Kara wrote in and asked me to further explain the difference between a service business’s financial statements and that of a product business. I’ll provide another example that should make it more understandable. Definitely check out my previous tutorial before reading this. It is available here The Balance Sheet.
Ever since you made all that money with Mark, your employee, you have been fixated on franchising. Many friends want to learn how to caricature and you want to try out cost method accounting (tax benefits)!
You decide to teach your caricature methods to your friends and help them market for a flat fee of $500. You start your new franchise service called Cartoon You.
I improved upon this tutorial with some great video tutorials which you can find here:
Since you aren’t going to have any inventory, you can use cost method accounting. The only difference between the balance sheet of your accrual method business and the new one is the lack of an inventory section. For that reason, I won’t dwell on the balance sheet.
The income statements are quite different though. The income statement for a service company focuses on Cost of Sales and Expenses. There is no space for inventory, because there is no inventory in a service based business.
You classify those expenses that are directly related to the delivery of your service as Costs of Sales. Your specific costs of sales are going to be:
Expenses are costs that are not directly related to the services you sell. Your expenses will include:
Note: By general expenses, I’m referring to things like office equipment, business cards, paper, etc.
Other expenses service business’s often have include:
Getting a Loan
You decide to get a loan for $500 from a local consumer loan company. You agree to pay them back the loan in 3 months with a payment of $192 each month. This is an estimate based on a 15% interest charge.
One Class and Two Income Statements
You get 3 people to sign up for your class. Two people pay for the class on credit for a total of $1,000. The other student pays their $500 in cash. Here are your total cost of sales for this first class:
You also have the following expenses during your first month in business:
Based off of the above information, this is what your income statement would look like based on the Accrual Method of accounting.
This is what your income statement would look if it was created using Cost Method accounting.
Remember with Cost Method accounting, you are trying to minimize earnings so that you pay less in taxes. This method of accounting allows you to only count that income that was paid in cash. Since two students paid with credit, your sales are only $500 instead of $1,500.
I’m assuming that all of the expenses and costs of sales above were paid in cash. If any were purchased on credit, you would not be allowed to list them of course.
Is it a Cost of Sale or Expense?
Don’t get hung up on what is a cost of sale and what is an expense. The IRS just wants your reporting to stay consistent, so use them in the way that makes the most sense to you.
This article is for information purposes by the way. I’m not an accountant, but just a former stock broker 🙂
That’s All Folks
If you have any questions or comments leave them in the comment section below.
I’ll be wrapping up all of this financial stuff very soon. If you would like to recommend the next tutorial leave a comment.
Till Next Time