Profit and loss statements are a great tool to monitor the profitability and health of a company. At first glance they seem fairly simple; however, there are some important things to remember when working with these statements. There is real life, and there are taxes. They look alike but one is an orange and the other is a tangerine. The profit and loss statement typically looks at a company’s profitability from a tax perspective. Therefore, there are some important things to keep in mind when taking a brief analysis of the profit and loss statement.
First, there is the income section. From a tax perspective, this is what is taxable and what is not. Obviously, any sales or fees charged are considered income. Money put into the company from owners’ contributions or borrowed money is not considered income. This is a common mistake that many new businesses make; counting capital contribution as income. Another common misconception occurs when looking at money that came in and then went directly out to a particular expense. Many assume that money is not taxed, justifying that, “I broke even, so I don’t need to report it.” All money from sales or fees charged is considered income; the money paid out is an expense. What is not taxed are owner contributions, sale of stock to shareholders and borrowed money for equipment for future growth and expenses.
Second on a profit and loss statement is the cost of goods section. This section shows what it costs to provide the service or to purchase/make the product sold. If the company is a manufacturing company, the cost of the materials, labor, shipping and such would be included as the cost of goods.
The third section includes expenses. There are two basic types of expenses, real and phantom. The best example of a real expense would be utility bills, payroll or any other type of expense that does not build the asset side of the balance sheet. Phantom expenses are expenses such as depreciation. Depreciation is not an expense that comes out of the bank account. Rather, it is an expense that is taken over time for an asset purchased, such as a computer.
Some expenses are a hybrid of real and phantom. An example would be a mortgage payment on a piece of property. The tax expense would be the interest deduction, the phantom expense would be the depreciation and the principal payment goes to the balance sheet to lower the liability. From a real life point of view, the mortgage payment is an expense. From a tax point of view, it is split.
The profit and loss statement serves mainly as a snapshot of where the company stands from a tax point of view. When the profit and loss statement as a whole, it is important to have an understanding of and pay attention to ratios on the statement. For example, a wholesaler’s cost of goods would generally run between 45 to 55 percent of the total sales. Any deviation from that should be explainable through the inventory values on the balance sheet. If the inventory values remain the same and the cost of goods is higher, it’s time to begin asking questions to account for the difference. The ratios are different for each industry and can also assist the Internal Revenue Service determine if an audit is needed.
Another useful aspect of profit and loss ratios is that they help company managers make more informed decisions. For example: If the rents are running around 20 percent of the gross income; are there any steps to get that particular expense under control? The Internal Revenue Service has industry standard ratios as a guideline and any deviation above the norm triggers an audit. This doesn’t mean you will not be entitled to the deduction; they will just want to take a look at it for accuracy.
The last thing to consider is how the report is calculated: cash or accrual basis? Cash basis income is reported when received, and expenses are reported when paid. All individuals and sole proprietors report on a cash basis and it’s the easiest way to look at the profit and loss statement. It also gives a pretty good picture of where the company stands on a particular date. An accrual basis reporting reports the income when billed and expenses when occurred. The accrual basis makes the tax return a little more complex. The accrual basis report gives a better understanding of what the companies short term future looks like since all the income expected and all the expenses expected are on the report.
Profit and loss statements appear, on the surface, to be a simple overview of a company’s financial story however, a closer look reveals that these statements are very complex. When read correctly they can be an asset for any business in determining the financial future.
Al Wagner, President, Trinity Tax Consultants, Inc.