May
27
2019

Understand the Income Statement

The Income Statement is one of the financial reports that you should be receiving from your accountant regularly. At least once a month, you should be able to see how your operations are doing. You will be able to react in a timely manner if you can see how your business fares in the market. If you are profitable and hitting your targets, the income statement will show that you are doing the right thing and you can push to achieve more. If you are incurring losses, you can immediately make corrective actions to nudge your business back to the right direction.

Frequency of Reporting

The Income Statement shows if your business is profitable or not for a given period. Bigger companies prepare Income Statements on a weekly basis to closely monitor their performance. Small and medium enterprises prepare income statement on a monthly basis, mostly for tax reporting purposes. The frequency of the report preparation really depends on management’s discretion. You just need to consider the cost-benefit factor – if a huge fraction of the company’s resources will be spent on report preparation, management may just opt to a lesser frequency.

Level of Detail

Similar to frequency of preparation, the level of detail of the income statement also varies from company to company. I’ve seen three-page long income statements from multi-million companies who have strict financial control on all of their departments. But a shorter income statement works, as well, as long as management is able to get the information they need to make sound decisions.

Regardless of the frequency of preparation and level of detail, all income statements share common elements:

Revenues
Direct Costs (or Cost of Goods Sold or Cost of Services)
Gross Profit
Operating Expenses
Gains and Losses

Revenues

Revenues pertain to the fees earned from providing services or the amounts of merchandise sold. Service companies usually call revenues as Service Revenues or Fees Earned. Manufacturers and merchandisers, on the other hand, have Sales Revenues or Sales on their income statements.

Before we move on to the other elements, let us discuss the ACCRUAL METHOD of accounting. Under this method, revenues are reported on the income statement in the period they are earned or delivered, not in the period when the cash is collected.

Let us use Computer Express, a company selling computers on credit, as an example. On March 10, 2012, the company was able to close a $3,000 deal with QXB Inc., a company that is setting up a new office. Computer Express is to deliver 50 brand new desktops to QXB Inc. on March 15. 2012 with a 30-day term. This means that QXB, Inc. has 30 days or until April 15, 2012 to pay for the full invoice amount. Under the accrual method, Computer Express will already include the $3,000 Sales Revenue from QXB, Inc. on their March 31, 2012 income statement even though the payment has been received.

Costs vs. Expenses

For you to better appreciate the Income Statement, it is important that you understand the difference between costs and expenses.

Costs or more commonly called Direct Costs pertain to the cost of producing or acquiring the goods or services sold. These include direct materials, direct labor and factory overhead.
Expenses, on the other hand, pertain to charges incurred in marketing and distributing the company’s products or services to the customers plus the expenses incurred for administrative purposes.

Direct costs are primarily driven by the quality of the goods or services provided by the company and the effectiveness of the Operations Team in controlling labor, materials and overhead. The Chief Operating Officer or the Operations Manager is responsible for ensuring that the materials and labor used in producing or acquiring the goods or services are optimal. They are also responsible for ensuring that there are no spoilages, wastages or pilferage in the operations floor.

The other department heads are responsible for controlling the company’s expenses.

The Sales Department normally works within the budget for Sales and Marketing Expenses. These normally include marketing materials, promotions, sales kits, customer discounts, salaries and wages of the Sales and Marketing team, etc.
The Office Administrator is responsible for the General and Administrative Expenses. These normally include office rent and utilities, salaries and wages of office personnel, transportation, etc.
The Finance or Accounting Department is responsible for the financing expenses. The Chief Finance Officer or the Finance Manager is responsible for managing the company’s finances to minimize interest expenses and other financing costs.

It is important that the various costs and expenses are accurately classified in the Income Statement to let management see the actual results of the company’s operations and do required action steps, if there are any.

Matching Principle

The Matching Principle is one of the basic underlying guidelines in accounting. The principle requires that costs and expenses should be reported on the income statement in the same period as the related revenues.

To illustrate, let us look at Haydz Bakery who started operations on November 1, 2012. During the month of November 2012, the bakery was able to sell 5,000 breads and cookies with Sales Revenues totalling to $10,000. Because of the owner’s good relationship with the suppliers, the company enjoys a 60-day term for all its raw material purchases. At the of the month, even though no payment for raw materials was made, Haydz Bakery still needs to compute for the actual direct materials used in producing the 5,000 breads and cookies. (Different methods can be used in doing this which will be discussed in later lessons.)

Similarly, any bills from utility suppliers (electricity, water, telephone) for the period November 1 to 30, 2012 that have not been paid by the end of the month should also be included in the income statement.

Conversely, advance payments for any expenses should not be included in the income statement for the month. On November 1, 2012, Haydz Bakery paid $4,000 for two months advance rent and two months rent deposit (monthly rent is $1,000). On November 30, 2012, the income statement should only reflect a $1,000 rent expense. The remaining $3,000 should be shown as assets on the Balance Sheet ($1,000 Prepaid Rent and $2,000 Deposit).

Gross Profit vs. Net Income

Since Gross Profit is Revenues less Direct Costs, it is primarily driven the goods or services provided by the company. Companies within the same industry normally have gross profit margins within a particular range. (Gross Profit Margin (%) = (Gross Profit / Revenues) x 100)

A high gross profit margin is good because it means that after paying for direct costs from the revenues earning, the company still has more money left over for operating expenses and net income. Companies with high gross profit margins enjoy good office locations and good compensation and benefits for their employees.

Net income, also commonly called the bottom line, is gross profit less operating and financing expenses.

The bottom line basically shows the final result of a company’s operations within a particular period.

When the bottom line is positive (net income), it means that the company was able to operate the business profitably – the sales generated by operations are enough to cover both direct costs and expenses. The net income is added to the stockholder’s equity which may either be distributed as dividends to stockholders or kept within the business as buffer for harder times or as additional capital for expansion.

When the bottom line is negative (net loss), it may mean that the Sales Team is not generating enough sales or revenues or that management is not keeping costs and expenses under control. Management may need to revisit its strategy and see how it can improve certain areas of the business. Incurring continuous net losses may prompt a company to take on debt to pay for its expenses.

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