Kurdistan Regional Government-Iraq

Ministry of Higher Education and Scientific Research

Lebanese French University
College of Administration and Economics
Department of accounting

Intermediate Accounting

The student’s name: Lana Tahr Azez

The name of the teacher: Pankaj
Academic year: 2019-2020
(Second Stage)
Class (A)

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 10. Profit And Loss Accounting

Contents
Introduction .................................................................................................................................... 2
Structure of the Profit and Loss Statement ..................................................................................... 3
Importance of Profit And Loss Accounting ................................................................................... 4
Source Information Used To Analyze Results ............................................................................... 5
The advantages of using the method of classification of expenses by nature: ............................... 6
Reference ........................................................................................................................................ 8

Introduction

Profit and loss accounts and balance sheets are two of the most useful tools to see how well a
company is performing.

The profit and loss (P&L) account is a basic record of an organization’s annual accounts. It will
show how much the company has earned, how much it has spent to earn that amount and the
difference between the two, which is the profit or loss made.

The P&L is calculated as follows: total sales minus the cost of those sales (also known as direct
or variable costs) will give you the gross profit. Subtract from that the fixed costs (for example
insurance, marketing, administration costs etc.) to find the net profit. Tax payments and
shareholder dividends must then be subtracted and an allowance can made for retained profit to
reinvest in the business. This will give you a picture of performance over a particular period in
time, either historical or forecast for the future.[1]

In contrast a balance sheet gives a snapshot at a specific moment in time, as it is constantly

changing with day-to-day activities, sales and expenditure.

The balance sheet shows the relationship between a firm’s assets and liabilities.

Assets are things that the company owns or money it is owed and are used to generate sales. There
will be fixed assets which are kept in the business long-term and include buildings, computers and
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machines. There will also be current assets which can be turned into cash in the short-term. An
example of a current asset would be customer invoices that are due for payment. The two are
added together to give a total asset worth.

Liabilities are concerned with money the firm owes to other people, both internally and externally,
such as bank loan repayments and shareholder funds. They are split into creditors due in less than
one year (short-term) such as invoices to be paid and creditors due in more than one year (long-
term) such as bank loans and mortgage repayments. The sum of the two gives an amount for total
liabilities.

Total assets will always be equal to total liabilities as assets are financed by liabilities. Hence the
name ‘balance sheet’.

Only limited companies and partnerships where the partners are limited companies are legally
obliged to complete these financial statements. It’s produced mainly for corporate purposes to be
used by the owners and shareholders and for Revenue and Customs (HMRC) for tax purposes.
However they are beneficial to all companies seeking finance to grow or expand their business as
potential investors will want to see current and projected performance.

Whilst they make take time to put together there are clear benefits to be gained. If the company
knows its financial position, it can manage it. Compiling a profit and loss account will ensure that
the business knows how much tax it is liable for and can therefore plan and budget for that in its
cash flow.[2]

Structure of the Profit and Loss Statement

As we have seen previously, the profit and loss account measures whether or not the company
has made a profit or loss on its operations during the period, through producing or buying
and selling its goods or services. It measures whether total sales or revenues are higher
than the total costs (profit), or whether total costs are higher than total sales or revenues
(loss). The total revenue of a business is generated from the provision of goods or services
and may be, for example, in the form of: [3]
■ Sales (goods)
■ Interest received (on loans)
■ rents (from property)
■ Subscriptions (to TV channels)
■ fees (professions)
■ Royalties (books, CDs). The total costs of a business include the expenditure incurred as a
result of the generation of revenue.
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 The total costs of a business include, for example:
■ Costs of goods purchased for resale
■ Costs of manufacturing goods for sale
■ Transport and distribution costs
■ Advertising
■ Promotion
■ Insurance
■ costs of the ‘consumption’ of fixed assets over their useful lives (depreciation)
■ Wages and salaries
■ Interest paid
■ Stationery costs
■ Photocopy costs
■ Communications costs
■ Electricity
■ Water and effluent costs
■ Travel expenses
■ Entertaining expenses
■ Postage.
Each of the above examples of costs (by no means an exhaustive list) incurred in the generation
of revenue by a business appears itself as a separate heading, or is grouped within one or other
of the other main headings within the profit and loss account the levels of profit that are derived
after allowing for the various categories of revenues and expenses. We will look at how a basic
profit and loss account is constructed to arrive at the profit on ordinary activities after taxation
(or net profit) for the company. Net profit is also sometimes called net earnings, from which
may be deducted dividends payable to ordinary shareholders. The net result is then the retained
profit for the financial year.

Importance of Profit And Loss Accounting

Most small businessmen do not prepare, read, understand or analyze their profit & loss account.
They think this document is required mainly by big companies and it is not necessary for small
businesses. As a business grows year-on-year, the issue for most businessmen is, how can one
determine their income-tax obligations? How can one avail loans from bankers? And finally the
most important concern is how to forecast their revenue and expenses while setting yearly targets?

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The profit & loss account provides information about an enterprise's income and expenses which
result in net profit or net loss. It helps a businessman to evaluate the performance of an enterprise
and provides a basis for forecasting future performance. It also provides valuable information
required by a banker while sanctioning a loan. The Profit & Loss account describes different
business activities such as revenues and expenses, particularly useful in assessing the risk of not
certain level of income in the future. It also provides information required to determine tax
obligations.[4]

A profit & loss account is not only the statement of income and expense, but it also enables you
to increase your earnings by reducing unnecessary expenses and increasing incomes," states Garg
Sharma Tandon & Associates, partner Sanjeev Tandon, a practising chartered accountant since
1995.

Setting and achieving targets is the bedrock for the growth of SMEs and setting a target requires
projection of revenues and expenses. An established SME can make projections for its future
revenue based on its past sales and expected income using their Profit & Loss account. As a small
business starts and grows, it may find that its expenses increase at a higher rate. The SMEs may
make accurate expense projections to avoid unnecessary expenses. The Profit & Loss account also
allows enterprises to see where it can improve its revenue streams and cut costs.

Source Information Used To Analyze Results

Profit or Income, is the money expression of gain as an activity result, and the main idea to
generate profit is a lucrative economic activity. The level of results represents for any manager a
way to measure efficiency. Results are reflected by Profit and Loss Account that explains how
they are obtained for each activity type, and how decisions are made at management level in order
to coordinate the entire firm activity. The main aspects of performance analysis are as follow:
1. Overall performance analysis based on Profit and Loss Account;
2. Financial performance analysis based on rates. Overall performance analysis based on Profit
and Loss Account The Profit and Loss Account allows tracking enterprise activity carried on types
of activity, over a period of acquisitions, payments, production, sales and cashing, thus influencing
the results account. Each of these activities belongs to a net result obtained from a financial plus
at each activity level. Profit and Loss Account sorts profit and expenses by activity: exploitation
activity, financial activity, extraordinary activity.
This account represents a financial statement that allows highlighting whole and partial results.
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With its help, we can explain the different stages of how exercise result it is established, allowing
us to draw some conclusions regarding the level of economic performances over a period of time.
During the development of economic theory, there were two models of Profit and Loss Account:
French model and Anglo- Saxon model. The French model is characterized by:
- The concept of production including the sold one, the stocked one and the capitalized one; -the
nature of expanses. This structure of expanses allows establishing intermediate management
balances and highlights value division among enterprise partners. The Anglo-Saxon model has
the largest applicability: USA, Great Britain, Canada, Holland and Japan; and it is different
because:
- It is based on sales as a sole source of income; - Expanses are classified by functions: production
(costs), distribution, administrative function, financial and other expenses. Unlike the French
model, the Anglo-Saxon model does not use notions like: capitalized production, because
production costs go directly to assets, stocked production because production costs of unsold
goods go straight to stocks value. This practice is based on the principle that wealth created by
company is generated by selling the production. In addition, this model is based on market value
of assets, cash flow being the main indicator of economic and financial analysis. As a result,
The different way to structure expenses (by nature- French model, by functions- Anglo-Saxon
model) enforces a different procedure to draw up the Profit and Loss Account
So, while the French model uses as the main source of information for the Profit and Loss Account,
financial accounting, the Anglo-Saxon model uses as main source of information management
accounting, thus allowing establishing sales costs based on identifying direct and indirect costs,
and their allocation

The advantages of using the method of classification of expenses by nature:

- Allows the use of profit and loss account in the calculation of intermediate balances, allows
macroeconomic aggregate calculations; - The information from the classification of expenses by
nature is useful in the estimation of the future cash flows for the enterprise; - This method is easy
to apply because it does not require the allocation of operating expenses on functional
classification. This model is suitable to the needs of small and medium-sized enterprises or to the
large ones that do not exceed certain thresholds of indicators used in European boundaries: the
turnover, the total assets and the number of employees. However, the Romanian specialist
generalized the structure by nature to all the enterprises, regardless of their size; the structure by
functions is found just in an explanatory note; - This method provides more objective and
verifiable information; - Facilitates the cash flow projections.[5]
The disadvantages (limits) of this method
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The disadvantages (limits) of this method:
- This model does not say anything about the performance of the management in achieving the
enterprise functions. If we analyze the scheme of profit or loss of the exercise with the
classification of expenses by function, is seen that the revenue item represents the turnover. By
lowering the cost of sales from the income (the turnover) is obtained the gross profit indicator,
which in fact is the gross margin on cost of sales. The cost of sales includes all costs for supplies,
services provided by third parties, labor, rent and depreciation expense used in the manufacturing
process of goods. The cost of an inventory item does not include the sales and administrative
expenses. So the sale cost does not include the distribution and administration expenses. The
distribution costs refer to expenses incurred in the promotion and distribution of the goods, sold
by the company. (Marketing costs, staff costs used in the distribution of products, depreciation,
rent space with commercial destination). The IAS 1 standard requires companies that use the
method of classification by function to present additional information about the nature of
expenses, including the depreciation and personnel expenses. The advantages of using the method
of classification of expenditure by their functions:
- This presentation often provides more relevant information to users than the classification of
expenses by nature, but the allocation of costs by functions can be often arbitrary and involves
considerable professional reasoning;
- This model of analysis offers information on performance management regarding the business,
the distribution and administration functions, so it is more relevant in the analysis of the financial
performance than the other models which says almost nothing about the performance of
enterprise;
- The presentation of expenses by function permits the determination of the gross margin, as a
difference between the turnover and the cost of sold goods or provided services. These indicators
provide important information used in the comparison of the enterprise efficiency. The limits of
the method:
- This model, even more relevant in the analysis of the financial performance, is less reliable,
because the allocation of costs depends on how the enterprise management defines its function.
Moreover, if managers make organizational changes and adjust the functions, then the information
cannot be compared over time;
- Does not allow the forecast for the future cash flows. Therefore IAS 1 requires to companies to
present the additional information on the nature of expenses, including the expenses with
depreciation and personnel.

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 Reference

1. Revsine, L., D.W. Collins, and W.B. Johnson, Financial reporting and analysis. 2005:
Prentice Hall.
2. Mazzarol, T. and S. Reboud, Work Book: Cash Flow, Profit and Working Capital, in
Workbook for Small Business Management. 2020, Springer. p. 117-125.
3. Bunget, O.C., Contabilitatea românească: între reformă şi convergenţă. 2005: Editura
Economică.
4. Jones, S. and M. Aiken, The Significance of the Profit and Loss Account in Nineteenth‐
Century Britain: A Reassessment. Abacus, 1994. 30(2): p. 196-230.
5. Man, M. and L. Gadau, The Profit and Loss Account in Different Approaches. Advantages
and Disadvantages. Annales Universitatis Apulensis: Series Oeconomica, 2010. 12(1): p.
152.