A business income statement, also called a profit and loss statement, is used to measure revenues and expenses over an accounting period. Unlike the balance sheet, which reflects the financial position at any given point in time, the income statement shows income and expenses for a period of time, usually one year. Income statements can be used to determine income tax payments, analyze a business’ expansion potential, evaluate the profitability of an enterprise and assist in loan repayment analysis.
Identifying the entity
Identifying the business entity is also important when preparing an income statement. The income statement should be prepared for the same entity as the balance sheet, either business, personal or consolidated. Because of the interrelationship between the balance sheet and income statement, the time period covered by the income statement should be the time between the beginning and ending balance sheets. The most common period is annually, although quarterly or monthly statements are sometimes desired.
Revenues and expenses
All income statements include two categories: revenues and expenses. However, income statements can be prepared two ways, depending on how revenues and expenses are derived. A cash income statement measures revenues only when received and expenses only when paid. An accrual income statement measures revenues when generated and expenses when incurred, whether or not cash actually changes hands. The cash income statement (illustrated in Exhibit 4) is the easiest to prepare but is inadequate for measuring true profitability because it fails to match the timing of income and expenses.
Depreciation, although not a cash expense, is included on both the cash and accrual income statements as a way of spreading the cost of capital purchases over their useful life. Accelerated depreciation is frequently used for tax purposes. If this is the case, it should be noted that accelerated depreciation is being used, because it could distort profitability.
The Schedule F tax form is often used as an income statement. Although the Schedule F can offer some valuable insight, it is not an income statement and should not be used as such. However, in some cases it can be used effectively if three to five years of information is provided and the business is in a stable operating mode with no major adjustments. Using a series of Schedule Fs as an income tax statement rests on the assumption that shifting income and expenses will even out over the years.
The Farm Financial Standards Council recommends the use of an accrual-adjusted income statement. Ideally, a business’ accounting records will produce an accrual statement; however, in practice, adjustments are made to the cash income statement (or Schedule F) to gain an accrual-adjusted income statement.
Exhibit 5 below illustrates how accrual adjustments are made. To convert cash income to accrual adjusted income, we must look at changes between the beginning-of-year and end-of year balance sheets. Adjustments to revenue include changes in inventories and accounts receivable. In the expense section, adjustments are made for changes in unused assets, prepaid expenses, accrued expenses and accounts payable. Gains or losses on the sale of capital assets are also added or subtracted.
Revenues and expenses can come from a variety of sources in an agricultural business. Categories of revenues that are usually included in an income statement are:
- Realized cash revenues from the sale of agricultural commodities.
- Unrealized income from changes in the quantity or value of crop and livestock inventories.
- Realized capital gains from the sale of capital assets.
- Income from custom work and government payments.
Expense items included on the income statement vary with the type of business but include all operating expenses, interest and depreciation.