Income Statement/ Profit and Loss Statement – Meaning and Example

Income Statement

An Income Statement (also known as a Profit and Loss Statement) shows a business’s net income for a certain period. It is prepared by making closing entries.

 

Closing entries

Closing entries do two things:

  • Transfer revenues and expenses balance to one single place – the income summary account – so that the net income can be computed.
  • Close the books: to reset the revenues and expenses accounts balance to zero.

 

You may be asking: why do we need to reset the balance of the revenues and expenses account? This can be explained with the analogy below:

Say you have just picked up fishing as a new hobby and you are interested in counting how much you have caught each day. So on Day 1, you went fishing and caught the following:

 

 Income Statement Analogy  Income Statement Analogy  Income Statement Analogy
 Income Statement Analogy  Income Statement Analogy

Your friend asks you how much you have caught, so you count: one… two… three… four… five… 5!

On Day 2, you go fishing again and got the following results:

 Income Statement Analogy  Income Statement Analogy  Income Statement Analogy

How many have you got today? 8? No, you do not start counting from 6 (where you left off last time). Instead, you start counting at 1.

The income statement is in a way similar to this. It shows the business’s net income for a certain period, e.g. a year. To keep track of how much your business makes each year, you have to reset the revenue and expenses account to zero at year end.

 

So how do you actually prepare an Income Statement?

Start off by going through the revenue accounts and expenses accounts and find the total of each account. Say your business produced the following figures:

Account Type Balance ($)
Sales revenue Revenue 10,000 Credit
Interest income Revenue 320 Credit
Cost of Goods Sold Expense 5,500 Debit
Selling and Distribution Expense 1,000 Debit
Administrative Expenses Expense 650 Debit

 

Now, debit the revenue accounts and credit the income summary account

Dr. Sales revenue 10,000
Cr. Income summary 10,000

 

Dr. Interest income 320
Cr. Income summary 320

 

The effects of these entries are as follows:

The income summary account now has credit entries of $10,000 and $320. This means we have transferred the revenue items from two separate accounts to one account.

We just debited the revenue accounts. The debit entries offset the credit balance of the revenue accounts. We have reset the revenue accounts to zero.

 

Next, we credit the expense accounts and debit the income summary account

Dr. Income summary 5,500
Cr. Cost of Goods Sold 5,500

 

Dr. Income summary 1,000
Cr. Selling and Distribution 1,000

 

Dr. Income summary 650
Cr. Administrative expenses 650

 

The effects of these entries are as follows:

The income summary account now has debit entries of $5,500, $1,000 and $650. This means we have transferred the expense items from three separate accounts to one account.

We just credited revenue accounts. The credit entries offset the debit balance of the revenue accounts. We have reset the debit accounts to zero.

Income Summary Account
(Debit) $ (Credit) $
Cost of Goods Sold 5,500 Sales Revenue 10,000
Selling and Distribution 1,000 Interest Income 320
Administrative expenses 650

Now we rearrange the items in the income summary account. The credit amounts will be treated as positive while debit amounts will be treated as negatives. The ending product will be as follows:

An Example of an Income Statement

An Example of an Income Statement

The end result is we have a positive amount of $3,170 on the bottom line. We have a credit amount of $3,170.

 

One Last Step

Now you have finished preparing an income statement, you have to close the income summary account as well. The “net income” amount represents how much your business has earned in 2014. Starting January 1 2015, this amount has to be reset. So we transfer this net income amount to our “retained earnings” account:

Dr. Income summary 3,170
Cr. Retained Earnings 3,170

 

“Retained Earnings” shows how much the business has accumulated throughout the years. It shows the number of fish you have caught since you started the hobby rather than how many you caught in a particular day. There is no need to reset the retained earnings account.

With the retained earnings account updated, you can now start preparing the Balance Sheet.

 

References:

Horngren, C., Sundem, G., Elliott, J., & Philbrick, D. (2014). Recording Transactions. In Introduction to Financial Accounting (Eleventh ed., pp. 110-112).

 

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