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.
