The statement of profit or loss is a statement in which two key elements of financial statements – income and expenses – are matched to arrive at profit or loss. Many businesses distinguish between:
gross profit earned on trading (revenue less cost of sales)
profit for the period (sometimes referred to as net profit) after other income and expenses In the first part of the statement of profit or loss revenue from selling goods is compared with direct costs of acquiring or producing the goods sold to arrive at a gross profit figure. From this, deductions are made in the second half of the statement (which we will call the expenses
section) in respect of indirect costs (overheads). Additions may also be made to gross profit in respect of non-trading income.
Gross profit = revenue from sales, less cost of sales
Profit for the period = gross profit less expenses plus non-trading income
Business owners want to know how much profit or loss has been made, but there is only limited information value in the profit figure. In order to exercise financial control effectively, managers must know how much revenue and other income has been earned, what costs have been, and whether the performance of sales or the control of costs appears to be satisfactory.
The statement of profit or loss matches income earned to the expenses of earning that income.
This is why prepayments and accrued expenses appear in the financial statements. Prepayments are excluded from expenses in the statement of profit or loss and are included in receivables in the statement of financial position, because they relate to future periods.
Accrued expenses are added to expenses in the statement of profit or loss and shown as payables in the statement of financial position, because they relate to the current period but have not been paid as cash in the period.
6.1.1 Gross profit
Gross profit is the difference between:
the value of sales revenue; and
the purchase or production cost of the goods sold: cost of sales.
In a retail business, the cost of the goods sold is their purchase cost from suppliers. In a manufacturing business, the production cost of goods sold is the cost of raw materials in the finished goods, plus labour costs required to make the goods, plus an amount of production 'overhead' costs. In many types of business the cost of sales also includes:
the cost of employing those people directly involved in making or providing a service
maintenance and depreciation on non-current assets used directly in making sales, plus losses on their disposal
Gross profit represents the profit made directly from the sale of goods or services. It can be represented as a percentage of revenue, called the gross profit margin.
Gross profit margin = Gross profit
× 100
Revenue
The gross profit margin can be used to compare the results of different periods to see how well the costs of sales are being controlled as revenue changes. It can also be used to compare the results of different businesses in the same industry.
We shall see more about margins in Chapter 7.
6.1.2 Profit for the period
Thesecond part of the statement of profit or loss shows the net profit for the reporting period.
The net profit is:
Gross profit X
Plus any other income from sources other than the sale of goods X Minus other business expenses, not included in the cost of goods sold (X)
X Income from other sources will include:
profit on disposals of non-current assets
dividends or interest received from investments
rental income from property owned but not otherwise used by the business
amounts due in respect of insurance claims
C H A P T E R 2
Business expenses not directly related to cost of sales appear in the statement of profit or loss under one of three headings.
Distribution costs. Expenses associated with selling and delivering goods to customers.
They include the following:
– salaries, wages and sales commission of employees
– marketing costs (eg, advertising and sales promotion expenses)
– the costs of running and maintaining delivery vans, including depreciation on these and any losses on their disposal
Administrative costs. Expenses of providing management and administration for the business. Examples include:
– management and office staff salaries – rent and local business or property taxes – insurance
– telephone and postage – printing and stationery – heating and lighting
– irrecoverable debts written off or increases in allowance for receivables. Sometimes customers fail to pay what they owe and a business has to decide to write the debt off if there is no prospect of it being paid or create an allowance in respect of the amounts that are unlikely to be collected. The amount of debt written off or increase in an allowance is an expense in the statement of profit or loss. Allowances for receivables are described more fully in Chapter 8.
– the cost of running and maintaining other non-current assets such as office buildings, plus depreciation and losses on disposal of these.
Finance costs. These include:
– interest on loans
– bank overdraft interest
At this stage of your studies, you should list out all expenses when calculating profit or loss for the year. In Chapter 12 we will consider the presentation requirements under IAS 1, Preparation of Financial Statements.
Worked example: Preparing a statement of profit or loss
On 1 June 20X5, Jock Heiss commenced trading as an ice cream salesman, using a van.
(a) He borrowed £2,000 from his bank, and the interest cost of the loan was £25 per month.
(b) He rented the van for £1,000 for three months. Running expenses for the van averaged
£300 per month.
(c) He hired an assistant for £100 per month.
(d) His main business was to sell ice cream to customers in the street, but he also did special catering for business customers, supplying ice creams for office parties. Sales to these customers were usually on credit.
(e) For the three months to 31 August 20X5, his total sales were as follows.
Cash sales £8,900
Credit sales £1,100
(f) He purchased his ice cream from a local manufacturer, Floors Co. The purchase cost in the three months to 31 August 20X5 was £6,200, and at 31 August he had sold every item. He still owed £700 to Floors Co for unpaid purchases on credit.
(g) One of his credit sale customers has gone bankrupt (insolvent), owing Jock £250. Jock has decided to write off the debt in full, with no prospect of getting any of the money owed.
(h) He used his own home for his office work. Telephone and postage expenses for the three months to 31 August were £150, which he paid in cash.
(i) During the period he paid himself £300 per month.
A statement of profit or loss can be presented in various formats, but here we will use a vertical format similar to the one used in IAS 1. (It is not exactly the same.)
Jock Heiss
Statement of profit or loss
for the three months ended 31 August 20X5
£ £
Revenue (8,900 + 1,100) 10,000
Cost of sales (6,200)
Gross profit 3,800
Expenses
Wages (3 100) 300
Van rental 1,000
Van expenses (3 300) 900
Irrecoverable debt written off 250
Telephone and postage 150
Interest charges (3 25) 75
(2,675)
Profit for the period 1,125