Study guide: The Statement of Profit or Loss

📋 Course Outline

1. Purpose and Commercial Activity
2. Profit and Loss Terminology
3. Revenue Recognition and Accruals
4. Trading Account and Cost of Sales
5. Expenses and Net Profit
6. Returns, Discounts, and Delivery
7. Service Business and Financial Statements

📖 1. Purpose and Commercial Activity

🔑 Key Concepts & Definitions

• Statement of profit or loss: Statement that reports a business’s revenue and expenses over a period to show its financial performance to interested parties such as investors, lenders, employees, and HMRC.

📝 Essential Points

• A profit figure helps owners and managers decide how much profit can be distributed or reinvested and whether operational changes are needed.

• Commercial activity may involve: trading in goods manufactured by another business, manufacturing goods for direct sale or sale to traders, providing services, combining trading, manufacturing, and service activities

📖 2. Profit and Loss Terminology

🔑 Key Concepts & Definitions

• Revenue: The amount of goods or services sold.
• Profit: The surplus remaining when revenue exceeds expenditure.
• Expenses: Amounts incurred in purchasing or manufacturing goods and in other business expenditure.
• Loss: The deficit that occurs when expenditure exceeds revenue.

★ Must-know

📌 Gross profit is revenue less direct costs or cost of sales, whereas net profit is what remains after all expenses are deducted.

Further detail

• The statement of profit or loss is also called the profit and loss account in the UK or the income statement.

💡 Memory Hook

Gross profit covers the product; net profit covers the whole business.

📖 3. Revenue Recognition and Accruals

🔑 Key Concepts & Definitions

• Revenue recognition: Revenue recognition is the principle that determines when and how revenue is recorded; revenue is recognized when goods or services are delivered and the amount can be measured reliably, even if cash has not been received.
• Accrual principle: The accrual principle requires transactions to be recorded in the period in which they occur, with revenues recorded when earned and expenses when incurred, regardless of when cash is received or paid.

📝 Essential Points

• If a product is delivered in March and payment is received in April, the revenue is recognized in March when delivery occurs.

• For a Basic-Fit membership paid upfront at €240 for a year beginning in July, €120 belongs to the accounting year ending 31 December and the remaining six months belong to the following year.

• A €50 Fnac gift card generates no revenue when purchased; revenue is recognized when the card is spent.

• Electricity used in December is recorded as a December expense even if the invoice arrives in January.

💡 Memory Hook

Cash marks when money moves; accruals mark when income is earned or expense incurred.

📖 4. Trading Account and Cost of Sales

★ Must-know

• Cost of sales is calculated by adding purchases to opening inventory and deducting closing inventory.

Further detail

• Mary’s purchase of a cooker for £135 and sale for £195 produces gross profit of £60 on that transaction.

• An inventory movement account records opening inventory, purchases added to inventory, sales deducted from inventory, and the resulting closing inventory.

• Mary’s June inventory example begins with 30 cookers, sells 76, and receives deliveries of 35 cookers on 10 June and 40 on 24 June, with cookers bought at £135 each.

• For Mary’s year ended 31 October 20X3, opening inventory was £4,725, closing inventory was £6,480, purchases were £153,900, and sales comprised 986 cookers at £195 and 141 cookers at £175.

📖 5. Expenses and Net Profit

★ Must-know

📐 Formula - $\text{Profit} = \text{Revenue} - \text{Expenses}$

Further detail

• Typical expenses fall into these categories:
  • premises costs: rent, business rates, insurance, electricity, gas, water, and repairs
  • selling and distribution costs: haulage, delivery services, sales staff salaries and commissions, and website costs
  • administration costs: phone, stationery, administrative staff salaries, and computer costs
  • finance costs: bank charges and interest on loans

📌 Rent for the period is an expense, whereas equipment purchases are capitalized as assets.

• Revenue of £10,000 less expenses of £7,500 gives profit of £2,500.

• Profit increases the owner’s capital or equity in the statement of financial position.

📖 6. Returns, Discounts, and Delivery

★ Must-know

• Goods returned are sales returns in the supplier’s books and purchases returns in the customer’s books.

• Sales returns are deducted from revenue, whereas purchases returns are deducted from purchases.

• Trade discounts are offered, for example, to regular customers buying large volumes, whereas financial discounts encourage prompt payment.

Further detail

• A 0.5% early-settlement discount on a £3,000 invoice reduces the amount payable to £2,985 if the customer pays within 30 days.

📌 If prompt payment is expected, the sale is recorded at the discounted amount; if it is not expected, the full invoice is recorded, and an unexpectedly claimed discount is deducted from revenue.

📌 When the customer is obliged to pay delivery charges such as import duties, those charges are included in the value of purchases.

• For Brooklyn’s football cartons, each carton costs £52 and import duty is £5 per carton, so the purchase cost includes £57 per carton.

📖 7. Service Business and Financial Statements

★ Must-know

📌 A service business does not need a trading account when it has no inventory movements, so its statement of profit or loss is generally revenue less expenses.

Further detail

• Using knowledge from Chapters 2 and 3, prepare both a statement of profit or loss and a statement of financial position.