session 3

LMT SCHOOL OF MANAGEMENT, THAPAR UNIVERSITYMasters of Business Administration

Course: Financial Reporting and AnalysisFaculty: Dr. Sonia Garg (Email: [email protected])

Session 3: Understanding Financial Statements: Profit and Loss Statement

Duration: 60 minsSlides: 13

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Certain concepts • Accounting Period: Accounting measures activities for a specified interval

of time, called the accounting period

• Conservatism: Prudent reporting based on a healthy skepticism builds confidence in the results and the long run, best serves all divergent interests (anticipate no profits but anticipate all losses)– Recognize revenues only when they are reasonably certain– Recognize expenses as soon as they are reasonable

• Realization: The conservatism concept suggests the period of recognition whereas the realization concept suggests the amount of revenue that should be recognized (that is reasonably certain)

• Matching: When a given event affects both revenues and expenses, the effect on each should be recognized in the same accounting period

Understanding Financial Statements: Profit & Loss Statement

21/04/2023 Understanding Financial Statements: Profit & Loss Statement

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Income• It represents the increase in economic benefits during the

accounting period, in the form of inflows or increase in asset or a decrease in liability

• Both revenue and gains are part of income– Revenue arises from ordinary business activities e.g. sales, fees,

interest, dividends, royalties, rent, etc.– Gains represent all items that are income but not revenue e.g. gain

from disposal of fixed asset

• Recognize income when there is an increase in future economic benefits by an increase in asset (cash/ account receivable) and a decrease in liability (waiver of account payable)

Premium received on issue of shares is not income; its equity recorded under Reserves a& Surplus


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Expenditure & Expenses• Cost: monetary measurement of the amount of resources used for

some purpose

• Expenditure: decrease in asset or an increase in liability associated with the incurrence of cost

• Expense: item of cost applicable to current accounting period

• When an expenditure is made, the related cost is either an asset or an expense. If it benefits future periods it is an asset else it is an expense.

• Dividends are not expenses, they are distribution of net income


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Recognition of expenses

• Costs associated with the activities of the period are expenses of the period

• Costs that cannot be associated with the revenues of future period are also expenses of the period

1. Direct matching2. Period costs3. Costs not associated with future revenue


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Possible Transactions• Expenditures of this year that are also expenses of this year (Item acquired and

consumed)

• Expenditures of prior year that become expenses during this year, they were assets on the B/S at the beginning of the year– Inventories– Prepaid expenses– Long-lived assets (depreciation)

• Expenditures of this year that will become expenses in future years (e.g. product costs that become part of inventory)

• Expenses of this year that will be paid in future years– Accrued wages (or wages payable)– Accrued interest (of interest payable)

Recognize as expense in P/L

Recognize as expense in P/L and reduce the asset in B/S

Recognize as asset in B/S

Recognize as expense in P/L and as liability in B/S


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Simple Profit and

Loss Statement

GARSDEN CORPORATIONIncome Statement

For the year ended March 31, 2014

Net Sales Rs. 75478221

Cost of Sales (52227004)

Gross Margin 23251217

Research and Development Expense (2158677)

Selling, General and Administrative Expense (8726696)

Operating Income 12365844

Other Revenues (Expenses):

Interest Expense (363000)

Interest and Dividends Revenue 43533

Royalty Revenues 420010

Profit before tax (PBT) 12466387

Provision for Income Tax (4986555)

Net Income 7479832

Statement of Retained Earnings

Retained Earnings at the beginning of the year 16027144

Add: Net Income 7479832

Deduct: Dividends 4390000

Retained Earnings at the end of the year 19116976


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Gross Sales and Net Sales

• Gross Sales is total invoice price excluding taxes. Taxes are not revenues, they are collections that business makes on behalf of the government

• Sales returns and allowances value of goods returned and allowance for defective goods

• Sales discount is the discount for prompt cash payment

• Trade discounts are discounts on catalog prices reduced to form the actual selling price, these are not recorded

Detail of Net Sales Gross Sales 77157525Less: Returns and discounts (528348)Less: Sales Discounts (1150956)Net Sales 75478221


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Other Items in P/L Statement• Cost of sales is the cost of goods and services sold as per the matching concept

(product costs)

• Gross Margin is the difference between the net sales and the cost of sales

• Expenses like R&D and Selling and Administrative are period costs

• Both product and period costs when reduced from net sales give the operating income

• Net Income is found by reducing the operating income by interest expense and provision for income taxes

• Net Income is added to retained earnings

• Retained earnings relate P/L to B/S


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PROBLEMSProblem 3-1a. Not an expense for June - not incurredb. Expense for Junec. Expense for Juned. Expense for Junee. Expense for Junef. Not an expense for June - asset acquired

Problem 3-2Revenues = $275,000Expenses: Cost of goods sold $164,000

Rent 3,300Salaries 27,400Taxes 1,375Other 50,240

246,315

Net income = 275,000 - 246,315 = $28,685


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Problem 3-3Beginning inventory 27,000Purchases 78,000Available for sale 105,000Ending inventory (31,000)Cost of goods sold 74,000

Problem 3-4(1) Sales $85,000 Cost of goods sold 45,000 Gross margin $40,000

(2) Gross Margin = (40,000 / 85,000)*100 = 47%(3) Profit Margin = (9000/85000)*100 = 11%

The Woden Corporation had a tax rate of 40 % [($6,000 / $15,000)*100] on its pretax profit that represented 17.7 % of its sales [($15,000 / $85,000)*100]

The company’s operating expenses were 82.3 % of sales [($70,000 / $85,000)*100] and its cost of goods sold was 53% of sales


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Problem 3-5a. Depreciation. Each year for the next 5 years depreciation will be charged to income.b. No income statement charge. Land is not depreciated.c. Cost of goods sold. $3,500 charged to current year’s income. $3,500 charged to next year’s

income.d. Subscription expense. $36 charged to current year. $36 charged to next year. Alternatively,

$72 charged to current year on grounds $72 is immaterial.

Problem 3-6Asset value:October 1, 20X5 $30,000December 31, 20X5 26,250December 31, 20X6 11,250December 31, 20X7 0Expenses:20X5 $3,750 ($1,250 x 3 months)20X6 $15,000 ($1,250 x 12 months)20X7 $11,250 ($1,250 x 9 months)One month’s insurance charge is $1,250 ($30, 000 / 24 months)


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Problem 3-7• Truck purchase has no income

statement effect. It is an asset.

• Sales are recorded as earned, not when cash is received.

• Bad debt provision of 5 percent related to sales on credit ($33,400 - $20,500) must be recognized. Wages expense is recognized as incurred, not when paid.

• March’s utility bill is an expense of March when the obligation was incurred.

• Income tax provision relates to pretax income. Must be matched with related income.

session 3

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