Chapter 4

Main financial statements: The Income Statement (Profit and Loss Account)

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Introduction

The income statement (often known as profit and loss account) is one of the three most important financial statements. Effectively, it records an organisation's income and expenses and is prepared from the trial balance. For UK companies, it is required by the Companies Act 1985. An income statement seeks to determine an organisation's profit (i.e., income less expenses) over a period of time. It is thus concerned with measuring an organisation's performance. Different organisations will have different income statements. Indeed, they also have slightly different names. In this chapter, we focus on understanding the purpose, nature, contents and layout of the income statement of the sole trader. The preparation of the income statement of the sole trader from the trial balance is covered in Chapter 6. In Chapter 7 we investigate the preparation of the income statements of partnerships and limited companies. In this chapter, I have used the term ‘income statement’ which is recommended by the International Accounting Standards Board. I prefer this to the term statement of comprehensive income which is also international accounting terminology as the latter includes items such as gains on foreign exchange which is outside the scope of this book. Sometimes the term profit and loss account is used for sole traders, partnerships or for nonlisted companies. However, to avoid confusion I use the term ‘income statement’ for all those business enterprises.

Context

The income statement, along with the statement of financial position and statement of cash flows, is one of the three major financial statements. It is prepared from the trial balance and presents an organisation's income and expenses over a period of time. This period may vary. Many businesses prepare a monthly income statement for internal management purposes. Annual accounts are prepared for external users like shareholders or the tax authorities. From now on we generally discuss a yearly income statement. By contrast, the statement of financial position presents an organisation's assets, liabilities and equity and is presented at a particular point in time. The statement of cash flows shows the cash inflows and outflows of a business.

The major parts of the income statement are:

As Soundbite 4.1 above shows, profits are central to evaluating an organisation's performance. The profit figure is extremely important as it is used for a variety of purposes. It is used as an overall measure of performance and for more specific purposes, such as the basis by which companies distribute dividends to shareholders or as a starting point for working out taxation payable to the government. An organisation's profit performance is closely followed by analysts and by the press. In Real-World View 4.1, for example, HSBC have produced record results.

Definitions

As Definition 4.1 indicates, an income statement represents the income less the expenses of an organisation. Essentially, income represents money earned by the organisation (for example, revenue or sales), while expenses represent the costs of generating these sales (for example, purchases) and of running the business (for example, telephone expenses). Definition 4.1 gives a working and a formal definition of an income statement and an official definition from the Chartered Institute of Management Accountants.

Broadly, a working definition of income is the revenue and other gains earned by a business, while expenses are the costs incurred running a business. The International Accounting Standards Board formally defines income and expenses using the concept of an increase or a decrease in economic benefit. Incomes are thus increases in economic benefit (i.e., increases in assets or decreases in third party liabilities) which increase owner's equity. Expenses are decreases in economic benefit (i.e., decreases in assets or increases in third party liabilities) that decrease owner's equity. Both working and formal definitions are provided in Definition 4.2.

Layout

The income statement is nowadays conventionally presented in a vertical format (such as in Figure 4.1 below). Here we begin with revenue (sales) and then deduct the expenses. In the UK, the 1985 Companies Act sets out several possible formats, which are still broadly followed. For sole traders or partnerships, a full income statement is sometimes prepared using all the figures from the trial balance. Often, however, the income statement is presented in summary form, with many individual revenues and expenses grouped together. For companies presenting their results to the shareholders in the annual report, the exact relationship to the original trial balance is often unclear. Examples of Marks & Spencer plc and AstraZeneca plc income statements (profit and loss accounts) are given in Company Snapshots 2.1 (in Chapter 2) and 7.1 in Chapter 7 respectively.

By contrast the income statement (sometimes called the trading and profit and loss account) of the sole trader is more clearly derived from the trial balance. In this section we explain the theory behind this in more detail. In the following section the main terminology is explained. In order to be more realistic, we use the adapted income statement of a real person, a sole trader who runs a public house (pub). This is presented in Figure 4.1.

The corresponding statement of financial position (balance sheet) for R. Beer is presented in the next chapter in Figure 5.2. In Chapter 6, we show how to prepare an income statement from the trial balance.

Main Components

Figure 4.2 shows the six main components of the income statement (revenue or sales, cost of sales, gross profit, other income, expenses and net profit) of a sole trader.

These six components are shown in Figure 4.3. In the first column, an overview definition is provided. This is followed by some general examples and then, whenever possible, a specific example. These components are then discussed in more detail in the text. The same order is used as for R. Beer's income statement.

Revenue or Sales

Generating sales is a key ingredient of business success. However, the nature of sales varies considerably from organisation to organisation. For companies, the word ‘revenue’ or sometimes ‘turnover’ is used for sales. In this book, for consistency, we use the term revenue in the financial statements and sales more generally. In the Management Accounting section, we keep return on sales and sales variances rather than return on revenue and revenue variances as this is customary usage. We do, however, use contribution/revenue ratio as this seems more consistent. However, practice in this area is variable. Essentially, revenue is the income that an organisation generates from its operations. For example, Brook Brothers in Real-World View 4.2 sold clothes.

Sales may be made for credit or for cash. Credit sales create debtors, who owe the business money. A business reports the balance that these debtors owe as an asset called ‘trade receivables’. Some businesses, such as supermarkets, have predominantly cash customers. By contrast, manufacturing businesses will have largely credit customers. A further distinction is between businesses that primarily sell goods (for example, supermarkets which supply food) and those which supply services (for example, a bank). Revenue is very diverse. In Company Snapshot 4.1, for example, Stagecoach Plc's revenue for 2011 is shown divided up into UK Bus and Rail, and North America.

In the modern world, both developed and developing countries have varied businesses with varied revenue. For example, banks can have interest earned, football clubs gate receipts, merchandising and television broadcasts. Companies like the UK's Independent Television (ITV) are dependent on advertising revenues. If revenues increase or decrease then this can affect their share price quite dramatically as is the case in Real-World View 4.3.

Revenue recognition is a topic that has concerned accountants for generations. In many cases, it is not straightforward to determine the exact timing or nature of a sale. An illustration of this is when should a sale be recognised on a leasing contract? There are many similar examples which accountants continue to wrestle with.

The great variety of revenue is indicated in Figure 4.4 which provides an overview of the different types of revenue. This figure is for guidance only. The division between credit and cash is, in particular, very rough and ready.

Revenue is reduced by sales returns. These are simply goods which are returned by customers, usually because they are faulty or damaged. Company Snapshot 4.2 demonstrates the revenue for Christian Dior, a French company, famous for fashion, fragrance and jewellery. Interestingly, Christian Dior analyse their revenue in three ways: by business group, globally and by currency.

Cost of Sales

Cost of sales is essentially the expense of directly providing the revenue. Cost of sales is normally primarily found in businesses which buy and sell goods rather than those which provide services. The main component of cost of sales is purchases. However, purchases are adjusted for other items such as purchases returns (goods returned to suppliers), carriage inwards (i.e., the cost of delivering the goods from the supplier), and, of particular importance, inventory. Company Snapshot 4.3 shows the cost of sales for J. Sainsbury plc:

In businesses that manufacture products, rather than buy and sell goods, the cost of revenue is more complicated. It will contain, for example, those costs which can be directly related to manufacturing. Figure 4.5 presents a detailed example of cost of sales.

Gross Profit

Gross profit is simply revenue (sales) less cost of sales. It is a good measure of how much an organisation makes for every £1 of goods sold. In other words, the mark-up an organisation is making. Mark-ups and margins are discussed in Pause for Thought 4.2.

Businesses watch their cost of sales and their gross profit margins very closely. Gross profit is determined by taking cost of sales from revenue (this section of the income statement is sometimes called the trading account).

Other Income

This is basically income from activities other than trading. So it might be interest from money in a bank or building society (interest received). Or it might be dividends received from an investment or profit on sale of a particular item of plant, property and equipment. In the case of the R. Beer example it was income from the gaming machine. Sometimes organisations report operating profits. Operating profit is concerned with trading activities (e.g., revenue, purchases and expenses). Other income would be excluded.

Expenses

Expenses are many and varied. They are simply the costs incurred in meeting revenue. Some companies itemise their expenses in their accounts. For example, British Airways in 2009 list their main expenses in their income statement (see Company Snapshot 4.4). Some common expenses are listed below.

• Accountants’ fees
• Advertising
• Insurance
• Light and heat
• Petrol consumed
• Sales commission
• Business rates
• Rent paid
• Repairs and renewals
• Telephone bill

Most expenses are a result of a cash payment (e.g., rent paid) or will result in a cash payment (e.g., rent owing). However, depreciation is a non-cash payment. It represents the expense of using property, plant and equipment, such as motor vehicles, which wear out over time. The topic of depreciation is dealt with in more detail in Chapter 5.

Net Profit

Net profit is simply the amount left over after cost of sales and expenses have been deducted from revenue. It is a key method of measuring a business's performance. It is often expressed as a percentage of revenue, giving a net profit to revenue ratio.

Profit

The concept of profit seems a simple one, at first. Take a barrow boy, Jim, selling fruit and vegetables from his barrow in Manchester. If he buys £50 of fruit and vegetables in the morning and by the evening has sold all his goods for £70, Jim has made a profit of £20. However, in practice profit measurement is much more complicated and often elusive. Although there is a set of rules which guide the determination of income and expenses, there are also many assumptions which underpin the calculation of profit. The main factors which complicate matters are:

• the accruals or matching concept
• estimation
• changing prices
• the wearing out of assets.

Soundbite 4.2 shows that profit, and profit generation, is central to any successful business.

Accruals or Matching Concept

It is essential to appreciate that the whole purpose of the income statement is to match income earned and expenses incurred. This is the accruals or matching concept which we saw in Chapter 2. Income earned and expenses incurred are not the same as cash paid and cash received. We have already seen that depreciation is a non-cash item. However, it is also important to realise that for many other income and expense items the cash received and paid during the year are not the same as income earned and expenses incurred. When we are attempting to arrive at income earned and expenses incurred we have to estimate certain items such as amounts owing (known as accruals). We also need to adjust for items paid this year which will, in fact, be incurred next year (for example, rent paid in advance).

Estimating

Accounting is often about estimation. This is because we often have uncertain information. For example, we may estimate the outstanding telephone bill or the value of closing inventory.

Changing Prices

If the price of a non-current asset (such as property, plant and equipment) rises then we have a gain from holding that asset. Indeed, property is often revalued. Is this gain profit? Well, yes in the sense that the organisation has gained. But no, in that it is not a profit from trading. This whole area is clouded with uncertainty. There are different views. Normally such property, plant and equipment gains are only included in the accounts when the plant, property and equipment are sold.

Wearing Out of Assets

Assets wear out and this is accounted for by the concept of depreciation. However, calculating depreciation involves a lot of assumptions, for example, length of asset life. Profit is thus contingent upon many adjustments, assumptions and estimates. All in all, therefore, the determination of profit is more an art than a science.

It is true to say that different accountants will calculate different profits. And they might all be correct! It is, however, also true that despite the assumptions needed to arrive at profits, profits are a key determinant by which businesses of all sorts are judged. Real-World View 4.4, for example, shows the profits of leading UK football clubs in 2008.

Sometimes, an asset will have lost more value than is accounted for via depreciation. In this case, the value of the asset may be written down. This is called impairment.

Listed Companies

Listed companies in Europe follow International Financial Reporting Standards (IFRS) for their group accounts. Under IFRS, companies should present an income statement (sometimes called the profit and loss account). Under IFRS sales are conventionally termed revenue. The listed company is covered in depth in Chapter 7.

Capital and Revenue Expenditure

One example of the many decisions which an accountant must make is the distinction between capital and revenue expenditure. Capital expenditure is usually associated with items in the statement of financial position, such as property, plant and equipment, in other words, assets which may last for more than one year (e.g., land and buildings, plant and machinery, motor vehicles, and fixtures and fittings). By contrast, revenue expenditure is usually associated with income statement items such as telephone, light and heat or purchases. This appears simple, but sometimes it is not. For example, to a student, is this book a capital or a revenue expenditure? Well, it has elements of both. A capital expenditure in that you may keep it for reference. A revenue expenditure in that its main use will probably be over a relatively short period of time. So we can choose! Often when there is uncertainty small-value items are charged to the profit and loss account. Interestingly, the WorldCom accounting scandal involved WorldCom incorrectly treating £2.5 billion of revenue expenditure as capital expenditure. This had the effect of increasing profit by £2.5 billion.

Limitations

So does the income statement provide a realistic view of the performance of the company over the year, especially of profit? The answer is, maybe! The income statement does list income and expenses and thus arrives at profit. However, there are many estimates which mean that the profit figure is inherently subjective. At the end of a year, for example, there is a need to estimate the amount of phone calls made. This brings subjectivity into the estimation of profit. Another example is that the loss in value of property, plant and equipment is not accurately measured. Similarly, the valuation of inventory is very subjective. It should be noted that given the wealth of detail in companies’ accounts, the figures presented are generally summarised.

Interpretation

The income statement, despite its limitations, is often used for performance comparisons between companies and for the same company over time. These performance comparisons can then be used as the basis for investment decisions. Profitability ratios are often used to assess a company's performance over time or relative to other companies (for example, profit is often measured against revenue or capital employed). Ratios are more fully explained in Chapter 9.

Conclusion

The income statement presents an organisation's income and expenses over a period. It allows the determination of both gross and net profit. In many ways, making a profit is the key to business success (as Soundbite 4.3 shows). Gross profit is essentially an organisation's profit from trading. Net profit represents profit after all expenses have been taken into account. It is important to realise that the income statement is concerned with matching revenues earned with expenses incurred. It is not, therefore, a record of cash paid less cash received. Profit is not a precise absolute figure: it depends on many estimates and assumptions. However, despite its subjectivity, profit forms a key element in the performance evaluation of an organisation.

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