In this video, we're going to look at the income statement. What is income and how is it different than cash flow? The components of the income statement are revenues and expenses, what are they and how are they recognized? Income or profitability is a measure of the performance of the company during a period of time. Profitability is why many firms exist. I mean, the term for profit firms relates to the income statement. So it's a very important statement. Remember that the income statement helps link changes in the balance sheet. It feeds directly into the balance sheet account retained earnings. Retained earnings is the cumulative income that the firm has reported over its life net of the amount that's no longer retained because it was paid out as a dividend. We could think of the balance sheet equation as existing at the beginning of the year, assets equals liabilities plus owners equity, and also at the end of the year. The income statement is about how the balance sheet changed from the beginning to the end of the year. It explicitly links to the change in the retained earnings account within the balance sheet. Now, how do we calculate income? An important term is the term accrual accounting and accrual accounting simply means income is not the same thing as cash flow. Revenues and expenses are tied to business activities not to cash going in or out. Ideally, income represents the change or the increase in economic value that's associated with the business activity. Cash flow is more about the receipt of the value. The difference is one of timing, many business activities generate value at a different point than they actually generate cash or use up cash. If you invest in property plant and equipment, the cash may go out the door now but the benefits may happen over an extended period of time. Cash flow statements ignore that, income statements try to incorporate that. It's very common for cash outflows to generate inflows in different points in time and what accrual accounting tries to do is match up the efforts and the accomplishments. Income statement format. Usually, we try to give more details about the types of costs and we see that costs are different in different industries. So, we start with revenues and then we subtract out just the costs of goods sold. These are the costs necessary to produce the product. The difference is referred to as the gross profit sometimes, you hear the term gross margin. Then, we've got a line where we subtract other types of costs that are important costs but not necessarily costs use to produce the product per se. We call these other operating costs selling, general, administrative costs, R&D things like that. Once we subtract to that, that's referred to as the operating income of the firm. Then, we subtract other types of costs more financial type costs like interest costs or other more tangential gains and losses. That gives us the pre-tax income subtract the tax expense and then we've got the bottom line net income number that shows up on the income statement. Now, let's talk more about the components. Revenue, top line on the income statement. Revenue is the increase in stockholder's equity not necessarily in the form of cash though from providing goods and services. Now, we only recognize revenue and accounting when two criteria are met. It's earned and that means that the goods or services have been provided and it's realized the realizable. That means you can figure out with some reasonably precise estimate how much cash you're actually going to collect. So, revenue is not the same as cash. You could recognize revenue before you get the cash. A credit sale is a good example of that. You make the sale and you don't collect the cash till later. The income statement recognizes the revenue when you make the sale. You can also have situations where you recognize the revenue after you get the cash. This usually happens if you haven't delivered the service yet. If a customer makes a deposit on a product, you've got the cash but you can't call that revenue yet because you still need to deliver the product or if a customer prepays for a year's service on a software license or something like that, you get the cash up front but you've got to spread out the recognition of the revenue. So again, it's one of timing. Revenue is related to the underlying business activity whereas cash is the receipt of the economic value in the form of cash. Expenses. Well expenses are the decreases in stockholder's equity that arise in the process of generating revenue. Again, not necessarily the cash outflow that's happening this period. We try to recognize expenses to the extent that we can by matching them to the revenues that they helped generate. In that way, we can get the profitability of that activity. That's not always easy to do. And so, if we can't, then we more match the expense to the underlying period of time in which they occur. So, for example, if we produce some products this period and spend money to acquire inventory but we don't sell that inventory this period, we don't record the costs of production in this period's income statement. Instead, we hold them back from the income statement by keeping them on the balancesheet and wait till the sales occur, hopefully, next period and then match the revenues with the costs that we paid this period. So, the income statement tries to measure efforts and accomplishments, it doesn't just look at what year did the check clear. Matching is an important part of the income statement. Another important principle in the calculation of income is something called conservatism. Conservatism is the idea that it's better to have a good surprise than a bad surprise. So, we're going to avoid bad surprises by writing things down quicker. If things look like they're going bad, we'll recognize losses up front but we'll hold back on the recognition of gains. This introduces an asymmetry into accounting, good news and bad news are not reflected equally and that's something important to keep in mind as well. So, the income statement or the profit and loss statement is one of the most heavily looked at statements within a company. It's important to understand how the revenues are calculated and how the expenses are calculated.
