Every business needs to report their performance to the Securities and Exchange Commission (SEC). There are three key financial statements that present the performance of the business[i]. They are the balance sheet, statement of cash flows and the Income statement. It is thus mandatory for a business to prepare an income statement.
What is an income statement?
The income statement is also known as the Profit and loss statement. It shows the sales of the company and the profits earned over a particular period of time. The statement may be prepared monthly, quarterly and/or annually. This statement tells your shareholders how much revenue you have earned over a period of time and whether you have made profits or loss.
What does it contain?
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While the format of the income statement can vary depending on your business, the following contents need to be there in every income statement[ii].
- Revenue or Income: Every business exists to make money. How much money you have earned is your income or revenue. This needs to be listed in the income statement. The discounts offered and sales returns need to be deducted from the total sales amount earned to compute revenue.
- Cost of goods sold (COGS): The cost of goods sold is the cost you incur to manufacture your product or deliver your service. All direct expenses like cost of raw material, cost of labor needs to be included in COGS. Overhead costs are not included as they are indirect expenses.
- Gross profit: Revenue – COGS = Gross Profit. It is fairly simple. Once you have computed the cost of goods sold, deduct the amount from the total revenue you have earned. That gives you the gross profit.
- Expenses: A business incurs many expenses that include salaries, office administration expenses, rent, fees paid to consultants, etc. These expenses need to be listed out in the income statement.
- Net income: The net income is nothing but Gross Profit – Expenses. This is our income after deducting all expenses incurred by you. If the number is in the negative, then it means you have not made a profit, but have incurred a loss. This value is net income before taxes. Once you compute tax due and deduct it from net income, you get the net income after tax.
Why is it important?
Firstly, it is statutory, which means as per law, you need to compulsorily file this statement with the SEC. The second reason is that it is a simple statement that tells you how much money you made, how much money you spent and what is the final bottom line. One glance at this statement will tell if you made a profit or a loss[iii]. It also tells you how much of a profit or loss you made?
This statement is useful for accountants as it helps them to analyze your business. They can then suggest how to make the business more profitable, by either increasing incomes or reducing expenses.
Investors and lenders find this an important statement as it helps them to decide whether to invest in your company or lend you money. It helps them to ascertain the profitability of your business, so they can take an informed decision.
An income statement is a mandatory accounting report to be prepared by a business. It helps a business to present details on income earned and the profitability of the business.