5 THE INCOME STATEMENT 5.1 Introduction In paragraph 1.2 we defined the statement of financial position as ‘a statement of the financial position of a business at a given date. And the income statement is ‘a summary of the results of a business’s transactions for a period ending on the date of the statement of financial position. This should be enough to show the difference between the two statements. The statement of financial position shows the position which has been arrived at after a period’s transactions; these transactions are recorded in a business’s income statement. Having stressed the difference between the two, we must not forget the essential connection which binds them together. The income statement results in a figure for profit or loss. Where do you think this figure appears in the statement of financial position? It should be added to (or if a loss deducted from) capital. 5.2 Pro forma income statement We will return to Percy Pilbeam’s business in the next chapter: for the moment, the pro forma profit and loss account which follows on the next page will show you the items which most businesses are likely to have in their accounts. 25 Income Statement for the year ended 31 December 20X1 £ Revenue Less cost of sales Opening inventories on 1 January 20X1 Purchases Less closing inventories on 31 Dec 20X1 £ X X X (X) ____ X ____ Gross profit X Other income Discounts received Rent receivable X X ____ X Less expenses Administrative expenses Rent Rates Lighting and heating Telephone Postage Insurance Stationery Office salaries Depreciation Accountancy and audit fees Bank charges and interest Irrecoverable debts X X X X X X X X X X X X Distribution costs Delivery costs Van running expenses Van depreciation Advertising Discounts allowed X X X X X ____ (X) ____ Net profit X ____ 26 5.3 The trading account The first part of the account (down as far as gross profit) is known in many businesses as the trading account, since it shows the results of the actual buying and selling operation of a business. A retailing or wholesaling business merely buys goods and sells them; clearly a manufacturing concern will have much more detailed costs to account for, and you will meet these later on in your studies. The same principles apply to all businesses, but a buying and selling operation is easier to understand. As you can see from the pro forma, the gross profit arrived at is the result of subtracting cost of sales from revenue. The thing to remember here is that, whereas revenue should be a larger amount than cost of sales, the actual goods concerned will be the same. Cost of sales or ‘cost of goods sold’ means exactly that: the cost of the goods actually sold during the year or period. ‘Revenue’ thus means the selling price of the goods during the same period. 5.4 Revenue This is a figure easily calculated provided that businesses keep proper records of all their sales. Later on in your studies you will come across the problems which arise if they don’t. For the moment, the only thing to remember is that ‘revenue’ means all goods sold, not just cash received. If goods have been sold on credit, these too are included, even if they haven’t yet been paid for by customers. 5.5 Cost of sales As the pro forma shows, the way to find the cost of the goods actually sold during a period is to take: (a) the cost of goods in stock at the beginning of the period known as opening inventories. and add (b) the cost of goods bought during the period ‘purchases’. and then deduct (c) the cost of goods in stock at the end of the period: closing inventories. What this does is to take the cost of goods available for sale during the period (opening inventories plus purchases) and deduct the cost of the goods which weren’t sold during the period (closing inventories). This gives the cost of the goods which were sold. 27 5.6 Gross profit The resulting gross profit is a very useful figure, since it shows how successful the main activity of the business has been (ie. the buying and selling of goods, as opposed to incidental expenses). You would have to be supremely incompetent to achieve a good loss. Gross profit is often expressed as a percentage of revenue; this ratio is known as the gross profit margin, and can usefully be compared within a business, period by period, or with other similar businesses. Gross profit margin = 5.7 Gross profit x 100% Sales Example A business had goods in stock at 1 January which had cost £15,000; at 31 December inventories at cost was £25,000. It bought goods from £70,000 during the year, and its sales amounted to £80,000. Prepare a trading account and find the gross profit and gross profit margin. £ Revenue Cost of sales Opening inventories Purchases Less closing inventories £ ……. ……. ……. (……) ……. ____ ….. % Gross profit margin Answer £ Revenue Cost of sales Opening inventories Purchases Less closing inventories £ 80,000 15,000 70,000 (25,000) ______ (60,000) _________ Gross profit 20,000 _________ Gross profit margin 25% 28 5.8 Other income and expenditure After arriving at gross profit, we must show other items of income and expenditure (mainly expenditure) which are relevant to the business but are incidental to it and not part of the buying, selling or manufacturing of the goods. The pro forma shows an example of how to set this out. There are many ways of categorising expenditure, but the subdivision between administration and distribution is as convenient as any, and is in fact the one required by law for the accounts of companies. There are three particular things to note about this part of the account, and we will finish this chapter with them. 5.9 Net profit and drawings As you can see, the pro forma ends up with net profit, and this is the figure which is taken to the statement of financial position to be added to capital. (A net loss would be deducted from capital; this would of course happen if total expenditure exceeded gross profit.) However, you may remember that in arriving at Percy Pilbeam’s overall increase in funds in Chapter 3, we deducted Percy’s drawings (the amount which he took out of the business for himself). Try and think of a reason why these don’t appear in the profit and loss account. The main reason is because drawings are not an expense of the business. Drawings are an appropriation of profit, rather than a charge on it. They should therefore be deducted after arriving at net trading profit. Lastly, can you think what the equivalent of drawings is in the accounts of a company? Dividends paid to shareholders. 5.10 Charge for the year In the trading account, we show, as sales and purchases, the value of all goods sold or bought during a period, irrespective of whether or not cash has yet been received or paid in respect of those goods. The same principle applies to other income and expenditure. We need to show only what is due for the period, not just what has been received or paid, or the most recent bill. People such as landlords and electricity boards often have different financial year-ends from those of their customers (it doesn’t always have to be 31 December). Thus they will charge for their services for different periods, and we have to account according to our own financial year or period. For example, suppose that Percy Pilbeam’s landlord makes up his account to 30 June in each year, whereas Percy makes his up to 31 December. The landlord will doubtless increase the rent each year (such is the way of landlords), but from 1 July rather than 1 January. 29 If Percy’s rent for the year ending 30 June 19X1 is £1,000, and this is increased to £1,200 for the year ending 30 June 19X2, can you work out how much Percy should show as an expense for the year ending 31 December 19X1? We have to divide Percy’s year into two to work it out, as follows: 1 January 19X1 30 June 19X1 6 × £1,000 12 £ = 1 July 19X1 31 December 19X1 6 × £1,200 = 12 500 600 _______ Total for 1.1.X1 31.12.X1 1,100 _______ £1,100 is the amount Percy will show in his income statement for rent. The charge for the year is £1,100, never mind when he actually paid his landlord (in arrears, in advance or in monthly installments). 5.11 Capital and revenue expenditure In paragraph 4.4, while talking about non-current assets, we made the distinction between capital and revenue expenditure. The purchase of a van, for example, which will be used in the business for several years, is a capital expense; rent or electricity on the other hand are revenue expenses. You should now be able to see, from the pro forma, where the revenue expenses fit in. They are charged, as they are incurred (see the last paragraph), directly to the income statement. Capital expenditure on the other hand, is charged to the income statement only gradually, over the period of the non-current asset’s useful life. This last item appears as an expense in the income statement; its name is depreciation. 5.12 Revision questions (1) (a) (b) What is revenue less cost of sales? The final figure in the income statement is called what? (2) A business’s sales for a year amount to £120,000. Only £100,000 of these have been paid for by customers. What will revenue be? (3) How is cost of sales calculated? (4) A business has opening inventories of £20,000 and closing inventories of £30,000. During the year it bought goods costing £70,000 of which £10,000 have not yet been paid for. What is the cost of goods sold for the year? £……………………………………………………………………………………….. 30 (5) A business’s sales amount to £300,000 for a year. Its cost of goods sold is £210,000. What is its gross profit margin? ………………………………………………………………………………………… (6) A business pays rates in advance each 1 April for the next year ending 31 March. On 1 April 19X1 it paid £1,600 for the year ending 31 March 19X2. On 1 April 19x2 it paid £2,000 for the year ending 31 March 19X3. The business’s year-end is 31 December. What amount should it show as an expense for the year ended 31 December 19X2? £ ………………………………………………………………………………………… (7) Classify the following as capital or revenue expenditure in the books of a business: (a) Purchase of premises ………………………………………………………………………………... (b) Depreciation of vans ………………………………………………………………………………... (c) Accountancy fee ………………………………………………………………………………... (d) Purchase of a cash register ………………………………………………………………………………... (e) Purchase of stationery ………………………………………………………………………………... (f) Purchase of goods for resale ………………………………………………………………………………... (g) Petrol for the proprietor’s wife’s private car ………………………………………………………………………………... 31 Answers (1) (a) (b) Gross profit Net profit (2) £120,000 (includes sales where customer has not yet paid). (3) Opening inventories Add Purchases Less Closing inventories X X (X) _____ Cost of sales X _____ We are determining the cost of goods sold in the period. Closing inventories will be sold next year. (4) £ Opening stock 20,000 Add Purchases 70,000 Less Closing inventories (30,000) _________ Cost of sales 60,000 _________ (5) Sales Less £ 300,000 (210,000) Cost of sales _________ Gross profit 90,000 _________ Gross profit margin (6) Period = = Gross profit Sales ×100% ×100% × 30% 90, 000 300, 000 1.1.X2 31.3.X2 = 3 months = 3 12 × 1,600 = 1.4.X2 31.12.X2 = 9 months = 9 12 × 2,000 = £ 400 1,500 ________ Rates expense for the year ended 31 December 19X2 1,900 ________ (7) (a) (b) (c) (d) (e) (f) (g) Capital Revenue Revenue Capital Revenue Revenue Neither a drawing (unless the car is being used on business). 32