Profit and loss account
Introduction
A large income is the best recipe for happiness I ever heard of.
JANE AUSTEN (1775–1817)
Introduction
Figure 4.1 identifies where the profit and loss account fits into the set of accounts. It is a link or bridge between the opening and closing balance sheets of an accounting period. Its function is to identify the total revenue earned and the total costs incurred over that period. The difference between these two values is the operating profit. It is, therefore, a document that relates to a very precise time period. There are many accounting rules to do with the identification of revenue and costs.
Total revenue earned
Total revenue earned is generally the amount invoiced and, in most situations, there is no problem with its accurate identification. However, if we receive cash today for a contract to supply a service over the next three years, when should we take that into our accounts as revenue?
Also, there could be more than one view on the subject of what constitutes total revenue in the second year of, say, a large, three-year civil works project. Finally, if we are an engineering company and we sell a warehouse, is that part of revenue?
Total costs incurred
The figure for total costs can give rise to even more intractable problems.
Two rules will help to identify costs that must be included:
- those costs that relate directly to the revenue, for example the direct cost of the goods sold; and
- those costs that relate to the time period covered by the accounts, such as staff salaries for the period.
Even with these rules, however, there are still many areas where the decision could go either way. Should research and development costs be charged in the year in which they were incurred? If we replace the factory roof in a period, is that correctly chargeable as a cost? We could question whether a particular depreciation charge is correct. The list can go on.
The statement of accounting policies attached to all published accounts will give some information regarding this aspect and it is wise to examine it before attempting an analysis of the financial statements.
Figure 4.1 Place of the profit and loss account in company
Profit and loss – general observations
In a situation where accountants can sometimes differ, it is not surprising that non-accounting managers go astray. One or two basic signposts will eliminate many problems that arise for the non-specialist in understanding this account.
The distinction between profit and cash flow is a common cause of confusion. The profit and loss account as such is not concerned with cash flow. This is covered by a separate statement. For instance, employees’ pay incurred but not yet paid must be charged as cost even though there has been no cash flow. On the other hand, payments to suppliers for goods received are not costs, simply cash flow. Costs are incurred when goods are consumed, not when they are purchased or paid for.
Cash spent on the purchase of assets is not a cost, but the corresponding depreciation over the following years is.
A loan repayment is not a cost because an asset (cash) and a liability (loan) are both reduced by the same amount, so there is no loss in value by this transaction.
In recent years, the question of extraordinary items has been much discussed. The issue here is whether large, one-off gains or losses should be included with normal trading activities. We can readily accept for analysis purposes the argument that these should be set to one side and not allowed to distort the normal operating results. This was the approach used in producing accounts for many years. However, in some companies, the rule was used selectively. Items became extraordinary or otherwise in order to present the desired picture. The rule has now been changed to avoid the possibility of distortion.
Finally the question of timing is vital. Having established what the true costs and revenue are, we must locate them in the correct time period. The issue mainly arises just before and just after the cut-off date between accounting periods. As shown in figure 4.2, we may have to move revenue or costs forwards or backwards to get them into their correct time periods.
Profit/loss – terms
Total revenue less total operating cost gives operating or trading profit. This is the first profit figure we encounter in the statements of account but there are many other definitions of profit.
We will identify four specific definitions and assign financial terms to them. These are related to the way profit is distributed.
All the assets used in the business have played a part in generating the operating profit to which we give the term ‘earnings before interest and tax (EBIT)’. Therefore this profit belongs to and must be distributed among those who have provided the assets. This is done according to well defined rules.
Figure 4.2 The profit and loss account – timing adjustments
Figure 4.3 illustrates the process of distribution or ‘appropriation’ as it is called in the textbooks. There is a fixed order in the queue for distribution as follows:
- to the lenders (interest)
- to the taxation authorities (tax)
- to the shareholders (dividends/retentions).
At each of the stages of appropriation the profit remaining is given a precise identification tag. Stripped of non-essentials, the following is a layout of a standard profit and loss appropriation account. When looking at a set of accounts for the first time it may be difficult to see this structure because the form of layout is not as regular as we see in the balance sheet. However if one starts at the EBT figure, it is usually possible to work up and down to the other items shown:
- EBIT – Earnings before interest and tax
Deduct interest - EBT – Earnings before tax
Deduct tax - EAT – Earnings after tax
Deduct dividend - RE – Retained earnings
(See appendix 1 for further discussion of unusual items.)
Figure 4.3 The profit and loss account – distribution or appropriation of profits
Working data
Throughout the various stages of the book we will work with three sets of data:
- The Example Co. plc has been devised with simple numbers to highlight various aspects of accounts and show the calculation of ratios (see figure 4.4).
- The US Consolidated Company Inc. (see figure 4.5).
- Sectoral/geographical data (see appendix 3).
The Example Company plc
Figure 4.4 shows for the Example Company plc:
- the balance sheet
- the profit/loss account
- share data.
It is worth while spending a moment looking over the now familiar five-box balance sheet and the structured profit/loss account to become familiar with the figures. They will be used a lot in the following chapters.
Please review the following items:
Balance Sheet
- Fixed assets
- Current assets
- Current liabilities
- Long-term loans
- Owners’ funds
Profit/Loss Account
- EBIT
Interest - EBT
Tax - EAT
Dividends - RE
Figure 4.4 Working data – the Example Co. plc
The US Consolidated Company Inc.
This company is made up of an aggregate of the accounts of approximately 40 large successful US public companies drawn from different business sectors. These companies are flagships of US industry and they have been selected to provide aggregate data for the calculation of ratios that can be used as standards or norms for good industrial performance (see appendix 2).
The balance sheet and profit/loss account for the year 2000 are laid out according to our agreed structure in figure 4.5. We will use these for setting targets of performance.
The aggregate stockmarket value of these companies in mid-2001 was $1,876.5 bn.
Sectoral/geographical data
In addition to the above, almost 200 high-profit companies from different business sectors and four geographic areas have been selected to indicate the types of variation that arise in different types of operation in different locations. These business sectors are:
- health care
- food
- machinery and equipment
- retail.
The locations are:
- US
- UK
- EU
- Japan.
This produces 16 subgroups for which results are compared and reported in graphical form throughout the book.
Figure 4.5 Working data – the US Consolidated Company Inc.
