1. Managing Finance and Budgets
Lecture 5
Profit & Loss Accounts

2. Session 5 – Learning Outcomes
Understand the terms within the Profit & Loss Account, and be able to interpret a Profit & Loss account relating to a particular organisation.
Be able to discuss certain key issues:
Cash versus Profit
Capital/Revenue expenditure
Depreciation
Cost of Sales & Valuation of Stocks
Provision for Bad Debt.

3. Presentation 5 – Menu Section A Profit & Loss: Some Terms
B The Profit & Loss Account Format
C Profit & Loss: Some Issues
D Preparation for Seminar 5

4. Section A The Profit & Loss Account

5. The Profit and Loss Account
In Week 2 we saw an example of a Profit and Loss account for a day’s trading in a lemonade stall.
Before we see an example of a ‘real’ Profit and Loss account, we need to understand:
the idea of revenue
the idea of expenses

6. Further Financial Terms
Income – An amount of money which comes in to, or is earned by, the business during an accounting period - sometimes called Revenue
Turnover - total value of sales over a given period – this is sometimes called Income or Revenue
So what is actually meant by the term Revenue?
Revenue – technically this simply refers to the inflow of assets, or the reduction in claims that arise as a result of trading operations.

7. Financial Terms
Expenditure – An amount of money which has been spent by, or goes out from, the business during an accounting period.
Cost - the amount of actual or notional expenditure incurred on or attributable to a specified thing or activity (fixed, variable, direct, indirect )

8. Profit & Loss Equation for a period
Total expenses incurred in generating the revenue
less
equals
Total revenue

9. The Format of the P & L Account
Normally a Profit & Loss Account will consist of:
Sales (Turnover)
Less Cost of Sales
= Gross Profit
Less Overheads
= Net profit
Less Interest on Loans
= Profit Before Tax
Less Tax
= Profit after Tax
Less Dividends
= Retained profit for the year
P & L Terms:
For a quick explanation
Click Here

10. Terms on the Profit and Loss Account
Turnover: Total value of sales over a given period - sometimes called Income or Revenue
Cost of Sales: The costs incurred in making the sales in a given period
Overheads: Other costs incurred in running the business, but not directly related to making sales
Interest on Loans: Money paid to lenders for the privilege of borrowing money.
Tax: Money paid to the government as a contribution to the National Exchequer.
Dividends: Money paid to shareholders as a ‘reward’ for investing in the company.
For a more in-depth explanation, please click on the item

11. Turnover Sale of goods or Fees for services Subscriptions
Interest earned
To all intents and purposes,
Income = Revenue = Sales = Turnover
VAT is excluded from Sales figures (and all other figures)

12. Cost of Sales (Direct Costs)
Costs which are directly related to the cost of providing the goods or service (Cost of Sales)
For example: Goods purchased for resale
Direct Labour costs
Raw materials, Packaging, Energy
Direct Costs often vary with sales
(though some Direct Costs can be FIXED)

13. Overheads (Indirect Costs)
Operating Expenses
Costs which are not directly related to sales.
Costs which are incurred even when an organisation produces no output. Often Fixed Costs
For example: Administrative salaries
Advertising, Stationery, Rent &
Rates
Insurance, Bank charges
Depreciation
Indirect Costs do not (necessarily) vary with sales
Interest usually shown later

14. Interest on Loans Includes
Interest on Bank loans and other formal loan arrangements (e.g. debentures). These are normally charged at some fixed rate e.g. 12% of the loan
Interest on Overdrafts (rates may be variable), and more expensive (e.g. up to 15%)
Does not include
Money paid to shareholders in dividends
Interest charged by creditors for late payment

15. Tax
Corporation Tax is charged on profits made after all costs and interest charges (but not dividends) have been accounted for.
The current rate of tax is 19% for SMEs and 30% for large companies, but there are allowances which mean that this will be reduced.
In the examples in the slides, a ‘flat rate’ of 20% is used, to simplify calculations
For more on tax, consult:

16. Dividends
Limited companies are financed primarily through shareholding.
Shareholders buy shares in the company. These may have a face value ranging anywhere from 1 penny to thousands of pounds.
At the end of each financial period, the directors of the company may decide to issue dividends. This is money paid to the shareholders out of net profit after tax , as a reward for their continued investment.
The dividend paid does not affect the face value of the share.

17. Profit or (Loss) There are many different sorts of profit:
Gross Profit = Sales less Direct Costs
Operating Profit = Sales less Direct Costs less Indirect Costs
Profit before tax = Operating Profit less Interest
Profit after tax = Profit before tax less tax
Retained profit = Profit after tax less dividends

18. Section B The Profit & Loss Account Format

19. Sample Profit & Loss Account
The next slide shows a profit and loss account for a company over a one-year period.
The format varies according to the type of business, but there is a fairly uniform convention to structure the accounts in the following way:
Total Income:
Less expenditure item #1
Less expenditure item #2
Less expenditure item #3 etc.
= Earned Surplus (Profit)

20. Turnover (Sales) (Income) £ 100,000 Cost of Sales (Direct Costs)
Materials £10,000
Transport £ 5,000
Labour £15,000
Total Cost of Sales £ 30, %
Gross Profit (Gross Margin) £ 70, %
Overheads (Indirect Costs)
Administrative salaries £18,000
Depreciation £ 5,000
Rent & Rates £ 4,000
Total Overheads £ 27, %
Operating Profit (Net Margin) £ 43, %
Interest on loans £ 3,000
Profit before tax £ 40, %
Corporation tax due £8,000
Profit after tax & interest £ 32, %
Dividends payable £22,000
Retained Profit (Earned Surplus) £ 10, %

21. This is called the Trading Account
Turnover (Sales) (Income) £ 100,000
Cost of Sales (Direct Costs)
Materials £10,000
Transport £ 5,000
Labour £15,000
Total Cost of Sales £ 30, %
Gross Profit (Gross Margin) £ 70, %
Overheads (Indirect Costs)
Administrative salaries £18,000
Depreciation £ 5,000
Rent & Rates £ 4,000
Total Overheads £ 27, %
Operating Profit (Net Margin) £ 43, %
Interest on loans £ 3,000
Profit before tax £ 40, %
Corporation tax due £8,000
Profit after tax & interest £ 32, %
Dividends payable £22,000
Retained Profit (Earned Surplus) £ 10, %
The first part of the account is usually concerned with the total amount of income and working out the Gross Profit.
This is called the Trading Account

22. Turnover (Sales) (Income) £ 100,000
Cost of Sales (Direct Costs)
Materials £10,000
Transport £ 5,000
Labour £15,000
Total Cost of Sales £ 30, %
Gross Profit (Gross Margin) £ 70, %
Overheads (Indirect Costs)
Administrative salaries £18,000
Depreciation £ 5,000
Rent & Rates £ 4,000
Total Overheads £ 27, %
Operating Profit (Net Margin) £ 43, %
Interest on loans £ 3,000
Profit before tax £ 40, %
Corporation tax due £8,000
Profit after tax & interest £ 32, %
Dividends payable £22,000
Retained Profit (Earned Surplus) £ 10, %
The next part of the account is usually concerned with the indirect costs and working out the Net Profit.

23. Turnover (Sales) (Income) £ 100,000
Cost of Sales (Direct Costs)
Materials £10,000
Transport £ 5,000
Labour £15,000
Total Cost of Sales £ 30, %
Gross Profit (Gross Margin) £ 70, %
Overheads (Indirect Costs)
Administrative salaries £18,000
Depreciation £ 5,000
Rent & Rates £ 4,000
Total Overheads £ 27, %
Operating Profit (Net Margin) £ 43, %
Interest on loans £ 3,000
Profit before tax £ 40, %
Corporation tax due £8,000
Profit after tax & interest £ 32, %
Dividends payable £22,000
Retained Profit (Earned Surplus) £ 10, %
The final part of the account is usually concerned with the interest which needs to paid, tax, and dividends to shareholders.

24. Turnover (Sales) (Income) £ 100,000
Cost of Sales (Direct Costs)
Materials £10,000
Transport £ 5,000
Labour £15,000
Total Cost of Sales £ 30, %
Gross Profit (Gross Margin) £ 70, %
Overheads (Indirect Costs)
Administrative salaries £18,000
Depreciation £ 5,000
Rent & Rates £ 4,000
Total Overheads £ 27, %
Operating Profit (Net Margin) £ 43, %
Interest on loans £ 3,000
Profit before tax £ 40, %
Corporation tax due £8,000
Profit after tax & interest £ 32, %
Dividends payable £22,000
Retained Profit (Earned Surplus) £ 10, %
The bottom line here is what the company has actually made as a profit over the year.
This is the Surplus.

25. Activity 5.2 Re-examine P & L Account
Suppose the company in the example just explored needed money for business expansion.
Which items of expenditure would you consider reducing, so as to increase the amount of retained surplus?
Answer

26. Turnover (Sales) (Income) £ 100,000 Cost of Sales (Direct Costs)
Materials £10,000
Transport £ 5,000
Labour £15,000
Total Cost of Sales £ 30, %
Gross Profit (Gross Margin) £ 70, %
Overheads (Indirect Costs)
Administrative salaries £18,000
Depreciation £ 5,000
Rent & Rates £ 4,000
Total Overheads £ 27, %
Operating Profit (Net Margin) £ 43, %
Interest on loans £ 3,000
Profit before tax £ 40, %
Corporation tax due £8,000
Profit after tax & interest £ 32, %
Dividends payable £22,000
Retained Profit (Earned Surplus) £ 10, %

27. Turnover (Sales) (Income) £ 100,000 Cost of Sales (Direct Costs)
Materials £10,000
Transport £ 5,000
Labour £15,000
Total Cost of Sales £ 30, %
Gross Profit (Gross Margin) £ 70, %
Overheads (Indirect Costs)
Administrative salaries £18,000
Depreciation £ 5,000
Rent & Rates £ 4,000
Total Overheads £ 27, %
Operating Profit (Net Margin) £ 43, %
Interest on loans £ 3,000
Profit before tax £ 40, %
Corporation tax due £8,000
Profit after tax & interest £ 32, %
Dividends payable £22,000
Retained Profit (Earned Surplus) £ 10, %
Reduce Labour Costs:
15% is a large proportion of turnover. May be difficult.
Reduce Admin:
18% is a very large proportion of turnover.
Reduce Dividends:
22% is far too high if we are looking to expand the business.

28. Section C The Profit & Loss Account Some Issues

29. Some Issues Cash versus Profit Capital & Revenue Costs Cost of Sales
Valuation of Stocks
Depreciation
Bad Debt Provision
Prepaid Expenses
Accrued Expenses

30. Cash Versus Profit
In accounting terms, to calculate Profit (or Loss) Sales Income must be matched against relevant expenditure for a given period
Some goods may be purchased on credit, some sales may be sold on credit
Some purchases may have a useful life which lasts longer than the given period
Therefore Profit in accounting terms is NOT equivalent to Cash in less cash out during that period

31. Capital & Revenue Costs
Capital Costs are incurred in purchasing assets
Revenue Costs are incurred in delivering the goods or services and operating the company
Capital Costs are not charged directly to the Profit & Loss Account. They are reflected in a depreciation charge over their useful life.
Accounting profit = Revenue Income less Revenue Expenditure - Capital expenditure is only deducted from Accounting profit through depreciation
To “capitalise” an item means to treat it as capital expenditure

32. Cost of Sales (1) This is the cost of goods sold over a period.
For retail and manufacturing companies this will mainly be the amount of stock throughput, and can be calculated by:
Opening stock level for the Period
+ Amount of stock purchased during the period
- Closing stock level for the Period
= Cost of materials during the Period

33. Cost of Sales Example
At the start of January, a small furniture retailer held £35,000 worth of stock. During the month, a further £12, 000 was bought in, and at the end of the month, the stock level was £27,000.
Calculate the cost of Sales for January.
Opening stock: £35,000
Purchases: £12,000
Total £47,000
less Closing stock: £27,000
Cost of materials: £20,000

34. Cost of Sales (2)
In service and some manufacturing industries, The cost of sales may also include other Direct Costs. These are costs directly incurred as a result of making the sale, manufacturing the item, or in carrying out the service.
Direct Costs:
Cost of Materials
Labour costs incurred
Transportation costs
Fuel & other costs

35. Stock Valuation
Opening and Closing Stocks must be taken into account when calculating Direct Costs to in order to keep to the matching convention
Where sales volume is high (or prices are standard) an average price may be used
Manufacturing Companies may incorporate cost of manufacture into stock value (e.g. materials, power, labour)

36. Stock Valuation Conventions
Where stock is bought in at different times, from different suppliers and at different prices, the valuation of stock may be an issue.
There are basically three conventions:
FIFO (First In First Out)
LIFO (Last In First Out)
AVCO (Weighted Average Cost)

37. Stock Valuation Methods
Three methods
First in, first out (FIFO)
Last in, first out (LIFO)
Weighted average cost (AVCO)

38. Stock Purchases and Sales
Opening Stock Level 200 £10 each
Purchase # £12 each
Purchase # £15 each
Sales £20 each

39. FIFO Stock Valuation Example
Opening Stock Level 200 £10 each
Purchase # £12 each
Purchase # £15 each
Sales £20 each
FIFO = First in, First Out
Items will be sold in the order in which they were bought.
The 400 items sold will be made up of:
200 £10 each £2000 (prev. stock)
100 £12 each £1200 (purch. #1)
100 £15 each £1500 (purch. #2)
Total Cost of Sales: £4700

40. LIFO Stock Valuation Example
Opening Stock Level 200 £10 each
Purchase # £12 each
Purchase # £15 each
Sales £20 each
FIFO = First in, First Out
Items will be sold in the reverse order of purchase.
The 400 items sold will be made up of:
200 £15 each £3000 (purch. # 2)
100 £12 each £1200 (purch. # 1)
100 £10 each £1000 (prev. stock)
Total Cost of Sales: £5200

41. AVCO Stock Valuation Example
Opening Stock Level 200 £10 each £2000
Purchase # £12 each £1200
Purchase # £15 each £3000
Sales £20 each
AVCO = Weighted Average Cost
An average cost will be calculated.
All items sold will be charged at that cost.
Total value of stock = £2000+ £ £3000 = £6200
Total no. of items = = 500
Average value of stock = £6200/500 = £12.40 per item
Total Cost of Sales = £ = £4960

42. Depreciation
Depreciation is the method used to spread the cost of a purchase (normally of a fixed asset) over a number of time periods (usually years)
This is a way of charging to the business the cost of the asset, in a way which accounts for the ‘wear and tear’ of the asset, and the fact that over time it is reducing in value.
Depreciation is shown in the Profit & Loss Account as an Overhead

43. Calculating a depreciation charge
Factors to be considered
Cost of the asset
Useful life of the asset
Residual value of the asset
Depreciation method
The depreciation charge is calculated as a result of these four factors:
Initial Cost
How long it will be used for
What it will be worth at the end
Calculation method

44. Calculating an annual depreciation charge
less
Residual value
equals
Cost
Depreciable amount
Annual depreciation charge
Year 1
Year 3
Year 2
Year 4 and so on
Whatever method is used, the procedure is the same:

45. Depreciation Methods There are two main methods used:
Straight-line depreciation = Cost of item divided by number of years over which it is to be written off
Reducing balance = Current value x Depreciation%

46. The same amount is used to reduce the asset value each year.
Graph of written-down value against time using the straight-line method
Written-down value (£000)
Asset life (years) 10 20 30 40 1 2 3 4
The same amount is used to reduce the asset value each year.

47. The amount used to reduce the asset value decreases year on year.
Graph of written-down value against time using the reducing balance method
Written-down value (£000)
Asset life (years) 10 20 30 40 1 2 3 4
The amount used to reduce the asset value decreases year on year.

48. Depreciation calculation
Purchase of a piece of equipment costing £10,000
Straight-line over 5 years Reducing balance at 30%
Written down Written down
Depreciation Value Depreciation Value
Year £ 2, £ 8, £ 3, £ 7,000
Year £ 2, £ 6, £ 2, £ 4,900
Year £ 2, £ 4, £ 1, £ 3,430
Year £ 2, £ 2, £ 1, £ 2,401
Year £ 2, £ £ £ 1,681
Year £ £ £ £ 1,176

49. The Problem of Bad & Doubtful Debts
Many businesses sell goods on credit. The revenue generated is recognised in accounts as soon as the goods are passed to the customer.
As soon as this happens, the sale is recorded, and the amounts appear as Turnover on the P & L account, and as Trade Debtors on the Balance Sheet.
There is a risk that the customer will not, or cannot pay. If this occurs then this is called a bad debt and must be written off.
This involves reducing debtors on the Balance Sheet, and creating an expense in the ‘Overheads’ section for Bad Debt.

50. Provision for Doubtful Debt
In some enterprises the problem of bad debt is endemic, and it may not be possible to identify with certainty the amount of debt which is “bad”, or which will not be retrieved.
In this case, the business will use past experience to estimate the amount of debt which might be lost in the accounting period.
The Provision for Doubtful Debt is calculated as an estimate and this will be used to reduce debtors on the Balance Sheet, and create an expense in the ‘Overheads’ section called Provision for Doubtful Debt.

51. Prepaid Expenses
Pre-paid expenses - goods or services which have been paid for in advance.
When you eat in MacDonald's, they require you to pay ‘up front’ before you get the food. At the point at which you have paid, before you get your meal. This is a prepaid expense.
Prepaid expenses are things like rent & rates paid in advance, as well as some consultancy fees.

52. Accrued Expenses
Accrued expenses - any amount which the organisation owes for expenses already consumed but for which a bill has not been yet received or paid
When you eat in a ‘posh’ restaurant they normally provide you with the food, then present you with the bill at the end. At the point at which you have eaten the meal, but not paid, this is an accrued expense.
Accrued expenses are things like tax, dividends, wages and fuel bills.

53. Seminar 5 - Activities Preparation: read M & A Chapter 3
Carry out Self-Assessment Question 3.1; the answer is at the back of the book.
Also M & A ex. 3.4; answer also at the back of the book
Activities to prepare for the seminar:
P & L Activity Spreadsheet
M & A ex. 3.8