Help session to students with little or no accounting or finance background Income and Cash Flow Statements by Binam Ghimire

The Income Statement (Profit & Loss Account)

Example: On Day 1 Anne starts a business with 1 cash
Balance Sheet as at Day 1 Current Assets Cash TOTAL ASSETS Equity (Annes Capital) Capital Introduced EQUITY AT END OF DAY 1 1 1 1 1

On Day 2 all the cash is used to buy inventory

Balance Sheet as at Day 2 Current Assets Inventory TOTAL ASSETS Equity (Annes Capital) At end of Day 1 No changes during Day 2 EQUITY AT END OF DAY 2 1 1 1 1

The Income Statement (Profit & Loss Account)

Example (cont.): On Day 3 all the inventory is sold for 1.50 cash

Balance Sheet as at Day 3 Current Assets Cash TOTAL ASSETS Equity (Annes Capital) At end of Day 2 Add Profit earned during Day 3 EQUITY AT END OF DAY 3

1.50 1.50 1.00 0.50 1.50

Note: The ASSETS involved in this example are CASH and INVENTORY PROFIT is a REASON why the assets have increased Profit is NOT an asset, it is part of EQUITY

The Income Statement (Profit & Loss Account)

Dave starts a taxi business at the beginning of year 1, introducing 15,000 of his own cash which is all used immediately to buy a taxi. The taxi is estimated to last for 3 years and then be worthless and Dave plans to cease trading. Income from fares amounts to 25,000 each year. Running expenses, such as fuel costs, amount to 11,000 each year. Discussion: 1. How much total profit does the taxi business make during its lifetime? 2. 3. How useful is this information? What additional financial information would be useful?

The Income Statement (Profit & Loss Account)

Answers: 1 - Dave s business starts with 15,000 During whole life of business (3 years): Fares = 25,000 x 3 years Running Expenses 11,000 x 3 years Taxi Net INCREASE (PROFIT) Business ends with original 15,000 + 27,000

= = = = =

+75,000 -33,000 -15,000 +27,000 42,000

i.e. 27,000 MORE than it started with WITHOUT the owner putting more in and WITHOUT borrowing Profit over WHOLE life of business = 27,000 for 3 years

2 - Of limited use

The Income Statement (Profit & Loss Account)

Answers (cont.): 3-

Need to calculate profit PERIODICALLY at LEAST once a year (is Dave s profit 9,000 per year?) Need DETAIL of income and expenses to improve performance Need detailed accounting records (book-keeping) Need summary of financial position on a regular basis i.e. a Balance Sheet At END of each period draw up FINAL Accounts:
Income Statement to calculate PROFIT for the whole period Balance Sheet to summarise assets, liabilities & equity the business has remaining as at end of each period

The Income Statement (Profit & Loss Account)

4. What is the net cash flow for each year, assuming all transactions are for Year 1 Year 2 Year 3 Total cash?
Cash Flow Statement for . Cash inflows: Capital Introduced Fares Total Cash Inflows Cash outflows: New Taxi Running Expenses Total Cash Outflows Net Cash flow Opening Cash Closing Cash 0 0 (3 Years)

The Income Statement (Profit & Loss Account)

Answers (cont.): 4
CASH FLOW Inflows: Cap. Introduced Fares Total Cash In Outflows New Taxi Running expenses Total Cash Out Net Cash Flow Opening Cash Closing Cash 1 15,000 25,000 40,000 15,000 11,000 2 0 25,000 25,000 0 11,000 3 0 25,000 25,000 0 11,000 TOTAL 15,000 75,000 90,000 15,000 33,000

26,000 14,000 0 14,000

11,000 14,000 14,000 28,000

11,000 14,000 28,000 42,000

48,000 42,000 0 42,000

The Income Statement (Profit & Loss Account)

5. Discuss how much profit should Dave recognise each year?

Income Statement for

Year 1

Year 2

Year 3

Total (3 Years)

Income from fares Expenses: Fuel etc. Taxi depreciation Profit for the year

The Income Statement (Profit & Loss Account)

Answers (cont.): 5 Profit MIGHT be calculated as follows:
Income Statement Income (earned) Fares Expenses (used up) Fuel etc. Depreciation 1 2 3 TOTAL

25,000

25,000

25,000

75,000

11,000 5,000

11,000 5,000

11,000 5,000

33,000 15,000

Profit

9,000

9,000

9,000

27,000

The Income Statement (Profit & Loss Account)

6. Discuss what should appear on the Balance Sheet of the business as at the end of each year:

Balance Sheet as at end of .. Non-Current Assets Taxi (net book value) Current Assets Cash TOTAL ASSETS Equity Opening Capital b/f from last year Capital Introduced during year Profit for year Drawings by owner during year Closing Capital at end of year

Year 1

Year 2

Year 3

The Income Statement (Profit & Loss Account)

Answers (cont.): 6
Balance Sheet at end of Non-Current Assets Taxi (net book value) Current Assets Cash TOTAL ASSETS Equity Opening Capital b/f Capital intro in year Profit for year Drawings Capital at end of year 1 10,000 14,000 24,000 0 15,000 9,000 0 24,000 2 5,000 28,000 33,000 24,000 0 9,000 0 33,000 3 0 42,000 42,000 33,000 0 9,000 0 42,000

The Income Statement (Profit & Loss Account)

Answers (cont.): 6

Notes:
Dave s equity has gone up from the initial capital introduced of 15,000 to 42,000 by the end of Year 3 due to . Cash flow and profit are NOT the same thing (see accruals concept below). Dave can choose how he wishes to depreciate his taxi. He should apply whichever method he chooses CONSISTENTLY so his profits can be compared from year to year. Other taxi businesses, however, may choose other methods of depreciation. This makes the comparison of results between different businesses (inter firm comparison) difficult.

The Income Statement (Profit & Loss Account)

7. Discuss - why might accounts preparers wish to overstate profits and assets?
Answer: - Management looks good - Bonuses based on profits - Increase equity value if current owners wish to sell business (or shares in business)

8. Discuss - why might accounts preparers wish to understate profits and assets?
Answer: - Tax avoidance - Low profits this year may enable better profits to be declared next year

9. What safeguards should prevent the manipulation of accounting information?

Answer: - Audits by independent accountants - Accounting concepts - Accounting standards

10. Are these safeguards effective?

Answer: - Accounting scandals would suggest safeguards not effective enough!! - Accounting and financial reporting continue to develop

The Income Statement (Profit & Loss Account)

The Calculation of Profit The calculation of profit is the subject of much debate. As profit is the most important measure of the success or otherwise of a business, there may be an incentive for managers to manipulate the figures when calculating profit for an accounting period. The CONSISTENT application of the relevant accounting CONCEPTS is, therefore essential when calculating profit.
Consistency Concept - Calculated on a consistent basis Going Concern Concept - Business assumed to continue for foreseeable future Periodicity Concept - Calculated at regular intervals Accruals Concept - Accruals Accounting used to calculate profit (Matching concept).

The Income Statement (Profit & Loss Account)

GOING CONCERN CONCEPT (Continuity ) Unless there is evidence to the contrary, it assumed that the business will continue to operate indefinitely as a going concern . This is important when placing values on assets. E.g. At the end of years 1 & 2 Dave s taxi was valued on the assumption that it would still be used by the business in the future i.e. the business would not be forced to sell the taxi before the end of its useful life. PERIODICITY CONCEPT (Cut-Off ) During the life of a business, profit will be calculated periodically, usually at least once a year. This is known as the PERIODICITY CONCEPT (or TIME INTERVAL CONCEPT) i.e. for reporting purposes the life of the business is cut up into separate periods. Period 1 s profit will be calculated separately from period 2 s etc. The periodicity concept creates the problem of deciding which transactions relate to this year as opposed to next year i.e. which side of the CUT-OFF point do they occur?

The Income Statement (Profit & Loss Account)

ACCRUALS CONCEPT (Accruals Accounting ) Profit is calculated in accordance with the ACCRUALS CONCEPT All income and charges relating to the financial period should be taken into account WITHOUT regard to the date of payment or receipt of cash. Profit is calculated by matching: (i) Income earned during the period (whether received or not) with (ii) Expenses relating exclusively to the period/used up (whether paid for or not) Note The accruals concept results in profit NOT being equal to net cash flow for the accounting period.
So, to calculate profit: Match .. Income earned (date cash is received NOT relevant) with Expenses incurred/used (date cash paid NOT relevant) e.g. Income for year 3 Less Expenses for year 3 = Profit for year 3

The Income Statement (Profit & Loss Account)

Required: Fill in the missing information concerning the following transaction, assuming the financial year ends 31st December . Goods are sold for 600 on 2 months credit in November, year 3 a) 600 sales income will be recognised in the Income Statement for the year ended 31st December Year Answer: Year 3 b) The Cash will be received in the month of Answer: January Year 4 Year

c) The Balance Sheet as at 31st December Year 3 will show 600 as a , under the heading Answer: Trade receivable 600, Current Assets

The Income Statement (Profit & Loss Account)

The Income Statement To calculate the profit or loss for an accounting period a separate Income Statement (Profit and Loss Account) is drawn up. The Income Statement shows the detail of how profit is calculated, usually starting with the gross profit, which is the difference between the selling price of goods and services sold and the cost of buying or making those goods.

The Income Statement (Profit & Loss Account)

Example: Neil buys and sells one type of article only. Month 1: Purchases 5 articles @ 1.00 each Sales 3 articles @ 1.50 each Required: a. Calculate the Gross Profit for Month 1 b. Prepare the final accounts for Neil s business for Month 2 from the following details:
Trial Balance as at end of Month 2 Month 2 Purchases Month 2 Sales 7 articles @ 1.00 each 8 articles @ 1.50 each 2 1 1 3 100 101 6 5 119 119 Dr 7 12 Cr

Inventory at start of Month 2 Interest Received Wages Office expenses Cash at Bank Neils Capital (equity) at end of Month 1 Trade Receivables Trade Payables

The Income Statement (Profit & Loss Account)

Answers : a
Income Statement for Month 1 Sales (3 units @ 1.50) Less Cost of sales: Purchases (5 @ 1) Less Closing inventory (2 @ 1)

4.50 5.00 3.00 2.00

Gross Profit (33.33%)

1.50

The Income Statement (Profit & Loss Account)

Answers : b
Income Statement for Month 2 Sales (8 units) Less Cost of sales: Opening Inventory (2 units) Add Purchases (7 units) (Available for sale 9 units) Less Closing Inventory (1 unit) Gross Profit (33.33%) Add Other Income Interest received etc. Less Overhead Expenses Wages Office Expenses Net Profit 2 7 9 12

8 4 1 5

1 3

4 1

The Income Statement (Profit & Loss Account)

Answers : b
The following statement may be used by Sole Traders to explain why the Equity in the business has changed from that shown the Balance Sheet at the end of the previous period. This statement is NOT used by limited companies.

Capital Movements during Month 2 Net profit for period Less Drawings during period Retained Profit for period Add Capital at start of period + Cap Int. Closing Capital

1 0 1 101 102

NOTE: NOT used by Limited Companies

The Income Statement (Profit & Loss Account)

Answers : b

Balance Sheet as at end Month 2 Non-Current Assets Current Assets Inventory Trade Receivables Cash & Bank TOTAL ASSETS Equity Neil s Capital Non-Current Liabilities Current Liabilities Trade Payables TOTAL EQUITY & LIABILITIES

1 6 100

107 107 102 0 5 107

Assessment Notes: The incorporation of end of period adjustments into the ledger accounts will not be assessed. You will be provided with pro-formas in the coursework assessment test in November. You will NOT be provided with pro-formas in the end of semester examination in December.

The Income Statement (Profit & Loss Account)

Gross Profit Margin: Neil
1 unit Gross Profit Selling Price Gross Profit Margin 50 x 150 50p 150p

100

33.3%

i.e. 1/3rd of selling price is profit 33.3p out of every 100 is profit

3 units Gross Profit Margin 150 x 450

100

33.3%

8 units Gross Profit Margin 400 x 1,200

100

33.3%

The Income Statement (Profit & Loss Account)

What Gross Profit will Neil make if his sales total .
I. 1,200 Answer: 1,200 x 33.3/100 = 400

II. 3,000 Answer: 3,000 x 33.3% = 1,000

Inter-relationship between final accounts and accounting records

Final accounts Debit Income statement

Double entry rules Credit Income EARNED

Expenses USED

Balance sheet

Assets owed

Liability owed + equity

Inter-relationship between final accounts and accounting records

Income Statement Income: what is earned Expenses: what is used up .during accounting period Balance Sheet Assets: what is owned Liabilities: what is owed at end of accounting period

Self Assessment Questions

Multiple Choice Questions (i) Gross Profit is: (a)Sales less purchases (b)Cost of goods sold less closing stock (c) Excess of sales over cost of sales (d)Net profit less expenses for the period Answer:

(ii) What is the Gross Profit Margin of a business that records the following for an accounting period: Sales 30,000; Purchases 18,000; Cost of Sales 20,000 (a)10% (b) 33.3% (c) 40% (d)10,000 Answer: b 30,000 20,000 = gross profit 10,000 10,000/30,000 x 100 = gross profit margin of 33.3%

Self Assessment Questions

True - False Questions: Are the following statements true or false?

(i) Profit reduces both capital and net assets. False. Trading at a Profit INCREASES net assets and capital. (ii) Inventory is a current liability. False. Inventory (stock) is a current asset. (iii) Drawings are a business overhead. False. Drawings are NOT a business expense so do NOT influence business profits. They are business assets taken for personal use of the owner. (iv) If a Sole Trader pays himself wages , this is treated as an overhead. False. The reward of the owner of the business is profit NOT wages. Whenever the owner withdraws money or other assets from the business it is treated as drawings.

Thank You

Note : Images were downloaded between 28th April to 2nd May 2011 Examples are from Atrill and McLaney, 2011 and others. detail references can be provided on request

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