What is an Income Statement?

what-is-an-income-statementThe income statement, sometimes called the profit and loss statement or P&L, is used to assess profitability, as the expenses for the period are deducted from the revenues. When net income is positive, it is a called profit. When negative, it is a loss.

Where the balance sheet shows the financial position at a point in time, the income statement shows the change in equity as a result of expenses and revenues (equity can also change for example as a result of issuing shares, repurchasing shares, and paying dividends). Hence, the income statement shows the performance of the firm over some period. In public financial reports, this period typically is a quarter or a year. Within the firm monthly reporting is common practice as well.

Continuing the worksheet example, the income statement can be derived from the expenses and revenue which were added to retained earnings (transactions on 10, 15 and 26 January; the transaction on 31st of January is a dividend payment, which is not an expense).


Income Statement Example

income-statement-example

Naturally, for-profit firms will engage in activities to maximize net income. Net income increases when assets increase relative to liabilities (abstracting from cash transactions between the firm and the shareholders such as issuing new shares or paying a dividend). For example, a trading firm will try to exchange inventory for more than they have paid for. At the same time, other assets may decline in value (machines need repairs, wages need to be paid, etc) and liabilities may increase (interest expenses are incurred). Thus, the balance sheet has a direct relation with the income statement.

It is important to realize that revenue and expenses are not (always) the same as cash inflows and outflows. For a given cash outflow, an expense can be recognized in a period prior to payment, the same period or a later period. The same idea holds for revenues and incoming cash flows. This is what accounting makes very flexible and at the same time it opens the door for manipulation of net income. Accounting principles provide guidance and rules on when to recognize revenue and expenses.


Profit and Loss Statement Example

Generally, accounting principles require that a company recognized revenue when it has delivered the goods/services to the customer, even if the customer has not paid yet. This is quite common in business-to-business transactions where companies grant credit to their customers. Payment by the customer needs to be reasonably certain though for the revenue to be recognized. (I.e., selling goods on credit to customers who are unlikely to pay would not result in revenue.)

The technicalities of this relation as well as the timing differences between cash flows and revenues/expenses are discussed in accrual accounting.


Income Statement Explained

Key points:

– the income statement shows net income over some period (usually a quarter or a year) – the income statement is sometimes called the profit and loss statement (or, ‘P&L’)

– net income equals revenues minus expenses

– accounting principles determine when revenues and expenses need to be recognized

– the balance sheet and income statement are interconnected

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