The income statement

FUNDAMENTALS OF FINANCIAL ACCOUNTING

THE FRAMEWORK OF FINANCIAL STATEMENTS

short-term liquidity of an organisation. In Nadim’s statement of fi nancial position above, the net current assets (working capital) is $41 (60−19).

In order to prepare the above statement you should recognise that individual assets, cap-ital and liabilities are grouped under fi ve main headings as:

1. non-current assets

In the course of his business, Nadim will attempt to earn money by selling his goods to customers. The money earned in this way is referred to as the sales revenue (or simply the sales ) of the business. To sell goods, he fi rst has to buy them (or manufacture them – but we shall assume that Nadim is a retailer rather than a manufacturer). Obviously, there is a cost involved in the buying of the goods. The difference between the cost of the goods he sells and the sales revenue earned from customers is called the gross profi t of the business.

Apart from having to purchase goods, Nadim incurs other costs in running his business.

He must buy fuel for his delivery van. He probably pays rent for the warehouse or shop premises in which he stores his goods. If he employs anyone to help him he will have to pay wages. All of these costs have to be paid for from the gross profi t earned by selling goods. The amount remaining after all of these expenses have been paid is called the net profi t of the business.

What happens to this net profi t once it has been earned?

● As a private individual, Nadim has living expenses like everyone else. He will need to withdraw some of the net profi t from the business to pay for these; such a withdrawal is referred to as drawings .

● Any profi t that Nadim does not need to withdraw simply remains in the business, increasing his capital.

In Example 2.A, you saw that Ahmed, trading as Ahmed’s Matches, made a profi t of

$10.50, and withdrew $5 for himself, leaving the other $5.50 in the business to increase his capital.

Example 2.C

In the following month, Nadim sells goods on credit to his customers for $6,000. He already had some inven-tories, costing $10,000, so he used $1,000 worth of that existing inventory, and bought in another $3,000 worth of inventories that was all used to fulfi l the order. He has not yet paid for this extra inventory. His rent bill for the month is $500 and his van running costs are $300. He withdraws $200 from the business for his private use.

Present an income statement for Nadim for this month, and a statement of fi nancial position at the end of the month.

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THE FRAMEWORK OF FINANCIAL STATEMENTS

Solution

Income statement for the month

$’000 $’000 specially. See Section 2.5.1 for another way to calculate the cost of goods sold.

2. Nadim’s drawings are not business expenses, but are deducted from his capital on the statement of fi nancial position below.

The part of the income statement which calculates gross profi t is known as the trading account. This comprises sales less cost of goods sold equals gross profi t. The trading account is thus a sub-section of the income state-ment although its name does not appear within the income statestate-ment. Nevertheless, it is a very important part of the income statement.

Statement of fi nancial position at the end of the month

Assets $’000 $’000 Capital and liabilities

Capital 66

Notice that the capital of the business has increased by $1,000 – the amount of net profi t retained in the busi-ness. It is possible to prepare a statement of changes in capital, showing exactly how the fi gure of $65,000 has risen to $66,000.

27 FUNDAMENTALS OF FINANCIAL ACCOUNTING

THE FRAMEWORK OF FINANCIAL STATEMENTS

Statement of changes in capital

$’000 $’000

You should see clearly from this statement how the income statement links up with the statement of fi nancial position: the net profi t earned, shown in the income statement, becomes an addition to capital in the statement of fi nancial position, and Nadim’s draw-ings are deducted from this.

In Chapter 13 we will learn more about the income statement and how it may be part of a statement of comprehensive income. However, until Chapter 13, we will just refer to the income statement.

2.5.1 The cost of goods sold

We shall be looking at the income statement in more detail later on, but at this stage it is worth noting one general point, which will be illustrated by the particular example of the cost of goods sold.

In computing the profi t earned in a period the accountant’s task is:

● fi rst, to establish the sales revenue earned in the period;

● second, to establish the costs incurred by the business in earning this revenue.

This second point is not as simple as it might sound. For example, it would not be true to say that the costs incurred in an accounting period are equal to the sums of money expended in the period. This could be illustrated by many examples, some of which you will encoun-ter laencoun-ter in the text. For now, we focus on one particular cost: The cost of goods sold .

A trader may be continually buying goods and selling them on to customers. At the moment he draws up his fi nancial statements it is likely that he has inventories that have been purchased in the period but not yet sold. It would be wrong to include the cost of this closing inventory as part of the cost of goods sold, for the simple reason that these goods have not yet been sold.

Looking back to the beginning of the accounting period, it is likely that opening inven-tories were on hand. These have presumably been sold in this period and their cost must form part of the cost of goods sold, even though they were purchased in an earlier period.

What all this illustrates is that the cost of goods sold in an accounting period is not the same as the cost of goods purchased in the period. In fact, to calculate the cost of goods sold we need to do the following calculation (presented here using the fi gures from Nadim’s business above):

$

Cost of opening inventories at the start of the period 10,000

Cost of purchases during the period 3,000

13,000

Less: cost of closing inventories at the end of the

period 9,000

Cost of goods sold 4,000

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THE FRAMEWORK OF FINANCIAL STATEMENTS

It is this fi gure of $4,000 – not the purchases of $3,000 – that is matched with the sales revenue for the period in order to derive the fi gure of gross profi t.

Exercise 2.2

Explain briefl y what is meant by the following terms:

● assets; future. Includes non-current assets (land, buildings, machinery, etc.) and current assets (inventories, receivables, cash, etc.).

● Liabilities. Financial obligations or amounts owed by an organisation. Includes loans, overdrafts and payables.

● Capital. The amount of investment made by the owner(s) in the organisation, and not yet withdrawn. The amount includes initial and subsequent amounts introduced by the owner(s), plus any profi ts earned that have been retained in the organisation.

● Revenue. Amounts earned by the activities of the organisation, which eventually result in receiving money. Includes sales revenue, interest received and so on. Revenue increases profi t.

● Expense. Costs used up in the activities of the organisation. Includes heat, light, local business tax, inventories consumed, wages and so on. Expenses reduce profi t.

Exercise 2.3

On 1 June 20X1, J Brown started business as a jobbing gardener with a capital of $2,000 in cash. A list of fi gures extracted from his records on 31 May 20X2 shows the following:

$

Private expenses paid from bank 1,500

Cash in hand and bank 180

Cash received from customers 3,000

Capital at the start of the year 2,000

Inventories of seeds, plants, etc. at the end of the year 100

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THE FRAMEWORK OF FINANCIAL STATEMENTS

You are required to prepare:

(A) an account to show J Brown’s profi t or loss for the year ended 31 May 20X2, (B) a statement of fi nancial position as at 31 May 20X2.

Solution

Income statement of J Brown for the year ended 31 May 20X2

$ $

Statement of fi nancial position of J Brown as at 31 May 20X2

Assets $ $

Note that in Example 2.C, Nadim’s business made a profi t of $1,200. But his bank balance remained unchanged and his cash holdings actually fell. This was because some of his transac-tions that affected profi t did not affect cash at the same time. For example, his customers did not pay Nadim, nor did Nadim pay his suppliers, until after the end of the month. Also, there was a transaction that affected cash, but not profi t – Nadim took $200 cash in drawings, which