CONSTRUCTING FINANCIAL STATEMENTS 69
Reporting profitability
Businesses exist to make a profit. Thus, as we saw in Chapter 3, the basic accounting
concept is that:
profit=income−expenses
However, business profitability is determined by the matching principle –matching
income earned with the expenses incurred in earning that income.Incomeis the value
of sales of goods or services produced by the business.Expensesare all the
costs incurred in buying, making or providing those goods or services and all
the marketing and selling, production, logistics, human resource, IT, financing,
administration and management costs involved in operating the business.
The profit (or loss) of a business for a financial period is reported in aProfit and
Loss account. This will typically appear as in Table 6.1.
Theturnoveris the business income or sales of goods and services. The cost of
salesiseither:
žthe cost of providing a service; or
žthe cost of buying goods sold by a retailer; or
žthe cost of raw materials and production costs for a product manufacturer.
However, not all the goods bought by a retailer or used in production will have
been sold in the same period as the sales are made. The matching principle requires
that the business adjusts for increases or decreases ininventory– the stock of goods
bought or produced for resale but not yet sold. Therefore, the cost of sales in the
accounts is more properly described as the cost of goodssold, not the cost of goods
produced. Because the production and sale of services are simultaneous, the cost of
services produced always equals the cost of services sold (there is no such thing as
an inventory of services). The treatment of inventory is covered in more detail in
Chapter 11. The distinction between cost of sales and expenses leads to two types
of profit being reported: gross profit and operating profit.
Gross profitis the difference between the sellingpriceand the purchase (or
production)costof the goods or services sold. Using a simple example, a retailer
selling baked beans may buy each tin for 5p and sell it for 9p. The gross profit is
4p per tin.
gross profit=sales−cost of sales
Table 6.1 Profit and Loss account
Turnover 2,000,000
Less: cost of sales 1,500,000Gross profit 500,000
Less: selling, administration and finance expenses 400,000Operating profit before interest and tax 100,000