My son-in-law is directionally challenged.  My daughter did most of the driving because she wanted to get to her destination.  With the loss of my daughter, it looked like my son-in-law was destined to spend most of his time lost.  After one such wilderness experience he broke down and purchased a GPS.  He knows with confidence that the GPS will guide him step-by-step to his desired destination.  For the business owner, the Income Statement, like a GPS, monitors business progress throughout the fiscal period. 

Where as the Balance Sheet is a snapshot of the Asset, Liability and Equity accounts at a particular time, the Income Statement is a cumulative record of the revenue earned and expenses incurred throughout a period of time, such as a month, quarter or year.  I think of the Income Statement as a series of buckets that capture the inflow of revenue and the outflow of expenses for a business.  Allow me to expand on this analogy a bit.

At the beginning of each business period (referred to as a fiscal period) all the buckets are empty.  Throughout the period, monies flow into the business in the form of revenue from products sold or services performed.  Monies flow out of the business in the form of expenses that are incurred to provide the products and operate the business.  Imagine a record of this money flow being captured by a series of buckets. 

Revenue flows into the business and is collected in a large bucket.  It would be nice if the owner got to keep all this money, but unfortunately there are a few leaks and a spigot through which the monies flow into a series of other buckets.  Examples of some leaks that might be encountered that reduce the total amount of revenue coming into the business are discounts applied to the sales price or the consumer’s return of products that are not suitable for resale. 

The spigot attached to the side of the revenue bucket allows monies to flow into buckets that represent the cost (expense) of making or purchasing the products sold by the company.  In the case of a retail merchandising company or a manufacturer, monies first flow into a bucket that represents the cost of making the goods sold or manufactured.  This first expense bucket captures the direct material, direct labor and the overhead that are applied to the making or stocking of products that customers buy. Generally companies that perform a service do not have a cost of goods sold bucket.  If the flow of monies exceeds the cost of making or stocking the goods that were sold, the excess flows over the top of the bucket and is captured by other expense buckets.  The overflow is referred to as Gross Profit and represents the monies that are available to cover non-manufacturing/non-production costs and provide a profit from the business.

There are commonly two major categories of non-manufacturing/non-production buckets.  One set of buckets is for Sales and Marketing expenses and another is for General and Administrative Expenses.  Sales and Marketing buckets include labor (salaries and wages of the Sales and Marketing staff), advertising, market research, sales campaigns and other costs associated with making  customers aware of the company’s products.  General and Administrative buckets capture the costs necessary to support the retail or manufacturing operation but are not directly related to the production of a product. Examples include the office of the company president, the accounting operation, human resources (recruiting, training and supporting employees), benefit programs, professional advisors such as attorneys or tax CPAs, administrative supplies, information technology (phones, computers, software and local networks), depreciation of non-manufacturing equipment, vehicles and buildings, interest on loans, and the myriad of other costs incurred to support the company.  If the company has performed well, there is a trickle of funds that remains after the diversion of the money flow into these many expense buckets.  These left over monies represent the profit that the company has earned from the operation of the business.  But, there is one more leak in the flow of funds –taxes.  The government has decreed that it should share in your good fortune as a wise and profitable business owner by taking a piece of your profits. Aren’t you a lucky duck? Whatever is left, you, as the business owner, get to keep.  

Many business owners rely on the income statement to provide an indication of the success of their business.  If records are kept on an accrual basis, business owners could be lulled into thinking they are doing well when in fact they are in trouble. The next statement that we will discuss is the cash flow statement, which is an EXTREMELY important report for monitoring cash availability in the business.