The Statement of Financial Position and Statement of Profit or Loss
Every transaction has two effects, and after every transaction what the business owns still equals what it owes. That one idea produces both of the main financial statements: the statement of financial position lists what the business owns (assets) and owes (capital and liabilities) at a date, and the statement of profit or loss shows how the profit for a period was made. This chapter works through the idea transaction by transaction, sets out the standard layouts and their terminology, separates capital from revenue expenditure (and profit from cash), and states the accounting equation that you will use again and again. It ends with the codes businesses use to name their accounts.
1 Introduction
In this chapter we will look at what information the Statement of Financial Position and Statement of Profit or Loss are giving and also examine the standard layout and terminology that you should be aware of.
2 The dual (or double) effect of transactions
The first lecture works through all eleven transactions below, building the list of what the business owns and owes after each one. Pause it and try a few yourself. On the recording the tutor sometimes says “pounds” where the page says dollars — the figures are the same.
Let us consider the effect of the following transactions on a sole trader:
(a) The owner puts $10,000 into a separate bank account for the business.
The business owns | $ | The business owes | $ |
Cash | 10,000 | Capital | 10,000 |
Total | 10,000 | Total | 10,000 |
The business now has cash of $10,000 — an asset (anything owned by the business). Treating the business as separate from its owner, it owes the owner $10,000 — its capital.
(b) The business buys a shop for $2,000.
The business owns | $ | The business owes | $ |
Shop | 2,000 | Capital | 10,000 |
Cash | 8,000 | ||
Total | 10,000 | Total | 10,000 |
Two effects: cash falls by $2,000 and a new asset, the shop, appears. Total assets are unchanged.
(c) The business buys goods for resale (in cash) for $1,000.
The business owns | $ | The business owes | $ |
Shop | 2,000 | Capital | 10,000 |
Inventory | 1,000 | ||
Cash | 7,000 | ||
Total | 10,000 | Total | 10,000 |
Cash falls by $1,000 and a new asset appears: goods bought to sell, called inventory (the old word was “stock”).
(d) The business buys more goods for resale (on credit) for $2,000.
The business owns | $ | The business owes | $ |
Shop | 2,000 | Capital | 10,000 |
Inventory | 3,000 | Payables | 2,000 |
Cash | 7,000 | ||
Total | 12,000 | Total | 12,000 |
“On credit” means the goods are paid for later. Inventory rises by $2,000 and the business now owes the supplier $2,000 — a payable. Money owed to anyone other than the owner is a liability.
(e) The business buys a car for $3,000 (cash).
The business owns | $ | The business owes | $ |
Shop | 2,000 | Capital | 10,000 |
Car | 3,000 | Payables | 2,000 |
Inventory | 3,000 | ||
Cash | 4,000 | ||
Total | 12,000 | Total | 12,000 |
Cash falls by $3,000 and a new asset, the car, appears.
(f) The business sells half of the goods for $2,400 (cash).
The business owns | $ | The business owes | $ |
Shop | 2,000 | Capital | 10,000 |
Car | 3,000 | Profit | 900 |
Inventory | 1,500 | Payables | 2,000 |
Cash | 6,400 | ||
Total | 12,900 | Total | 12,900 |
Cash rises by $2,400 and inventory falls by half of $3,000, i.e. $1,500. Assets are now $12,900, but only $12,000 is owed to the owner and the supplier. The extra $900 is profit — goods costing $1,500 sold for $2,400 — and profit belongs to the owner.
(g) The business sells the remainder of the goods for $2,800 on credit.
The business owns | $ | The business owes | $ |
Shop | 2,000 | Capital | 10,000 |
Car | 3,000 | Profit | 2,200 |
Receivables | 2,800 | Payables | 2,000 |
Cash | 6,400 | ||
Total | 14,200 | Total | 14,200 |
Inventory falls to nil and the customer now owes the business $2,800 — a receivable (the old word was “debtor”). Total sales are $5,200 ($2,400 + $2,800) for goods that cost $3,000 ($1,000 + $2,000), so profit to date is $2,200.
(h) The business pays $600 of the amount owing, on account.
The business owns | $ | The business owes | $ |
Shop | 2,000 | Capital | 10,000 |
Car | 3,000 | Profit | 2,200 |
Receivables | 2,800 | Payables | 1,400 |
Cash | 5,800 | ||
Total | 13,600 | Total | 13,600 |
“On account” means part of the amount owed. Cash falls by $600 and the payable falls by $600 to $1,400.
(i) The business pays electricity of $200.
The business owns | $ | The business owes | $ |
Shop | 2,000 | Capital | 10,000 |
Car | 3,000 | Profit | 2,000 |
Receivables | 2,800 | Payables | 1,400 |
Cash | 5,600 | ||
Total | 13,400 | Total | 13,400 |
Cash falls by $200, but no asset appears — electricity is used up in running the business. It is an expense, so the second effect is that profit falls by $200, to $2,000.
(j) The business receives half of the amount owing to it, on account.
The business owns | $ | The business owes | $ |
Shop | 2,000 | Capital | 10,000 |
Car | 3,000 | Profit | 2,000 |
Receivables | 1,400 | Payables | 1,400 |
Cash | 7,000 | ||
Total | 13,400 | Total | 13,400 |
The customer pays $1,400 (half of $2,800): cash rises by $1,400 and receivables fall by $1,400.
(k) The owner takes $1,200 from the business.
The business owns | $ | The business owes | $ |
Shop | 2,000 | Capital | 10,000 |
Car | 3,000 | Profit | 2,000 |
Receivables | 1,400 | Less: drawings | (1,200) |
Cash | 5,800 | Payables | 1,400 |
Total | 12,200 | Total | 12,200 |
Cash falls by $1,200 and the amount owed to the owner falls by $1,200, to $10,800. Money the owner takes out is called drawings (or withdrawals). It does not change the profit — the business still made $2,000 — it reduces what the business owes the owner.
Check on profit:
$ | $ | |
Sales ($2,400 + $2,800) | 5,200 | |
Less: cost of the goods sold ($1,000 + $2,000) | (3,000) | |
Gross profit | 2,200 | |
Less: expenses – electricity | (200) | |
Net profit | 2,000 |
Every transaction had two effects, and after every one, what the business owns equalled what it owes.
In each case, the summary we have prepared is effectively a Statement of Financial Position and shows the owner: how much they are owed, why they are owed it, and how the amount is held within the business.
The check made on the profit is effectively a Statement of Profit or Loss. This shows the owner how the profit was actually made.
3 The Statement of Financial Position
The second lecture talks through this layout and the terminology table. At one point the tutor says non-current liabilities are those payable in less than a year — he means current liabilities; the definitions in the table below are right.
Below is an example of the layout of a Statement of Financial Position for a sole trader:
Statement of Financial Position as at 31 March 2017
$ | $ | |
ASSETS | ||
Non-current assets | ||
Land and buildings | 100,000 | |
Plant and equipment | 50,000 | |
Fixtures and fittings | 20,000 | |
Motor vehicles | 30,000 | |
200,000 | ||
Current assets | ||
Inventories | 10,000 | |
Trade receivables | 12,000 | |
Prepayments | 3,000 | |
Cash | 4,000 | |
29,000 | ||
Total assets | 229,000 | |
CAPITAL AND LIABILITIES | ||
Capital | ||
Capital at 1 April 2016 | 130,000 | |
Profit for the year to 31 March 2017 | 50,000 | |
Less: drawings | (10,000) | |
170,000 | ||
Non-current liabilities | ||
8% loan | 25,000 | |
Current liabilities | ||
Accruals | 2,000 | |
Trade payables | 20,000 | |
Bank overdraft | 12,000 | |
34,000 | ||
Total capital and liabilities | 229,000 |
Assets are always split into non-current first and current second; liabilities likewise. For a sole trader the capital section shows the capital owed to the owner at the start of the year, adds the profit for the year and deducts the drawings, giving the capital at the end of the year ($170,000) — which is next year’s opening capital. A limited company’s statement is almost the same; only the capital section differs (Chapter 16).
Terminology
Term | Meaning |
Asset | Anything owned (or controlled) by the business |
Non-current asset | An asset the business intends to keep and use (for longer than 12 months) — for example buildings, machines, furniture, vehicles |
Current asset | Any asset that is not a non-current asset: assets that keep changing as the business trades, such as inventory, receivables, prepayments and cash |
Inventory | An asset bought by the business intended for sale (goods for resale) |
Trade receivables | Amounts owed to the business by customers |
Prepayment | A payment made by the business in advance, for something it has not yet used (Chapter 4) |
Capital | Amount owing by the business to the proprietor (owner) |
Drawings (or withdrawals) | Anything taken from the business by the owner — usually cash, but goods taken for the owner’s own use are drawings too. Whatever the owner calls it (even “wages” or “interest”), it is drawings: it reduces capital and is never an expense |
Liability | Amount owing by the business (to anyone other than the owner) |
Current liability | A liability due within 12 months of the Statement of Financial Position date |
Non-current liability | A liability due more than 12 months from the date of the Statement of Financial Position. A loan repaid in instalments is split: the part due within 12 months is current, the rest non-current |
Trade payables | Liability due to suppliers |
Accrual | An expense the business has used but not yet been billed for or paid at the year end (Chapter 4) |
Bank overdraft | Liability due to the bank (a “negative” bank balance), repayable on demand and so always current |
The IASB’s Conceptual Framework (Chapter 23) gives the formal definitions of these elements of the financial statements. You should recognise them:
Element | Formal definition |
Asset | A present economic resource controlled by the entity as a result of past events |
Liability | A present obligation of the entity to transfer an economic resource as a result of past events |
Equity (capital) | The residual interest in the assets of the entity after deducting all its liabilities |
Income | Increases in assets, or decreases in liabilities, that result in increases in equity, other than contributions from the owners |
Expenses | Decreases in assets, or increases in liabilities, that result in decreases in equity, other than distributions to the owners |
4 The Statement of Profit or Loss
Below is an example of the layout of a Statement of Profit or Loss for a sole trader:
Statement of Profit or Loss for the year ended 31 March 2017
$ | $ | |
Sales revenue | 180,000 | |
Cost of sales: | ||
Opening inventory | 30,000 | |
Purchases | 120,000 | |
150,000 | ||
Less: closing inventory | (40,000) | |
110,000 | ||
Gross profit | 70,000 | |
Other income: | ||
Rent received | 10,000 | |
Interest received | 1,000 | 11,000 |
81,000 | ||
Expenses: | ||
Rent | 5,000 | |
Electricity | 3,000 | |
Telephone | 2,000 | |
Wages and salaries | 15,000 | |
Motor expenses | 6,000 | |
31,000 | ||
Net profit | 50,000 |
Cost of sales is the cost of the goods actually sold: the inventory held at the start of the year, plus the goods bought in the year, less the goods still unsold at the end ($30,000 + $120,000 − $40,000 = $110,000). The net profit of $50,000 is the profit for the year that is added to the owner’s capital in the statement of financial position above.
Terminology
Term | Meaning |
Revenue | Income from the business’s main activity — the total sales for the period. Also called sales, sales revenue or turnover |
Purchases | In accounting, always the purchase of goods for resale. Buying a car or a building is not “purchases” — that is buying a non-current asset |
Cost of sales | Opening inventory + purchases − closing inventory: the cost of the goods sold in the period |
Gross profit | Revenue less cost of sales — the profit made on buying and selling goods |
Trading Account | The name for the top part of the statement of profit or loss, down to gross profit. It is not written as a heading on the statement |
Other income | Income from activities other than selling the business’s goods, such as rent or interest received; added after gross profit |
Expenses | The costs of running the business (rent, electricity, wages of employees, motor running costs …). Amounts taken by the owner are drawings, not expenses |
Net profit | Gross profit plus other income, less expenses: the profit for the year, which belongs to the owner |
5 The difference between Capital and Revenue items
The fourth lecture covers sections 5 and 6, including Examples 1 and 2. It does not cover section 5.1 (cash and profit), the formal element definitions in section 3, or the accounting codes in section 7 — read those here. In its one-line summary of section 5 the tutor says revenue expenditure appears in the statement of financial position; he means the statement of profit or loss, as he says a moment earlier and as the page says.
You should note from the previous exercises that when we pay for anything, there are two possible reasons. Either we buy an asset, which appears on the Statement of Financial Position, or we pay an expense, which appears on the Statement of Profit or Loss.
We call the purchase of assets (for the Statement of Financial Position) Capital Expenditure, whereas the payment of expenses (for the Statement of Profit or Loss) is called Revenue Expenditure.
Be careful with the words. “Capital expenditure” has nothing to do with the owner’s capital: it means buying a non-current asset. “Revenue expenditure” is spending on expenses — it is called that because the expenses are paid in order to earn revenue.
5.1 Cash and profit
Profit and cash are not the same thing, and a business can make a profit while its cash falls (or the reverse). Profit is income less expenses for the period; cash moves for other reasons as well:
Capital expenditure uses cash but is not an expense — the asset goes on the statement of financial position.
Credit sales count in profit when the goods are sold, but the cash arrives only when the customer pays.
Credit purchases count in cost of sales when the goods are sold, but the cash leaves only when the supplier is paid.
Capital introduced by the owner brings in cash but is not income; drawings take cash out but are not an expense.
In the eleven transactions of section 2 the business made a net profit of $2,000, but it ended with cash of $5,800. The difference is explained by the items that affect cash and profit differently:
$ | $ | |
Net profit | 2,000 | |
Add: capital introduced by the owner | 10,000 | |
Less: shop and car bought (capital expenditure) | (5,000) | |
Less: sales not yet received from the customer (receivables) | (1,400) | |
Add: purchases not yet paid to the supplier (payables) | 1,400 | |
Less: drawings | (1,200) | |
Cash at the end | 5,800 |
The business started with no cash, so the closing cash balance is the whole of the cash movement.
Chapter 17 (statements of cash flows) returns to the difference between profit and cash.
6 The Accounting Equation
You should note from the earlier illustrations that at any point in time:
ASSETS = CAPITAL + LIABILITIES
It follows from this that:
ASSETS – LIABILITIES = CAPITAL
The term “net assets” is often used to refer to assets – liabilities, and so:
NET ASSETS = CAPITAL
Over a period of time (for example, over a year), the net assets of a business will change. Since the above equation is true at any point in time, it also holds true that over a period of time:
INCREASE IN NET ASSETS = INCREASE IN CAPITAL
There are only three reasons why the capital of a business should change over time:
More capital introduced (this will increase the capital)
Profit for the period (this will increase the capital)
Drawings during the period (this will reduce the capital)
(A loss is simply a negative profit, so it is not a fourth reason.)
Therefore, finally, over a period of time,
INCREASE IN NET ASSETS = CAPITAL INTRODUCED + PROFIT – DRAWINGS
On 1 January, net assets of a business were $25,000. On 31 December they had increased to $32,000. During the year the owner had introduced more capital of $10,000 and had made drawings of $7,000.
You are required to calculate the profit for the year
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On 1 January, the net assets of a business were $118,000. On 31 December, the net assets were $150,000. During the year the owner had introduced no additional capital, and the profit for the year was $54,000
How much were the drawings during the year?
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7 Accounting codes
As we have seen, there are no ‘standard’ names for individual assets, liabilities, income, and expenses. For example, different businesses may refer to their telephone expense as ‘telephone’ or ‘telephone expense’ or whatever they want.
There is therefore a danger - especially when there are several bookkeepers recording transactions - of there being confusion, with different people using different names.
It is therefore very common to give each item a ‘code number’ and to list them all in a ‘chart of accounts’. Using these code numbers will also help to speed up the entering of transactions when using accounting software on computers.
An example of how part of a chart of accounts might appear is as follows:
Account number | Description |
10 | Cash |
20 | Trade receivables |
30 | Inventory |
100 | Non-current assets – Fixtures and fittings |
110 | Non-current assets – Plant and machinery |
120 | Non-current assets – Computer equipment |
200 | Trade payables |
300 | Capital |
400 | Sales revenue |
500 | Purchases |
510 | Telephone |
The codes are usually grouped in ranges, so the number itself shows what kind of account it is — here, codes below 100 are current assets, the 100s non-current assets, the 200s liabilities, the 300s capital, the 400s income and the 500s expenses. Each transaction is given its code when it is recorded (a telephone bill is coded 510), so the software posts it to the right account, everybody uses the same name for it, and the totals for each code feed straight into the trial balance and the financial statements.
8 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
The Statement of Financial Position and Statement of Profit or Loss
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