What is an Income Statement?

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From the course by University of Michigan

Accounting for Decision Making

31 ratings

University of Michigan

Accounting for Decision Making

31 ratings

Through this course, you will start by addressing the two “big questions” of accounting: “What do I have?” and “How did I do over time?” You will see how the two key financial statements – the balance sheet and the income statement - are designed to answer these questions and then move on to consider how individual transactions aggregate to make up these financial statements. After developing a broad understanding of accounting and financial statements, you will begin to develop a more nuanced understanding of individual components of doing business, such as making a sale or building inventory. By considering many of the more common actions of a company, you will build your understanding of accounting, and explore these concepts by applying them across various types of transactions. Once you understand these individual concepts better, you will be ready to return to the overall financial statements and use them as informational tools, including building ratios. You can do this course standalone or to qualify for the residential component of the Finance for Strategic Decision-Making Executive Education program. For more information, see the FAQ below.

From the lesson

Why Do We Have Accounting and How Can You Make it Work for You?

Every organized society needs information about its activities and accomplishments. Accounting was created to fulfill this need. In this module we will explore how accounting was designed to meet the needs of decision makers and what this means to you as a user of accounting information. We will discuss the concept behind accrual accounting including introducing the two primary accrual accounting financial statements - the balance sheet and income statement. This module will discuss the purpose and goal of those financial statements, but we will save your experience in creating those statements until module two. In lesson two of this module, we will explore some basic bookkeeping tools that will get you ready to create a set of financial statements. The material in this module is likely to take less than a week, but we will make up for it in module two.

Why Do We Have Accounting?10:08

What is Accrual Accounting?8:53

What is a Balance Sheet?9:14

What is an Income Statement?8:04

Comparing the Two Statements6:34

Meet the Instructors

Greg Miller
Professor
Ross School of Business

Welcome. In this video we're going to discuss

the income statement or the answer to the second big question in life.

I should probably remind you of what that second big question is first.

It's how well did the organization perform during

a given period of time or what happened over time?

The income statement was actually invented to answer that question.

People found they kept asking it over and over

again so they thought maybe what we should do is

create some sort of a tool that will get at this in

a standardized way across a lot of different companies.

It gives us the flow of the value changes for

a specific period of time so that we can answer this question of how well did we do?

Now, what do you need to know if you want to answer that question?

Let's think of it from a common sense standpoint first.

You're asking yourself what came into the firm?

What did we have to use up to get that to come into the firm?

And then how much net value did we create once this was all done?

Now, if you've looked at an income statement you haven't seen those words

because accountants have put them into some sort of an accounting speak or jargon.

When we talk about what came into a firm,

we call it revenue.

And when we talk about what you've used up,

we call that expenses.

And when we put the two of these together to

figure out how much net value creation you've had,

we call that net income.

Let me give you a little more insight into what we mean by some of these items.

If you think of revenues,

a good working definition of it is value received from

customers for performing the company's primary activities.

That'll get you pretty much there.

But if you look at what accounting guidance has

said when they're trying to explain revenue,

they get a little more complicated.

They'll say," revenues are inflows or other enhancements of an asset of an entity

or settlements of its liabilities during a period from delivering or producing goods,

rendering services or other activities that

constitute the entities ongoing central operations."

What do they really mean?

That we've created value through our primary business activity.

Let's take a look at expenses.

We can get a pretty good working definition there, too.

Expenses are value used up during the period in order to create

revenues or fulfill other requirements of the firm during this period.

Now again, the standard setters have made this a little more complicated.

They tell us expenses are outflows or other using up of

assets or incurrences of liabilities during a period from delivering or producing goods,

rendering services or carrying out other activities

that constitute the entities ongoing central operations.

Again, what they're really trying to get out there is,

we've done something that's used up value during

this period and we're going to call that an expense.

Now that we have definitions let's think about

how all this comes together in an income statement.

We're going to look at the basic format.

Income statements always start with revenue at the top.

When people use that phrase top line,

that's what they mean, how much revenue did you have?

That's all the value that's come into the firm.

Now what we're going to do is think about all the expenses it took to create that value.

But on an income statement,

we're going to break those expenses down into different categories.

Each of those categories represents a group of expenses that behave in a similar way.

So, the very first expense we think about,

is cost of goods sold.

Those are the costs that are so directly related to

generating the revenue that we think we can match it up pretty closely.

When we take the revenues and then we take out the costs of goods

sold that leads to what's called gross profit.

I'm sure that's a term you've heard before.

It's the gross profit because it's only considering

some of the cost that we had to incur to generate the revenue.

So it's gross of those costs but we haven't netted out the rest of them.

What are those other costs?

Well, we've got this category called selling general and administrative expenses.

Often people will call this SG&A,

if you've heard that term before.

Now, you'll notice the very first word here is

selling so you're probably asking yourself,

well, why isn't that in cost of goods sold?

These may be selling expenses that aren't quite as direct.

For example, in cost of goods sold we would put all

of the cost of building the item we're going to sell.

In selling we might put something like

the cost of the sales people who stand on the floor.

We're going to pay them the same this period no matter how much they actually

sell so it's not as direct as the cost of goods sold.

Whether a firm puts a specific cost in cost of goods sold or

selling general and administrative really varies with the firm's business model.

We'll talk about this in some other videos as well,

but there's some judgment involved in the geography of where

things go on the income statement depending on how you think about your business model.

Now, after we have those selling,

general and administrative expenses,

we also have other operational expenses.

You're probably asking yourself what's left after the selling,

general and administrative expenses?

Well, it's other.

That's why other's in the name.

Again, it really varies across companies.

For example, in most companies they would put

the cost of the accountants who keep track of everything in selling,

general and administrative expense if accountants were part of the administration.

But some companies might say, "well,

those are other operational expenses because there are things that we're

doing separate from running the underlying business."

Now, however they lump all of these things,

once they've put together all of these operating expenses,

we come down to what we call operating profit.

When you hear people use the term 'below the line',

this is usually the line they're talking about.

This line item tells us at this point these are the basic profits,

the net value that we've created from the ongoing operations of our firm.

Now, there are still expenses that go below those though,

other incomes and expenses.

This is things like our taxes that we're going to

pay or some sort of expenses for a non-typical item.

Once we take out those other expenses we

finally have this line item called gains and losses.

These are representing economic changes in value of the firm that don't come

from ongoing primary activities and we'll come back to these in several videos.

After all of those items we finally come down to

that net income number which represents the total value created for the firm.

Now, we're going to go back in and in

other videos look at each one of these line items in

much more detail but it's important for you to keep

in mind this overall structure of an income statement.

When I talk about geography and you may hear other people use

this term or they may call it classification or other words like that,

what they're saying is,

"in what part of the income statement do we include

a certain cost or a certain value that's come in?"

And the structure always pretty much looks like this so

that it gives you some idea of what your options would be.

Now, let's move on to the more important part.

Once you have an income statement,

what are you going to use it for?

Remember, our goal is to provide information to decision makers so

the income statement should provide information on important decisions.

What if you're asking a question like,

"How much should we sell during this period?

The income statement would be great for that," or "What did it cost us to make sales?

How much value did we create from our core operations?

What did it cost us to run our administrative services this period?

How much net value did we create as a company?"

Or "How much interest did we incur during this period?"

Notice what all of these questions have in common.

They're all talking about some sort of value change that happened over a specific period.

Any time you're asking yourself a question like that,

the income statement is the right place to start.

I hope these video has helped you understand what the income statement is good for and

the format of the income statement so that you can

better use it as a tool for making decisions in the future.

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