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This chapter will be concerned with the second of the financial statements, the profit and loss account or income statement. Although profit and loss accounts are prepared by all forms of business entity, this chapter, in a similar way to Chapter 2, deals primarily with the profit and loss accounts of limited companies, both private and public.
This chapter deals with how profit and loss accounts are structured and how the accounts within the profit and loss account are categorised. Each of the items within each of the profit and loss account categories will be described in detail and form the basis to enable the preparation of a profit and loss account of a limited company in the appropriate format. We will look at the relationship between the profit and loss account and the balance sheet and provide an introduction to the relationship between profit or loss and cash flow.
Like the balance sheet, the profit and loss account is subjective largely because of the impact on costs of the variety of approaches that may be taken to the valuation of assets and liabilities. The profit and loss account may also be considered in its measurement of the trading performance of the business see Fig. The profit and loss account calculates whether or not the company has made a profit or loss on its operations during the period, through producing and selling its goods or services.
The result, the net earnings or net profit or loss , is derived from deducting expenses incurred from revenues derived throughout the period between two 'pauses'. The total of the expenses debits and revenues credits accounts within the general ledger comprise the profit and loss account. The total of these may be a net debit or a net credit. A net debit represents a loss and a net credit represents a profit. The net profit or loss is reflected in the balance sheet of the business under the heading 'retained profits', which is part of 'shareholders' equity'.
All the other accounts within the general ledger, other than expenses and revenues, may be summarised into various other non-profit and loss account categories and these represent all the other balances that complete the overall balance sheet of the business.
There are three main points to consider regarding the profit and loss account and how it differs from the cash flow statement. First, revenues or sales or income and expenses or costs or expenditure are not necessarily accounted for when cash transfers occur. Sales are normally accounted for when goods or services are delivered and accepted by the customer. Cash will rarely be received immediately from the customer, except in businesses like high-street retailers and supermarkets; it is normally received weeks or months later.
Second, the profit and loss account does not take into account all the events that impact on the financial position of the company. For example, an issue of new shares in the company, or a loan to the company, will increase cash but they are neither revenue nor expenses. Third, non-cash flow items, for example depreciation and bad debts, reduce the profit, or increase the loss, of the company but do not represent outflows of cash. These topics will be covered in detail in the next chapter.
Therefore it can be seen that net profit is not the same as cash flow. A company may get into financial difficulties if it suffers a severe cash shortage even though it may have positive net earnings profit.
The profit and loss account of a private limited company or a public limited company should be able to tell us all about the results of the company's activities over specified accounting periods.
The profit and loss account shows us what revenues have been generated and what costs incurred in revenues, sales or income generating those revenues, and therefore the increase or decrease in wealth of the business during the period. The same note of caution we mentioned in Chapter 2 that should be exercised in the analysis of balance sheet information, applies to profit and loss account information.
The profit and loss account is an historical statement and so it does not tell us anything about the ability of the business to sustain or improve upon its performance over subsequent periods. There is not always consistency between the information included in one company's profit and loss account and that of another company. As with the balance sheet, the profit and loss accounts of two companies even within the same industry may be very difficult to compare.
This will be illustrated in the wide variety of methods of depreciation calculations and stock valuation methods examined in this chapter. In addition, the bases of financial ratios to be examined in detail in Chapter 5 used by analysts in looking at a company's profit and loss account may often be different.
It is often said of profit and loss statements, as well as of balance sheets, that the value of every item included in them is a matter of opinion. This is due not only to the alternative stock valuation and depreciation methods, but also because of the subjective assessment of whether the settlement of a customer account is doubtful or not, and the sometimes imprecise evaluation of accruals and provisions.
What is profit? We saw from the worked examples in Chapter 2 that profit or loss may be considered from two perspectives. We may consider these perspectives to illustrate the links between the profit and loss account and the balance sheet. The first perspective, which is not suggested as a method for calculating profit in practice, compares the balance sheet of an entity at the start of an accounting period with the balance sheet at the end of the accounting period.
We may see from these that the values of each of the components of the balance sheet may have changed. For example, levels of stocks, debtors, creditors, cash, fixed assets, and accruals may have changed during an accounting period.
We have seen that the net value of the assets and liabilities in the balance sheet represents the capital, or equity, or the wealth of the business at a point in time. The change in wealth over an accounting period between the beginning and end of the accounting period is the profit or loss for the period reflected in the retained earnings category in the balance sheet.
Profit or loss considered in this way can be represented in the equation:total assets TA 0 total liabilities TL equity E! This is the method used in practice to calculate the profit or loss for an accounting period. This summary, or profit and loss account, gives the same result as that derived by simply looking at the change in wealth between the beginning and end of the accounting period. It is the same because all the transactions relating to items contained in the profit and loss account are also all reflected in some way within one or more balance sheet categories.
For example, sales are reflected in debtors, expenses are reflected in creditors, cost of goods that have been sold came out of stocks. Profit or loss considered in this way can be represented in the equation: profit P total revenue TR 0 total costs TC Using the opening balance sheet 1 March below and the further transactions a and b , we are able to: i show how the balance sheet will change after these transactions events have taken place ii identify the profit which the shareholders should consider is potentially distributable as a dividend.
In this chapter we will look at the profit and loss account from the second perspective. We will look at how a profit and loss account is constructed and prepared by deducting total costs from total revenues, as the second of the three key financial statements that are required to be prepared by a limited company.
A trading company, Squirrel Ltd, has an accounting period that covers the 12 months to 31 December The quarterly invoice covering that period was not expected until late March The above information may be used to look at why the annual net profit should be revenues less expenses, and why there should be accounting concepts applied to the treatment of those expenses.
The profit and loss account for a year tries to match revenues and expenses for that year complying with the matching concept -see Chapter 1. The term 'net profit' means the difference between revenues and expenses. Gross profit is derived from sales less the costs of those sales, and net profit is derived from deducting expenses from gross profit.
Net profit is not the difference between cash receipts and cash payments. Cash inflows and outflows suffer from timing differences. The reported sales for the year must relate only to the 12 months to 31 December. Using the matching concept, the expenses must also be for 12 months. Without these adjustments, the expenses would not represent 12 months' expenses.
Net profit for the 12 months to 31 December for Squirrel Ltd is therefore: There must be an application of concepts and standard practices in arriving at net profit, otherwise users of financial information would not have reasonable confidence in the amounts being shown in the accounts reported by companies, large or small.
Worked Example 3. Structure of the profit and loss accountAs we have seen previously, the profit and loss account measures whether or not the company has made a profit or loss on its operations during the period, through producing or buying and selling its goods or services.
It measures whether total sales or revenues are higher than the total costs profit , or whether total costs are higher than total sales or revenues loss. The total costs of a business include the expenditure incurred as a result of the generation of revenue. Each of the above examples of costs by no means an exhaustive list incurred in the generation of revenue by a business appears itself as a separate heading, or is grouped within one or other of the other main headings within the profit and loss account.
Figure 3. We will look at how a basic profit and loss account is constructed to arrive at the profit on ordinary activities after taxation or net profit for the company. Net profit is also sometimes called net earnings, from which may be deducted dividends payable to ordinary shareholders. The net result is then the retained profit for the financial year. Each of the categories of revenue and cost within the profit and loss account see Fig. TurnoverThe main source of income for a company is its turnover, primarily comprised of sales of its products and services to third-party customers.
Revenues and costs are not necessarily accounted for when cash transfers occur. Sales are normally accounted for when goods or services are delivered and invoiced, and accepted by the customer, even if payment is not received until some time later, even in a subsequent trading period. It should be noted that a cost or expense is the financial result of the 'consumption' that occurred during the accounting period that relates directly or indirectly to the production or sales of the goods or services, and is accounted for as it is incurred rather than on a cash payment basis.
Costs may be cash-related, invoiced costs such as raw materials or non-cash items like depreciation charges. Gross margin or gross profit The difference between turnover, or sales, and COS is gross profit or gross margin. It needs to be positive and large enough to at least cover all other expenses.
Other operating expenses: distribution costs and administrative expensesAlthough not directly related to the production process, but contributing to the activity of the company, there are further costs that are termed 'other operating expenses'. These include distribution costs and selling costs, administration costs, and research and development costs unless they relate to specific projects and the costs may be deferred to future periods.
Distribution costs include the costs of selling and delivering goods and services. Such costs may include: Administrative expenses effectively include all costs not included in cost of sales, distribution costs, and financial costs.
Distribution costs and administrative expenses include all expenses related to the 'normal' operations of the company, except those directly related to manufacturing like the costs of the purchasing department, logistics department, and quality department. They also exclude the share of overhead costs, for example, heating and lighting, business rates, water and effluent costs, relating to manufacturing activities. Administrative expenses exclude financial expenses and revenues, because these are really a function of the financial structure of the company the extent of its funding by owners' share capital and by lenders' debt, or loans , and any other non-operational expenses and revenues.
Other operating incomeOther operating income includes all other revenues that have not been included in other parts of the profit and loss account. It does not include sales of goods or services, reported turnover, or any sort of interest receivable, reported within the net interest category.
Operating profit OP Operating profit see The operating profit is the net of all operating revenues and costs, regardless of the financial structure of the company and whatever exceptional events occurred during the period that resulted in exceptional costs.
Get New Customers Online www. Dear visitor! Interest on capital Stationary Returns inwards. Example 2: The following trial balance was taken from the books of Habib-ur-Rehman on December 31, About us! Also see formula of gross margin ratio method with financial analysis, balance sheet and income statement analysis tutorials for free download on Accounting4Management. Closing stock on December 31,
These solutions for Financial Statements are extremely popular among Class 11 Commerce students for Accountancy Financial Statements Solutions come handy for quickly completing your homework and preparing for exams. Financial Statement of…. Trading Account. Adjusted Purchase. Gross Profit Balancing Figure. Note :. As adjusted purchases is given, it means opening and closing stock are already adjusted.
Preparation of Trading Account. Preparation of Profit & Loss Account. Preparation of Balance Sheet. Cash Method of Accounting.
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Blank Profit and Loss Statement Type. Profit and loss statements or just income statements are most essential to enterprise. Please fill in the fields that apply to your business. File Format.
Where forecasts provide an estimate of your financial position, financial statements are historical and outline the actual results achieved. Financial statements are usually produced monthly and at the end of the financial year. It is important to set aside time each month to analyse your financial statements, to enable you to control and improve your business. Usually produced monthly, this is a summary of income and expenses for your business. Gross profit is an indicator of efficiency.
The balance sheet , by comparison, provides a financial snapshot at a given moment. It doesn't show day-to-day transactions or the current profitability of the business. Any profits not paid out as dividends are shown in the retained profit column on the balance sheet. For example, if sales income exceeds spending in the period preceding publication of the accounts, all other things being equal, current assets will be higher than if expenses had outstripped income over the same period. Breadcrumb Home Guides Finance Financial planning and accounts The relationship between balance sheets and profit and loss accounts. Balance sheets The relationship between balance sheets and profit and loss accounts. In this guide: Introduction Balance sheet reporting - who, when and where?
Profit and Loss Account is the first financial statement prepared before preparing the Balance Sheet. Difference between the Profit and Loss account and Balance Sheet:-The Profit and Loss account is the statement of income and expenses which showing the net profit and loss for the particular period while balance sheet is the statement of assets, liabilities and capital which showing the actual financial position of an entity. For fixed assets this must be what Account and Balance Sheet. For fixed assets this must be what. Consolidated Statement of Profit and Loss. A Profit Format. Profit is calculated in a Trading and Profit and Loss Account.
The revenue items form part of the trading and profit and loss account, the capital items help in the preparation of a balance sheet. Expenditure. Whenever.
Trading Account Trading account refers to that account which is prepared by the company to shows the transactions results which includes buying and selling during an accounting period. The Profit and Loss Account starts with the credit from the Trading Account in respect of gross profit or debit if there is gross loss. Thereafter, all those expenses or losses which have not been debited to the Trading Account are debited to the Profit and Loss Account. Trading account shows the result of buying and selling of goods, It is prepared to determine the gross profit or the gross loss of a trader. It is prepared at the stage of final accounts preparation..
The trading account shows the income from sales and the direct costs of making those sales. It includes the balance of stocks at the start and end of the year. Overheads and expenses: Costs not directly involved in the production process indirect costs. Jim co-founded tutor2u alongside his twin brother Geoff! Jim is a well-known Business writer and presenter as well as being one of the UK's leading educational technology entrepreneurs. Reach the audience you really want to apply for your teaching vacancy by posting directly to our website and related social media audiences.
Can be used to compare trade this year with trade last year Business Studies Online: Slide 1. This is the amount of money that will be kept in the business Calculated by subtracting expenses from Gross Profit Calculated by subtracting tax from net profit Business Studies Online: Slide 4. They speed up the cycle People who owe the business money. They slow down the cycle. Business Studies Online: Slide 9.
The trading profit and loss account is made up of two separate accounts within the general ledger. The purpose of the two accounts is to separately identify the gross profit and net profit of the business. The trading account is the top part of the trading profit and loss account and is used to determine the gross profit.