Profit and loss
account
Now usually referred to as an income statement
Identifies profit for an accounting period
An alternative indicator of financial health
Balances are again extracted from the accounts
Largely in the form of costs or charges
Prepared on accruals basis
Profit = revenue - costs
Revenue
The income of the enterprise within period
Sales during the period on the accruals basis
Not actual cash inflows
The expectation is a truthful figure reported
• overstate
– mislead third parties
• understate
– reduce the tax bill
Strongly reliant on trust
Cost of sales
A self explanatory idea
How much it costs to make sales
Link with the balance sheet – stock value
• add
opening stock, deduct closing stock
Cost of sales differs by type of business
• retailers
– bought in goods
• manufacturers
– materials
• service
providers – a lower proportion
Operating expenses
The many different expenses/charges
Carefully recorded in the ledgers
Use cumulative total costs for period
Labour costs normally identified first
• wages
and salaries
• ‘uplift’
costs – tax and social insurance
• pension
provisions
The additional charges against revenue
• utilities
• rent
and rates/local taxes
• telephone,
postal, internet charges
• insurance
• lease
payments
• professional
fees
Adjust for any prepayments or accruals
Depreciation
Charge for the use of fixed assets
Do not charge the whole cost at purchase
Write-down over time
• flow
through principle
Distinct from capital allowances
• amounts
allowed for taxation purposes
• adjustment
through balance sheet
Amortisation of intangible assets
A number of different approaches used
• straight
line – simple, equal write-downs
• reducing
balance – same % each year
• usage
– per hour, per mile, per activity
Need to consider both
• useful
(envisaged) life
• residual
value
Write-back any gain at sale through accounts
Interest
In addition charges for interest payments
• overdrafts
• bank
loans
• personal
loans
• debentures
and preference shares
These charges are in addition to capital sums
Recognised costs of doing business
Profit
In practice many different profit concepts exist
• gross
profit
• operating
profit
• profit
for year
A fourth measure is highly insightful
• PBIT
– profit before interest and taxation
• adjust
for depreciation and interest charges
Allows comparison between different enterprises
Dividends
Payments to shareholders
The reward for being prepared to take a risk
Usually a nominal amount per share
Dividends are not charges but deductions
Deductions set against profit
Strict rules exist about how much dividend paid
Dividends result in cash outflow from enterprise
After dividends are paid
• retained
earnings
Transferred to the balance sheet
Has the effect of increasing the owners’ equity
In large enterprises impacts market value
Where losses occur, retained earnings reduce
Market values may also fall prompting sale
Drawings
An interesting financial convention
Removing ‘value’ from a (small) business
• taking
cash from a till or bank account
• taking
food, drink, clothes, etc
Their value must be added back to profit
Provides a true profit figure
Adjust any retained earnings and current assets
Cash
All businesses need cash to function
• more
specifically access to cash (at bank)
Constant need to make cash payments
• to
employees
• to
suppliers
• to
government
• to
shareholders
In the absence of cash a business will flounder
Accruals convention
Profit is the excess of revenue over expenses
Within a specific accounting period
As represented in the income statement
No suggestion this equates with cash position
• revenue
includes debtors
• expenses
include creditors
Matching in a period on accruals convention
You might ask why?
Accruals accounting is viewed as enabling
Reflects the reality of doing mature business
• reasonable
expectations
• coupled
with ‘trust’
Accounting periods are a social construction
They are imposed upon economic activity
Accruals convention allows accomodation
Cash and cash
equivalents
Have already distinguished cash and bank
In addition there are cash equivalents
• very
liquid current assets
• short-term
investments
As well as being readily convertible (‘cashable’)
Should not reduce in value
Premium bonds are probably best example………
Statement of cash
flows
A relatively recent requirement
Albeit with a long history
During my own qualification years we had SSAFs
Now long forgotten (an interesting attribute)
1992: International Accounting Standard (IAS) 7
Mandatory requirement from 1994
Must include a CFS within financial statements
Purpose is to identify (visualise) for a period
Change in cash/equivalent balances
Complements the B/S and P&L account
Identifies three different cash flows
• cash
flows from operating activities
• cash
flows from investing activities
• cash
flows from financing activities
In sum: net increase/decrease in cash/equivalents
Operating activities
Cash inflows and outflows for operations
• actual
revenue from cash sales
• cash
from debtors
• actual
payments for goods/inventory
• payments
to creditors
• wages
and salaries
• taxes
collected and forwarded
• interest
payments and dividends
Investing activities
This is where you find capital investments
• outflows
to purchase fixed assets
• one-off
cash payment or instalments
Also include income from sale of such assets
• not
profit on sale – through the P&L
In addition any investments in other businesses
Complemented by any income generated
Financing activities
Businesses also experience cash flows when
• issuing
shares (net inflow)
• redeeming
shares share (outflow)
• taking
on long term loans (inflow)
• paying
off long term loans
Might elect to include dividend payments here
Highlights long term health of a business
In combination
Each element provides a different visibility
Requirement to utilise all three
Later 1970s/1980s interest in a fourth statement
• value
added statement
Re-presents information to identify
How value added is distributed to stakeholders
In some quarters regarded as problematic
