The Income statement: Understanding the components.

THE 5 COMPONENTS

Towards the end of the last post we wrote that the income statement has only 5 components, they are–

  • Sales ( or revenue or  income )
  • Direct cost
  • Gross profit (or it could be gross loss)
  • Indirect cost
  • Net profit (or it could be net loss)

So the question that remained to be answered was – Why does the income statement looks complicated if there are only 5 components? We will try to find the answer in this post. Before we explain that, we need to remember that –

  • Sales – direct costs = gross profit
  • Gross profit – indirect costs = net profit.

So, amoung the five elements, gross profit and net profit are single figures and will be displayed as such in the revenue statement. That leaves us with three figures – sales, direct cost and indirect costs.The Sales figure should be less complicated when compared to direct and indirect costs. These statements look complicated due to the complex nature of businesses done by big business houses.

For example a company like reliance has income from various sources like oil production business, oil refining and marketing business, petrochemicals  etc.These different segments may be separately shown in their revenue statement and hence, the first item in their revenue statement –‘sales’ would show four different figures and also the grand total of the four segments. When these figures are shown separately, it looks complicated. Such separate disclosure is essential for the reader to understand the proportion of income from different products. Separate disclosure can also be made based on geographical locations or any other viable separator. There will not be separate disclosure for credit sales and cash sales. (Recall the matching principle)

COSTS AND EXPENSES

There are two types of expenses.

(1) Directly related to the sale and

(2) Indirect expenses.

All expenses direct or indirect will be deducted from the revenues. By ‘directly related’ we mean that such costs are normally directly proportional to the volume of sales.  Direct costs are also known as “costs of sales” or “cost of goods sold”. This figure will be shown separately in the income statement as a deduction from the ‘Total revenues’ or ‘total sales’ figure.

The resultant figure after deduction is termed as ‘gross profit’. From the gross profit that the company has made, it needs to meet all its operational expenses like advertisement, salary to staff, rent etc.These expenses , which are not directly proportional to the sales are called indirect expenses. They are also known as ‘overheads’ or operating expenses.

Both direct costs and indirect cost also follow the matching principle and hence, those figures may not represent money actually paid.

CASH AND NON-CASH EXPENSES

At this point it is important for you to understand two more terms which are required to understand the profit and loss statement completely. They are: (1) cash expense and (2) non cash expense. Cash expense are expenses which are payable in cash. Non cash expenses are expenses for which there is no outflow of cash, but it will still be recorded as an expense. That’s because as far as an accountant is concerned the term expense has wider meaning and includes outflow of cash or outflow of other valuable assets or decreases in economic benefits or depletions of assets

Regardless of whether an expense is cash or non-cash in nature, it will be shown as deduction from the gross profit in an income statement. So if asset like machinery is used in business, the proportionate cost of machinery will be deducted as expense. Technically it’s called depreciation. It’s an expense. Precisely, it’s a non cash expense since there is no cash outflow.

Expenses – is it good or bad?

If a revenue statement shows too much expenses which affects the profitability of the company, that’s a bad sign. It’s important for the management to find out areas where they can save costs and expenses so that it improves the company’s profitability. Any such steps (for example spotting unnecessary down time in a manufacturing process) taken by a company is a positive sign.

We now know that expenses can be classified – as direct and indirect or as cash and non cash expense. Expenses can also be classified in many other ways –for example it can be classified on the basis of controllability –as controllable and un controllable expense or based on variability- as fixed and variable expenses.

In a revenue statement, instead of showing all the expenses as one figure, accountants would show it in maximum detail as possible so that the users, especially investors, can get further insights into the way in which the company is operating.

Now we hope you have understood why an income statement looks complicated at the beginning. It’s because, additional details are provided for clarity and transparency. At the end, any income statement can be trimmed down to just those five elements.

You may like these posts:

  1. The Income statement : Understanding the “matching principle”.
  2. The Income statement : Basics
  3. The components of financial statements

1 Response to “The Income statement: Understanding the components.”

Leny thomas

April 19, 2012 at 12:30 am

I have to say thanks for this one. Very well explained.

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