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    Why Isn’t My Net Income What I Think it Should Be?

    [fa icon="clock-o"] Dec 2, 2014 10:01:00 AM [fa icon="user"] Mary Rossi [fa icon="folder-open'] Quickbooks, Small Business, For Accountants

    Help for Small Business Owners to Understand their Profit & Loss

    small_business_bookkeepingAre you having a hard time understanding how your accountant arrives at your net income when you have an amount in your mind and the amounts are significantly different?

    Some examples I have come across:

    • The roof repair to our building cost us $45,000; shouldn’t this reduce my income by $45k?
    • My business spent $25,000 on household items for our rental properties; shouldn’t this show up on my income statement as an expense and on the balance sheet with an increase in my assets?
    • The down payment on the new truck was $9,000; shouldn’t this reduce my income by $9k?
    • My truck was in an accident and was a total loss; shouldn’t this reduce my income by the price I paid for it?

    These common mistakes happen because of the basic misunderstanding of the types of accounts and how they play out in the financial statements. In addition, Net Worth and Net Income need to be better understood; they are not the same.

    There are 5 types of accounts:

    1. Assets
    2. Liabilities
    3. Equity/Capital
    4. Revenues
    5. Expenses

    The balance sheet consists of the Assets, Liabilities and Equity:

    Net Worth = Assets – Liabilities

    The Revenues and Expenses appear on the Incomes Statement:

    Net Income = Revenues – Expense

    When a small business owner learns which account each item belongs in, overall understanding of what net income will be increases quickly and there is a much better grasp of their overall financial picture.

    Now for a brief lesson on each account type and some examples:

    Account Type

    Assets

    Liabilities

    Equity

    Revenues

    Expenses

    Definition

    Resource owned by a company to produce revenues & can provide future services for business

    Claim against assets for which a business is legally responsible

    Owners’ claim on assets

    Money that is made by or paid to a business based on what service/item is provided

    An item of
    business outlay chargeable
    against revenue
    for a specific
    period

    Common Examples

    Cash, Accounts Receivable, Inventory, Supplies, Prepaid items, Land, Vehicles, Machinery & Equipment, Office building, Factory, Copyrights, Goodwill, Patents 

    Accounts Payable, Notes Payable, Mortgage, Other Payables

    Owner’s Capital, Owner’s Draw, Stock, Retained Earnings, Dividends

    Service Revenue, Sales Revenue, Interest Revenue, Gain/(Loss) on Disposal of assets

    Advertising, Amortization & Depreciation,
    Cost of Goods Sold, 
    Income Tax, Insurance, Interest, 
    Maintenance & Repairs, Rent, Salaries & Wages, Supplies, Utilities

    Increase/ Decrease

    Increase = Debit (this doesn’t make sense  – you just need to learn the rule)

    Decrease = Credit

    Increase = Credit

    Decrease = Debit

    Increase = Credit

    Decrease = Debit

    Increase = Credit

    Decrease = Debit

    Increase = Debit

    Decrease = Credit

    So now you have a basic understanding of the 5 types of accounts. When the money in and out of your business is properly classified with debits always equaling credits, you can run a Trial Balance. This is a list of all your accounts with debits balance accounts in the left column equaling credits balance accounts in the right.  

    Now what? First, the Income Statement is compiled taking the total of all the Revenue Accounts and subtracting all the Expense Accounts resulting in Net Income. Next, the Balance Sheet is created using the remaining accounts from the Trial Balance; all the assets, liabilities and equity accounts. In order for the Balance Sheet to ‘balance’, the Net Income is added to the Equity Account.

    Let’s analyze each of the misconceptions mentioned at the top of this article and see how each scenario plays out. Put every transaction in journal entry format, and debits must equal credits.

    The roof repair to our building cost us $45,000; shouldn’t this reduce my income by $45k?

    Debit: Building Improvement (an asset) $45,000

    Credit: Cash (an asset) or Loan Payable (a liability) $45,000

    Notice both sides of this entry affect Balance Sheet accounts, so there is no effect on the Income Statement until the depreciation is calculated. The depreciation is the portion of the asset that is used up in the fiscal period.

    My business spent $25,000 on household items for our rental properties; shouldn’t this show up on my income statement as an expense and on the balance sheet with an increase in my assets?

    The proper entry would be:

    Debit: Supplies Expense (an expense) $25,000

    Credit: Cash (an asset) $25,000

    Notice the debit side of the entry hits the Income Statement reducing revenue and the credit side hits the Balance Sheet with a reduction of an asset. It cannot hit the balance sheet as an increase in assets and the Income Statement as an expense since you paid for it somehow. The entry won’t work. Return to our table and you will see an increase in assets is a debit. You already used your debit for the Supplies Expense.  When you purchase something the debits must equal credits! You can’t have two debits. 

    The down payment on the new truck with a $59k sticker price was $9,000; shouldn’t this reduce my income by $9k?

    The proper entry would be:

    Debit: Truck (an asset $59,000

    Credit: Cash (an asset) $9,000                 

    Credit: Truck Loan (a liability) $50,000

    In this entry, nothing hits the Income Statement accounts and similar to the roof example above, the only affect on Net Income will be when the depreciation is expensed for the year. 

    My truck was in an accident and was a total loss; shouldn’t this reduce my income by the price I paid for it?

    Before making the proper entry, the depreciation should be calculated and recorded up to the date of the accident and the total amount that has been depreciated is up to date, called Accumulated Depreciation. Let us assume the truck cost $72,000 and accumulated depreciation is $30,000.

    The proper entry to would be:                 

    Debit: Accumulated Depreciation (a contra asset) $30,000

    Credit: Truck (an asset) $72,000

    Debit: Loss on Truck (revenue; contra) $42,000

    This one is a little tricky as the loss would be a debit balance and would appear in the other income/loss section. It is not an expense, but goes against revenue. The loss would only decrease revenues by the $42k, not the $72k the owner originally thought.

    Understanding the account types and how they play out on the financial statements helps you understand how your accountant arrives at the Net Worth and Net Income of your business. You are not an accountant. Hire one to do what they do best. I have found the more a business owner grasps these basic concepts, he or she has a better grasp of their overall financial picture, which significantly helps in making sound business decisions.

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    Mary Rossi

    Written by Mary Rossi