In accounting, there are three major financial statements: the balance sheet, income statement and statement of cash flow. An income statement is used in accounting to show revenues and expenses for a business. The income statement is an important tool for investors seeking to gauge the health of a business and determine whether it is a worthy investment. There are two methods used to prepare income statements: single-step and multi-step.
The single-step method simply reports revenues in one section and expenses in another, yielding the gross profit. This method does not break down operating expenses nor attribute them to different contributions of revenues. This makes it difficult to judge whether the business is operating efficiently. Shareholders see the earnings per share from the single-step income statement but do not have much insight as to how the earnings were produced. Additionally, since operating and nonoperating expenses are not separated, an increase in earnings per share can seem skewed if, perhaps, property was sold during the accounting period. As this nonoperating source of income could boost profits, investors may be led with a false sense of hope that earnings are on the rise, when, in fact, the increase was not from the business’ main productions.
In the multi-step method, revenues and expenses are stated in categories, including the separation of operating revenues and expenses from nonoperating revenues and expenses. The way this income statement is structured gives three important figures: gross profit, operating profit and net profit. This gives investors a better look at where a business is profitable, what its weaknesses are and whether it is operating efficiently. For example, operating profit is determined by subtracting all operating expenses from the gross profit figure (revenues minus cost of goods sold). This figure demonstrates how a company uses its resources and whether it does so efficiently. Also, with the multi-step method, a business can add notes and more detailed information about certain parts of the income statement. This is a huge benefit for companies seeking to explain any particular sections with regard to their individual business.
While both methods are allowed under generally accepted accounting principles, or GAAP, different types of companies may benefit from using one or the other. Generally, smaller businesses or those with more simplified business practices use the single-method income statement. For example, a sole proprietor with only one business product uses the single method to calculate gross profit from his or her one product line and single source of expenses. A major distributor such as Amazon has many different sources of revenue and expenses ranging from its online marketplace for other retailers to products it develops and sells directly to the public. Also, as it is a publicly traded company, Amazon needs to report very detailed information on its income statement. Therefore, Amazon would use the multi-step method.