The Income Statement / Profit and Loss Account

The income statement / profit
and loss account measures the
sales made and the costs
incurred over a particular time
period. For external reporting
this is usually for a year but
internally most businesses will
prepare their income statement /
profit and loss account on a
weekly or a monthly basis.
The income statement / profit
and loss account captures a sale
when the product or service is
delivered to the customer. Cash
may or may not change hands at
this stage.
Costs are recorded in the income
statement / profit and loss
account to reflect the costs of
making the sales during that time
period. This is called the
matching or accruals concept.
This concept states that the
costs recorded must match to
the sales made in the relevant
time period .
Although the jargon in an
income statement / profit and
loss account may vary (especially
from country to country) the
costs are always deducted from
sales in order of how closely
they relate to the sale itself. The
order that cost deduction
appears is therefore:
1. Cost of product sold
2. Sales, general and administration
costs
3. Interest expense
4. Tax expense
After costs are deducted from
sales, we are left with the
bottom line profit (also known
as the net income or profit
after tax) which belongs to
the shareholders, and
consequently is reflected as
part of shareholders ’ equity
on the balance sheet.
The Balance Sheet
The balance sheet shows the
position that the business is in at
the end of the relevant time
period . It shows the assets the
business has, its liabilities, and
the amount of equity belonging
to the shareholders. The reason
it is called the balance sheet is
because total assets must equal
liabilities and shareholders ’
equity as illustrated below:
Assets = Liabilities +
Shareholders ’ Equity
The 2 sides of this equation must
always equal or balance.
The liabilities and equity
section shows where the
business gets its funds and the
assets section shows how
those funds have been used .
The assets section is generally
divided into 2 sub-sections,
showing the short term and long
term assets. In this context, a
long term item is one whose life
in the business is expected to be
longer than 1 year.
Examples of long term or fixed
assets include:
Property
Plant and machinery
Financial investments that are to
be held for the long term
Patents
Licenses
Short term assets are those
whose lives are shorter than 1
year and include:
Inventories or stock
Account recievables / debtors
(when credit is given to
customers)
Cash
Financial investments that are to
be held for the short term only
(i.e. less than 1 year)
Liabilities are also broken down
into short and long term items.
Short term liabilities include:
Accounts payable / creditors
(when credit is taken from
suppliers)
Income taxes payable
Short term borrowings (where
the repayment date is within 1
year)
Long term liabilities include
borrowings where the repayment
date is longer than 1 year from
the balance sheet date.
Shareholders’ equity is made
up of 2 key pieces. The capital
piece represents the shares
bought by the investors when
the business was set up. This
represents the cash that was
physically given to the
business by the investors, i.e.
shareholders. The 2nd (and
often more significant) piece is
retained earnings / profit and
loss reserve . This is the
cumulative profit earned that
has not been paid to the
owners in dividends but has
been re-invested in the future
growth of the business instead.
The Cash Flow Statement
The final area is the cash flow
statement. This shows how cash
has been generated and used
over the relevant time period.
Most cash flow statement styles
will present the flows of cash
using 3 main categories:
Operating cash flows
Investing cash flows
Financing cash flows
Operating cash flows will
include the flows from the
core operations of the
business and is driven by
trading . Investing cash flows
deal with any investments in
the future of the business . Any
new plant and equipment would
be included in this section. And
finally the financing section
deals with any investments
made by shareholders and any
dividends paid to them . Any
new borrowings or any
repayments of existing loans
would also be shown in this
section.