INCOME STATEMENT
As explained above, profit results from an excess of income over the cost of producing that income. The terms 'income' and 'expenditure' must now be defined, and the concept of capital and revenue must be considered.
Revenue income results from the sale of trading assets (eg. stocks held for resale), and is compared against revenue expenditure, which is the result of making the assets saleable. The result of this comparison gives a revenue profit (or loss if it is a minus quantity). The revenue profit is very important, because it is the result of the business operations for the financial period, and the source from which distributions can be made to owners/shareholders to give them a return on their investments.
Capital income is proceeds from the sale of non-trading assets (fixed assets or investments). Capital expenditure is the cost of acquiring fixed assets or investments. The excess of proceeds from the sale of any fixed asset or investment over its cost to date is capital profit. Capital profit is disclosed separately in the profit-and-loss account, and it is unusual for such profits to be distributed to the business owners.
Here is an example of several items, showing how they should be classified in the annual published profit-and-loss account and balance sheet:
capital
purchase of leasehold premises
solicitor's fees in connection with the purchase of leasehold premises
cost of new machinery
customs duty charges on new machinery from supplier to factory
carriage on new machinery from supplier to factory
cost of installing new machinery
revenue
annual depreciation of leasehold premises
annual ground rent of lease
removal expenses
annual patent renewal fees (but not original patent costs).
Having distinguished between capital and revenue, the importance of measuring revenue income and expenditure against time must be considered. To arrive at a profit from operations during a financial period, a comparison of the income and the relevant costs for that period only must be made. This means that, if a cost is incurred in one financial period, but the cost relates to income that will be earned in a subsequent period, then that cost must be carried forward to be matched against the appropriate income. Obviously if it is required to make comparisons of profit made over a number of periods, each period must be of the same duration.
There are two ways in which 'income' earned for a financial period is defined. Some businesses take income on a receipts basis, ie, the cash actually received during the period. However, it is much wider practice to take income on an accruals basis, in which case cash not yet received from credit sales is included as an asset called 'debtors' in the balance sheet.
The Trading and Profit and Loss Account
The management of a business need to know the profit and loss from the business operations during its financial year, but there is little advantage knowing only the amount of profit earned. In order to exercise effective financial control over the operations, management need to know the interaction of the various types of costs with sales and other income, and to compare the performance of sales, and the control of costs during the current period compared to those of previous periods. This is the reason for the preparation of the trading and profit and loss account.
The following layouts show alternative formats for a trading and profit and loss account, ie, horizontal and vertical:
Horizontal presentation:
Trading & Profit And Loss Account For The Year Ended (Date)
 |
| | | | | | |
| Cost of goods sold | | 50000 | | Sales | | 62000 |
| Gross profit carried down | | 12000 | | | | |
| | | | | | |
| | | 62000 | | | | 62000 |
| | | | | | |
|
| | | | | | |
|
| Selling expenses | | 8000 | | Gross profit bt down | | 12000 |
| Administration expenses | | 2000 | | | | |
| Finance expenses | | 100 | | | | |
| Nett profit transferred to | | | | | | |
| the balance sheet | | 2800 | | Income from investments | | 900 |
| | | | | | |
| Vertical presentation: | | | | | | |
Trading & Profit And Loss Account For The Year Ended (Date)
|
| | | | | |
| Sales | | | | 62000 |
| Less: | Cost of goods sold | | | | 50000 |
| |
|
| Gross profit from sales | | | | 12000 |
| Add: | Income earned from investments | | | | 900 |
| |
|
| Less: | Selling expenses | | 8000 | | |
| | Administrative expenses | | 2000 | | |
| | Finance expenses | | 100 | | |
| | | |
|
| | | | | 10100 |
| |
| Nett profit transferred to the balance sheet | | | | 2800 |
| |
|
| |
Irrespective of whether the business is retail, wholesale, or manufacture, the trading account is concerned with the comparison of turnover (gross sales value from the sale of finished goods) with the cost of making those goods saleable. The difference is the gross profit of sales. If difference was wholesale, the cost of sales might comprise the following expenditure: purchase cost of the goods from the manufacturer, and carriage, freight and insurance expenses incurred in transporting the goods from the manufacturer.
The profit and loss account is concerned with:
- Distinguishing between gross profit earned from trading activities, and income from other sources, such as interest or dividends from investments or capital profits.
- Disclosing the various types of expenses involved in making the sales to customers (selling and distribution), and overheads (other general expenses) that any business incurs - for example, heating, lighting, and financial expenses - during the normal course of trading.
- Arriving at an amount of net profit from all the business activities during that financial period. This figure is the net increase in assets for that period, and is added to the capital at the end of the period to maintain the relationship:
| assets |
= |
capital |
+ |
liabilities |
The list that follows shows various types of expenditure incurred by a business:
Selling and distribution expenses:
sales directors salary
salesmen's salaries and commissions
travelling and entertainment expenses
delivery and vehicle maintenance expenses
marketing costs
discounts allowed
bad debts - these arise when debtors do not pay and there is little likelihood of the sums owed being recovered. The sums are written-off to the revenue control account in the financial period in which they occur, less any recovery that might have been made of bad debts charged in previous financial period.
Administrative expenses:
director's salaries
office salaries and wages
rent
rates
insurance
postage, printing, stationery
telephone charges
heating and lighting
Finance expenses:
bank charges
interest of loan and bank overdraft
hire purchase interest
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