The Income Statement presents a summary of an entity’s Revenues (what the company earned from sales of products and services) and Expenses (what was expended to earn this revenue) for a specific period of time, such as a month, a quarter, or a year. This period of time is known as the accounting period. One key difference between the Income Statement and the Balance Sheet is that the Income Statement reflects a period of time rather than a single moment in time as with the Balance Sheet. The Income Statement is also called a Statement of Earnings or a Statement of Operations.
The preparation of the Income Statement serves several purposes. Often, the only reason one uses the Income Statement is to concentrate on the “bottom line” or Net Income (Revenue minus Expenses). The Income Statement can also be useful for analyzing changes in the Revenue data over a period of time, or determining ratios of particular Expenses to Revenue and how these ratios have been changing over certain periods of time. These two topics will be discussed in chapter 8. (See Appendix B for a real-life example of an Income Statement from Station Casinos, Inc.)
The Income Statement Illustrated
In Figure 4.1 we can see all of the bicycle company’s Revenue and Expenses for its first year in business. By reviewing these numbers Sam can also see her “bottom line,” that is, her company’s Net Income for the year. In general, Income Statements are organized into three sections. The first section shows the Revenues earned from the sale of goods and/or services for the period being reported.
In the case of the Solana Beach Bicycle Company (Figure 4.1) this period is one year. The second section lists the Expenses the business has incurred to earn these Revenues during the period represented by the Income Statement. The third section is the difference between these Revenues and Expenses in which we hope the Revenues outweigh the Expenses, indicating a profit. If the Expenses are greater than the Revenues, this would indicate a loss—not a great thing in a business.
In the example below, the numbers listed inside of parentheses represent subtractions.
The Accrual Concept
The Accrual Concept addresses the issue of when Revenue is recognized on the Income Statement. Revenue is recognized when it is earned and Expenses are recognized as they are incurred regardless of when the cash changes hands; this is referred to as accrual basis of accounting.
This type of accounting is used by businesses throughout the United States for the presentation of their financial statements. Some small firms and most individuals still use the cash basis of accounting to determine their income and Income Taxes. Under the cash basis of accounting, Revenue is not reported until cash is received, and Expenses are not reported until cash is disbursed.
Cash Basis of Accounting : The reason a small business might use the cash basis of accounting is that it is easier than the accrual system to keep track of the Revenues and Expenses. No assumptions have to be made (for instance, for depreciation), and no accruals have to be made for items such as Accounts Receivable and Accounts Payable. Accounting entries are only made when cash is actually exchanged.
Generally Accepted Accounting Principles require the accrual system of accounting, and thus most financial statements that you will encounter and that are used by investors and bankers will be prepared under the accrual system of accounting. It is for this reason that throughout the remainder of this book, we will use only the accrual basis of accounting for all of our examples.
Revenue (or sales) is what the company earned during a particular period of time from the sale of merchandise or from the rendering of services to its customers. Revenue can come from several sources; a firm can generate Revenue from sales, interest, dividends, royalties, or any combination of these. The sum of all of these sources is the total Revenues of a business.
As shown in Figure 4.1, Revenue of $35,500 is from the sale of bicycles. If you look towards the bottom of the Income Statement, you’ll see that the bicycle company also earned Revenue from doing repairs ($3,850). This repair Revenue has been separated from the sales Revenue above, because the main business is sales and not repairs.
At this point there has been no discussion of Net Income. Revenue is one component of Net Income, but it is not the whole story. Expenses and other items need to be added to or subtracted from Revenue to arrive at the Net Income figure.
Alert! Revenue Versus Cash Flow: It is important to note that Revenue is not equal to cash flow. Revenue can be generated prior to a business receiving cash. In other words, a sale can be made in which only a promise to pay is generated, but cash does not change hands. Even though the cash will not be collected until some point in the future, the Revenue is recognized at the time that the merchandise has been transferred to the buyer, or the services have been performed by the seller. Therefore, it is possible for a company to have a large amount of sales (or Revenue) and still have a cash flow problem, since they have not collected the money yet.
In Figure 4.1, we can see that the $35,500 of sales was generated by collecting cash and promises to pay cash in the future. You cannot tell simply by reading this one number called Sales how much was generated from each of these two sources individually. But you can tell that at the end of the year, there is still $9,175 owed from the sales, meaning that $9,175 is expected but has not been received in cash yet. You know this from the Balance Sheet in Figure 3.2 (Accounts Receivable at December 31, 2006).
The reason that you cannot tell in total how much was sold on account during the year is because some of the Accounts Receivable could have been paid off during the year before this Balance Sheet was generated. The $9,175 only reflects how much is still owed to the business on December 31, 2006.
Expenses represent the cost of doing business. Examples of Expenses are rent, utilities, bank service fees, tool and equipment Expenses, bad debt Expense, and salaries. In our current example, the Expenses of Solana Beach Bicycle Company fall under the title of Operating Expenses. These are all of the Expenses for the year 2006 that were incurred by the shop in order to generate Revenue in the operation of the business. The total is $7,565. Another Expense that does not appear in the listing of operating Expenses— but is necessary to generate Revenue—is Cost of Goods Sold ($14,200).This Expense is the cost of either the bicycles purchased by the company or the components used to build the bicycles that were sold during 2006.
There is an important distinction to be made between an expenditure and an Expense. An expenditure is the spending of cash. All Expenses are expenditures; however, not all expenditures are Expenses. It sounds confusing, but it’s really quite simple. An Expense is an expenditure that generates Revenue. If the expenditure does not immediately generate Revenue, it is not an Expense. Consider the purchase of a building. When the purchase of a building is made it does not immediately produce Revenue. At that point in time the purchase is considered an expenditure. However, over time this building will be used in the production of Revenue, and the building (and other such Long-Term Assets) depreciate or are used up. The depreciation of the building thus becomes an Expense and is matched with those Revenues it helped to generate.
Net income represents the difference between Revenues generated during the period and the related Expenses, which generated that Revenue. Prior to calculating Net Income, a company first calculates gross income. The gross income is sales (or total Revenues) minus the cost of those goods that were sold. Gross income does not take operating Expenses into account; Net Income, on the other hand, is the gross income minus all of the operating Expenses, plus or minus other Revenues and Expenses.
Once again note that the term cash is not used.As with Revenue, part of the “bottom line” or Net Income could be made up of cash, but other parts could be made up of promises to receive cash or promises to pay cash in the future.
Expand Your Focus : When evaluating your business, you should not solely concentrate on Net Income in the financial statements. This is certainly a useful number (especially if it is compared to previous years’ figures), but there are several other important numbers and ratios that ultimately might be important to your decisions. Some of these numbers might include gross income, the trend of salary Expenses (are they going up too fast?), how much cash is on hand at the end of the year, how sales have been increasing, if at all. Outside of the company it is important to pay attention to the competition as well as the economy as a whole. These are just a few examples of why, if you only focus on the Net Income figure, you will lose sight of the whole picture.
In Figure 4.1, the term “Net Income” appears three times. The first time is “Net Income from Operations.” This number, $13,735 represents the income earned from selling bicycles, the main product of Solana Beach Bicycle Company. In addition to selling bicycles, the company also did some repairs. These repairs generated Revenue of $3,850 during the year. This Revenue is shown separately because it is not the main business of this shop. Thus, after the other Revenues and Expenses are added to “Net Income from Operations,” a new total is derived labeled “Net Income Before Taxes.” This number is $15,585. After the taxes are paid on this total we arrive at the “bottom line” or “Net Income after taxes” of $10,385.
Confusing? Maybe a little, but accounting convention requires that we separate out Net Income from the main operations of the business and from other income earned from other types of sales and services. After these two numbers are shown separately on the Income Statement, we have to show what the government is going to take in taxes before we can finally arrive at the “bottom line.”
Interest and Income Taxes
Other items subtracted from Revenues and Expenses before determining the total Net Income are Interest and Income Taxes. Most accountants classify interest and taxes as an “Other Expense” of the period, not as an operating Expense. The reason for this is that interest and taxes do not produce mainstream Revenue but are necessary to pay in order to stay in business.
Bad Debt Expense
One operating Expense shown in Figure 4.1 is Bad Debt Expense for $175. This Expense represents the amount of the Accounts Receivable that the company anticipates that it will be not be able to collect. Most businesses try to keep this number to a minimum, in order to keep their Expenses low. The amount of $175, in the case of the Solana Beach Bicycle Company is an estimation made by management; in most businesses this estimate is made based upon prior year’s experience of their collections of Accounts Receivable.
QUICK Tip : Keep Bad Debts in Check: In order to keep your Bad Debt Expense to a minimum, it is important that you do extensive credit checks on those customers to whom you are going to extend credit. This can be done with the help of professional services such as Dunn and Bradstreet and by reviewing and understanding their financial statements prior to extending this credit.
ANSWER : It is not possible to make a complete analysis of a company just by looking at one financial statement. Sam, the owner, and we as outsiders would also need to look at the Balance Sheet as well as the Statement of Cash Flows (to be discussed in the next chapter). It is important to note that the Solana Beach Bicycle Company did make a profit of $10,385.
Many new small businesses do not make a profit for the first three or four years, so that is impressive. In planning for the year ahead, Sam might decide to put more money into advertising and expand the repair business. Only 10 percent of the company’s Revenue came from repairs, so there could be room for growth in that area of the business. Other information that would be helpful to look at includes the other financial statements as well as the budgets for the next two years, 2007 and 2008.