Reading and understanding your statement of income or profit and loss statement

Published: 12th January 2009
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Among the four basic components of financial statements (the balance sheet, statement of changes in equity, income statement and cash flow statement), the statement of income is the most interesting and exciting to read by its common users. This is true, since it indicates if an entity is having a profit or a loss, and that every business owners, investors, creditors and even the tax authorities may primarily want to see and know first if an entity is earning or making money out of running its business and utilizing its resources.

An income statement also called profit and loss statement (P&L) or sometimes prepared as statement of operation, is a formal statement showing the performance of an entity for a given period of time. The performance of the entity is primarily measured in terms of the level of income earned by the entity through the effective and efficient utilization of its resources. Income statement indicates how revenue (money received or receivable earned from the sale of products and services before costs and expenses are taken out) is transformed into net income or net profit (the result after all revenues, costs and expenses have been accounted for). This income performance is used to be known as the results of operations of the entity.

Different from common entities, a non-profit organization does not prepare an income statement or a profit and loss statement since it is established not to earn money but to carry out its purpose like charity, environment care, cultural development and other activities to help the society. That's why they are usually exempted from income tax. The formal statement prepared by these organizations to show their performance is called statement of supports, revenues and expenses. A fund accounting method is usually used on these types of entities. Actually the statement of revenues, support and expenses are the same with the statement of income although the term income or profit is not used.

The information about the performance and profitability of an entity is useful in predicting the capacity of the entity to generate cash flows from its existing resources. It is also useful in forming judgment about the effectiveness of employing additional resources. Owners and investors of the entity use the income statement to determine if the entity made or lost money for a given period of time. In others words it is used to know if the entity is earning or losing. It also tells us if production and employment of products or services for sell will give us additional profit or loss.

The income statement is prepared "for a given period of time". In other words, a period must expire before the performance of an entity can be properly measured. The income statement covers a period, unlike a balance sheet which is prepared as of given date or particular moment in time. For example a company that prepares financial statements on a calendar year December 31, 2007, its balance sheet should be dated "as of December 31, 2007" and its income statements should be dated "for the year ended December 31, 2007". If financial statement is prepared only for a six-month from June 1, 2007 to December 31, 2007, its balance sheet should still be dated "as of December 31, 2007" since it is for the point of time, while its income statement will be dated "for the six-month period ended December 31, 2007" which means the statement is a report for the six month period time from June 1, 2007 to December 31, 2007.

The components of income statement are revenues, expenses and net income (the income after deducting all of cost and expenses during the accounting period). Revenues include sales of products or services. It may also be deducted by sales discounts or sales refunds. Revenues are recognized whether they are already collected or not. This is called the accrual basis of accounting. Revenue is recognized as it is earned regardless of being received or not. For example, a company that sells canned goods, the sales from canned goods to customers is recognized as revenue once the ownership of the goods is transferred to the customer regardless of whether the price money is already collected in the form of cash or cash in bank or not collected in the form of an accounts receivable. Revenue or income is defined as "increase in economic benefit during the accounting period in the form of inflow or increase in asset or decrease in liability that results in increase in equity, other than contribution from equity participants". In other words, it is an inflow of future economic benefit that increases equity or capital, other than contributions by owners, proprietor (single proprietorship), partners (partnership) or stockholders (corporation).

Other sources of revenue includes income from rendering of service (accountant's fees, lawyer's fees, insurance agent commissions, talent fees, etc.); use of the company's resources (interest, rents, royalties and dividend income); and disposals of resources other than products (gains on sale of investments, property and equipment and intangible assets).

An expense is defined as "decrease in economic benefit during the accounting period in the form of outflow or decrease in asset and increase in liability that results in decrease in equity, other than distribution to equity participants". In simple words, it is an outflow of future economic benefit that decreases equity, other than drawing paid to proprietors and partners or dividend paid to stockholders.

Generally, expenses include cost of sales, selling expenses, administrative expenses, other expenses and income tax expense (if an entity is subject to income tax).The cost of sales is the direct costs attributable to the cost of products or services sold. In an analytical view, it is the sales after deducting your mark-up on the goods or services sold. Cost of sales is used to determine the gross profit amount and ratio of a certain entity. Gross profit is what you get after deducting cost of sales from your total revenues. Gross profit is computed by dividing your gross profit to your total revenues.

The cost of sales of a merchandising company is composed of goods available for sale (beginning inventory plus net purchases) minus ending inventory. While the cost of sales of a manufacturing company consists of raw materials used (beginning raw materials plus net purchases less ending raw materials), plus direct labor, plus factory overhead, plus beginning goods in process, less ending goods in process, plus beginning finish goods, less ending finish goods.

Selling expenses constitute costs which are directly related to selling, advertising and delivery of goods to customers. These include sales commissions, salesman salaries and traveling expenses, marketing expenses, advertising expenses, freight-out, depreciation of delivery equipment and store equipment, and other expenses related directly to selling activities.

Administrative expenses represent cost of administering the business. This includes all operating expenses not related to selling and cost of goods sold. Examples of administrative expenses include salaries of general officers and of administrative staff or employees, office supplies, taxes and licenses, depreciation of administrative building and equipment, insurance, amortization of intangible assets and doubtful account expense.

Other expenses or charges are those expenses which are not directly related to the expenses discussed in the preceding paragraphs. These include charges to income such as loss on sale of property and equipment, loss on sale of long-term investments and other losses.

After recognizing and understanding an entity's revenues and all its expenses including income tax, we realize that what is left after deducting all expenses from all income is the net income or net profit if the entity is performing efficiently and effectively, and net loss if the entity is ineffectively and inefficiently employing its resources. However a certain entity having net loss for a certain period of time cannot be absolutely judged that it is performing poorly in doing business. A particular company may incur losses because of the fact that it is only in its early years of operations since its establishment. Therefore, it is always a wise move if we read and analyze income statement for a series of years instead of reading it for only a year or two year periods of time. There are also some qualitative factors that we might need to consider like its participation to our society and protection of our environment.


The author is a Certified Public Accountant. He has been in the public practice of accounting and business professional services for more than four years. You can visit his site for more business articles and insights at www.BusinessAccent.Com /
www.BusinessPull.Com


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