Understanding the Income Statement

Income Statement Explained

Income statement is a list of all revenues earned during the fiscal year and of all expenses incurred in the same period of time. Whether you are preparing the financial statements for a small business or a multinational corporation, income statement is one of the four statements you will have to create. A basic accounting knowledge is necessary to understand mechanisms behind the income statement, or statement of earnings, as it is sometimes referred to.

Anyone that has taken a basic accounting course knows that there are three parts in income statement; first, revenues, generated by the sales of merchandise and service activities, second, expenses-necessary to generates sales and operate a company and finally the net income or loss, depending on how successful the company was in its operations.

One major difference between the income statement and the balance sheet is that, income statement represents a summary of an entire fiscal year rather than a snapshot at a particular date like balance sheet does.

Income statement is created using the accrual principal, which addresses the issue of revenue and expense recognition. According to it, revenue is recognized when it is earned and not when the cash is received, and expense is recognized when it is incurred. Again cash exchange has no impact on this process.

Let's discuss a common income statement. First line is revenues; it is a number that company generated from sales, dividends, royalties, interest or the combination of them. After revenue, comes cost of goods sold. It is a cost of merchandise, or services that have been sold. For an auto dealer, it will be the price of an automobile that it paid to the manufacturer. Difference between sales and Cost Of Goods Soldis gross profit.

Gross profit is followed by the group of expenses called operating expenses. These are the expenses that were incurred to generate sales. When the operating expenses are subtracted from the gross profit, we end up with the income from operations.

After the minor revenues and expenses are added and subtracted from the income from operations, we arrive to the income before taxes. This is the figure that determines income tax. Difference between income before taxes and income tax is net income.

Let's discuss a single transaction to clarify the impact it has on the income statement and balance sheet to summarize the article. Let's say ABC auto dealership sold a car for $50,000.00. Price that it paid to the manufacturer was $40,000.00. So, sales were $50,000.00 COGS was $40,000.00 and the gross profit was $10,000.00. Let's see effect on the balance sheet; cash will increase by $50,000.00, inventory will decrease by $40,000.00 and retained earnings will increase by $10,000.00 since net income will have a positive effect on retained earnings. Thus, assets increased by $10,000.00 and liabilities plus owner's equity have increased by the same amount. Accounting equation is correct.

This is a short and very basic summary of an income statement for non-accountants. It gives a basic idea on income statement and its components. If you would like to learn more, there are web sites like the authors that offer discussions and articles by professionals, have lists of books that offer a more detailed information on basic accounting courses. One of the examples is author of this article's book. It is a very good source on accounting and profession in general. You will find some interesting discussions about accounting concepts, principles, accounting fraud and ethics issues profession faces today.

I hope this short article will give you a basic information on income statement and will motivate you to learn more about the subject.


Dr. Label has a BS in Accounting from the University of California, Berkeley and an MBA and Ph.D. in Accounting from UCLA. He has worked for a Big 4 CPA firm and has his CPA. He has taught at several universities in both the US and abroad including Georgetown University, NYU, UCLA, University of Nevada, Las Vegas in the US and in Germany, Thailand, Peru, Chile. Bolivia, Brazil and Mexico. He has written more than 40 articles in professional journals as well as 5 books on accounting, the latest o...

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