Introduction to Income Statement
Most small business owners know of the income statement which is also referred to as the profit and loss statement. The income statement is used for, “reporting a company’s financial performance over a period of time.” The income statement can be presented in cash basis and in accrual basis. The income statement can contain four distinct sections: Income, Cost of Goods Sold/Cost of Labor, Operating Expenses, and Other Income/Other Expenses.
Accrual Basis vs Cash Basis
The basis of accounting, “refers to the methodology under which revenues and expenses are recognized in the financial statements of a business.” The two main methodologies used are cash basis and accrual basis.
The accrual basis methodology recognizes revenue and expenses that have been incurred whether or not they have been paid. This methodology allows for the recognition of bad debt and follows the matching principle. The matching principle states that revenue and expenses should be recognized at the same time.
The importance of using this methodology for small business comes to play when considering gross profit. For most businesses, there is a relationship between income and cost of goods sold/cost of labor. The revenue and the related expenses may not necessarily happen at the same time. A company may pay contractors ahead of the period when the revenue gets posted to the income statement. It’s important to have an idea of a company’s gross profit to determine the amount of profit needed to meet normal operating expense obligations. As a small business owner, if you accrue your expenses and income, it’s important to review your A/R aging and A/P aging schedules to determine your companies ability to collect funds from customers and pay vendors in a timely manner.
The cash basis methodology recognizes revenue and expenses when they are collected and paid out, respectively. This methodology is simpler for business owners to understand, because it’s a matter of recording cash in and cash out transactions, and helps small business owners get an accurate picture of cash on hand without complex reports.
The importance of using this methodology for small businesses comes into play in understanding cash balances as well as understanding taxable income (except C-corporations). Using cash basis accounting allows business owners to easily estimate their taxable income generated by the business. The drawback to using this methodology is that it may not portray the health of the company accurately.
Most accounting systems allow for business owners to switch between both methodologies so there’s no need to choose one over the other.
Income Statement Sections
The income/revenue section of the income statement is the first section, which presents a summary of all income generating activities for the main business operations. This section can be as detailed as separating each line of revenue generating activities, or simply named, “Revenue/Sales.” For smaller businesses this section is usually very general and combines the income generated from goods and services sold to customer