Why Income Isn’t Always Income

Why Income Isn’t Always Income

Judging by the title, an income statement is supposed to show the income of a company. It
would be a reasonable assumption to say that the income statement shows a company’s profit for a given
period- usually a month, quarter, or year. It’s only a short leap of imagination to conclude that the income
statement shows how much cash the company took in during that period, how much it spent, and how much
was left over. That “leftover” amount would then be the company’s profit, right?

Alas, no. Except for some very small businesses that do their accounting this way (called cash-based
accounting) that notion of an income statement and profit is based on a fundamental misconception. In fact,
an income statement measures something quite different from cash in the door, cash out of the door, and the
cash left over. It measures sales (aka revenues), costs (also called expenses), and profit (income).
Any income statement begins with sales. When a business delivers a product or service to a customer,
accountants say it has made a sale. Never mind if the customer has paid for the product or service yet- the
business may count the amount of the sale on the top line of its income statement for the period in question.
No money at all may have changed hands. Of course, for cash-based businesses such as retailers and
restaurants, sales and cash coming in are pretty much the same. But most businesses must wait thirty days or more to collect on their sales, and manufacturers of big products such as aeroplanes may have to wait months. (you can see that managing a company such as Boeing would entail having a lot of cash on hand to cover payroll and operating costs until the company is paid for its work.)

What is the “cost” line of the income statement? Costs and expenses a company reports on are not
necessarily the ones it wrote checks for during that period. The costs and expenses on the income statement
are those it incurred in generating the sales recorded during that same time period. Accountants call this the
matching principle- all costs should be matched to the associated revenue for the period represented in the
income statement- and it’s the key to understanding how profit is determined. Let’s look at a couple of
examples to illustrate this concept.

If an ink-and-toner supplier buys a truckload of cartridges in June to resell to customers over the next
several months, it does not record the cost of all those cartridges in June. Rather, it records the cost of each
cartridge when the cartridge is sold. The reason for this is the matching principle

And if a delivery company buys a truck in January that it plans to use over the next three years, the
cost of the truck is depreciated over the whole three years, with one-thirty-sixth (12 months x 3 years) of the
truck’s cost appearing as an expense on the income statement each month (assuming something called the
straight-line method of depreciation, which means that an even amount of depreciation is allotted to each
period of time). Why? The matching principle. The truck is one of the many costs associated with the work
performed during each of the thirty-six months- the work that shows up in that month’s income statement.
You can see how far we are from simply tracking cash in and cash out. Tracking the flow of cash in and
out the door is the job of another financial document, namely the cash flow statement. You can also see how
far we are from simple objective reality. Accountants can’t just tally up the flow of dollars, they have to decide
which costs are associated with the sales. They have to make assumptions and come up with estimates. In the
process, they may introduce bias into the numbers.

Understanding this bias when looking at the income statement, as well as realizing what goes into
the green or red number at the bottom of the page can help you make wiser decisions within your position.
By understanding the fact that there is a bias within the numbers you can take them with a grain of salt and dig
deeper into the why of the numbers. Using this to make more informed decisions can make a huge
difference in the work of a manager, executive, or even an entry-level employees career.

Source: Financial Intelligence by Karen Berman, Joe Knight and John Case. Joe Knight, and his
partners, Joe Cornwell and Joe Van Den Berge from Setpoint Inc. together have built two
companies with 25-year history of successfully implementing these principles in their thriving
businesses. Setpoint Inc. designs and implements custom rides and attractions for the top
amusement and theme parks in the world and Setpoint Systems delivers custom automation
and robotics that helps manufacturers large and small improve the way they make and
distribute goods.

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