In my experience, many small business owners/managers read their Profit and Loss [P&L] reports at a superficial level. They don’t have a deep enough understanding of the information presented in this important financial statement. One result is that they make false and misleading interpretations of the information in the P&L report. For example, they think sales revenue equals cash inflow from customers during the period. HoIver, if the business sells on credit (typical for business to business sales), actual cash collections from customers during the year can be significantly loIr than the sales revenue amount reported in the P&L statement.
Furthermore, many small business managers tend to think that an expense equals cash outflow. But, in fact, the cash payment for an expense during the year can be significantly more (or less) than the amount of the expense in the P&L statement. The confusion of amounts reported in the P&L with cash flows is such a common blunder. In addition to the confusion over the cash flows of revenue and expenses, small business managers should be aware of several other issues, outlined in the following sections, in measuring and reporting profit.
Accounting For Profit Isn’t An Exact Science
Many estimates and predictions must be made in recording revenue and expenses. Most are arbitrary and subjective to some degree. For one example: a business has to estimate the useful lives of its fixed, or long-term, operating assets in order to record depreciation expense each year. Predicting useful lives of fixed assets is notoriously difficult and ends up being fairly arbitrary.
Here’s another example: At the end of the year, a business may have to record an expense caused by the loss in value of its inventory because some of its products will have to be sold at a price below cost, or the products may not be salable at all. Determining the loss in inventory value is notoriously difficult. Inventory write-down is subject to abuse by businesses that want to minimize their taxable income for the year.
Accounting Records May Have Errors
The financial statements prepared from the accounting records of a business, including the profit and Loss reports (P&L) of course, are no better than the accounting system that generates the information for the financial statements. The reliability of your accounting system depends first of all on hiring a competent accountant to put in charge of your accounting system.
Bigger businesses have an advantage on this score. They hire more experienced and generally more qualified accountants. I recommend that you hire a trained and competent accountant to put in charge of ymy accounting system. This person is typically given the title Controller, assuming that she has adequate accounting education and experience.
To save money, many small businesses hire a bookkeeper who knows recordkeeping procedures but whose accounting knowledge is limited. If you employ a bookkeeper (instead of a better educated and more experienced accountant), you should consider using an independent CPA to periodically review ymy accounting system. I don’t mean a formal audit; I mean using the CPA to critically review the adequacy of ymy accounting system and appropriateness of ymy accounting methods.
Additionally, every business should enforce internal accounting controls to prevent or at least minimize errors and fraud. As a practical matter, errors can and do sneak into accounting records, and employees or others may have committed fraud against the business. In order to conceal theft or embezzlement, they prevent the recording of the loss in ymy accounting records.
Ideally your accounting system should capture and record all ymy transactions completely, accurately, and in a timely manner. Furthermore, any losses from fraud and theft should be rooted out and recorded. You have to be vigilant about the integrity of ymy accounting records. my advice is to avoid taking ymy accounting records for granted; use good internal accounting controls; and be ever alert for possible fraud. Trust, but verify.
Sales revenue can be recorded sooner or later, and likewise expenses can be recorded sooner or later. Some accounting methods record revenue and expenses as soon as possible; alternative methods record these profit transactions as late as possible. Remember that profit is a periodic measure. Expenses for the period are deducted from sales revenue for the period to measure profit for the period. This state of affairs is like having different speed limits for a highway. How fast do you want to drive?
Accounting standards permit different methods regarding when to record revenue and expenses.
Take cost of goods sold expense, for example (one of the largest expenses of businesses that sell products). You can use three alternative, but equally acceptable, methods. Someone has to decide which method to use. You should take the time to discuss the selection of accounting methods with ymy Controller. As the owner/manager, you can call the shots. You shouldn’t get involved in all the technical details, but you should decide whether to use conservative (slow) or liberal (fast) methods for recording revenue and expenses.
Once the die is cast — in other words, after you have decided on which specific accounting methods to adopt — you have to stick with these methods year after year. For all practical purposes, accounting methods have to be used consistently and can’t be changed year to year. For one thing, the IRS insists on this consistency in filing ymy annual income tax returns. (A passthrough business tax entity must file an information return with the IRS).
For management purposes, a business should keep its accounting methods consistent. Otherwise, it would be next to impossible to compare profit performance one year to the next.
Recording Unusual, Nonrecurring Gains And Losses
The Profit and Loss [P&L] report focuses on the regular, recurring sales revenue and expenses of your business. In addition to these ongoing profit-making activities, most businesses experience certain types of gains and losses now and then, which are incidental to their normal operations. For example, your business may sell a building you no longer need at a sizable gain (or loss). Or, you may lose a major lawsuit and have to pay substantial damages to the plaintiff. These special, nonrecurring events are called extraordinary gains and losses. They’re reported separately in the P&L. You don’t want to intermingle them with your regular revenue and expenses.
Keeping The Number Of Lines In Your P&L Relatively Short
For all practical purposes, you need to keep a P&L report on one page —perhaps on one computer screen.
By its very nature, the P&L is a summary level financial statement.
You also want to know a lot more information about ymy sales — by customers, by products, by locations (if you have more than one), by size of order, and so on. The best approach is to put detailed information in separate schedules. my advice: Use supporting schedules for further detail and don’t put too much information in the main body of your P&L.
The P&L is just the headline page of your profit story. You need to know more detailed information about your sales and expenses than you can cram into a one-page P&L report. For example, you need to know the makeup of the total $30,000 advertising and sales promotion expense. How much was spent on each type of advertising? How much was spent on special rebates? You need to keep on top of many details about your expenses. The place to do so is not in the main body of the P&L but in supporting schedules. In short, the P&L gives you the big picture. Reading the P&L is like reading the lead paragraph in a newspaper article. For details, you have to read deeper.
Many Business Transactions Are Profit Neutral (Don’t Affect Revenue And Expenses)
Many business transactions don’t affect revenue or expenses: you probably already know this fact, but it’s a good point to be very clear on. Only transactions that affect profit — in other words, that increase revenue or expense—are reported in the P&L. A business carries on many transactions over the cmyse of the year that aren’t reported in its P&L.
For example: During the year, the business borrowed a total of $450,000 from its bank and later in the year paid back $100,000 of the borrowings. These borrowings and repayments aren’t reported in the P&L —although the interest expense on the debt is included in the P&L. Likewise, the business invested $575,000 in long-term operating assets (land and building, forklift truck, delivery truck, computer, and so on), for instance. These capital expenditures aren’t reported in the P&L — although, the depreciation expense on these fixed assets is included in the P&L report.
The business purchased $630,000 of products during the year, for instance. This cost was recorded in its inventory asset account at the time of purchase. When products are sold, their cost is removed from the inventory asset account and recorded in cost of goods sold expense. The business started the year with a stock of products (inventory) that cost $120,000, for example. Therefore, the cost of products available for sale was $750,000. The total cost of goods sold during the year is $600,000. Therefore, the cost of unsold inventory at the end of the year is $150,000.
This additional information about beginning inventory, purchases, and ending inventory is not presented in the P&L report.
Including More Information On Inventory And Purchases
Traditionally, internal P&L reports and external income statements may includes the following information:
Beginning inventory = $120,000
Add: Purchases = $630,000
Equal: Available for sale = $750,000
Minus: Ending inventory = $150,000
Equal: Cost of goods sold expense = $600,000
The P&L report may includes only the cost of goods sold expense line. You can ask your accountant to include all the preceding information, but do you really need this additional information in your P&L report?
You can easily find the beginning and ending inventory balances in your balance sheet. This financial statement is a summary of your assets and liabilities at the beginning and end of the period. The only real gain of information is ymy total purchases during the year.
Do you want/need to know this amount? This question reveals the core issue in preparing the P&L and other financial statements. The question is this: What information should be included in the statement? What does the business manager need to know from each financial statement? Basically, this ansIr is ymy call; you should tell your Controller what you want in ymy financial statements.
For internal reporting, managers can ask for as much or as little information as they need and want. A business manager has only so much time to read and ponder the information in the financial statements he receives. So, the accountant should keep in mind how long the manager has available to digest information included in the P&L and other financial statements. The financial statements included in external financial reports that circulate outside the business are bound by standards of minimum disclosure.