The Profit and Loss Account

What information does a profit and loss account (income statement) provide? How does the selection of accounting methods for depreciation and stock costing affect measuring and reporting financial performance?

"The purpose of the profit and loss account is to measure and report how much profit the business has generated over a period" (Atrill & McLaney, 2006). Where the balance sheet recorded the relationship between assets and claims, the profit and loss account shows the relationship between revenue - which is a measure of economic benefit to a business that comes from activities such as sales, services and interest - and expense - which is a
measure of economic loss that is caused by activities such as the purchasing of stock, paying salaries or renting plant. The profit and loss account shows the result of the equation:

Profit (loss) for period = total revenue for period - total expenses incurred creating the revenue

Depreciation models the fact that the majority of non - current assets do not have an infinite amount of use - in the act of generating revenue they will be used up. An example of this is a piece of manufacturing equipment - as it performs its duties in working towards producing whatever the business needs it will, over time, begin to wear out, malfunction, and maybe even cease working altogether. Depreciation is almost like double entry accounting for assets - its benefit to the business is recorded on one side of the equation while the cost of providing this benefit in terms of maintenance and value is recorded on the other side.

Depreciation is made up of four concepts. Fair Value is the cost of purchase, delivery, installation as well as future alterations or upgrades. Useful Life differentiates between physical life - how long an asset will work for - and economic life - how long the benefits of using an asset remain higher than the costs involved. Computer equipment may work for ten years, but the rapid improvements in speed and performance make its economic life much shorter. Residual Value is a disposal value - basically a payment made to the business by someone buying the asset. Depreciation method is how the depreciable amount of the assets life is allocated amongst accounting periods.

Choosing this method is based on the pattern of benefits consumed by the asset - an even spread of benefits over time would lead to a business choosing to adopt the straight line method, but an increasing decline in benefit over time - this is the return you would expect from computer equipment - would lead a business to choose a reducing balance method.

The measuring of the cost of stock in a business is important because of the effect that it has on both the calculation of profit and financial position. A business will calculate the cost of stock at the start and end of a reporting period, and can make common assumptions about how stock is handled - stating that the oldest inventories are the first to be sold (known as FIFO or first in last out) or that the newest inventories are the first to be sold (known as LIFO or last in first out). A business could also use an average cost of inventories held - useful, I suppose, if the business holds a lot of stock that is older and has less value because it will hide this fact on the profit and loss account.

References:

Atrill, P. and McLaney, E. (2006) Accounting and Finance for Non - Specialists 5th Ed. Harlow, Essex: Pearson Education Ltd.