Looking at businesses that sell products

Figure 5-1 presents a classic profit report for a product-oriented business; this report, called the income statement, would be sent to its outside, or external, owners and lenders. (The report could just as easily be called the net income statement because the bottom-line profit term preferred by accountants is net income, but the word net is dropped from the title, and it’s most often called the income statement.) Alternative titles for the external profit report include earnings statement, operating statement, statement of operating results, and statement of earnings. Note: Profit reports prepared for managers that stay inside a business are usually called P&L (profit and loss) statements, but this moniker isn’t used much in external financial reporting.

The heading of an income statement identifies the business (which in this example is incorporated — thus the “Inc.” following the name), the financial statement title (“Income Statement”), and the time period summarized by the statement (“Year Ended December 31, 2017”). I explain the legal organization structures of businesses in Chapter 4.

You may be tempted to start reading an income statement at the bottom line. But this financial report is designed for you to read from the top line (sales revenue) and proceed down to the last — the bottom line (net income). Each step down the ladder in an income statement involves the deduction of an expense. In Figure 5-1, four expenses are deducted from the sales revenue amount, and four profit lines are given: gross margin, operating earnings, earnings before income tax, and net income:

• Gross margin (also called gross profit) = sales revenue minus the cost of goods (products) sold expense but before operating and other expenses are considered
• Operating earnings (or loss) = profit (or loss) before interest and income tax expenses are deducted from gross margin
• Earnings (or loss) before income tax = profit (or loss) after deducting interest expense from operating earnings but before income tax expense
• Net income = final profit for period after deducting all expenses from sales revenue, which is commonly called the “bottom line”

Although you see income statements with fewer than four profit lines, you seldom see an income statement with more.

Terminology in income statements varies somewhat from business to business, but you can usually determine the meaning of a term from its context and placement in the income statement.

Notice in Figure 5-1 that below the net income line, the earnings per share (EPS) amount is reported. This important number equals net income divided by the number of ownership shares the business corporation has issued and that are being held by its shareholders. All public corporations whose stock shares are traded in stock markets must report this key metric. EPS is compared to the current market price of the stock to help judge whether the stock is over- or underpriced. Private companies aren’t required to report EPS, but they may decide to do so. If a private business decides to report its EPS, it should follow the accounting standard for calculating this number. I discuss the calculation of EPS in Chapter 9.

The standard practice for almost all businesses is to report two-year comparative financial statements in side-by-side columns — for the period just ended and for the same period one year ago. Indeed, some companies present three-year comparative financial statements. Two-year or three-year financial statements may be legally required, such as for public companies whose debt and ownership shares are traded in a public market. I have to confess that the income statement in Figure 5-1 is incomplete in this regard. It should have a companion column for the year ended December 31, 2016. To ease up on the amount of numbers, however, I show only the most recent year.

Looking at businesses that sell services

Figure 5-2 presents a typical income statement for a service-oriented business. I keep the sales revenue and operating earnings the same amount for both the product and the service businesses so you can more easily compare the two.

If a business sells services and doesn’t sell products, it doesn’t have a cost of goods sold expense; therefore, the company doesn’t show a gross margin line. Some service businesses report a cost of sales expense line, but this isn’t uniform at all. Even if they do, the business might not deduct this expense line from sales revenue to show a gross margin line equivalent to the one product companies report.

In Figure 5-2, the first profit line is operating earnings, which is profit before interest and income tax. The service business example in Figure 5-2 discloses three broad types of expenses. In passing, you may notice that the interest expense for the service business is lower than for the product business (compare with Figure 5-1). Therefore, it has higher earnings before income tax and higher net income.

The premise of financial reporting is that of adequate disclosure, but you find many variations in the reporting of expenses. A business — whether a product or service company or an investment company — has fairly wide latitude regarding the number of expense lines to disclose in its external income statement. A CPA auditor (assuming the company’s financial report is audited) may not be satisfied that just three expenses provide enough detail about the operating activities of the business. Accounting standards do not dictate that particular expenses must be disclosed (other than cost of goods sold expense).

Public companies must disclose certain expenses in their publicly available fillings with the federal Securities and Exchange Commission (SEC). Filing reports to the SEC is one thing; in their reports to shareholders, most businesses are relatively stingy regarding how many expenses are revealed in their income statements.

Looking at investment businesses

Figure 5-3 presents an income statement for an investment business. Notice that this income statement discloses three types of revenue: interest and dividends that were earned, gains from sales of investments during the year, and unrealized gains of the market value of its investment portfolio. Instead of gains, the business could’ve had realized and unrealized losses during a down year, of course. Generally, investment businesses are either required or are under a good deal of pressure to report their three types of investment return. Investment companies might not borrow money and thus have no interest expense. Or they might. I show interest expense in Figure 5-3 for the investment business example.

I should mention in passing that public investment companies, such as mutual funds and exchange traded securities (ETS), are heavily regulated by the SEC as well as other types of investment entities that raise capital in public offerings. My purpose in showing the income statement for an investment business (Figure 5-3) is simply for comparison with businesses that sell products and those that sell services (see Figures 5-1 and 5-2).

Revenue and expense effects on assets and liabilities

Here’s the gist of the two-by-two matrix shown in Figure 5-4. In recording a sale, the bookkeeper increases a revenue account. The revenue account accumulates sale after sale during the period. So at the end of the period, the total sales revenue for the period is the balance in the account. This amount is the cumulative end-of-period total of all sales during the period. All sales revenue accounts are combined for the period, and one grand total is reported in the income statement on the top line. As each sale (or other type of revenue event) is recorded, either an asset account is increased or a liability account is decreased.

I’m reasonably sure you follow that revenue increases an asset. For example, if all sales are made for cash, the company’s cash account increases accordingly. On the other hand, you may have trouble understanding that certain revenue transactions are recorded with a decrease in a liability. Here’s why: Customers may pay in advance for a product or service to be delivered later (examples are prepaying for theater or airline tickets and making a down payment for future delivery of products). In recording such advance payments from customers, the business increases cash, of course, and increases a liability account usually called deferred revenue. The term deferred simply means postponed. When the product or service is delivered to the customer — and not before then — the bookkeeper records the amount of revenue that has now been earned and decreases the deferred revenue liability by the same amount.

Recording expenses is rather straightforward. When an expense is recorded, a specific expense account is increased, and either an asset account is decreased or a liability account is increased the same amount. For example, to record the cost of goods sold, the expense with this name is increased, say, $35,000, and in the same entry, the inventory asset account is decreased $35,000. Alternatively, an expense entry may involve a liability account instead of an asset account. For example, suppose the business receives a $10,000 bill from its CPA auditor that it will pay later. In recording the bill from the CPA, the audit expense account is increased $10,000, and a liability account called accounts payable is increased $10,000.

The summary framework of Figure 5-4 has no exceptions. Recording revenue and expenses (as well as gains and losses) always follow these rules. So where does this leave you for understanding profit? Profit itself doesn’t show up in Figure 5-4, does it? Profit depends on amounts recorded for revenue and expenses, of course, as I show in the next section.

Comparing three scenarios of profit

Figure 5-5 presents three scenarios of profit in terms of changes in the assets and liabilities of a business. In all three cases, the business makes the same amount of profit: $10, as you see in the abbreviated income statements on the right side. (I keep the numbers small, but you can think of $10 million instead of $10 if you prefer.)

To find the amount of profit, first determine the amount of revenue and expenses for each case. In all three cases, total expenses are $90, but the changes in assets and liabilities differ:

• In Case 1, revenue consists of $100 asset increases; no liability was involved in recording revenue.
• In Case 2, revenue was from $100 decreases in a liability.
• In Case 3, you see both asset increases and liability decreases for revenue.

Revenue and expenses are originally recorded as increases or decreases in different asset and liability accounts. Cash is just one asset. I explain the other assets and the liabilities in the later section “Scanning the assets and liabilities used to record revenue and expenses.”

Some businesses make sales for cash; cash is received at the time of the sale. In recording these sales, a revenue account is increased and the cash account is increased. Some expenses are recorded at the time of cutting a check to pay the expense. In recording these expenses, an appropriate expense account is increased and the cash asset account is decreased. However, for most businesses, the majority of their revenue and expense transactions do not simultaneously affect cash.

For most businesses, cash comes into play before or after revenue and expenses are recorded. For example, a business buys products from its supplier that it will sell sometime later to its customers. The purchase is paid for before the goods are sold. No expense is recorded until products are sold. Here’s another example: A business makes sales on credit to its customers. In recording credit sales, a sales revenue account is increased and an asset account called accounts receivable is increased. Sometime later, the receivables are collected in cash. The amount of cash actually collected through the end of the period may be less than the amount of sales revenue recorded.

Cash inflow from revenue is almost always different from revenue for the period. Furthermore, cash outflow for expenses is almost always different from expenses for the period. The lesson is this: Do not equate revenue with cash inflow, and do not equate expenses with cash outflows. The net cash flow from profit for the period — revenue inflow minus expense outflow — is bound to be higher or lower than the accounting-based measure of profit for the period. The income statement does not report cash flows!

This chapter lays the foundation for Chapter 7, where I explain cash flow from profit. Cash flow is an enormously important topic in every business. I’m sure even Apple, with its huge treasure of marketable investments, worries about its cash flow.

Folding profit into retained earnings

After profit is determined for the period, which means that all revenue and expenses have been recorded for the period, the profit amount is entered as an increase in retained earnings. Doing this keeps the accounting equation in balance. For Case 1 in Figure 5-5, for example, the changes in the accounting equation for the period are as follows:

The $40 increase on the asset side is balanced by the $30 increase in liabilities and the $10 increase in retained earnings on the opposite side of the accounting equation. The books are in balance.

In most situations, not all annual profit is distributed to owners; some is retained in the business. Unfortunately, the retained earnings account sounds like an asset in the minds of many people. It isn’t! It’s a source-of-assets account, not an asset account. It’s on the right-hand side of the accounting equation; assets are on the left side. For more information, see the sidebar “So why is it called retained earnings?”

The product business in Figure 5-1 earned $1.69 million profit for the year. Therefore, during the year, its retained earnings increased this amount because net income is recorded in this owners’ equity account. You know this for sure, but what you can’t tell from the income statement is how the assets and liabilities of the business were affected by its sale and expense activities during the period. The product company’s $1.69 million net income resulted in some mixture of changes in its assets and liabilities, such that its owners’ equity increased $1.69 million. Could be that its assets increased $1.0 million and its liabilities increased $0.69 million, but you can’t tell this from the income statement.

The financial gyrations in assets and operating liabilities from profit-making activities are especially important for business managers to understand and pay attention to because they have to manage and control the changes. It would be dangerous to assume that making a profit has only beneficial effects on assets and liabilities. One of the main purposes of the statement of cash flows, which I discuss in Chapter 7, is to summarize the financial changes caused by the profit activities of the business during the year.

Making sales: Accounts receivable and deferred revenue

Many businesses allow their customers to buy their products or services on credit, or “on the cuff,” as they said in the old days. The customer buys now and pays later. To record credit sales, a business uses an asset account called accounts receivable. Recording a credit sale increases sales revenue and increases accounts receivable. The business records now and collects later. The immediate recording of credit sales is one aspect of the accrual basis of accounting. When the customer pays the business, cash is increased and accounts receivable is decreased. In most cases, a business doesn’t collect all of its credit sales by the end of the year, so it reports a balance for its accounts receivable in its end-of-period balance sheet (see Chapter 6).

In contrast to making sales on credit, some businesses collect cash before they deliver their products or services to customers. For example, I pay The New York Times for a one-year subscription at the start of the year. During the year, the newspaper “delivers” the product one day at a time. Another example is when you buy and pay for an airline ticket days or weeks ahead of your flight. There are many examples of advance payments by customers. When a business receives advance payments from customers, it increases cash (of course) and increases a liability account called deferred revenue. Sales revenue isn’t recorded until the product or service is delivered to the customer. When delivered sales revenue is increased, the liability account is decreased, which reflects that part of the liability has been “paid down” by delivery of the product or service.

Increases or decreases in the asset accounts receivable and the liability account deferred revenue affect cash flow during the year from the profit-making activities of the business. I explain cash flow in Chapter 7. Until then, keep in mind that the balance of accounts receivable is money waiting in the wings to be collected in the near future, and the balance in deferred revenue is the amount of money collected in advance from customers. These two accounts appear in the balance sheet, which I discuss in Chapter 6.

Selling products: Inventory

The cost of goods sold is one of the primary expenses of businesses that sell products. (In Figure 5-1, notice that this expense equals more than half the sales revenue for the year.) This expense is just what its name implies: the cost that a business pays for the products it sells to customers. A business makes profit by setting its sales prices high enough to cover the costs of products sold, the costs of operating the business, interest on borrowed money, and income taxes (assuming that the business pays income tax), with something left over for profit.

When the business acquires products (by purchase or manufacture), the cost of the products goes into an inventory asset account (and, of course, the cost is either deducted from the cash account or added to a liability account, depending on whether the business pays cash or buys on credit). When a customer buys that product, the business transfers the cost of the products sold from the inventory asset account to the cost of goods sold expense account because the products are no longer in the business’s inventory; the products have been delivered to the customer.

In the first layer in the income statement of a product company, the cost of goods sold expense is deducted from the sales revenue for the goods sold. Almost all businesses that sell products report the cost of goods sold as a separate expense in their income statements, as you see in Figure 5-1. Most report this expense as shown in Figure 5-1 so that gross margin is reported. But some product companies simply report cost of goods sold as one expense among many and do not call attention to gross margin. Actually, you see many variations on the theme of reporting gross margin. Some businesses use the broader term “cost of sales,” which includes cost of goods sold as well as other costs.

A business that sells products needs to have a stock of those products on hand for ready sale to its customers. When you drive by an auto dealer and see all the cars, SUVs, and pickup trucks waiting to be sold, remember that these products are inventory. The cost of unsold products (goods held in inventory) is not yet an expense; only after the products are actually sold does the cost get recorded as an expense. In this way, the cost of goods sold expense is correctly matched against the sales revenue from the goods sold. Correctly matching expenses against sales revenue is the essential starting point of accounting for profit.

Prepaying operating costs: Prepaid expenses

Prepaid expenses are the opposite of unpaid expenses. For example, a business buys fire insurance and general liability insurance (in case a customer who slips on a wet floor or is insulted by a careless salesperson sues the business). Insurance premiums must be paid ahead of time, before coverage starts. The premium cost is allocated to expense in the actual periods benefited. At the end of the year, the business may be only halfway through the insurance coverage period, so it should allocate only half the premium cost as an expense. (For a six-month policy, you charge one-sixth of the premium cost to each of the six months covered.) At the time the premium is paid, the entire amount is recorded as an increase in the prepaid expenses asset account. For each period of coverage, the appropriate fraction of the cost is recorded as a decrease in the asset account and as an increase in the insurance expense account.

In another example, a business pays cash to stock up on office supplies that it may not use up for several months. The cost is recorded in the prepaid expenses asset account at the time of purchase; when the supplies are used, the appropriate amount is subtracted from the prepaid expenses asset account and recorded in the office supplies expense account.

Using the prepaid expenses asset account is not so much for the purpose of reporting all the assets of a business, because the balance in the account compared with other assets and total assets is typically small. Rather, using this account is an example of allocating costs to expenses in the period benefited by the costs, which isn’t always the same period in which the business pays those costs. The prepayment of these expenses lays the groundwork for continuing operations seamlessly into the next year.

Fixed assets: depreciation expense

Long-term operating assets that are not held for sale in the ordinary course of business are called generically fixed assets; these include buildings, machinery, office equipment, vehicles, computers and data-processing equipment, shelving and cabinets, and so on. The term fixed assets is informal, or accounting slang. The more formal term used in financial reports is property, plant, and equipment. It’s easier to say fixed assets, which I do in this section.

Depreciation refers to spreading out the cost of a fixed asset over the years of its useful life to a business, instead of charging the entire cost to expense in the year of purchase. That way, each year of use bears a share of the total cost. For example, autos and light trucks are typically depreciated over five years; the idea is to charge a fraction of the total cost to depreciation expense during each of the five years. (The actual fraction each year depends on the method of depreciation used, which I explain in Chapter 8.)

Depreciation applies only to fixed assets that a business owns, not those it rents or leases. If a company leases or rents fixed assets, which is quite common, the rent it pays each month is charged to rent expense. (I don’t go into the current controversy regarding leases and rent expense at this point; see Chapter 8 for details on this hot topic.) Depreciation is a real expense but not a cash outlay expense in the year it’s recorded. The cash outlay occurred when the fixed asset was acquired. See the sidebar “The special character of depreciation” for more information.

Suppose a business records $100,000 depreciation for the period. You’d think that the depreciation expense account would be increased $100,000 and one or more fixed asset accounts would be decreased $100,000. Well, not so fast. Instead of directly decreasing the fixed asset account, the bookkeeper increases a contra asset account called accumulated depreciation. The balance in this negative account is deducted from the balance of the fixed asset account. In this manner, the original acquisition cost of the fixed asset is preserved, and the historical cost is reported in the balance sheet. I discuss this practice in Chapter 6.

Take a look back at the product company income statement example in Figure 5-1. From the information supplied in this income statement, you don’t know the amount of depreciation expense the business recorded in 2017. However, the footnotes to the business’s financial statements and its statement of cash flows reveal this amount. In 2017, the business recorded $775,000 depreciation expense. Basically, this expense decreases the book value (the recorded value) of its depreciable assets. Book value equals original cost minus the accumulated depreciation recorded so far. Book value may be different — indeed, quite a bit different — compared with the current replacement value of fixed assets.

Unpaid expenses: Accounts payable, accrued expenses payable, and income tax payable

A typical business pays many expenses after the period in which the expenses are recorded. Following are common examples:

• A business hires a law firm that does a lot of legal work during the year, but the company doesn’t pay the bill until the following year.
• A business matches retirement contributions made by its employees but doesn’t pay its share of the latest payroll until the following year.
• A business has unpaid bills for telephone service, gas, electricity, and water that it used during the year.

Accountants use three types of liability accounts to record a business’s unpaid expenses:

• Accounts payable: This account is used for items that the business buys on credit and for which it receives an invoice (a bill) either in hard copy or over the Internet. For example, your business receives an invoice from its lawyers for legal work done. As soon as you receive the invoice, you record in the accounts payable liability account the amount that you owe. Later, when you pay the invoice, you subtract that amount from the accounts payable account, and your cash goes down by the same amount.

• Accrued expenses payable: A business has to make estimates for several unpaid costs at the end of the year because it hasn’t received invoices or other types of bills for them. Examples of accrued expenses include the following:

  • Unused vacation and sick days that employees carry over to the following year, which the business has to pay for in the coming year
  • Unpaid bonuses to salespeople
  • The cost of future repairs and part replacements on products that customers have bought and haven’t yet returned for repair
  • The daily accumulation of interest on borrowed money that won’t be paid until the end of the loan period

  Without invoices to reference, you have to examine your business operations carefully to determine which liabilities of this sort to record.

• Income tax payable: This account is used for income taxes that a business still owes to the IRS at the end of the year. The income tax expense for the year is the total amount based on the taxable income for the entire year. Your business may not pay 100 percent of its income tax expense during the year; it may owe a small fraction to the IRS at year’s end. You record the unpaid amount in the income tax payable account.

  Note: A business may be organized legally as a pass-through tax entity for income tax purposes, which means that it doesn’t pay income tax itself but instead passes its taxable income on to its owners. Chapter 4 explains these types of business entities. The business I refer to here is an ordinary corporation that pays income tax.