5 THE INCOME STATEMENT
5.1 Introduction
In paragraph 1.2 we defined the balance sheet 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 balance sheet.
This should be enough to show the difference between the two statements. The balance sheet
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 balance sheet?
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.
Income Statement for the year ended 31 December 20X1
£ £
Revenue X
Less cost of sales
Opening inventories on 1 January 20X1 X
Purchases X
Less closing inventories on 31 Dec 20X1 (X)
____
X
____
Gross profit X
Other income
Discounts received X
Rent receivable X
____
X
Less expenses
Administrative expenses
Rent X
Rates X
Lighting and heating X
Telephone X
Postage X
Insurance X
Stationery X
Office salaries X
Depreciation X
Accountancy and audit fees X
Bank charges and interest X
Irrecoverable debts X
Distribution costs
Delivery costs X
Van running expenses X
Van depreciation X
Advertising X
Discounts allowed X
____
(X)
____
Net profit X
____
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.
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
Gross profit margin = Sales x 100%
5.7 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 80,000
Cost of sales
Opening inventories 15,000
Purchases 70,000
Less closing inventories (25,000)
______
(60,000)
_________
Gross profit 20,000
_________
Gross profit margin 25%
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 balance sheet 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.
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
12 × £1,000 = 500
1 July 19X1 31 December 19X1
6
12 × £1,200 = 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) What is revenue less cost of sales?
(b) 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?
£………………………………………………………………………………………..
(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
………………………………………………………………………………...
Answers
(1) (a) Gross profit
(b) Net profit
(2) £120,000 (includes sales where customer has not yet paid).
(3) Opening inventories X
Add Purchases X
Less Closing inventories (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 300,000
Less Cost of sales (210,000)
_________
Gross profit 90,000
_________
Gross profit
Gross profit margin = Sales ×100%
90 , 000
300 , 000
= ×100% × 30%
(6) Period 1.1.X2 31.3.X2 £
3
= 3 months = 12 × 1,600 = 400
1.4.X2 31.12.X2
9
= 9 months = 12 × 2,000 = 1,500
________
Rates expense for the year ended
31 December 19X2 1,900
________
(7) (a) Capital
(b) Revenue
(c) Revenue
(d) Capital
(e) Revenue
(f) Revenue
(g) Neither a drawing (unless the car is being used on business).