Income Statement Explained

Providing data for, and using information gained from, an income statement is a necessary skill for an effective manager. One of the most important concepts you need to understand is how the timing of a transaction affects the figures in any given period.

Those unfamiliar with financial processes and procedures are often surprised when a monthly income statement does not show the effects of individual transactions that they expected to see. This includes both the revenue generated by a sale and the expenses and costs incurred in making that sale happen.

There are two reasons why this occurs:

1. There may be a long delay between the date a transaction was agreed with a customer or supplier and the date of the payment was made or received.

2. There may be confusion over when a transaction should properly be recorded.

The importance of transaction timing

Until a sale or an expense becomes an irrevocable transaction it cannot be recorded in your income statement. Only when an organization, either yours or one of your suppliers, acts on the promise to deliver do we have an accounting event that should be recorded.

Any event that is simply a request or promise, which can be rescinded without penalty, does not represent an irrevocable transaction that you can record on your income statement. Events that are not recorded at the time they occur are shown in the example below.

One of Gary's Garden Furniture salesmen sells a $7,500 suite of furniture. This particular suite is not in stock and must be ordered in. The customer pays a deposit of $500 for the suite. The $7,500 sale will not be recorded in the income statement as a sale. This is because the customer has not received the suite.

The order placed by the salesman to the supplier will not appear. This is because the supplier has not shipped the suite to Gary's.

The raising of a purchase order will not be reflected in the income statement because Gary's has not actually received any goods from the supplier at this point.

Even when the supplier confirms receipt of the purchase order this will not appear in the statement. This is because Gary's have not yet taken possession of the suite.

The $500 deposit will be recorded as a receipt because the company has received this cash, but the sale will only be itemized in the income statement when it has actually been delivered to the customer. This could be several weeks later and is likely to appear in the next quarterly statement. Similarly, the cost of buying in this suite would be itemized in the statement as a cost in the month that Gary's took possession of it at their warehouse.

Income statements should not be used as an aid to budgeting

Much of this confusion arises because managers try to use the income statements to assist them in managing and monitoring the divisional or departmental budget. Income statements are not designed to be used this way. If you do want to use them to help with budgeting then they must be used in conjunction with an integrated enterprise accounting system that can keep track of sales made and purchase orders received but not yet fulfilled.

This Accounting Terminology Checklist outlines the terminology, concepts and conventions that are accepted within the accounting profession.

You may also be interested in:
Income Statement Definition | Income Statement Format | Multiple-Step Income Statement | Operating Expenses Definition | Income Statement Ratios | Common-Size Income Statements | Common-Size Analysis | Income Statement Cash Flow.

Key Points

  • Do not be surprised if a monthly income statement does not show the effects of individual transactions that you might expect to see.
  • Income statements ONLY show irrevocable transactions; they do not show requests or promises.
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