages, sales commissions, and expenses for utilities like electricity and transportation.

All expenses linked to non-core business activities, like interest paid on loan money.

All expenses that go towards a loss-making sale of long-term assets, one-time or any other unusual costs, or expenses towards lawsuits.

While primary revenue and expenses offer insights into how well the company’s core business is performing, the secondary revenue and expenses account for the company’s involvement and its expertise in managing the ad-hoc, non-core activities. Compared to the income from the sale of manufactured goods, a substantially high-interest income from money lying in the bank indicates that the business may not be utilizing the available cash to its full potential by expanding the production capacity, or it is facing challenges in increasing its market share amid competition. Recurring rental income gained by hosting billboards at the company factory situated along a highway indicates that the management is capitalizing upon the available resources and assets for additional profitability.

Mathematically, the Net Income is calculated based on the following:

Net Income = (Revenue + Gains) – (Expenses + Losses)

To understand the above details with some real numbers, let’s assume that a fictitious sports merchandise business, which additionally provides training, is reporting its income statement for the most recent quarter.

It received $25,800 from the sale of sports goods and $5,000 from training services. It spent various amounts as listed for the given activities that total $10,650. It realized net gains of $2,000 from the sale of an old van, and incurred losses worth $800 for settling a dispute raised by a consumer. The net income comes to $21,350 for the given quarter. The above example is the simplest forms of the income statement that any standard business can generate. It is called the Single-Step Income Statement as it is based on the simple calculation that sums up revenue and gains and subtracts expenses and losses.

However, real-world companies often operate on a global scale, have diversified business segments offering a mix of products and services, and frequently get involved in mergers, acquisitions, and strategic partnerships. Such wide array of operations, diversified set of expenses, various business activities, and the need for reporting in a standard format as per regulatory compliance leads to multiple and complex accounting entries in the income statement.

Listed companies follow the Multiple-Step Income Statement which segregates the operating revenues, operating expenses, and gains from the non-operating revenues, non-operating expenses, and losses, and offer many more details through the income statement. Essentially, the different measures of profitability in a multiple-step income statement are reported at four different levels in a business’ operations – gross, operating, pre-tax and after-tax. As we shall shortly see in the following example, this segregation helps in identifying how the income and profitability are moving/changing from one level to the other. For instance, high gross profit but lower operating income indicates higher expenses, while higher pre-tax profit and lower post-tax profit indicates loss of earnings to taxes and other one-time, unusual expenses.

Let’s look at the most recent annual income statements of two large, publicly-listed, multinational companies from different sectors of Technology (Microsoft) and Retail (Walmart).

Data Courtesy: Yahoo! Finance