The Income Statement is also often called a Profit and Loss Statement, and, less commonly, a Statement of Operations, an Earnings Statement, or an Operating Statement, depending upon the industry or geographic area that you operate in. For our purposes, they are all one and the same.
What It Is
"C'mon Tyler, this is a waste of time; everyone knows what an income statement is!" I can hear your argument now. Well, knowing what it is and understanding are two different things, so have a little patience. Let's start by looking at Wikipedia's definition of the income statement as
"a company's financial statement that indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the "top line") is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as the "bottom line"). It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs (e.g.,depreciation and amortization of various assets) and taxes."
Clear as mud? Here is another way to look at it. If you remember from our lesson on the balance sheet and on retained earnings, the balance sheet represents, at one given moment in time, a company's assets (everything it owns that has value) less its liabilities (everything it owes or that will cost it money in the future) to get at its equity (the net value of the company). What the income statement does, together with the statement of owner's equity, is to tell the story of the change in a balance sheet over a period of time.
Let's boil this down to the simplest level, and ignore everyone out there who is screaming out exceptions that really don't apply to most of you as entrepreneurs and owners of small businesses. Your Net Income (the bottom line of your income statement) must be equal to the increase (or minus the decrease) in your assets over the year minus the increase (or plus the decrease) in your liabilities plus any cash paid out to the owner.
Now think about this, increased assets make you feel happy, right? After all, they represent items that have value to the business and that should, in the future, bring you money. Increased liabilities should make you a little uneasy. Your liabilities are money that you will have to pay out someday, which will make you unhappy. I hate paying money, but I sure love getting it! Maybe that's why my wife calls me a cheap sonofabitch. Now, your distributions are money that you have already taken out; and so they gave you happiness at some point in the past. So really, net income is your overall increase in future happiness, less the increase in future unhappiness and plus the amount you have already taken out in past happiness!
Why Important
The income statement is the single most important vital sign of the health of your business. If income is good, then more assets can be put to use for the business and more money can be distributed to the owners. The flip side is that when income is negative, which means that you have a loss, then you will have less money to take out of your business as distributions and you will have to support your operations by either selling off assets or by increasing liabilities.
Presentation
If you have accounting software, like QuickBooks, then you will get a basic presentation as part of the package. In virtually all businesses, the income statement starts with sales and ends with expenses. If your enterprise is either manufacturing or retail related, then the basic presentation is Sales - Cost of Sales (also called Cost of Goods Sold) = Gross Income - Sales Expense, Operating Expense, and all other expenses + income not from ordinary operations (such as the gains on the sales of assets besides inventory or interest income) - expenses not from ordinary operations (including taxes, although I would consider taxes pretty ordinary) = Net Income.
Oh my God! I've just totally turned geeky-accountant super-nerd on you guys! Look, presentations vary wildly from industry to industry and from one set of accounting standards to the next. If you need to present the statements to others then you'll probably end up getting an accountant to put them together, anyway. So just put them together in the way that makes sense for you and helps you find the information that you need.
What is Revenue
Now that we know what the net income must be, let's take a peek under the hood to see some of the gory details. The basic income statement is divided between items that have made you money or will make you money in the future, income or revenue, and items which have cost you money or will cost you money, expenses. As you may imagine, we want to keep close tabs on those warm, fuzzy revenues so that we can nurture them and make them grow and thrive. Therefore, we group the revenues together and lump them at the top of the page. Your revenues can further be divided by important products or divisions to provide the readers of the income statement with more information. Finally, some items are always segregated from the general revenue items due to their unusual nature, including unrealized gain or loss on assets, realized gains or losses on assets, interest income, and other items.
What is an Expense
Expenses are the Devil, prying money from your pockets either now or in the future. Every business has to deal with the Devil in order to operate, but we want to keep track of these deals so that we know how much of our soul we still have left! As you may imagine, we further segregate expenses into sub-categories. Cost of Goods Sold (also called Cost of Sales) is the money you spend to purchase or make the product that you sell. General and Administrative Expenses are more peripheral items that pop up in the course of running a business. Your accounting software, wages paid to the janitor or the secretary, Internet service for the office, basically anything that can't be directly attributed to the purchase or manufacture of your product.
How To Prepare Your First Income Statement
If you are using QuickBooks or another accounting program then it is seemingly easy to put the income statement together. The problem with most of those programs is that they can't tell you when you put garbage in them. So you will want test your income statement by following the steps below.
Step One: Make sure your balance sheet is up-to-date and accurate.
At the end of the year I go down my balance sheet line by line and make sure every amount makes sense to me. In fact, that is the first step of an auditor if you get your statements audited. I like looking at at least two periods side by side, since inconsistencies are more apparent that way. Make any adjustments that you need and move on to Step Two.
Step Two: Calculate Your Retained Earnings
I've already written about this in detail in another article, but basically your retained earnings are the bridge between your balance sheets for the current and prior periods. Any change must be reflected in retained earnings, which is in return the product of your income plus any contributions in capital and less any distributions of capital. So if you can get the correct number for any capital that you took out (other than wages, which will go onto the income statement and for which you will pay payroll taxes) or put into the business then you can isolate the change in retained earnings due to net income. Can you figure those out? Good, then any remaining change in net assets must be due to net income. Now you have your net income and, if you are using an accounting software, you should check your number for net income with the number that you just calculated. If they don't match, well, you're screwed and I can't help you anymore. No, just kidding, you'll have to adjust your income on the income statement to match.
Step Three: Fill In the Blanks
Now plug the number that number into the bottom line of your income
statement and start filling in the details. When you have everything
in but it doesn't total up then just plug the difference, if it is
minor enough, into some sort of Miscellaneous Expense or Miscellaneous
Income account. Don't worry your accountant does that all the time!