When you’re running a business, your income statement (a.k.a. your profit and loss statement, a.k.a. “How much money did I make?” statement) is the financial statement you’re most familiar with.
But how familiar are we really? It’s a really simple statement, right?
Profit – Expenses = Net Income
But wait! There are more ways of looking at this!
Profit – Cost of Goods Sold = Gross Profit
Gross Profit – Expenses = Net Income
Hang on! There’s even more…
Less: Sales Returns and Allowances
Cost of Goods Sold
Less: Purchase Returns & Allowances
Net Cost of Goods Sold
Net Revenue – Net Cost of Goods Sold = Gross profit.
Now, what about freight costs?
Let’s say you’re a retail company. The freight that you pay to get your inventory into the warehouse before it’s sold is COGS (cost of goods sold). The freight that you pay to ship inventory to your customers is not COGS!
COGS is defined as all of the costs necessary to get the goods ready for sale. By the time I’m shipping to my customer, the goods have been sold, which means they were already “ready for sale” by the time I shipped them. That’s a selling expense, not COGS.
The income statement seems very simple, at the outset, to most small businesses, but depending on your business model, it can be infinitely more complex.
Want to see some interesting examples of income statements?
Google your favorite online retailer + “income statement.” For example, take a look at Best Buy’s income statement.
That should keep you busy for a while.
As to the question of how to prepare an income statement, you have to think in terms of who’s going to be looking at it.
If you are mostly using it for internal purposes, to make decisions about the company, then it matters less. In this case, the only person outside of your company who is looking at it would be your tax preparer. They will no doubt give you some guidance for what they need to see in order to get your tax returns done. Outside of that, have at it. Lay it out based on what you feel gives you the best information.
Technically, if you don’t sell inventory, then you don’t have COGS. Still, many service-based businesses use the COGS section of their income statement to describe “direct expenses.” These are expenses that would only be incurred if revenue were earned.
For example, a bookkeeping firm might show the salaries they pay their bookkeepers as COGS, so they can see a gross profit number that shows specifically how much money they’re making on their bookkeepers.
Loan covenants—which you must follow if have a loan or line of credit with your bank—might impact how you structure your accounts, although much of that is likely to impact the balance sheet.
There are certain metrics that you might call for your special attention. Any ratios involving “return,” such as “return on investment” or “return on assets,” mean we’re putting net income in the numerator. The question becomes: Which things should be included in “operating income” and which things should be placed “below the line?”
Investors often want to see what is called EBITDA (earnings before interest, taxes, depreciation, and amortization).
Investors want to look at how the business is performing without regard to these things. It gives investors (and perhaps lenders, too) a clearer picture of how the business is really operating.
In cases like this, you want to set these accounts up as “Other Income / Expenses” so that they show up at the very bottom of the income statement, “below the line,” where the line is the operating profit, or net ordinary income.
To help you understand how your income statement should be prepared, an accounting professional who can look at your specific needs.
In fact, when setting up a chart of accounts for new companies, I often start with the most minimal chart of accounts. This lets me create what we need as we go. The chart of accounts, and with that, the financial reports, take shape based on what needs arise as we move forward and record financial transactions.
In the end, we want something that gives us a clear picture of the financial performance, and picture of a company, over a range of time and at any moment in time. From an audit standpoint, we need something that fairly presents the financial picture of a company in all material respects.
As a small business owner, when you look at your own income statement, you should be able to get a feeling that it “looks right.” In my experience, even though they are not accountants, when business owners tell me it doesn’t look right, I believe them. Then we’ll dig in and figure out where it might be off, and why. Then we can correct anything that needs correcting or get clarification that it actually is correct.
Over the years, I’ve developed an “internal audit” process of sorts that I use with clients, to get at the root of whether the financial statements are accurate. Then we clean them up, as needed, and we maintain them going forward from there.
So, does your income statement look right to you? See my video above to help you decide.