Income statement and balance sheet form part of the financial statements of an organization. This chapter will focus on the income statement. We all know that businesses exist for making profits. The calculation of profits and losses is therefore vital. The owners or management will want to know the profits for multiple reasons. They may need to know profits to compare the actual profits with what they expected (and probably make change to the business strategy), to convince banks they can pay interest obligations as they fall due, to ascertain how much they can draw from the business, to calculate taxes or to convince someone who wants to buy the business about the success of the business. The profits are calculated by drawing up an “Income statement"(also known as profit and loss account). The first part of the income statement consists of calculating the gross profit. Gross profit is the amount by which the sales revenue exceeds the cost of goods sold (Goods that have been sold to generate that revenue). If the cost of goods sold exceeds the sales revenue, it results in a “Gross loss”. The second part of the income statement consists of calculating the Net profit. Net profit, consists of the gross profit plus revenues other than sales revenue for example interest received from a bank account, or rent recieved less the total expenditure incurred during the period other than the cost of goods sold. If the expenditure incurred is greater than the gross profit plus other revenue, it results in a “Net Loss”. Let us now see how the income statement is drawn. The gross profit is calculated using the formula Sales - Cost of Goods Sold = Gross Profit. The required information to draw the first part of the income statement (also known as trading account) can be found in the trial balance. Let’s assume that following is the trial balance of Bourne Brothers at the end of their first year in the business:
It is not necessary that all goods that were purchased have been sold. The purchases figure therefore includes an amount that represents goods that were unsold at the end of the period. The unsold goods (known as closing stock) will therefore need to be deducted from the purchases figure before calculating the gross profit. The closing stock can be found out by physically counting the stock. The physical count of stock is known as stock take. Let's assume that the unsold stock is $2,500. The opening stock figure will need to be added to the purchases figure. In the case of Bourne brothers this figure is nill since it is the first year of trading.
After having calculated the gross profit we can construct the first part of the income statement. To do this we need to close off the sales and purchases accounts at the end of the period so that they start the next period with no balance. To do so, we need to create a trading account and then make the following entries:
(a) The sales account balance is transferred to the trading account by:
1 Debiting the sales account (thus closing it).
2 Crediting the trading account.
(b) The purchases account balance is transferred to the trading account by:
1 Debiting the trading account.
2 Crediting the purchases account (thus closing it)
(c) An entry needs to be passed in the books for the closing stock with the following entry:
1 Debit a closing stock account with the value of the closing stock.
2 Credit the trading account (thus completing the double entry).
The Trading account will look like this:
The trading account is now closed off. Since the sales revenue exceeds the costs the balance is called “gross profit” It is not called “balance”, and is not brought down to the next period.
The other accounts used in these double entries appear as shown below. To keep from unnecessarily complicating things lets assume we have not been given information of entries before the year end, all we have been given is the closing balances. Lets call the closing balance simply 'balance'.
Note that the entry of the closing stock on the credit side of the trading account is actually a deduction from the purchases on the debit side. Later you will see in the Income Statement that the closing stock is shown as a deduction from the purchases and the figure then disclosed is described as 'cost of goods sold'.
Just like the trading account we will now draw up a profit and loss account, firstly transferring the gross profit from the trading account to the credit of the profit and loss account. The entry in the trading account will now be changed to read 'Gross profit transferred to profit and loss':
Then, any revenue account balances, other than sales (for example rent received, bank interest received), are transferred to the credit of the profit and loss account. To keep things simple let’s assume no such revenues are received. The expenses of the year are then transferred to the debit of the profit and loss account. The profit and loss account will now look like this:
The expense accounts closed off will now appear as follows:
We will now prepare the income statement for the year ending 31 December 2010.
Consequences for the Capital Account
No credit entry has yet been made for Net Profit of $100 which is being shown as the balancing figure in the profit and loss account. Normally the credit entry would be the “balance b/d” at the commencement of the following period, but because the net profit increases owners equity (capital), the account credited will be the capital account. Therefore the entry in the profit and loss account will be changed to read “Net profit transferred to capital”. The trading account and the profit and loss account and all the revenue and expense accounts, can thus be seen to be serving the purpose of saving the capital account from being littered with unnecessary detail. Profit increases the capital whereas loss decreases the capital. Therefore, instead of littering the capital account after each transaction, the respective items of profit and loss, and of revenue and expense, are gathered in appropriate accounts and then brought together in the income statement and the increase in the capital, i.e. the net profit, is determined (in the case of a net loss, the decrease in the capital is determined)
Drawings Account
A separate drawings account is used for the same purpose; avoiding unnecessary detail in the capital account. There will be only one figure for drawings entered in the debit side of the capital account. This figure will be the total of the balance in the drawings account.
The Capital account and drawings account will now look as follows:
Note that the word balance is used in the drawings account since we do not know the actual drawings that took place during the year.