What is an income statement?

An income statement is a financial report that examines a company’s income and expenses. This statement forms part of the three main financial reports used by accountants to show a business’s financial position as it relates to profit and is, at the very least, prepared on an annual basis. It is important to note that an income statement alone cannot accurately portray a company’s financial position since it only deals with profit and loss. In order to see a more complete picture, this statement must be examined alongside a cash flow analysis and balance sheet.

Some important general information regarding income statements

Why is an income statement important in business?

The income statement is a business management and accounting tool that breaks down the company’s revenues and expenses into clearly defined categories. These categories can show managers and entrepreneurs how the different areas in a company are performing and if they are actively contributing to the company’s success. Income statements are also used by investors to decide if a business is a viable consideration; an income statement that proves consistently good net profits is nearly always a lucrative investment opportunity. Income statements are an integral part of any business’s financial statements and, as such, are almost always required by financial institutions when a company applies for financing products.

Should all businesses prepare income statements?

Yes, every business needs to prepare financial statements. Many freelancers and entrepreneurs operate their businesses as an extension of their personal finances so don’t necessarily have clear accounting processes. While this approach is fine when your business is still very small, it can quickly lead to confusion between personal finances and business finances. Financial statements are a key element of reporting in any business, irrespective of the age or size of the enterprise. When your business is still in its infancy you can prepare basic financial statements from your kitchen table, but as it grows a more formal accounting process is recommended. These statements will help you to effectively manage your business and can help to foster growth in your bottom line.

Are there different types of income statements?

There are two types of income statements, single step and multi-step. Although the statements report on the same information their layout can differ slightly. In a single-step income statement information is grouped simply as expenses and income without any sub-groups. Multi-step income statements are more detailed and contain several sub-headings that make the statement more professional and easier to understand. Single-step statements also omit the pre-tax figures and offer only post-tax bottom lines. In a multi-step statement figures are provided with and without tax so that the reader can clearly see the effect that taxation has on the businesses profitability.

Does an income statement account for indirect costs?

Yes, a complete income statement should include all operating expenses, whether they are direct or indirect. Hidden costs like depreciation and interest expenses are often overlooked when compiling financial statements. Not including these costs in your calculations can lead to incorrect net income figures, which will, in turn, affect the profit figures reported by the income statement. Accounting errors can be difficult to spot where hidden costs are concerned, which is why many businesses use their accountant for the task.

Does an income statement include information on the assets owned by a company?

The income statement does not provide information on the assets owned by the business since it primarily deals with the net income generated from the sale of goods and services. While the income statement may report on the expenses related to purchasing assets such as vehicles and equipment, it will not include the capital value of those assets. The value of assets owned by the company is reported in the balance sheet.

Is there a difference between income statements meant for internal use and those meant for the tax authorities?

Financial statements, including income statements, that are used for reporting net profit figures to HMRC should be compiled by a chartered accountant and signed by the company’s director. In general, income statements that have been prepared for internal use do not meet these requirements since it can be costly to have your chartered accountant prepare non-essential documents. Internal use statements can also omit certain information or present a summarised version which would make them unacceptable for official purposes. It is important to note that HMRC imposes taxes on a business based on the reported net profit as shown on the entity’s financial statements and, therefore, official-use statements should be as complete as possible.

Why are some companies required to release their financial statements to the public?

When a company is floated on the stock exchange it is, in effect, owned by many different shareholders. The law requires that these companies make their annual financial statements available to the public so that shareholders can see what the company’s operating profit was, and if it is being managed in an acceptable way. Financial statements are often a key consideration when deciding whether or not to invest in a company and publicly traded companies provide their financial statements to make it easier for investors to evaluate the viability of the investment. Another reason for this requirement is transparency; since the company is using shareholder funds to generate its operating income, the financial statements are subject to public scrutiny.

Preparing an income statement

Can anyone prepare an income statement?

Almost anyone can draw up an income statement since there are clear rules regarding the way in which the document should be compiled, but many companies choose to have their annual income statement prepared by their accountant. This is normally done as part of preparing the annual financial statements and can often be a legal requirement for larger companies. Many of the commercially available accounting applications can prepare an income statement in a few clicks without the need for any advanced accounting experience. As a freelancer, it is advised that you learn to compile your own income statement since it will give you greater insight into the profitability of your business and allow you to identify which areas you are overspending on so that you can improve the bottom line figures. If you are looking to prepare your own financial statements take a look at the requirements for acceptable statements before putting pen to paper.

What documents are required to prepare an income statement?

In order to prepare an income statement, you will need to know the revenue and expenses that the business has had during a specific period of time. If you are looking at an income statement as part of the process of buying a business, you should be aware that revenue shown is not actual cash, but rather the sales that were recorded. In other words, cash doesn’t have to be in the company bank account to be counted as revenue on this statement. This same principle is applicable to expenses as any invoices received during the accounting period will be entered as expenses whether they have been paid or not. Costs such as interest on loans, bank charges and income tax should also be accounted for on the income statement. After entering all the revenues and expenses the balance sheet should indicate what the gross profit was for the specified accounting period.

What format does an income statement need?

Whether single-step or multi-step, the basic inclusions should be:

• Gross Profit (sales turnover).
• Costs (sometimes called operating expenses).
• Net Income (profit after costs).

Within each of these, in a multi-step statement, will be subgroups for ease of reference. For example, costs are grouped into various categories which might include administrative expenses, buy-in costs of goods sold, rent and utilities, and any other cost associated with running your business.
The last line of an income statement should always be the net income that the company made during the reporting period. To determine the net income, you should subtract the total costs from the gross profit.

How often should an income statement be prepared?

The frequency varies from business to business, but all companies, big and small, need to prepare an income statement at least once a year. Depending on the size of the enterprise, income statements may be prepared quarterly, monthly or weekly. For high-turnover, cash heavy businesses like casinos, income statements may even be a daily part of the accounting procedures. For all businesses, an income statement is a useful management tool that is essential in identifying problems early on. Preparing a basic income statement on a monthly basis and comparing it to the previous month’s statement will give you a clear idea of the progress your business is making but, more importantly, warn you of any pending financial issues with enough time to rectify them.
For freelancers, an income statement will be much less detailed than for a retail business. Nevertheless, for all entrepreneurs, a regularly updated document that covers all financial aspects of their work will be invaluable in maintaining margins and achieving goals. There are number of templates available online, any of which can be amended to suit your particular business activities.

The income statement in relation to other financial statements

How does an income statement relate to the other financial statements?

The income statement is closely linked to the balance sheet and cash flow statement. The information on each of these three statements is sourced from the others as each document is designed to supply information relating to a specific accounting aspect. In short, the income statement deals with revenue, the balance sheet deals with assets, and the cash flow statement looks at liquidity in the business. Because all three elements determine the success or failure of an enterprise, it is not possible to fully separate the statements from each other. It is important to note that while an income statement can give you a snapshot of the profitability of a business, the financial statements show you what the net value of a business is.

What is the difference between an income statement and a cash flow statement?

While an income statement reports net income and profit values, a cash flow statement shows what the actual cash position in the business is at any particular time. Cash flow statements are very useful for predicting the changes in the business’s cash reserves and are essential to financial planning. Without a cash flow statement, a business would know how much profit it is ultimately making, but it will have no idea if the outgoings outstrip incomings to a dangerous level at any point in the defined accounting period. By using a cash flow statement as a long-term planning tool, you will be able to anticipate the potential need for overdraft or loan facilities, and plan ahead to ensure that the business remains liquid.

What are the differences between an income statement and a balance sheet?

The purpose of a balance sheet is to indicate the assets and liabilities that a company has at a specific point in time. The balance sheet is effectively a summary of the cash flow and income statements and is used in accounting to show the value of a business. The key difference between the income statement and balance sheet is the information that they report. The balance sheet does not look at the number of goods sold or the net profit of a business, but it does take this figure from the income statement and reports it as part of the company’s assets.