Text b the profit and loss account (the income statement) the cash-flow statement

A Profit and Loss account is a summary of a firm's revenues and expenses during a specified accounting period. The Profit and Loss account is sometimes called the income statement, the earnings statement or the statement of income and expenses. It may be prepared monthly, quarterly, semiannually, or annually. A Profit and Loss account covering the previous year must be included in a corporation's annual report to its stockholders.

Figure 3.2 shows the profit and loss account for Northeast Art Supply. Note that it consists of four sections. Generally, revenues less cost of goods sold less operating expenses equals net income from operations.

NORTHEAST ART SUPPLY, INС Profit and loss account For the year ended December 31, 20..
Revenues Gross sales Less sales returns and allowances Less sales discounts Net sales Cost of goods sold Beginning inventory, January1, 20.. Purchases Less purchase discounts Net purchases Cost of goods available for sale Less ending inventory December 31, 20.. Cost of goods sold Gross profit on sales Operating expenses Selling expenses Sales salaries Advertising Sales promotion Depreciation – store equipment Miscellaneous selling expenses Total selling expenses General expenses Office salaries Rent Depreciation – delivery equipment Depreciation – office furniture Utilities expenses Insurance expenses Miscellaneous expenses Total general expenses Total operating expenses Net income from operations Less interest expenses Net income before taxes Less federal income tax Net income after taxes	$ 9,500 4,500 $346,000 11,000 $ 30,000 6,000 2,500 3,000 1,500 $ 18,000 8,500 4,000 1,500 2,500 1,000 500	$465,000 14,000 $40,000 335,000 $375,000 41,000 $ 43,000 36,000	$451,000 334,000 117,000 79,000 $37,500 2,000 $ 35,500 5,325 $ 30,175

Figure 3.2

Revenues

Revenues are dollar amounts received by a firm. Northeast obtains its revenues solely from the sale of its products. The revenues section of its profit and loss account begins with gross sales. Gross sales are the total dollar amount of all goods and services sold during the accounting period. From this are deducted the dollar amounts of

► Sales returns or merchandise returned to the firm by its customers

► Sales allowances or price reductions offered to customers who accept slightly damaged or soiled merchandise

► Sales discounts, or price reductions offered by manufacturers and suppliers to customers who pay their bills promptly.

The remainder is the firm's net sales. Net sales are – the actual dollar amount received by the firm for the goods and services it has sold, after adjustment for returns, allowances, and discounts. For Northeast Art, net sales are $451,000.

Cost of Goods Sold

According to Figure 3.2, Northeast began its accounting period with a merchandise inventory that cost $40,000 (see beginning inventory under Cost of goods sold). During the period, the firm purchased for resale merchandise worth $346,000. But, after taking advantage of purchase discounts, it paid only $335,000 for this merchandise. Thus, during the year Northeast had goods available for sale valued at $40,000 + $335,000 = $375,000.

At the end of the accounting period, Northeast had an ending inventory of $41,000. Thus it had sold all but S41,000 worth of the available goods. The cost of goods sold by Northeast was therefore $375,000 less $41,000, or $334,000.

This is the standard method of determining the cost of the goods sold by a retailing or wholesaling firm during an accounting period. It may be summarized as follows:

beginning net ending

Cost of goods sold = inventory + purchases - inventory

A manufacturer must include its raw-materials inventories, work-in-process inventories, and direct manufacturing costs in this computation.

A firm's gross profit on sales is its net sales less the cost of goods sold. For Northeast, this was $117,000.

Operating Expenses

A firm's operating expenses are those costs that do not result directly from the purchase or manufacture of the products it sells. They are generally classed as either selling expenses or general expenses.

Selling expenses are costs that are related to the firm’s marketing activities. They include salaries for members of the sales force, advertising and other promotional expenses, and the costs involved in operating stores. For Northeast Art, selling expenses total $43,000.

General expenses are costs that are incurred in managing a business. They are sometimes called administrative expenses. Typical general expenses are the salaries of office workers and the costs of maintaining offices. A catchcall account called miscellaneous expense is usually included in the general expenses section of the profit and loss account. For Northeast Art general expenses total $36,500. Now it is possible to total both selling and general expenses for Northeast Art. As illustrated in Figure 3.2, total operating expenses are $79,500.

Net Income

Net income is the profit earned (or the loss suffered) by a firm during an accounting period, after all expenses have been deducted from revenues. In Figure 3.2 Northeast's net income from operations is computed as gross profit on sales ($117,000) less total operating expenses ($79,500). For Northeast Art, net income from operations totals $37,500. From this, an interest expense of $2,000 is deducted to give a net income before taxes of $35,500. The interest expense is deducted in this category because it is not an operating expense. It is, rather, an expense that results from financing the business.

Northeast's federal income taxes, based on its pretax income, are $5,325. Although these taxes may or may not be payable immediately, they are definitely an expense that must be deducted from income. This leaves Northeast with a net income after taxes of $30,175. This amount may be used to pay a dividend to stockholders, retained or reinvested in the firm, used to reduce the firm's debts, or all three.

Cash Flow Statement

The balance sheet and profit and loss account are important accounting statements. But they do not contain a sufficiently wide range of information to enable users to make a full assessment of a company’s performance. Most specifically, an important gap is left because the profit and loss account provides financial information relating to only a limited range of financial transactions entered into during an accountant period, namely those which impinge on the calculation of reported profits, i.e. revenues and expenditures. Other transactions involving flows of cash, such as an issue of shares or debentures or the purchase of a fixed asset, are not reported in the profit and loss account since these are capital transactions. The view gradually developed that capital inflows and outflows, which often involve large amounts of money, should be reported to investors and the cash flow statement was devised to provide this information. FRS1, entitled “Cash Flow Statements”, makes publication a requirement. The statement must contain full details of the cash inflows and outflows which have taken place during an accountant period, and it is thought that the information it contains, when used in conjunction with other details in the corporate report, will help bankers and other users when they assess:

• An enterprise’s ability to generate positive future net cash flows.

• Whether an enterprise is likely to be able to meet its financial obligations.

• The effect on the enterprise’s financial position of investments undertaken during the accounting period.

• The reasons for differences between profits and cash flows arising from normally operating activity.

• The value of a business as the statement provides a useful input for business valuation models based on estimates of likely future cash flows.

All enterprises are required to present a cash flow statement that reports cash flows during the reporting period, classified as follows:

Operating activities: Principal revenue-producing activities and other activities that do not include investing or financing activities.

Investing activities: Acquisition and disposal of long-term assets and other investments not included in cash equivalents.

Financial activities: Activities that change the size and composition of the equity capital and borrowings.

Key terms.

Beginning inventory – початкові запаси (запаси на початок періоду) – goods on hand and available for sale to customers at the beginning of the accounting period.

Cash flow statement – звіт про рух грошових коштів – a statement showing the sources of cash receipts and purchase of cash payments during an accounting period.

Cost of goods sold – собівартість реалізованої продукції (проданих товарів) – a computation appearing as a separate section of an income statement showing the cost of goods sold during the period. Computed by adding net delivered cost of merchandise purchases to beginning inventory to obtain cost of goods available for sale, and then deducting from this total the amount of the ending inventory.

Ending inventory – кінцеві запаси (запаси на кінець періоду) – goods still on hand and available for sale to customers at the end of the accounting period.

Expenses – витрати – the cost of the goods and services used up in the process of obtaining revenue. Sometimes referred to as expired costs.

General expenses – загальні витрати – expenses of general offices, accounting departments, personnel office, credit and collection department and activities other than the selling of goods. A subdivision of operating expenses.

Gross profit on sales – валовий прибуток від реалізації – revenue from sales minus cost of goods sold.

Investing activities – інвестиційна діяльність – a heading required in the cash-flow statement of an organization by Financial Reporting Standard 1, Cash Flow Statements, which shows the cash flows related to the acquisition or disposal of any asset held by the organization as a fixed asset or as a current-asset investment, other than assets included within cash equivalents.

Net income – чистий дохід – the excess of revenue earned over the related expenses for a given period.

Operating expenses – операційні витрати, витрати по основних видах діяльності – include both selling expenses and general and administrative expenses. Deducted from gross profit on sales to determine income from operations or net income.

Profit and loss account (income statement) – звіт про фінансові результати (звіт про прибутки та збитки) – a report used to evaluate the performance of a business by matching its revenue and related expenses for a particular accounting period. Shows the net income and the net loss.

Revenue – дохід, виручка – the price of goods sold and services rendered by a business. Equal to the inflow of cash and receivables in exchange for services rendered or goods delivered during the period.

Sales discounts – знижка для стимулювання збуту та збільшення обсягу продажу – a reduction in the price of goods below list price . A discount granted by a company to a client, for example for a bulk purchase or a prompt payment, or for buyers who pay cash. It is shown as an expense in the profit and loss account.

Sales returns – повернення товару – goods returned to an organization by customers, usually because they are unsatisfactory.

Selling expenses – витрати на реалізацію товарів – expenses of marketing the product, such as advertising, sales salaries, and delivery of merchandise to customers. A subdivision of operating expenses.

FRS (Financial Reporting Standards) – стандарти фінансової звітності – any of a series of standards issued by the UK Accounting Standards Board. Many of the more recent FRSs have the aim of harmonizing UK practice with the standards published by the International Accounting Standards Board.