Entrepreneurs tend to put all their attention on the Income Statement…
They want to know how much their sales are, their gross profit, and, of course, net profit.
What is the Balance Sheet good for? It does not tell you anything about operations, right?
Wrong.
Here is something you may not have known – the Income Statement lives inside the Balance Sheet.
The two statements are intricately linked, joined at the hip.
The Income Statement lives inside the Equity section of your Balance Sheet.
Think of it like this – Net Profit, or Net Loss lives inside the Equity section of your Balance Sheet.
How to Fix a Broken Income Statement
Whenever I have looked at an Income Statement that I suspect is incorrect, or just a plain mess, I go the Balance Sheet to fix.
In fact, the only way to correct a messy Income Statement is by going to the Balance Sheet.
Because…
All the Dead Bodies are on the Balance Sheet
Let us look at one dead body that ends up on the Balance Sheet and is the most glaring one.
Inventory.
Inventory and Cost of Goods Sold, which is on the Income Statement, are interconnected.
When you buy goods for resale, they go to the Balance Sheet, as an asset.
Once sold, they move to the Income Statement as an expense. If you have a real-time costing system that tracks when items are sold, then you will have few problems.
The system is tracking as goods are sold and moving them to your Income Statement, as a cost, or expense.
Inventory Hides a Lot of Dead Bodies
When you have manufactured goods, or grown plants in the case of a grower, you may not be counting inventory every month.
If your inventory is over-valued on the Balance Sheet, then your cost of goods sold (an expense) on the Income Statement is under-stated.
If cost of goods sold are understated, then Net Profit is over-stated.
You are happy at the high profits, and it is a fake high because a dead body is living on your Balance Sheet – inventory that does not exist because it has been sold.
When does that dead body get unburied? When you do an inventory count, often at year-end. By then it is too late. You have relied on 11 months of over-stated Net Profits. Your happy feeling comes crashing down.
Culprit Number Two – Bad Debts
The other big culprit hiding dead bodies on the Balance Sheet is Accounts Receivable.
Past sales that ended up as Revenue on your Income Statement, may now be living inside your accounts receivable, dead as a doornail. Uncollectable.
The fix?
Well, first, try hard to collect them, or even send them to a collection agency if you have to.
If they are dead, move them to the Income Statement as Bad Debt expense.
Most people wait until year-end to cleanup, giving false numbers on your monthly Income Statements.
Culprit Number Three – Deferred Costs
Often business owners will defer costs under the premise that there is future value in those costs.
In other words, current expenses get treated as assets.
But are they?
Is there value in those costs being capitalized on your Balance Sheet.
Unless you can sell those capitalized costs as an asset, write them off. Software development is something that could be considered an asset. Most deferred costs should be written off.
Culprit Number Four – Under-Performing Assets
Old, worn out and unused assets should be removed and written off as an expense to the Income Statement.
This is less common a problem and can be done once a year at year-end.
Culprit Number Five – Deferred Revenue
Some businesses report as sales what should go on the Balance Sheet as a liability.
When you receive cash for something not delivered yet, that is a deposit, and should be recorded on the Balance Sheet, as deferred revenue.
Only when you have performed the service or sold the goods should that be moved to the Income Statement as sales.
Culprit Number Six – Unrecorded Liabilities
It is important to ensure that all supplier bills are recorded as expenses in the month incurred. These bills are expenses and could overstate your Net Profit by under-stating your expenses.
Also, if expenses are recorded in the incorrect period, it makes your monthly Income Statements have wild swings. One month shows a big profit, the next month a loss.
Culprit Number Seven – Unreconciled Loans
Loans and mortgages that carry interest should be reconciled and recorded each month.
The interest expense needs to be recorded on the Income Statement.
The above seven culprits cover most of the dead bodies that might be buried on your Balance Sheet.
Thanks for reading…