Watch out for the profits

In the title paragraph, I pretty much summarized the gist of the income statement: Income and expenses! And they need to be matched up in the period to which they belong. We beancounters call this the matching principle. Every month beancounters devote some time to match sales incurred in a particular month with the related expenses. It makes sense because, ultimately, we want to figure out whether or not we are running a successful operation in any given period, whether it is a month, a quarter, or a year (by successful, I mean profitable). And if this isn't enough, there is another one of these sacred rules, but I promise it will be the last for a while. Generally, any of the three statements are prepared on an accrual basis. This means a sale is recorded as soon as a service is rendered or a product is delivered. The same applies to the expenses. But an easier way to understand it is that you don't need to wait for the cash to come in before a sale is recorded. You might think: "what nonsense, such a complicated faff." 

But imagine if a sale is only recorded when you receive cash or an expense is recorded once you paid your supplier. In no way would I be able to apply the matching principle. 

 

A simple example: Take the inventory we ordered for Jolly Brewing Ltd. worth £16,000 and £3,000. On a cash basis, we would record expenses worth £19,000 because we paid for it upfront, but this would not match the costs with the beer sales for the first three months! Why? Because we still had inventory worth £9,000 left in stock at the end of the three months! We have, therefore, not consumed the entire inventory.

 

The accrual standard makes sense because you can better understand your business activities with the help of the matching principle. 

I must acknowledge, though, that the matching principle has its weak spots. The most prominent one is that it is open to assumptions and estimates, which must be performed to align costs with revenues in each given month.

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But now, without further ado, the general format of the income statement: 

Sales - Cost Of Goods Sold - General Expenses - Taxes = Net Profit

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Let's go through each position to get a better feel for things. Oh, and before I forget, the income statement goes by a few names, such as "Statement of Profit and Loss," "Operating Statement," or "Statement of Income." But it is all the same! 

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Everything starts with Sales

Everything starts with income from the services or products we offer for sale. The more we can sell, the better it is! But sometimes companies can get a little bit too keen to record sth as a sale because they want to demonstrate that they are money-making machines. When they are in this kind of hurry, they forget one of the other holy principles of accounting called: "Revenue recognition." This fundamental principle is so important that I want to give you the original definition set out in IFRS 15 (IFRS stands for International Financial Reporting Standards - which is the holy book of accountants)

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Definition: By applying IFRS 15, an entity recognizes revenue to depict the transfer of promised goods or services to the customer in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

 

Let me translate:

This means that you can't record a sale before you haven't delivered, whether a service or an actual physical product. 

A simple example: Whenever you buy a concert ticket, do you think the organizer can record a sale straight away? Nope! Because when they take payment from you (mostly well in advance before the concert starts) they have not performed any service yet. A service is performed only after the band has concluded its concert; thus, a sale can be recorded. In the meantime, the money you have transferred to the event organizer must be recorded as a liability on the balance sheet. Quite clever because the event organizer is liable and obliged to perform a service for you! The liability account on the balance sheet for these transactions is called "Deferred Revenue." But this is already advanced stuff and only a bit of trivia at this point. 

 

Lastly, we beancounters use many names for "sales," such as revenue or sales income.

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Cost Of Goods Sold

In this income statement section, accountants like to combine all costs incurred in producing and getting a product ready to be sold. 

As a mental bridge, think of all the stuff that can be directly associated with producing and selling your product and service. All these costs typically fluctuate with the quantity produced, and accountants like to speak of variable costs precisely because they move directly in line with the amount produced. 

So let's take our Jolly Brewing Ltd and summarize all the direct costs that fall under the Cost of Goods sold.

• Hops, grains, and other brewing agents (the more beer we brew, the more hops we use)

• Salary of the worker helping with the bottling (typically, direct labor is charged for the hours worked, and the more you sell, the more hours have to be performed)

All these costs are direct in nature, attributable to the beer we produced for the German customer, and were incurred to get the beer ready for shipment/selling. They are also variable, meaning they fluctuate with the quantity of beer produced. 

Now, what about other expenses such as rent or the salary of a beancounter like me? Well, they are indirect and fixed costs because they can not be directly linked to the product, nor do they fluctuate with the level of beer produced or sold, nor were they necessary to get the beer ready for shipment. 

Freight-out is a tricky one and certainly subject to debate, but one could argue that it is variable in nature (the more beer we produce, the more freight we are being charged, as freight costs are driven by weight). 

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As always, these things are better explained with an example, in this case, the Profit and loss workings of Jolly Brewing Ltd.

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Let me guess, your eyes wandered straight down to the Net Profit line, which is perfectly fine, but we need to understand how we got there. We know we could sell our beer to our German customer, so this entry goes first. As with so many things these days (politics, the quality of our rivers, etc...), it only goes down from here. So let us start from the top. 

As explained in an earlier section, the cost of producing our beer is £10,000. If the logic of arriving at this figure is not entirely sticking yet, let me explain it in cooking terms.

Let's assume you had 5 cans of chopped tomatoes at the start of the month; during the month, your partner bought 3 more cans as she had not checked the food cupboard (silly mistake). At the end of the month, you do the prudent thing and count the cans, so you know where things stand. This little exercise resulted in 6 six cans of chopped tomatoes in the cupboard at the end of the month. How can this be? Well, I forgot to mention that you did a spag bol for the family. Question: How much did you use?  

The answer is easy! Just apply the formula: Opening stock: (5 cans), plus purchases (3 cans), minus end stock (6 cans), equals the monthly consumption, which is 2 cans! simples

In the picture of the Profit and loss statement, I put the £10,000 under COGS which, as explained earlier, is not quite the complete picture. I think the name COGS (Cost of Goods Sold) says it all: it should contain all costs incurred to sell the product... And as you can see from the picture above, in addition to the cost of producing the beer also, the cost of selling the beer is included. Now there is one slight inaccuracy left in this. You might rightly ask what about your colleague you have employed to help you in the company. In strict accounting terms, a portion of payroll/staff costs has to be included in COGS, namely those directly engaged in producing the product, such as machine operators whose pay varies with the amount of output produced. However, in more and more companies, staff are being paid a fixed yearly salary, so I find it challenging and somewhat misleading to portray them as variable costs. 

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The overheads

Crucially and most importantly, for effective cost management, COGS should only include variable costs, which fluctuate by the amount you sell/produce! The overheads should, therefore, mostly contain the stuff that stays roughly the same no matter how much you sell or not. Presenting your profit and loss statement is extremely helpful in volatile times. My boss, for example, immediately sees the potential impact of these sticky costs and therefore knows well in advance the result of a potential downturn on the horizon. In our example, I included the payroll costs in the overhead section as our helpful employee Mike does all sorts of things together with us! Other more intuitive overhead costs are for example, insurance and marketing, as these costs are incurred for the general benefit of the business in one case to protect against any claims of food poising and in the other case to make us more popular to a broader audience!  

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With the overheads determined, it is time to determine the first accurate operating result of the business, abbreviated as EBITDA or, in other words, the Earnings before interest, tax, and depreciation. This particular result is often used to determine how much cash the business generates from its ongoing operations. This makes sense as interest is a supporting cost sometimes incurred to start a business. On the other hand, tax is only incurred if your ongoing operations are profitable, and depreciation, which deserves a special mention. 

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Depreciation

The best way to describe it is an expense that accounts for using a particular asset (such as machines or a computer) over time. For example, Jolly Brew Ltd acquired a used brewing kit that the vendor assured us would last another 5 years. Considering this fact, it would only make sense to spread the cost equally over five years. Or in other words, each year, the machine becomes less valuable and loses its value gradually. We must account for this loss of value through a depreciation expense in the P&L. 

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Net Profit

With all costs determined, there is nothing else to do but subtract the interest and depreciation expense from the EBITDA figure to arrive at our destination: Net Profit!

£375 is left in our pockets, a mere 1.5% of sales! Relatively measly, you might think, but there is more to it which we will explain in the Cash Flow statement section!

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In conclusion! 

The Income Statement is like the Colorado River in the United States. It starts as a bountiful source of water held up at various stages to take stock of its bounty, and after multiple locations downstream, most of the time, nothing more than a little trickle of water is left. This happens when you are not careful with your resources!

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