You will need to open up an income statement for sole-proprietorship, partnership, private/public company, and manufacturing company.
Purposes of Income Statement:
1) To calculate the profits or losses of a business;
2) To prepare reports for stakeholders, (stakeholders are people who are interested in your business, it could be creditors or investors); and
3) To calculate tax required by government policies.
Understand Gross Profit
Most people doesn’t know what is the meaning of gross profit, they only know it’s a form of profit! This is the same as knowing nothing at all!
GROSS PROFIT is profit resulting from your sales over cost of goods sold.
Imagine you yourself selling one DVD movie to one customer at $4. This is your sale, $4.
The cost of your empty DVD disc is $0.50. This is your cost of goods sold. * People tend to be confused with the term ‘goods’. Goods is a term used to refer to a lot of things, and in this case, it means lots of empty DVDs. But for illustration purpose. I only used one DVD as an example.
Go back to the definition of Gross Profit,
We can rewrite it as
Gross Profit = Sales – Cost of Goods Sold
= 4 – 0.50
Understand Cost of Goods Sold
Now, I wonder if you have realized that the phrase of ‘cost of goods sold’ does seems tricky.
Cost of Goods Sold can be further broken down into it’s part,
Opening Inventory+ Purchases – Closing Inventory = Cost of Goods Sold
You can skip the explanation if you want, but for some reason, I think learning it can actually reinforce your memory. There are cases where people sometimes couldn’t recall their memory due to last minute revising. And this will be the time you apply your understanding.
At the beginning of the year, you have 200 empty DVDs at hand. And during the year, you have purchased 400 empty DVDs. At the end of the year, you are left with 100 empty DVDs. Assume the price of Empty DVDs is $0.50.
If you really concentrate on the word Cost Of Goods Sold, you will see that it means the original cost of empty DVDs that have been sold. Now, this 100 empty DVDs left are ‘unsold’. Therefore, there are not included in the calculation of Cost of Goods Sold.
Now, back to Opening Inventory and Purchases. Why do we have to add it up?
Imagine your shop is selling DVDs, if you don’t buy empty DVDs, how can you sell your final DVDs to customer? Now if you already have 200 empty DVDs at hand, you need to buy more in order to sell enough for your customers. This is the reason why Opening Stock needs to add up with Purchases.
By combining all of this explanation, therefore we arrived at the same formula given earlier of:
Cost Of Goods Sold = Opening Stock + Purchases – Closing Stock
Now we are all done, this is how we can start to draw an income statement.
[Please note that Trading & Profit and Loss Account = Income Statement! For the explanation below, I have retained earlier explanation for ease of understanding.]
Trading Account is simply a calculation of Gross Profit. You will get to see it later. But for now, just know this,
Gross Profit = Sales – Cost of Goods Sold
Gross Profit = Sales – (Opening Stock + Purchases – Closing Stock)
Points to remember:
1) Mark is awarded to title.
2) Use Net Sales instead of Sales*
3) Use Net Purchase instead of Purchase*
*If applicable, I will further explain it later on.
Net Sales / Turnover
Sales need to be net, i.e. after any deduction on sales. If you had been selling 400 DVDs to customers, they are bound to be some customers which would come after you claiming bad DVDs. And in this case, say 30 DVDs were returned to you. This is called Sales Return or Return Inward. You need to memorize both of the terms. Assuming the selling price was at $4. Now we try to compute the Net Sales.
Net Sales / Turnover = Sales – Sales Return / Return Inward
Net Sales = (400 – 30) x 4
= 370 x 4
In exam, sales return was sometimes used instead of return inward, or otherwise. Therefore, it is important to remember their terms.
Just like Net Sales, Net Purchases are any addition or deduction made to the original purchases. In this case, imagine you purchased 600 empty DVDs. The cost of this purchases may include cost of insurance, freight cost or transportation cost or carriage inwards, purchase return or return outwards and etc. As long as anything that you paid in order to get that 600 DVDs into your shop, you will have to add it. Whilst anything you return back to your suppliers, you deduct it from your original purchases.
Net Purchases = Purchases + Any Cost That You Paid* – Return Outward
* The reason that I put ‘any cost that you paid’ is because there are too many additions that can be included, students should remember the general rule of ‘anything that you paid to get the DVDs into your shop.’
Profit And Loss Account
Inside Profit And Loss Account,
Net Profit = Gross Profit + Revenues/Other Income- Expenses
= A positive amount is called Net Profit
= A negative amount is called Net Loss
In most examination, the answers will always be Net Profit. Unless you are in A Level, then a loss is also possible.
Other Income is any amount of money that profits a business. For instance, discount received from purchasing the empty DVDs.
Position on Vertical format, below Gross Profit, above Expenses.
Expenses are any amounts that will not profit a business but are necessary to keep the business operating. Example of expenses include rent, wages, salaries, electricity, depreciation, discount allowed and etc.
Position on Vertical Format, below Revenues, above Net Profit.
Income Statement – Vertical Format
Updated on 12/11/2017
- Edited grammatical errors.
- Changed ‘Trading and Profit & Loss Account’ to ‘Income Statement’.
- Changed ‘stock’ to ‘inventory’.
- Revised the format of Income Statement to GCSE ‘O’ Level Examination standard (also the terms used such as ‘stock’ to ‘inventory’).
- Removed Horizontal Format style of Income Statement. (Please learn vertical format instead).