Before proceeding let us remember that:-

· Sales minus direct costs are equal to gross profit

· Gross profit minus indirect costs are equal to net profit.

Out of the elements mentioned above, gross profit and net profit are prominent figures that stand out in an income statement.

We are then left out with sales, direct, and indirect costs. When we compare direct with indirect cost, the sales figure is less confusing. All these statements appear to be complicated because of the complex nature of businesses done by big companies.

A big company like Reliance will have income from multiple sources such as oil production, oil refining, marketing, petrochemicals, and many more. The performance of each of these may be shown separately in their individual revenue statement and therefore, their first item in their statement namely ‘sales’ will show four or more different figures and the total of all segments. The figures would appear complicated when shown separately.

They must be shown separately so that the reader would be able to understand how the different segments of the business have contributed to the income. Disclosure is also made separately based on geographical or other factors.

Cost and Expenses

There are two types of expenses.

(1) Expenses directly related to the sale and

(2) Indirect expenses.

All direct or indirect expenses are deducted from the revenues. When we say ‘directly related’ it is meant that all such costs are usually directly proportional to the sales volume. These costs are also called as “costs of sales” or “cost of goods sold”. These figures are shown separately in the income statement.

The figure after deducting the costs is the ‘gross profit’. Out of the gross profit made by the company, the operational expenses like salary to employees, advertisement, rent, etc. has to be met. These expenses are called indirect expenses, ‘overheads’, or operating expenses. Both these expenses direct and indirect costs may not represent actual cash outflow.

Cash and Non-cash expenses

Now let us look into two other terms that are needed to fully understand the profit and loss statement. ‘Cash expense’ and ‘Non-cash expense' - Although Cash expenses have been paid in cash and Non-cash expenses had not incurred any outflow of cash, both are shown as an expense. The reason for this is that, for an accountant, the term expense includes outflow of cash or any other valuable assets. It could also be a decrease in assets or economic benefits.

Whatever be the nature of an expense, cash or non-cash, in the income statement it is shown as a deduction from the gross profit. In the case of an asset like machinery which is used in the business, a proportion of the cost of machinery, termed as depreciation, is deducted as an expense. This expense being a non-cash expense, there is no cash outflow.

Expenses – is it good or bad?

When we find that there are too many expenses in the income statement affecting the profitability, then it is not a good sign. It is then the responsibility of the management to locate areas where they can cut costs and expenses to improve the profitability of the company. Any step taken by a company in this regard can be considered to be a positive sign.

Fixed and variable expenses are another classification. It is based on whether the expenses are controllable or uncontrollable. We know that the expenses are classified as direct expense and indirect expense or as cash expense and non-cash expense. Expenses are also be classified as – for example, it can be classified on whether the expense is controllable or uncontrollable, or whether it is variable one - as fixed expenses and variable expenses.

The reason why the income statements look complicated at the start is because of the additional details which are provided for clarity and make it more transparent. To this end, the accountants provide the maximum possible detail in the income statement, so that the public and investors, in particular, can get a fairly good insight into the way a company is functioning.