Operating and Non-operating Expenses — Like revenues, expenses can be classified as: (1) operating expenses and (2) non-operating expenses. Expenses relating to the main operations or business of the firm are called operating expenses. Examples include manufacturing expenses (such as raw material consumed, wages, and salaried, power and fuel, depreciation, etc.), general and administrative expenses and selling and distribution expenses. Expenses which are incidental or indirect to the main operations of the firm are called non-operating expenses. Expenses incurred in generating non-operating revenues are classified in this category.
The basic information revealed by the profit and loss account is about the income (or loss) of the firm. The heading of the income statement includes the name of the firm, type of statement and the period of time to which the statement relates. Like the balance sheet, the income statement may be presented in several forms. Two popular forms are: the step-form and the account0form. The step-form income statement may be single-step or multi-step. The single-step income statement records all revenue items first, then the expense items. The total of expenses is subtracted from the total revenue to obtain the net income or net profit. The multi-step income statement gives more useful information. It makes a distinction between operating revenue and the non-operating revenue. It also reveals the following concepts of profit:
- Gross profit (GP). The difference between sales and cost of goods sold (CGS). CGS includes manufacturing costs.
- Operating profit (OP). The difference between gross profit and operating expenses consisting of general and administrative and selling expenses and depreciation. (OP = GP — OEXP — DEP). Note that interest charges (INT) on borrowed funds are not subtracted. Thus operating profit may also be known as profit before interest and taxes (PBIT). PBIT measures the performance of the firm’s operations without regard to the sources of financing (i.e. debt or equity), and may include other incomes.
- Profit before taxes (PBT). The difference between profit before interest and taxes and interest charges (PBT = PBIT — INT). PBT may also include non-operating profit (viz. non-operating revenue minus non-operating expenses).
- Net Profit (NP). The difference between profit before tax and taxes (NP = PBT — TAX). Net profit is also called profit after taxes (PAT).
The profit and loss account can also be prepared in the account-form. The account form divides it into two sides; the left hand side is used to record expense items and the right-hand lists revenue items.
The profit and loss account may contain the details of the broad categories of expense items. For example, cost of goods sold will include cost of materials consumes, wages and salaries and other manufacturing expenses, such as fuel and power, repairs and maintenance, consumable stores, employees welfare expenses, insurance of goods etc. Similarly, general and administrative expenses may include salaries, directors’ remuneration, rent, rates and taxes, staff welfare expenses, etc. The usual practice is to prepare the profit and loss account in the summary form and details regarding expenses and revenue are given in separate schedules. Also, the cost of goods sold figure is not given in the published annual accounts.
Functions of the Income Statement — The income statement match revenue and expenses to determine the firm’s net profit and net loss. It represents a flow of economic data — flow of revenues and expenses during a period of time. The statement also helps reveal the changes in the balance sheet from the end of one period to the end of another period. The important functions of the income statement are:
- It gives concise summary of the firm’s revenues and expenses during a period of time.
- It measures the firm’s profitability.
In terms of the overall accounting functions, the profit and loss account:
- Accumulates economic data — revenue (REV) and expenses (EXP) in accordance with the model: REP — EXP = NP, where REV is revenue, EXP is expenses and NP represents net profit;
- Measures net profit by matching revenues and expenses according to basic accounting principles;
- Communicates information regarding the results of the firm’s activities to owners and others.