3.2 The Income Statement
Income statements, in contrast to the balance sheet, are “flow” statements, and are thus not static like the balance sheet; think of it instead as a moving picture, rather than as a photograph. The income statement will reflect cumulative data for a period ending on a certain date. The “period” has a starting and ending date; it may cover a year, half-year, quarter, or even a month.
Over the course of the period, the numbers, whether they be revenues or expenses, will grow only larger. The sole exception to this is the profit figures, including gross profits, earnings before interest and taxes (EBIT), and net income. These data may go either up or down depending on the relative growth of the revenues and expenses that make up those “net” figures. That is, if revenues grew less than expenses over a period, the net profit may go down over time. Take note that expenses are bracketed numbers to indicate that they are subtractions from revenue in order to arrive at profits.
Again, all other entries are the result of the accountant’s summarization of revenue and expense bookkeeping entries, which only grow in size over time (with some few exceptions). Profits are merely the calculation of differences between revenues and expenses in the summary income statement. If expenses grow faster than revenues, profits may decrease in time.
In contrast, balance sheet numbers will change, in theory, daily, and may either increase or decrease. At the year’s end, the “books are closed” and all the income statement numbers revert to zero; we start all over again. The balance sheet, in contrast, never reverts to zero; the company always has some assets and liabilities. A very simple income statement will look something like the following:
XYZ Corp. Income Statement for the Year Ending 12.31.XX
You must note that expenses are bracketed as they are reductions (subtractions) to revenue in arriving at the profits numbers, i.e., Gross Profits, EBIT, and Net Income.
The key connection between the income statement and balance sheet has largely to do with “addition to retained earnings.” When the books are “closed” at year’s end, this addition (or deduction) is transferred to “retained earnings” in the balance sheet; the income statement is “closed out,” and everything in the income statement reverts back to zero. If dividends are paid when there is a loss, the cash used to pay the dividends will have to come from (past years’) retained earnings. “Retained earnings” represent the accumulation of historically retained profits, which were not paid out as dividends, but instead were retained by the corporation, since the corporation’s inception.
As an accountant (or financial analyst), you may think of revenues as credits (right hand) and expenses as debits (left hand) of the “T-accounts” to which reference was made in the prior chapter. Think of the income statement as part of the balance sheet’s equity section, which is also a credit balance account. W