Let’s set the scene here: You, an accounting professional, are preparing to review financial statements with a small business client. Your client, a small business owner, refuses to take the time to meet with you to review this information. His reason? “If I’m making money on every job, and there’s money in the bank, then I must be profitable!”
…Okay, we all know this is not an accurate representation of his business performance.
If you’ve been in the accounting field for as long as I have, you’ve probably heard this same explanation, or something similar, time after time. Have you ever taken a moment, though, to try understanding exactly why your clients believe this? The majority of the time, it’s because they don’t fully understand how to read these reports, or what they really mean.
You’re probably wondering to yourself, “Don’t you need a solid foundation and understanding of basic accounting to even START a business?” Well, yeah, you should. But as accounting professionals, we know that’s not always the case. We take for granted the information we already know about properly setting up, organizing, and running a business efficiently.
A lot of the time, when a client starts their business, their main focus is on income generating activities. They consider the accounting a necessary evil, often neglecting this responsibility. The result may be an improperly set up accounting system that includes an excessive number of GL accounts. We have all seen a chart of accounts that includes an income account for every. single. item and customer. This is often the result of having an under-qualified person managing their day to day bookkeeping. Just because their uncle or sister in-law needs a job, doesn’t mean that they’re the right person to be handling these critical business tasks.
Don’t worry, though, there are ways help your client more easily understand this critical information! In this five part series, we’ll take a look at the five basic financial reports that you should absolutely make sure that your clients understand, and why they’re relevant to their business. You’ll learn how to explain how they relate to each other, and why each of them only tells a small part of the bigger picture. Hopefully, by the end, you’ll have a better understanding of how to illustrate these concepts to your clients, and to make your job (and theirs!) easier in the future.
Basic Financials 101: Part 1 – The Profit & Loss Report
This report can also be referred to as the Income Statement or Statement of Activity. Doesn’t matter how you explain it to your clients, this report breaks down their income and expenses, what they received for the products, and service that they sold and the expenses that they incurred. This report should also be run over a period of time that is relevant to your client’s business. It is divided into three main sections in the following order:
- Income – This is the amount of money you receive for sales. It might be broken down by general types of items you sell or service that you provide. This does not include sales tax if you collect it.
- Cost of Goods Sold (COGS)– These are the expenses directly related to sales (for example, If you buy and sell widgets, the cost of purchasing the widgets that you sell is a COGS). This would include the cost of raw materials and labor if you produce the product.
- Expenses – These are the expenses that you incur to run your business. They are costs like rent, utilities, office supplies, and insurance. Oftentimes, these are considered overhead costs. Some people refer to these expenses as “what it takes to keep the doors open and lights on.”
- Gross Profit – This is the sum of your total income (what you received for goods and services sold) less your COGS (what it cost to purchase or make the items or services you sold). This DOES NOT include your overhead expenses, by the way. [Income – COGS = Gross Profit]
- Net Income – This is the bottom line! Gross Profit less expenses. This shows how your business performed for the period selected for the report. [Gross Profits – Expenses = Net Income]
Here’s a handy visual you can use for your clients so they can see what it should look like!
As a reminder, make sure your clients know that net income IS NOT THE SAME as money in the bank. In Part 2 of this series we will look at the Balance Sheet report and explain other factors that affect cash balances.