Financial Reporting Basics – Income Statement
Before we can dive into the details of standard accounting reports, Earl needs to make a decision: accrual basis or cash basis accounting method?
Matt the CPA: The reason we have to decide this first is because financial reports are going to look very different depending on whether you go with cash basis or accrual basis.
Earl: I don’t want to make it too complicated.
Matt the CPA: I recommend that you use accrual basis accounting. I know this is just a side hustle right now, but if it starts growing a lot, it’s going to be a pain to change the way you do your books.
Earl: Accrual sounds kind of a little bit, you know, intimidating. I just want to do…
Matt the CPA: Yeah, fine. I’m just a certified CPA, what would I know.
Earl: Haha, yeah… Can we just decide this later? It’d be nice to have accounting software that could do both.
Income statement basics explained
The first standard report that Matt the CPA is going to introduce to Earl is the income statement. The income statement shows Earl how profitable his business is. If we want to know how profitable Grasscreek Enterprises is during a period of time, we would want to take a look at the increase in revenue during that period minus any expenses. The income statement breaks down revenue and expenses into more detail and shows the net profit / net loss after you subtract all expenses from revenue.
So those are all terms that Earl is somewhat familiar with.
Earl: So far, so good.
Let’s take a look at the revenue sources that Earl predicts. Grasscreek Enterprises is engaged by clients as a consulting service, so Earl will bill them at an hourly rate for any work that he does. Earl sends them invoices at the end of every month with net 30 terms.
Matt the CPA: Hey you know, most businesses actually use accrual basis accounting, so how about we revisit the accrual basis vs cash basis debate. I know you’re probably more familiar with cash in and cash out, but there are reasons why accrual accounting might be better for you.
Earl: I’m listening.
Matt the CPA: As your business grows it may get a little bit more sophisticated, and there are certain things that are just going to be more difficult when you do cash based accounting.
Earl: For example?
Matt the CPA: Let’s say you decide that you want to collect a retainer from a new client because you don’t know them that well.
Earl: Sounds like a good idea. How is that a problem with cash basis accounting method?
Matt the CPA: Well should you really count that as revenue if you haven’t earned it yet? What if the client changes their mind and wants a refund of their unused retainer?
Under the accrual method, if Earl collects a retainer upfront, that money is booked in the liability account Unearned Revenue that Earl can “earn” overtime as he bills against the collected retainer. Also, if Earl does some consulting for a client and sends them an invoice for $1,000, that $1,000 is going to get booked as revenue the same day he sends the invoice even though the client won’t be paying until later.
When Earl finally does get paid, he’s going to have to make an entry that shows the money was actually paid and that there is no longer money being owed (accounts receivable).
Matt the CPA: We can keep talking about accrual basis accounting until you feel comfortable with it but essentially your revenue is going to show up in the income statement for the period range when the work was billed, not when you get paid.
Earl: Nothing that I have done in life has prepared me for this moment. I’m going to just trust you on this.
Matt the CPA: I’m gl9ioad you are coming around because cash basis method doesn’t do a great job of making sure that expenses show up in a meaningful way on your income statement.
Earl: Ok, be honest. Was cash-based accounting made up by accountants so that you can make fun of newbies?
So we’re going to talk about that a little bit later but essentially my revenue is not going to change when I get paid. It’s just going to…where the money…where the value is it’s going to shift but there’s no new…wher9e the asset is, it’s going to shift but there’s not going to be any new revenue. Okay, and then the other main part of the income statement is the expenses. So now that Matt has kind of convinced me that I should do accrual accounting, that he’s basically looking at my bank fee and saying ‘Okay what did you actually end up paying for these you know? Because you can’t just magically do marketing. There’s tools that you have to pay for, marketing research tools and there’s maybe some contractors that I had to pay for.
So I want to track all those as expenses against kind of the revenue that I’m earning, and I can, in Zip Books for example, you can tag expenses to specific clients so I can look at you know, profitability. You know, I can look at profitability by client or I can also tag a client with an expense and say it’s reimbursable or it’s billable so that when I send the invoice, it automatically adds that expense to the invoice which is kind of nice but that’s kind of outside the you know, the kind of the big picture that we’re staying on right now is just essentially all of my revenue and all of my expenses.
So Matt’s going to explain to me that ‘Hey you know, you had say $500 worth of expenses between all of the difference you know, sub-contracting and software that you’re paying for as a marketing consultant, and so you know, you’re going to take that away from the you know, income that you made and so that now you’re essentially subtracting those two, or you’re subtracting the expenses from your revenue and that gives you your income.
So that…it gets a little bit more complicated than that but that’s basically what it is, so big picture, the income statement is there to essentially record all of your revenues that you’ve earned during the period of time the income statement’s been generated for, and then to report expenses that also happen at the same time. So it’s essentially just your net income between the two, and then you know, obviously if the company lost money then it could be a net loss instead of a net income.