Income statement should tell us about the results of company's activities over specific accounting period. It shows what revenues have been generated and what costs were incurred to generate those revenues. It shows the increase or decrease of the business wealth over the account period.
It is a historical statement so caution should be taken when analysing the information as it does not tell us about the ability of the business to sustain or improve upon its performance over the period.
It is often said, that the income statement and balance sheet information is a matter of opinion as there are different methods of inventory valuation and depreciation methods used. Additionally, the assessment of whether the settlement of customer accounts is doubtful or not that may imprecise evaluation of accruals and provisions.
Profit - to calculate profit, comparing balance sheet at the start of an accounting period and at the end of an accounting period is not the suggested method of calculating profits. This is because the values of different components may have changed ( i.e levels of inventory, accounts receivable, accounts payable, cash, non-current assets). The value of assets and liabilities represents the capital or wealth of the business at any time. The profit or loss is represented in the Retained earnings as:
Total assets - Total liabilities = Equity + Retained profit
Another perspective considers profits by summarising all the trading and non-trading transactions that has occurred during the accounting period. This is the method used in practice and provides the information on change in wealth between the accounting periods.
Profit = total revenues - total costs
and,
Retained profit = Profit - Dividends
Gross profit or gross margin is derived from sales revenue less the cost of those sales. Profit is derived from dedcucting expenses from the gross profit.
Income statement formats
IAS1 presents the minimum information that should be disclosed in the income statement.
The minimum information are:
* Revenue;
* Finance costs;
* Profits or losses deriving from discontinued operations;
* Income tax expenses;
* Profit or loss for the year.
The costs and expenses should be presented according to business functions (for example distribution costs and administrative expenses), or according to their nature ( for example employee expenses, depreciation etc).
Many companies present the income statement based on the business functions as it is believed to provide more accurate information on the business performance.
The expenses based on the nature may be more relevant for management accounting for forecasting and planning.
Some " exceptional items" - income or costs of abnormal size, also must be disclosed separately in the income statement to give the fair and true value. For example, write off from inventory, write-downs of property, restructuring of company activity, reversals of provisions, disposals of plant, property or equipment, discontinued operations, litigation settlements.
There are also 'extraordinary items' which are different from 'exceptional items' which are income or costs derived from unusual events not expected to be frequently or regular. For example, complete destruction of a factory. These also must be added as a separate statement in the income statement.
Earnings per share - are required to be presented in relation to the profit or loss attributable to ordinary equity shareholder and for total profit or loss attributed to those shareholders.
Basic earnings per share are calculated by dividing the earnings ( profit) by the weighted average number of ordinary shares over the year.
Group financial statements should be prepared for holding company in addition to the financial statements required to be prepared for each individual company within the group.
Structure of income statement
Income statement measures of whether the company has made a profit or loss. It measures whether the total revenue is higher then the total costs or vice versa.
The total revenue may include:
* sales of goods and services;
* interests received ( for example, form loans);
* rents ( from property);
* subscriptions;
* fees;
* royalties;
* dividends received (from investments).
The total cost of a business include:
* cost of goods purchased for sale;
* cost of manufacturing goods for sale;
* transport and distribution costs;
* advertising;
* promotion;
* insurance;
* cost of the consumption of non-current assets over their useful life ( depreciation);
* wages and salaries;
* interest paid;
* stationary costs;
* photocopy costs;
* communication costs;
* electricity;
* water and effluent costs;
* travel expenses;
* entertaining expenses;
* postage.
The list is not exhaustive can appear in separate heading or be grouped in the income statement.
The definitions
Revenues - the main source of income, primarily comprising the sale of products and services. Sales revenues are normally accounted for when goods were invoiced and accepted by the customer even if the payment was not received.
Cost of sales (COS) - costs may be cash related, invoiced costs of materials, and non-cash items. These can be directly related to goods or indirectly.
The sum of direct costs plus the manufacturing expenses include:
* costs of raw materials and inventories used,
* cost of inward freight paid by the company,
* packaging costs,
* direct production salaries and wages,
* production expenses, including depreciation,
Gross profit (or gross margin) - is the difference between the revenues and costs of sales (COS) and it needs to cover all expenses.
Distribution costs and administrative expenses - not directly related to the production process but contributing to the activity of the company are called 'other operating expenses". These include distribution costs and selling costs, administrative expenses, research and development costs. Distribution costs include the costs of selling and delivering the goods and services:
* advertising;
* market research;
* promotion;
* costs of the sales department;
* outbound freight costs;
* delivery vehicle fleet costs;
* cost of warehouse.
Administrative expenses include all costs not included in the cost of sales, distribution costs and financial costs. For example:
* cost of service departments ( finance, human resources, R&D, engineering);
* telephone costs;
* computer costs.
Distribution costs and administrative costs include all expenses relating to 'normal' operations of the company, expect those directly related to manufacturing i.e costs of purchasing department, logistic department or quality department. They also exclude the share of overheads, for example heating and lightning, property taxes, water and effluent costs relating to manufacturing activities.
Other income - include all other revenues not included as part of the income statement. It does not include sale of goods and services.
Operating profit - is the net of all operating revenues and costs regardless of the financial structure or whether exceptional events occurred. The disclosure of operating profit is not mandatory to be disclosed.
Operating profit = Revenues - COS - distribution costs - administrative expenses + other income
Operating profit is the measure of the profitability of the operation regardless of interests payable and receivable, amount of corporation tax. It is therefore extremely important because it allows comparisons operating in the same market but having different financial policies.
Finance income - include interests receivable and dividends receivable and other financial costs such as bank transfers.
Profit before tax = Operating profit + Finance income - finance costs
Income tax expense - corporation tax is payable of profits for limited companies. The tax is shown in the income statements, balance sheet and statement of cashflows. The tax on the income statement would of been calculated and agreed with HRMC.
Profit for the year - is the net profit after tax and the final change is the corporation tax.
The profit for the year resulted from:
assets owned generated profit;
operating profits has been used to pay interests to banks and corporation tax.
The profit may be paid in dividends or held in equity or both. The profit is used to provide shareholders returns but it has to be high enough to reward the risks.
Dividends on ordinary shares - dividends to be paid on equity shares and they are usually deducted from the profit. They include any interim payments that may have been paid.
Dividends on preference shares - some companies issue preference shares and these pay as dividends at a set percentage to preference shareholders before the payment of equity dividends. It is treated as finance costs and charged directly to the income statement.
Retained earnings - is what is left from profit for the year after deducting dividends for the year. The company annual report and accounts is required to include disclosure the statement of reconciliation of the movement of shareholders funds that have taken place between the beginning and the end of financial year. It is called "Statement of changes in equity".
The balance sheet and income statement
The balance sheet and income statement are both historical statements and they show different financial information. The balance sheet shows the financial position at the start and the end of the accounting period and the income statement shows what was happening in that period.
They are, however, linked.
The cumulative balance on the profit and loss account is reflected within the equity, category of the balance sheet representing the increase in the book wealth of the business. Some of the items contained in the income statement are also reflected in some way in the balance sheet.
Sales to customers on credit are the starting point of income statement that increases trade receivables. Cash received from customers increases cash and reduces trade receivables. Purchases of goods on credit increase inventories and increase trade payables. Cash paid to suppliers reduces cash and reduces trade payables. Inventory sold reduces inventories and it is a cost on the income statement. Depreciation of non-current assets increase the cost in the income statement. Payments of expenses reduces cash and are cost in the income statement. Payments for additional non-current assets increase non-current assets and reduces cash. Issues of ordinary shares increases equity and increase cash.
Income statement movements can have a significant impact on the balance sheet in the areas of inventory and depreciation.
The way in which specific balance sheet items are valued have impact on the income statement profit. It might be through using up the of inventory, machinery or finished products. Such changes must be reflected in the income statement.
Depreciation
The total cost of using of non-current assets over its life may be defined as original investment less the estimate of the portion of its costs that may be recovered at the end of its useful life. A fair proportion of the total cost (depreciation) should be charged to the income statement during the period to which revenue is generated. In the same way the value of the non-current asset is reduced by the same amount in the balance sheet.
The income statement for the year aims to match revenues and expenses for that year. When it is clear that an asset is no longer capable to generate economic benefits it should be written out of the accounts immediately. One of the company's expenses relates to the use of non-current assets and spread the economic use over time (depreciation). The choice of method for depreciating will result in different amounts of depreciation for the year and the annual income statement can be quite different because of that decision. IAS 36 requires companies to formally review their non-current assets for any changes in value (impairment).
When calculating the depreciation we need to determine:
* the useful life of an asset;
* the correct way to spread the total cost of the asset over its useful life;
* physical limitations regarding of the useful life (intensity of use, adequacy of maintenance);
* economic limitations (technological advancements, business growth).
Companies can use different methods for depreciation:
* straight line;
* reducing balance;
* sum of the digits.
The straight line and the reducing balance are most frequently used.
Straight line depreciation - is calculated by deducting the residual value from the acquisition costs to obtain the net cost of the asset. Then dividing the results by the life of the asset.
Reducing balance method is used to derive the rate (d) to reduce the cost of the asset, period by period.
The sum of the digits method - considers the life on an asset and allocates the net cost of an asset through the sums of the digits. For example, for 5 years, the sum of the digits is 15.
So each year the depreciation would be calculated:
1st year 1/15 X ( acquisition cost - residual cost)
2nd year 2/15 X ( acquisition cost - residual cost)
3rd year 3/15 X ( acquisition cost - residual cost)
4th year 4/15 X ( acquisition cost - residual cost)
5th year 5/15 X ( acquisition cost - residual cost)
There are many other alternative methods used for depreciation and they will impact the profit levels each year. Whichever methods is used it must be consistent from one accounting method to another. The method must be disclosed in the annual report and include the depreciation rates. The amounts account for cost in the income statement and reduction in original value of non-current asset in the balance sheet.
Cost of sales
Inventories of raw materials, finished products or work in progress pose problems for validation. For example, because raw materials may be purchased from different locations with additional costs (duties, insurance, freight) and the cost of inventory should comprise the expenditure that has been incurred. Additionally packaging that may be used during production, partly finished products or fully finished product must be correctly calculated to give full cost. Moreover, homogeneous items within various inventory categories are continuously purchased and consumed and they must be valued at the lower of purchase cost (or production cost) and their net reusable value.
There are many methods of calculating of the costs of inventories:
* FIFO - first in first out - most popular method and it means that we assume that the oldest inventory is used first and costs are matched with the physical flow of inventory.
* LIFO - last in first out - most recent acquired items of inventory and their costs are first to be used - this one is not permitted in UK.
* weighted average cost - is permitted in the UK - assumes that individual units cannot be tracked through the system.
* market value - we need to choose which market value is most appropriate.
The choice of method would depend on volumes of inventories, costs of inventories and management information requirements.
Variations in profits would be reported from period to period, there must also be consistency in valuation method from period to period.
Bad and doubtful debts
When goods and services are sold to customer on credit the invoice is issued to obtain settlement. The sale is reflected in the revenue on the income statement. The transaction is debited to account receivable to be due from customer in line with agreed payment terms. In an event of invoice not being settled at all and as long as this is known with reasonable certainty, the debt is seen as 'bad debt' and must be written off as cost.
Profit and loss and cash flow
The profit and loss and cash flow does not mean the same thing.The profit earned and the cash generated may be very different. Even if company appear to trade profitably, they may have cash difficulties.
Profit is the matter of opinion. Cash is the matter of fact.
Profit is important, but cashflow is very important. The profits derived often differ from cash inflows and outflows during the same period because cash may not be paid or may of been received in advance.
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