The income statement presents the information about the performance of the firm over a period of time. It reports the economic results of the business entity by matching sales revenue inflows, and expense outflows to show the results of operations—net income or net loss. This statement is also referred to as Profit & Loss account. Its value increases substantially if it is compared with benchmarks such as budget, prior month or prior year.
Thus the components of the income statement can be listed as follows:
The income statement equation is:
Revenues- Expenses = Net Income
Depending on the business, sales might be called differently on the income statement. For example sales of services are often termed as revenues. Although, the essence very much remains the same.
Gross profit is the amount that remains after factory level expenses are deducted from net sales, the factory level expenses may include fright inward, labour cost, cost of raw materials. All this can be clubbed together to form cost of goods sold.
Subtracting operating expenses from gross profits gives us operating profit. Operating expenses include salaries to staff, advertising, rent, depreciation, administration costs etc. Subsequently subtracting interest and taxes we get the net profit or profit after taxes.
There can be other expenses which are likely to happen and are normal in course of doing business. Examples include:
1. Profit or loss on selling off equipment no longer used by the company or on the disposition of investments that were incidental to the business.
2. Interest income and interest expense are financial costs and must not be confused with operating costs.
Depreciation expense can be calculated using straight line or accelerated method of depreciation. The straight line method recognises an equal amount of depreciation every year whereas in accelerated method initially higher depreciation expenses are charged than in later years.
Inventory can be valued by FIFO (First In, First Out), LIFO (Last In, First Out) and weighted average methods. Different methods have different implications on profits because it affects the cost of goods sold differently.
In FIFO, the first item purchased is assumed to be the first item sold and is valued accordingly. In LIFO the last item purchased is assumed to be sold first.
LIFO is prohibited under IFRS, whereas it is allowed under US GAAP. FIFO is allowed under both IFRS and US GAAP.
Pro forma Income Statement:
Net sales 25000
Cost of goods sold 9000
Gross Profit 16000
Selling, general, and administrative expenses 8000
Operating Profit 6000
Net interest expense 500
Income before Tax (EBT) 5500
Net income (Profit after tax) 5200
Allocation of net income
Addition to retained earnings 3500