3- Statement of Profit and Loss Flashcards
What does Statement of Profit and Loss Show?
- Income of a firm- revenue earned by firms minus its expenses.
3 types of payment methods
- Cash on delivery
- Paid in arrears
- Paid in advance
Cash on delivery
Services and goods paid at the time the services are consumed or goods received.
Examples of cash on delivery
Goods from supermarket, takeaway food.
Paid in arrears
Services consumed and goods delivered and paid for at a later time.
May be invoiced at the time of delivery (typical for goods) or at a later time (common for services).
Examples of payments in arrears
Goods sold by one firm to another (invoiced at the time), electricity consumed (invoiced at a later date).
Paid in advance
Services and goods ordered and paid for in advance.
Examples of payments in advance
Rent on commercial premises, tickets for a flight.
Why Can’t We Use Cash Flows for Profit?
The timing mismatch between payments for sales and payments for their related costs makes it impossible to produce a meaningful value profit for an accounting period based on cash flows.
The Accrual Principle
Revenue should be recognised when earned regardless of when paid for. Expenses should be recognised when incurred regardless of when paid for.
IFRS Revenue Recognition Requirements
- the rights to all economic benefits from a product or a service, and responsibilities for any risks, have been transferred from the seller to the buyer without recourse (or returns can be reliably estimated)
- and the amount of revenue and associated costs can be measured reliably.
Different expenses
- Product costs
- Costs of running the business
- Selling and distribution costs
Problem with reporting expenses
- IFRS is not very proscriptive in terms of reporting
- US GAAP/ SEC Reporting
- Wide variation in terms of level of reporting and presentation
- Creates comparability problems
Product costs
Comprise all of the costs expended on a goods or service that are needed to generate the revenue from selling the goods or service.
Examples of product costs
- Direct costs such as raw materials and labour
- Fair share of the manufacturing overheads.
Matching Principle
Costs associated with revenues should be recognised in the same periods in which the revenues are recognised.
Reason for the matching principle
Needed to report meaningful value for profit
Gross/ Trading Profit
Revenue minus cost-of-sales
Period costs
Costs that cannot be easily be matched with revenues.
Corporate overheads
The costs of running the business
Manufacturing overheads
Transformed into product costs
Application of the Accrual Principle to Period Costs
Costs incurred for services received or things consumed that cannot be directly associated with revenues should be recognized in the same periods in which the benefits from the service were received or consumption took place.
Examples of corporate overheads
- Head office itself (building, staff)
- Marketing
- Data centres, call centres and IT network
- May include selling and distribution costs- Reported as “Other operating expenses” or “Selling, General and Administrative (SG&A) expenses”
Core Operating Profit
Gross profit - other operating expenses
Operating Profit (PBIT)
- Core operating profit + other income
- Other income may include rental income and dividends from equity investments
- Profit before interest and tax (PBIT)
- The operating profit on the firm’s operating assets
What do the Operating Profits Go To?
- Financial creditors- for loan expenses, bonds etc.
- Tax authorities- Tax expenses towards infrastructure, security and legal system on which firm depends, education and health of its employee
- Minority interests Claims of profits from minority shareholders in one or more of a firm’s subsidiaries
- Profit attributable to owners
Credit sales
Firms transact most of their business with one another on credit terms, typically of 30-60 days.
Reasons and pitfalls of credit sales
- Free financing for customer
- Have credit risk for supplier
- People in credit control want to keep payment terms short
- People working in sales and marketing want generous payment terms
Credit sales- trade receivables
- Used to record invoices issued by the company to its customers for goods and services it has sold to them on credit.
- Represents amounts owed to the firm due for payment (normally within 12 months).
- Value of gross trade receivables is shown in the notes to the accounts.
Credit sales: trade payables
- Used to record the value of invoices received by the company from its suppliers for goods and services it has bought from them on credit.
- Represents amounts owed by the firm due for payment (normally within 12 months) and its value shown in the statement of financial position.
Accrued income
Value of revenue earned that has not yet been invoiced.
Accrued expenses
Value of expenses incurred for which an invoice has not yet been received (e.g. estimated electricity consumption.
Unearned income at end of period
Unearned income at start of period
‒ Revenue from advance sales
+Payments received from customers
Prepayments at end of period
Prepayments at start of period
‒ Expenses consumed / goods received
+Payments made to suppliers
Trade receivables at end of period
Trade receivables at start of period
+Revenue from credit sales
‒Payments received from customers
Revenue from credit sales
Trade receivables at end of period
‒ Trade receivables at start of period
+Payments received from customers
Working capital
- Concerns a firm’s trading assets and liabilities
- Defined as working capital = current assets – current liabilities
- Working capital represents the portion of current assets which must be funded by long-term financing
- Can be positive and negative
When positive what does working capital represent?
Working capital represents the portion of current assets which must be funded by long-term financing.
When negative what does working capital represent?
it represents the portion of current liabilities that are available to fund a firm’s non-current assets.
