Income Statement This module provides an introduction to the income statement, one of the essential financial statements in accounting. In addition, some simple percentage of revenues calculations, basic transactions, and debits and credits are covered. We suggest doing the balance sheet module prior to working on this module. Author: Stu James © 2014 Stu James and Management by the Numbers, Inc.

The income statement is one of the essential financial statements (reports) for a company and is a required filing for all public companies. Understanding how to read and interpret an income statement is an important skill for a business person or investor. The income statement provides important information about the financial health of a company over a certain period of time (usually a year or a quarter). This information includes: Revenues (sales of product/services) Expenses (costs of doing business) I NTRODUCTION TO THE I NCOME S TATEMENT 2 Introduction to the Income Statement MBTN | Management by the Numbers

S AMPLE I NCOME S TATEMENT 3 Sample Income Statement MBTN | Management by the Numbers Facebook, Inc. Quarter ending Sept 30, 2013 $millions Revenues2,015 Expenses1,593 Net Income422 Here is a (very) simplified income statement for Facebook, Inc. for the 3 month period ending Sept 30, What can we say about this income statement? First, note that Revenues – Expenses = Net Income (2, ,593 = 422) Second, note that the reporting period is for 3 months (July 1- Sept 30, 2013) We can also say that Facebook is a profitable company during this period, because revenues exceed total expenses, leaving net income of $422 million. Now let’s look at these areas in more detail.

T OTAL R EVENUE 4 Total Revenue MBTN | Management by the Numbers Facebook, Inc. Inc. Statement$Millions Total Revenue2,015 Cost of Revenue506 Gross Profit1,509 Research and Development369 Selling, General and Admin.403 Operating Income or Loss737 Interest Expense21 Net Non-Recurring Events0 Income Taxes294 Net Income422 Total Revenue is the combined total for all sales in a period. Total revenue is all sales from products and services for the company (aka the “top line” of the business – as opposed to the “bottom line” or net income.). Publically, only a single line will be shown for revenue, but internally to the company, revenue will be reported in a very detailed fashion – broken out by product line, geographic region, etc. Definition: Total Revenue = Net sales of all products and services.

G ROSS P ROFIT 5 Gross Profit MBTN | Management by the Numbers Facebook, Inc. Inc. Statement$Millions Total Revenue2,015 Cost of Revenue506 Gross Profit1,509 Research and Development369 Selling, General and Admin.403 Operating Income or Loss737 Interest Expense21 Net Non-Recurring Events0 Income Taxes294 Net Income422 Subtracting the Cost of Revenue leaves Gross Profit. Gross Profit is what is left after subtracting cost of revenue. Cost of Revenue (or Cost of Sales) includes any direct expenses (cost of goods / services sold) associated with revenues. Gross profit (as a percent) varies widely by business type. Both gross profit and cost of revenue are often expressed as % of total revenue for comparisons. Definition: Gross Profit = Total Revenue – Cost of Revenue

G ROSS P ROFIT 6 Gross Profit MBTN | Management by the Numbers Sept 2013 (3 months)$MilAs % Total Revenue2,015100% Cost of Revenue50625% Gross Profit1,50975% Percentages help analysts compare data. For example, how is Facebook doing compared to the previous year? Facebook is growing rapidly (2,015 vs. 1,262 previous year, 60% growth). But analysts also want to see how that growth has affected their margin. Expressed as a % of total revenue, we can see that the percentage is stable and even improved some (75% vs. 74%). Definitions: Gross Profit % = Gross Profit /Total Revenue Cost of Revenue % = Cost of Revenue / Total Revenue Sept 2012 (3 months)$MilAs % Total Revenue1,262100% Cost of Revenue32226% Gross Profit94074%

O PERATING I NCOME 7 Operating Income MBTN | Management by the Numbers Facebook, Inc. Inc. Statement$Millions Total Revenue2,015 Cost of Revenue506 Gross Profit1,509 Research & Development (R&D)369 Selling, General & Admin. (SGA)403 Operating Income or Loss737 Interest Expense21 Net Non-Recurring Events0 Income Taxes294 Net Income422 Now let’s look at the next section of the Income Statement. Operating Income (or EBIT – Earnings before Interest and Taxes) represents a company's earnings from its normal operations (not including interest expense, taxes and one-time costs). It is calculated by subtracting other on-going operating expenses from Gross Profit. Operating income is often used by analysts rather than net income as a measure of profitability. Definition: Operating Income = Gross Profit – (SGA + R&D)

G ROSS P ROFIT 8 Operating Income MBTN | Management by the Numbers Sept 2013 (3 months)$MilAs % Gross Profit1,50975% Research + Develop.36918% Sell. Gen. + Admin.40320% Operating Income73735% Let’s Compare Operating Income (%) for 2012 vs While Facebook is spending more on R&D and SGA than in 2012, as a percent of total revenue, these expenses are less than in This means that operating income is growing at a faster rate than revenue (95% vs. 60%). This bodes well for future profitability presuming revenue continues to grow. Definitions: Operating Income % = Operating Income / Total Revenue Sept 2012 (3 months)$MilAs % Gross Profit94074% Research + Develop.24419% Sell. Gen. + Admin.31925% Operating Income37730%

N ET I NCOME 9 Net Income MBTN | Management by the Numbers Facebook, Inc. Inc. Statement$Millions Total Revenue2,015 Cost of Revenue506 Gross Profit1,509 Research and Development369 General, Selling and Admin.403 Operating Income or Loss737 Interest Expense21 Net Non-Recurring Events0 Income Taxes294 Net Income422 Net Income is the “bottom line” of the Income Statement Definition: Net Income = Oper. Income - Interest - Taxes - Non Recurring Items To calculate Net Income, or the “bottom line” of a business, we subtract remaining expenses from operating income. For various reasons, analysts separate out interest expense (financing costs), net non-recurring events (special situations) and income taxes from the normal operating costs of a business.

T RANSACTIONS 10 Transactions MBTN | Management by the Numbers Since we’ve already introduced transactions, debits, credits and T-accounts in the balance sheet, we’ll focus here on how revenue and expense items are handled. Two important points. First, generally a transaction that impacts revenue or expense accounts will also impact the balance sheet. Second, for the most part, revenue accounts are usually credited (increased) and expense accounts are usually debited (also increased). So, throughout the accounting period, the revenue and expense accounts are accumulating balances that indicate whether the business is profitable or not (revenues > expenses). Account CategoryDebit / CreditAccount Balance RevenueCreditIncrease ExpensesDebitIncrease

T RANSACTIONS 11 Transactions MBTN | Management by the Numbers Let’s walk through a few examples. Consider the following transactions: A customer purchasing an item for $1,000 cash Recognizing the $600 cost of the $1,000 item Loan payment of $3,000 ($2,000 is interest and $1,000 is principal) The business purchasing a marketing list for $2,500 to be paid later A customer receiving $500 of services (invoiced to be paid later) Definition: Assets = Liabilities + Shareholder Equity + (Revenues – Expenses)* Now we can now extend our basic accounting equation to include expenses and revenues by showing the revenues and expenses of the current accounting period as below: *Note – this is simplified a bit so as not to get bogged down in some details until later.

S AMPLE T RANSACTIONS 12 Sample Transactions MBTN | Management by the Numbers A customer purchasing an item for $1,000 cash Assets=Liab. + SE + (Revenues – Expenses) CashRevenues DebitsCreditsDebitsCredits $1000 = Increase The cash account is debited (increases) by $1,000, reflecting the receipt of cash, and the revenue account is credited (also increases) by $1,000. Debits and credits are equal ($1,000 = $1,000) Assets = Liabilities + SH Equity + (Revenues – Expenses) ($1,000 + $0 = $0 + $0 + $1,000 - $0)

S AMPLE T RANSACTIONS 13 Sample Transactions MBTN | Management by the Numbers Recognizing the $600 cost of the $1,000 item Assets=Liab. + SE + (Revenues – Expenses) Inventory (Asset)Cost of Revenue (Expense) DebitsCreditsDebitsCredits $600 = Decrease Expense account increases, but this side of the equation decreases (b/c negative) Debits and credits are equal ($600 = $600) Assets = Liabilities + SH Equity + (Revenues – Expenses) -$600 = $0 + $0 + $0 + ($0 - $600) Insight The net of these first two transactions is a $400 improvement to the “bottom line” or net income (Rev-Exp=Net Inc: $1,000 - $600 = $400).

S AMPLE T RANSACTIONS 14 Sample Transactions MBTN | Management by the Numbers Loan payment of $3,000 ($2,000 interest / $1,000 principal) Assets=Liab. + SE + (Revenues – Expenses) Cash (Asset)Loan (Liability) DebitsCreditsDebitsCredits $3000 =$1000 Interest (Expense) DebitsCreditsDebitsCredits = $2000 Assets decrease by $3000 Liabilities decrease by $1,000, Expenses increase by $2,000 (total decrease of $3,000 b/c expense is negative) Debits and credits are equal ($3,000 = $3,000) Assets = Liabilities + SH Equity + (Revenues – Expenses) -$3,000 = -$1,000 + $0 + ($0 - $2,000)

S AMPLE T RANSACTIONS 15 Sample Transactions MBTN | Management by the Numbers The business purchasing a marketing list for $2,500 to be paid later Assets=Liab. + SE + (Revenues – Expenses) Accounts Payable (Liability) DebitsCreditsDebitsCredits =$2500 SG&A (Expense) DebitsCreditsDebitsCredits = $2500 No net change Liabilities increase by $2,500, Expenses increase by $2,500. Net change = 0 Debits and credits are equal ($2,500 = $2,500) Assets = Liabilities + SH Equity + (Revenues – Expenses) $0= $2,500 + $0 + ($0 - $2,500)

S AMPLE T RANSACTIONS 16 Sample Transactions MBTN | Management by the Numbers A customer receiving $500 of services (invoiced to be paid later) Assets=Liab. + SE + (Revenues – Expenses) Accounts ReceivableRevenues DebitsCreditsDebitsCredits $500 = Increase Accounts Receivable is debited (increases) by $500 reflecting the purchase of services and the revenue account is credited (also increases) by $500. This is similar to the first transaction except that the asset is a promise from the customer to pay at a later time (Accounts Receivable). An important point that applies to the last two transactions is to note when a sale or expense is recognized. This depends on the accounting system being used.

C ASH VS. A CCRUAL A CCOUNTING S YSTEMS 17 Cash vs. Accrual Accounting Systems MBTN | Management by the Numbers The determination of when revenues or expenses are recognized (entered) on the Income Statement depends primarily on what type of accounting system, Cash or Accrual, is being used. The focus of this module is to compare how transactions are entered in cash or accrual systems. Accrual systems have additional guidelines for determining how and when transactions are recorded, which is not addressed here. Definitions: In a cash-based accounting system, revenues and expenses are recognized when cash is received for the transaction. In an accrual-based accounting system, revenues and expenses are recognized when the economic transaction occurs (not necessarily when cash is exchanged), with the goal to match revenues with their associated expenses.

C ASH VS. A CCRUAL A CCOUNTING S YSTEMS 18 Cash vs. Accrual Accounting Systems MBTN | Management by the Numbers The cash-based accounting system is easier to understand and simpler (as it reduces the number and complexity of transactions), but is generally allowable for use only by smaller businesses. Let’s use the last transaction to demonstrate the difference between the two systems. But we’ll add a few more details to highlight the difference between the two systems. On Aug 15 th, a customer receives services for $500 (this is the economic transaction - when services were rendered and the obligation to pay is initiated. On Sept 15 th, the customer is invoiced. On Oct 15 th, the customer pays the invoice in full. How and when would these transactions be recorded under a cash and an accrual based accounting system?

C ASH S YSTEM E XAMPLE 19 Cash System Example MBTN | Management by the Numbers In a cash-based accounting system, there is a single transaction that takes place when the payment is received (on Oct 15 th ). Cash increases, as does revenues, as shown below. Assets=Liab. + SE + (Revenues – Expenses) CashRevenues DebitsCreditsDebitsCredits $500 = Increase Easy. Single step. Now let’s see how this works under an accrual accounting system.

A CCRUAL S YSTEM E XAMPLE 20 Accrual System Example MBTN | Management by the Numbers In an accrual system, the event is a multi-part accounting transaction consisting of the revenue recognition and the payment of the invoice. Assets=Liab. + SE + (Revenues – Expenses) Accounts ReceivableRevenues DebitsCreditsDebitsCredits $500 = Increase On Aug 15th, according to generally accepted principles, one would recognize the revenues at that time with an off-setting debit to accounts receivable (promise by the customer to pay later). On Sep 15 th, the customer is invoiced. Technically, this would not be an accounting event since the revenue has already been recognized in Aug. Practically speaking, however, most accounting systems link the creation of the invoice with the accounting transaction.

A CCRUAL S YSTEM E XAMPLE 21 Accrual System Example MBTN | Management by the Numbers Finally, on Oct 15th, the customer pays the invoice, resulting in the transaction that closes the loop. In addition, in most computerized accounting systems, this will clear the customer’s statement showing that they no longer owe any money. Assets=Liab. + SE + (Revenues – Expenses) Cash DebitsCreditsDebitsCredits $500 = Accounts Receivable DebitsCreditsDebitsCredits $500 = Cash increases. Accounts Receivable decreases. No net change to overall assets. No change

C ASH VS. A CCRUAL A CCOUNTING S YSTEMS 22 Cash vs. Accrual Accounting Systems MBTN | Management by the Numbers Let’s spend a moment talking about two important timing distinctions that could easily be glossed over here, but that should be highlighted. First is that the business should invoice the customer at the time the services are rendered. This is so that the timing of the revenues (invoice for services) match the expenses (presumably the salaries paid for the people performing those services) and that they are in the same month. Second is that the accrual system will show the revenues in the Sept 30 th income statement, whereas the cash system will show them on the Dec 31st statement. These types of timing differences can have significant implications, especially with regard to tax liabilities.

B UILDING AN I NCOME S TATEMENT 23 Building an Income Statement MBTN | Management by the Numbers The last example we’ll show is to create an Income Statement from scratch for a start-up coffee shop. While this is obviously a very simplified exercise, it will help you understand how the transactions build together to create the Income Statement. On the next page, there are 6 transactions that you can use to test your comprehension. Try to build it yourself before checking the answer key. We’ve also provided the detail on all the individual transactions so you can follow how the accounts were updated.

B UILDING AN I NCOME S TATEMENT 24 Building an Income Statement MBTN | Management by the Numbers Create an income statement for the month of January from the following transactions – use a cash system: The coffee shop sells $8,000 of coffee (all cash purchases). The coffee shop pays $4,500 in barista wages. The coffee shop purchases $2,500 of coffee and milk for cash. The coffee shop purchases an advertisement running January- June in the local paper for $1,200 (pays in advance). The coffee shop receives a request for a special order of $2,500 of fair trade Guatemalan coffee. The coffee shop makes a loan payment of $600, of which $400 is interest and $200 is principal. Ready, set, go – don’t advance until you’ve tried it!

B UILDING AN I NCOME S TATEMENT 25 Building an Income Statement MBTN | Management by the Numbers Coffee Shop Income Statement$ Total Revenue8,000 Cost of Revenue7,000 Gross Profit1,000 Research and Development0 Selling, General and Admin.1,200 Operating Income or Loss-200 Interest Expense400 Net Non-Recurring Events0 Income Taxes0 Net Income-600 Cash system – Income Statement for January Though very simple, this exercise provides a good sense of how the income statement accumulates values over time. Note that the balance sheet is also affected by these transactions. The detail of the transactions and T accounts are shown on the following pages for reference. Follow-up question:What would be different if using an accrual system instead of cash?

B UILDING AN I NCOME S TATEMENT 26 Building an Income Statement MBTN | Management by the Numbers Assets=Liab. + SE + (Revenues – Expenses) CashRevenues DebitsCreditsDebitsCredits $8000= Increase Assets=Liab. + SE + (Revenues – Expenses) CashCost of Revenues DebitsCreditsDebitsCredits $4000= DecreaseExpenses Increase, but remember, negative Assets=Liab. + SE + (Revenues – Expenses) CashCost of Revenues DebitsCreditsDebitsCredits $2500= DecreaseExpenses Increase, but remember, negative

B UILDING AN I NCOME S TATEMENT 27 Building an Income Statement MBTN | Management by the Numbers Assets=Liab. + SE + (Revenues – Expenses) CashSelling, General & Admin. DebitsCreditsDebitsCredits $1200= DecreaseExpenses Increase, but remember, negative If the coffee shop had used an accrual system, $200 would have been an expense (as above) but the remainder of $1,000 (Feb- June advertising) would have been an asset of a pre-paid expense. The special order for Guatemalan coffee is tricky. It isn’t clear from the description if this is a binding order or not. Generally, this type of order would not be recognized until delivery was made. So, there is no accounting transaction necessary for this special order yet and no difference (yet) between cash and accrual systems.

B UILDING AN I NCOME S TATEMENT 28 Building an Income Statement MBTN | Management by the Numbers Assets=Liab. + SE + (Revenues – Expenses) CashInterest DebitsCreditsDebitsCredits $600=$400 CashLoan (Liabilities) DebitsCreditsDebitsCredits =$200 Decrease Liabilities decrease. Expenses Increase, but remember, negative The loan payment transaction impacts both the income statement (interest expense) and two accounts of the balance sheet – an asset account (cash) and a liability account (loans).

C ASH VS. A CCRUAL I NCOME S TATEMENT 29 Cash vs. Accrual Income Statement MBTN | Management by the Numbers Cash System$ Total Revenue8,000 Cost of Revenue7,000 Gross Profit1,000 Research and Development0 Selling, General and Admin.1,200 Operating Income or Loss-200 Interest Expense400 Net Non-Recurring Events0 Income Taxes0 Net Income-600 Accrual System$ Total Revenue8,000 Cost of Revenue7,000 Gross Profit1,000 Research and Development0 Selling, General and Admin.200 Operating Income or Loss800 Interest Expense400 Net Non-Recurring Events0 Income Taxes0 Net Income400 Insight Now we can see how the two different systems can lead to significantly different results. The cash system shows a loss for January, whereas the accrual system shows a profit!

The MBTN Balance Sheet module introduces the Balance Sheet financial statement, at a similar level to that used in the Income Statement module. It is recommended to start with the balance sheet module and then cover the income statement. F INANCIAL S TATEMENTS – F URTHER R EFERENCE 30 Financial Statements - Further Reference MBTN | Management by the Numbers