4.2. Finding Profit

As I say in the previous section, when reading an income statement your job is asking pertinent questions. Here's an important question: What happened to the business's financial condition as the result of earning $1.69 million net income for the year (refer to Figure 4-1)? The financial condition of a business consists of its assets on the one side and its liabilities and owners' equity on the other side. (The financial condition of a business at a point in time is reported in its balance sheet, which I discuss in detail in Chapter 5.)

To phrase the question a little differently: How did the company's assets, liabilities, and owners' equity change during the year as the result of its revenue and expense transactions that yielded $1.69 million profit? You can't record revenue without increasing a particular asset (or decreasing a particular liability in some cases). And you can't record an expense without decreasing a particular asset or increasing a particular liability. Revenue and expenses are not ephemeral things, like smoke blowing in the wind. These two components of profit cause real changes in assets and liabilities.

When you see the sales revenue in Figure 4-1, you should be thinking that there was $26 million inflow of assets during the year. (In the example, no liabilities are involved in recording sales.) The company's total expenses for the year were $24.31 million ($26 million sales revenue minus $1.69 million net income). Expenses decrease assets ...

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