2. Components of the statement of financial results and their calculation

2. Components of the statement of financial results and their calculation
An income statement is a financial report detailing a company’s income and expenses over a reporting period. It can also be referred to as a profit and loss (P&L) statement and is typically prepared quarterly or annually. An income statement typically includes the following information:

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  Revenue: How much money a business took in during a reporting period
  
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  Expenses: How much money a business spent during a reporting period
  
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  Costs of goods sold (COGS): The total costs associated with component parts of whatever product or service a company makes and sells
  
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  Gross profit: Revenue minus costs of goods sold
  
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  Operating income: Gross profit minus operating expenses
  
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  Income before taxes: Operating income minus non-operating expenses
  
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  Net income: Income before taxes
  
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  Earnings per share (EPS): Net income divided by the total number of outstanding shares
  
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  Depreciation: Value lost by assets, such as inventory, equipment, and property, over time
  
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  EBITDA: Earnings before interest, depreciation, taxes, and amortization
  

Income statements depict a company’s financial performance over a reporting period. Because the income statement details revenues and expenses, it provides a glimpse into which business activities brought in revenue and which cost the organization money—information investors can use to understand its health and executives can use to find areas for improvement.
An income statement presents the revenues and expenses and resulting net income or net loss for a specific period of time. The income statement reports the success or profitability of the company’s operations over a specific period of time. For example, Softbyte Inc.’s income statement is dated “For the month ended September 30, 2020”. It is prepared from the data which is given before appearing in the revenue and expense columns.
Softbyte Inc.
Income statement
For the month ended September 30,2020
Revenues
Service revenue $4700
Expenses
Salaries and wages expenses $900
Rent expense 600
Advertising expense 250
Utilities expense 200
Total expenses $1950
Net income $2750

The heading of the statement identifies the company, the type of statement, and the time period covered by the statement. The income statement lists revenue first, followed by expenses. Finally, the statement shows net income or a net loss. When revenues exceed expenses, net income results. When expenses exceed revenues, a net loss results. Note that the income statement does not include investment and dividend transactions between the stockholders and the business in measuring net income.

Mathematically, the Net Income is calculated based on the following:
Net Income = (Revenue + Gains) – (Expenses + Losses)
To understand the above details with some real numbers, let’s assume that a fictitious sports merchandise business, which additionally provides training, is reporting its income statement for the most recent quarter.
The process of preparing income statements is also different in merchandising and manufacturing companies. The accountant must classify each item into categories in a correct way.

Cost of goods sold

Selling and administrative expenses

Selling and administrative expenses

Raw materials inventory

Work in process inventory

Finished goods inventory

Raw materials purchase

Direct labor

Manufacturing overhead

Cost flows and Classification in manufacturing company

Now we will look the components and their calculation structure in merchandising companies. Merchandising companies that purchase and sell directly to consumers are called retailers. Merchandising companies that sell to retailers are known as wholesalers. The primary source of revenues for merchandising companies is the sale of merchandise, often referred to simply as sales revenue or sales. A merchandising company has two categories of expenses: cost of goods sold and operating expenses.

Cost of goods sold is the total cost of merchandise sold during the period. This expense is directly related to the revenue recognized from the sale of goods.
Sales revenue - Cost of Goods Sold= Gross profit
Gross profit - Operating Expenses= Net income or loss
The flow of costs for merchandising company is as follows. Beginning inventory plus the cost of goods purchased is the cost of goods available for sale. As goods are sold, they are assigned to cost of goods sold. Those goods that are not sold by the end of the accounting period represent ending inventory. Companies use one of two systems to account for inventory: a perpetual inventory system or a periodic inventory system.
In a perpetual inventory system, companies keep detailed records of the cost of each inventory purchase and sale. These records continuously – perpetually – shoe the inventory that should be on hand for every item. For example, a Ford dealership has separate inventory records for each automobile, truck, and van on its lot and showroom floor. Similarly, a Kroger grocery store uses bar codes and optical scanners to keep a daily running record of every box of cereal and every jar of jelly that it buys and sells. Under a perpetual inventory system, a company determines the cost of goods sold each time a sale occurs. Perpetual inventory is a method of accounting for inventory that records the sale or purchase of inventory immediately through the use of computerized point-of-sale systems and enterprise asset management software. The perpetual inventory provides a highly detailed view of changes in inventory with immediate reporting of the amount of inventory in stock, and accurately reflects the level of goods on hand. Within this system, a company makes no effort at keeping detailed inventory records of products on hand; rather, purchases of goods are recorded as a debit to the inventory database. Effectively, the cost of goods sold includes such elements as direct labor and materials costs and direct factory overhead costs. A perpetual inventory system is distinguished from a periodic inventory system, a method in which a company maintains records of its inventory by regularly scheduled physical counts. A perpetual inventory system is superior to the older periodic inventory system because it allows for immediate tracking of sales and inventory levels for individual items, which helps to prevent stockouts. A perpetual inventory does not need to be adjusted manually by the company's accountants, except to the extent it disagrees with the physical inventory count due to loss, breakage, or theft.
The periodic inventory system is a method of inventory valuation for financial reporting purposes in which a physical count of the inventory is performed at specific intervals. This accounting method takes inventory at the beginning of a period, adds new inventory purchases during the period, and deducts ending inventory to derive the cost of goods sold (COGS).
Under the periodic inventory system, a company will not know its unit inventory levels nor COGS until the physical count process is complete. This system may be acceptable for a business with a low number of SKUs in a slow-moving market, but for all others, the perpetual inventory system is considered superior for the following main reasons:

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   The perpetual system continuously updates the inventory asset ledger in a company's database system, giving management an instant view of inventory; the periodic system is time-consuming and can produce stale numbers that are less useful to management.
   
2. 
   The perpetual system keeps updated COGS as movements of inventory occur; the periodic system cannot give accurate COGS figures between counting periods.
   
3. 
   The perpetual system tracks individual inventory items so that in case there are defective items—for example, the source of the problem can quickly be identified; the periodic system would most likely not allow for prompt resolution.
   
4. 
   The perpetual system is tech-based and data can be backed-up, organized, and manipulated to generate informative reports; the periodic system is manual and more prone to human error, and data can be misplaced or lost.
   

In a periodic inventory system, companies do not keep detailed inventory records of the goods on hand throughout the period. Instead, they determine the cost of goods sold only at the end of the accounting period -- that is, periodically. At that point, the company takes a physical inventory count to determine the cost of goods on hand.
To determine the cost of goods sold under a periodic inventory system, the following steps are necessary:

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   Determine the cost of goods on hand at the beginning of the accounting period.
   
2. 
   Add to it the cost of goods purchased.
   
3. 
   Subtract the cost of goods on hand at the end of the accounting period.
   

Companies can choose from several methods to account for the cost of inventory held for sale, but the total inventory cost expensed is the same using any method. The difference between the methods is the timing of when the inventory cost is recognized, and the cost of inventory sold is posted to the cost of sales expense account. The first in, first-out (FIFO) method assumes the oldest units are sold first, while the last-in, first-out (LIFO) method records the newest units as those sold first. Businesses can simplify the inventory costing process by using a weighted average cost, or the total inventory cost divided by the number of units in inventory.
The calculation of the Cost of Goods Sold¹
Cost of Goods Sold is also known as “cost of sales” or its acronym “COGS.” COGS refers to the cost of goods that are either manufactured or purchased and then sold. COGS counts as a business expense and affects how much profit a company makes on its products.
The cost of goods sold is found on a business’s income statement, one of the top financial reports in accounting. An income statement reports income for a certain accounting period, such as a year, quarter, or month.
COGS is usually found on an income statement directly beneath “sales” or “income.” An income statement is also called a “profit and loss statement.” The cost of goods sold is actually a tax reporting requirement. According to the IRS, companies that make and sell products or buy and resell goods need to calculate COGS to write off the expense. This decreases the total amount of taxes they need to pay. To do this, a business needs to figure out the value of its inventory at the beginning and end of every tax year. Its end-of-year value is subtracted from its beginning of year value to find the cost of goods sold. The below section deals with calculating the cost of goods sold. A higher cost of goods sold means a company pays less tax, but it also means a company makes less profit. Something needs to change. The cost of goods should be minimized in order to increase profits.
The items that make up costs of goods sold include:

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  Cost of items intended for resale
  
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  Cost of raw materials
  
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  Cost of parts used to make a product
  
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  Direct labor costs
  
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  Supplies used in either making or selling the product
  
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  Overhead costs, like utilities for the manufacturing site
  
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  Shipping or freight in costs
  
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  Indirect costs, like distribution or sales force costs
  
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  Container costs