Understanding Business Accounting For Dummies, 2nd Edition (38 page)

Prepaid expenses +15,000

Fixed assets
-25,000

Net increase of assets +£125,000

Changes in Operating Liabilities

Creditors (Accounts payable) +30,000

Accrued expenses payable +35,000

Income tax payable
+5,000

Less increase of operating liabilities -£70,000

Less increase of operating liabilities -£70,000

Non-cash components of profit +£55,000

Note:
The amounts shown in this summary are the
changes
- the increases and decreases - in the accounts caused by the sales revenue and expense transactions of your business during the year.

And there you have the story of the £60,000 profit - equal to the £5,000 increase of cash plus the £125,000 increase of non-cash assets minus the £70,000 increase in operating liabilities. Probably your biggest surprise here is that, even though your business earned £60,000 in profit for the year, your cash balance increased only £5,000. In managing your profit-making activities (sales revenue and expenses) during the year, you caused cash and three other assets to increase, one asset to decrease, and three operating liabilities to increase. Notice that we've put the onus on you, the owner or manager of the business. The point is that these increases and decreases don't happen automatically - they are the result of management decisions.

By the by, you may not like referring to expenses as profit-making activity but they are! The main point is that expenses should generate sales revenue. Advertising expense creates the incentive in customers to buy products sold by the business. Buying products at £60 cost per unit and selling them for £100 per unit generates £40 profit before other expenses are considered - even though the business has £60 of expense (cost of goods sold). Much of business profit-making is built on the model of incurring, say, £90 in expenses to generate, say, £100 in sales revenue.

Other transactions also change the assets, debt, and owners' equity accounts of a business - such as borrowing money and buying new fixed assets. The balance sheet, in other words, is changed by all the business's transactions. The profit-making transactions (sales and expenses) are the main transactions changing the balance sheet, but many other transactions are recorded in the asset, liability, and owners' equity accounts. Therefore, a separate summary of the profit-making transactions - limited to sales revenue and expenses - that ends with the profit for the period is a standard part of a complete financial report. This separate profit report is called the
profit and loss account
.

Reporting Profit to Managers and Investors: The Profit and Loss Account

At the end of each period, the accountant prepares a profit report called a
profit and loss account.
You may think that the report would be called the
net
profit and loss account
because the bottom-line profit term preferred by accountants is
net income
- but the word
net
is dropped off the title. Other variations of the term are also used, such as
statement of operating results
and
statement of earnings.
Traditionally, the profit and loss account has been called the
profit and loss statement,
or simply the
P&L
, although in external financial reports, businesses and accountants often use the term
income statement
.

The profit and loss account reports the business's sales and expense transactions for the period, with the final profit result on the bottom line. These transactions are
inflows
and
outflows
:
Sales revenue is an inflow, and expenses are outflows. Profit, the bottom line, is the
net
inflow. Please note that we didn't say
cash
flow. Making profit involves the inflows and outflows of many assets other than cash, as demonstrated in the steps in the profit-making process examined earlier in the chapter. In the business example earlier in the chapter, the earning of profit involved cash and four other asset accounts as well as three operating liabilities.

The annual profit and loss account included in an external financial report that circulates outside a business has two basic sections (or
layers
):

The first section presents the usual, ordinary, continuing sales and expense operations of the business for the year.

The second section presents any unusual, extraordinary, and non-recurring gains and losses that the business recorded in the year.

However, a business that didn't experience any extraordinary gains or losses wouldn't include that second section in its profit and loss account - its profit and loss account would consist simply of the first section.

Reporting normal, ongoing profit-making operations

The top section of a profit and loss account (which is the only section of the profit and loss account if the business doesn't have extraordinary gains or losses to report) typically breaks down total expenses for the year into at least four basic classes. (Refer to the sample profit and loss account at the end of this section for an example.)

Cost-of-goods-sold-expense:
The cost of the products sold to customers for which the company received the sales revenue reported on the first line of the profit and loss account. The profit line following the deduction of this expense from sales revenue is called
gross margin
(or
gross profit
) - that's your profit before you factor in the other expenses.

Note:
Companies that sell services rather than products (airlines, cinemas, accountancy firms and so on) often do not have a cost-of-goods-sold expense line in their profit and loss accounts.

Sales, administrative, and general expenses:
A broad, catch-all category for all expenses except those reported on the other lines in the profit and loss account. This expense combines such things as legal fees, the boss's salary, advertising costs, travel and entertainment costs, and much more - probably including some of the company's dirty laundry buried deep within.

The next profit line, which is generally called
earnings before interest and tax
and abbreviated EBIT, is the result after deducting the sales, administrative, and general expenses from gross margin.

Interest expense:
Interest paid on borrowed money (applies only to businesses that have borrowed money, obviously). This expense is usually reported on a separate line even though it may be relatively small. The profit line after deducting interest expense from earnings before interest and tax is typically called
earnings before income tax
or something similar
.
(Unfortunately, accounting terminology is not entirely uniform and standardised; you see variations from business to business.)