The Income Statement

What it shows

The income statement — also called the profit and loss account or statement of comprehensive income — reports performance over a period: revenue earned, costs incurred and the resulting profit. It covers a span of time, unlike the balance sheet which is a single instant.

Structure

• Revenue — income from the main activity, recognised when control of goods or services passes to the customer, not when cash is received.
• Cost of sales — the direct cost of what was sold: materials, direct labour, direct production overhead.
• Gross profit — revenue less cost of sales. The margin available to cover everything else.
• Operating expenses — selling, administrative, research, depreciation and amortisation.
• Operating profit — profit from trading, before financing and tax. The cleanest measure of how the business itself performs.
• Finance costs and income — interest paid and received.
• Profit before tax.
• Tax.
• Profit for the period.
• Other comprehensive income — gains and losses not passing through profit, such as revaluations and some currency translation.

Margins

Read margins, not just absolute figures. Gross margin reflects pricing power and production efficiency; operating margin reflects overhead control. A rising revenue with a falling gross margin means growth is being bought with discounting, which is a very different story from the revenue line alone.

Revenue recognition

This is where most accounting manipulation occurs, because revenue is the number everyone watches. The principle is that revenue is recognised as control transfers, which may be at a point in time or over time. Judgement enters in long-term contracts, bundled goods and services, agent versus principal questions (do you record the whole transaction value or only your commission?), and where there are rights of return. Read the revenue recognition policy in the notes; it is one of the most informative paragraphs in a set of accounts.

Terms that are not defined by standards

EBITDA — earnings before interest, tax, depreciation and amortisation — and various “adjusted” or “underlying” profit measures are not defined by accounting standards. They can be useful for comparing operating performance across businesses with different financing and asset structures, and they can equally be used to exclude inconvenient costs. Always check what has been adjusted out, whether the same items are excluded every year, and whether the adjustments are genuinely one-off. A company that has reported exceptional restructuring costs every year for five years does not have exceptional restructuring costs.

Profit is an opinion

Profit depends on judgements: useful lives for depreciation, provisions, inventory valuation, bad debt allowances, and revenue timing. Two honest accountants can reach different profits from the same facts. Cash, by contrast, is a matter of record — which is why the cash flow statement matters so much.