alt="An illustration of an abbreviated classified balance sheet."/>
FIGURE 2-1: An abbreviated classified balance sheet.
Posting Profit or Loss: The Income Statement
Next up in your exciting walkthrough of the three financial statements is (drum roll, please) … the income statement, which shows income, expenses, gains, and losses. It’s also known as a statement of profit or loss (or P&L) — mostly among non-accountants, particularly small business owners. As the true financial accountant that you are (or soon will be!), you use the term income statement rather than statement of profit or loss.
Here, I provide only a brief introduction to the income statement. For the complete scoop on the income statement, the accounts reflecting on it, and how to prepare one, see Chapter 10.
Keeping a scorecard for business activity
The income statement shows financial results for the period it represents. It lets the user know how the business is doing in the short-term. And you have to keep in mind that the company’s performance is not just a question of whether it made or lost money during the financial period. The issue at hand is more a matter of the relationship among the different accounts on the income statement.
For example, maybe you see that a company’s gross profit, which is the difference between sales and cost of goods sold, is $500,000. (Not sure what cost of goods sold is? No worries — you can find out in the next section of this chapter!) Based on the amount of gross sales or historical trends, you expect gross profit to be $700,000. Well, your scorecard is coming in $200,000 short — not good. And if you’re a member of company management or an owner, you need to find out why.
Perhaps you’re saying, “But wait — what about the equity section of the balance sheet? Doesn’t that provide a scorecard too?” Well, think back to the definition of retained earnings I give earlier in this chapter: Retained earnings is the accumulated total of net income or loss from the first day the company is in business all the way to the date on the balance sheet (less dividends and other items that I discuss in Chapter 9). Retained earnings does provide valuable information, but because it’s an accumulation of income that you can’t definitely tie to any specific financial period, and because it can potentially be reduced by other accounting transactions such as dividends, it does not provide a scorecard like the income statement does.
Studying the income statement components
Your financial accounting textbook homes in on a few income statement components: revenue, cost of goods sold, operating expenses, and other items of gain and loss. In this section, I give you just the basics on each. For a more comprehensive explanation of all the income statement accounts, be sure to read Chapter 10.
Revenue
Revenue is the inflow of assets, such as cash or accounts receivable, that the company brings in by selling a product or providing a service to its customers. In other words, it’s the amount of money the company brings in doing whatever it’s in the business of doing.
The revenue account shows up on the income statement as sales, gross sales, or gross receipts. All three names mean the same thing: revenue before reporting any deductions from revenue. Deductions from revenue can be sales discounts, which reflect any discount a business gives to a good vendor who pays early, or sales returns and allowances, which reflect all products customers return to the company after the sale is complete.
Cost of goods sold
The cost of goods sold (COGS) reflects all costs directly tied to any product a company makes or sells, whether the company is a merchandiser or a manufacturing company.
If a company is a merchandiser (it buys products from a manufacturer and sells them to the general public), the COGS is figured by calculating how much it cost to buy the items the company holds for resale. Keep in mind that to accurately calculate this amount, you have to understand how to value ending inventory, which is the inventory remaining on the retails shop’s shelves at the end of the financial period, a topic I discuss in Chapter 13.
Because a manufacturer makes products, its COGS consists of raw material costs plus the labor costs directly related to making any products that the manufacturer offers for sale to the merchandiser. COGS also includes factory overhead, which consists of all other costs incurred while making the products.
Operating expenses
Operating expenses are expenses a company incurs that relate to central operations and aren’t directly tied to COGS. Two key categories of operating expenses show up on the income statement:
Selling expenses: Any expenses a company incurs to sell its goods or services to customers. Some examples are salaries and commissions paid to sales staff; advertising expense; store supplies; and depreciation (see Chapter 12) of a retail shop’s furniture, equipment, and store fixtures. Typical retail shop depreciable items include cash registers, display cases, and clothing racks.
General and administrative (G&A) expenses: All expenses a company incurs to keep up the normal business operations. Some examples are office supplies, officer and office payroll, nonfactory rent and utilities, and accounting and legal services. If, after getting an A in your financial accounting class, you’re so bowled over by the subject that you seek employment as a financial accountant, your payroll is lumped into G&A too.
Other income and expense
You classify all other income the company brings in peripherally as other revenue or other income; either description is fine. This category includes interest or dividends paid on investments or any gain realized when the company disposes of an asset. For example, the company purchases new computers and sells the old ones; the amount the company makes from the sale of
