Profit and Loss Account or

Income Statement

MANAC I
Basic Concepts Covered:
1. Money measurement.
2. Entity.
3. Going concern.
4. Cost.
5. Dual aspect.
6. Accounting period.
7. Conservatism.
8. Realization.
9. Matching.
10. Consistency.
11. Materiality
12. Diversity among independent entities
13. Dependability of the data
14. Property Right concept
 Balance Sheet - Review

 Status report.
 Financial position at point in time.
 Assets = liabilities + shareholders’ equity.
Financial Statements and Financial
Accounting
 Financial Statements are the products of
Accounting

 HOW ARE YOU ?

 HOW ARE YOU DOING ?

 Accounting is an important support function for

monitoring business.
Payments Receipts

Results = Profit
Loss

- there is a limit to the accuracy of

such a crude estimation
Examples………

 For instance, a businessman who takes a loan from

a bank may, in the absence of any accounting
knowledge, merge all receipts from customers with
the bank loan receipts, and call the resultant figure
the ‘total income’ for the period
 In another instance, the same businessman may
acquire some equipment for long-term benefits but,
merge all payments relating to day-to-day expenses
with the total cost of the equipment to cal the
resultant figure the ‘total expenses’ for that period

 Is it right to say that Total Income – Total Expenses=Profit

Learning's……

 All Receipts cannot constitute a part of Income

(Some are liabilities or owners equity called Sources
of Funds)
 All Payments cannot constitute a part of Expenses
(some are Assets called as Applications of Funds)

 Benefits are called as Assets or Application of Funds

 Sacrifices are called Liabilities and Owner’s equity or
Sources of Funds
Learning's……

 Benefits are called as Assets or Application

of Funds
 Sacrifices are called Liabilities and Owner’s
equity or Sources of Funds

 Hence, it is necessary to isolate Incomes from

Sources of funds and Expenses from Application
of funds
 Kutty’s Cabs Case
List of Transactions for Rewanchal Software Ltd. (RSL)
 On March 1, Rewanchal & others invest Rs. 50,000 in cash in RSL.

 On March 2, Rewanchal took a loan of Rs. 20,000 from Venu for RSL.

 On March 3, RSL purchased for cash two computers, each costing Rs.
29,000.
 On March 4, RSL purchased supplies for floppy disks and stationary
for Rs. 6,000 on credit.
 On March 19, RSL completes its maiden sale of software to a retail
store and receives a price of Rs. 12,000.
 On March 21, RSL pays Rs. 2,000 to its creditors for supplies.

 On March 29, RSL pays salaries to its employees, amounting to Rs.

4,000 and as office rent Rs. 1,200.
 On March 30, RSL completes a software package for a shoe shop.
The customer agrees to pay the price of Rs. 8,000 a week later.
 On March 31, Rewanchal withdraws Rs. 3,500 for his personal use.
Questions asked by owners/managers

 Was it a good year or bad year?

 What was the volume of operations?
 What was the margin available on sales realization?
 The answer…

Profit and Loss Account

or
Income Statement
10
Profit and Loss Account

 While a Balance Sheet

 Reports value of assets, liabilities and owners

equity at a particular point in time

 And Reflects net change in owner(s) equity
brought about by operations
 A Profit & Loss Account shows a company's
earnings and expenses over a given period of
time
 It exclusively summarizes revenue and expenses
of the period and shows the net difference i.e.,
profit or loss of the period
Example 1

 Prepare income statement from the following

 Professional fee income 50,000
 Telephone expense 5,000
 Salaries expense 10,000
 Rent expense 12,000
Example 2

 Prepare income statement from the following

 Professional fee income 26,000
 Telephone expense 5,000
 Salaries expense 10,000
 Rent expense 12,000
Basic Concepts Covered:

1. Accounting period.
2. Conservatism.
3. Realization.
4. Matching.
5. Consistency.
6. Materiality.

 Related to Profit and Loss Account

Accounting Period

 Net income for life of company:

 = Money in - money out

 Accounting period:
 Specified arbitrary interval of time.

 Accounting year
Example

 In January 2013 IIMK agrees to buy a new

Mini Bus from KTC Automobile for delivering
in August 2013. Although this is a good news
to KTC Automobile, it may also possible that
something will go wrong and the sale will not
be materialized.
Concepts …

 Therefore, conservatism concept requires that the revenue not

be recorded, that is, recognized, until the Mini Bus is actually
delivered.

 Conservatism
 “Anticipate no gains, but provide for all possible losses” and
“if in doubt, write it off”
 Results in an understatement of profits and values

 Close nexus with idea of ‘capital maintenance’

 Recognize revenues only when they are reasonably certain

 Recognize expense as soon as they are reasonably possible

Conservatism

 “… prudent reporting based on healthy

skepticism… builds confidence in the
results....”
 Preference for understatement rather than
overstatement of assets and earnings (and
Owners’ equity).
 If 2 estimates are equally likely, use the one that
results in smaller assets and earnings.
Conservatism: More Formally

 Recognize revenues when reasonably

certain.
 Recognize expenses when reasonably
possible.

 Requires judgment.
Application of Conservatism: Inventory

 How much should the following inventory items

be valued at 12/31:
 Cost of item A is $500. We could sell item A

for $800.
 Cost of item B is also $500. Because of a new

competitor’s product on the market, item B can

be sold for only $400.
 Example of lower of cost or market (LCM).
Example

 During the football season, you went to QRS

shop for buying a LCD TV whose listed price
is Rs.29,900. But, you get a special offer
price of Rs. 24,000
 In this case, revenue is the amount at which
the sale is made, rather than the list price.
 So in this case……………..?
Accounting Concepts

 Realization
 Determines the point of time when revenue
and hence returns (or profits) can be
recognized objectively, unbiased, and with
certainty
Realization

 Indicates amount of revenue that should be

recognized.
 Conservatism concept indicates when revenue
should be recognized.
 Recognize as revenue:
 Amount that is reasonably certain to be realized.

 Realized = cash received.

Accounting Concepts

 Matching
 Determining the profits after charging the
expenses of a period with the revenues
earned in the same period

 Consistency
 Once a choice is made for the treatment of a
transaction, the same is consistently
followed
Consistency

 Once an accounting method is selected use

for all subsequent events of same character.
 Can change if there is sound reason to
change.
 Must be disclosed to users.
 Consistency overtime not over different types
of transactions.
Materiality

 Insignificant events may be disregarded.

 Amounts need not be exact as long as inaccuracy
would not affect decisions of users.
 Full disclosure of all important info.
 Overriding concern: Would knowledge of
event affect decisions of users?
 Application of judgment and common sense.
Measurement of Income

Identify Identify Match identified

realized related revenues and
revenues costs expired costs

 Comparing the revenue from sales against the cost of

resources parted with for earning that revenue
Illustration …

 Mr Khan starts his business on 1st July. He took a loan of

Rs. 1,00,000/- from bank @ 12% per annum for
purchasing plant & machinery, on the same day. The
machine has a life of 10 years with no scrap value. He
also paid Rs. 60,000/-, three months rent in advance
 Bank borrowing does not represent revenue – increase in cash
is offset by an increase in liabilities
 Interest (Rs. 1000) depreciation (Rs. 833/-) are accrued
expenses for July
 Rent expense for July will be Rs. 20000/-
Illustration …

 Khan had written orders worth Rs. 2,00,000 in the month of

June itself (even before starting his business). He started the
production accordingly; the total production cost was Rs.
1,20,000; sales of merchandise to its customers till 31-07-2006
are as follows:
 Total Sales = Rs. 95,000 (Cash Sales 25,000 and Credit
Sales to Rajesh Rs. 70,000)
 Sales for June:
 Nil – Because revenue is recognized only when goods are

sold to the customers and not on receiving the order or on

incurring the production cost
Solution

 Sales for July:

 Rs 95,000

 Accounting equation would be:

 Cash + Debtors = Liabilities + Owner(s) Equity

 25,000 + 70,000 = 0 + 95,000

 When Rajesh pays Rs. 70,000 in August

 Sales does not occur

 Cash would increase by Rs. 70,000 and the

debtors would decrease. The amount of owner(s)

equity remains same
Accrual Principle

 It is a generally accepted accounting principle

(GAAP)
 Evaluates every transaction in terms of its impact on
owner(s) equity
 Implies recognized revenue results in increase in
owner(s) equity and expired costs or recognized
expense results in decrease in owner(s) equity
 Net income arises from events that change
owner(s) equity in a specified period which are not
necessarily the same as change in the cash position
Accrual Vs Cash Basis

Basis of
Accrual Basis Cash Basis
Accounting
Revenue When cash is
When earned
collected
Expense When cash is
When incurred
paid
GAAP
Yes No
Compliance
Illustration

 We purchase merchandise worth Rs. 1,000 during

the period; sell one half of this during the period for
Rs. 750. Rental for the facilities during the period
was Rs. 200
 Discussion…

Item Remarks
Cost of inventory Rs 1000 The purchase prices of the merchandise.
Increase in owners equity i.e., The sale proceeds realized in exchange of one
Revenue Rs 750 half of the merchandise.
Expenses i.e., expiration of The cost of the merchandise parted with in
inventoriable cost Rs 500 exchange for the revenue. The cost with respect
to the revenue earned and hence expired cost.
Expenses i.e. expiration of The cost of rent for the facility is a cost incurred
non-inventoriable cost Rs 200 during the period and expiring during the period
i.e., a period cost.
Ending Inventory Rs 500 The unexpired cost. An asset merchandise
inventory, as a convention valued at cost.
 Accounting Period

• A convenient segment of time, to collect,

summarize and report all information on the material
changes in owner(s) equity during the period
• Realization and Accrual principle will have to be
applied in the context of the accounting period
t0 Accounting period -1 t1 Accounting period -2 t2
Profit & Loss
Profit & Loss
Balance Balance Account for the Balance
Account for the first
Sheet 0 Sheet 1 second accounting Sheet 2
accounting period
period
 Links in the information chain which makes up the life
of the enterprise
Matching Revenues & Expenses

 The entire process of periodic earnings

measurement
 Means deducting from revenues of a period the cost
of goods sold or other expenses that can be
identified with such revenues, or of that period, on
the basis of a cause and effect relationship
 The expenses to be matched against the revenue of
the period will be all those costs expiring during the
accounting period
Revenue

 Broadly, it is the total amount realized from the sale

of goods (or provision of services) together with
earnings from interest, dividend, rents and other
items of income
 ‘Operating income’ Vs ‘non-operating income’
 Implication of Realization Principle
 If the right to receive that income is created or

the time for which the income relates have

expired it is accrued income
Characteristics of Revenue

 Normally, generated out of business activities

 Results in inflow of assets (cash or receivable) and
outflow of goods or services
 Usually related to a specific period i.e., revenue of
one year cannot be included in revenue of the
other year
 Leads to increases in owner(s) equity
 Different from ‘profit’ or ‘net income’
Expense

 The expiration of the assets and the resultant

decrease in assets leading to the decrease in
owner(s) equity
 Costs incurred and expired in connection with the
earning of revenue
 Sacrifice made or resource consumed in relation to
the revenues earned during an accounting period
 Costs that have expired during an accounting period
are treated as expense
 The expired cost, directly or indirectly related to a
given fiscal period
Characteristics of Expense

 Expenses are incurred for the purpose of

generating revenue or benefit
 Benefit is usually derived during the same
accounting period under consideration
 It is related to a particular period. However, the
payment of expenses can be made before the
recognition of expense or afterwards
 Leads to decreases in owner’s equity
More on expenses…

Expenses of a given period are

 Costs and expenses of current accounting period
 Costs incurred in a previous accounting period that
become expenses or expired costs during this year
(such as prepaid rent and prepaid insurance)
 Expenses of this year, the monetary outlay for which
will be made during a subsequent period (such as
salaries payable and taxes payable)
Expense recognition

Under following circumstances:

 In the period in which there is direct identification or
association with the revenue of the period
 An indirect association with the revenue of the
period
 Measurable expiration of assets (unexpired costs)
though not associated with the production of
revenue for the current period
 Assets that become expenses: inventories, prepaid
expenses, and long-lived assets
 Profit & Loss Account Preparation

 It is a summary of all ‘accounts’ dealing with transactions relating

to revenue and expenses
 Done by summarizing all individual accounts accumulating
information on different items relating to the elements of ‘expense’
and ‘revenue’
Assets = Liabilities + Contributed Capital + Revenue – Expenses – Dividends
A = L + C + R - (E + D)
 ‘Revenue - (Expenses + Dividends or Drawings)’ is equal to the ‘Retained
Earnings’
Example 3

 Prepare classified income statement from the

following
 Sales 30,000
 Sales returns 5,000
 Cost of goods sold 7,000
 Operating expenses 8,000
 Interest income 4,000
Example 4 - XYZ Corp had following information as of
December 21, 2012

 Equipment 15,000  Cost of goods sold

 Cash 10,000 18,000
 Sales 30,000  Sales commissions 5,000
 Capital stock 10,000
 Accounts Payable 9,000
 RE (Jan.1) 4,000
 Advertising exp 2000
 Dividends 3,000
Example 4 - XYZ Corp had following information as of
December 21, 2012

Profit = 2,000 B/S total=25,000

 Equipment 15,000  Cost of goods sold

 Cash 10,000 18,000

 Sales 30,000  Sales commissions 5,000

 Capital stock 10,000

 Accounts Payable 9,000  SOLUTION:

 RE (Jan.1) 4,000  A(15+10)=L(9)+CC(10)+
 Advertising exp 2000
R(30)-E(2+18+5)-
D(3)+RE(4 for next
 Dividends 3,000
month)
See Handout for

 Profit and Loss Account of companies