How to Create an Income Statement Step-by-Step

An income statement, often called a profit and loss (P&L) statement, serves as a financial report summarizing a company’s revenues, costs, and expenses over a specific period. Its main purpose is to show a business’s financial performance and how effectively it generates profit. Understanding this document is important for businesses to track their progress and for external parties, like investors, to assess financial health.

Identifying and Classifying Revenue

Revenue represents the total amount of money a business earns from its activities before any expenses are deducted. The most common source of revenue comes from selling products or providing services. This can include direct sales of goods, fees for services rendered, or recurring income from subscriptions.

Businesses may also generate revenue from non-operating sources, from activities outside core business functions. Examples include interest earned on investments, rent received from property not used in core operations, or dividends from stock holdings. Identifying all income sources, both operating and non-operating, is the first step in preparing a comprehensive income statement.

Revenue recognition, under accrual accounting, requires that revenue is recorded when it is earned, not necessarily when cash is received. This means if a service is performed or a product is delivered, the revenue is recognized even if the customer has not yet paid. This approach provides a more accurate picture of a company’s financial performance by matching revenue with the period it was earned.

Identifying and Classifying Expenses

Expenses are the costs a business incurs to generate its revenue. They are categorized to show where money is spent. Proper classification is important for accurate financial reporting.

One primary category is the Cost of Goods Sold (COGS), representing direct costs of producing goods or services. For manufacturers, this includes raw materials, direct labor, and manufacturing overhead like factory utilities. Service businesses have a similar concept, often called Cost of Services Sold, which includes expenses directly tied to service delivery.

Operating expenses are those incurred from normal day-to-day operations, not directly tied to production. Examples include administrative salaries, office rent, utilities, marketing, and insurance. Depreciation, expensing a tangible asset’s cost over its useful life, is also an operating expense.

Non-operating expenses are costs not directly related to a company’s core business activities. Common examples include interest paid on loans, losses from selling assets (e.g., old equipment), or one-time legal settlements. These expenses are typically presented separately on the income statement to distinguish them from the costs of regular operations, for a clearer view of core business performance.

Assembling the Income Statement

Constructing the income statement involves arranging the identified revenues and expenses into a standard format to calculate a company’s net income or loss. The process begins with total revenue.

From the total revenue, the Cost of Goods Sold (COGS) is subtracted to arrive at the gross profit. Gross profit shows money remaining from sales after covering direct production costs. For example, if a business had $500,000 in revenue and $200,000 in COGS, its gross profit would be $300,000.

Next, all operating expenses are deducted from the gross profit to calculate the operating income, also known as Earnings Before Interest and Taxes (EBIT). This reflects core business profitability before financing costs or taxes. Continuing the example, if operating expenses totaled $100,000, the operating income would be $200,000.

Finally, non-operating items, such as interest expense, are subtracted from the operating income, followed by income tax expense, to arrive at the net income. Net income, or the “bottom line,” represents the company’s total profit or loss after all expenses, including taxes. For instance, if interest expense was $10,000 and income tax expense was $40,000, the net income would be $150,000 ($200,000 – $10,000 – $40,000). The income statement indicates the period it covers (e.g., month, quarter, or year), providing a snapshot of financial performance.