The income statement

The income statement (IAS 1 calls it the statement of profit or loss) reports performance over a period: the income the business earned and the expenses it incurred to earn it. It is built from the revenue and expense accounts of the adjusted trial balance — never from cash movements — so a sale made on credit in December is December revenue even if the customer pays in January.

A classified (multi-step) format adds subtotals, each answering a different question:

• Net revenue — sales less returns, allowances and discounts. What did customers actually commit to pay?
• Gross profit — net revenue less cost of sales (the cost of the goods sold, not of all goods bought). Is the business selling above what its goods cost? Gross margin = gross profit ÷ net revenue.
• Operating profit — gross profit less operating expenses: salaries, rent, utilities, advertising, depreciation, credit losses. Does the core business make money before funding decisions?
• Profit before tax — operating profit plus other income (such as interest earned on deposits) less finance costs (interest on borrowings). Interest sits below operating profit because it reflects how the business is financed, not how well it trades.
• Profit for the period — after income tax expense. This is the figure that flows into retained earnings.

What never appears: balance sheet items (cash, receivables, inventory still on hand, loans), repayments of loan principal (only the interest is an expense), purchases of long-term assets (they are capitalised and depreciated) and dividends (distributions to owners, shown in the statement of changes in equity). These are the most common errors in a draft statement — and every one of them distorts profit.

Expenses by nature or by function. IAS 1 lets an entity analyse expenses either by nature (employee costs, depreciation, raw materials) or by function (cost of sales, distribution, administration), whichever gives more relevant information. An entity using the function method must also disclose depreciation, amortisation and employee benefits expense by nature in the notes.

Worked example — reading Harbour's statement line by line. Start with gross sales of 120,000 and deduct customer returns of 3,000: net revenue 117,000. Deduct the cost of the goods actually sold (68,000) — not the 66,800 of goods bought: purchases and the cost of sales rarely match, and the difference is the change in inventory (here inventory moved from 23,200 to 22,000). That leaves gross profit of 49,000. Deduct the operating expenses of running the shop (salaries including the December accrual, rent used rather than rent paid, utilities, advertising, depreciation): operating profit 13,200. Deduct loan interest of 1,500: profit before tax 11,700. Deduct this year's tax charge of 2,340 (not the 1,900 paid this year, which settled last year's liability): profit for the year 9,360. The 6,000 loan repayment, the 12,000 of new equipment and the 3,000 dividend appear nowhere in it.