The Rest of the Profit and Loss Statement

This article is the ninth installment in an ongoing series focusing on accounting and financial matters for corporate counsel.

The first thing I do as I start writing each of these installments is pull out my old 1,300-page graduate school Intermediate Accounting textbook and refresh myself on the basics that should be taught about the topic I am discussing. I was totally shocked to find, however, that there are no chapters at all in the book for Expenses and most of the other elements of net income.

Based on the textbook, one would think that the only thing that mattered on the Income Statement was Revenues, which have been enshrouded in non-stop accounting controversy for over 30 years. Financial Accounting literature seems to marginalize the expenses of running a business, covering them broad-brush with the Matching Principal (account for the costs of generating revenue when the revenue is recognized) and the Consistency Principal (however you choose to account for Expenses, account for them consistently from one period to the next).

GAAP's failure to focus on Expenses flies totally in the face of my 30-years' experience as a practitioner ' whether working as management, an outside accountant, an insolvency adviser, a business valuator, or a fraud examiner, expenses have always been a key area of focus and concern. Expenses are the tools that companies use to generate revenue. They are the most controllable thing for management, and hence where management can have the most short-term impact. Analyzing how a company spends its money tells you almost everything you need to know about its management and a lot of what you need to know about its future prospects.

Financial Statement Presentation

Expenses tend to be clumped into broad categories on the Income Statement. The first category is called Cost of Goods Sold or Cost of Services, and represents the direct costs associated with providing the goods or services that generated the company's revenue. The definition of “direct” can vary from company to company. Plant management, freight costs, warehousing costs, design and purchasing costs, and engineering costs are all examples of costs that could legitimately be considered as either “direct” or “indirect.”

Cost of Goods or Services Sold consist of labor, materials, and overhead directly allocable to what was provided to the customer. It is driven by input prices paid by the company, the level (volume) of activity, and the efficiency of the organization.

Gross Margin is the difference between what was sold and the direct cost of those sales. Other than revenue and net income, it is usually the number on the income statement that is most focused on.

Two companies that conduct every aspect of their business identically the same except for their accounting can report very different gross margins based on how they classify expenses. An analyst comparing gross margins across different companies would need to drill further into the Cost of Sales numbers to determine what is and is not included in them.

Selling, General, and Administrative expenses (SG&A) are all of the other ordinary costs of running the business that are not included in Cost of Sales or Cost of Services. These typically include salaries and benefits, occupancy costs, advertising, supplies, professional fees, and “corporate” expenses. Presentation on the financial statements can vary from one company to another based on management's interpretation of what is important to show.

Some companies clump so many different expenses into broad categories that it is very difficult to glean any useful information out of the totals presented. Others report in such minute detail that it is easy to lose the forest for the trees. A good medium is to report on key expenses (those that are really important to the business), separately and then lump the others together in broader categories.

There are a few different ways to categorize operating expenses, and again the only standards are reasonableness and consistency. Some of the different reporting formats used include:

• Functional (i.e., Selling, Administrative, etc.);
• By type of expense (i.e., payroll, benefits, occupancy costs, etc.); and
• By categorization of expense (i.e., variable or fixed).

After operating expenses on the Income Statement, but before net-income, are non-operating items (interest, gain or loss on disposals of assets, etc.), non-recurring costs such as restructuring costs or casualty losses, and income taxes. These are all shown separately to help the analyst evaluate the performance of on-going operations.

Reality

Don't feel impotent if you can't learn much from a single Income Statement ' top-level financial statements are usually very limited in how much information they provide. To gain a good understanding of how a company spends its money, it is usually necessary to get into deeper levels of detail. Knowing that a company's occupancy costs are high, for example, is not a very actionable piece of information. Being able to pinpoint which elements of occupancy costs ' rent, property tax, utilities, maintenance, repairs, security, etc., is critical to evaluating and possibly correcting those high costs. The difference between having this information in a useful format or not usually depends on the quality of the company's Controller or chief accountant. If the financial reports aren't giving you the information you need, blame the Controller, not yourself.

Expenses can be good or bad, depending on whether they are really helping to generate income. If the CEO has a luxury car, for example, the costs related to the car are expenses. If the CEO is constantly visiting or transporting customers with that car and the customers are impressed enough to buy more because of it, then the money was well spent. On the other hand, if that car isn't generating income somehow, then it is still a business expense from an accounting standpoint, but a questionable one from a business perspective. Expenses need to be evaluated in the context of the overall business operations and environment.

There is an entirely separate (from financial accounting) branch of accounting, called Managerial Accounting, which focuses directly on the costs and expenses of running the business. Managerial Accounting is concerned with providing useful and actionable information to management, whereas Financial Accounting focuses on reporting to shareholders, creditors, and other outsiders. Managerial Accounting helps managers actually operate the business, while Financial Accounting reports on past performance. It will be covered in future installments of this series.

Michael Goldman, MBA, CPA, CVA, CFE, CFF , is principal of Michael Goldman and Associates, LLC in Deerfield, IL. He may be reached at [email protected].

This article is the ninth installment in an ongoing series focusing on accounting and financial matters for corporate counsel.

The first thing I do as I start writing each of these installments is pull out my old 1,300-page graduate school Intermediate Accounting textbook and refresh myself on the basics that should be taught about the topic I am discussing. I was totally shocked to find, however, that there are no chapters at all in the book for Expenses and most of the other elements of net income.

Based on the textbook, one would think that the only thing that mattered on the Income Statement was Revenues, which have been enshrouded in non-stop accounting controversy for over 30 years. Financial Accounting literature seems to marginalize the expenses of running a business, covering them broad-brush with the Matching Principal (account for the costs of generating revenue when the revenue is recognized) and the Consistency Principal (however you choose to account for Expenses, account for them consistently from one period to the next).

GAAP's failure to focus on Expenses flies totally in the face of my 30-years' experience as a practitioner ' whether working as management, an outside accountant, an insolvency adviser, a business valuator, or a fraud examiner, expenses have always been a key area of focus and concern. Expenses are the tools that companies use to generate revenue. They are the most controllable thing for management, and hence where management can have the most short-term impact. Analyzing how a company spends its money tells you almost everything you need to know about its management and a lot of what you need to know about its future prospects.

Financial Statement Presentation

Expenses tend to be clumped into broad categories on the Income Statement. The first category is called Cost of Goods Sold or Cost of Services, and represents the direct costs associated with providing the goods or services that generated the company's revenue. The definition of “direct” can vary from company to company. Plant management, freight costs, warehousing costs, design and purchasing costs, and engineering costs are all examples of costs that could legitimately be considered as either “direct” or “indirect.”

Cost of Goods or Services Sold consist of labor, materials, and overhead directly allocable to what was provided to the customer. It is driven by input prices paid by the company, the level (volume) of activity, and the efficiency of the organization.

Gross Margin is the difference between what was sold and the direct cost of those sales. Other than revenue and net income, it is usually the number on the income statement that is most focused on.

Two companies that conduct every aspect of their business identically the same except for their accounting can report very different gross margins based on how they classify expenses. An analyst comparing gross margins across different companies would need to drill further into the Cost of Sales numbers to determine what is and is not included in them.

Selling, General, and Administrative expenses (SG&A) are all of the other ordinary costs of running the business that are not included in Cost of Sales or Cost of Services. These typically include salaries and benefits, occupancy costs, advertising, supplies, professional fees, and “corporate” expenses. Presentation on the financial statements can vary from one company to another based on management's interpretation of what is important to show.

Some companies clump so many different expenses into broad categories that it is very difficult to glean any useful information out of the totals presented. Others report in such minute detail that it is easy to lose the forest for the trees. A good medium is to report on key expenses (those that are really important to the business), separately and then lump the others together in broader categories.

There are a few different ways to categorize operating expenses, and again the only standards are reasonableness and consistency. Some of the different reporting formats used include:

• Functional (i.e., Selling, Administrative, etc.);
• By type of expense (i.e., payroll, benefits, occupancy costs, etc.); and
• By categorization of expense (i.e., variable or fixed).

After operating expenses on the Income Statement, but before net-income, are non-operating items (interest, gain or loss on disposals of assets, etc.), non-recurring costs such as restructuring costs or casualty losses, and income taxes. These are all shown separately to help the analyst evaluate the performance of on-going operations.

Reality

Don't feel impotent if you can't learn much from a single Income Statement ' top-level financial statements are usually very limited in how much information they provide. To gain a good understanding of how a company spends its money, it is usually necessary to get into deeper levels of detail. Knowing that a company's occupancy costs are high, for example, is not a very actionable piece of information. Being able to pinpoint which elements of occupancy costs ' rent, property tax, utilities, maintenance, repairs, security, etc., is critical to evaluating and possibly correcting those high costs. The difference between having this information in a useful format or not usually depends on the quality of the company's Controller or chief accountant. If the financial reports aren't giving you the information you need, blame the Controller, not yourself.

Expenses can be good or bad, depending on whether they are really helping to generate income. If the CEO has a luxury car, for example, the costs related to the car are expenses. If the CEO is constantly visiting or transporting customers with that car and the customers are impressed enough to buy more because of it, then the money was well spent. On the other hand, if that car isn't generating income somehow, then it is still a business expense from an accounting standpoint, but a questionable one from a business perspective. Expenses need to be evaluated in the context of the overall business operations and environment.

There is an entirely separate (from financial accounting) branch of accounting, called Managerial Accounting, which focuses directly on the costs and expenses of running the business. Managerial Accounting is concerned with providing useful and actionable information to management, whereas Financial Accounting focuses on reporting to shareholders, creditors, and other outsiders. Managerial Accounting helps managers actually operate the business, while Financial Accounting reports on past performance. It will be covered in future installments of this series.

Michael Goldman, MBA, CPA, CVA, CFE, CFF , is principal of Michael Goldman and Associates, LLC in Deerfield, IL. He may be reached at [email protected].