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Jeff Ward |
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Basics of Accounting - The Income Statement In the last lesson we looked at Assets, Liabilities, and Owners Equity, and how these accounts are measured at a point in time to determine the Balance Sheet of a firm. The Balance Sheet tells us if there are assets (things we own) that are enough to pay off our liabilities (things we owe). In a successful business, we hope that the difference between the two gets greater to the advantage of Assets. In other words, we hope that over time we can increase the value of assets, or decrease the value of liabilities, through the profitable operation of our company. In this lesson we will look at the financial statement that measures how our operation is performing over a period of time by measuring two new categories of accounts – Revenue and Expenses.
These two categories of accounts are the major components of what is called the Income Statement. The difference between the two results in either a profit or loss for the period of time being measured. The equation for the Income Statement is: REVENUE – EXPENSES = PROFIT (OR LOSS) The Income Statement Figure A below shows the structure of an Income Statement, and how we calculate our profit or loss. Definitions of Accounts REVENUE – money paid for the goods we sell. There may be several categories for revenue. Think of a movie theater – revenue comes in for tickets sold, and also for money taken in at the concession stand. There would be two entries for revenue to reflect these two sources of cash. A restaurant may break out revenue into sales of food and sales of alcohol – this may help in determining taxes if there is a different tax rate on alcohol sales than on food sales. At many concerts there is a concession stand selling souvenirs – tee shirts, CDs, etc. There would be revenue entries for ticket sales, and also for sales of merchandise. On the Income Statement all revenue types (and there may only be one) are added so that there is one totaled amount. EXPENSES – money we pay to others so we can generate revenue.
When a company is selling products, those products are often purchased from another company. We must establish how much we paid for the goods we eventually sold. Why is this complicated? It would be simple if we bought a case of product and sold the contents, one-by-one, until they were all gone. Then our Cost of Goods sold would very easily match up against the revenue we received for selling them. What happens for real, however, is that we buy a case of product that has, say, a hundred individual boxes inside, at $1.00 for each individual box. We don’t want to run out of inventory to sell, so when we get down to, say, 25 boxes left, we buy another case. Now we have 125 boxes for sale. We continue selling right up until the end of the month, when we have 30 left on our shelf. How do we figure out our Cost of Goods Sold? Value of Inventory:
Cost of Goods Sold: To calculate Cost of Goods Sold, we take inventory at the beginning of the period of time. (Well, really we are taking it at the END of the previous period. That number becomes the Ending Inventory number for the LAST time period, and Beginning Inventory for the period that is just starting.)
During the period of time we make purchases of new inventory, and we add all of them together at the end of the time period and enter that amount as Purchases (in our example, we only made one purchase, for $100). Adding the Beginning Inventory and Purchases together tells us how much we had for sale during the time period (not all at once, but spread out across the time period).
We take another inventory at the end of the time period, and deduct this from the Goods Available for Sale, and the remaining number is the cost of the items that were sold to produce the Revenue we have reported.
LIFO, FIFO, or What the heck? Ok, seem simple? Well here’s the kicker – what if we paid $1.00 per unit sold for the first batch of inventory, and $1.50 for the next batch? How do we know which ones were sold? How do we value the Ending Inventory number – number of units left times $1.00 or $1.50?
The easiest method is to average the two costs. We multiply the number of units we purchased at $1.00, and we multiply the number of units we purchased at $1.50, add these two numbers together and divide by the total number of units purchased. In our little example, we bought 100 boxes at $1.00, for $100. Later we bought another 100 at $1.50 per unit, for $150. We add these two together to get $250, and divide by the total number of units purchased – 200 – to get a final “average cost” of our inventory of $1.25 per unit. Even though we did not actually pay $1.25 for anything, we use this number, times the remaining units at the end of the time period, to determine Ending Inventory. In our example, the Ending Inventory would be $37.50, and our Cost of Goods Sold would be $212.50.
Cost of Goods Sold: FIFO There is another way to figure out the value of the remaining inventory, based on the idea of first in, first out. The idea here is that we are carefully moving inventory from the back of the shelf to the front, and putting any new purchases of inventory at the back to slowly make its way to the front as customers buy the units. We can assume from this scenario that those units left on the shelf are the ones we most recently purchased, so will be valued at the last price we paid for the product.
Cost of Goods Sold: LIFO There is yet another way to figure out the value of the remaining inventory, based on the idea of last in, first out. Here, when we buy new units we simply shove the older ones to the back of the shelf to make room for the new ones. Customers, taking from the front of the shelf, will be buying units we paid $1.50 for, and leaving the older, $1 units remaining on the shelf. In this scenario the units left on the shelf are the ones purchased at the oldest price, or $1.00.
Cost of Goods Sold: So which of these three methods is correct? All are acceptable under GAAP! Probably the most “accurate” is the average cost method, but accountants may want to use one of the other methods depending on who the particular reader is to be.
If the reader will be a lender, we would want to show lower expenses because it makes our profit higher, so we might use FIFO. If we are reporting to the IRS, we might want to show as little profit as possible, so would want high expenses and would use LIFO.
Back to Expenses:
· Operating Expenses Almost all other expenses incurred by a business are categorized into a broad group known as Operating Expenses, because they are the bills that must be paid in order for the business to continue operating. The major types of Operating Expenses are rent, payroll, marketing, utilities, depreciation (which we are accumulating on the Balance Sheet but expensing on the Income Statement), licenses, local taxes, and legal and accounting fees. There can be many other types of Operating Expenses depending on the type of business.
And remember: REVENUE minus EXPENSES equals PROFIT or (LOSS)
PROFIT or LOSS – how we did. The number we calculate with the above formula is our “profit”, or “loss”. Our Balance Sheet measured at the END of the time period used to measure the Income Statement will reflect the profit by having increases in asset accounts – cash, inventory, or equipment, etc., or with decreases in liabilities – we pay a bill off with the profit, etc. Our Owners Equity will also go up by the amount of the profit.
Likewise, if we have a loss it will be reflected in lower assets or higher liabilities, and by a decrease in Owners Equity.
But unless the business is a no-for-profit (church, charity, etc.) there is one more category of expenses – Federal Income Taxes. These are generally posted AFTER the Revenue minus Expenses calculation, as the tax is calculated by multiplying the applicable tax rate (per IRS instructions) by the Net Profit Before Tax figure.
Please look at this link for more background
information on the Income Statement: Figure A Joe Jones INCOME STATEMENT For the Twelve Months Ending December 31, 2001 Revenue from Operations $500,000 Cost of Goods Sold: Cost of Goods
Sold -$275,000 Operating Expenses: Rent
$50,000 Net Profit $ 58,250 |
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