Question

Is the income statement organized by nature or by function?

Answer 1

The expenses in an income statement are either classified by their nature or by their function.

1. Income Statement by Nature of Expense

An income statement by nature method is the one in which expenses are disclosed according to their nature such as depreciation, transports costs, rent expense, wages and salaries etc. There is no reallocation of these expenses to different functions of the entity (i.e. cost of goods sold, selling costs, administrative costs and other expenses).

This method of disclosure of expenses is used in single step income statement and it is usually employed by small businesses due to its simplicity. However there is drawback in this method that it cannot be used to calculate gross profit within the income statement.

2.Income Statement by Function of Expense:

An income statement by function is the one in which expenses are disclosed according to their functions such are cost of goods sold, selling expenses, administrative expenses, other expenses/losses etc. This method allows us to calculate gross profit and operating profit within the income statement and therefore it is usually used in the multi-step format of income statement. Most large and medium sized businesses use the function method of expense disclosure.