3

The profit and loss account

This chapter will show you:

• How we recognise revenue and costs
• The distinction between profit and cash flow

Introduction

Figure 3.1 identifies where the profit and loss account fits into the set of accounts. It is a link or bridge between the opening and closing balance sheets of an accounting period. Its function is to identify the total revenue earned and the total costs incurred over that period. The difference between these two values is the operating profit. It is, therefore, a document that relates to a very precise time period. There are many accounting rules to do with the identification of revenue and costs.

Revenue

Total revenue earned is generally the amount invoiced and, in most situations, there is no problem with its accurate identification.

‘Revenue recognition’, the question of when we should recognise revenue in accounts, continues to be a topical accounting issue. Here are three examples of areas of debate:

Figure 3.1 Place of the profit and loss account in company

1. If a company receives cash today for a contract to supply a service over three years, should they recognise the revenue now or divide it across the three years?
2. What constitutes revenue in the second year of a large, three-year civil works project?
3. If an engineering company sells a warehouse, is that part of revenue?

Costs

The figure for total costs can give rise to even more intractable problems.

Two rules will help to identify costs that must be included:

• those costs that relate directly to the revenue, for example the direct cost of the goods sold; and
• those costs that relate to the time period covered by the accounts, such as staff salaries for the period.

Even with these rules, however, there are still many areas where the decision could go either way. For example, should research and development costs be charged in the year in which they were incurred? If we replace the factory roof in a period, is that correctly chargeable as a cost? We could question whether a particular depreciation charge is correct. The list can go on.

In the analysis of a company’s accounts, it is well to ask what important assumptions or accounting policies have had an effect on the final profit.

In all published accounts there should be a statement of accounting policies. It is wise to examine it before attempting an analysis of the financial statements.

Common causes of confusion

In a situation where accountants can sometimes differ, it is not surprising that non-accounting managers go astray. One or two basic signposts will eliminate many problems that arise for the non-specialist in understanding this account.

The distinction between profit and cash flow is a common cause of confusion. The profit and loss account as such is not concerned with cash flow. This is covered by a separate statement. For instance, a cost from a supplier incurred but not yet paid must be charged as cost even though there has been no cash flow. On the other hand, payments to suppliers for goods received are not costs, simply cash flow. Costs are incurred when goods are consumed, not when they are purchased or paid for.

Cash spent on the purchase of assets is not a cost. The cost recognised is the corresponding depreciation over the following years.

A loan repayment is not a cost because an asset (cash) and a liability (loan) are both reduced by the same amount, so there is no loss in value by this transaction.

Finally the question of timing is vital. Having established what the true costs and revenue are, we must locate them in the correct time period. The issue mainly arises just before and just after the cut-off date between accounting periods. As shown in Figure 3.2, we may have to move revenue or costs forwards or backwards to get them into their correct time periods.

Figure 3.2 The profit and loss account – timing adjustments

Alternative measures of profit

There are many other definitions of profit, mostly related to the way profit is distributed. In many businesses the term ‘bottom line’ is commonly used. Each of the following measures could be used as suitable alternative ‘bottom lines’.

EBIT (Earnings before interest and tax)

This is the first profit figure we encounter in the profit and loss account. It is also known as PBIT (profit before interest and tax) or alternatively operating profit or even trading profit.

In simple terms it is just total revenue less total operating cost.

All the business’s assets have played a part in generating operating profit or EBIT. Therefore this profit belongs to and must be distributed among those who have provided the assets. This is done according to well defined rules.

Figure 3.3 illustrates the process of distribution or ‘appropriation’ of profit. There is a fixed order in the queue for distribution as follows:

• to the lenders (interest)
• to the taxation authorities (tax)
• to the shareholders (dividends/retentions).

Figure 3.3 The profit and loss account – distribution or appropriation of profits

The profit and loss appropriation account

At each of the stages of appropriation the profit remaining is given a precise identification tag. Stripped of non-essentials, the following is a layout of a standard profit and loss appropriation account. When looking at a set of accounts for the first time it may be difficult to see this structure because the form of layout is not as regular as we see in the balance sheet. However, if one starts at the EBT figure, it is usually possible to work up and down to the other items shown:

EBT (Earnings before tax)

This is the profit remaining after debt providers have been paid. It is a commonly used performance measure for divisions of a large business, where tax is organised and paid centrally.

EBT is sometimes referred to as PBT (profit before tax).

EAT (Earnings after tax)

This is the profit remaining after both debt providers and the tax authorities have been paid.

EAT is used to calculate distributable profits (usually the same as EAT but there are exceptions), which is the profit left for the shareholders out of which dividends can be paid.

EAT is sometimes referred to as PAT (profit after tax).

We will return to EAT when we review investor ratios in Chapter 11, as it is used to calculate the important ratio of earnings per share (EPS).

RE (Retained earnings)

This is the profit left in the business after debt providers, tax authorities and shareholders have been paid.

Retained earnings are an important source of business finance. If earnings are retained within a business it can be a sign that the directors are confident about the future. The business could be ‘saving’ for a future investment opportunity. Retained earnings also increase the owners’ funds section of the balance sheet, which in turn will increase the value of the business. The size of owners’ funds also impacts on ‘leverage’, covered in Chapter 9 on financial strength.