Statement of Profit or Loss (income statements)

An income statement is a financial document of the business that records all income generated
by the business as well as the costs incurred by the business and thus the profit or loss made
over the financial year. It tells managers and shareholders if the business is profiting.
(The brackets mean we minus from the number above.)

The income statement will consist of :

Sales revenue = total sales ( the total amount of cash made from sales before deducting costs)
Cost of Sales = total variable cost of production + (opening inventory of finished goods –
closing inventory of finished goods)
Cost of goods sold = opening balance + purchases - (closing balance)
Gross Profit = Sales Revenue – Cost of Sales
Expenses = all overheads/fixed costs
Net Profit = Gross Profit – Expenses
Profit after Tax = Net Profit – Tax
Dividends = share of profit given to shareholders; return on shares
Retained Profit for the year = Profit after Tax – Dividends.
These retained earnings are the kept aside for use in the business.
( So retained profit is the money left over once costs, taxes and dividends have been deducted.)

Amending an income statement / statement of profit or loss

●​ This may be necessary due to errors or changes in accounting policies or estimates.
●​ The process of amending a statement of profit or loss involves identifying and correcting
the errors or changes, adjusting the financial figures accordingly, and reissuing the
statement of profit or loss.
●​ The amendment should include a clear explanation of the reason for the change and the
impact it has on the financial results.
●​ It's important to note that amendments should be made as soon as possible after an
error or change is discovered to ensure the accuracy of financial information.
●​ Failure to correct errors or changes in a timely manner can lead to misinterpretation of
financial results and can erode stakeholder confidence in the organization's financial
reporting.

The impact on the statement of profit or loss a given change

There are many changes that could impact the statement of profit or loss, but here are a few
examples :
●​ Change in revenue: An increase in revenue would result in a higher gross profit and net
profit, while a decrease in revenue would lead to the opposite. For instance, if a
 company introduces a new product that becomes very popular, its revenue will increase,
and this will lead to a higher gross profit and net profit.
●​ Change in cost of sales: A decrease in cost of sales would result in a higher gross
profit and net profit, while an increase in cost of sales would lead to the opposite. For
example, if a company discovers a more cost-effective way to produce its products, it
could reduce its cost of sales and increase its gross profit and net profit.
●​ Change in expenses: An increase in expenses would lead to a lower profit from
operations and net profit, while a decrease in expenses would lead to the opposite. For
instance, if a company decides to expand its marketing budget, this would increase its
expenses and lower its net profit.
●​ Change in taxation: An increase in taxation would lead to a lower profit for the year,
while a decrease in taxation would lead to the opposite. For example, if a government
introduces a new tax that applies to a company's products, this would increase its
taxation and lower its profit for the year.

Revenue expenditure:
They provide short term benefit, helping to meet the ongoing operational costs of running a
business.
Generally any expenditure on costs other than non-current assets
They will ALL be recorded in FULL on each year’s statement of profit or loss.

Capital expenditure:
Any item bought by a business and retained for more than one year, that is the purchase of
fixed or non-current assets
Not recorded in full on statement of profit or loss
Recorded on statement of financial position as an increase in non current fixed assets and
increase in how it was financed (such as loan)

Depreciation
The decline in the value of a non-current asset over time.

Depreciation is the process of allocating the cost of a tangible asset over its useful life. It is an
accounting method used to reflect the declining value of an asset over time.

The role of depreciation in the accounts is to spread the cost of a long-lived asset over its
useful life, rather than recording the entire cost as an expense in the year of acquisition. This
helps to match expenses with revenues in the periods in which the asset is used to generate
revenue. Depreciation also reflects the idea that assets wear out, become obsolete, or lose their
value over time.

For example, suppose a company purchases a machine for $50,000 that is expected to last
10 years. The company can depreciate the machine over its useful life, which means it can
allocate $5,000 of the machine's cost to each year of its useful life. This way, the company
can expense $5,000 each year of the machine's use, rather than recording the entire $50,000
as an expense in the year of purchase.

Depreciation can have a significant impact on a company's financial statements. It reduces the
value of the asset on the balance sheet over time and also reduces the company's reported
profits on the income statement, as depreciation expense is recorded as an operating expense.
Straight line depreciation

●​ Residual value, also known as salvage value, is the estimated value of an asset at the
end of its useful life.
●​ It is the amount that the company expects to receive by selling the asset after it has
been fully depreciated.
●​ In straight line depreciation, the residual value is deducted from the cost of the asset to
determine the depreciable base, which is then divided by the estimated useful life of the
asset to determine the annual depreciation expense.
●​ Straight line depreciation affects both the statement of financial position and income
statement in different ways.
Depreciation makes changes on statement of financial position
1.​ Net book value: Historical cost - accumulated depreciation value (deduct from value of
the asset)
2.​ Listed as a non-cash expense (reduce from retained earnings from the statement of
profit or loss)

Valuing Inventory
Inventory must be recorded at
●​ historical cost price (what you originally paid for it)
●​ or net realisable value
whichever is lower

Inventory refers to the stock of goods and materials that a business holds in order to meet
customer demand. It includes raw materials, work-in-progress items, and finished goods that are
ready for sale. Inventory is important for several reasons, including:
●​ Meeting customer demand: By having inventory on hand, businesses can quickly fulfill
customer orders and avoid stockouts.
●​ Production planning: Businesses can use inventory levels to plan their production
schedules and ensure they have the necessary materials and components to meet
production targets.
●​ Cost management: Inventory represents a significant investment for many businesses,
so managing it effectively is important for controlling costs and maximizing profits.
●​ Risk management: Holding inventory can help businesses manage risks such as supply
chain disruptions, unexpected demand changes, and production issues.

Why is it difficult to value inventory?

Inventory valuation can be difficult due to various reasons:
●​ Cost Fluctuations: The cost of inventory items can change frequently, making it
challenging to maintain a consistent valuation method. For example, the price of raw
materials can vary based on market demand or supply chain disruptions, making it
difficult to determine the actual value of the inventory.
●​ Obsolescence: Inventory items can become obsolete, especially in industries that rely
on technology. For example, a company that produces smartphones may have inventory
 that becomes outdated as new models are released, making it difficult to determine the
value of the obsolete inventory.
●​ Damaged or Lost Inventory: Inventory items may be damaged, lost or stolen, leading
to discrepancies in inventory records. This makes it difficult to determine the actual
quantity and value of inventory on hand.
●​ Depreciation: Inventory items that are not sold immediately can lose value due to
depreciation, making it difficult to determine their current value.
●​ Different Valuation Methods: Different valuation methods, such as First-In-First-Out
(FIFO) and Last-In-First-Out (LIFO), can lead to different inventory valuations. This
makes it difficult to compare the financial performance of companies that use different
valuation methods.

For example, let's say a clothing retailer has inventory that includes various types of clothing
items purchased at different times and prices. If the company uses the FIFO method, it assumes
that the oldest items in inventory are sold first, and the newest items remain in inventory.
However, if the company uses the LIFO method, it assumes that the newest items are sold first,
and the oldest items remain in inventory. This can lead to different inventory valuations and
affect the company's financial statements.

Overall, inventory valuation can be difficult due to various factors, and it is important for
businesses to maintain accurate inventory records and use consistent valuation methods to
ensure accurate financial reporting.

Net Realisable Value Method

The amount for which an asset (inventory) can be sold, deducting any additional costs incurred
in selling it - it is only used on the statement of financial position when NRV is estimated to be
below the historical cost.

Net realizable value = Final S.P - Expenses incurred to bring an asset in saleable condition

The net realizable value (NRV) method is a way to value inventory that works by :
estimated selling price of goods (-) the estimated costs to complete and sell them.
It is a conservative approach that assumes a lower value for inventory, compared to the cost
method.
●​ The NRV method works by taking the estimated selling price of inventory, subtracting
any estimated costs of completing or selling it, and arriving at a net realizable value.
●​ This net realizable value is then compared to the original cost of the inventory to
determine if there has been any decrease in value.

For example, suppose a company has inventory that cost $10,000 to purchase, but due to
market conditions, it is estimated that the inventory can only be sold for $8,000. Additionally,
there are estimated costs of $1,000 to complete and sell the inventory. Using the NRV method,
the net realizable value of the inventory would be $7,000 ($8,000 selling price - $1,000
estimated costs), which is lower than the original cost of $10,000.

The limitations of the NRV method include the subjectivity of the estimates used to arrive at the
net realizable value, which may be influenced by factors such as market conditions, competition,
and changes in technology. Additionally, the NRV method may not be suitable for all types of
inventory, such as unique or specialized items with limited markets.