Chapter 33- income statements

Question 1

What does the income statement report?

Answer 1

• the level of profit or loss that the business has made in a given period of time (usually one year)
• often known as the trading or accounting period

Question 2

What is the income statement a measure of?

Answer 2

• the performance of the business
• used to inform shareholders and other potentially interested stakeholders of how well the business has performed

Question 3

Why is the layout of the income statement important ?

Answer 3

• as the reader is able to see quickly the levels of revenues and costs within the business
• may be helpful when assessing the level of performance
• or considering how such performance can be improved

Question 4

Profit

Answer 4

• the difference between the level of income generated and the costs incurred by the business
• calculated by substracting the total costs from the total revenue

Question 5

Profit can also be defined as

Answer 5

• return on investment
• reward for taking risks
• source of income for the business
• measure of performance and noted by stakeholders, such as the shareholders, employees and suppliers

Question 6

Gross profit

Answer 6

Revenue - cost of sales

Question 7

Operating profit

Answer 7

Gross profit - expenses

Question 8

Profit before tax

Answer 8

Operating profit - finance costs

Question 9

Profit for the year

Answer 9

Profit and dividends - tax

Question 10

What does an income statement contain?

Answer 10

• it always states the trading period so that stakeholders know that this information will tell them how the business has performed in a given time period
• profits for public limited companies are normally declared every 6 months
• some of the larger companies declare their profits quarterly
• half year profits are known as the ‘interim results’
• financial year can start at any time but the majority of businesses use either the tax year which runs from April to April or the calendar year, January to December

Question 11

Revenue (turnover)

Answer 11

• simple calculation based on the level of sales and their value
• price x sales
• important to ensure that the figures used are realistic
• as in many instances the price of the goods or services will include VAT and possibly excise duties
• taxes included in the price of the good will have to be deducted to gain an appropriate figure

Question 12

Cost of sales

Answer 12

• describes the direct costs of producing the goods
• only direct or variable costs are counted and subtracted
• once the cost of sales has been calculated and subtracted from the sales revenue the residue is the gross profit

Question 13

How do you calculate the cost of sales

Answer 13

Opening inventory (from previous year) + purchases in this year - closing inventory (what stock is left)

Answer is the total amount that has to be taken off the total sales revenue to calculate the gross profit for that year

Question 14

Gross profit

Answer 14

• sales revenue - cost of sales
• only considers the direct costs of production

Question 15

Operating profit

Answer 15

• gross profit - expenses
• more realistic measure of profit as it accounts for both direct costs (variable costs) and expenses (overheads or fixed costs)

Question 16

Profit before tax

Answer 16

• operating profit - finance costs (interest paid)
• Any additional cost to the business is interest on loans
• these are treated separately as they are not related to the actual costs incurred with the production of the goods

Question 17

Profit for the year (retained profit)

Answer 17

• net profit - tax and dividends
• shareholders may be paid a dividend (their reward for holding shares in the business)
• government will want to deduct tax on the profits (corporation tax)
• profit for the year is the money which the business can use after deductions have been made
• may be invested into the business in the form of new capital equipment or it may be used to pay off some of the debts of the buisness

Question 18

Non-operating income/ expenses

Answer 18

• on some income statements there may be reference to ‘interest received or earned
• this is an additonal source of income that has been generated within the period of time for that particular income statement period
• figure is simply added to the accounts usually after operating profit and before net profit
• another source of income could be rents or dividends which the business has earned from its investments in other businesses

Question 19

Divisions of the income statement

Answer 19

Can be divided into three divisions or sections
1. Trading account
2. Income statement
3. Appropriation account

Question 20

Trading account

Answer 20

• this part of the income statement concentrates on the figures that are used to calculate the gross profit
• trading account considers just the sales revenue and the cost of sales
• can be used to judge the efficiency of the business in terms of its ability to convert its factors of production into finished goods (its ability to change the raw material into saleable goods)

Question 21

Income statement

Answer 21

• account concentrates on the calculation of the operating profit for the business
• considers not only sales revenue and the cost of sales, but also the overheads of the business such as machinery, salaries, and expenditure of the accounting and marketing departments
• account is a more accurate reflection of the success of the business
• account will enable the business to assess its efficiency in ensuring that overheads are kept under control

Question 22

Appropriation account

Answer 22

• this part of the accounts concentrate on what actually happens to the profits that are made
• looks at how much is distributed to the shareholders in the form of dividends and what proportion is retained by the business for future investment

Question 23

What could cause the cost of sales not falling even though sales revenue has fallen?

Answer 23

• may be due to a loss of benefits from economies of scale or perhaps the actual costs have risen because of increased cost of raw materials or direct labour
• may also be due to the number of goods sold at a reduced price

Question 24

What may the fall of expenses be due to?

Answer 24

• fewer machines bought
• sales may have been expected to rise so additonal overheads were incurred

Question 25

How can retained profit be the same?

Answer 25

- possibly because the dividend paid has decreased

Question 26

Usefulness of income statements

Answer 26

- enables the business to make decisions - management can use the income statement to monitor the progress of the business in terms of targets - allows comparisons to be made between financial years - figures can be used to calculate particular ratios to help assess the performance of the business - help the business in formulating its objectives for the future - provides other stakeholders with valuable information e.g. a bank may be interested to note the amount of profit a business has made in order to assess the amount of risk involved and therefore help it decide whether to lend money to the business - investors will look to see whether they should invest their money in the business e.g. a profitable business is more likely to attract future investors - employees are able to see how much profit the business made and therefore note whether the business is in a strong position to increase its wages and salaries - suppliers may want to see the income statement as evidence of an ability to pay for materials supplied