Today’s post is by our resident accounting guru, Andrea Whitney. For more of the Accounting 101 series, click here.
When you want to see how your company is doing for a period of time, you want to review the P/L, also known as the Profit and Loss Statement (or the Income Statement). This is going to give you a breakdown of your income and your expenses. And these are? And what do these do? And what does this have to do with the price of tea in China?
First there is Revenue, also known as Income. Income is recognized whenever a business sells a product or performs a service.
Next are expenses. Expenses occur whenever you spend on an item, whether it’s a reduction of your cash, a reduction of an asset or the creation of a liability. In an Income Statement, expenses should be categorized for a company to understand their different levels of profit.
The first expense category is Cost of Goods Sold (COGS), which is composed of the costs related to sale of goods and/or services. These include all items in payroll that are the employer’s portions: FICA, Medicare, FUTA and SUTA taxes and Worker’s Comp. Cost of Goods Sold would also include discounts and bad debt from writing off clients’ invoices.
Once you have your Revenue and your COGS, you will know your company’s gross profit (subtract COGS from Revenue). Congratulations, you’ve completed the top half of the P/L statement!
Operating Income & Income Before Taxes
But you’re not done yet; next, you’ll want to know your Operating Income. This is the amount of income/loss you have after you subtract your Operating Expenses from your Other Income.
What are Operating Expenses? These are items related to the day-to-day operations of the business. They include: rent, utilities, office supplies, advertising, license fees, legal fees, Insurance, property taxes, travel and vehicle expenses.
But wait, we’re not done; there may be other items. Other Expenses are next in the detailed P/L. These are costs that are incurred by the company outside day-to-day operations, so they’re not considered to be related to the core operations of the business.
Other Expenses are totaled with your Operating Expenses to get to the Total Expenses Before Interest. Interest expense comes after all of these; it’s the expense for the cost of interest for a period of time (basically, the cost of money itself).
And what about Other Income? This includes earnings from activities other than normal business operations, such as investment income, foreign exchange gains, rent income and profit from the sale of non-inventory assets.
Subtract your total Operating Expenses from Other Income to get your Operating Income (or loss), then add the Operating Income from your Gross Profit (or subtract if it’s a loss). Now we have Income Before Taxes.
Taxes & Equity
We then list Income tax as an expense paid for this period’s taxes. Deduct it from Income Before Taxes (to arrive at Income After Taxes!).
If you had any equity earnings, they need to be listed next. If your company has invested in stocks or other subsidiaries and owns more than 50% interest in the entity, the equity method accounting is used. That means that the firm you’ve invested in will report its equity earnings, and your company will show its share of those earnings.
If the subsidiary your company invested in lost money, the company would then show this under Equity Loss. You also have the possibility of being a minority interest owner. This would be if your company owned less than 50% of the company. The income earned from this subsidiary would show as minority interest income. If the minority interest happened to have a net loss, you portion of the net loss would be considered minority interest expense.
Once you’ve adjusted your Income Before Taxes by the income or loss from equity, you’ve arrived at your Net Income from Continuing Operations.
Now it’s time to account for the one-offs, the gain or loss of an infrequent nature that is unlikely to occur again in the normal course of a business. These include income on sale of assets, insurance settlements, one-time sales, etc. These items are called Extraordinary Charges. Adjust your Net Income from Continuing Operations by these Extraordinary Charges, and finally…
We’re at Net Income! Almost.
After all the adjustments have been made, you then need to apportion out the value of your preferred stock dividends and other adjustments to conclude the value of the net income that is applied to your common stockholders. So, subtract the proportion of your income that’s technically owned by other people.
Once this all has been done, you now have the end all Net Income or (hopefully not) Net Loss. It’s been a long journey, but now you know your costs, revenues, equities, etc. in some pretty major depth. Good job!