An income statement is a financial statement that reports on a company’s profitability over a period of time. The income statement is also referred to as a Profit and Loss Statement (P&L). Or less commonly as a statement of revenues and expenses. While an income statement can be compiled for any time period, it most commonly summarizes a month, a quarter or a year. Also, it commonly shows a comparison to previous periods so the reader can understand the trend over time. Income statements commonly show the performance of a whole company. But can also be compiled for a business unit, location or even a project.

When business leaders ask “what’s the bottom line?” they are referring to the income statement. Since the bottom line of the income statement is Net Income – a measure of profitability. This expression has been expanded to mean a meaningful and measurable impact on the business. Similarly, when business leaders speak of adding to “the top line”, they are referring to revenue since that’s at the top of the income statement.

Before you start looking at line items an income statement it is useful to define some core concepts of accounting and financial reporting.

Revenues are not the same as cash inflows, but they are commonly confused. The main difference is that Revenue is recorded when earned and show on the P&L on whereas Cash is recorded when received and shows on the Cash Flow Statement. For instance, a company may take a deposit up front, but not earn the revenue until the product is delivered. Or a company may invoice their client for services rendered, thus recording revenues earned, but not receive the cash until 60 days later. Decisions and policies about when to recognize revenue (i.e. Revenue Recognition) should be made with the assistance of a CPA. 

Sales and Revenue are two concepts that are also commonly confused. The terms are used interchangeably even by accountants at large companies! Sales refer to an executed contract for the provision of goods or services. Whereas Revenue indicates earned income. For instance, a sales rep may close a ‘Sale’ for a $100,000 project in a given month. The company may then start work and earn $25,000 of Revenue in each of the next four months, and Receive Cash 30 days later.

Just below Revenue on the income statement, you’ll find Cost of Sales (COS) or Cost of Goods Sold (COGS). This line item attempts to describe the expenses that are directly associated with the revenue earned. It can include the cost of inventory sold, wages of project team members, subcontractors, etc.. Determination of what expenses to include in COGS should be done with the assistance of a CPA with management accounting expertise, and is related to the concepts of fixed vs. variable costs, direct vs. indirect expenses. 

Gross Profit = Total Revenue – Total COGS. 

Subtracting COS from Revenue gives the Gross Profit for the period. Therefore, if Gross Profit is negative, no amount of increased sales will result in a profitable company.

Not all cash outflows are recorded as expenses on the books, and therefore don’t show up on the income statement. Purchase of equipment is an obvious example – equipment is an considered an asset that will be used over a long period of time and can feasibly be sold in future. Less obvious examples are when R&D focused companies choose to capitalize some of their development expenses. Capitalizing expenses creates assets on the balance sheet and these decisions and policies should be made with assistance from a CPA – they have important impacts on business valuation, M&A and eligibility for tax credits.

Not all expenses are associated with cash outflows. Similar to the concept of Revenue Recognition, companies must decide when an expense has been incurred. For instance, companies may prepay their insurance premiums all in one lump sum, but spread out the expense on a monthly basis in the books, so the cash transaction is separate from the expense. Similarly, the concepts of Depreciation and Amortization relate to how much of an asset’s life has been used up. Some amount of depreciation expense is recorded on the books each year but does not affect cash.

The Net Income “bottom line” is ultimately what matters, as it reflects the overall profit earned by the company. This is also known as Net Profit. But some of the expenses a company incurs are more related to how it chooses to finance itself than the profitability of its regular business activities. Some companies may pay high interest on credit cards and operating lines of credit. Whereas others may have a lower debt service load. Net Operating Profit considers the profitability of the daily operations with financing expenses removed – i.e. considering only the operating expenses.

Net income = Revenues – Expenses

For the same reason it is also interesting to look at Income Before Taxes – some businesses may be more tax efficient than others and you may want to consider only the operating profit.

Here is an example of the simplest possible income statement. 

Here is an example of an income statement for a SaaS tech statup. 

If you are looking for help constructing and organizing your income statement for your company, please get help from a CPA. Chart of accounts design is important for your future ability to report and analyse your company financial performance. It’s the first step in accounting policy decisions around revenue and expense recognition and capitalization of expenses.

Income statements are used internally by company management. To understand financial performance of the business as a whole, of products, projects, business units and key business activities. The company’s financials including the income statement are shared with prospective investors prior to transactions and as part of M&A activity. They are provided to boards of directors and to shareholders at minimum on an annual basis (for private companies). As well as at least quarterly for public companies. The income statement is an important component of transparency and governance. It informs shareholder decisions, facilitates conversations with management and influences investor market activity.

Here’s how to read an income statement

1. Start at the top and check the reporting period – which year/quarter/month is reported?
2. Next look at the line items, starting with total Revenue and compare to previous periods – is it growing?
3. Next look at Cost of Goods sold and Gross Profit – is the business earning a healthy margin and is it improving over time?
4. Scan through the largest expense lines under the SG&A section – are there any significant changes from prior periods, does anything look too high?
5. Down at the bottom, look at Operating Income and Net Income – are these proportional to previous periods? Did Net Income increase? If Net Income is low or negative, ask if the company is making investments in order to earn future income. If Net Income is high, ask yourself if the company is investing too little in future growth and will experience declining income in future.

It is risky and unnecessary to create an income statement manually or in a spreadsheet. Income statements should only be generated from accounting software (such as Quickbooks Online, Xero, Netsuite, SAP, etc.). It should not be modified thereafter (unless for analysis purposes). Prior to exporting an income statement from your accounting system, it is best practice to ensure that the bookkeeping for the period in question is complete and correct. Meaning bank reconciliations are done, and the accountant has reviewed the books to ensure policies are followed, transactions are treated consistently between periods.

Having complete and correct income statements is the basis for forecasting net income. Income statements that include forecasts are called Pro-forma income statements. They can be constructed to show the growth trend of an ongoing business, or the impact of a major financial transaction such as a loan, equipment purchase or corporate merger/acquisition. Consistent application of accounting policies, decisions about revenue recognition (or timing of expenses), and treatment of transactions is vital for forecasting. This is the only way to create income statements that show true historical trends on each line of the income statement. Accordingly, forecasting without knowledge of historical trends and without up-to-date numbers is impossible.

If you would like help re-organizing your income statements, the underlying chart of accounts and data, please contact us. Entreflow operates a CPA accounting firm in Vancouver and another office in Ontario in case you need an accounting firm in Toronto. We work online, across Canada. We’ve built charts of accounts for hundreds of companies.