Duration: 60

mins
Slides: 13

LMT SCHOOL OF MANAGEMENT, THAPAR

UNIVERSITY
Masters of Business Administration

Course: Financial Reporting and Analysis

Faculty: Dr. Sonia Garg (Email:
sonia.garg@thapar.edu)

Session 3: Understanding Financial Statements:

Profit and Loss Statement

Certain concepts
Accounting Period: Accounting measures activities for a specified
interval of time, called the accounting period
Conservatism: Prudent reporting based on a healthy skepticism
builds confidence in the results and the long run, best serves all
divergent interests (anticipate no profits but anticipate all losses)
Recognize revenues only when they are reasonably certain
Recognize expenses as soon as they are reasonable

Realization: The conservatism concept suggests the period of

recognition whereas the realization concept suggests the amount
of revenue that should be recognized (that is reasonably certain)
Matching: When a given event affects both revenues and
expenses, the effect on each should be recognized in the same
accounting period
8/17/15

Understanding Financial Statements: Profit &

Loss Statement

Income
It represents the increase in economic benefits during
the accounting period, in the form of inflows or
increase in asset or a decrease in liability
Premium received on issue of
Both revenue and gains are part of

shares is not income; its

equity recorded under
Reserves a& Surplus
income

Revenue arises from ordinary business activities e.g. sales,

fees, interest, dividends, royalties, rent, etc.
Gains represent all items that are income but not revenue
e.g. gain from disposal of fixed asset

Recognize income when there is an increase in future

economic benefits by an increase in asset (cash/
account receivable) and a decrease in liability (waiver
of account payable)
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Understanding Financial
Statements: Profit & Loss
Statement

Expenditure & Expenses

Cost: monetary measurement of the amount of resources used
for some purpose
Expenditure: decrease in asset or an increase in liability
associated with the incurrence of cost
Expense: item of cost applicable to current accounting period
When an expenditure is made, the related cost is either an
asset or an expense. If it benefits future periods it is an asset
else it is an expense.
Dividends are not expenses, they are distribution of net income
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Understanding Financial
Statements: Profit & Loss
Statement

Recognition of expenses
Costs associated with the activities of the
period are expenses of the period
Costs that cannot be associated with the
revenues of future period are also
expenses of the period
1. Direct matching
2. Period costs
3. Costs not associated with future revenue
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Understanding Financial
Statements: Profit & Loss
Statement

Possible Transactions
Expenditures of this year that are also expenses of this year (Item
Recognize as
acquired and consumed)
expense in P/L
Expenditures of prior year that become expenses during this year,
they were assets on the B/S at the beginning of Recognize
the year as expense
Inventories
Prepaid expenses
Long-lived assets (depreciation)

in P/L and reduce the

asset in B/S

Expenditures of this year that will become expenses in future years

Recognize
(e.g. product costs that become part of inventory)
as asset in
B/S
Expenses of this year that will be paid in future years
Recognize as
Accrued wages (or wages payable)
expense in P/L and
Accrued interest (of interest payable)
as liability in B/S
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Understanding Financial
Statements: Profit & Loss
Statement

GARSDEN CORPORATION
Income Statement
For the year ended March 31, 2014
Net Sales

Rs. 75478221

Cost of Sales

(52227004)

Gross Margin

23251217

Research and Development Expense

(2158677)

Selling, General and Administrative

Expense

(8726696)

Operating Income

12365844

Simple
Profit and
Loss
Statement

Other Revenues (Expenses):

Interest Expense

(363000)

Interest and Dividends Revenue

43533

Royalty Revenues

420010

Profit before tax (PBT)

12466387

Provision for Income Tax

(4986555)

Net Income

7479832

Statement of Retained Earnings

Retained Earnings at the beginning of
the year
Add:8/17/15
Net Income

16027144

Understanding Financial
7479832
Statements: Profit & Loss
Statement

Detail of Net Sales

Gross Sales
and Net Sales

Gross Sales

7715752
5

Less: Returns and

discounts

(528348
)

Less: Sales Discounts

(115095
6)

Gross Sales is total invoice price excluding taxes. Taxes

Net Sales
7547822
are not revenues, they are collections that business 1
makes on behalf of the government
Sales returns and allowances value of goods returned
and allowance for defective goods
Sales discount is the discount for prompt cash payment
Trade discounts are discounts on catalog prices reduced
to form the actual selling price, these are not recorded
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Understanding Financial
Statements: Profit & Loss
Statement

Other Items in P/L

Statement

Cost of sales is the cost of goods and services sold as per the matching
concept (product costs)
Gross Margin is the difference between the net sales and the cost of sales
Expenses like R&D and Selling and Administrative are period costs
Both product and period costs when reduced from net sales give the
operating income
Net Income is found by reducing the operating income by interest
expense and provision for income taxes
Net Income is added to retained earnings
Retained earnings relate P/L to B/S
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Understanding Financial
Statements: Profit & Loss
Statement

PROBLEMS
Problem 3-1
a. Not an expense for June - not incurred
b. Expense for June
c. Expense for June
d. Expense for June
e. Expense for June
f. Not an expense for June - asset acquired
Problem 3-2
Revenues = $275,000
Expenses: Cost of goods sold $164,000
Rent 3,300
Salaries 27,400
Taxes 1,375
Other 50,240
246,315
Net income = 275,000 - 246,315 = $28,685
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Understanding Financial
Statements: Profit & Loss
Statement

10

Problem 3-3
Beginning inventory
Purchases 78,000
Available for sale
Ending inventory
Cost of goods sold

Problem 3-4
(1) Sales
$85,000
Cost of goods sold
Gross margin

27,000
105,000
(31,000)
74,000

45,000
$40,000

(2) Gross Margin = (40,000 / 85,000)*100 = 47%

(3) Profit Margin = (9000/85000)*100 = 11%
The Woden Corporation had a tax rate of 40 % [($6,000 / $15,000)*100] on its
pretax profit that represented 17.7 % of its sales [($15,000 / $85,000)*100]
The companys operating expenses were 82.3 % of sales [($70,000 /
$85,000)*100] and its cost of goods sold was 53% of sales
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Understanding Financial
Statements: Profit & Loss
Statement

11

Problem 3-5
a.
Depreciation. Each year for the next 5 years depreciation will be charged
to income.
b.
No income statement charge. Land is not depreciated.
c.
Cost of goods sold. $3,500 charged to current years income. $3,500
charged to next years income.
d.
Subscription expense. $36 charged to current year. $36 charged to next
year. Alternatively, $72 charged to current year on grounds $72 is
immaterial.
Problem 3-6
Asset value:
October 1, 20X5
$30,000
December 31, 20X5
26,250
December 31, 20X6
11,250
December 31, 20X7
0
Expenses:
20X5 $3,750 ($1,250 x 3 months)
20X6 $15,000 ($1,250 x 12 months)
20X7 $11,250 ($1,250 x 9 months)
One months insurance charge is $1,250 ($30, 000 / 24 months)
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Understanding Financial
Statements: Profit & Loss
Statement

12

Problem 3-7
Truck purchase has no income
statement effect. It is an
asset.
Sales are recorded as earned,
not when cash is received.
Bad debt provision of 5
percent related to sales on
credit ($33,400 - $20,500)
must be recognized. Wages
expense is recognized as
incurred, not when paid.
Marchs utility bill is an
expense of March when the
obligation was incurred.
Income tax provision relates to
pretax income. Must be Understanding Financial
matched with related income.
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Statements: Profit & Loss
Statement

13