Accounting 101 for Small Businesses

How To Prepare A Profit And Loss Statement (i.e. Income Statement)

How do you know whether your company is profitable or losing money? You can’t rely on your feelings or perceptions about how the company is doing. You need to depend on facts, which you present in an income statement, also referred to as a profit and loss (P&L) statement.

Overview

The income statement is a recap of your company’s income and expenses over a specified period of time. This can be monthly, quarterly or annually. In income statement parlance, it is expressed as “for the year ending December 31, 2015,” for an annual income statement, or “for the three months ending September 30, 2015,” for a quarter running from July 1 through the end of September.

The period you choose depends on your needs. If you use the income statement to review your operations, select any period that works for you. This may be quarterly or even monthly. If you need the statement for a loan application, typically the statement is year-to-date, ending with the most recent month; you will likely have to provide a statement for the prior full year as well.

Revenue

Revenue is all income that a company receives. This includes:

  • Operating revenue from the sale of goods and services.
  • Non-operating revenue, such as interest received on loans made by the company or rent received from subleasing space.
  • Gains on the sale of long-term assets (e.g. a vehicle, building, etc.) or other gains (e.g. a lawsuit recovery). Gains reported on the income statement is not the gross proceeds on a sale; it is the amount by which the proceeds exceed the asset’s value on the company’s books.

Revenue on the income statement is reported when the goods or services have been provided to the customer or client. Revenue for this purpose does not depend upon the receipt of payment. For example, if you perform a service, account for revenue when the work is done, even though you have not yet received payment. Similarly, if you are a retailer selling goods, report the revenue on the income statement when the goods are sold, even though the invoice for the transaction has not yet been paid. If you are paid on the spot—either with cash, a check, a credit or debit card payment, or other electronic transfer—then receipts and revenue are the same for the purposes of your income statement.

Expenses

List and total up your expenses incurred to produce your company’s revenue. Separate your expenses into various categories to help you better see how money is being spent. Typical categories of expenses include:

  • Operating expenses: The cost of goods sold if you have inventory, payroll, overhead (e.g. rent, utilities, insurance, communication costs, etc.) and marketing.
  • Non-operating expenses: Interest expense, which accounts for interest payable for debt, such as bonds, loans, lines of credit, etc.
  • Losses: Losses on the sale of assets and lawsuit damages. Losses reported on the income statement are the amount by which the proceeds are less than the asset’s value on the company’s books.

Expenses usually are reported when there is a liability for payment. For example, employee compensation is reported as an expense even if the company has not yet paid it.

Some expenses are matched to revenue for reporting purposes. For example, commissions owed to a salesperson are reported when the revenue from the sales are reported, even if the commissions have not yet been paid. Similarly, inventory expenses are reported in tandem with sales of inventory items.

Not all payments by a company are treated as expenses on an income statement. For example, paying down principal on a loan is an outlay of cash but not treated as an expense on the income statement. Also, there may be extraordinary expenses that you want to display in a separate revenue category in order to highlight them and better understand your income and expenses for the period.

Creating an Income Statement

To create an income statement manually, start by selecting the method you’ll use to list your entries. There are two basic methods:

  • Single-step method: Determine net income by subtracting expenses and losses from revenue and gains. This type of statement is used primarily by service businesses. You simply list your revenue and gains, and add up your categories described earlier to find a subtotal of profit; then list your expenses and losses according to the categories explained earlier; again, total them up. This can be expressed in the following equation:

Net income (or loss) = (revenue + gains) – (expenses + losses)

Subtract from the subtotal of revenue and gains the subtotal of expenses and losses. A positive difference is your net income. If the result is negative, this is your net loss.

  • Multiple-step method: Segregate operating revenue and expenses from other revenue and expenses. This method allows you to show gross profit, which is net sales minus the cost of goods sold. This method is better suited for inventory-based businesses. Again, you’ll total your revenue and expenses in the various categories, factoring in the cost of goods sold to arrive at net income or net loss.

You can display the information in any way that is most useful to you when using an income statement for internal purposes (not for bank loans or public consumption). For example, you can segregate income and expenses according to product lines to see which line is more profitable.

As a practical matter, if you use a sound accounting system, such as QuickBooks, you can generate an income statement automatically. You do not have to enter revenue and gains or expenses and losses; your system does this for you based on information that you’ve already entered into your accounting system.

Conclusion

An income statement is a reflection of the company’s past activities and is a required statement for financial reporting (along with the balance sheet and cash flow statement). It’s important to track and review your income and expenses so you can plan ahead for future growth. If you have any concerns about creating or understanding your income statement, work with a CPA or other knowledgeable financial specialist.

Download a free income statement template to get started. Or check out our guide to financial reporting to learn more about the essential financial statements.

Chapter 3.
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Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.