Know about Meaning and Importance of Income Statement

Balance sheets, cash flow, and income statement are the three financial statements or reports that every organisation prepares to summarise the financial performance. An income statement also known as a profit and loss statement. It is a vital financial document in an entity that provides insight into the entity’s operations, performing and underperforming sectors, the efficiency of the management, and such other details. While the balance sheet is the synopsis of the financial performance of an entity as on a particular date, an income statement is a snapshot of income and expenditure for a specific period. This article poses all the details of an income statement, such as its meaning, definition, the requirement for income statement preparation, and other such details.

What is an Income Statement?

Statement of income and expenditure is a part of financial statements prepared and required by every entity. The focus of the income statement is to provide all the financial information about the profitability status in a period to the readers, creditors, and investors. With regards to Corporate financial statements, an income statement meaning is the recording of the entity’s profit and loss over the period. The net profit of any organisation is derived by deducting the operating and non-operating expenses from the company’s total revenue. An income statement is often examined by the business owners, accountants, and investors for examining any shortcomings and finding solutions for the same.

The income statement is also known as:

1. Statement of operations
2. Revenue statement
3. Statement of Income
4. Statement of earnings
5. Profit and loss statement

 The most commonly used term is the profit and loss statement when financial accounting is concerned. However, all the above terms mean the same and are often used interchangeably. 

Did you know? There are 79 unicorns in India with a total valuation of $260.5 billion. Out of these, 42 unicorns were started in 2021.

Importance of income statement

 The income statement is prepared by several entities annually, quarterly and monthly. This is one of the crucial documents among all the financial documents since it shows the entity’s profitability and its business status.  

Some of the major reasons depicting the importance of an Income statement are mentioned below:

1. Assistance in decision making

Business owners and other parties concerned with the business get an insight into the current financial position of the entity through the income statement. The accuracy and the data in the income statement let the management get an insight into the income and expenditure. Accordingly, they can make better, wise, and swift decisions about the transactions of the entity. 

2. Tracking the profitability

 The income statement shows the profitability and the current financial status of an entity. So it becomes simple for the stakeholders, shareholders, and owners to track the running status of the entity.  

3. Compliance

 When you own and run a business, it is also essential to comply with the various laws prevailing in the area, follow the regulations abiding by the entity, and pay the taxes as applicable. It is mandatory by law to pay the taxes. For calculating tax liability and other compliances, income statements and other financial statements such as cash flow statements and balance sheets help with all the required data and information. 

Uses of an Income statement

 The primary and most important purpose of an income statement is to provide full proof about an entity’s business activities and profitability. Some of its other vital uses are: 

• Profit and loss statement also known as the income statement. When it is prepared department-wise, it gives a peep into its activities, profitability, expenses, and sustainability.
• The investors and management can make swift and better decisions and form strategies for a specific product, department, or the business as a whole. 
•  An annual income statement lets the management create plans, and short-term strategies can be created based on the quarterly and monthly statements.  
•  Crucial decisions such as opening or shutting down a department, targeting a particular group of customers, pushing sales, increasing production activities, and such other decisions can be taken based on the income statement. 
•  The performance of the entity over some time and comparison of the performance with the previous years and a quarter can be done with the thorough study of the income statement and other financial documents.  
• Based on them, the investors can also perform various analyses, such as if the entity has reduced overhead expenses and operating expenses without compromising the quantity and quality of the production.

Components of the Income statement

The most common format of the income statement of almost all the entities includes the following line items:

1. Revenue
2. Expenses
3. Profit

Also Read: What is Double Entry System of Accounting

Types of an income statement

The income statement is the most vital document where the financial health of an entity is concerned. There are two types of income statement, namely:

1. Single-step income statement

The income statement format in the single step is a basic kind of reporting of the entity. It is prepared by calculating the net income as stated in the following equation:

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

2. Multi-step income statement

 Under this kind of income statement, the net income is calculated in a three-tier process. The non-operational expenses and revenues are separated from the operational expenses and revenues. The equation for the calculation of income is as follows: 

Gross Profit = Net Sales – Cost of Goods Sold

Operating Income = Gross Profit – Operating Expenses

Net Income = Operating Income + Other Non-Operating Items

Structure of an Income Statement

A normal and common income statement has a structure that applies to most industries. Following line items normally form the structure of the income statement:

1. Revenue

Revenue can be defined as the entity’s income earned or generated during a specific period with the day-to-day business activity or any other special or non-recurring activities.

2. Expenses

The outflow of cash for purchases of goods or services and the amount incurred for various activities such as administration and others of the business or employee cost is called expenses. Expenses can be further classified as mentioned below:

• Cost of Goods Sold

The cost of goods sold (COGS) is the direct cost incurred for the production of primary goods sold by the entity. In the case of the service industry, it is the direct expenses that are relevant for the income generated or the core business activity of the entity.

• General, selling, and administration expenses

All the expenses incurred for the day-to-day activities apart from the direct income relevant to the business’s core activity are categorised under general, selling, and administration expenses.

3. Gross Profit

The revenue or the income that the company generates from the business’s core activity after deducting the cost of goods sold is called gross profit.

4. Operating Income

Operating income is arrived at after deducting the indirect expenses such as wages, depreciation, and other costs from the gross profit of the entity.

5. Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)

Amortisation expenses, depreciation, taxes, and interest are the below the line expenses. This implies that these expenses are not the actual expenses to run the entity’s operations but are the expenses of allied activities. EBITDA is calculated to understand the earnings from the core business activities of the entity.

6. Income Before Taxes

After deducting all the expenses and interest but before deducting any taxes such as current tax, deferred tax (in case of Company), and other such taxes as applicable, income before taxes.

7. Net Income

Net income is the indirect income generated by an entity during a period after deducting all the costs, operating expenses, interest, and taxes from the revenue. This is the actual earnings of the entity during a particular period and is added to the retained earnings. The more the net income of the entity, the more prosperous the organisation is.

8. Earnings per Share

The earnings or the net income of the organisation, especially the corporate, is distributed amongst the shareholders. The distribution method is based on holdings of shares by the shareholders. Therefore, it is essential to calculate earnings per share. Earnings per share are calculated by dividing the net income by the number of outstanding shares as of the specific date.

9. Depreciation

The fixed assets, both tangible and intangible assets, decrease in value with the assets’ time and wear and tear. This decreased value of the asset is written off in the books of accounts in a defined period. The amount written off is called depreciation.

All the above line items are further divided into various categories. For instance, expenses are further segregated into wages, procurement costs, interest paid, debt expenses, wages, and other such expenses.

Income Statement Example

A common template of income statement example is mentioned below:

How to create an Income Statement?

The meaning of financial statements is redefined with the advancement of technology and software and analysis tools. It is very simple to prepare the income statement and can be created at any point in time and date.

 Some of the steps to follow to create an income statement and integrate the same in financial models to project future and create strategic plans are mentioned below:

1.  In the income statement template, input the historical data of any period. To differentiate between the calculated data and the hardcoded data, format the historical data in a particular format. Formatting the data is essential so that the user understands the cells that contain formulae or the ones where the data needs to be input. Ensure that you use a consistent method of formatting throughout to avoid confusion.
2.  The historical data can be analysed to create drivers, project future assumptions and create strategic decisions based on the same. 
3. The assumptions and drivers in hand create forecasted future values for the income statement to be used in the future. Ensure all the line items are appropriately projected considering various terms and conditions.    

Also Read: What is the List of Accounting Standard

Conclusion

This article has been a thorough and detailed answer to what is an income statement. The income statement is an essential and crucial financial tool as it provides an insight into the management efficiency, operations of the entity, glitches having an impact on profitability, and the performance of the company as compared to the other peers. Therefore, by incorporating the essential details, a proper income statement can be developed. For more information, subscribe to Legal Tree.