Income Statements Made Simple
January 06, 2016
If you're not an accountant, the thought of deciphering an income statement can be a daunting task and quite scary. Actually, when taken in small increments, the income statement can easily be understood.
To eliminate any confusion, many times an income statement is referred to as a profit and loss statement, a P&L, or operating statement. All income statements are essentially the same with revenues at the top and expenses toward the bottom calculating to a net profit figure.
Some income statements are in summary form while others are more detailed. When the summary form is used, various revenue and expense accounts are categorized into major groups rather than listing each account separately, as would be the case with a detailed income statement. The bottom line figure, of course, remains the same regardless of the type of statement.
An income statement might be for one period of time only, such as for a single month, quarter, or annual period. There might also be current periods and year-to-date figures listed on the same statement. Additionally, an income statement might include comparison figures for the current period and prior period or the current period and prior year, same period (meaning July this year compared to July last year).
Historical income statements are, also, used by many small businesses. Historical income statements are used for multiple periods or years. Normally, a data based spreadsheet is used with periods or years at the top and income statements accounts on the left side. The easiest way to prepare this type of statement and the most efficient to use is to put the oldest period or year at the top, far left of the spreadsheet. Each additional period or year is then added to the right. This allows a complete historical review of the business at a glance.
An income statement should give a true financial picture of a business. Many times, however, items are entered that can distort its accuracy. When an income statement includes personal items, related party transactions not at fair market value, or an extraordinary salary of the owner (high or low), the income statement will not reflect the true financial nature of the business. The goal of an income statement is to be accurate as possible so when distorting items are eliminated, a more accurate income statement emerges.
Common Size Income Statement
A common size income statement converts all dollars to percentages. It is an excellent way to review trends and compare period-to-period or year-to-year revenue and expense items. While it is difficult at times when using dollar only figures to spot anomalies, any abnormalities are exposed much faster when percentages are used.
A common size statement is prepared in the same manner as a regular income statement (current or historical), only percentages are used rather than dollars. It is a great management tool and allows a small business owner to question why some items increased, decreased, or were out of the ordinary.
Cash versus Accrual
A cash basis income statement recognizes revenue when the money is actually received (not when it is earned or a sale is made) and recognizes expenses when the bills are paid (not when the expenses were incurred).
An accrual basis income statement, on the other hand, recognizes revenue when it is earned (regardless of when the money is received) and recognizes expenses when they are incurred (regardless of when they are paid).
Many small businesses keep their books on the cash basis that is easier; however, the income statement can be misleading or distorted because all forms of income and expenses are not recorded. Cash basis makes the process of observing unusual trends more difficult.
It Tells a Story
An income statement tells a story of the business. All of the figures represent some type of action – marketing, selling, manufacturing, servicing, etc. Something happened in a business to produce every figure on the income statement. Studying the income statement tells a story – good or bad...repeat the good and change the bad!
Posted by Richard Weinberger, PhD, CPA
Chief Executive Officer
Association of Accredited Small Business Consultants