Notes on Financial Statements and Income Statement Concepts

What Financial Statements Do

• Financial statements present the company’s financial position and performance.

• They aim to provide useful information about finances and cash flows to help users make economic decisions.

• They include details on:

  • Assets

  • Liabilities

  • Equity

  • Income and expenses (including gains and losses)

  • Contributions by and distributions to owners

  • Cash flows

• This information, along with notes, helps users predict future cash flows, especially their timing and certainty.

• Key reports/types:

  • Balance sheet or statement of financial position

  • Income statement

  • Statement of comprehensive income

  • Statement of cash flows

  • Statement of stockholders' equity

• Timing:

  • Income statement reports financial activity over a period (e.g., 3\text{-month period} or year).

  • Balance sheet reports financial activity at a point in time, providing a snapshot of finances.

• Information reported:

  • Income statement reports on revenues and expenses, showing profit or loss.

  • Balance sheet reports on assets, liabilities, and equity.

• Significance:

  • The income statement reports the overall results of a business’s financial performance, showing how much earnings it generates.

  • The balance sheet helps analyze whether a company has enough liquid assets to meet its financial obligations.

• The term financial statement may refer to:

  • General-purpose, external financial reports distributed to people outside the company.

  • More-detailed, internal financial reports used internally by management.

• They also show the results of management’s stewardship of resources entrusted to it.

• To meet these goals, they include details on: assets, liabilities, equity, income/expenses, contributions/distributions to owners, and cash flows.

Income Statement (IS) vs. Statement of Comprehensive Income (SCI)

• The Income Statement presents the results of the entity’s operations and financial performance by reporting revenues and expenses.

• The Statement of Comprehensive Income presents the entity’s net income, along with the effects of other comprehensive income, resulting in comprehensive income.

SCI Formats

• An entity can choose to present the SCI in either of two formats:

  • Two-statement format: Separates the net income statement and the comprehensive income statement.

  • Single-statement format: Combines all income, gains, and losses into one continuous report.

Income Statement (IS) Overview

• Also known as:

  • Statement of operations

  • Profit and loss statement

  • Statement of earnings

• It is one of a company’s main financial statements.

• The purpose is to report a summary of a company’s:

  • Revenues

  • Expenses

  • Gains and losses

  • Net income for a specific period (year, quarter, etc.)

• An IS, including a quarterly IS, covers a specific period; a quarterly IS covers 3\text{-month period}.

• An IS is used to balance the accounting books and assess the financial health of a company.

Items Appearing in the Income Statement (IS)

• The main items reported:

  • Revenues – Amounts earned from the sale of goods and/or providing services.

  • Expenses – Includes cost of goods sold, selling and distribution costs, general or administrative expenses, other expenses, and interest expense (finance cost).

  • Gains and losses – For example, the sale of a noncurrent asset at an amount different from its book value.

  • Net income – Calculated by subtracting expenses and losses from revenues and gains.

How the Income Statement Amounts Are Calculated

• Income statement amounts are best calculated for a specific period using the accrual basis of accounting.

• Under the accrual basis:

  • Revenues are the amounts earned, not necessarily the cash received.

  • Expenses are the amounts that match the revenues or were used up during the period, not just the cash paid out.

Income Statement Summary

• An income statement reports a company’s financial performance by presenting its revenues, gains, expenses, and losses for a given period.

• Basic formula:

  • \text{Revenues} - \text{Expenses} = \text{Net Income before tax}

• Net Income before tax – Income Tax Expense = Net Income

• There should be proper and separate reporting of income tax payments.

• Final simplified formula:

  • \text{Revenues} - \text{Expenses} = \text{Net Income}

Elements of Financial Performance

• Income/Revenue: Increases in economic benefits during the period through inflows or asset enhancements, or liability decreases, raising equity (excluding equity contributions).

• Expenses: Decreases in economic benefits through outflows or asset depletions, or liability increases, lowering equity (excluding equity distributions).

• Income includes revenues (from ordinary activities) and gains (non-regular increases, e.g., gain on sale of assets).

  • Example: Selling inventory earns sales revenue; selling equipment above carrying value records a gain.

• Gains vs. Losses:

  • Expenses: Decreases in economic benefits from regular operations (e.g., salaries, rent, depreciation).

  • Losses: Not from regular operations (e.g., fire, disasters, sale of assets).

Forms of Income Statement

1) Natural Form (Nature of Expense Method)

• Expenses shown by their nature (e.g., salaries, rent).

• Used in service businesses.

• Also called Single-Step Income Statement (one step: revenue − expenses = net income/loss).

2) Functional Form (Cost of Sales Method)

• Expenses shown by function (e.g., cost of sales, selling, administrative).

• Used in merchandising businesses.

• Also called Multi-Step Income Statement (multiple steps to compute net income/loss).

Single-Step vs Multi-Step Statements (IS formats)

• Single-Step: All revenues and gains are grouped together and all expenses and losses are grouped together; one step to compute net income.

• Multi-Step (often used for merchandising): Separates operating and non-operating activities to show gross profit, operating income, and other income/expenses before arriving at net income.

Income Statement Accounts (Examples)

• Service Income: Revenues from performing services.

  • Examples: Laundry income, Medical fees, Dental fees, Legal fees, Consultancy fees

• Expenses: 1) Salaries or Wages Expense

  • Payments to employees for their services.

  • Includes salaries, wages, 13th month pay, COLA, and other benefits.
    2) Utilities Expense

  • Costs related to electricity, fuel, water, and telecom services.
    3) Supplies Expense

  • Cost of office supplies used in daily operations.
    4) Insurance Expense

  • Expired portion of insurance premiums (e.g., health, vehicle, property).
    5) Depreciation Expense

  • Estimated yearly cost of tangible assets (e.g., buildings, equipment).
    6) Bad Debts Expense

  • Estimated uncollectible accounts receivable for the period.
    7) Interest Expense / Finance Cost

  • Charges for borrowing funds.

The Multi-Step Income Statement (Merchandising Context)

• This format is used in a merchandising business.

• Key components include:

  • Sales: The proceeds from the sales price of goods sold to the revenue account in the accounting period when the sales were made.

Merchandising IS Components and Calculations

• Sales

  • The proceeds from the sales price of goods sold to the revenue account in the accounting period when the sales were made.

• Sales Returns and Allowances

  • The account used to record returns acknowledged or allowances granted by the supplier to the buyer from the sale of goods.

• Sales Discount

  • A reduction from the sales price of the merchandise or goods sold granted by the seller to the buyer or customer for paying within the discount period.

• 🔹 Freight-out or Delivery Expense

  • The cost of transporting the merchandise or goods from the seller’s place to the buyer’s place of business.

• 🔹 Net Sales

  • The first line after the heading of the income statement is the net sales.

  • To show the details of its computation, it is supported by a note to financial statement.

• 🔹 Cost of Sales

  • The cost of sales or cost of goods sold represents the merchandise inventory sold by the business to its customers.

  • This comprises the company’s biggest expense and is deducted from net sales to arrive at the gross profit.

• 🔹 Purchases

  • The account used to record the cost of the goods or merchandise bought for the purpose of resale.

• 🔹 Purchase Returns and Allowances

  • The account used to record returns acknowledged or allowances granted by the supplier to the buyer from the purchase of goods.

• 🔹 Purchase Discount

  • A reduction from the purchase price of the merchandise or goods bought granted by the supplier to the buyer or customer for paying within the discount period.

• 🔹 Freight-in

  • The cost of transporting the merchandise or goods from the seller’s place to the buyer’s place of business.

  • Also called Transportation-in.

• 🔹 Other Income

  • Income derived from sources other than the company’s main line of business.

  • Examples: Interest income, Dividends income, Commissions income, Rent income, Gain on sale of assets

  • To show the details of this income account, it is supported by a note to financial statement.

Distribution / Selling Expenses

• Distribution Expenses / Selling Expenses are those incurred in directly selling the merchandise. This includes:
  1) Salaries of sales personnel
  2) Expenses incurred in promoting or advertising the product
  3) Commission on sales
  4) Store supplies used
  5) Utilities used in the store
  6) Depreciation expense of assets used in the store
  7) Freight-out or delivery expense – the cost of transporting the merchandise to the customer’s place of business

General / Administrative Expenses

• General or administrative expenses are expenses necessary in the management of the office. This includes:
  1) Salaries of office personnel
  2) Office supplies used in the office
  3) Utilities used in the office
  4) Depreciation of office assets
  5) Provision of bad debts or uncollectible accounts

Other Expenses

• Other expenses are expenses not connected to the operating activities of the business.

  • Examples: Loss on sale of assets, Discount lost

Finance Costs

• Finance costs are the interest expense paid for the use of borrowed funds.

Other Notes and Concepts

• Freight-in (Transportation-in) is the cost of transporting the merchandise from the seller to the buyer.

• Freight-out or Delivery Expense is the cost of transporting the merchandise from the seller to the buyer.

• Other Income items include interest, dividends, commissions, rent, and gains on asset sales; these are shown separately to highlight non-operating sources of income.

• The Net Sales line in merchandising IS is often accompanied by a note detailing its computation (i.e., sales minus returns/allowances and discounts).

• Purchases, Purchase Returns and Allowances, Purchase Discount, and Freight-in relate to the cost of inventory and cost of goods available for sale; Freight-in is part of the cost of acquiring inventory, while Freight-out is a selling expense.

• The IS can be presented in two formats (single-step or multi-step) depending on whether operating details (like gross profit and operating income) are shown explicitly.

• The SCI includes components of other comprehensive income beyond net income; the choice of two-statement vs single-statement format affects how comprehensively these items are presented.