If a Balance Sheet is like a picture, a snapshot of a point in time, then the Income Statement is like a movie. Think of the statements going in this order: Balance Sheet snapshot, then Income Statement movie, then another Balance Sheet snapshot at the end of the movie, and so on. It shows you what went on in the business over a period of time, usually a month, quarter or year. Remember, the Balance Sheet’s left side (List of Assets) is the Debit side, and the right side (Liabilities & Equity) are Credits. The Income Statement’s (a.k.a. Profit & Loss or just P&L) job is to show a breakdown, by category, of how the equity in the company changed as a result of doing business that period. It shows that either the company made money, which increases equity (a credit), or it lost money, which decreases equity (a debit).
Knowing this allows you to figure out the debits and credits on the Income Statement. If the company made money, which we know increases equity, then credits must have exceeded debits, therefore, income is a credit, because we need more income (and credits) to increase equity on the balance sheet, and so expenses must be debits. If the company lost money, it’s expenses exceeded income, therefore, debits exceeded credits. Whatever the “bottom line” is on the income statement, profit or loss, flows through to add to, or subtract from, the equity on the end-of-the-period balance sheet.
All these statements are designed to answer the question, “what is going on in my business?” so that the owner is not guessing, or going on hunches and gut instincts. Another one I see a lot is relying on whatever the bank balance says, as a way to tell what is going on with the business. That is not good. The owner needs certain information to make better, longer-term decisions. A good bookkeeping system gathers this information efficiently and is able to give the owner these reports easily, quickly, and efficiently. If you think it’s good to operate a business based on how much cash is in the checking account, you really need to go back and learn the fundamentals of business accounting if you don’t want to be fooled by false information!
The Income Statement answers the question, “WHERE did we make or lose money”? This is why income and expenses are grouped into categories, or “accounts”. These accounts are further grouped by major category such as “Cost of Goods Sold”, which are the direct costs, such as materials and labor. Another major category of expenses are “Selling, General, and Administrative” or SG&A, which might be listed separately as Selling Expenses, then G&A. Again, when properly designed and setup, this quickly shows the owner which area of the business is OK and which ones are out of whack in relation to the others or in relation to your past history. Efficiency means, for instance, the owner can quickly see “General & Administrative” (your overhead) has been climbing over time, pinpoint a particular account that’s the culprit, and narrow the search to those bills that hit that account. Quick and efficient, and no guessing! That’s what a good accounting system does for you.
Finally, I will share with you a debit and credit secret insight. I hope it is obvious that every transaction involves an equal amount of debits and credits. After all, things must remain in balance! Knowing one side, leads you to figure out what the other side should be. OK, here’s the secret: most normal, daily transactions that are part of the business that the company conducts with the outside world, in other words, transactions which affect income or expenses, involve BOTH the Income Statement AND the Balance Sheet. You record a sale: Credit Sales (I/S) and Debit Accounts Receivable (B/S). Enter a bill: Debit an Expense (I/S), Credit Accounts Payable (a B/S Liability).
Receiving payments or paying bills are transactions but they don’t add to income or expense, because those were already recorded as such. You receive a payment: Debit cash and Credit Accounts Receivable (both B/S asset accounts). Pay a bill: Debit Accounts Payable (Liab) and Credit cash (again, both B/S accounts). Note the distinction, a transaction that is part of the normal business with the outside world affects both statements. That’s why if the business borrows $100,000 from the bank, that’s obviously not revenue from customers, even though it increases cash. In that case you would Debit cash and Credit Long Term Debt (both B/S accounts). Buying a piece of equipment with that $100,000 has nothing to do with customer transactions (normal expenses) so you would Debit Equipment (asset) and Credit Cash (also an Asset).
To summarize, only outside-customer-related transactions will end up as part of the Income Statement, with the other side of the transaction affecting a Balance Sheet account. This is why a properly done accounting system is essential to the owner. Cash in the checking account increased so we must be making money, right? Wrong! Where did the increase come from? That’s the question! Did you simply borrow money? Did you collect a lot of receivables (sales from past months) but you had few current month sales? Remember the fundamental question, did THE BUSINESS generate money? That is the question that the Income Statement, or Profit & Loss Statement will answer!
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