Part 1, Lesson 3

### What is an income statement?

The income statement presents the total revenues and expenses of a business for a specific period of time.  Most publicly traded companies will report an income statement at the end of every three months (quarterly income statement) and at the end of their fiscal year (the annual income statement).

Think of the income statement as a bridge between the beginning balance sheet and ending balance sheet.  In other words, the income statement helps to “explain” the activity that occurred from one date to the next date, whereas the balance sheet provides a financial snapshot on a fixed date in time.

Imagine yourself on the beach.  You take a still photograph of the sunrise.  You take a video starting at sunrise until sunset, and then, you take a still photograph of the sunset.  The sunrise picture is your balance sheet at the start of the day, the video is the income statement that shows what happened between sunrise and sunset, and the sunset picture is your balance sheet at the end of the day.

### Accrual Basis vs. Cash Basis Accounting

Most financial statements you will encounter from public companies are presented based on an important accounting principle referred to as “Accrual Basis.”

The accrual method states that revenue is recognized in the period in which it is earned and expenses are realized in the period in which they are occur.  A closely related rule is the matching principle, which states that expenses should generally be matched to the revenues they are associated with.  For example, if a company pays a sales agent a 5% sales commission, then, this commission expense should be incurred in the same period in which the revenue is recognized regardless of when the sales commission is actually paid out.

Cash basis accounting presents financial statements based on when cash is actually exchanged.  As an investor in publicly traded companies, you will most likely never encounter this type of statement.

Examples of Accrual Method

• Question – Company A sells \$75,000 worth of t-shirts in March, but only receives \$35,000 in cash for these sales in March. The remaining \$40,000 of cash comes in April.  What is the amount of March revenues for Company A?
• Answer – Company A’s March revenue is \$75,000.  Accrual basis states that revenue is recognized when earned, not when the cash is received.

• Question – Company B receives \$50,000 of cash in April for televisions sold in March. Is this \$50,000 cash payment recognized as revenue in April?
• Answer – No.  The \$50,000 should have been recognized in March when the televisions were actually sold.

• Question – Company C has two employees who are paid \$5,000 each per month. In June, Company C is short on cash, so they delay payments of the June salaries until July.  What is Company’s C’s June salary expense vs. July salary expense?
• Answer – The June salary expense is \$10,000, and the July salary expense is also \$10,000.  The accrual method states that expenses are realized when they are incurred.  Just because Company C did not have cash to pay out June salaries does not change the fact that they still incurred a salary expense in June.

• Question – Company D receives an electric utility bill for the 30 days covering June 15th to July 15th. The bill is not due until August 15th.  How should the company accrue its electric utility expense?
• Answer – Company D should pro-rate the utility bill according to when it was incurred.  Therefore, the portion of the bill associated with June 15th to June 30th should appear on the June income statement, and the portion of the bill associated with July 1st to July 15th should appear on the July income statement.  The August 15th payment due date has no bearing on when the expense is incurred.

### John’s Pizzeria – First Month in Business

In Part 1, Lesson 2, we created the initial balance sheet for John’s Pizzeria.  John funded his pizzeria through equity and debt, purchased FF&E, purchased inventory, and purchased supplies.  Let’s now build an income statement for John’s Pizzeria’s first month of operations.

In his first month (January 2019), John’s Pizzeria had the following activity:

1. Sold 800 pizzas for \$20 each
2. Hired one employee on January 1st at a salary rate of \$4,000 per month
3. Signed a lease on January 1st at a rate of \$1,000 per month
4. Incurred a \$500 electric bill
5. Consumed \$250 worth of supplies in January
6. Depreciated FF&E based on a 10-year useful life
7. Agreed to pay 10% yearly interest on both the short-term and long-term debt he has incurred
8. Owed federal and state taxes at an assumed rate of 40% of pre-tax profits

Let’s build out the income statement one line at a time:

1. Sold 800 pizzas for \$20 each

Selling pizza is a revenue item for John’s Pizzeria, so \$16,000 worth of sales will be recognized in January.  Note below that the income statement is shown “For the Period Ending January 31, 2019.”  This differs from the balance sheet which was shown only for a specific date.

John’s Pizzeria – Income Statement
For the Period Ending January 31, 2019

 Revenue \$16,000

Now, whenever we sell an item, there is always a cost associated with that sale.  This is usually referred to as “Cost of Goods Sold.”  If we refer to Part 1, Lesson 2, we will remember that John bought 1,000 frozen pizzas for his inventory at a cost of \$10 each.  Therefore, his cost of goods sold for January was 800 pizzas * \$10 each = \$8,000.  Let’s add this in:

John’s Pizzeria – Income Statement
For the Period Ending January 31, 2019

 Revenue \$16,000 – Cost of Goods Sold (\$8,000) = Gross Profit \$8,000

Gross Profit is an important accounting term to remember.  Gross profit refers to Revenue less Cost of Goods Sold (COGS).  “Gross profit” is often used interchangeably with “gross margin” and is a good measure of the profitability of the items that a business is selling.

2. Hired one employee on January 1st at a salary rate of \$4,000 per month
3. Signed a lease on January 1st at a rate of \$1,000 per month
4. Incurred a \$500 electric bill
5. Consumed \$250 worth of supplies in January

John’s Pizzeria – Income Statement
For the Period Ending January 31, 2019

 Revenue \$16,000 – Cost of Goods Sold (\$8,000) = Gross Profit \$8,000 – Salary Expense (\$4,000) – Rent Expense (\$1,000) – Electric Utility Expense (\$500) – Supplies Expense (\$250)

These additions to the income statement are relatively straightforward as they are expensed as incurred, regardless of the timing of when the payments are paid out of cash.

6. Depreciated FF&E based on a 10-year useful life

Depreciation is the expensing of a fixed asset based on its useful life.  We will have a more detailed discussion on depreciation in a subsequent lesson.  For now, it is helpful to think of depreciation as simply the gradual “consumption” of a company’s fixed asset.  For example, if we assume John’s Pizzeria’s furniture and equipment will last for 10 years and have no value at the end of the 10 years, then, we will “use up” 10% of the value of the FF&E each year for 10 years.

The starting balance of the FF&E is \$60,000.  Utilizing a 10-year useful life implies that the yearly depreciation expense is \$6,000.  The monthly depreciation expense would be \$6,000 / 12 = \$500 of monthly depreciation.

John’s Pizzeria – Income Statement
For the Period Ending January 31, 2019

 Revenue \$16,000 – Cost of Goods Sold (\$8,000) = Gross Profit \$8,000 – Salary Expense (\$4,000) – Rent Expense (\$1,000) – Electric Utility Expense (\$500) – Supplies Expense (\$250) – Depreciation Expense (\$500) = Operating Profit \$1,750

7. Agreed to pay 10% yearly interest on both the short-term and long-term debt he has incurred
8. Owed federal and state taxes at an assumed rate of 40% of pre-tax profits

John’s Pizzeria – Income Statement
For the Period Ending January 31, 2019

 Revenue \$16,000 – Cost of Goods Sold (\$8,000) = Gross Profit \$8,000 – Salary Expense (\$4,000) – Rent Expense (\$1,000) – Electric Utility Expense (\$500) – Supplies Expense (\$250) – Depreciation Expense (\$500) = Operating Profit \$1,750 – Interest Expense (\$1,000) = Earnings Before Taxes \$750 – Income Tax Expense at 40% (\$300) = Net Income \$450

In addition to gross profit, “operating profit” is another important accounting term to remember.  Operating profit is also referred to as Earnings Before Interest and Taxes or EBIT.  It is essentially the revenue less all expenses of the business except for interest and taxes.

John’s Pizzeria has \$120,000 in short and long-term debt and is responsible for paying the bank interest at a rate equal to 10% per year, which would amount to \$12,000 in interest per year or \$1,000 of interest per month as noted above.  After deducting \$1,000 in interest expense, we come to \$750 in pre-tax profits.

John’s Pizzeria owes 40% of pre-tax profits to the federal and state government, which amounts to \$300 for January.

This leaves a total of \$450 in net income for the month of January.