How Does the Income Statement Work?

The income statement tells us how profitable the company is. Profit tells us how much is leftover for shareholders after paying all the costs of running the company! It is calculated as revenue less expenses. And even though profit gets its own statement, it will still change the balance in retained earnings. This should make sense because profit is what is leftover for shareholders, and retained earnings is an equity account belonging to shareholders.

Importantly, the income statement only holds balances for a period of time, then these balances are closed out to retained earnings. To illustrate, let’s pretend we have an empty glass. Every time we make a sale, we add water to the glass; big sales = lots of water and small sales = a little bit of water. And every time we incur an expense, we pour water out of the glass. We’re going to hold onto this water for a period of time, maybe a year?, then we’ll empty the water out so we can start measuring water over the next period. Of course, the water represents profit: what the company has earned over the period less the cost of those earnings. And at the end of the period, profit is emptied out to… you got it… retained earnings! So, we were correct in the previous chapter to post sales and expenses to retained earnings—they go there eventually—but first they make a stop in the income statement.

Who cares about profit? Many users are interested in profit. As an employee, you might look at profit to see if the company can afford to give you a bonus or pay raise. The government is interested in profit to see how much income tax a company should pay. Of course, shareholders care about profit because it belongs to shareholders and increases their wealth!