The Importance Of The Income Statement In Accounting

What Is an Income Statement?

The income statement shows the company's revenues, expenses, and profitability over a period of time.

In other words, when figuring out how profitable a business is, you need to know how much revenue it generates and how much it spends.

How Is Revenue Recorded On The Income Statement?

Wasslak generates most of its revenue from the fees it charges for delivering packages. Using accrual accounting, revenues are recorded when they are earned, not when the company collects cash. This income recognition method is one of the basic accrual accounting principles.

For instance, if Abdullah of Wasslak delivers 1,000 packages in December and gets SAR 4 for each one, he has technically generated SAR 4,000 in revenue that month. He sends his clients invoices for these fees, and according to his terms, they must pay by January 10 of next year.

Even though his clients won't pay Wasslak until January 10, the accrual method of accounting says that the SAR 4,000 in revenue should be recorded in December because it was earned at that time. When the delivery costs are subtracted from this revenue, the income statement for December will demonstrate how profitable Wasslak was that month.

Read more about the difference between accrual accounting and cash basis accounting.

When Abdullah gets the SAR 4,000 in cash from his clients on January 10, he will record a journal entry to show that he has received the money. This SAR 4,000 in income will not be counted as income for January because it has already been reported as income in December when it was earned. Therefore, accounts receivable will be credited by SAR 4,000 in January, and cash will be debited with the same amount to close the cycle.

Understanding of Expenses

Samy now looks at the second section of the income statement showing the expenses. Similarly to revenue, expenses can also appear on the income statement before any cash outflow happens.

For instance, if Abdullah hires somebody to support him with December deliveries and agrees to pay him SAR 500 on January 3, that SAR 500 cost needs to be shown on the December income statement as the corresponding task was performed then. Simply put, expenses need to be recorded when their corresponding task or good benefited the company rather than when they are actually paid for in cash.

Next, Samy tells Abdullah that putting the SAR 500 in wages on the December income statement will show that the cost of the workers who delivered the packages in December equals the total revenue they generated.

Samy is happy to see that Abdullah already knows this basic accounting principle. To become profitable, the company had to pay some business costs in December, such as petrol for the delivery van and radio ads.

Abdullah asks Samy for another instance of a cost that will not be paid in December but would need to be recorded as an expenditure on December's income statement. Samy utilizes the Interest Expense on borrowed money as an example.

Read more: What is the importance of an income statement for a business?

He tells Abdullah to imagine that Wasslak borrows SAR 20,000 from Abdullah's uncle on December 1 and that the company agrees to pay Abdullah's uncle 6% interest per year, totaling SAR 1,200. This SAR 1,200 interest will be paid on December 1 of every year. Even though his uncle only gets the interest once a year, Abdullah sees that he has to account for a small amount of that interest every day.

If Abdullah is making monthly income statements, he should put one month's worth of Interest Expenses on each one. Accordingly, the Interest Expense for Wasslak will be SAR 100 per month for the whole year (SAR 20,000 multiplied by 6% and then divided by 12). The SAR 100 Interest Expense is recorded as a cost that has to be paid to generate the revenue displayed on income statements.

Samy tells Abdullah that the income statement is a bit more complex than what he just explained, but he wants Abdullah to learn some basic accounting ideas and terms first before jumping to the details. Samy ensures that Abdullah understands one simple yet essential aspect:

an income statement doesn't necessarily show how much cash is coming in, but:

1. How much revenue did the company generate during the period.
2. How much it spent during the same period.

The bottom line is that the goal of the income statement is to showcase how profitable a company was during a certain time period, be it a net profit, breakeven, or net loss.