How to Read an Income Account

This department is designed to help readers In a better understanding of the general business conditions which affect their investments. It is obviously impossible to give advice as to specific investments.

by HOWARD DOUGLAS DOZIER

A FORTUNE awaits the inventor of a projector which, when plugged into a business, will throw upon a screen the changes which are constantly taking place in its affairs. Until he appears we must continue to depend for our information upon the handmade balance sheets and income statements prepared by accountants.

The balance sheets at the beginning and at the end of a fiscal period, whether a quarter, a half, or a whole year, are photographs of the condition of a business as of those two instants. The income account, on the other hand, is a motion picture of the inflow and the outflow of money or its equivalent which are responsible for a business getting from where it was to where it is. What really flows into a business is, of course, raw materials or goods for sale, the use of laud and the wear of machinery and equipment, labor and management, and other factors readily called to mind, all of which tech nology and skill integrate into finished products or services. The inflow of these materials and immaterial causes an outflow of money. The outflow of finished products and services brings an inflow of money. The technicians keep tabs on the stream of materials and immaterials, the accountants on the reverse flow of funds. Leaving now the technicians with their ‘makings’ and their ‘made,’ let us turn to the accountants. For our purposes here we shall need the services of two, one to keep up with our balance sheet, which shows how much a corporation owes and how much it owns, and another to keep up with what it takes in and what it pays out. As we have already seen in the Financial counselor for August, ‘ Anatomy of a Balance Sheet,’a solvent corporation always owes all it owns. It is also true that a corporation which is making money, as we say, pays out to somebody or earmarks for somebody all the revenues it receives.

To the income accountant a business is a reservoir of funds, which stand at one level at one time and at another level at another time. He too stands — stands by impassively and watches cold-bloodedly, observes, measures, and registers the results of management and technology on the altitude of the level of these funds. Periodically he records the changes and reports on the causes which have brought them about. The catalogue in which he sets down his findings is the corporate income account, of which the following may be taken as a bare, though typical, outline: —

Revenues

GroSS monies received for goods and services $1,000,000

Miscellaneous other monies received. 250,000

Interest and dividends from investment 50.000 $1,300.000

Expenses

Cost of goods sold or raw materials worked up $ 500,000

Salaries and wages 300,000

Professional fees $5,000

Advertising. 50,000

Reserve for taxes not yet due. 25,000

Reserve for depreciation of plant, equipment, and machinery 50,000

Reserve for other specified purposes $5,000 975,000

Net operating income $ 325,000

Interest on bonds $ 60,000

Amortization of bond discount (See Financial Counselor for July) 5,000 65,000

Net profit belonging to all classes of stockholders $ 260,000

Dividends paid in cash to stockholders $ 160,000

Surplus retained by management in business for stockholders 100,000 260,000

Revenues not paid out or earmarked $0,000,000

The sources of the revenues shown in this hypothetical income account are so obvious as to need no comment. For purposes of simplicity in showing what becomes of them, I am going to assume that the treasurer of the company and its income accountant work out between themselves the simplest possible plan for handling these funds. The treasurer is to receive all monies coming into the company and deposit them in a bank for safekeeping until needed. Once each week he is to draw enough actual cash out of the bank to pay or to provide for the payment of claims arising against the business during the week. This involves paying cash to those to whom it is due or to their representatives. The accountant is to keep up with what the treasurer does and is to make a report at the end of the year. But he is to act also as the representative of the absentee creditors.

We may assume that he in effect, though not in actual practice of course, provides himself with a number of envelopes suitable for the purpose for which they are to be used. He marks a large one ’revenues’ and then a number of small ones successively ’wages and salaries, ‘goods and services purchased,”raw materials, ’advertising,’ and so on, until he has as many envelopes marked as there are classifications into which he wants to separate the operating expenses. Then he designates Others as ’interest,”dividends,’and ’surplus,’ which he thinks of as nonoperating expenses.

On pay day each week the treasurer takes his place at his wicket and the accountant takes his place at the tail end of the pay queue. The accountant must learn what the treasurer has done during the week, and moreover he must collect and hold for the absentee creditors the money the business owes them. When all have disappeared except the accountant, he and the treasurer proceed to carry out their prearranged plan. First the two of them put into the envelope marked ‘revenues’ all the bank deposit slips of the week. This represents all the monies received by the company. Then they put into the one marked ’salaries and wages’ the signed receipts of officers and workers equal in amount to the sum of money which the treasurer has paid out on this account.

They continue this process until they come to the envelopes marked ‘reserve for this’ and ‘reserve for that.’ These envelopes are those of absentee creditors, and the accountant collects in cash from the treasurer what the business owes each and puts it away in the proper envelope. The accountant represents also the bondholders and the stockholders. He therefore collects weekly what the business owes the Former on account of interest and the latter on account of dividends and surplus. All these various sums of money he tucks away neatly, each in its proper envelope.

This performance is repeated fifty-one weeks in the year, but the fifty-second week the programme is a little different and somewhat more elaborate; christmas is still in the air. All the faithful are in the pay queue, including the accountant as usual, but he is no longer the tail. He is followed by two representatives of the ’management of the business and a whole raft of bondholders and stockholders, all of them being his clients. As soon as the customary transactions between the treasurer and the accountant for the week have been completed, the treasurer steps aside and leaves the accountant to have it out with his clients.

First comes one of the representatives of management, demanding the money which has been going into the ‘depreciation.’ envelope all year. The accountant pays him and receives a receipt in full for the amount turned over. This receipt the accountant substitutes in the envelope for the cash taken out. No sooner has this representative of management got his cash than he seeks out the other accountant whose services we are using,— namely, the one who keeps up with the balance sheet,—and says, ’See what I have for you: enough money to pay for all the wear and tear and out-of-dateness on all plant and equipment during the whole year.’ Whereupon the balance-sheet accountant reduces the value of plant and equipment by the amount of money received and increases his record of cash on hand by that amount. No change lakes place in the total amount of assets; the only change is in their character.

Next in line are the bondholders and the stockholders, demanding what is in the ‘interest’ and ’dividend’ envelopes respectively. This they get and go on their way, the bondholders rejoicing that they got their interest and the stockholders grumbling because they did not get, besides their dividends, a part of what was in the ‘surplus’ envelope.

Finally comes the other representative of management to take away what is in the ’surplus’ envelope, a sum of money which in reality belongs to the common stockholders, but which management has decided not to turn over to the stockholders and which the courts will not make the management turn over to them. The income accountant stands and delivers, and this representative of management forthwith betakes himself to the balance-sheet accountant and reports his success. The balance-sheet accountant accepts the cash, increases his record of cash on hand by that amount, and increases by the same amount the debt which management owes the stockholders. Both assets and liabilities are increased, assets by the amount of cash received and liabilities by the same amount, which is covered into surplus.

The affairs of the income accountant have now been liquidated for the year. He has no cash, but rather one envelope filled with bank deposit slips and others with receipts for monies paid. With these he goes to his office, where he computes, adds and subtracts, takes totals and subtotals, labeling as he goes all the information which he develops. His summary of all the information that he has kept in his envelopes during the year is the income account of the corporation which employs him. However elaborate it may be, it is typified by the skeleton shown at the beginning of this paper.

It is thus that a business gets from where it was on January I to where it is on December 31.