The Income Statement presents a summary of an entity’s Revenues (what the company earned from sales of products and services) and Expenses (what was expended to earn this revenue) for a specific period of time, such as a month, a quarter, or a year. This period of time is known as the accounting period. One key difference between the Income Statement and the Balance Sheet is that the Income Statement reflects a period of time rather than a single moment in time as with the Balance Sheet. The Income Statement is also called a Statement of Earnings or a Statement of Operations.
The preparation of the Income Statement serves several purposes. Often the only reason one uses the Income Statement is to concentrate on the “bottom line” or Net Income (Revenue minus Expenses). The Income Statement can also be useful for analyzing changes in the Revenue data over a period of time, or determining ratios of particular Expenses to Revenue and how these ratios have been changing over certain periods of time.
Many people consider it the most important financial report because it shows whether a business achieved its profitability goal—that is, whether it earned an acceptable income. Four major types of items appear on income statements: revenues, expenses, gains, and losses. Revenues are inflows of assets (or reductions in liabilities) that result from providing goods and services to customers; they arise from a firm’s ongoing operations.
Sales of inventory to customers, for example, generate assets (cash or accounts receivable) and constitute revenues. Expenses arise from consuming resources in order to generate revenues. The cost of inventory sold to customers illustrates an expense.
Gains, as with revenues, increase assets or decrease liabilities, yet they arise from activities that are not central to a firm’s major operations. For example, a gain would result from selling land for more than its carrying (book) value. Losses are similar to expenses in that they decrease assets or increase liabilities, but they are not central to a firm’s major activities. The sale of land at an amount less than its carrying value would result in a loss.
At the end of this chapter, You will know to:
- Explain when to recognize revenues.
- Explain when to recognize expenses.
- Interpret the components of the income statement.
- Analyze income statement information using various ratios.
- Describe the effects that reported earnings have on managers’ wealth and, consequently, on their accounting policy decisions.