Why Should the Income Statement Be Prepared First?

Financial statements provide a comprehensive view of a company’s financial performance and position, offering insights for stakeholders like investors, creditors, and management. These documents summarize financial activities and health, helping to assess profitability, stability, and economic standing. They are also important for tax compliance and informed business decisions.

The Income Statement’s Critical Output

The income statement, often called the profit and loss (P&L) statement, details a company’s financial performance over a specific period, such as a quarter or a year. It lists revenues, expenses, gains, and losses, ultimately calculating the net income or net loss. Revenues are income from sales or services, while expenses are costs incurred to generate those revenues.

Net income is the positive result when a company’s revenues and gains exceed its expenses and losses. Conversely, a net loss occurs when expenses outweigh revenues. This “bottom line” figure indicates a company’s profitability or unprofitability during the reporting period. It serves as a primary measure of how efficiently a business operates.

The income statement does not differentiate between cash and non-cash transactions, including sales made on credit and expenses incurred but not yet paid. Its purpose is to show how net revenue transforms into net earnings. This makes the net income figure an output summarizing a period’s financial performance before considering cash movement.

Connecting Net Income to Other Financial Statements

The net income or net loss calculated on the income statement is a direct input for other financial reports. It directly impacts the retained earnings component within the equity section of the balance sheet. Retained earnings represent the cumulative portion of a company’s profits reinvested back into the business rather than distributed as dividends to shareholders.

When a company generates net income, this amount increases the retained earnings balance on the balance sheet, reflecting an increase in shareholders’ equity. Conversely, a net loss will decrease retained earnings. This direct flow establishes a clear link, making the income statement a prerequisite for accurately completing the balance sheet.

The net income figure also serves as a starting point for preparing the Statement of Cash Flows, particularly when using the indirect method. This method begins with net income and then adjusts for non-cash expenses, such as depreciation, and changes in working capital accounts to arrive at the actual cash flow from operating activities. This highlights the interconnectedness of the financial statements, as the income statement’s output informs the cash flow analysis.

The Underlying Accounting Principles

The sequential preparation of financial statements, starting with the income statement, is rooted in accounting principles. The accrual basis of accounting is central to this order, dictating that revenues are recognized when earned and expenses when incurred, regardless of when cash changes hands. This provides a more accurate picture of a company’s financial performance over a period.

The matching principle requires expenses to be recognized in the same period as the revenues they helped generate. For instance, the cost of goods sold is expensed when the related sales revenue is recognized. This principle ensures the income statement accurately reflects the profitability of specific business activities by associating costs with the benefits they produce.

These principles collectively make the income statement the logical first step. By applying accrual accounting and the matching principle, the income statement determines profitability or unprofitability for a given period. This profitability figure, net income, is then used for updating the equity section of the balance sheet and for reconciling cash flows, establishing the order for comprehensive financial reporting.