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Back to basics: Profit & Loss vs Balance Sheet

by | May 28, 2022

The Profit and Loss report and Balance Sheet are two of accounting’s most famous reports. Everyone’s heard of them, every accounting software can generate them, and even the IRS is interested in them. And, they’re famous for good reason. Together, they give you a big picture understanding of your accounting records. And, while you may have to dig deeper for more detail, your Profit and Loss and Balance Sheet will show signs and hints of what’s happening in the rest of your accounting records and in your less-famous reports.

But, the difference between them (besides obviously having different names) and the importance of each report is not exactly obvious. They both just seem like reports with business numbers on them. And, while that’s true (they areee reports with business numbers on them), your Profit and Loss and Balance Sheet are two different reports that give you a summary of two different parts of your accounting records and aren’t interchangeable. You can’t review your Profit & Loss to learn about your Balance Sheet and vice versa. Each report has its place.

 

The five account types:

Every transaction in the entire business world can be described with a combination of the five account types: revenues, expenses, assets, liabilities, and equities. These are the building blocks of accounting and can be loosely grouped into two sets. Revenue and expenses tend to be transactions that occur during normal operations and everyday activities. And, assets, liabilities, and equities tend to be either longer-term transactions or holding accounts that track important information*. (For example, assets include literal cash in the bank, Accounts Receivable, and property. Liabilities include loans, Accounts Payable, and various amounts you owe. Equities include paid-in capital and retained earnings. These aren’t immediate everyday transactions. They’re just keeping track.)

Profit & Loss reports detail the first set (revenue and expenses) and report on the historic operating activities during a specific time period (eg, last quarter, January thru June, last year, etc). Balance Sheets detail the second set (assets, liabilities, and equities) and report the historic levels on a specific day (eg, December 31st). You typically pick up a Profit & Loss when you want to learn about what happened during standard operations. And, you pick up a Balance Sheet to learn about what’s sitting in the various holding accounts and might get ‘unlocked’ one day (eg, Accounts Receiveable might be collected, Loans Payable may come due, etc).

(* note: this is a bit of an oversimplification. Entire degrees are taught and rulebooks are written about the nuances of accounting and these five accounts. But, this email is about financial reports.)

 

Reporting period :

A Profit and Loss will always be for a time period and a Balance Sheet will always be for a specific date. That little nuance means that Profit & Loss reports will inherently show activity that happened (eg, you spent $XXX on Software Expense during this time period) while Balance Sheets don’t (eg, Accounts Receiveable was at $YYY on this date). When you’re reviewing the reports together, you’ll always want to generate a Balance Sheet for the start and end of the Profit & Loss period. For example, if you’re reviewing your Profit and Loss for 2021, you’d also want to review your Balance Sheet for January 1, 2021, and December 31, 2021. Comparing those two Balance Sheets will help you see the changes and activity.

 

Why banks and the IRS care :

Banks, the IRS, and other external stakeholders care about your reports for slightlyyy different reasons than you do. You review your reports to learn about your business and make better-informed decisions. You’re not really running numbers, doing math, looking at ratios, or doing complex analyses. But, that’s what banks and tax departments are doing. They’re reviewing your reports to learn about your business and get a big picture understanding. Then, banks use that understanding to figure out if you’re creditworthy (ie, how much profit you’re earning, your assets-to-liabilities ratio, etc), and tax departments use it to figure out how much to tax you owe and to suss out if you’re committing fraud on the tax return.

 

Tweaking and customizing them:

You can add a lot of detail and context to a Profit & Loss thru tweaking and customizing it. For example, you can split ‘Revenue’ into multiple income streams like ‘Monthly retainer revenue’ and ‘Project revenue’, etc. Or, you can rearrange your expenses so they make more sense, like grouping all your employee expenses together (eg, salary, payroll tax, benefits, payroll software, etc). Balance Sheets are a little more rigid and less customizable because there are fewer Balance Sheet transactions and everything important already gets a dedicated tracking account (ie, you’re already tracking all your loans as separate items). And, anything worth reviewing in greater detail has a separate report (for example, if you’d like to review your Accounts Receiveable in greater detail, you’d review the A/R Aging report instead of forcing detail into a Balance Sheet). So, while you may want to tweak your Profit and Loss to understand it better, you’re kinda stuck with your Balance Sheet.

 

Underlying data:

Profit & Loss reports and Balance Sheets both suffer from a data problem. They’re only as good as the data used to create them (aka, garbage in, garbage out). Neither report corrects for mistakes or inaccuracies. And, your accounting software just assembles reports from the accounting data it has, including all your bank/credit card transactions, invoices, bills, etc. Anything you’ve entered (or haven’t entered) is compiled into whichever report you ask for. Don’t assume either report is correct because the software generated it. The software could be carrying forward errors. Take a few minutes to review each report and the underlying data to make sure it’s accurate before using it to make decisions.

(Check out this prior issue to learn more about reviewing Profit & Loss reports for inaccuracies: Trust but verify (aka how to spot check a Profit & Loss report). You can also apply many of those same tests to a Balance Sheet like checking your cash balance against bank statements or loans payable against your loan principal balances.)

 

Action Item:

Generate a Profit & Loss and two Balance Sheets. Then, compare what’s included in each report.

 

PS, this email was inspired by a reader’s question: 🤔 What’s the difference between a Profit & Loss and a Balance Sheet?

If you have a question you’d like answered, either hit reply and let me know or, if you’d prefer to keep it anonymous, drop it in this form.

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