How to Prepare an Income Statement

The income statement tells a clear story about a company’s financial performance over a specific period. It’s the report card that answers the fundamental question: "Did we make or lose money?" Preparing one correctly is a foundational accounting skill that provides vital information for business leaders, investors, and lenders. This guide will walk you through building an income statement from the ground up, explaining each component so you can understand the numbers, not just report them.

What Exactly Is an Income Statement?

Before you start building, it's important to grasp the core concept. The income statement, also known as the Profit and Loss (P&L) statement, summarizes a company's revenues, costs, and expenses during a specific timeframe, such as a month, quarter, or year. Unlike the balance sheet, which is a snapshot of a single moment in time, the income statement shows performance over a period.

At its heart, the income statement follows a simple formula:

Revenues - Expenses = Net Income

Everything else is just detail and context. Understanding the sub-calculations, such as gross profit and operating income, transforms the statement from a simple math problem into a powerful analytical tool.

Gathering Your Raw Materials: The Data You'll Need

You can't build a house without lumber and nails, and you can't prepare an income statement without accurate financial data. The primary source for this information is the trial balance, a report that lists the balances for every account in the general ledger.

From your trial balance and other accounting records, you'll need to pull the following totals for your chosen period:

• Revenue/Sales Figures: This includes all income generated from the sale of goods or services. Be sure to account for sales returns and allowances.
• Cost of Goods Sold (COGS): These are the direct costs tied to producing the goods or services you sell. For a product-based business, this includes raw materials and direct labor. For a service business, it might be the direct costs to deliver that service.
• Operating Expenses: These are the costs needed to run the business that aren’t directly tied to production. They are often categorized as Selling, General, and Administrative (SG&A) expenses. This includes salaries, rent, marketing, utilities, professional fees, and insurance.
• Non-Operating Items: This category includes revenues and expenses from activities outside the company's main line of business, such as interest income earned on investments or interest expense paid on debt.
• Income Tax Information: The provision for income taxes your business owes for the period. Accurately determining this figure often requires careful tax research.

Step-by-Step Guide to Building Your Income Statement

Once your data is gathered and organized, you can assemble the income statement. We’ll follow the "multi-step" format, which is more detailed and useful for analysis than the simpler "single-step" version.

Step 1: Start with the Top Line: Revenue

Your income statement always starts with your "top-line" revenue. This is the total amount of money generated from sales of your products or services.

Begin with your Gross Sales for the period. Then, subtract any contra-revenue accounts like Sales Returns and Allowances (for returned products) and Sales Discounts (offered for early payment). The result is your Net Revenue or Net Sales. This is the first official line item on your statement.

Example: A coffee shop has $100,000 in gross sales but processed $2,000 in refunds for incorrect orders. Their Net Revenue is $98,000.

Step 2: Calculate Cost of Goods Sold (COGS)

Next, you need to determine the direct cost of the products you sold. If you hold inventory, the standard COGS formula is:

Beginning Inventory + Purchases - Ending Inventory = COGS

If you run a service business, this might be called the Cost of Services or Cost of Revenue and would include the direct labor and supply costs associated with providing your service.

Example: The coffee shop started the quarter with $10,000 worth of coffee beans, milk, and cups. They purchased $30,000 more during the quarter and ended with $8,000 in inventory. Their COGS is $10,000 + $30,000 - $8,000 = $32,000.

Step 3: Determine Gross Profit

This is your first key profitability metric. It shows how much profit the business makes on its core products or services before overhead is subtracted.

Net Revenue - COGS = Gross Profit

A healthy gross profit indicates that your pricing and production costs are well-managed. A low or declining gross profit margin could signal issues with pricing power or rising supply costs.

Example: The coffee shop's Gross Profit is $98,000 (Net Revenue) - $32,000 (COGS) = $66,000.

Step 4: List Operating Expenses (OPEX)

Now, subtract the indirect costs required to keep the business running. These are the general overhead expenses. Common examples include:

• Wages and salaries (for non-production staff)
• Rent and utilities for your office or storefront
• Marketing and advertising costs
• Office supplies
• Insurance
• Depreciation and amortization expense

Summing these up gives you your Total Operating Expenses.

Example: The coffee shop's operating expenses total $35,000, which includes barista salaries ($25,000), rent ($5,000), marketing ($3,000), and utilities ($2,000).

Step 5: Calculate Operating Income

This figure reveals how much profit the company generated from its primary business activities. It's often referred to as Earnings Before Interest and Taxes (EBIT).

Gross Profit - Total Operating Expenses = Operating Income

This is a closely watched metric because it isolates the performance of the core business from the effects of financing (interest) and taxes.

Example: The coffee shop's Operating Income is $66,000 (Gross Profit) - $35,000 (Total Operating Expenses) = $31,000.

Step 6: Account for Non-Operating Items

Next, add or subtract any revenues and expenses unrelated to the central business operations. These can include:

• Interest Expense: Paid on business loans or lines of credit.
• Interest Income: Earned from bank accounts or investments.
• Gain or Loss on Sale of Assets: For example, selling a company vehicle for more or less than its book value.

Example: The coffee shop paid $1,000 in interest on a small business loan.

Step 7: Find Your Earnings Before Tax (EBT)

This is the pre-tax profit, calculated by adjusting operating income for non-operating items.

Operating Income +/- Non-Operating Items = Earnings Before Tax

Example: The coffee shop's EBT is $31,000 (Operating Income) - $1,000 (Interest Expense) = $30,000.

Step 8: Calculate the Bottom Line: Net Income

You’ve reached the final line. To get here, subtract the tax expense from your EBT.

Earnings Before Tax - Income Tax Expense = Net Income

Net income is arguably the most famous accounting figure. It shows the absolute profitability of the entire business after all revenues have been recognized and all costs and expenses have been accounted for. This profit can be distributed to owners as dividends or reinvested in the business.

Example: The coffee shop calculates its provision for income tax to be $6,000. Its Net Income is $30,000 (EBT) - $6,000 (Taxes) = $24,000.

Using Software to Automate the Process

While understanding the manual process is necessary for proper analysis and troubleshooting, most modern businesses don't build income statements in a spreadsheet. Accounting software automates this entire process, saving time and reducing the risk of manual error. The key is setting it up correctly.

• QuickBooks Online: After your Chart of Accounts is set up correctly and transactions are categorized throughout the period, QuickBooks can generate a P&L statement in a few clicks. It automatically pulls the data for each account and organizes it into the standard format.
• Xero: Similar to QuickBooks, Xero's reporting suite creates a real-time income statement based on coded transactions. The accuracy is driven by consistent and correct bank reconciliation and bookkeeping.
• Wave: For freelancers and small businesses, Wave provides free accounting tools that can produce a basic income statement once income and expense transactions are logged.

Remember, these tools are only as reliable as the information they are given. An incorrectly classified expense or a missed revenue entry will produce an inaccurate income statement. "Garbage in, garbage out" is the oldest rule in accounting technology.

Final Thoughts

Preparing an income statement is a logical process of layering a company's revenues and expenses to measure its profitability over time. Whether you use accounting software or assemble it manually, understanding each step from net revenue to gross profit, operating income, and finally net income allows you to interpret the story that the numbers are telling.

While much of the statement is straightforward bookkeeping, certain line items, like the provision for income tax, often require complex judgment calls and research into specific tax codes. For these moments, getting a fast, defensible answer is key. Our platform, Feather AI, gives accounting and tax professionals instant, citation-backed answers from authoritative sources such as the IRC and IRS guidance, helping ensure every figure on your financials is accurate and audit-ready.