The Virtual CFO

The Revenue Section of the Income Statement

The revenue section of the income statement shows the revenue of your company by source. This is designated by the codes you use when sales are entered into the accounting system (“Financial Statements, Chart of Accounts, and Accounting Codes ” and “Don’t Over-Code Revenue and Expense Accounts in Your Accounting System ”).

Some examples of revenue by source would be hot dog sales, hot dog combo sales, drink sales, dessert sales, etc. By segregating the types of sales you have, you are able track and analyze your revenue sources.

This is especially helpful when your income statement includes prior period amounts as well as the current period’s revenues. By comparing prior periods with your current sales revenue, you are able to see what areas you are excelling in, what areas you need improvement in, trends (upward or downward), and possibly identify new revenue sources.

The sum of all the revenues in the income statement is called the gross revenue.

Overview of the Income Statement

I was the CFO of two construction companies. At each of these firms, I held monthly P&L meetings with each project manager (P&L is short for a profit and loss statement, which is another name for the income statement). During these meetings, we would go over the project manager’s total profit and loss, as well as individual revenue and expense categories for each of the project managers’ projects.

One of the most memorable comments from one of these meetings was when a veteran project manager proclaimed, “I don’t care about anything on this report except the bottom right-hand number”. What he was referring to was the year-to-date net profit for each of his projects.

I hope that you are interested in more than the bottom line when you are reviewing your firm’s income statement.

The income statement reports three main areas of your company’s financial performance for a given period of time. These areas are:

1. Revenues;
2. The Cost-of-Sales Expenses; and
3. The General and Administrative Expenses (expenses that cannot be directly tied to the production of a product or service, sometimes called overhead).  

The income statement also reports the gross profit for your company (revenue less cost-of-sales) and the net profit (gross profit less general and administrative expenses).

Over the next few posts, I will explain each area of the income statement.

Don’t Create Too Many Revenue and Expense Accounts in Your Accounting System – My Personal Experience with This

I was once the CFO of a construction company that had way too many revenue and expense accounts in its accounting system.

This firm regularly installed underground utilities (high-pressure gas, water, and sewer lines). The person who set up this company’s accounting system created an expense category not only for every type and size of underground pipe, but also for every possible depth that the pipe could be buried. So you had a master category for 5” DIP (ductile iron pipe), but following the master category you had “5 Inch DIP –6 Inch Trench, 5 Inch DIP –12 Inch Trench”, 5 Inch DIP –18 Inch Trench”, etc.

At this firm, the project managers were responsible for coding invoices before they were entered into the accounting system. Coding an invoice is where you determine the expense category or categories an invoice should be recoded to. Having project managers’ code invoices is a control many construction companies use to insure that vendors are billing for the correct items and quantities for a job.

Over 95% of the codes at this construction company were never used by the project managers. Instead, the project managers would code the invoices to the master category (i.e., 5 Inch DIP) so they wouldn’t have to waste time researching the correct trench depth, or depths, code(s) for each individual invoice.

This company would have been better served if they had implemented an accounting system that only had master categories of expenses, because these were the accounts the project managers used.

Don’t Over-Code Revenue and Expense Accounts in Your Accounting System

On Monday, I posted “Financial Statements, Chart of Accounts, and Accounting Codes” where I discussed how you can use accounting codes to designate the sources of revenue and expense in your accounting system.

I’d like to give a little advice concerning the number of revenue and expense codes/accounts you setup in your accounting system. It is usually better to establish broad revenue and expense categories than create codes for every possible type of transaction you may incur. I like to call this accounting phenomena “over-coding”.

For example, it is better to have “plain hot dog sales” as a revenue account than setup accounts for every possible variety of plain hot dog that you sell (i.e., “plain hot dog - no condiments sales”, “plain hot dog with mustard sales”, “plain hot dog with relish sales”, etc.). The same goes for expense accounts. I have found that it is better to have “mobile hot dog stand maintenance expense” as an account instead of maintenance expense accounts for every individual mobile hot dog stand.

Too many revenue and expense codes make financial statements difficult to understand and analyze because they report too much detail. It also takes more time to enter sales or purchase invoices when you have an excessive number of revenue and/or expense accounts because you have to spend time researching each transaction to make sure it is coded to the correct category.

Financial Statements, Chart of Accounts, and Accounting Codes

Before I begin discussing financial statements, let me first define the chart of accounts and accounting codes.

The backbone of any accounting system is the chart of accounts, which is a list of accounts that are used to track similar financial tractions. Hot dog sales, drink sales, hot dog and bun expense, drink expense, and mobile hot dog stand are all examples of accounts.

Accounting codes are a set of numbers, or alphanumeric characters, used to identify accounts. 1001 – hot dog sales, 1002 - drink sales, 2001 – hot dog and bun expense, 2002 – drink expense, and 5001 – mobile hot dog stand expense are all examples of accounts with codes.

Whenever you make a sale or a purchase, you enter the code as a shortcut to tell the accounting system where the transaction needs to be placed. This is what is called “coding” in accounting. Coding transactions is a quick way to associate a transaction with the correct account in your accounting system.

The reason that the chart of accounts and accounting codes are important is that coded transactions are what make up the figures reported on your financial statements.

The Financial Statements Small Business Owners and Entrepreneurs Need to Use

As I discussed in the previous post, financial statements are the report cards of business.

Below is a summary of the standard financial statements that you should use to monitor the progress of your company:

• Income Statement – Shows the revenue, expenses, and the profit/loss of your company for a specific period of time.

• Balance Sheet – Shows the financial position of your company on a specific date. The balance sheet includes assets (cash, accounts receivable, property, and equipment), liabilities (accounts and notes payable, and taxes payable), and owners equity (contributed capital and retained earnings, which is the profit of your company that has not been distributed to the owners).

• Cash Flow Statement – Shows the change in your company’s cash balance(s) for a specific period of time. The cash flow statement is broken down into cash flows from operating activities, investing activities, and financing activities (remember “Happiness is a Positive Cash Flow”!).

• Statement of Owner’s Equity – Shows the equity you have in your company on a specific date. Equity is basically the value of the investment you have in your company.

Over the next few weeks, I’ll discuss each financial statement in more detail.

Financial Statements - The Report Cards of Business

When I opened my logistics company in 1993, I had very little exposure to financial statements beyond the principals of accounting class I took in college (I graduated with two undergraduate degrees, one in marketing and the other in transportation and logistics).

What I did know about financial statements came from my experience as the general manager of a small truck line. In this position, I reviewed the monthly income statement the firm’s CPA delivered each month. I did not understand or use the other financial statements the CPA prepared.

Once my logistics company was up and running, it was evident that I needed more financial management and accounting information than an income statement could provide. This is when I began to learn about the other financial statements that were available to small business owners.

Right after I opened my logistics firm, my accountant recommended that I use a DOS version of Peachtree as the accounting system for my company. With his help, I set up Peachtree and began to use it to track the financial progress of my entrepreneurial business. As Microsoft’s Windows for Workgroups became the standard for workgroup networking, I migrated my company’s accounting to QuickBooks for Windows. Through this experience, I learned that both of these small business accounting software products provide most of the financial statements a small business owner needs.

During this time I also learned that financial statements are truly the report cards of business that small business owners and entrepreneurs need to understand.

In this blog series, I will discuss each of these financial statements in more detail.

Happy 4th of July

I hope you and your family is having a great and safe Fourth of July weekend.

This morning, Adam Savage of Mythbusters Twittered that he reads the Declaration of Independence and the Bill of Rights every 4th of July.

Sounds like a good thing to do on our country's birthday.

One Final Thought on Small Business Budgeting

Over the last couple of weeks, I’ve discussed the importance of budgeting for small businesses. I have also walked you through the process of creating a budget for your company. Now I want to take a step back and throw some common sense into the mix.

Don’t let the process of forming and monitoring your budget consume more of your time than is absolutely necessary. Planning is essential to success. However, it is easy to get caught up in the budget creation and monitoring process, and be constantly analyzing your firm’s progress and tweaking the budget to get it more in line with reality.

When you’re doing this, you aren’t selling and producing, which are the most important jobs you perform as a small business owner.

If the budget creation and monitoring process requires a great deal of time, you need to consider outsourcing the function to a CPA (CPA for Small Business, LLC offers this service) or delegating the task to someone else in your company.

Revising Your Budget

When you start using your budget as a tool, you may find that your revenue and expense estimates are not falling in line with the actual performance of your company. When this occurs, you have two choices.

The first choice is to not revise the budget you created for the period and continually analyze the differences to determine how you can become more proficient at making estimates for the next budget. This is a good choice if the differences are not that large.

If the variances are large, I recommend that you revise your budget to be more in line with the actual performance of your company. It really doesn’t do you any good to anticipate a certain level of performance for your firm if there is no way your business is going to attain it. It is better to get your expectations (i.e., budget) in line with the actual performance your company will experience for the balance of the budget period. This can also be a good learning experience that will allow you to gain a better understanding of the revenues, expenses, and cash flows of your business.