How to Prepare an Income Statement

The income statement is another name for the small business owner’s profit and loss statement. It is one of the three financial statements that business firms usually prepare; the others being the balance sheet and statement of cash flows.

The income statement shows the profitability of the firm over a period of time. Set your income statement up by first choosing a time frame, such as the current month, quarter or full year's worth of accumulated financial results. 

The income statement table below is presented with a line-by-line explanation so you can look at the profit or loss after deducting each expense.

Line 1 shows the gross revenue or sales figure. It equates to the total amount of sales in dollars that the firm has made for the given income statement period. If your firm sold 40,000 widgets at $25 each, you would show $1,000,000 on the sales line. You would show the amount sold, even if you've billed your customers but haven't yet collected the money.

Line 2 has a $500,000 entry for cost of goods sold. This cost covers the purchase of units of your product for sale. Cost of goods sold is often a firm's largest expense. Cost of goods sold contains all costs directly related to producing your product, such as direct labor, and purchases of raw materials.

If you buy goods wholesale and then resell them, you would also reflect that on this line. For example, 40,000 widgets purchased at a wholesale cost of $12.50 each equals $500,000 cost of goods sold during the period reflected on this income statement.

Line 3: Subtract the cost of goods sold from gross sales to get gross profit (Line 3). 

Line 4: From the $500,000 gross profit, subtract selling and administration (S,G&A) expenses. This $250,000 item represents your office expenses, such as costs not directly related to producing goods for sale. If you have several related expenses, such as telephone, electric and water bills, you can group them into one line called "utilities."

S,G&A expenses also include costs like wages, sales commissions, office rent, and legal and accounting fees.

Line 5 shows the company's depreciation expense. When you buy a building or equipment for your business, you depreciate it over a period of time. Depreciation is a non-cash expense and serves as a tax shelter, so it is shown on the income statement.

Line 6: After subtracting selling and administrative expenses and depreciation, you arrive at the operating profit. Operating profit is also called earnings before interest and taxes (EBIT), which in this case totals $170,000.

Line 7: After you calculate EBIT, add your company's interest expense. Interest is what you pay on any debt your company owes. To calculate the interest on the debt, you have to know the interest rate you are paying and multiply it by the principal amount of your debt. For this example, the interest amount is assumed at $30,000 and goes on Line 7.

Line 8: After subtracting your interest expense from EBIT, you arrive at earnings before taxes on Line 8.

Line 9: Fill in the amount you pay in federal, state, local, and payroll taxes on Line 9. The tax rate, in this example, is 21 percent. 

Line 10: After you subtract the tax expense, you'll arrive at the earnings available to your common shareholders, which is stated on Line 10.

Line 11: If you have investors in your firm or if you take a salary from your firm, Line 11 is where you record the draw or the dividends.

Line 12 Subtract all of the expenses above from line 3, gross profit, to calculate your company's net income (profit). This represents the money you have left to put back, or reinvest, into the firm in the form of retained earnings.

Transfer this net income amount to your balance sheet at the end of your accounting period, to the retained earnings account. Aside from being reinvested in the company, this amount might also be used to pay future dividends.

The table below shows an example of a very simplified income statement. The income statement of your company may be a little more complex and contain more line items. This statement should serve to give you the basic layout and an idea of how a profit/loss statement, or income statement, works.

XYZ Company Income Statement For the Year Ending Dec. 31, 2018

1. Sales $1,000,000
2. Cost of Goods Sold $500,000
3. Gross Profit $500,000
4. Selling & Administrative Expense $250,000
5. Depreciation $80,000
6. Operating Profit (EBIT) $170,000
7. Interest $30,000
8. Earnings Before Taxes (EBT) $140,000
9. Taxes (21%) $29,400
10. Earnings Available to Common Shareholders $110,600
11. Dividends or Owner Draw $20,000
12. Net Income $90,600

Additionally, verify that repeating transactions get recorded in the same general ledger accounts each time so that when you compare income statement line items from one period to the next, you feel comfortable knowing you're comparing apples to apples.A company's income statement is only as accurate as the quality of its data. It makes sense to review your accounting transactions at a detailed level, especially if one of the line items on your income statement seems unusually large or small.

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