Basic Accounting:
The Importance of the Income Statement

Let's take a moment to catch our breath in the discussion of the Income Statement, and look at all the information we've absorbed so far and the importance of the Income Statement in fulfilling the financial picture for the state of a business.

The Income Statement is a direct result of the information that is recorded in the journals and ledgers, and then transformed into concise, compiled revenue and expense figures.  It is usually prepared directly from the monthly "closing of the books" and provides an accurate picture of the revenue and expense of the business for a specified period of time; usually a month, quarter or year.  The Income statement is used by management within the company, but also by investors and creditors outside the company to evaluate profitability, performance and aid in the assessment of risk for the investor or creditor.

The Income Statement is divided into three parts: Total revenues, total expenses, and net income.  The first section listed on the Income Statement is the Total Revenues reported for the particular period of time reported.  Other than revenues generated from the normal operations of business, there are other sources of revenue that must also be included in the "Total Revenue" area.  Rent and Interest Revenue would be included at this point.  Next, you have the section known as "Total Expenses".  This section includes all expenses incurred in the direct operation of the business.  The most common forms of expense include wages, salaries, rents, utilities, insurance and supplies.  Almost every business has an inclusion of variable expenses that is lumped into one category known as "miscellaneous expense"; these expenses are generally listed from largest to smallest, with miscellaneous always being the last expense reported, no matter how large or small. Finally, the entry known as "Net Income" is a result of the subtraction of the total expenses from the total revenues.

The Net Income that is reported on the Income Statement is then transferred to the Statement of Owner's Equity, and incorporated further into the information that is made available through the Financial Statements. 

There are basically two formats for preparing the Income Statement: single-step and multiple-step.  The single-step statement is a recording of two groups of information: income and expense and the net result.  Expenses are deducted from revenues, and no separation of operating activities or expenses is provided.  The single-step method does not tie individual contributions to the area responsible for the contribution.  In this way, it is as inconclusive as the direct format for the Statement of Cash Flows when it comes to accountability.

The multiple-step method, although a bit more complex, provides the more useful information simply because it separates the operating and non-operating activities and classifies revenue and expense accordingly.  The end result is a better comparison of performance and ratio to ratio computations of the company's finances.

Analysts, investors, stockholders, potential investors and lenders use these reports in order to assess the financial health of a business.  A sample Income Statement was provided in the first article in this series.  The importance of this report and the ability to accurately read and analyze the information is invaluable to an accountant.  So, take the time to become familiar with this report, as well as the other 3 that complete the Financial Statement set.

Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.