Creating a Profit and Loss Statement
Ask yourself the following questions:
- How are the products and services that I offer my customers affecting my business?
- Am I profiting, and if so how much, from these products and services that I offer?
To answer these questions, you need to look at an income statement, which:
- Provides detailed information about increases and decreases in your assets
- Exposes current and past trends
- Projects what your assets might look like in the future
- Identifies possible problem areas in your business.
Elements of Income
The elements of income are generally divided into four categories:
- Revenues - inflows or other enhancements of financial assets of your business. They may also be settlements of your liabilities from delivering or producing goods and services, or engaging in other activities that constitute your company's ongoing major or central operation.
- Expenses - outflows of assets or incurrence of liabilities from delivering or producing goods and services, or carrying out other activities that constitute your company's ongoing major or central operations
- Gains - increases in net assets from peripheral or incidental transactions and from all other transactions, events and circumstances affecting your company, except those resulting from revenues or investments by owners
- Losses - decreases in your company's net assets
Your income is measured as the resource inflows (revenue and gains) less resource outflows (expenses and losses) over a period of time. There most basic method to determine your income is the Transaction Approach, which compares the amounts used in revenue expenses, gains and losses. This method requires a clear definition of when the income elements should be recognized or recorded in the financial statement. In other words, you must know beforehand when your company will gain net assets and when to list them on your statement to provide the most beneficial use of those assets.
Revenue and Gain Recognition
Under the generally accepted accounting principle of accrual, revenue recognition does not always occur when cash is received. Generally, service organizations such as accounting firms, use the cash basis of accounting and only recognize income when they are paid by a client (not when the client was billed). For businesses that sell products and carry inventory, the recognition of a sale occurs when the product is sold, not when payment is received.
Expense and Loss Recognition
In order to determine your income, you must establish criteria for revenue recognition and the principles for recognizing expenses and losses must be clearly defined. Some expenses are directly associated with revenues. These expenses can be recognized in the same period as the related revenues. Other expenses are not associated with specific revenues. These expenses are recognized in the time period when they are paid or they are incurred. Still, other expenses are not recognized currently as expenses because they relate to future revenues; therefore, these expenses are reported as assets. Expense recognition, then, can be divided into three sub-categories: direct matching, systematic and rational allocation, and immediate recognition.
Expenses that are directly related to your revenues should be estimated and “matched” against recognized revenues for the accounting period. Your direct expenses include not only those expenses that have been incurred, such as shipping costs and sales commissions, but also anticipated expenses such as costs of collection, losses from uncollectable receivables, and warranty costs for potential product deficiencies.
Many expenses are incurred to obtain goods and services that indirectly help to generate revenue. Examples include office salaries, utilities, and general advertising and selling expenses. Since these goods and services are used almost immediately, their costs are recognized as expenses in the period of acquisition. Most losses also fit in the immediate recognition category since they arise from peripheral or incidental transactions not directly related to revenues. Examples of losses in the immediate recognition category include losses from disposition of used equipment, natural catastrophes (i.e., earthquakes or hurricanes), and losses from disposition of investments.
The methods you adopt for recognizing expenses and losses should appear reasonable to an unbiased observer and should be followed consistently unless the underlying conditions surrounding the assets change. Some expenses are related to the goods your company produces. These expenses may be deferred in inventory values if the goods are unsold at the end of an accounting period. Examples of expenses deferred in inventory values include depreciation on production machinery and plant insurance. Other expenses are related to accounting periods and should be allocated directly as an expense of the immediate time period. Examples of this include depreciation of delivery trucks and amortization of bond discount.
Changes in Estimates
When reporting periodic revenues and matching expenses incurred to generate those revenues, you must continually make judgments. The numbers you report in the financial statements reflect these judgments and are based on estimates such as the number of years of useful life for depreciable assets, the amount of uncollectable accounts expected, or the amount of warranty liability to be recorded on the books. Over time, estimates may need to be revised which will affect the income statement.
Cost of Goods Sold
Your cost of goods is equal the sum of your beginning inventory, net purchases, and all other buying, freight, and storage costs relating to the acquisition of goods. Your net purchases balance is developed by subtracting purchase returns and allowances and purchase discounts from gross purchases. Your cost of sold goods can then be calculated by subtracting your ending inventory from your cost of goods available for sale. When you manufacture your goods, additional elements enter into the cost. Aside from material costs, you will incur labor and overhead costs to convert raw material to a finished good. A manufacturing company has three inventories rather than one: raw materials, goods in process, and finished goods.
Operating expenses may be reported in two parts*:
- Selling expenses - sales salaries and commissions as well as related payroll taxes, advertising and store displays, store supplies used, depreciation of store furniture and equipment, and delivery expenses
- General and Administrative expenses - officers' and office salaries as well as related payroll taxes, office supplies used, depreciation of office furniture and fixtures, telephone, postage, business licenses and fees, legal and accounting services, and contributions
* Manufacturing companies should allocate charges related jointly to both production and administrative functions in an equitable manner between manufacturing overhead and operating expenses.
Other Revenues and Gains
Other revenue and gains include items identified with the peripheral activities of your company such revenue from financial activities (i.e., rents, interest and dividends) and gains from the sale of assets (i.e., equipment or investments).
Other Expenses and Losses
This section parallels other revenues and gains; however, the items result in deductions from, rather than increases to, your operating income. Examples include interest expense and losses from the sale of assets.
Income Tax on Continuing Operations
Your total income tax expense for a period is allocated to various components of your income. One amount is computed for income from your continuing operations, and separate computations are made for any irregular or extraordinary items you may find.
American Association of Certified Public Accountants, (AICPA), 1211 Avenue of the Americas, New York, N.Y.
Eric Press, "Analyzing Financial Statements" (Lebahar-Friedman, 1999)
Leopold Bernstein and John Wild, "Analysis of Financial Statements" (McGraw-Hill, 2000)
Martin Mellman et. al., "Accounting for Effective Decision Making" (Irwin Professional Press, 1994)
Peter Atrill and Eddie McLaney, "Accounting and Finance for Non-Specialists" (Prentice Hall, 1997)