1-8 rdr02 - Profit/Loss or Income Statement

Recall from the last lecture, we had computed the balance sheet of Geo ppv at dd/mm/yy.
It looked something like this, (for transactions 01 - 06 only):

(Vertical) Balance Sheet of Geo ppv at dd/mm/yy

(FA) Fixed Assets Premises 2000

Equipment 2000
4000 (d)
(CA) Current Assets Stock 500
Debtors 1000
Cash 1500
Prepayments 500 3500 (a)
Less
(CL) Current Liabilities Creditors 1500 (b)
(NCA) Net Current Assets 2000 (a-b=c)
(NA) Net Assets 6000 (d+c)
Represented by:
(OE) Owner Equity 6000
(CE) Capital Employed 6000

Suppose now that geo ppv sells half the stock for £8250; £4250 represented a sale for cash, and
the balance, of £4000 was a sale on credit. In this situation, the business has sacrificed some of
its asset of stock (£500 x 0.5) £250, in return for cash (the cash sale of £4250) and debtors of
£4000 (the credit sale of £4000). Thus the transaction has generated a net gain in assets of:

Cash 4250 Asset increase

Debtors 4000 Asset increase
8250
Stock -250 Asset sacrifice
8000 Net gain

This net gain is a profit of course. Clearly geo ppv sold stock costing £250 for £8250. The result of
this is a profit of (£8250 less £250) £8000. Thus, after the transaction cash will increase by £4250,
the debtors will increase by £4000, and the stock will reduce by £250.

Although the firm geo ppv has made this profit, the net gain is ultimately due to the owners of geo
ppv. This is the case because it was the owners who "staked" geo ppv (not the staff employed, or
anyone else) with the initial £6000. Therefore it is the owners who (owning all assets less liabilities)
will finally benefit when some (their) the firm's assets are sacrificed in this transaction. Thus, the
ownership interest in the business has increased from £6000 (initial stake) to £6000 plus gains of
£8000 (or a total of £14000) to date.

In fact, had the owners been willing to sell geo ppv after it was set up, but before this transaction,
they would have contemplated a sale price of around £6000. But now the assets of the business
have been put to work and have generated a gain of £8000. So after this transaction, any price
discourse relating to a sale of the business would start at around the £14,000 level, since the
owners would wish to recover the cost of their initial stake AND their profits to date in any potential
sale of the business.

So the effect of this transaction is to increase net assets of geo ppv by £8000 (+£4250 (cash)
+ £4000 (debtors) - £250 (stock used up)), and to increase owner equity by the same amount.

We post this transaction (no. 07) across the accounting equation proforma, in the usual way, as
shown below:

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2-8 rdr02 - Profit/Loss or Income Statement

transaction 07 Assets = Liabilities + Equity

[entity geo ppv] £000 £000 £000
Cash rec'd +£4.25k
Debtors +£4.00k
Stock sacrifice -£0.25k
Owner equity (profits) ___ +£8.00k
+£8.00k +£8.00k

We can also update the balance sheet above to reflect the latest transaction:

(Vertical) Balance Sheet of Geo ppv at dd/mm/yy

(FA) Fixed Assets Premises 2000

Equipment 2000
4000 (d)
(CA) Current Assets Stock 250 [was 500, less 250 = 250]

Debtors 5000 [was 1000, plus 4000 = 5000]

Cash 5750 [was 1500, plus 4250 = 5750]

Prepayments 500 11500 (a)

Less
(CL) Current Liabilities Creditors 1500 (b)
(NCA) Net Current Assets 10000 (a-b=c)
(NA) Net Assets 14000 (d+c)
Represented by:
(OE) Owner Equity (capital introduced) 6000
(PL) Profit/Loss (to date) [ie 4250+4000-250 = 8000] 8000
(CE) Capital Employed 14000

We can see clearly here, that the net assets have increased from £6000 to £14000, an increase
of £8000, which is the profit to date. Also looking at the financing section we can see that both the
initial stake and the profits to date are now financing the business, and the owner equity has
increased to £14000.

It's not always clear how the balance sheet has changed from before the profit making transaction
to after it, so traditionally we enclose another statement, the profit and loss account to highlight
any trading changes that have taken place.

Consider the event horizon…

----->---… trading events…------------> time -->

[disclosed in P/L]
B/S before trading [P/L = 8000] B/S after trading
events…. events….
[usually referred to as [usually referred to as
the opening B/S] the closing B/S]
[NA=6000] [NA=6000+P/L]
[ie Opening NA] [NA=6000+8000 = 14000]
[ie Closing NA]

It is the Profit/Loss account which connects the opening B/S with the closing B/S. We therefore
describe the Profit/Loss account as "...Profit/Loss for the period ending…" The P/L account of Geo
ppv accompanying the above B/S would disclose the trading events as follows:

Profit/Loss Account of Geo ppv for P/E dd/mm/yy

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3-8 rdr02 - Profit/Loss or Income Statement

Sales [ie 4250 cash sales+4000 credit sales] 8250

Less
Cost of Sales [ie stock consumed or 'used up of 250] 250
Profit (for the Period) 8000

Turning now to the prepaid rent. This was an asset in the last accounting period because it was
rent paid in advance. We are now in the second accounting period, and so, the rent is used up
merely with the passage of time; it changes from prepaid rent , to rent expense . The effect of
this transaction is to reduce profits from £8000 to (£8000 less £500) £7500.
Putting this transaction (08) across the accounting equation proforma, we have:

transaction 08 Assets = Liabilities + Equity

[entity geo ppv] £000 £000 £000
Rent pia (used up) -£0.5k
Owner equity (rent expense) ___ -£0.5k

Updating Geo ppv's P/L for transaction (08) we have:

Profit/Loss Account of Geo ppv for P/E dd/mm/yy 1

Sales ( or Turnover) [as before] 8250

Less
Cost of Sales [as before] 250
Gross Profit 8000
Less
Expenses Rent [new item] 500

Net Profit (for the Period) 7500

The net assets on Geo ppv's B/S will be reduced by £500 due to the consumption (using up) of the
asset Rent pia, as follows:

Balance Sheet of Geo ppv at dd/mm/yy 1

(FA) Fixed Assets Premises 2000
Equipment 2000
4000 (d)
(CA) Current Assets Stock 250
Debtors 5000
Cash 5750
Prepayments 0 11000 (a)
Less
(CL) Current Liabilities Creditors 1500 (b)
(NCA) Net Current Assets 9500 (a-b=c)
(NA) Net Assets 13500 (d+c)
Represented by:
(OE) Owner Equity (capital introduced) 6000
(PL) Profit/Loss (to date) 7500
(CE) Capital Employed 13500

We can now introduce a new form of current liability called the accrual . Suppose we had

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4-8 rdr02 - Profit/Loss or Income Statement

incurred telephone expenses in this second period of account, amounting to £300. Further suppose
that the telephone company had not actually sent us the bill. We knew we'd incurred the cost,
because we contacted the 'phone company who confirmed the amount owing, but said that they
would bill us next month. This form of transaction is known as an accrual, and is the reverse of a
prepayment.

Recall that, with a prepayment we pay in advance now, & the expense is consumed in a later
accounting period. With an accrual , we incur the expense now, but will pay in a later
accounting period. So, an accrual for expenses incurred but not paid in the present period is just
like a creditor (a dated obligation of the biz)

Putting this transaction (09) across the accounting equation proforma, we have:
transaction 09 Assets = Liabilities + Equity
[entity geo ppv] £000 £000 £000
Accrual (or creditors) +£0.3k
Owner equity ('phone expense) ___ -£0.3k

Updating Geo ppv's P/L for transaction (09) we have:

Profit/Loss Account of Geo ppv for P/E dd/mm/yy 2

Sales ( or Turnover) [as before] 8250
Less
Cost of Sales [as before] 250
Gross Profit 8000
Less
Expenses Rent expense [as before] 500
Telephone expense [new item] 300
800
Net Profit (for the Period) 7200

Note that on a P/L account we distinguish between Gross and Net profits. Gross profits are the
intrinsic profits from the firm's prime activity, ie, Sales less the related Cost of Sales incurred in
generating those sales. The prime activity for Geo ppv is buying and selling pork pies. Does the
basic operation make a profit? This question is answered by the existence or otherwise of a
gross profit (or loss). In this case the basic operation is profitable.

The Net profit considers the profits after deduction of (operating) expenses. These are expenses
necessarily incurred to sustain the business operation. Are the expenses too large, and is there a
net profit or loss after operating expenses are questions answered by the size of the net profit.

After net profits come charges which depend upon the size of the net profit, eg taxation, drawings
(dividends for companies). We cannot know the tax bill until we know the net profit figure. Such
charges are known as appropriations of profit .

So the P/L account comes in three sections; Sales down to Gross Profit is called the Trading
Account , Gross Profit down to Net Profit is called the Profit and Loss Account , and Net profit
down to profits kept within the business (ie after taxes and drawings or dividends) or Retained
Profit is called the Appropriation Account . The whole is referred to formally as the Trading and
Profit and Loss Account , but we also refer to it informally as the Profit and Loss Account , or
the Income Statement .

Much of accounting nomenclature comes from manufacturing industry. Clearly in a service

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5-8 rdr02 - Profit/Loss or Income Statement

industry we would have to determine the key indicators by inspection and knowledge of the
business sector. So descriptions such as Gross Fee Income and Net Fee Income , depend upon
the firm and would be different for (say) a firm of lawyers and a firm of property speculators.

After transaction (09), the net assets on Geo ppv's B/S will be reduced by a further £300 due to the
recognition of additional expenses (incurred but not yet paid for) of telephone charges as follows:

Balance Sheet of Geo ppv at dd/mm/yy 2

(FA) Fixed Assets Premises 2000

Equipment 2000
4000 (d)
(CA) Current Assets Stock 250
Debtors 5000
Cash 5750
Prepayments 0 11000 (a)
Less
(CL) Current Liabilities Creditors 1500
Accruals 300 1800 (b)
(NCA) Net Current Assets 9200 (a-b=c)
(NA) Net Assets 13200 (d+c)
Represented by:
(OE) Owner Equity (capital introduced) 6000
(PL) Profit/Loss (to date) 7200
(CE) Capital Employed 13200

We can take up accruals for any form of foreseen liability. For instance we may be heading for a
legal dispute with a customer, and we know there will be legal fees to pay before we are through.
Assume potential legal fees will be £1000. We can accrue, or (as it's sometimes called) make
provisions for pending legal fees (see transaction 10):

transaction 10 Assets = Liabilities + Equity

[entity geo ppv] £000 £000 £000
Provisions, or accrual (or creditors) +£1.0k
OE (legal fees provision) ___ -£1.0k

Updating Geo ppv's P/L for transaction (10) we have:

Profit/Loss Account of Geo ppv for P/E dd/mm/yy 3

Sales ( or Turnover) [as before] 8250

Less
Cost of Sales [as before] 250
Gross Profit 8000
Less
Expenses Rent expense 500
Telephone expense [as before] 300
Legal Fees [new item] 1000
1800
Net Profit (for the Period) 6200

After transaction (10), net assets on Geo ppv's B/S will be reduced by a further £1000 due to the

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6-8 rdr02 - Profit/Loss or Income Statement

recognition of pending legal expenses (incurred but not yet paid for).

Assume we are now at the year end (dd/mm/yy4). We must recognise that we have consumed
one year of the leased premises (say it was a lease of 5 years duration); we can now no longer
disclose it on the balance sheet at £2000, for this represents a leased premise with 5 years left.
Now we only have 4 years left. Merely through the passage of time we have consumed 1 years
worth of the life of the lease. This is reflected in the balance sheet by writing the lease down to
£1600, (ie £2000 less 2000x1/5). This writing down is referred to as lease amortisation . In the
same way, equipment and other fixed assets would also be reduced as we have consumed some
of their productive capacity. No asset has an infinite life, they all get used up (older) over time.

Assume the equipment has a life of 10 years. Thus by the year end we will have consumed
1 years worth of the productive capacity of the equipment. Again we reflect this consumption of
assets in the balance sheet by writing the equipment down to £1800, (ie £2000 less 2000x 1/10).
This writing down effect in the case of equipment is called depreciation .

Putting these last two transactions (11 & 12) across the accounting equation proforma, we have:

transaction 11 Assets = Liabilities + Equity

[entity geo ppv] £000 £000 £000
Lease amortisation -£0.4k
OE (amortisation charge) ___ -£0.4k

transaction 12 Assets = Liabilities + Equity

[entity geo ppv] £000 £000 £000
Equipment depreciation -£0.2k
OE (depreciation charge) ___ -£0.2k

Updating Geo ppv's B/S and P/L for transactions (11 & 12) we have:

Balance Sheet of Geo ppv at dd/mm/yy 4

(FA) Fixed Assets Premises [2000 less 400] 1600

Equipment [2000 less 200] 1800
3400 (d)
(CA) Current Assets Stock 250
Debtors 5000
Cash 5750
Prepayments 0 11000 (a)
Less
(CL) Current Liabilities Creditors 1500
Accruals/Provisions 1300 2800 (b)
(NCA) Net Current Assets 8200 (a-b=c)
(NA) Net Assets 11600 (d+c)
Represented by:
(OE) Owner Equity (capital introduced) 6000
(PL) Profit/Loss (to date) 5600
(CE) Capital Employed 11600

The related Profit/Loss account for Geo ppv at the year end will be:-

Profit/Loss Account of Geo ppv for Y/E dd/mm/yy 4

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7-8 rdr02 - Profit/Loss or Income Statement

Sales ( or Turnover) [as before] 8250

Less
Cost of Sales [as before] 250
Gross Profit 8000
Less
Expenses Rent expense [as before] 500
Telephone expense [as before] 300
Legal Fees expense [as before] 1000
Lease Amortisation expense [new item] 400
Equipment Depreciation expense [new item] 200
2400
Net Profit (for the year) 5600

We recorded these transactions in a 3-column array (assets = liabilities + equity) as summarised

below:

transactions 07 - 12 (A)ssets = (L)iabilities + (E)quity Tran

[entity geo ppv] £000 £000 £000 No
Cash rec'd +£4.25k 07
Debtors +£4.00k 07
Stock sacrifice -£0.25k 07
Owner equity (profits) +£8.00k 07
Rent pia (used up) -£0.5k 08
Owner equity (rent expense) -£0.5k 08
Accrued (or creditors) +£0.3k 09
Owner equity ('phone expense) -£0.3k 09
Provisions, or accrual (or creditors) +£1.0k 10
OE (legal fees provision) -£1.0k 10
Lease amortisation -£0.4k 11
OE (amortisation charge) -£0.4k 11
Equipment depreciation -£0.2k 12
OE (depreciation charge) -£0.2k 12

It's more usual to split the Equity column into 3 sub-columns, one for the true equity movements,
(ie capital introduced or withdrawn), one for revenues (which increase profits, and therefore
increase equity), and one for expenses (which decrease profits, and so decrease equity).
Rearranging the above array into 5 columns we have the usual arrangement which we discussed
and used in the tutorials:
+ (E)quity + -
transactions 07 - 12 (A)ssets = (L)iabilities (R)evenue (E)xpense Tran
[entity geo ppv] £000 £000 £000 £000 £000 No
Cash rec'd +£4.25k 07
Debtors +£4.00k 07
Sales +£8.25k 07
Stock (used up) -£0.25k 07
Cost of Sales -£0.25k 07
Rent pia -£0.5k 08
Rent expense -£0.5k 08

+ (E)quity + -
transactions 07 - 12 (A)ssets = (L)iabilities (R)evenue (E)xpense Tran

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8-8 rdr02 - Profit/Loss or Income Statement

[entity geo ppv] £000 £000 £000 £000 £000 No

Accruals +£0.3k 09
Telephone expense -£0.3k 09
Accruals +£1.0k 10
Legal expense provision -£1.0k 10
Lease amortisation -£0.4k 11
Amortisation charge -£0.4k 11
Equip. depreciation -£0.2k 12
Depreciation charge -£0.2k 12
(A) (L) (E) (R) (Ex)
Totals +£6.9k +£1.3k +£8.25k -£2.65k
Add Trans (01 - 06) +£7.5k +£1.5k +£6k ___ ___
+£14.4k +£2.8k +£6k +£8.25k -£2.65k

Per financial a/cs at

dd/mm/yy4 above:

Fixed Assets +£3.4k

Current Assets +£11.0k
+£14.4k

Current Liabilities +£2.8k

Owner Equity +£6k

Revenues +£8.25k
less Expenses -£2.65k
Net Profit (for the year) +£5.60k
[Accounting Equation] +£14.4k = +£2.8k +£6.0k +£5.6k

Again, for completeness we could re-draft the above balance sheet of Geo ppv (mk4) in
an "international accounting standards" (IAS) format, and also the Profit/Loss account
known under IAS as the Income Statement

[IAS format] Geo ppv SoFP at dd/mm/yy 4 Geo ppv Inc. Sta. Ye dd/mm/yy 4
Premises 1600 Sales Revenue 8250
Equipment 1800 Cost of Sales 250
Non-current assets (e) 3400 Gross Profit 8000
Stock/Inventory 250 Less
Debtors/Rec'bles 5000 Expenses 2400
Cash 5750 Profit for the Year 5600
Current assets (f) 11000
Total assets (e+f) 14400
Owner equity 6000
Profit for the Year 5600
Equity (g) 11600
Creditors/Pay'bles 1500
Accruals & Provisions 1300
Current liabilities (h) 2800
Total equity and liabilities (g+h) 14400

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