What’s there to understand? The bottom line is the last line on the Profit & Loss (P&L) statement and it is either a profit or a loss. That’s all you need to know, isn’t it? Yes, it is important to know whether you are making a profit or losing money, but understanding how financial statements work is knowing the nature of each account and how it fits into the scheme of things. In other words, did you know that the entire P&L statement is just an extension of one number in the Equity section of your Balance Sheet?

If you have a set of business financial statements, take a quick look at them. First look at the Net Profit or Loss line on your P&L statement. Let’s say it reads $48,567.32. Now look at your Balance Sheet and find the Equity section. You should see that same number $48,567.32 on a line called Net Profit or Loss or something similar.

Why is this? Net Profit means an increase (credit) in Equity and Net Loss means a decrease (debit) in Equity. Equity is what is yours. Therefore, if you have an increase in Equity (credit) then it makes sense to think that you have an increase in Assets (debit), probably in the form of cash, receivables, inventory or property. Or, you might have a decrease in Liabilities (debit) indicating an increase in Equity since you now no longer owe as much to creditors.

Similarly, it stands to reason that if you have a loss, indicating a decrease in Equity, that you will be showing a decrease (credit) in your Assets. In other words, you now own less. You may find it helpful to print a copy of the Accounting Model which is the formula that explains how transactions are recorded as debits or credits depending whether they are an Asset, Liability, Equity, Revenue, or Expense item, and whether they represent an increase or decrease. By using the Accounting Model to trace through the above debits and credits you will begin learning how accounting logic works. Use the following URL to access the Accounting Model:

http://www.reallifeaccounting.com/ accounting_model.asp

It may also help to think of the Balance Sheet as working the same way as a reservoir of water. At any point in time you can measure how much water a reservoir contains. In addition, there is always a river that flows into and fills the reservoir and an outlet, such as a dam, where the reservoir is drained. The reservoir level always reflects whatever water came in and went out.

The Balance Sheet, like the reservoir, is a reflection of the financial activity of your business at a given point in time. This is usually measured at the end of an accounting period, i.e., month, quarter, and year-end. The P&L statement can be thought of as the river that flows into and out of the reservoir. The P&L statement is a measure of the revenue and expense activity that occurred during an accounting period, such as at the beginning of a month to the end of the month, etc. The point to remember is that a Balance Sheet always reflects the activity of revenue and expense that has occurred in the past and current accounting periods.

Now that we have that concept established, here is a tip: When your business is a sole proprietorship, the way you pay yourself is through an account called “Owner’s Draw”. This account is located in the Equity section of the Balance Sheet and represents a decrease in Equity when you take a personal draw. However, sometimes owners get mixed up as to whether they are taxed on the draw amount or net profit so let’s clear up the confusion.

When a draw is taken, cash is being decreased, but where did the cash come from in the first place? Here are a couple of possibilities:

1) Maybe you borrowed some money and put it in the business, but then decided to use some of the money for personal purposes. You don’t have to pay tax on borrowed money.

2) Or maybe a while ago, you contributed some personal money that had previously been taxed and are now paying back. You certainly wouldn’t have to pay taxes on the same money twice. Because the money withdrawn from the business may include previously taxed money, the rule is that you pay tax on Net Profit because Net Profit relates to newly earned income not previously taxed. If you keep your books on an accrual basis, then Net Profit may be quite different than your cash draws. This is because your revenue may include sales that haven’t yet been paid (Accounts Receivable) and expenses you haven’t yet paid (Accounts Payable).

Even if your books are recorded on a cash basis, your Net Profit may not relate directly to cash. For instance, usually a business has some depreciation that is a non-cash deduction. Or, you may have expenses charged on credit cards that have not yet been paid.

Perhaps you can now see that there are several reasons why the Owner’s Draw is something different than Net Profit even though there is a loose relationship between the amount of money available to the owner and Net Profit.


Keywords: Net Profit, Equity, Accounting, Owner's Draw, Sole Proprietorship, P&L Statement, Balance Sheet

About the Author
John Day, Sonora, CA USA
jday@reallifeaccounting.com
http://www.reallifeaccounting.com
John W. Day, MBA is the author of Real Life Accounting for Non-Accountants, an online course in accounting basics. He has written 3 e-Books pertaining to small business accounting and writes a monthly newsletter on accounting issues.