Overview of Financial Statements
Financial statements are used by managers, shareholders, investors, lenders, and the government for different reasons and purposes. Essentially, financial statements show the financial status of an entity and are comprised of income statement, balance sheet, and cash flow statement.
The Income Statement
Also referred as an earnings statement or a profit and loss (P&L) statement, the income statement details the business’ financial performance for a certain month, quarter, and year. Unlike the balance sheet, the income statement evinces an entity’s business activity over time. In addition, it rehashes the generated income and deducts the incurred expenditures in the derivation of that income in order to compute the net profit or loss for a given accounting period.
The income statement, together with the balance sheet, is an essential financial report which illustrates the revenue-generating capacity and financial status of an entity.
Importance of an Income Statement
An income statement fundamentally addresses queries related to the financial performance of a business (e.g. does it generate profit or not?). Moreover, it describes the results of business transactions that generate income in exchange for goods or rendered services. In addition, it reflects the incurred expenditures in relation to activities involved in generating income. The income statement indicates the net profit gained by a business irrespective of whether the entity generated profit or incurred losses.
The Internal Revenue Service (IRS) compels businesses to prepare an income statement. It is solely the financial statement necessitated by IRS as it is utilized in estimating taxes on the earned profits. Also, a frequently prepared income statement will provide owners up-to-date and essential information with regards to the income and expenditures and inform them whether adjustments should be made in order to make up for losses or curtail expenses.
Preparing an Income Statement
According to a guide from Baruch College – The City University of New York, the income statement follows the accrual accounting system wherein earned income and incurred expenses are both recorded. Thus, earned income may consist of sales on credit that the entity has yet to receive cash while expenses may include bills the entity has not yet settled.
In constructing an income statement, the following four profit measures should be indicated: gross profit, operating profit, profit before taxes, and net profit. Gross profit is determined by deducting net sales from the cost of goods sold, or to simply put,
Gross Profit = Net Sales – Cost of Goods Sold
Net Operating Profit = Gross Profit – Selling and Administrative Expenses
Profit Before Taxes = Net Operating Profit + (Other Income – Other Expenses)
Net Profit (or Net Loss) = Profit Before Taxes – Income Taxes
The first step in preparing an income statement is to fill in the heading of the worksheet with the company’s name and the accounting period that is being examined. Next, specify the total sales or any allowances and compute for the net sales. The cost of sales will also be determined in order to calculate the gross profit. Then, compute for the net operating profit through the selling, general, and administrative expenses disclosed in the worksheet. Lastly, calculate for the net profit from the stated other incomes or expenses and for the net profit before income taxes in the worksheet.
Net sales are the overall sales for the accounting period minus the allowances for the trade discounts and returns. The permitted amount for returns differs depending on the type of business. Net sales can also be described as the amount of money derived from sold goods or rendered services. The equation for the net sales is,
Net Sales = Gross Sales – (Return and Allowances)
Cost of Goods Sold
Also referred as cost of sales, the cost of goods sold is the total amount paid for the sold products throughout the accounting period. It should be noted that the cost of goods sold does not cover the selling or administrative expenses. The cost of goods sold is merely the price of goods or the cost incurred by the business in order to manufacture its products or prepare its services.
In mathematical terms,
Cost of Goods Sold = Inventory at the start + Purchased materials – Ending inventory
There are instances wherein there will be no cost of goods sold. This applies to service and professional companies since they have no inventory of their goods but earn income from fees, royalties, and commissions. However, the expenses in providing their services will be reflected on their selling and administrative expenses.
In the case of wholesalers and retailers, there are various ways on how to compute the cost of goods sold. They can either use a direct or indirect method.
The cost of goods sold can also be indirectly determined via the deflating sales figure. The equations are
Cost of Goods Sold ($) = Total Sales ($) – Gross Profit ($), where
Gross Profit ($) = Total Sales x Gross Margin (%)
The technique in accumulating the cost of goods sold for manufacturers is different compared to the method used by retailers and wholesalers. Manufacturers include the direct labor, indirect labor, factory overhead, and materials and supply.
Selling and Administrative Expenses
Selling expenses and administrative expenses are the two kinds of expenses reported by all types of companies on their income statement. Selling expenses are incurred expenditures, either directly or indirectly, throughout the marketing process. They can be the payroll of salespeople, sales office costs, advertising, and shipping among others. Basically, these are expenses when taking and fulfilling orders.
On the other hand, administrative expenses are expenditures during the business operation excluding the sales of goods. These expenses can be in the form of payroll for non-sales personnel, overhead expenses, and utilities among other things.
Other Income and Expenses
These are income or expense items that are not directly associated with the business proceedings. Other incomes include earnings from interests, dividends, and royalties. On the contrary, other expenses are unforeseen losses such as loss from the disposition of equipment or machineries.
Income taxes are an inevitable part of any business transaction and can be taxed by the local, state, and/or federal government. Income taxes can be calculated by using published tax tables.
Also termed as net profit or earnings, net income is the last item on the financial statement. It shows the gained base profit by an entity during the specified accounting period.
Issues on Financial Statements
Through an entity’s income statement, their financial position can be accurately established. However, there are some concerns that may affect this desired outcome.
❖ Items such as brand recognition, organizational reputation, and customer loyalty are important and relevant business items but are not evaluated and reported on the income statement.
❖ By using different valuation methods permitted in accounting, various profit results will be obtained. For instance, FIFO and LIFO will each yield disparate profit outcomes.
❖ Some values recorded on the income statement are based on judgments and appraisals. An example is the depreciation expenses which is established on approximation of its useful life and salvage value.
❖ The income statement cannot specify the owner’s assets and liabilities, and the Accounts Receivable and Payable.