What is it and what are the components?
An Income Statement (referred as the P&L statement or statement of operations) details how much revenue (inflows of economic resources for providing goods and services) a company generates and how much expenses (outflows of economic resources, depletion of assets, or incurring liabilities that decrease equity) a company incurs.
Earnings before Interest and Taxes (“EBIT”) equal the difference between revenues minus operating expenses and Depreciation/Amortization. Operating profit is sometimes referred as EBIT. Operating expenses may include cost of goods sold (COGS), selling, general, and administrative (SG&A), and development. Net Income is the final “profit” after paying for interest and taxes.
COGS are direct costs resulting from the production of the good the company received revenues from. Revenue minus your COGS would equal your Gross Margin. SG&A costs include direct selling expenses (linked to the sale of the product) or indirect expenses (cannot directly be linked to the sale but are allocated proportionately in the business). Examples of SG&A costs include advertising, salaries, rent, utilities, and etc.
Depreciation is the process of systematically allocating costs of long-lived assets over the period during which assets are expected to provide economic benefit; amortization is similar to depreciation but for long-lived intangible assets with a finite life. They both can be accounted using the cost or revaluation model (U.S GAAP only allows for the cost model). The cost model is the book value of the asset which is the amount on the asset minus accumulated depreciation. The original amount of the asset is the purchase price. Depreciation can either be allocated using the straight-line or accelerated methods.
Income statements may present items with subtotals and grouped either by their nature or function. Example of grouping by nature is equipment depreciation and manufacturing depreciation into one “depreciation” line item. Example of grouping by function is putting similar in nature line items (depreciation, material costs, and salaries) into one, such as COGS.
Revenue and Expense Realization or Recognition
Companies must disclose revenue recognition policies in the notes of their financial statements. Under IFRS, revenue from the sale of goods is recognized when (i) the entity has transferred to the buyer the significant risks and rewards of ownership; (ii) the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; (iii) the amount of revenue can be measured reliably; (iv) it is probable that the economic benefits associated with the transaction will flow to the entity; and (v) the costs incurred or to be incurred in respect of the transaction can be measured reliably.
Essentially, risk has been transferred, ownership control changes, revenue and cost can be measured reliably, and there is probable economic benefit. Under US GAAP revenue is realized (GAAP doesn’t refer to it as recognition) and earned when (i) there is evidence of an arrangement between buyers and sellers; (ii) the product has been delivered, or the service has been rendered; (iii) the price is determinable; and (iv) the seller is reasonably sure of collecting money.
A general principle for expense recognition is the matching principle. The matching principle states a company recognizes expenses when associated revenues are recognized, therefore, expenses and revenues are matched. Associated revenues and expenses result directly from the same transactions. The principle requires that COGS be recorded in the same period as revenues, from the sale of goods. Moreover, period costs (expenditures that reduced revenues directly) are also reflected in the period when a company makes the expenditure or incurs the liability.