For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.
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Introduction
The income statement is one of the main financial statements of a business. Other names for the income statement include:
Statement of income
Statement of operations
Statement of earnings
Profit and loss (P&L) statement
Consolidated statement of income (operations, earnings)
The income statement reports revenues, expenses, gains, losses, and the resulting net income which occurred during the accounting period shown in its heading. Typical periods or time intervals covered by an income statement include:
Year ended December 31, 2023
Year ended June 30, 2023
Nine months ended September 30, 2023
Three months ended March 31, 2023
Month ended August 31, 2023
52/53 weeks ended February 1, 2023
The following is an outline of an income statement for a regular U.S. corporation:
Below are additional details for the lines in Example Corporation’s income statement:
Operating revenues are the amounts earned from the company’s main business activities. Common operating revenues are:
Operating income is the result of subtracting the company’s operating expenses from its operating revenues.
Nonoperating revenues or income, nonoperating expenses, gains, and losses result from activities outside of the company’s main business activities. Common examples for retailers and manufacturers include investment income, interest expense, and the gain or loss on the sale of equipment that had been used in the business.
Income before income tax expense is the combination of the amount of operating income and the nonoperating amounts.
Income tax expense is the federal, state, and local income taxes relating to the amounts appearing on the income statement. (The actual amount paid will likely be different, since the amount paid is based on the amounts on the corporation’s income tax returns.)
Net income is the amount of earnings remaining after subtracting the income tax expense.
Notes to the financial statements refers the reader to important information that could not be communicated by the amounts shown on the face of the income statement.
Note:
If a corporation’s shares of common stock are traded on a stock exchange, the earnings per share and the average number of shares outstanding must also be shown on the income statement.
Additional details and examples of income statements will be provided later.
accrual method of accounting is also referred to as the accrual basis of accounting, or accrual accounting. (The accrual method is different from the cash basis or tax basis.)
For the income statement, the accrual method means:
Revenues are reported (recognized) on the income statement in the accounting period when they are earned, which is often different from the period when payment is received from the customers.
For example, if a company delivers products to a customer in December 2023 but the customer is allowed to pay in January 2024, the company will report the sale as part of its December’s revenues.
Common examples of revenues include the sales of products to customers and providing services for clients.
Expenses are the costs and expenses incurred to earn the company’s revenues during the period of the income statement. It is common for an expense to be reported on the income statement in an accounting period different from when the company paid out the money.
For example, in June a retailer purchased and paid for products at a cost of $6,000. In July, the retailer sells the products for $10,000. There was no expense reported on the June income statement since none of the products were sold. (The $6,000 cost reduced the retailer’s cash and increased its inventory, both of which are reported on June’s balance sheet.) The retailer’s July income statement will recognize the expense cost of sales $6,000 as necessary to earn the $10,000 in sales.
Some costs will not be directly caused by sales and must be allocated. For example, a retailer may have purchased a delivery truck two years ago at a cost of $60,000. The truck was expected to be used for 60 months and have no salvage value. Therefore, every month for 60 months, the retailer’s income statement will report depreciation expense of $1,000.
Other costs such as salaries, advertising, rent, utilities, etc. have no future value that can be measured. Those costs will be reported as expenses when the costs are incurred or used up. In other words, July’s rent and utilities will be reported as an expense on the July income statement (even if the utilities used in July will be paid in August).
A gain is reported on the income statement when a company sells a long-term asset for more than the asset’s book value. For example, if a company sells its old delivery truck for $10,000 and its book value was $6,000, the income statement will report a $4,000 gain on the sale of the truck.
A loss is reported on the income statement when a company sells a long-term asset for less than the asset’s book value. If the company sells its old delivery truck for $5,000 and its book value was $6,000, the income statement will report a $1,000 loss on the sale of the truck.
Net income or net earnings is the amount by which the income statement’s revenues and gains exceeded the amount of expenses and losses. A net loss is reported when revenues and gains were less than the amount of expenses and losses.
It is important to understand that the income statement’s focus is to report a company’s profitability during a relatively short time interval such as a month, three months, six months, a year, and so on.
The income statement does not report the company’s cash receipts and disbursements. To learn about the cash amounts, users should review the company’s statement of cash flows. (You can learn more about that financial statement by visiting our Cash Flow Statement Explanation.)
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Example of an Income Statement
We will be referring to the following income statement for Example Corporation as we continue our explanation of the income statement.
Example Corporation is engaged in the purchase and sale of goods (products, merchandise). It is also a regular U.S. corporation which means the income statement will include income tax expense.
Income statement is one in a set of five financial statements
Reading only the income statement is not sufficient for understanding the financial activities of a business. Therefore, a business should distribute a set of five financial statements consisting of the following:
In addition to the above items, the set of financial statements must also include notes to the financial statements. The notes are important because the amounts on the face of the financial statements cannot adequately communicate the complexities of a business. To make readers of the income statement (or any other financial statement) aware of the significant information in the notes, one of the following sentences is shown near the bottom of every financial statement:
The accompanying notes are an integral part of the financial statements.
The accompanying Notes to Financial Statements are an integral part of this financial statement.
Comparative income statement
A comparative income statement displays three columns of amounts. This gives the reader two years of previous income statement amounts to put the most recent year’s amounts in perspective.
Since the column containing the amounts from the most recent year is the most relevant, it will be positioned closest to the descriptions. The column containing the oldest amounts is positioned furthest from the descriptions.
The heading of a comparative annual income statement will be changed to read “Years ended December 31″ (since three years of income statements are shown. The years will be indicated at the top of each column of amounts.
Rounding of amounts
Except for small companies, the amounts shown on the income statement are likely rounded to the nearest thousand or million dollars (along with a notation to inform the reader).
For example, the income statement of a large corporation with sales of $8,349,792,354.78 will report $8,349.8 and a notation such as (In millions, except earnings per share).
The income statement of a mid-size corporation with sales of $24,340,290.88 might report $24,340 and the notation (In thousands except per share amounts).
Rounding amounts is beneficial because it allows readers to focus on the most important digits. Omitting insignificant digits is also justified by the concept of materiality, because a lender or investor will not be misled without the least important digits.
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Components of the Income Statement
Below we will discuss each section of the income statement starting with the heading.
Heading of the income statement
In addition to the name of the company and the name of the financial statement, the heading of the income statement informs the reader of the period or time interval during which the reported amounts occurred. Typical periods of time are a year, year-to-date, three months, one month, 52 weeks, 13 weeks, 4 or 5 weeks, and others.
In the U.S., the annual time periods or time intervals could be:
A calendar year, which covers the 12 months from January 1 through December 31
A fiscal year, which covers the 12 months that ends on a date other than December 31. An example is the 12 months from July 1 through June 30.
A fiscal year, which covers a 52-week period (with a 53-week period every six years). An example is a retailer whose fiscal year ends on the Saturday closest to February 1. During the year, the retailer will have 4-week and 5-week periods instead of months and will have 13-week periods instead of quarters.
Net sales
Net sales is the first amount shown on the income statement of a retailer, manufacturer, or other companies which sell products. In other words, sales are generally the main operating revenues for companies selling goods.
Net sales is the combination of the following amounts which occurred during the period shown in the income statement’s heading:
Sales of goods, products, merchandise, etc. originally billed to customers
Reductions for goods that were returned by customers
Reductions for allowances granted to customers
Reductions for customers paying the amount owed during a discount period
Sales are reported (recognized) on the income statement when the ownership of the goods passes from the company to the customer. In many companies this occurs before the customer pays for the goods. For example, if goods are sold to a customer in December 2023, but the customer is allowed to pay in January 2024, the amount of the sale is reported on the December 2023 income statement (and a receivable is recorded on the balance sheet at the time of the sale). When the customer’s money is received in January 2024, the receivable is removed.
Sales of goods, products, and merchandise are operating revenues for a company in the business of purchasing and selling goods. (If the merchant sells its old delivery truck, the amount received is not included in net sales since the merchant is not in the business of selling trucks.)
Cost of sales (cost of goods sold, cost of products sold)
The cost of sales, cost of goods sold, or cost of products sold is the company’s cost for the products that it sold during the period indicated in the income statement’s heading. The cost of the sales is the dominating operating expense for companies that sell products. No other operating expense will come close to a company’s cost of sales since it is often 60-80% of the net sales. Therefore, it is critical for the cost of the items sold to be calculated accurately.
The cost of sales is related to the cost of the items in inventory. If an error is made in counting or calculating the cost of the ending inventory, it is likely to cause the cost of sales, gross profit and net income to be incorrect.
A retailer’s cost of sales includes the cost paid to the supplier plus any other costs to get the items into the warehouse and ready for sale. For example, if a retailer purchases a product for $300 and pays an additional $20 of shipping costs to get the item into its warehouse, the cost of the product is $320.
A manufacturer’s cost of sales is the cost of producing the goods that were sold. This includes the cost of raw materials, direct labor, and manufacturing overhead related to the items sold. Determining the manufacturer’s cost of goods is complicated by the need to allocate the manufacturing overhead costs.
In the U.S., a company can select from several cost flow assumptions when calculating its cost of sales and ending inventory. However, the company cannot switch cost flow assumptions more than once.
Gross profit (sometimes shown as gross margin) is the result of subtracting the cost of sales from net sales, as shown in Example Corporation’s partial income statement:
For any company to be profitable (have a positive net income), its gross profit must be greater than its selling, general and administrative expenses and nonoperating items such as interest expense.
Some people use the term gross margin to mean the gross profit percentage, which is the amount of gross profit divided by net sales. Expressing the gross profit as a percentage of net sales allows the company’s executives and financial analysts to see if the company was able to maintain its selling prices and gross profit percentages. The percentage also allows a company to compare its percentage to that of its competitors. Maintaining the gross profit percentages is often difficult because of pricing pressure from other companies, higher costs from suppliers, general inflation, and more.
The gross profit percentages (or gross margins) for Example Corporation have been improving as shown by the following calculations:
Year 2023 was 22.1% = gross profit of $880 / net sales of $3,980
Year 2022 was 21.3% = gross profit of $800 / net sales of $3,750
Year 2021 was 20.6% = gross profit of $700 / net sales of $3,400
Selling, general and administrative expenses
The selling, general and administrative expenses are commonly referred to as SG&A.
For a retailer, SG&A include the salaries, wages, rents, utilities, depreciation of assets, advertising, insurance, and other expenses associated with the retailer’s primary activities, which are the purchasing and selling of merchandise.
[The expenses associated with secondary activities (such as the interest expense associated with its financing activities) are not included in SG&A. The interest expense and other nonoperating expenses will be shown on the income statement after the operating income is presented.]
A manufacturer’s main or primary activities include both the production and sale of its products. The costs in the production of the goods are included in the cost of sales (also known as the cost of goods sold). The manufacturer’s selling and general administrative expenses are reported as SG&A expenses similar to those of a retailer.
Both the manufacturer’s cost of sales and its SG&A expenses are operating expenses.
Operating income
Operating income = operating revenues – operating expenses
Example Corporation’s operating revenues are its net sales. Its operating expenses are its cost of sales and SG&A as shown in Example Corporation’s partial income statement:
Recall that the operating revenues for retailers and manufacturers are the amounts earned from its main activities including its net sales. The operating revenues of a service business are the amounts earned from its main activity of providing services.
The operating expenses are the expenses associated with earning the operating revenues and maintaining its operations. Operating expenses for a retailer and manufacturer are the cost of sales and SG&A expenses. Operating expenses for a service business are the cost of services and SG&A expenses.
Interest expense
Interest expense is a nonoperating expense for most businesses since financing is outside of their main activities of purchasing/producing goods and selling goods and/or providing services.
[Interest expense for a bank would be an operating expense, since the bank’s main activities involve paying interest to attract deposits that can be lent to borrowers to earn interest revenue.]
Since the interest expense incurred by retailers, distributors, and manufacturers is a nonoperating expense, it is presented after operating income as shown by hypothetical amounts in Example Corporation’s partial income statement:
Loss on sale of equipment
When a company sells or scraps a long-term asset that had been used in the business, the asset’s cost and accumulated depreciation must be removed from the company’s accounts. In its place will be the cash received for the asset.
Since the company is not in the business of selling long-term assets, the amount received is not included in its operating revenues. Instead, only the gain or loss on the sale is shown on the income statement after the operating income.
To illustrate, assume a company had purchased equipment 8 years ago at a cost of $70,000 and its accumulated depreciation on the date of the sale was $55,000. The combination or net of these two amounts is $15,000, which is known as the equipment’s book value or carrying value.
If the company receives less than the book value, the difference is reported as a loss on the company’s income statement. If the asset had a book value of $15,000 and the company received $10,000 the company will report loss on sale of equipment of $5,000.
You can see from Example Corporation that the loss is listed after the operating income on the following partial income statement:
[If the company had received cash of $18,000 for the old equipment with a book value of $15,000, the company would report a $3,000 gain on sale of equipment.]
Income before income taxes
To arrive at the corporation’s income before income taxes or earnings before income taxes, the corporation’s nonoperating revenues and expenses, gains and losses on the sale of long-term assets, and “other” items are added/subtracted from the operating income as seen in the following partial income statement:
Income tax expense
Regular corporations (as opposed to other types of U.S. corporations and entities) must report on its income statement the amount of income tax expense that is associated with the items and amounts shown on the income statement. Typically there will be differences as to when the amounts will be reported on the income statement versus the corporation’s income tax return. As a result, the income tax expense shown on the income statement will not be the amount paid by the corporation for that year.
(The amount of income taxes paid by the corporation is available in the corporation’s statement of cash flows or notes to the financial statements.)
Net income
After subtracting the income tax expense, the resulting amount (referred to as the bottom line) is the corporation’s net income or net earnings. The net income for Example Corporation can be see here:
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How Net Income Affects Stockholders’ Equity
A positive net income reported on a corporation’s income statement also increases the amount of the corporation’s retained earnings. Retained earnings is a separate item reported in the stockholders’ equity section of the balance sheet. Hence, the income statement and balance sheet are connected. (A net loss, or negative net income on the income statement decreases the amount of the corporation’s retained earnings.)
In the case of a sole proprietorship, the net income reported on the income statement will increase the owner’s capital account, which is part of owner’s equity. A net loss will decrease the owner’s capital account.
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Statement of Comprehensive Income
The statement of comprehensive income contains a few amounts that are not reported on the income statement. These items are referred to as other comprehensive income.
The other component of comprehensive income is the net income reported on the company’s income statement. Therefore, the two major components of the the statement of comprehensive income are:
Net income (or net loss) from the income statement
Other comprehensive income
The specific items that comprise other comprehensive income will be listed on the statement of comprehensive income. Items that commonly appear as other comprehensive income include the following:
Foreign currency adjustments
Unrealized gains/losses on pension and other postretirement benefit plans
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How Other Comprehensive Income Affects Stockholders’ Equity
A corporation’s positive amount of other comprehensive income causes the corporation’s accumulated other comprehensive income to increase. (Other comprehensive losses cause the corporation’s accumulated other comprehensive income to decrease.)
Accumulated other comprehensive income is a separate item appearing in the stockholders’ equity section of the corporation’s balance sheet.
Here’s a Tip
A corporation’s net income increases its retained earnings
A corporation’s other comprehensive income increases its accumulated other comprehensive income
Net income + Other comprehensive income = Comprehensive income
Retained earnings and accumulated other comprehensive income are shown separately within stockholders’ equity
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Additional Information Regarding the Income Statement
Owner’s compensation does not appear on a sole proprietorship income statement
The income statement of a sole proprietorship does not report an expense for the owner working in the business. The reason is that the owner of the sole proprietorship is not paid a salary. As a result, the net income of a sole proprietorship cannot be directly compared to the net income of a regular corporation where the owner is paid a salary.
For instance, assume that the income statement of a business organized as a sole proprietorship reported a net income of $100,000. The $100,000 reflects the combination of (1) the owner’s compensation for working in the business, and (2) the earnings of the business.
If the same business had been organized as a regular corporation and the owner/stockholder received a salary of $80,000, the income statement will report a net income of $20,000. The reason is that the $80,000 salary will be listed on the corporation’s income statement as salary expense.
Historical cost principle
The income statement amounts are generally based on the historical amounts at the time of the original transaction. (Changes in the fair value of marketable securities are an exception.)
To illustrate, assume that XXL Company’s office and warehouse building was constructed 20 years ago at a cost of $750,000 and was estimated to have a useful life of 25 years with no salvage value. Each year’s income statement will likely report depreciation expense of $30,000.
If the XXL Company or a competitor were to construct a similar building today, the cost might be $1,500,000 and the income statement will be reporting depreciation expense of $60,000.
What is the cost of using the facilities this year? Is it logical to match the costs from 20 years ago with the current year revenues? That’s what occurs because of the historical cost principle.
Average costs and opportunity costs
Some important costs are not shown in the income statement. Two examples are (1) the cost of making and selling one or more additional units of product, and (2) the cost of missing an opportunity.
To illustrate, assume that in a typical week Artisan Bread Company (ABC) produces 3,000 loaves of bread which will be sold for $7 a loaf. The cost of the ingredients is $1 per loaf and the other costs (bakers, rent, depreciation, etc.) are $6,000 every week regardless of the number of loaves produced. Therefore,
If 2,000 loaves are produced, the average cost is $4 per loaf ($2,000 for ingredients + $6,000 of fixed costs = $8,000/2,000 loaves)
If 4,000 loaves are produced, the average cost is $2.50 per loaf ($4,000 for ingredients + $6,000 of fixed costs = $10,000/4,000 loaves)
The cost of making one additional loaf is $1 since the cost of ingredients is the only cost that will change
Now assume that ABC decides to sell its breads at a special event but is unsure of the number of loaves to produce. To avoid baking loaves that will not sell and lose the average cost, ABC decides to bake 100 loaves. It ends up that the 100 loaves were sold within an hour, and it becomes clear that an additional 200 loaves could have been sold. What was the cost of not producing 200 additional loaves? In other words, what was the opportunity cost or opportunity lost?
The cost of missing the opportunity to sell 200 additional loaves will never be listed on ABC’s income statement. However, we can compute the opportunity cost of not producing the 200 additional loaves:
Additional expenses avoided = $200 (200 loaves X $1 of ingredients)
Opportunity cost = $1,200 ($1,400 – $200)
Someone will say “Hindsight is 20/20! How would ABC have known?”
Well, ABC could have understood that the average costs of $2.50 to $4 per loaf were not relevant. In our example, the only relevant amount is the $1 per loaf cost of ingredients.
If ABC understood that by spending an additional $1 it could possibly earn $7, it may have produced more loaves. In other words, risking $200 in ingredients to potentially receive an additional $1,400 may have motivated ABC to produce more loaves. Looking at it another way, ABC would recover the additional $200 cost for ingredients by selling just 30 of the 200 additional loaves. After the 30 loaves are sold, ABC will be increasing its net income by $7 for each additional loaf sold.
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Income Statements That Remain Inside the Company
The income statement format that we discussed and the requirement for issuing the set of five financial statements pertains to the financial statements that are distributed to people outside of the company, such as investors, lenders, financial analysts, etc. The financial statements that remain inside the company can be in a format different from those required by US GAAP.
More detailed and/or less complete
It is common for the internal income statements to contain schedules of expenses to support the amount of a company’s SG&A expenses. Some schedules will be limited to the expenses of a specific department such as IT, accounting, international marketing, human resources, etc. This allows each department’s manager to closely monitor its expenses without being distracted by the expenses of another department.
Income statements can also be prepared for a company’s major segments, such as the consumer products division and the industrial products division. Other formats are also possible.
Contribution Margin Format
An internal income statement can be prepared to emphasize the contribution margin of a company’s products and product lines. The contribution margin examines the amount of net sales remaining after deducting only the costs and expenses that will vary in total as volume changes. Here is the concept in the form of an equation:
Contribution margin = sales – all variable costs and variable expenses
A brief example using hypothetical amounts in an income statement arranged in the contribution margin format is shown here:
After the contribution margin is shown, the $6,000 of fixed costs and fixed expenses that are directly traceable to each product line are subtracted.
The subtotal tells the reader the amount of profit that is available to cover the $20,000 of common fixed expenses. Common expenses means they have to be arbitrarily assigned to the product lines. Often the total amount of the common expenses will not decrease when a product line is eliminated.
The contribution margin format allows the company’s executives to see the relative profitability of its products or other segments. Seeing how profits will change when the volumes increase or decrease may be valuable.
Where to Go From Here
We recommend taking our Practice Quiz next, and then continuing with the rest of our Income Statement materials (see the full outline below).
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Usually financial statements refer to the balance sheet, income statement, statement of cash flows, statement of retained earnings, and statement of stockholders’ equity.
The balance sheet reports information as of a date (a point in time). The income statement, statement of cash flows, statement of retained earnings, and the statement of stockholders’ equity report information for a period of time (or time interval) such as a year, quarter, or month.
Costs that are matched with revenues on the income statement. For example, Cost of Goods Sold is an expense caused by Sales. Insurance Expense, Wages Expense, Advertising Expense, Interest Expense are expenses matched with the period of time in the heading of the income statement. Under the accrual basis of accounting, the matching is NOT based on the date that the expenses are paid.
Expenses associated with the main activity of the business are referred to as operating expenses. Expenses associated with a peripheral activity are nonoperating or other expenses. For example, a retailer’s interest expense is a nonoperating expense. A bank’s interest expense is an operating expense.
Generally, expenses are debited to a specific expense account and the normal balance of an expense account is a debit balance. When an expense account is debited, the account credited might be Cash (if cash was paid at the time of the expense), Accounts Payable (if cash will be paid after the expense is recorded), or Prepaid Expense (if cash was paid before the expense was recorded.)
Gains result from the sale of an asset (other than inventory). A gain is measured by the proceeds from the sale minus the amount shown on the company’s books. Since the gain is outside of the main activity of a business, it is reported as a nonoperating or other revenue on the company’s income statement.
This is the bottom line of the income statement. It is the mathematical result of revenues and gains minus the cost of goods sold and all expenses and losses (including income tax expense if the company is a regular corporation) provided the result is a positive amount. If the net amount is a negative amount, it is referred to as a net loss.
Net sales is the gross amount of Sales minus Sales Returns and Allowances, and Sales Discounts for the time interval indicated on the income statement.
Under the accrual basis of accounting, the Service Revenues account reports the fees earned by a company during the time period indicated in the heading of the income statement. Service Revenues include work completed whether or not it was billed. Service Revenues is an operating revenue account and will appear at the beginning of the company’s income statement.
Operating expenses are the costs of a company’s main operations that have been used up during the period indicated on the income statement. For example, a retailer’s operating expenses consist of its cost of goods sold and its selling, general and administrative expenses (SG&A).
Cost of goods sold is usually the largest expense on the income statement of a company selling products or goods. Cost of Goods Sold is a general ledger account under the perpetual inventory system.
Under the periodic inventory system there will not be an account entitled Cost of Goods Sold. Instead, the cost of goods sold is computed as follows: cost of beginning inventory + cost of goods purchased (net of any returns or allowances) + freight-in – cost of ending inventory.
This account balance or this calculated amount will be matched with the sales amount on the income statement.
Also referred to as SG&A. For a manufacturer these are expenses outside of the manufacturing function. (However, interest expense and other nonoperating expenses are not included; they are reported separately.) These expenses are not considered to be product costs and are not allocated to items in inventory or to cost of goods sold. Instead these expenses are reported on the income statement of the period in which they occur. These expenses are sometimes referred to as operating expenses.
A company’s profit before nonoperating or other items. Other or nonoperating items include interest income, interest expense, and gains and losses on sale of assets used in the business, loss on lawsuit, etc.
Income or revenue earned by a company that is outside of its main operating activities. For a retailer the interest earned on its temporary investments is a nonoperating revenue (or nonoperating income).
An expense outside of a company’s main operating activities of buying and selling merchandise or providing services. For example, interest expense is a nonoperating expense.
An expense outside of a company’s main operating activities of buying and selling merchandise or providing services. For example, interest expense is a nonoperating expense.
This account is a non-operating or “other” expense for the cost of borrowed money or other credit. The amount of interest expense appearing on the income statement is the cost of the money that was used during the time interval shown in the heading of the income statement, not the amount of interest paid during that period of time.
This is the bottom line of the income statement. It is the mathematical result of revenues and gains minus the cost of goods sold and all expenses and losses (including income tax expense if the company is a regular corporation) provided the result is a positive amount. If the net amount is a negative amount, it is referred to as a net loss.
The type of stock that is present at every corporation. (Some corporations have preferred stock in addition to their common stock.) Shares of common stock provide evidence of ownership in a corporation. Holders of common stock elect the corporation’s directors and share in the distribution of profits of the company via dividends. If the corporation were to liquidate, the secured lenders would be paid first, followed by unsecured lenders, preferred stockholders (if any), and lastly the common stockholders.
The general guidelines and principles, standards and detailed rules, plus industry practices that exist for financial reporting. Often referred to by its acronymn GAAP.
The accounting method under which revenues are recognized on the income statement when they are earned (rather than when the cash is received). The balance sheet is also affected at the time of the revenues by either an increase in Cash (if the service or sale was for cash), an increase in Accounts Receivable (if the service was performed on credit), or a decrease in Unearned Revenues (if the service was performed after the customer had paid in advance for the service).
Under the accrual basis of accounting, expenses are matched with revenues on the income statement when the expenses expire or title has transferred to the buyer, rather than at the time when expenses are paid. The balance sheet is also affected at the time of the expense by a decrease in Cash (if the expense was paid at the time the expense was incurred), an increase in Accounts Payable (if the expense will be paid in the future), or a decrease in Prepaid Expenses (if the expense was paid in advance).
Fees earned from providing services and the amounts of merchandise sold. Under the accrual basis of accounting, revenues are recorded at the time of delivering the service or the merchandise, even if cash is not received at the time of delivery. Often the term income is used instead of revenues.
Examples of revenue accounts include: Sales, Service Revenues, Fees Earned, Interest Revenue, Interest Income. Revenue accounts are credited when services are performed/billed and therefore will usually have credit balances. At the time that a revenue account is credited, the account debited might be Cash, Accounts Receivable, or Unearned Revenue depending if cash was received at the time of the service, if the customer was billed at the time of the service and will pay later, or if the customer had paid in advance of the service being performed.
If the revenues earned are a main activity of the business, they are considered to be operating revenues. If the revenues come from a secondary activity, they are considered to be nonoperating revenues. For example, interest earned by a manufacturer on its investments is a nonoperating revenue. Interest earned by a bank is considered to be part of operating revenues.
A revenue account that reports the sales of merchandise. Sales are reported in the accounting period in which title to the merchandise was transferred from the seller to the buyer.
A current asset whose ending balance should report the cost of a merchandiser’s products awaiting to be sold. The inventory of a manufacturer should report the cost of its raw materials, work-in-process, and finished goods. The cost of inventory should include all costs necessary to acquire the items and to get them ready for sale.
When inventory items are acquired or produced at varying costs, the company will need to make an assumption on how to flow the changing costs. See cost flow assumption.
If the net realizable value of the inventory is less than the actual cost of the inventory, it is often necessary to reduce the inventory amount.
The income statement account which contains a portion of the cost of plant and equipment that is being matched to the time interval shown in the heading of the income statement. (There is no depreciation expense for land.)
The book value of an asset is the amount of cost in its asset account less the accumulated depreciation applicable to the asset. The book value of a company is the amount of owner’s or stockholders’ equity. The book value of bonds payable is the combination of the accounts Bonds Payable and Discount on Bonds Payable or the combination of Bonds Payable and Premium on Bonds Payable.
One of the main financial statements (along with the income statement and balance sheet). The statement of cash flows reports the sources and uses of cash by operating activities, investing activities, financing activities, and certain supplemental information for the period specified in the heading of the statement. The statement of cash flows is also known as the cash flow statement.
The statement of comprehensive income covers the same period of time as the income statement, and consists of two major sections:
Net income (taken from the income statement)
Other comprehensive income (adjustments involving foreign currency translation, hedging, and postretirement benefits)
The sum of these two amounts is known as comprehensive income.
The amount of other comprehensive income is added/subtracted from the balance in the stockholders’ equity account Accumulated Other Comprehensive Income.
One of the main financial statements. The balance sheet reports the assets, liabilities, and owner’s (stockholders’) equity at a specific point in time, such as December 31. The balance sheet is also referred to as the Statement of Financial Position.
Also referred to as footnotes. These provide additional information pertaining to a company’s operations and financial position and are considered to be an integral part of the financial statements. The notes are required by the full disclosure principle.
An income statement with at least two columns of amounts. The column of amounts that is closest to the words will contain the amounts for the most recent period of time. The columns furthest from the words will be the amounts from older periods of time. The older amounts provide a frame of reference for understanding the recent amounts.
The accounting guideline that permits the violation of another accounting guideline if the amount is insignificant. For example, a profitable company with several million dollars of sales is likely to expense immediately a $200 printer instead of depreciating the printer over its useful life. The justification is that no lender or investor will be misled by a one-time expense of $200 instead of say $40 per year for five years. Another example is a large company’s reporting of financial statement amounts in thousands of dollars instead of amounts to the penny.
An accounting year that ends on a date other than December 31. For example, a school district might have a fiscal year of July 1, 2023 through June 30, 2024. A retailer might have a fiscal year consisting of the 52 or 53 weeks ending on the Saturday nearest to the first day of February.
Cost of goods sold is usually the largest expense on the income statement of a company selling products or goods. Cost of Goods Sold is a general ledger account under the perpetual inventory system.
Under the periodic inventory system there will not be an account entitled Cost of Goods Sold. Instead, the cost of goods sold is computed as follows: cost of beginning inventory + cost of goods purchased (net of any returns or allowances) + freight-in – cost of ending inventory.
This account balance or this calculated amount will be matched with the sales amount on the income statement.
Net sales revenues minus the cost of goods sold.
An assumption that determines the order in which costs should flow out of a balance sheet account (e.g. Inventory, Investments, Treasury Stock) when the item is sold. For an illustration of the cost flow assumption, see Explanation of Inventory and Cost of Goods Sold.
A term that is sometimes used interchangeably with gross profit. Others use the term to mean the percentage of gross profit dollars divided by net sales dollars.
Also referred to as peripheral activities. A company’s activities outside of its main activities of buying/producing and selling. Examples include a retailer’s financing function involving interest revenue and interest expense, disposal of long term assets used in the business, lawsuit settlements, renting out unused space, etc.
The amount of a long-term asset’s cost that has been allocated to Depreciation Expense since the time that the asset was acquired. Accumulated Depreciation is a long-term contra asset account (an asset account with a credit balance) that is reported on the balance sheet under the heading Property, Plant, and Equipment.
A record in the general ledger that is used to collect and store similar information. For example, a company will have a Cash account in which every transaction involving cash is recorded. A company selling merchandise on credit will record these sales in a Sales account and in an Accounts Receivable account.
The result of two or more amounts being combined. For example, net sales is equal to gross sales minus sales returns, sales allowances, and sales discounts. The net realizable value of accounts receivable is the combination of the debit balance in accounts receivable and the credit balance in the allowance for doubtful accounts. The book value of equipment is also a net amount: the cost of the equipment minus the accumulated depreciation of the equipment.
The book value of an asset is the amount of cost in its asset account less the accumulated depreciation applicable to the asset. The book value of a company is the amount of owner’s or stockholders’ equity. The book value of bonds payable is the combination of the accounts Bonds Payable and Discount on Bonds Payable or the combination of Bonds Payable and Premium on Bonds Payable.
A stockholders’ equity account that generally reports the net income of a corporation from its inception until the balance sheet date less the dividends declared from its inception to the date of the balance sheet.
A simple form of business where there is one owner. Legally the owner and the sole proprietorship are the same. However, for accounting purposes the economic entity assumption results in the sole proprietorship’s business transactions being accounted for separately from the owner’s personal transactions.
The statement of comprehensive income covers the same period of time as the income statement, and consists of two major sections:
Net income (taken from the income statement)
Other comprehensive income (adjustments involving foreign currency translation, hedging, and postretirement benefits)
The sum of these two amounts is known as comprehensive income.
The amount of other comprehensive income is added/subtracted from the balance in the stockholders’ equity account Accumulated Other Comprehensive Income.
A separate line within stockholders’ equity that reports the corporation’s cumulative income that has not been reported as part of net income on the corporation’s income statement. The items that would be included in this line involve the income or loss involving foreign currency transactions, hedges, and pension liabilities.
Also referred to as a shareholder. The owner of shares of stock in a corporation. Every corporation has common stock and those owners are known as common stockholders. Some corporations also issued preferred stock and those corporations will have both common stockholders and preferred stockholders.
Investments in common stock, preferred stock, corporate bonds, or government bonds that can be readily sold on a stock or bond exchange. These investments are reported as a current asset if the investor’s intention is to sell the securities within one year.
The systematic allocation of the cost of an asset from the balance sheet to Depreciation Expense on the income statement over the useful life of the asset. (The depreciation journal entry includes a debit to Depreciation Expense and a credit to Accumulated Depreciation, a contra asset account). The purpose is to allocate the cost to expense in order to comply with the matching principle. It is not intended to be a valuation process. In other words, the amount allocated to expense is not indicative of the economic value being consumed. Similarly, the amount not yet allocated is not an indication of its current market value.
Expenses which do not change in response to reasonable changes in sales or other activity.
The next best benefit foregone. The opportunity lost. Often measured as the contribution margin given up by not doing an activity. For example, if a sole proprietor is foregoing a salary and benefits of $50,000 at another job, the sole proprietor has an opportunity cost of $50,000. Accountants do not record opportunity costs in the general ledger or report them on the income statement, but they are costs that should be considered in making decisions.
The result of subtracting all variable expenses from revenues. It indicates the amount available from sales to cover the fixed expenses and profit.
An expense is variable when its total amount changes in proportion to the change in sales, production, or some other activity. In other words, a variable expense increases when an activity increases, and it decreases when the activity decreases.
Expenses which do not change in response to reasonable changes in sales or other activity.
For the past 52 years, Harold Averkamp (CPA, MBA) has
worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.
