ACCT1101 Chap.4 The Statement of Profit or Loss
The Statement of Profit or Loss
The statement of profit or loss, also called the income statement or the statement of financial performance, answers one question across a period of time: income less expenses, what was left.
Owners and managers use it to find the parts of the business that need attention, shareholders to judge whether the business is viable, and lenders to decide whether to advance funds.
The two elements are defined by their effect on equity. Income raises equity because resources grew or an obligation shrank, with anything the holders of equity claims put in carved out.
Its forms include revenue, sales, fees, interest, dividends received and royalties. An expense lowers equity because resources were consumed or an obligation was taken on, with anything paid out to those same holders carved out. Rent, electricity, supplies, insurance, interest and tax are the usual examples.
The exclusion clause at the end of each definition is doing real work: it is what keeps an owner's capital injection out of income and an owner's drawing out of expenses.
Between revenue and the bottom line there are named subtotals, and questions test whether you know which is which.
Gross profit is revenue less the cost of sales, applicable to retail and manufacturing, and it shows the mark up the business achieves on what it sells. EBIT strips out interest and tax to show the return from investment decisions alone. EBITDA strips depreciation and amortisation out as well, as a measure of raw operating earnings.
Profit can be quoted before or after tax, so the label always matters.
Finally, this statement feeds the other one. Its accounts are temporary: they are closed to zero at period end and the net result moves into retained earnings in equity, after any dividends. That is why the expanded accounting equation writes equity out as capital plus revenue less expenses less dividends.
What this chapter covers
- 01
What the statement reports, and over what span of time
- 02
The income definition and the contributions exclusion
- 03
The expense definition and the distributions exclusion
- 04
Cost of goods sold and which entities report it
- 05
Gross profit and what a gross margin is telling you
- 06
EBIT and EBITDA and what each one deliberately ignores
- 07
Temporary accounts, closing off, and the move into retained earnings
- 08
The expanded accounting equation and the four things that move equity
From a purchase and a sale to gross profit, with the trap in the middle
- +1The purchase creates an asset, not an expense. Forty monitors at $185 is $7,400 of inventory, with accounts payable rising $7,400. Nothing has been consumed and nothing earned, so the statement of profit or loss is untouched at this point.
- +1The sale has two halves and both must be recorded. Revenue is 14 at $310, which is $4,340. Of that, $2,790 arrives as cash from the 9 cash sales and $1,550 becomes accounts receivable from the 5 credit sales. Equity rises $4,340 through revenue.
- +1Now release the cost of what left the shelf. Cost of goods sold is 14 at $185, which is $2,590. Inventory falls $2,590 and equity falls by the same $2,590 through the expense. The remaining 26 monitors stay on the balance sheet at $4,810.
- +1Gross profit is revenue less cost of sales, so $4,340 less $2,590 gives $1,750. As a margin that is $1,750 over $4,340, or a little over 40 cents in every sales dollar.
Key terms
- Income
- Equity rising because resources grew or an obligation shrank, with owner contributions carved out.
- Expense
- Equity falling because resources were consumed or an obligation was taken on, with owner distributions carved out.
- Cost of goods sold
- The cost of the physical goods a business has actually sold to customers in the period, reported by retail and manufacturing entities.
- Gross profit
- Sales revenue less cost of goods sold, showing the margin earned before any operating expense is taken into account.
- EBIT
- Earnings before interest and taxation, isolating the return produced by investment decisions from the effects of funding and tax.
- EBITDA
- Earnings quoted before interest, tax and the depreciation and amortisation charges, used as a rough measure of what operations themselves earn.
- Temporary account
- An income or expense account whose balance is reduced to zero at period end, with the net result transferred into retained earnings.
The Statement of Profit or Loss FAQ
Why do income and expense definitions both end with an exclusion clause?
Because equity moves for two quite different reasons and only one of them is performance. An owner putting money in raises equity without the business having earned anything, and an owner taking money out lowers it without the business having consumed anything. The exclusions strip those owner transactions out so that what is left measures trading.
Is every business expected to report gross profit?
No. Gross profit requires a cost of sales figure, and that exists where physical goods are bought and resold or manufactured. A pure service business has no cost of goods sold in that sense, so its statement runs from revenue to operating expenses without the gross profit subtotal. If a question gives you a service business and asks for gross margin, check the wording carefully.
What is the point of EBITDA if profit is already reported?
It answers a different question. Profit after interest and tax mixes three things: how well the business trades, how it is funded, and what its tax position is. Stripping interest, tax, depreciation and amortisation leaves a figure closer to the cash generating capacity of the operations themselves, which is useful when comparing businesses with different debt levels and asset ages.
Where does profit actually go at the end of a period?
Into retained earnings, an equity account on the other statement, once any dividend has been taken out. That is the mechanical link between the two statements: the profit statement is emptied each period, and its net result accumulates permanently in equity.
Exam move
Get fluent at moving between the two statements, because that is where the marks concentrate. Take any small set of figures, calculate profit, then write the single line that shows retained earnings changing by that amount. If you can do that in both directions you understand the expanded equation.
Separately, drill the subtotals until the labels are automatic.
Write out one statement with revenue at the top and profit after tax at the bottom, and mark on it where gross profit, EBITDA, EBIT, profit before tax and profit after tax each sit. Questions often ask for a named subtotal rather than the bottom line, and losing a mark for computing the wrong level is an avoidable error.
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