Financial statements are essential for tracking a company’s financial health. When preparing financial reports, the income statement is the first financial statement to be prepared. It provides a summary of revenues, expenses, and profits or losses over a specific period.
This topic explains why the income statement is prepared first, its components, and how it affects other financial statements.
Why Is the Income Statement Prepared First?
The income statement is the first financial report prepared because it determines the net income or net loss for a period. This figure is then used in the statement of retained earnings and later in the balance sheet.
Since the income statement reports revenues and expenses, it provides a clear view of a company’s profitability, which is crucial for making business decisions.
Understanding the Income Statement
The income statement (also called the profit and loss statement) summarizes a company’s financial performance over a set time, such as a month, quarter, or year.
Key Components of the Income Statement
The income statement is divided into several sections:
- Revenue (Sales): The total amount earned from business operations.
- Cost of Goods Sold (COGS): The direct costs of producing goods or services.
- Gross Profit: Revenue minus COGS.
- Operating Expenses: Costs related to business operations, such as rent, salaries, and utilities.
- Operating Income: Gross profit minus operating expenses.
- Other Income and Expenses: Includes interest, taxes, and other financial activities.
- Net Income (or Net Loss): The final profit or loss after all expenses.
Example of an Income Statement
Below is a simplified income statement for a small business:
ABC Company – Income Statement for the Year Ending December 31, 2024
| Category | Amount ($) |
|---|---|
| Revenue (Sales) | 100,000 |
| Cost of Goods Sold | (40,000) |
| Gross Profit | 60,000 |
| Operating Expenses | (20,000) |
| Operating Income | 40,000 |
| Other Expenses (Taxes, Interest, etc.) | (5,000) |
| Net Income | 35,000 |
This format helps business owners, investors, and stakeholders analyze the company’s financial performance.
Relationship Between Financial Statements
The income statement connects to other financial reports:
-
Income Statement → Statement of Retained Earnings
- The net income from the income statement is transferred to the statement of retained earnings.
-
Statement of Retained Earnings → Balance Sheet
- The ending retained earnings balance is used in the equity section of the balance sheet.
-
Balance Sheet → Cash Flow Statement
- The cash flow statement starts with net income, adjusting for non-cash items and changes in working capital.
This sequence ensures accurate financial reporting.
Difference Between the Income Statement and Other Financial Statements
Each financial statement serves a different purpose:
| Financial Statement | Purpose | Prepared First? |
|---|---|---|
| Income Statement | Shows profitability | Yes ✅ |
| Statement of Retained Earnings | Tracks profit reinvestment | No |
| Balance Sheet | Displays assets, liabilities, and equity | No |
| Cash Flow Statement | Analyzes cash inflows and outflows | No |
Importance of Preparing the Income Statement First
1. Helps Determine Profitability
Business owners need to know if their company is profitable or operating at a loss before preparing other financial statements.
2. Provides Data for Other Reports
Since net income flows into other financial statements, the income statement must be completed first.
3. Assists in Business Decision-Making
Understanding revenue, expenses, and net profit helps businesses plan for growth, manage costs, and attract investors.
Common Mistakes When Preparing the Income Statement
Even though the income statement is the first financial report prepared, errors can occur. Here are some common mistakes to avoid:
1. Misclassifying Expenses
- Mistake: Recording a capital expense as an operating expense.
- Solution: Ensure all expenses are categorized correctly.
2. Ignoring Non-Operating Income and Expenses
- Mistake: Excluding interest income, tax expenses, or gains/losses from the statement.
- Solution: Include all relevant financial activities.
3. Using Incorrect Revenue Recognition Methods
- Mistake: Recording revenue before it is earned.
- Solution: Follow proper accounting principles (accrual or cash basis).
The income statement is always prepared first because it determines net income, which is necessary for the statement of retained earnings, balance sheet, and cash flow statement.
By preparing the income statement correctly, businesses can maintain accurate financial records, assess profitability, and make informed decisions.