Now that you understand the Chart of Accounts, you can start applying that information to the Profit & Loss report. This report can be as detailed or simple as your needs require. Some people create a very long complicated chart of accounts so they can analyze every tiny area of cash flow. Instead of just an Advertising category, they might have subcategories like Print, Online, and Marketing Materials. Most people prefer a simple chart of accounts to report information for tax preparation.
The Profit & Loss report uses two simple formulas:
Income is any money you received for services or goods. If you charge Sales Tax, that amount is not included in income because you are essentially acting as a tax collector for the county and those funds belong to them. You should have a separate income account called “Discounts and Refunds” to record any decreases in fees charged your customers. This will decrease your overall income and show up on the Profit & Loss as a negative number. This helps to visualize the amount you have reduced potential income to analyze your business activities.
Cost of Goods Sold accounts are reserved for the items that you must purchase in order to produce your product. This includes raw materials needed to create the goods as well as direct labor costs to produce the goods.
Expenses are operating costs such as payroll, supplies, rent & utilities, telephone and computer costs. The IRS is very particular about what is considered a “usual and necessary business expense” and will quickly disallow anything outside the boundaries. The most troublesome areas that the IRS is targeting for audits because of gross non-compliance are Travel, Meals & Entertainment, Automobile, and the expensing of Tools & Supplies.
The final figure, Net Profit, is the amount flowing to your tax return. For those reporting their business income on a Schedule C, the Net Profit is the figure that is added to the 1040. For corporations reporting on an 1120 tax return, the final profit is distributed amongst the shareholders according to percentage of ownership and reported on K-1 forms. Each shareholder will receive a K1 and will use the information to prepare their personal tax returns.
Now, I want to explain the difference between Accrual and Cash reporting. Most small businesses are on a cash reporting basis. This means only income that has been physically received is counted and you only deduct the expenses that have already been paid. In accrual accounting, invoices that are unpaid at yearend (Accounts Receivable) are included in income and any bills that have been received but not paid (Accounts Payable) are included in your expenses. Your tax return from last year will have the basis clearly marked. Once you file one way, you must continue to file with that method or you must request a change. It’s very important to make sure you have the correct reporting basis selected for your Profit & Loss or you could pay more taxes than necessary.
Stay tuned for the next installment of this article series where I explain the Balance Sheet and why it is so important to reconcile your accounts.
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