An Income Statements attempts to present the earnings activity of a company for a given period of time. That period can be a month, quarter or year. It is one of three required statement in a set of financial statements, which also includes the Balance Sheet and Statement of Cash Flows.

Accrual accounting deals with matching revenues and expenses and placing them in the appropriate accounting period. Cash accounting records only cash activities. Both are useful.

The income statement presents results on an accrual basis; the Statement of Cash Flows on a cash basis.

Of the three required statements, it is the statement which requires the most judgment in preparing, as will be seen below. (However because double-entry accounting requires the books to "balance", whatever happens on the income statement has an affect on the reported amounts on the balance sheet.)

The generic categories are: revenues or sales, cost of sales, operating expenses, and other items, including income taxes, if the entity is an income tax paying entity (corporations pay taxes, partnerships generally do not).

In the simplest example, a company buys something, converts it to a finished product and sells it for cash, all in one year, with the customer having no residual potential claims (such as warranty) against the company. In this case, one records the sale (say $100), the cost of producing the product (say $50), the cost of selling the product (say $15) and the income taxes thereon ($100 less $50 less $15 = net income before taxes of $35, times the applicable tax rate, which results in an income tax amount of $10), with the difference, in this example, $25, equaling net income.

Unfortunately, this simplistic example happens only rarely, but it is the beginning point.
To create income statements in the real, more complex world, accountants use the concepts of revenue recognition and matching, among many other things. In order to understand what the numbers on an income statement mean; the reader of the statement must understand these concepts and the difficulties surrounding their application. While the footnotes, which are required for a complete financial statement presentation, help, they assume some basic understanding of the general concepts.

There is one other concept which must be understood before we go on: periodicity. In even the most complex situations, the net income of the company will, in the very long run equal the net cash generated. Another way

• 1
• 2
• 3
• next page >>

---

Add your voice

Know something about Understanding the income statement?
We want to hear your view. Write now!