For Businesses

For a business, gross income (also known as gross profit) is simply revenues minus cost of goods sold. You can see gross profit on the income statement above. Net income for a business is revenues minus cost of goods sold minus all other business expenses.

The difference between the two is quite clear for a business.

For Employees

For individuals, gross income is a person’s total income before any deductions (like taxes) are taken into account. Net income is a person’s total income minus any taxes or other deductions.

Net Income = Revenues – Expenses

Different Names

Business people use a couple of different names when talking about net income. Sometimes they call it net earnings or net profits (in some cases they simply say earnings or profits). Another popular name for it is “the bottom line.” It is sometimes called the bottom line because it is shown on the very bottom line of the income statement (as illustrated below).

Note that when a company has more expenses than revenues this is known as a net loss.

How to Calculate Net Income

Calculating the net income of a company is relatively easy once you have all the necessary information. Simply take all the revenues and subtract all of the expenses (as shown on the income statement above). The accountants of an organization will gather all of this information and place it on the income statement. They will also do all of the adding and subtracting for you; all you have to do is find the bottom line of the income statement. When calculating income, don’t forget to subtract out the cost of goods sold.

Example

Below is an example of the net income for Google for the fiscal year ended December 31, 2010. These numbers are reported in thousands. This means that Google had a net income of over $8 billion in December. Not bad right?

Information Pulled from Yahoo Finance.

Impact of Net Income on Management and the Stock Market

The number represented by net income is of paramount importance to company management, investors, and creditors. A manager’s pay may be directly impacted by income. If income is up, then the manager may receive a raise or a bonus. If income is down, then management may be paid less (or they may just get fired). Stock prices rise and fall depending on the net income of a company.

Why the Confusion?

Apart from not having the term “expenses” attached to it, COGS is also separated from the other expenses. Business owners and investors find it useful to separate COGS so that they can see the gross profit before all other expenses.

Example

Let’s pretend you are an accountant at your local Wal-Mart. Your Wal-Mart purchases $5,000 worth of water bottles. At the point of purchase, your journal entry would look like this:

Inventory (Water Bottles)           $5,000
                        Cash                         $5,000

Notice that at this point, there is still no COGS expense.

Now, let’s pretend that in one day your Wal-Mart sells all $5,000 worth of inventory for $10,000. The journal entry would look like this and a COGS expense would be incurred.

Cash              $10,000
    Sales Revenue       $10,000

Cost of Goods Sold (an expense)        $5,000
                              Inventory        $5,000

The cost of goods sold expense is recognized when a sale is made. More than you wanted to know? I surely hope so.

Examples of Accounting Business Expenses:

• Employee Salaries
• Utilities
• Cost of Inventory (Cost of Goods Sold)
• Interest Expense
• Administrative Expenses
• Depreciation Expenses
• Prepaid Expenses

Expenses are Found on the Income Statement

The expenses of a company are found on the income statement that is generated at the end of the year. Below is an example income statement that shows some common expenses:

Recognizing Expenses is Tricky

People often get confused about when to recognize accounting expenses. There are a lot of rules behind it (thank you FASB and IASB) but the general idea is that you recognize the expense when revenue is recognized. This goes back to the definition of an expense: the amount of assets used up in order to generate revenue (matching expenses to revenues is also known as the matching principle).

Let’s take a look at an example of recognizing expenses. Let’s pretend that you own a company that buys calculators wholesale, marks them up, and sells them for a profit. You are a retailer of calculators. When you purchase a batch of 200 calculators from your supplier this is not an expense because revenue is not being generated. You are exchanging one asset (cash) for another asset (inventory/calculators). The journal entry would look like this.

Now, let’s pretend that you sell the 200 calculators. You are giving up an asset (calculators) for sales revenue. When you exchange an asset for sales revenue, you have an expense. The journal entry would look like this:

Quick Note on Accrued Expenses

Because most accounting systems these days are based on accrual accounting, you will often see the term “accrued expenses.” Accrued expenses are simply those expenses that have been incurred but they haven’t been paid for in cash yet.

Often times the word “sales” is used in exchange for the word revenue. They mean the same thing in most cases. In fact, companies often call their revenues “Sales Revenues.”

Example of Revenue

Let’s pretend that you own a company that sells tomatoes. One day you sell 1,000 tomatoes for $100. The $100 represents the revenue that your company has made on that transaction.

Difference Between Gross Revenue and Net Revenue

It’s worth noting that most companies report net revenues. Gross revenues (or total revenue) are all of the money that a company should receive in a perfect world; a world without returns, broken inventory, and customers who don’t pay. In reality, some customers return their products, some inventory has defects, and some customers just flat out don’t pay. This means that businesses must make sale’s allowances (they estimate how much of the actual revenue they will receive). Net revenue is the amount of revenue after all these allowances are taken into consideration.

You would think that calculating the amount of revenue a company generates would be relatively straight forward. In many cases it is, but there are special cases where recognizing revenue can be extremely difficult. For this purpose the FASB is constantly toying around with the revenue recognition principles (part of the generally accepted accounting principles). These revenue recognition principles dictate when and if a company should recognize revenue.

Calculating the Accounting Book Value of Equity (and the book value per share of common stock)

Fortunately this is a really simple calculation. The book value of a company is measured by the amount of equity that is on the balance sheet. In the real world, you don’t need to calculate this number; it is simply given to you on the balance sheet in the owner’s equity section.

If you really want to calculate it you can. Remember that the accounting equation is Assets = Liabilities – Owners’ Equity (Book Value). Well, even with my algebra skills I can manipulate this equation so it gives us what we want.

Book Value (Owners’ Equity) = Asset – Liabilities

Why do we care about the book value of a company? Well, the truth is the book value serves as a nice conservative estimate of what the company is worth. In almost all situations the book value is going to underestimate the actual value of the company. This is due to accounting conservatism.

Book Value per Share of Common Stock

To calculate the Book Value per Share of Common Stock (BVPS) simply take the book value (which we showed how to calculate above) and divide it by the number of shares of common stock outstanding.

Accountants realize that the information they provide is not the end-all, be-all. Financial statements have limitations and any good accountant will admit that. Let’s take a look at some of the limitations for the balance sheet and income statement. At the end of this article we’ll discuss some general weaknesses of financial statements.

Limitations of the Balance Sheet

The balance sheet is one of the most useful pieces of financial information available to investors and creditors. That being said, it does have its limitations. Perhaps the biggest limitation is that the balance sheet does not actually represent the current market value of the company. If the balance sheet were perfect, then total assets minus total liabilities (or owners’ equity) would be equal to the current market value of the company. In reality the value of a company listed on the balance sheet (the book value) is always much lower than the actual market value.

Let’s take a look at Google’s 2010 balance sheet to clearly illustrate this limitation.

Google's Balance Sheet 2010

On December 31, 2010 Google’s balance sheet basically says that Google is valued at around $46 billion (the numbers above are reported in thousands). However, the market value of Google at the time is closer to $200 billion (market value is simply calculated as number of shares outstanding multiplied by price per stock).

Why the Difference?

The difference is so large for a couple of reasons:

(1) Accounting conservatism and the historical cost principle. Remember that a lot of the items listed on the balance sheet are recorded at historical cost. For example, land purchased fifty years ago has likely gone up in value, but accountants don’t reflect the increase in value on the balance sheet (they keep it at the historical cost).

(2) The monetary unit concept states that assets listed on the balance sheet need to be listed in dollar amounts. It can be extremely hard to put some of Google’s best assets into dollar amounts. Some of Google’s important economic assets include its extremely smart employees, its systems that allow for innovation, and its track record of releasing very useful products.

These limitations make it so the balance sheet usually under-reports (sometimes drastically) the actual value or financial position of the company.

Limitations of Income Statement

Probably the biggest limitation of the income statement is that it requires so many estimates. Below are two explanations of estimates that go on the income statement that can make a big difference in how users view the health of the company.

1. Depreciation Expense – Company management must determine the useful life and salvage value of their assets. They then use this information to calculate depreciation expense. The problem is nobody really knows the exact useful life of an asset. Estimates are made and these estimates can dramatically change the amount of depreciation expense.
2. Bad Debt Expense – Each year the company must estimate an allowance for bad debt – or the amount of receivables that won’t be collected. Companies are required to expense these uncollectible receivables. Obviously managers don’t want to take huge expenses so they have a tendency to expense less than they should.

Where there are estimates, there are opportunities for earnings management.

Some gains and losses can’t be quantified or reliably reported. These gains and losses never hit the income statement. For example a gain in a company’s brand name can’t be quantified or reliably reported.

General Limitations of Financial Statements

• Financial statements represent the past; there is no guarantee of future performance.
• Financials ignore qualitative aspects
• These statements don’t tell you everything that is going on within the company (the notes have a lot of good information in them)

Liabilities Definition

Liabilities are the obligations of the company. Most people intuitively think of liabilities as “I owe yous” or debts. As companies grow and operate they naturally take on some obligations. The most common liabilities are the obligations to pay back debt or provide a service to someone who has paid for it.

Examples of Liabilities

• Notes payable
• Accounts payable
• Unearned revenue
• Wages payable
• Utilities payable
• Warranties
• Taxes Payable
• Mortgage Payable

Notes Payable- Notes payable refer to the obligation to pay back money that has been borrowed. For example a company that is just starting out needs financing. This company may go to a bank and receive a loan for $100,000. The $100,000 is an asset, but the company now has the obligation to pay back the money to the bank (this obligation is a liability). The journal entry would look like this:

Cash              $100,000
      Notes Payable        $100,000

Accounts Payable – Companies purchase inventory from other companies on account. That is to say that they don’t pay cash for the inventory upfront (they buy on credit and plan to pay for the inventory in the future). This obligation to pay for inventory in the future is known as accounts payable. A journal entry would look like this:

Inventory          XXX
        Accounts Payable XXX

Unearned Revenue – This is a unique type of liability and many accounting students find it hard to grasp at first. Sometimes companies pay for goods or services before they actually receive them. If your company gets paid for goods or services before you deliver then it has an obligation to deliver those goods or services. This obligation is a liability known as unearned revenue.

When your company receives payment but hasn’t delivered:

Cash          XXX
     Unearned Revenue (liability)    XXX

When your company delivers the goods or services:

Unearned Revenue (liability)   XXX
                         Revenue            XXX

Wages Payable – When a company’s employee work, the company has an obligation to pay their employees. Until the company actually does pay the employees, this obligation is recognized as a liability.

As employees work:

Wage Expense        XXX
        Wages Payable  XXX

When the company makes payment:

Wages Payable         XXX
                  Cash             XXX

Classification of Liabilities

Keep in mind that on a classified balance sheet, liabilities are separated into two different categories: current liabilities and long-term liabilities (most balance sheets are classified).

Current Liabilities are simply those obligations that a company expects to pay off within the coming year. Long-term Liabilities (non-current) are those obligations that won’t be paid off within the next year.

Examples of Current Liabilities

• Accounts Payable
• Wages Payable
• Accrued Liabilities
• Unearned Revenues
• Current Portion of Long-Term Debt

Examples of Non-Current Liabilities

• Notes Payable
• Debentures
• Obligations under Capital Leases
• Deferred Income Tax
• Mortgage Loans

Comparative Balance Sheet Example

Keep in mind that normally with comparative financial statements the most recent year is shown on the left.

Comparative Income Statement Example

It’s worth noting that any accounting software that you purchase will have comparative financial statement templates ready for you. However, if you are looking to do these statements by yourself then here are some great templates for Excel.

You can find a comparative balance sheet template here:

http://office.microsoft.com/en-us/templates/results.aspx?qu=balance+sheet&origin=TC001113364#ai:TC010073876|

You can find a comparative income statement template here:

http://office.microsoft.com/en-us/templates/two-year-comparative-income-statement-TC001113364.aspx

Why are Comparative Financial Statements Useful?

Comparative financial statements are a handy way to see how well the business is doing this year as compared to last year. You usually need more than one year to perform any sort of trend analysis. Most ratio analysis also benefits from an additional year’s worth of information.