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•The Income Statement (IS), is the second key financial report which links two balance sheets together.

•It traces the financial implications of the business’operating activities from the start of the accounting period, to the end of the accounting period.

•The start and end balance sheets representing the ‘snapshot’ position at the beginning and end of the period. The income statement tells the ‘story’ of how the business got from one to the next one.

Profit: is deemed to be the excess of revenues earned by the business from selling its goods and services over and above the expenses incurred by the business in providing the products / services which have been sold.

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Here now is a slightly more detailed layout for the income statement which is in keeping with what you will see in the financial statements of limited companies.

Negative numbers are sometimes shown in brackets, and the order follows a fairly standard pattern as described earlier.

It is broken down from the headline of revenue coming in through the various types of expenditure paid out – cost of manufacture, overheads and then dividends and retained earnings.

So when should revenue be recognised?

‘Revenue arises as a result of benefit being transferred to a customer through the seller’s performance under a contract’ (Accounting Standards Board). In other words a business recognises revenue when it does what it has to do!

Difficulties arise when a contract is incomplete at a year end. Various solutions are possible:

Unbundling: Identifying smaller independent parts.

Value to date assessment: possibly done by an independent person, such as a surveyor.

Value outstanding assessment: An estimate of how much the customer would have to pay a third party to get the contract finished.

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•Financial reports relate to a set time scale, which is generally one year, but may be longer or shorter (consider situations where a business is acquired which has a different accounting year end).

•This ‘year’ is known as the accounting period, and is defined formally in the Companies Act.

•The Balance Sheet is:            a summary at a given point in time

•The Income Statement is:      a financial summary of the trading performance over the given trading period from one balance sheet date to the next.

•Profits to be retained in the business at the end of each accounting period are transferred from the Income Statement, to the balance sheet or ‘attributable to’ equity holders and minority interests

•This is usually under the heading of Retained Reserves

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Structure:

•The income statement (profit & loss account) is usually subdivided as above.

•The part below the dotted line is historically known as the “Appropriation account” This may be shown as part of the Income Statement or as part of a separate statement, known as the “Statement of changes in equity”

•It follows the usual format of two columns, with the figures in the right hand column being the ‘final’ ones

•Figures inset are added together and extended into the end column to be added or subtracted as appropriate.

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You may see the terms is also known as “Revenue”
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Gross profit:

•This figure is derived from the profits a business has made in ‘trading’ whatever it is in business to sell. So if the business makes aircraft all the costs of manufacturing would be included in the trading account.

•So the trading account includes the sales revenue, less whatever the cost of raw materials, direct labour, and direct expenses have been.

•If a business has generated a loss at this stage then things may not be looking very good.

•But it does not necessarily mean that the business is not a going concern, it may be trading on the WWW, for example, and set up costs may be either very high, or take a long time to begin the recover initial costs.

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Net Profit:

•The ‘operating section’ of the IS, includes all the other items of expenditure involved in trading.

•Items which might be included are the cost of running the offices, marketing, finance costs etc.

•The usual term for these items is overheads.

•All the overheads are deducted from the Gross Profit, to produce the Net Profit.

•Some items may be included in the appropriation account, such as interest, but this is not laid out by statute, it is a means of identifying interest costs where they can be readily seen by shareholders.

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This part of the income statement is not something that the operational manager has influence over.

In a large organisation the type of finance that the organisation uses is a decision is normally made centrally. Indeed it is a tenet of finance theory that operating decisions and financing decisions are separated.

Whilst tax is obviously an important cost of a business, it again is something that is managed centrally, by a specialist department

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Reporting of Profit:

There are a whole raft of rules that govern what is reported in a set of financial statements. By far the largest group is known as Accounting Standards. These impact accounts in two ways:

1.               Firstly they apply to any set of financial statements in the UK that are requiredto show “a true and fair view”, a requirement for all limited companies, for instance

2.               Secondly any qualified accountant preparing such a set of financial statementsis professionally obligated to follow those rules.

•However:

•The assessment of performance is a subjective area, as you have seen with depreciation already.

•More of this shortly

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•Firstly for a limited company it is legally “the directors” responsibility to prepare an annual set of accounts (S394 Companies Act 2006)

•Those accounts must show a “true and fair “ view of the balance sheet and profit.

•They must be in the format as set out by the Companies Act 2006 and one of the sets of Companies Rules. E.g. The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008

•If quoted on the stock market they need to disclose further information as set out by the London Stock Exchange.

•They should normally follow accounting standards, either International standards or local standards

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•This concept is a practical one based on the principle that outputs from the business should be ‘matched’ against the related ‘inputs’ which the business has incurred in generating those sales.

•In the extreme, consider a retail business that has sold goods, but not yet received an invoice for the goods from its suppliers, and thus not paid for them. It would obviously be wrong to compute the profit on the sale of goods at just the selling value.

•The cost of the goods must be taken into account and the liability to pay the supplier recognised.

•Accrual accounting is not a universal concept. Most individuals do not use it, merely monitoring cash movements, and historically the accounting by government has not used the principle, although most governments are moving towards such a system. It does however form a basis for all systems of business accounting (and profit measurement) throughout the world.

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