Accounting Issues: Part VI

The other central document of accounting is an income statement.  This represents a period of time, rather than the moment-in-time of the balance sheet. If all is working properly, the income statement should give investors an idea of the underlying processes that have made the present condition of the company what it is.

 

We won’t spend a lot of time on the income statement, simply because much of what we might say about it we’ve already said. The issues that arise in compiling an income statement look familiar to anyone who understands the latest balance sheet. 

For example, the expenses part of an income statement should indicate the costs of goods sold (COGS), that is, the costs directly attributable to such of the goods that have gone out the door in the hands of a customer over the past year or quarter, separately from all the other costs, especially the “general and administrative expenses.”

The issues that arise when valuing COGS are the same issues that arise when valuing  inventory in the preparation of the balance sheet, and we’ll say no more about them here.

Likewise, the issues that arise when we try to determine the amount of a year’s or quarter’s depreciation, in the expenses portion of the balance statement, are the same issues that we mentioned when we discussed the value of the equipment itself, as an asset on the balance sheet.

Then there is the bad debt expense. Some of the people to whom I extended store credit will never pay me back. I could hire a collection agency, but that may in many cases be a larger expense than it’s worth. So, suppose I just write them off after a certain period of time has passed. That’s a bad debt expense on the income statement, and it is a charge to the receivables account on the balance sheet.

I should be recovering my overhead costs from the pricing of my product. If I’m not, then I’m running a going-out-of-business sale. But if I am recovering the costs of overhead (our conveyor belt), I am liquidating that conveyor belt. It is turning year by year from a tangible asset into cash: enough cash to be used to buy another conveyor belt in due course.

Expenses (and losses) raise some convoluted issues of recognition and valuation. A critical point is that a business can’t wait until it has to pay some sum of cash before it records an expense. The expense may be incurred long before that, or it may not be incurred until sometime thereafter.

Because expenses may be incurred (they may accrue) before any payment must be made, accountants have to live with uncertainty.