Which items will not be shown in an income statement prepared for a service business?

Financial statements are tools for communicating financial information about a company to people outside the business. A company’s three primary financial statements are the balance sheet, the income statement and the statement of cash flows. Of these three, the income statement is often considered to be the most important tool for communicating and measuring the success of the business.

What is an Income Statement?

An income statement reports a company’s revenue, expenses and profit or loss during a specific accounting period. Income statements are also known as statements of earnings, statements of income, net income statements, profit and loss statements or simply “P&Ls,” among other names.

Key Takeaways

• An income statement includes a company’s revenue, expenses, gains, losses and profit for a specific accounting period.
• A company’s income statement is often considered the most important tool for communicating financial information to people outside the business.
• Income statements are used by managers, investors, lenders, and analysts to assess a company’s profitability, growth and efficiency. They are also used to compare different companies.
• Income statements can be produced in several formats, each providing a different level of detail about the company’s operations.

Income statement vs. balance sheet

The company’s three main financial statements—the income statement, balance sheet and cash flow statement—each serve a different purpose, although they are interrelated.

A balance sheet provides a snapshot of the value of a company’s assets, liabilities and equity at a specific point in time, typically the last day of an accounting period. Managers, investors and lenders often analyze balance sheets when evaluating how much a business is worth.

In contrast, an income statement provides a dynamic view of the business over a period of time—typically a month, quarter or year. It shows the revenue and profit generated from operations as well as other gains and losses. Investors and other stakeholders examine income statements to see how profitably leaders run a business.

The headings on these financial statements reflect the fact that a balance sheet is a snapshot taken at the end of a period, while an income statement reflects activities over the entire period. For example, a quarterly balance sheet might show assets and liabilities “as of Dec. 31,” while the corresponding income statement shows profit “for the three months ending Dec. 31.”

In both income statements and balance sheets, line items are often grouped into natural categories to help make the statements easier to read and help stakeholders find specific items of interest. Balance sheets list current assets, long-term assets, total assets, current liabilities, long term liabilities, total liabilities and accumulated retained earnings (or shareholder’s equity). Income statements show revenue, gains, expenses, losses and net income.

Income Statement Explained

Income statements present a great deal of information about a company’s activities during a specific period. It may be tempting to focus on “the bottom line”—the amount of net income—but there’s useful information throughout the entire income statement, from top to bottom.

By categorizing this data, the income statement can provide deeper insights into the company’s earnings. For example, separating operating expenses from one-time charges, such as a loss due to theft or natural disaster, can provide a better indication of the company’s likely future expense levels and profitability.

Why is an income statement important for your business?

Income statements are essential tools for communicating financial information to people outside the business. A company can present its income statement as evidence of its financial performance in order to obtain loans and investments, for example.

For the company’s managers, the income statement highlights the results of the company’s operating activities, including the critical relationship between revenue, expenses and profitability. This can help identify potential problems and areas that need improvement.

How are income statements used?

Income statements are used by a variety of people outside and inside the company.

Investors are among the biggest users of income statements. They examine a company’s historical performance, as reported on income statements, to determine its investment value and creditworthiness and to help predict its future success. While past results don’t guarantee future success, they are the most common way of gauging the economic value of a business and the likelihood of repayment of debt.

Other users include tax authorities such as the IRS, which review income statements to evaluate a company’s tax liability. Customers may use a company’s income statements to assess its long-term viability and stability. Unions examine the statements during salary negotiations.

Income statements are also used in various ways within the company. The income statement provides the foundation for many managerial accounting tools. Financial modeling, forecasting and analysis of key performance indicators use income statement data to aid in decision making.

Single- vs multi-step income statements

Income statements can be reported in several different formats, with varying levels of detail. A simple, summarized financial statement helps readers quickly get an overview of the company’s results; a statement with more detail enables readers to find specific information that is important to them.

Regardless of how information is presented, the same underlying data and accounting methods are used to create the statement. Two common formats are the single-step income statement and the multiple-step income statement.

What is a single-step income statement?

This format has one section for revenue and another for expenses. Each section may contain multiple line items. Total revenue and expenses are listed at the end of the respective sections.

Net income, calculated as total revenue minus total expenses, is reported at the end of the statement. “Single step” refers to the fact that only a single subtraction is needed to calculate net income.

What is a multiple-step income statement?

Multiple-step income statements are organized into separate sections for operating and non-operating activities. Each section lists revenue and related expenses. The operating activities section lists revenues and expenses that are directly related to core business activities. The non-operating activities section lists other income and expenses, such as interest payments on loans and realized gains or losses on investments.

A multi-step income statement also provides intermediary subtotals within each section. For example, the operating activities section typically includes subtotals, such as cost of goods sold (COGS) and gross profit. The multi-step income statement gets its name because multiple steps are needed to calculate net income. First, the subtotals are calculated from individual line items, then net income is calculated from the subtotals.

Another common format is the condensed income statement, which includes only summary totals of each expense category. Supplementary detail is provided on supporting schedules.

What is a common-size income statement?

To help compare financial statements from different businesses, accountants may “common size” them. For an income statement, this means adding a column that expresses every line on the financial statement as a percentage of total revenue.

What’s Included in an income statement?

The items on a multi-step income statement are divided into sections that separate operating revenue and expenses from the results of non-operating activities, taxes and extraordinary items. Accountants use some judgement when organizing these items, using breakdowns that most naturally reflects how the business works. Therefore, an income statement from a manufacturer may look very different from one issued by a professional services company.

However, for any income statement, there is a specific definition for each listed item. Here are some of the common elements included in multi-step income statements, listed in the order they typically appear.

• Revenue: Sales of goods and/or services. The income statement may list gross sales together with reductions for discounts, returns and allowances. These amounts are deducted from gross sales to provide an intermediate total called net sales revenue. Revenue from different product lines may be broken out as separate line items.
• Expenses: An umbrella term for costs incurred during the period. Often, expenses are grouped into natural classifications, such as cost of goods sold (COGS) and selling, general and administrative expenses (SG&A).
• COGS: A subset of operating expenses, COGS represents the direct costs of making or acquiring the products that generated revenue during the period. A services organization may simply call this “cost of sales,” since it doesn’t sell “goods.”
• SG&A: Includes all non-production operating expenses, including the costs to promote, sell and deliver products. SG&A includes items like rent, salaries, commissions, advertising and marketing expenses, and shipping costs.
• Gross profit : An intermediary subtotal, calculated as net sales revenue minus COGS, gross profit is a key metric used to assess the profitability and efficiency of a company’s core business.
• Operating income : This is an intermediary subtotal calculated by subtracting all operating expenses from net sales revenue. It can also be expressed as gross profit reduced by operating expenses outside of COGS, such as direct and indirect selling, marketing, general and administrative expenses. Operating income is also referred to as earnings before interest and taxes (EBIT).
• Income before taxes: This is another intermediary subtotal, which is farther down the income statement and therefore more comprehensive than the earlier subtotals. Income before taxes is total revenue minus total expenses, excluding taxes. Also known as earnings before taxes (EBT), this metric is useful for comparing companies because it peels away a company’s tax expenses.
• Net income: This is the final calculation at the bottom of the income statement, and it’s often called “the bottom line” for that reason. It is the total amount of all sales reduced by all expenses, including taxes. The formula for net income is:

Net Income = (revenue + gains) - (expenses + losses)

• Earnings per share: A metric used by public companies, earnings per share (EPS) is calculated as net income divided by the number of shares outstanding. EPS is used as an indicator of business performance in prospectuses, proxy materials and annual reports.
• Depreciation: This is a noncash expense that reflects a fixed asset’s loss in value over time. Depreciation expenses may be listed in different parts of the income statement, depending on the assets that they apply to. For example, depreciation of manufacturing equipment is typically a direct cost that’s included in COGS, while depreciation of computers used by administrative staff is included in other operating expenses. Amortization is an analogous method applied to intangible assets, such as patents.
• EBITDA: Earnings before interest, taxes, depreciation and amortization (EBITDA) is a commonly used metric. It’s calculated by working upwards from the bottom of the income statement, adding back expenses that were deducted to arrive at operating income (EBIT) and net income. Adding back the noncash expenses of depreciation and amortization may provide insight into a company’s cash flows and can be helpful when comparing different companies.

Video: Income Statement Explained

Revenues and Gains on the Income Statement

Revenue refers to money generated from operating activities. Depending on the nature of the company’s business and the type of income statement used, there may be several lines listing different sources of revenue, such as revenue from primary and secondary activities, or revenue by business unit or geography.

Gains are net proceeds generated by peripheral activities. They are listed in a separate section lower down on the income statement because they are not part of the everyday activities of a business. Common examples of gains include profits from disposal of assets, selling investments and proceeds from lawsuits.

Expenses and Losses on the Income Statement

Expenses are costs related to running the business. Expenses are typically broken down into operating expenses and nonoperating expenses, and may be further subdivided into categories. Within operating expenses, categories include COGS and SG&A.

Losses are reductions in net assets caused by incidental transactions. They are typically reported in a separate section of the income statement. Common examples of losses include write-offs of obsolete assets, payments due to lawsuits and losses on investments.

What are the limitations of an income statement?

Though the income statement presents a considerable amount of useful information, it has limitations. For example, unlike a statement of cash flows, an income statement does not distinguish between cash and noncash activities. This can distort analysis of a company’s viability: Insufficient cash flow is a common reason that apparently profitable companies go out of business.

In addition, income statements reflect only business activities that can be reliably quantified. For example, income statements don’t reflect missed business opportunities or positive or negative societal impacts.

The accounting method that a company uses also affects the income statement. Revenue and expenses may differ depending on whether the company uses cash-basis accounting versus accrual basis. The income statement is also affected by whether a company uses an accelerated method of calculating depreciation versus a straight-line method. These differences can make it difficult to compare the income statements of different companies—or even the statements produced by the same company in different periods.

9 Steps to Prepare an Income Statement

When preparing an income statement, first determine the period that the statement will cover, such as a month, quarter or year. Often, income statements include both the current period and a comparison with the corresponding period in the prior year.

Most modern accounting software suites can generate standard financial statements, including income statements. However, it’s useful to understand the steps involved:

1. Review the trial balance after it’s been properly closed and adjusted for the period.
2. Identify and compile the revenue accounts for inclusion in the revenue section of the income statement. These include sales accounts as well as any estimates for allowances, like bad debt or returns.
3. Find the expenses that roll into COGS, such as raw materials, direct labor and freight-in. COGS is the first expense section listed on the income statement, reading top to bottom.
4. Calculate gross profit by subtracting COGS from net sales revenue. You can also calculate gross margin by dividing gross profit by net sales revenue.
5. Aggregate the rest of the operating expenses, such as selling, marketing, administrative, travel, rent and other items, for inclusion in the operating expenses section of the income statement.
6. Calculate operating income as gross profit minus the operating expenses identified in step 5.
7. Insert any gains/losses or ancillary income and adjust income from operations accordingly to yield net income before taxes (EBT).
8. Calculate taxes based on the EBT amount.
9. Reduce EBT by the tax expense to get the net income for the period.

Income Statement Example

Sometimes a picture is worth a thousand words, as the following income statement examples illustrate. They show a single fictional company’s results presented three different ways: as a condensed income statement, a single-step income statement and a multi-step income statement.

KMR Bakery Inc. is an incorporated bakery that sells artisan cupcakes and specialty coffee. KMR rents its store, has a revolving credit line for buying ingredients and supplies, and employs several part-time workers. Occasionally, KMR rents out its facility for birthday parties. During the year, KMR replaced its cappuccino machine, selling the old one, which was fully depreciated, for a gain. For quality purposes, no finished goods inventory—baked cupcakes or brewed coffee—is held overnight.

Condensed income statement example:

KMR Bakery, Inc. INCOME STATEMENT For the Year Ended December 31, 2019

Single-step income statement example:

KMR Bakery, Inc. INCOME STATEMENT For the Year Ended December 31, 2019

Multi-step income statement example:

KMR Bakery, Inc. INCOME STATEMENT For the Year Ended December 31, 2019

Income Statement Analysis

The data on an income statement is analyzed by both internal and external users. Large organizations may have an entire department dedicated to financial planning and analysis that constantly scrutinizes the results of operations.

External users may be focused on a particular section of the income statement, such as interest expense, or they may use the data on the income statement to compute financial ratios for comparison with those of other companies.

In general, most income statement analysis can be thought of in three ways:

1. Horizontal analysis is the comparison of the same item over different periods, with an eye toward identifying trends or changes compared to a benchmark. Some examples include:
   1. Overall period-to-period comparisons, such as comparing Q1 2019 to Q1 2020
   2. Seasonal revenue comparisons
2. Ratio analysis uses industry-standard formulas to look at the relationships between different aspects of the business. These ratios are also used in comparisons with other companies and industry benchmarks, and when comparing the company’s performance in different periods. Some examples include:
   1. Price to earnings ratio (for public companies)
   2. Revenue mix by product line
   3. Gross margin (gross profit divided by revenue)
   4. Selling, general & administrative costs as a percentage of revenue, trending over time
   5. Contribution margin and breakeven analysis
3. Line item analysis takes a deep dive into a particular item on the income statement to examine its components in more detail. This is typically performed to ensure items aren’t missing—especially activity that occurs near either side of a cutoff period. It’s also used to examine items that are based on estimates. Any line items can be analyzed in this way.

Income Statement Template

You can use this free downloadable income statement template to create your own income statements. Download the template.

How to Prepare an Income Statement in a Financial Model

Income statements are also used in financial modelling. Financial modelling can help companies forecast future performance or analyze the impact of anticipated changes to the business, such as making an acquisition or discontinuing a product line.

The income statement is used in financial modeling as a template and a checklist, to frame assumptions and reflect their impact. It’s useful for these purposes because it highlights the relationships between revenue and expenses, gains, losses, and the related tax effects and changes to EPS.

Financial modelling often uses common-size income statements. Basic financial models are often prepared using spreadsheet templates, but more sophisticated modelling is done using financial planning products, especially those that integrate with a company’s accounting systems.

What are Common Drivers for Each Income Statement Item?

Financial modelling, forecasting and budgeting processes are a mixture of art and science. Most forecasting methods start by gathering historical data and identifying key business drivers. This information is used to create financial estimates that are incorporated into an income statement. Some common drivers of income statement items are summarized below.

Bottom line (no pun intended) the income statement is a critical tool for communicating a company’s performance to people outside and within the company. The data in income statements can be analyzed for many different purposes, including identifying trends, developing forecasts and comparing the company with competitors.

Companies with the most automated and integrated accounting systems, which handle data at the deepest levels, generate the most accurate financial statements and can more easily perform robust income statement analysis and prospective financial modelling. Additionally, these systems are invaluable for auditability and compliance.