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Definition of Income Statement

The income statement determines a company’s financial performance by showcasing its performance for a specific period. It records revenue and expenses to calculate the profit and loss within that period.

How to Create an Income Statement?

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Step 1: Selection of The Reporting Period

Companies report financial performances both quarterly and yearly. When an accountant plans to prepare an Income statement, he should decide the period for which the Income Statement will be made. Public companies must make timely disclosures of financial statements to the public.

Step 2: Generate Closing Balances

Separate line items appearing in the Income statement will come from different accounts. Ledgers are separate accounts where the closing balance can be found in the trial balance. So the accountant must generate the closing balance of different ledgers and match the Trial Balance report.

Step 3: Calculation of Revenue

Revenue is the first line item in Income Statement. Whatever the company does, sales in a given period will come under revenue. The actual operation of a business generates revenue, such as when a specific company sells shoes as its primary source of income.

Step 4: Calculation of Variable Cost

The accountant must determine the variable cost of a single quantity and multiply it by the total production quantity to calculate the total variable cost. Increasing the production rate of a particular product will result in a corresponding increase in the variable cost. Deducting the variable cost from revenue provides the accountant with the contribution.

Step 5: Determination of Contribution

The accountant refers to the remaining amount as a contribution when deducting the total variable cost from the total revenue. Focusing on “contribution” implies that this amount actively contributes to something. It is well understood that a company’s primary cost is fixed, as it must be paid regardless of production levels. Thus, this amount actively contributes to the highest cost, which is the fixed cost.

Step 6: Calculation of Fixed Cost Step 7: Determination of Interest Paid by The Company

The company issues bonds to raise capital from the market. The interest charged by the bondholders is a non-operating expense. Therefore, it must be deducted from operating profit(earnings before interest and tax) to get “Earnings before tax.”

Step 8: Calculation of Tax and Generation of Net Income

The company charges the tax rate on the Earnings before tax and refers to the remaining amount as the Net Income or profit for the period.

Example of Income Statement

Company XYZ is preparing for the annual result. The external auditor that the company has hired is calculating the net profit for the company. The details are mentioned below

Sales = $1,000,000

Variable Cost = $200,000

Fixed Cost = $300,000

Interest Paid = $100,000

Tax Rate = 20%

The Net Profit of the company is 32,000

Components

Some of the components are as follows:

Revenue: All company sales in a particular period are recorded under revenue. These are operating incomes that the company generates through its core operation.

Variable Cost: When production increases, the variable cost increases as it is directly linked to the manufacturing cost of each sold item.

Fixed Cost: It doesn’t vary with the number of goods produced. These are mainly indirect overhead expenses, such as Factory rent, etc.

Interest Cost: The company must pay fixed interest charges whenever it issues bonds to raise money. Higher the interest charge, the more levered the company is. Too much leverage may attract bankruptcy.

Tax: Every company has a different tax structure. The tax is charged from Earnings Before tax, and we get Net Income afterward.

Uses of Income Statement

Revenue Tracking: An analyst will not know the firm’s revenue if the Income Statement is not published regularly. The first item is revenue. To validate the revenue figure shown in the Income statement, you need to maintain proper documentation regarding actual sales.

Profitability Calculation: A firm may make a huge amount of sales, but its profitability can be low due to high expenses. Profitability increases when expenses are controlled. So it portrays an accurate picture of the expenses of a firm.

Business Activity: A firm’s net income can increase by selling old assets. These incomes are not part of operations. So it helps analysts to understand the exact income that is coming from operations.

Why Is Income Statement Important?

It is part of the Financial Statements being released by the company regularly. It helps analysts understand a particular company’s profitability, income, expense, etc.; all the information mentioned in the Income Statement is extremely important for stakeholders, analysts, tax authorities, and others. It is the doorway to the company’s operations.

Limitations

It is prepared based on accrual accounting. Therefore, the sales reflected in the Income Statement may not be the actual sales as per the cash-flow statement. The cash flow statement reflects the sales for which the company has received cash. Any sales made on credit will not reflect in the cash-flow statement. So the sales reflected under the Income statement may be misleading.

All the items reflected in the income statement are based on accounting rules, so management can manipulate them to show rosy pictures to the stakeholders.

Conclusion

An income statement is extremely important to gauge a company’s financial performance. All important line items are part of the Income statement. Studying a company’s income statement enables the calculation of several important ratios.