The Income Statement
September 17, 2007
The balance sheet is a snapshot of a business as of a given moment in time. The income statement isn’t. Rather, it’s a summary of everything that happened during a given period of time. The combined income statement in Table 4.2 shows what happened for two periods, the period from January 1, 2002, through December 31, 2002, and the period from January 1, 2003, through December 31, 2003. The moment in time of the balance sheet will always correspond to the last day of the period covered by the income statement.
We won’t need to go into every item on the income statement; most are self-explanatory. Let’s highlight some items that should raise red flags.
Sales Revenue
According to the income statement, Houston Sash & Door sold windows and doors totaling $1,881,117 during the period that began on January 1, 2003, and ended on December 31, 2003. Right? Not exactly.
The accountant who prepared the income statement wasn’t kind enough to break out for us the gross amount of sales and deduct from that number the sales returns the business experienced. Houston Sash & Door might actually have sold $2,381,177 worth of windows and doors, of which $500,000 worth was returned and not paid for. If a business has a high level of returns, it may mean that a high level of inferior goods has been shipped. If this is true, it may mean that lawsuits can be expected from customers who bought and paid for goods and now aren’t satisfied or, worse, have been injured by the goods or have had their businesses harmed by them. If you find an unusually high level of returns (which you can’t find from this income statement), keep digging.
Don’t forget what we learned about accounts receivable. In order to prettify the financial statements, the seller may have artificially increased sales by granting easy credit to unqualified customers. These sales show up as sales revenues on the income statement, as well as accounts receivable on the balance sheet, whether or not any of these sales ultimately bring in any cash.
Professional Services
This refers to legal and accounting fees the business incurred during the period. Compare 2002 with 2003. They were minuscule in 2002 and in excess of $58,000 in 2003. If the large increase represented accounting fees, it probably means that the business experienced an IRS audit. At the present time it may be impossible to determine whether the audit resulted favorably or whether a big tax bill is coming. Not only that, the IRS may have audited only one prior year. If the accountant took the same aggressive position with respect to a certain item(s) on the tax returns for other years, you may be faced with an audit for those years as well. If the large increase in professional services was due to legal fees, it probably means the business was involved in a lawsuit. Keep digging.
Net Income
We’ll see that the real income a business earns for its owners is different from the bottom-line figure that appears on the income statement. The net income Houston Sash & Door shows for the year ending December 31, 2003, is $280,397. But this doesn’t mean there’s $280,397 in cash available for the owner. There may be more! After all, we arrived at net income by deducting an amount for depreciation. But you don’t have to spend any money to get the depreciation deduction the way you do to get a deduction for office supplies, utilities, and the like. The point here is that there is a critical difference between a business’s net income and its cash flow. More on that later.
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