Introducing The Income Statement 1

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1 Circular 645 Introducing The Statement 1 P.J. van Blokland 2 Background This publication is one in a series outlining the four basic financial statements used in business today. These statements are the balance sheet, the income statement, the cash flow, and the statement of change in financial position. A fifth publication shows how these statements link together and a sixth shows how to use the information provided by the statements for a simple business analysis. This series tries to keep things simple and assumes no prior experience with financial statements. The income statement and its essential features are outlined in this publication. This should provide the reader with sufficient information to complete a proper income statement. Farmers, ranchers, nursery and grove operators, extension agents, agricultural lenders, and students should find this publication of interest. The series is based on a widely used methodology developed by Frey and Klinefelter called "Coordinated Financial Statements for Agriculture" (1). The example statements in the appendix come from Frey et al. (2). The publications in the series are listed in the reference section (3, 4, 5, 6, 7). What is an Statement? An income statement shows what has happened in a business over a specific period of time, usually a year. It is similar to a movie which illustrates changes in the cost and returns of a business over time, compared with the balance sheet, which just presents a snapshot of the firm on one specific day. As we will see later, the income statement is the flow statement that links two balance sheets. What Does an Statement Look Like? A complete income statement with its accompanying schedules is shown in the appendix, but it should be helpful to first examine simpler versions of this statement. A simple income statement is shown in Table 1. The income statement simply lists the revenue and expenses that occurred over the year and, by subtraction, the residual income. This income is available for family living expenses, paying income taxes, paying principal on loans, and investing in the business. However, the form as presented in Table 1 tells us little about the contributions of the various enterprises or how expenses were allocated. It also uses the three basic income statement terms, 1. This document is Circular 645, one of a series of the Department of Food and Resource Economics, Florida Cooperative Extension Service, Institute of Food and Agricultural Sciences, University of Florida. Published: May Reviewed: June Please visit the EDIS Web site at 2. P.J. van Blokland, Associate Professor, Food and Resource Economics Department, Indian River REC--Ft. Pierce, FL; Florida Cooperative Extension Service, Institute of Food and Agricultural Sciences, University of Florida, Gainesville, The Institute of Food and Agricultural Sciences (IFAS) is an Equal Employment Opportunity - Affirmative Action Employer authorized to provide research, educational information and other services only to individuals and institutions that function without regard to race, creed, color, religion, age, disability, sex, sexual orientation, marital status, national origin, political opinions or affiliations. For information on obtaining other extension publications, contact your county Cooperative Extension Service office. Florida Cooperative Extension Service / Institute of Food and Agricultural Sciences / University of Florida / Larry R. Arrington, Interim Dean

2 Introducing The Statement 2 namely, revenue, expenses, and income, rather loosely. A more detailed income statement is shown in Table 2. This is a more useful income statement, assuming that the items such as crop sales or variable costs are broken down into their components, e.g., corn, wheat, and cotton sales or fertilizer, chemical, and fuel costs. We can see here the contributions of the various enterprises and the gross margin of the farm. Gross margin shows what is left to pay fixed costs after deducting all variable costs. The farmer, therefore, can operate in the short run if he covers his variable expenses. Gross margin is also used in enterprise selection and analysis. For example, if two enterprises have similar fixed costs, such as corn and soybeans, then the farmer generally will grow the crop with the higher gross margin. Finally, this statement calculates net farm income or what is available for family living, financing, investing, and paying income and Social Security taxes. However, the form still does not provide all the information that managers need to make useful decisions about the business. Table 2 uses what is termed cash accounting methods, rather than accrual. The accrual method will provide better information because it shows the inventory changes that occur during the year. In addition, the form excludes a major proportion of the cash coming into the farm during the year. This is off-farm income, and for the majority of U.S. farms it is difficult to separate this income from the net farm income. The choice is made by the individual farm manager. At this stage, it may be more convenient to include it. The form also does not show what the farm itself produced during the year. All these points will be discussed more fully, but at this stage it might be more interesting to see what a summary of a useful income statement would look like (Table 3). How is an Statement Constructed? The three sections of a complete income statement - revenues, expenses, and income - will be examined in detail. Revenue Accrual System. Farm revenue mainly comes from enterprise sales. But revenue is also composed of inventory change, and this point requires some explanation. A manager needs to use an accrual system to really know what is going on in a business. A cash form of revenue accounting looks only at actual sales during the year, while an accrual system also includes inventory change. If we want to make meaningful management decisions, it is important to use the accrual system of accounting on most farms, simply because changes in inventory affect the business. The accrual system does require more work, but despite a generally held opinion, it will rarely lead to more taxes than the cash system. In fact, it will probably reduce taxes. So what is it? An illustration may help. A farmer sells $100,000 of grain during the year and feels he has done well. But what happened if his inventory of grain on January 1 was $40,000 and on December 31 it was $15,000? Some $25,000 of sales came from inventory and only $75,000 from production during the year. Not only would he be misled by his performance, but he has also reduced his current assets by $25,000. Now all this is fine if he knows what happened. But in the majority of cases, farmers are not certain what their beginning and ending inventories are, and therefore they are not certain what role this year's production played in net farm income and what came from previous years. So the accrual system is the way to go. Value of Farm Production. The other point in the revenue section concerns the value of farm production. This item is used in analyzing the farm business. It is important because it shows only what is produced by the farm. Suppose the farmer buys feeder cattle at 700 pounds and fattens them up to 1,000 pounds. His farm

3 Introducing The Statement 3 has added only 300 pounds before the sale, yet his revenue will reflect the full 1,000-pound value. So the total revenue overstates what the farm itself produced. We are after the value added by the farm. If he both raised and fattened his own cattle, then the total revenue and the value of farm production from these cattle would be the same. The same argument applies to feed purchased. If a farmer buys all his feed, say, to fatten pigs, he is again using inputs produced on other farms. If he produced this feed himself, the costs involved would be reflected in his expenses. Remember, we are after the value of farm production. Livestock and feed purchases are still expenses and have the same tax treatment. All we are doing is putting them in a better place in the income statement for managerial analysis. This section is fairly straightforward. We simply list the expenses that occurred during the year, though there may also be some inventory adjustments. For example, the farm supplies of fuel, fertilizers, or chemicals may have changed, and the change should be shown under the appropriate item. Realize that principal payments are not included in an income statement. These are balance sheet and cash flow items and only interest payments are shown here. This section deals with net farm income and off farm income in order to produce the true bottom line of any business, namely, net income. Net income is what is available to meet family living expenses, to invest on and off the farm, and to pay principal on capital debts (i.e., loans outstanding on intermediate and long-term assets such as machinery and real estate). Off-farm income is a net figure and excludes any expenses incurred in earning this income. These expenses are standard deductions that are listed in Schedule C of Form 1040, such as car expenses, depreciation, insurance, office supplies, repairs, and utilities involved in an off-farm job. that are part of the family living budget, such as clothes and lunches, are unfortunately not deductible. It may also be easier to record the wage received before taxes and let the income tax and Social Security line on the income statement take care of both farm and off-farm taxes. Thus, this section of the statement shows the amount of income earned by the farm and what is earned off farm in producing net income. As two-thirds of the U.S. farm family income is currently earned off farm, it is important for the manager to follow the relative proportion of all contributions to net income. Final Comments So this is what the income statement looks like. It provides a moving picture of the business and farm family performance for the year and links the balance sheets together. For example, the December 31, 1984 balance sheet would provide the inventory starting point for the January 1 to December 31, 1985 income statement, and the December 31, 1985 balance sheet becomes the end point. What happened during the year is shown by the income statement's net income, and this figure is largely responsible for any change in the net worth of the business. And that's all there is to it. Appendix Comments A complete income statement is shown in the appendix (Appendix pages 1,2, and 3 ). Note that the gross margin section is not included. However, it is worth at least considering including it. Realize also that this complete income statement is built from the accompanying schedules. These schedules take data from the beginning and ending balance sheets and from the year 5 records. These figures are entered in each schedule and the final schedule figures go on the income statement. References Frey., Thomas L., and Danny A. Klinefelter. "Coordinated Financial Statements for Agriculture," Agri Finance, 2nd edition. Skokie, IL

4 Introducing The Statement 4 Institute of Food and Agricultural Sciences, University of Florida, Gainesville, FL van Blokland, P.J. Introducing Farm Business Analysis, Extension Circular No Florida Cooperative Extension Service, University of Florida, Gainesville, FL Frey., Thomas L. et al Unpublished working paper, van Blokland, PJ. Introducing the Balance Sheet, Extension Circular No.651. Florida Cooperative Extension Service, Institute of Food and Agricultural Sciences, University of Florida, Gainesville, FL van Blokland, P.J. Introducing the Cash Flow, Extension Circular No.656. Florida Cooperative Extension Service, Institute of Food and Agricultural Sciences, University of Florida, Gainesville, FL van Blokland, P.J. Introducing the Statement of Change in Financial Position, Extension Circular No.658. Florida Cooperative Extension Service, Institute of Food and Agricultural Sciences, University of Florida, Gainesville, FL van Blokland, P.J. Linking the Financial Statements, Extension Circular No Florida Cooperative Extension Service,

5 Introducing The Statement 5 Table 1. A Simple Statement. Revenue Sales $ Total Sales (1) Costs $ Total Costs (2) (1) - (2) = $ Table 2. A more detailed income statement. Revenue $ Crop sales Livestock sales Other TOTAL REVENUE (1) Variable costs (2) (1) - (2) = Gross margin (3) Fixed costs (4) (2) + (4) = TOTAL COSTS (5) (1) - (5)

6 Introducing The Statement 6 Table 2. A more detailed income statement. or (3) - (4) = NET FARM INCOME Table 3. Summary of a Complete Statement. Revenue $ Crop sales (+) or (-) inventory change Livestock sales (+) or (-) inventory change Government payments Other Total revenue (1) Minus value of livestock and feed bought VALUE OF FARM PRODUCTION (2) Varaible costs (including interest) (3) (2) - (3) = Gross margin (4) Fixed costs (5) (3) + (5) = TOTAL COSTS (6) (2) - (6) or (4) - (5) = Net farm income plus off-farm income Minus income and social Security taxes NET INCOME