Welcome to part three in this series. In this third part of the series, we will be focused on the income statement and we'll be covering the following three areas. First, what is the purpose of an income statement and what does it show? Second, we'll discuss the key components of the income statement being revenue, expenses and net surplus or deficit. And finally, we'll consider some useful questions a director should consider when reviewing an income statement. 

We'll be referring to an example income statement for a fictitious company, Creative Arts Limited, and you can download a copy from the link in the video description. It will be helpful for you to have a copy of it available as we go through this session. 

In part two of this series, we discuss the difference between financial statements and management accounts. The example income statement for Creative Arts Limited is in the financial statements format. You may know an income statement by other names such as a statement of profit or loss, a statement of profit and loss, and other comprehensive income or a P and L, for short. They're all referring to the same document. 

So what is the purpose of an income statement and what does it show? The purpose of an income statement is to explain how the organisation has performed during a period of time. It shows, in summary how much of the different types of revenue have been earned and the different types of expenses that have been incurred. It will also show you whether the organisation has made a surplus or a deficit. 

A surplus or profit is when revenue is greater than expenses, and a deficit or loss is where expenses are greater than revenue. A review of the expenses will show how the organisation is using its resources to deliver its purpose. By reviewing income statements over multiple periods, you're able to identify trends and assess whether the operations of the organisation are financially sustainable. 

What is revenue? Revenue or income is the amount of money the organisation has earned during the period. Referring to our example income statement, total revenue is $1,185,800. In the arts and cultural sector, common types of revenue include ticket sales, government grants, corporate sponsorships, donations, membership fees, and interest in other income from investments 

An income statement is prepared on an accrual basis, and the Australian accounting standards have rules around when revenue is recognised in the income statement. There may be a difference between when income is received in cash and deposited into the company's bank account and when it is recognised as income, in the income statement. Some types of income will be earned without any further obligations on the organisation to do or deliver anything. An example of this type would be a regular donation. This income is recognised when received. 

Other types of income may be subject to the requirement for the organisation to do or deliver certain things. For example, an audience member may buy a subscription for a series of performances and pay for the entire subscription upfront. In this case, the organisation recognises the revenue as each performance is completed rather than upfront when the subscriber pays for the subscription. 

Another example is a government grant. The grant may be received in a full upfront, but is conditional upon the organisation achieving the deliverables or milestones as set out in the funding agreement. In this case, the grant income would be recognised as each deliverable is achieved. If the organisation has received income in cash and has not yet performed the service or obligation necessary to recognise the income, it's treated in the financial statements as unearned income, or revenue received in advance. 

Revenue received in advance will be recorded as a current liability in the balance sheet until the service or obligation is performed. Referring to our example balance sheet, Creative Arts Limited has revenue received in advance of $178,700, which is included in current liabilities. 

What are expenses and expense is a cost incurred while carrying out the organisation's activities. Referring to our example income statement, total expenses are $1,157,000. In the creative arts sector, common types of expenses include staff wages and artist fees, production, touring, and revenue costs, marketing, fundraising, administration, depreciation, and amortisation, and financing or interest expense. 

Under Australian accounting standards, expenses are recognised in income statement when they're incurred, which may be different to when they are paid. For example, let's assume Creative Arts Limited has programmes printed and delivered on 29 June. The printer provides their invoice with the delivery and it is paid by the company's finance team two weeks later. 

In this example, the expense we recorded in June in the income statement, even though the payment was not made until July, if certain expenses have been incurred but not yet paid for, this future obligation to pay will be recognised in the current section of the balance sheet as a trade payable, which is an amount due to a supplier. Referring to our example, balance sheet trade and other payables is $24,800. 

Subtracting total expenses from total revenue gives a surplus if it's a positive number or a deficit if it's a negative number. Referring to our example income statement, the surplus is $28,800. The surplus or deficit for a particular year is added or subtracted from the accumulation of all surpluses and deficits since the organisation began and is shown in the equity section of the balance sheet as accumulated surplus. Referring to our example balance sheet, the accumulated surplus is $354,100. 

A reminder that the example financial statement we've been referring to is in the financial statements format. The format of this income statement must follow the rules set out in the relevant legislation such as the ACNC Act and the Australian Accounting Standards. 

In the internal management accounts, the directors and management have the flexibility to provide the information in the format they want, and in as much granular detail as they need. It would also be usual for the income statement in the management accounts to show a comparison of the actual revenue and expenses with the budgeted numbers. 

If I was a director of our example company, Creative Arts Limited, when reviewing the income statement, I would ask questions to understand what types of revenue the organisation has and earned, what types of expenses have been incurred, and whether the revenue and expenses have been recognised on an accrual basis and in accordance with Australian accounting standards. 

To summarise the key learnings from this part of the series: First, an income statement shows how the organisation has performed financially during the period. Second, the income statement shows revenue or income earned and expenses incurred during the period and whether the organisation has made a surplus or a deficit. 

Finally, when reviewing an income statement, it is important that a director understands the types of revenues and expenses the organisation has earned or incurred, whether they have been correctly recorded on an accruals basis and in accordance with Australian accounting standards. Part six of this series will further explore how a director can read and interpret the income statement and what additional questions they may ask.