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Income Statements Explained – Elements Mastered – Step 2

REVENUE

There are many types of Revenues:

Sales (Turnover, The Top Line):
Sales are one form of Revenue that is earned by providing services or selling goods – i.e. it is a specific kind of income that required an effort to generate, and where customers/clients pay the business to gain ownership of the result.
TIP:
Sales are a type of Revenue – but because Sales are usually the largest, or only, type of income a business may have often the word Sales is used interchangeable with the words Revenue or Income.

Rents/Royalties/ Licence Fees:
Revenue can also be generated by enabling customers/clients to use business assets, without transferring the ownership of the asset. The label used will depend on the type of asset (although this can be quite arbitrary). In general:

• Buildings and Equipment generate Rental Income
• Writing, Artworks, etc. generate income called Royalties
• Software etc generates Licence Fees

Miscellaneous Income (Grants, Subsidies, Foreign Exchange Gains etc):
Indirect income related to regular business operations, but not correlated directly with Sales and/or Customers. They are part of normal day-to-day activities of running the business, but not paid by customers/clients, although in the case of a Foreign Exchange Gain may arise as the result of working with overseas clients or suppliers.

Other Income accounts:
Convention requires that if money is generated by an uncommon activity of the business, or an activity that is outside of management’s direct influence, then it should be included under “Other Income”. Other income accounts track the income such as one-off income, profit on the sale of an asset, or a one-off foreign exchange gain; they might have occurred in helping the business run, but they are not core to the kind of work the business undertakes, or regularly occurring.

 

EXPENSES

There are many types of Expenses:

Direct Expenses (Cost of Goods Sold or COGS):
The term “direct” describes the relationship between these costs and the sales revenue. e.g. if sales double, direct costs will also double. This may not be on an exact 1:1 relationship (1 more unit sold = 1 more unit of cost) as given in the example above, but the concept is that there is a “direct” correlation between the sales and the cost. Consider a tele-sales business selling steak-knives for every sale there is also the direct cost of the phone call, the cost of the knife and the cost of the shipping.
Direct Expenses usually only appear in Income Statements of businesses which are manufactures or retailers – supplying stock – and refers to expenses such as raw materials, inventory etc. Service businesses generally do not allocate any costs to Direct Expenses as the cannot hold, nor sell, their staff as “stock”.

Indirect Expense (Operating Expenses, General Expenses, Overheads):
Indirect Expenses are the costs incurred to keeping the business running; all the overheads and support functions. This typically includes salaries and wages of support staff, marketing and advertising, stationery, rents, electricity etc. There is no direct correlation between an increase in sales and an increase in these expenses – i.e. for every extra unit sold, there is not a corresponding extra unit of cost in this area.

Other Expense accounts:
Other expense accounts track the expenses that are only incidentally related to a company’s operations. Outgoings such as the costs of raising equity, loan interest and fines; although eventually this might help the business run, these are not core to the kind of work the business undertakes. Most companies borrow, some more than the others, however borrowing is a reflection of how much the business owners want to invest and risk in the business; the decisions around risk are therefore generally outside of management’s hands and thus not included as part of everyday business operations.

Extraordinary Items:
Income statement should not regularly contain extraordinary items since these items are called “extraordinary” for a specific reason— they do not occur as a frequent, or regular, part of operations. Examples include; unexpected natural disaster, prohibitions under new regulations. They are usually stated at the end of the Income Statement as a separate note; since they cannot be simply ignored, but are generally outside Management’s control.

Taxes:
Taxes are, from the point of view of management, mandatory and the amounts paid are set by various State and Federal Governments. The effectiveness of decision making has little impact on the amount of tax paid (the tax is a mandated % of profit), and therefore Taxes are reported by tradition right at the bottom of the Profit and Loss statement.

 

NOTES TO THE INCOME STATEMENTS

As mentioned already, convention is not a mandate – there is a lot of room for interpretation and variety. The Income statement, being a summary of what has gone on, allows for quite a bit of MANIPULATION:

• Was that really a staff bonus or a way of siphoning off funds?
• Is it an asset or simply a repair?

Similarly, the terms “common” and “uncommon” are very grey definitions; what I consider common, you may not! What occurs regularly in one business, such as foreign exchange for an internet book-seller, may be very uncommon to another business like your local newsagency. Also what I consider to be a Direct Expense may well be considered by you and your accountant as an Indirect Expense – sales people are sometimes considered one and just as often the other – conventions are not dictatorial, they are a guideline.
To aid clarification many Income Statements come with Notes providing extra details about the information summarised in the report. In some countries many of these are stipulated, and even state the values that trigger a requirement of more detail may be in force. Wherever possible read the notes – ideally these will give further clarity as to what “common” practices have been used, and what has been deemed regular business and what is extra-ordinary.
 
The next Step is covered in the following article:

Income Statements Explained – Layout Mastered – Step 3

To make understanding the story of what happened simpler, most income statements are multi-layered. What this means is they include sub-totals and totals through-out the report – find out why each sub-total and total has a reason how it is important.
 

Your Feedback is Welcome

If I haven’t quite explained something clearly enough – please post your question in the comments/reply section and I will endeavour to clarify it for everyone.