Hey folks! In the last blog, we touched upon the different financial reports/statements. Here we are going to focus on one of the primary statements, the income statement (IS). Usually when people think of financials the IS is the first one to come to mind. That’s because it measures if the company is making money or not. This statement is often referred to as a Profit and Loss Statement or P&L.
The statement is named after the final number at the bottom, the net income. If the net income is positive it means the business made a profit. If it is negative it means the business lost money. The net income could also be zero, meaning the business broke even.
The concept is straightforward. The P&L shows how much was made in sales and what expenses it took to generate those sales over a period of time. The difference is the profit, or net income. Usually an IS covers a month, quarter, or year. At the end of each period it resets to zero. This allows you to compare results from period to period.
For example, a January IS will show only January activity. A February IS will show only February activity. If you want to understand if your business did better or worse in February than in January, you compare the reports to see which line items went up or down.
The sales and expenses sections can be broken down however you choose. It’s best practice to create accounts based upon the type of business and industry. Examples of sales accounts could be the major service or product types or by locations. Expenses are split into two main groups. First is the cost of goods sold (COGS), also called Cost of Sales (COS). These expenses are directly attributable to a specific sale. If you sell widgets, then the cost to buy and build the widgets are a COGS. After COGS there is a subtotal called gross profit, or the difference between sales and COGS. The second expense section is all other expenses necessary in running a business, but don’t contribute directly to one sale. Examples include fuel, accounting and marketing expenses, office supplies, and so on.
Each company can set up their sales and expense accounts however they choose. Its important to consider how to classify transactions on the IS so that the data is helpful for you to analyze. For tax purposes, the IRS has a standard list of accounts. Your accountant will sort where each of your accounts is properly reported on tax returns. For internal accounting and managerial purposes, you do not have to use the IRS list of accounts. Set up the accounts so that the information collected in useful in assessing your businesses performance. For guidance, you can look up industry examples and ask your accountant.
Before we finish up, I need to bring up one qualm I have with QuickBooks Online (QBO) because it confuses a lot of clients. Technically QBO uses the wrong terminology to describe sales. In proper accounting speak, sales should be called sales or revenue. In QBO it is called income. In accounting terminology income, aka net income, is the difference between revenue and expenses. This is confusing because when a business owner is looking in QBO and wants to know their income, do they mean income (revenue) or net income (net of revenue and expenses)? When they are speaking with other business owners or mentors who do not use QBO are they understood correctly?
It is critical to understand the parts of the IS so that even if the wrong terminology is used, you understand what the numbers represent. My approach to dealing with this issue is to teach my clients the differences as they become more familiar with financial reporting and answer questions as they come up.
The P&L is critical in understanding business performance. As a business owner, you need to understand this statement to succeed in the long run. If you are unfamiliar with your own IS or would like more information, you can send me a message via my contact page.
Next up in Accounting 101 we will go over the second most common financial statement, the Balance Sheet. Have a wonderful week!