Understanding your Income Statement
Small Business Finance - How To Understand Expenses On The Income Statementby Bruce D Hunter
Expenses like income are treated differently depending on your method of accounting (cash or accrual). Cash accounting says a cost is "expensed" when you write the check to pay for it. Accrual accounting expenses the cost when the transaction occurs whether or not money is exchanged, e.g. a supplier may give you 30 days to pay your bill or you may pay your payroll/sales taxes monthly. Accrual accounting attempts to keep expenses matched up with the sale that generated it. Bills that are paid in a lump sum for the year can be accrued (spread out) each month; e.g. unemployment insurance is paid in lump sums which throws off your P&L because of the large payment.
A solution is to record the payment to the Pre-paid Expenses account within Current Assets on the Balance Sheet. You can then divide the amount by the number of months paid and then each month reduce the Pre-Paid Expenses by the smaller monthly payment and record it in the Unemployment Insurance account on your P&L.
Most of your expenses come from your checkbook register but there is a couple you will want to watch out for.
The principle portion of your loans and credit cards that you pay on your bill are not expenses. The principle portion paid should go to the liability account on the balance sheet for the loan. The interest portion of the bill is an expense. You need to look at the bill and split out the two portions.
Items that are purchased in the $500+ range (start ups and businesses with sales less than $300,000) are considered investments in the business and should be depreciated over an IRS predetermined time span. This is where tax law and Generally Accepted Accounting Principles are applied. Larger businesses are able to expense bigger ticket items. A small business puts these $500+ purchases on their balance sheet under long term assets.
Don't worry about recording depreciation monthly unless your accountant has given you a schedule. Depreciation becomes a non-cash expense and accounts for the items you put on the balance sheet above $500 earlier.
Something to watch out for with depreciation is that the new tax laws have accelerated the ability to depreciated your assets, a good thing for lowering taxes but it often leaves a small business looking like it is not re-investing in itself. Ask your accountant to run the depreciation schedule two ways, one for taxes using the acceptable accelerated depreciation and the second way using the straight line depreciation based upon the lifespan of the asset for your business books. Why is this important? Banks run ratios that use assets to determine bank ability. As for you, it will give you a better idea of when to re-invest in furniture, fixtures, and equipment.
The most difficult thing about using P&Ls and income statements is consistent coding of expenses into their appropriate accounts. If you are unsure about which accounts to use, start with the ones on the tax return you will be using; e.g. schedule C for sole proprietors.
Bruce Hunter is the CEO of CORE Magazine in Denver Colorado. CORE is the leading online source for small business startup. Visit our free online resource center now to get free access to information on small business finance.
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