CHAPTER 14
STATEMENTS OF PROFIT OR LOSS
14.0 LEARNING OBJECTIVES
By the end of this chapter, you should be able to explain the importance of the income statements and prepare the income statement with all the adjustments.
14.1 INTRODUCTION TO FINANCIAL STATEMENTS
You learnt in an earlier chapter that accounting is a process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information. This process is shown in figure 1. By now you have looked at the first five stages shown in the figure. The communication aspect that has been mentioned in this definition is the same as stage six in the figure. This is the last step in the definition of accounting. It refers to the preparation and presentation of financial statements. Financial statements ensure that the economic information is communicated to users in an effective manner.
Figure 14.1: The Accounting Process
The income statement is one of the components of financial statements which we should prepare and present to the users of accounting or economic information.
14.2 PURPOSE OF INCOME STATEMENTS
Businesses are set up for the sole reason of making profits. It is important for the owners of businesses to check whether they are making profits or not. The income statement is prepared in order to assess if the business is making profits or losses in a given period. This is referred to as financial performance of a business. This statement is prepared for a period and not as at any particular point in time.
14.3 INCOME STATEMENT FORMAT
The income statement has two components:
x Trading account x Profit and loss account
14.3.1 Trading Account
This section focuses on the revenue from the sale of goods and the cost of the goods which have been sold. The difference between the sales figure (revenue) and the cost of goods is called gross profit. Gross profit is an indicator of the initial profit earned by a business. If the cost of goods sold is greater than the sales figure, the outcome will be a gross loss. Normally, businesses should have gross profits. The profits will enable the organisations to cover non-trading expenses.
The cost of goods sold is made up opening inventories and purchase made in the period less closing inventories. Closing inventories, which are unsold inventories during a period, are not included in the cost of goods sold because they have not been sold. Closing inventories will become opening inventories in the following year. They will be part of the cost of goods sold in the period in which they will be sold.
2 Profit and Loss Account
Once the gross profit has been calculated in the trading account, the next step is to consider all the expenses not related to the trading activities. The net profit is calculated in this section. The net profit is the difference between gross profit and the other expenses. This figure is very important when assessing the financial performance of a business.
Expenses to be included in the preparation of the profit and loss account would have been included in the trial balance as shown in figure 1. So these expenses will be isolated from the trial balance prepared for the period.
Example 2
Continuing from example 1, Atate had the following expenses in the year ended 31 December 2012:
| Generalexpenses | K40,000 |
| Lightingexpenses | K80,000 |
| Rent | K190,000 |
Returns
In chapter 5, you covered returns inwards (sales returns) and returns outwards (purchases returns) day books. Returns inwards reduce the sales figure in the trading account. Returns outwards are subtracted from the purchases figure. Returns inwards and outwards are also recorded in the trial balance for the period.
Example 3
The following is an extract of the trial balance of Atate as at 31 December 2013.
| Dr | Cr | |
| K | K | |
| Sales | 1,000,000 | |
| Purchases | 500,000 | |
| Returnsinwards | 90,000 | |
| Returnsoutwards | 60,000 |
You are required to prepare a trading account for the period ended 31 December 2013.
Trading account for the year ended 31 December 2013
14.4.3 Carriage
When businesses have purchased inventory, they need to transport the inventories to the business premises. In the course of doing this, the businesses incur costs. These costs are called carriage inwards. In the trading account, carriage inwards is added to purchases.
As part of a marketing strategy, businesses may deliver goods to customers. In this case the business incurs costs. These costs are called carriage outwards. Carriage outwards are recorded as expenses in the profit and loss account.
14.4.4 Accruals and Prepayments
In chapter 13 you looked at how to account for accruals and prepayments. Accruals increase the respective expense items while prepayments reduce the respective expenses. This ensures that all the expenses period should be recorded as expenses in that period.
14.4.5 Depreciation
You have learnt that depreciation is an expense. As such depreciation charge for the period should be recorded as an expense in the profit and loss account.
14.4.6 Allowances for Receivables and Irrecoverable Debts
You will recall that irrecoverable debts (bad debts) are treated as expenses in the profit and loss account. Increases in the allowance for receivables (provision for doubtful debts) are recorded as expenses in the profit and loss account. On the other hand, decreases in the allowance for receivables are treated as income and so are added to gross profit in the profit and loss account.
SUMMARY OF THE CHAPTER
In this chapter you have looked at the purpose and preparation of the income statement. You have learnt that you need to make adjustment in order to establish a proper income statement. Some of the adjustments include allowances for receivables and irrecoverable debts, depreciation, accruals and depreciation.