1.3 Financial Statements: Income Statement

The overall purpose of financial statements is to evaluate the performance of a company, governmental entity, or not-for-profit entity. Each financial statement we examine has a unique function, and together they provide information to determine whether a company generated a profit or loss for a given period (such as a month, quarter, or year); the assets, which are resources of the company, and accompanying liabilities, which are obligations of the company, that are used to generate the profit or loss; owner interest in profits or losses; and the cash position of the company at the end of the period.

The four financial statements that perform these functions and the order in which we prepare them are:

1. Income Statement
2. Statement of Owner’s Equity
3. Balance Sheet
4. Statement of Cash Flows

Income Statement

The first financial statement prepared is the income statement, a statement that shows the organization’s financial performance for a given period of time.

Revenue – Expenses = Net Income

Let’s prepare the income statement so we can see how Cheesy Chuck’s performed for the month of June. Our first step is to determine the value of goods and services that the organization sold or provided for a given period of time. These are the inflows to the business, and because the inflows relate to the primary purpose of the business (making and selling popcorn), we classify those items as Revenues, Sales, or Fees Earned. For this example, we use Revenue. The revenue for Cheesy Chuck’s for the month of June is $85,000.

Next, we need to show the total expenses for Cheesy Chuck’s. Because Cheesy Chuck’s tracks different types of expenses, we need to add the amounts to calculate total expenses. If you added correctly, you get total expenses for the month of June of $79,200. The final step to create the income statement is to determine the amount of net income or net loss for Cheesy Chuck’s. Since revenues ($85,000) are greater than expenses ($79,200), Cheesy Chuck’s has a net income of $5,800 for the month of June.

A simple income statement is less detailed than the multi-step format. A simple income statement combines all revenues into one category, followed by all expenses, to produce net income. There are very few individual accounts and the statement does not consider cost of sales separate from operating expenses.

A multi-step income statement is more detailed than a simple income statement. Because of the additional detail, it is the option selected by many companies whose operations are more complex. Each revenue and expense account is listed individually under the appropriate category on the statement. The multi-step statement separates cost of goods sold from operating expenses and deducts cost of goods sold from net sales to obtain a gross margin (aka gross profit).

Revenue – Cost of Goods Sold = Gross Margin

Operating expenses are daily operational costs not associated with the direct selling of products or services. Operating expenses are broken down into selling expenses (such as advertising and marketing expenses) and general and administrative expenses (such as office supplies expense, and depreciation of office equipment). Deducting the operating expenses from gross margin produces income from operations.

Following income from operations are other revenue and expenses not obtained from selling goods or services or other daily operations. Other revenue and expenses examples include interest revenue, gains or losses on sales of assets (buildings, equipment, and machinery), and interest expense. Other revenue and expenses added to (or deducted from) income from operations produces net income (loss).

Let’s prepare Cheesy Chuck’s Classic Corn in the multi-step income statement format.  For now, accept that we will go into detail about cost of goods sold in Ch. 3.

Income Tax Expense is calculated at 21% or $1,218 ($5,800 x 21%).  Please note that the federal corporate income tax rate is 21% but individual states will have additional variable state income tax.  Please look the current state in which you reside to determine you state income tax rate.

Net Income of $4,582 will be used in the Statement of Owner’s Equity in the next section.

Note: Colors are used to aid in learning and should not be used on real-life financial statements.

Using the multi-step Income Statement puts the financial information in a common format that allows us to compare two companies to each other.  We will learn how to compare companies in Ch.  2.