Back to the Basics of Accounting (or) I Don’t Know a Thing about Accounting, Where Do I Start?
Sep 27, 2011
Part B (The Income Statement)
In my last blog, I started to answer the question “Are debits good or are they bad?” As I went through that some of the scenarios, I focused on entries that affected the Balance Sheet. However, the answers change when looking at the Income Statement. Recall that every entry requires both a debit and a credit. When a debit occurs on the balance sheet but the credit isn’t to an asset account or a liability or equity account, then the credit has to affect an Income Statement account. In general, credits on the income statement are made to revenue or sales accounts; debits are made to expense accounts.
As an example, assume you own your own appliance servicing company. A customer, Mrs. Prudence, has asked you to come and install a gas cooking appliance. The customer has paid for all of the supplies and the appliance already. You are connecting the appliance to the gas plumbing and making sure the connections are safe. The work is completed, it is done well, to code, and everyone is happy. Now you need to bill the customer, so you create an invoice for $250. Your account entry would be:
Debit Credit
Accounts Receivable 250.00
Service Revenue 250.00
Record service revenue for Mrs. Prudence 500 W. Main Street
In this example, a debit to Accounts Receivable is a “good thing” and the credit to Service Revenue is also a “good thing. Revenue accounts increase when a credit entry is posted to the account. However, a credit to the customer would look like this:
Debit Credit
Service Revenue 10.00
Accounts Receivable 10.00
Record good customer discount to Mrs. Prudence 500 W. Main Street
Now total Service Revenue would be $240 or 250 – 10. While the debit to service revenue is a bad thing it also may create additional customer loyalty from Mrs. Prudence and that loyalty could be important parts of helping your company remain competitive. There is a lot to weigh when doing financial analysis.
On the other hand, increases to expenses take place when expense accounts are debited. I usually view that as “bad.” (My preference is for a very black and white world with good and bad being easily recognized. Fortunately for me, I did reach the age of about 13 and found out that it isn’t always that easy to sort out…sometimes you have to use your judgment.)
Income Statement Structure
The basic structure of the income statement is very simple: Revenue minus expense = profit. However, the nature of the business of the company will have a significant impact on the actual structure. A professional organization may have an income statement that looks like this:
Professional Corp.
Income Statement
For the Year Ended
December 31, 201X
Net Revenue $1,525,000
Expenses:
Salaries and Wages $1,000,000
Benefits 200,000
Insurance 25,000
Other Expenses 150,000
Total Expenses 1,375,000
Net Income $ 150,000
A retail sales company would be better served by an income statement that recognizes revenue less cost of goods sold less general and administrative expenses and then income taxes for net income.
Retail Corp.
Income Statement
For the Year Ended
December 31, 201X
Net Revenue $1,525,000
Cost of Goods Sold 925,000
Gross Profit 600,000
Administrative Expenses:
Salaries and Wages $ 275,000
Benefits 75,000
Insurance 25,000
Other Expenses 130,000
Total Expenses 505,000
Net Income $ 95,000
A manufacturing company may have a more complex income statement because the company purchase raw materials and then converts and fabricates and assembles and welds and finishes the items. All that activity makes for many moving parts and it can be very helpful to generate an income statement that helps identify the various expenses. However, I typically do not like all income and expense items to appear on an income statement. Instead, I prefer for similar revenues to appear on the same line in a summarized manner and similar expenses to appear on the same line.
Manufacturing Corp.
Income Statement
For the Year Ended
December 31, 201X
Net Revenue $1,525,000
Cost of Goods Sold Materials $600,000
Manufacturing Labor 325,000
Manufacturing Costs 275,000
Cost of Goods Sold 1,200,000
Gross Profit 325,000
Administrative Expenses:
Salaries and Wages $ 125,000
Benefits 35,000
Insurance 25,000
Other Expenses 80,000
Total Expenses 265,000
Net Income $ 60,000
Think of it this way: just because you have created an account that could appear on the income statement doesn’t mean you have to show every account. Do you really want to see every general ledger account? I don’t. Instead, I like to summarize several accounts on a single line. Larger consolidated numbers can be more meaningful. Regardless of the type of financial organization however, credits increase profitability and debits reduce profits.
