Understanding the Income Statement (the Typical Explaination)

The following document is a standard teaching document. You will find it anytime you either ask or research for yourself, the answer to the question, "What is an Income Statement".

I have made my own notes that point out basic problems in this document and the problems that are taught to new business owners, "right out of the gate".  (Understand that I am not saying this document is WRONG. What I am saying, is that while it attempts to teach, its complexity and lack of insight into the reader perspective, creates more confusion then it needs to)

One of the Fundamental Principles of accounting is that revenue and the expenses necessary to earn this Revenue should be as accurate (as nearly as possible) when preparing reports (Income statement and Balance Sheets) for management regarding the results of the operations for a given time period, (month/year). Without accurate data, and records, sound financial decisions are not possible.

The Income Statement (a.k.a. Profit and Loss Statement) is usually prepared on the same date as the Balance Sheet; however, unlike the Balance Sheet, the Income statement does not provide information which is "frozen" for one moment in time.  It presents information for activities, which have occurred over a period of time. The Income Statement is sometimes called the Profit and Loss Statement (P & L Statement) because it traces a company's profits or losses over a period of time - usually one (1) year. The income statement is an exhibit of a basic business equation:

REVENUES minus COST and the associated EXPENSE equals NET INCOME (or Loss).

(This mathematical formula is taught to us all in business and is fundamentally flawed.  I hate that this is the math foundation that all business operates on.  You start out WRONG and generally, finish WRONG and you never know why.  Watch for my next article and you will find out WHY this math is WRONG!!!!!)

The Income Statement is traditionally organized into four (4) major categories of information:

1)   Revenues (Sales or Net Sales)

2)   Costs and Expenses (Operating Expenses)

These are usually presented as:

Cost of Goods Sold (COGS) or Cost of Sales

Operating Expenses

The Operating Expenses may be further sub-divided into:

Selling Costs and any other meaningful grouping, and General and Administrative Expenses (G & A)

3)   Tax on Income (Federal and / or State Taxes)

4)   Net Income for the Month/Year 

(There are 5 key points on any income statement and in order to, CONTROL YOUR OWN DESTINY, YOU MUST KNOW WHAT THEY ARE AND HOW TO MANAGE THEM!!!!)

The normal composition of an Income Statement lists all of the above for a one (1) month period, providing management an immediate insight into the total business activities of their company for a one (1) month period of time.  The statement normally lists year-to-date (YTD) figures as well.  YTD figures are a compilation of all figures for preceding months plus the current month.  This gives management an insight into the total business activities of their company over an extended period of time. (Normally 12 month or less.)

REVENUES (SALES or NET SALES): This section lists all money received by the company during the income statement period from the sale of products or services, or from other revenue sources.  The company may have any number of categories listed separately under the REVENUE (SALES) section of the Income Statement.

COST AND EXPENSES (OPERATING EXPENSES): Normally the first listing under the COST AND EXPENSE section of the Income Statement is "Cost of Goods Sold" (COGS) or "Cost of Sales" (COS) depending on the particular operation; Manufacturing or Retail sales etc. This listing is usually the largest single expense item on the Income Statement and it should include all costs except General and Administrative costs.(Specifically, tracking how much you spent on material and labor, to produce a product or service that is ready to sell)

COGS / COS "Cost of Sales" may be divided into "Direct" and "Indirect".  It should include all expenses that are directly attributable to the production or purchase of goods which are sold and services rendered, i.e., labor costs including taxes, contract labor, rental equipment, vehicles and associated expenses, freight, etc.

GENERAL AND ADMINISTRATIVE EXPENSES [G & A]:  These expenses include salaries and labor costs of all employees not in "Cost of Sales", the cost of office operation, rent, insurance and all other GENERAL costs required for the operation and management of the company that ARE NOT assignable to services rendered, production or sale of goods.  The company may have any number of individual categories listed under this section. 

DEPRECIATION EXPENSE:  There are numerous depreciation schedules and policies, i.e., straight line, declining balance, accelerated method, etc.    The company should use the depreciation method that most realistically reflects the decline in service potential of the assets and that results in the best earnings quality.  Management should discuss the various depreciation schedules now being used with the company Certified Public Account (CPA).

INTEREST EXPENSE:  This expense is the annual cost of financing the company through borrowed funds.

The Income Statement figure for TOTAL COST AND EXPENSES is a total of the entries for:

Cost of Sales (Direct and Indirect)

General and Administrative Expenses

Depreciation Expense

Interest Expense

TOTAL COST AND EXPENSES are DEDUCTED from TOTAL REVENUES.

The result is called Income Before Taxes or OPERATING PROFIT (LOSS).

TAXES ON INCOME:  Income taxes and other types of taxes are listed on the Balance Sheet as a Current Liability.  The Balance Sheet shows the total of all types of taxes owed as of the Balance sheet Date.  The amount shown is usually less than the total tax expenses for the year.  This is because taxes are normally paid in installments as the year progresses.  Some taxes have already been paid during the year prior to the Balance Sheet Date and the amount shown on the Balance Sheet will probably be paid in installments after the Balance Sheet date.

The actual expense of taxes paid during the year is shown on the Income Statement.  Some types of taxes are included in the figures for Selling Expense and General and Administrative expense.  The Income Taxes paid during the year are shown separately. On the Income Statement they are listed in a separate section called Taxes on Income.

Depending on how the company wishes to set up its Income Statement the next entry may be OTHER INCOME AND EXPENSE.  This category may be made up of such items as Bad Debt Recovery, provision for Income Taxes, Interest Income, Gain/Loss on Sale of Assets, etc.  The total of all items in this category are then added or deducted, whichever the case may be to/from the INCOME BEFORE TAXES  (Operating Profit (Loss)) figure. The result is NET INCOME for the year.

NET INCOME FOR THE YEAR is the most important item of financial information on the Income Statement.  It is the key measure of the company's performance.  The amount of profit achieved after all costs, expenses and taxes has been paid from revenues.

After reading this document. ask your self , "Dis this document help?" Probably not.  Especially if you are just starting out in business and have no financial training.

Keep in mind that the above layout and description for an income statement is what is referred to as "TAXED BASED ACCOUNTING". I will discuss this type of accounting in later articles.

Remember where, "MY", focus is. The small business owner.  They are this country's life blood. They are the ones that ensure our future.  This I state again because, "you must communicate at a level that accomplishes your goal and objective". 

I remember once attending a meeting where the speaker had a PhD in Business.  At the end of the long and very boring meeting every person in the room was confused and a tad bit angry.  Angry because of the money that was spent on this speaker and at the unusable information that was conveyed.   The truth was, the speaker did convey valuable information on strategic planning, but had no idea how to convey this information to people responsible for its implementation.  The speaker detected this uneasy feeling in the room, but instead of recognizing it for what it really was, stated to me, "these people act as if they just came out of a garage with this business!"  Reality, they were only out of their garage for 2 years, knew nothing of business planning, of managed growth, and absolutely knew nothing about financial management.  This speaker was retained to enlighten the team, instead he was speaking as if he were in a classroom of graduate students.

If your goal is to teach or train, you must communicate at a level that can be understood and actually utilized. 

My point, know your audience and speak to them, not at them.

This applies to any industry. For example, if a PhD in Social Work speaks to an offender as a PhD, how much impact on this person's life, will they really have?

This therefore, is the problem with this training document...............

My next several articles will explain the income statement in terms that anyone can easily understand and apply, no matter your background or your operating business entity.