Statement of profit or loss
Reports revenue and the costs incurred during a period of time, ending with profit or loss for that period. It is sometimes called an income statement.
Cambridge International A Level Business · Topic 10.1
Financial Statements
Financial statements summarise a business' financial performance and position. This topic develops the statement of profit or loss, statement of financial position, inventory valuation and depreciation, with the calculations and interpretation needed for A Level questions.
A LevelFinance & accountingCalculations includedExam-focused
What you need to master
You should be able to construct and interpret the main parts of financial statements, calculate profit measures and working capital, understand how transactions alter a statement of financial position, value inventory using net realisable value, calculate straight-line depreciation, and explain how the two main statements are linked.
Financial statements: the big picture
Businesses record financial information so managers and other stakeholders can judge performance and make decisions. Public companies in many countries prepare statements using International Financial Reporting Standards (IFRS), which helps make accounts more comparable across businesses and countries.
Statement of financial position
Shows the business' assets, liabilities and equity at a specific date. It was previously widely called the balance sheet.
Key distinction: the statement of profit or loss is a flow over a trading period; the statement of financial position is a snapshot at one point in time.
Statement of profit or loss
Purpose and meaning
A statement of profit or loss shows the sales revenue earned over a trading period and the relevant costs incurred to earn that revenue. A business makes a profit when revenue exceeds costs and a loss when costs exceed revenue.
Revenueincome from sales
− Cost of salesdirect costs of goods sold
= Gross profitbroad trading profit
− Expensesadministration, selling and other operating costs
= Operating profitprofit from operations
Gross profitGross profit = Revenue − Cost of sales
Cost of sales includes the direct costs associated with the goods or services sold.
Operating profitOperating profit = Gross profit − Operating expenses
This includes costs such as administration and selling expenses.
Profit before taxOperating profit + finance income − finance costs
Interest received adds to profit; interest paid reduces it.
Profit for the yearProfit before tax − Taxation
This is the profit available for distribution or retention.
Three important profit measures
Gross profit
Revenue less cost of sales. It gives an early indication of trading performance before other operating expenses are considered.
Operating profit
Gross profit less operating expenses. This is a stronger measure of the performance of the main business operations because it includes more of the costs of running the business.
Profit for the year
Includes trading and non-trading income, finance costs and taxation. A negative figure is a loss for the year.
Retained profit
The portion of profit for the year kept in the business after distributions to owners. It can finance future investment and growth.
How can profit be used?
Profits can be distributed to owners—for a company this normally means dividends to shareholders—or retained within the business. Retaining more profit can strengthen internal finance for investment, while paying more dividends may satisfy shareholders seeking current income. The appropriate balance depends on growth plans, cash needs and shareholder expectations.
What changes a statement of profit or loss?
Worked example: amending a statement of profit or loss
A business sells 20,000 units at $18. Cost of sales is $10 per unit. Operating expenses are $82,000, finance costs are $8,000 and tax is 20% of profit before tax.
Statement of profit or loss
| Revenue (20,000 × $18) | $360,000 |
| Cost of sales (20,000 × $10) | ($200,000) |
| Gross profit | $160,000 |
| Operating expenses | ($82,000) |
| Operating profit | $78,000 |
| Finance costs | ($8,000) |
| Profit before tax | $70,000 |
| Tax at 20% | ($14,000) |
| Profit for the year | $56,000 |
If sales volume rises, do not change revenue alone. Cost of sales is likely to change too. In exam calculations, follow every knock-on effect through the statement.
Evaluation: higher revenue does not guarantee higher profit. A sales increase may require lower prices, additional labour, distribution or capacity. Compare the scale of the revenue change with the scale of the cost change.
Statement of financial position
A financial snapshot
A statement of financial position records the assets and liabilities of a business on a particular date at the end of an accounting period. It therefore shows financial position at one moment rather than performance throughout a whole year. A consolidated statement combines information for the divisions or companies within a group.
Assets
Non-current assets
Assets the business expects to keep for at least a year and use in its operations rather than buy for resale. Examples include land, buildings, machinery, equipment and vehicles.
Current assets
Assets expected to be turned into cash, sold or used within the shorter term. Common examples include cash, trade receivables and inventories.
Liabilities and equity
Current liabilities
Debts due for payment within one year, such as overdrafts, taxes due and trade payables.
Non-current liabilities
Longer-term debts not expected to be repaid within one year, such as multi-year bank loans and mortgages.
Equity
The shareholders' stake in the company. It includes share capital and reserves/retained earnings.
Reserves
Accumulated profits that have not been distributed to owners and have instead remained invested in the business.
Key relationships
Net current assets / working capitalCurrent assets − Current liabilities
A positive figure means current assets exceed short-term liabilities, although the appropriate level varies by industry.
Net assets(Non-current assets + Current assets) − (Non-current liabilities + Current liabilities)
Net assets represent the residual value after liabilities are deducted from assets.
Assets
Resources owned or controlled by the business and used to support operations.
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Financing
Liabilities and equity show how those assets have been financed. The statement must balance after transactions are recorded.
Typical vertical format
Illustrative statement of financial position
| Non-current assets | $520,000 |
| Current assets | $210,000 |
| Current liabilities | ($145,000) |
| Net current assets | $65,000 |
| Non-current liabilities | ($180,000) |
| Net assets | $405,000 |
| Share capital | $250,000 |
| Reserves / retained earnings | $155,000 |
| Total equity | $405,000 |
Why does the statement matter?
Stakeholders use it to judge the scale and composition of assets, short-term financial position, debt levels, shareholder funds and changes from previous years. A bank considering a loan may focus on liquidity, existing borrowing and asset backing. Investors may consider growth in net assets and retained earnings. Suppliers may consider whether the business appears able to meet short-term obligations.
Amending a statement of financial position
Transactions normally create more than one change because the statement must remain balanced. Examples include:
Buy an asset for cash
Non-current assets rise while cash falls. Total assets may be unchanged.
Buy an asset using a long-term loan
Non-current assets rise and non-current liabilities rise by the same amount.
Repay a long-term loan with cash
Cash falls and non-current liabilities fall.
Issue shares to raise finance
Cash/assets rise and share capital/equity rises.
Depreciate a non-current asset
The carrying value of the asset falls and depreciation is recognised as an expense, reducing profit and retained earnings.
Sell inventory for cash
Inventory falls while cash rises; the sale also affects revenue and cost of sales in the statement of profit or loss.
Worked example: working capital
A business has current assets of $420,000 and current liabilities of $310,000.
Net current assets = $420,000 − $310,000 = $110,000.
If it pays $40,000 of trade payables using cash, current assets fall to $380,000 and current liabilities fall to $270,000. Working capital remains $110,000. This shows why a transaction can change individual figures without changing the final balance.
Evaluation: a statement of financial position is useful but it is only a snapshot. To judge a business well, compare with earlier years, competitors and information from the statement of profit or loss.
Inventory valuation
Inventory is a current asset, so its valuation affects the statement of financial position. It also affects cost of sales and therefore profit. Businesses need a reasonable inventory value so stakeholders are not misled about the financial position or performance of the business.
Why can inventory be difficult to value?
Perishability
Food and other short-life products may lose value as they approach the end of their saleable life.
Fashion and obsolescence
Clothing, electronics and other trend-sensitive products can lose value quickly when tastes or technology change.
Uncertain market price
Unique products such as antiques or art can be hard to value because different buyers may assign different prices.
External price movements
Commodity inventories can change sharply in value when world market prices move.
Net realisable value (NRV)
The NRV method values inventory at the amount expected from selling it, after deducting the costs needed to complete or make the sale.
Net realisable valueNRV = Expected selling value − Costs of sale/disposal
Under the approach used in the textbook, inventory is valued at the lower of its cost and its NRV.
1. Estimate selling valueWhat could the inventory realistically sell for?
2. Estimate selling costsAdvertising, distribution or other costs required to sell/dispose.
3. Calculate NRVSelling value less those costs.
Worked example: NRV
A retailer holds 1,600 units expected to sell for $25 each. Distribution and selling costs are expected to total $4,800.
Expected selling value = 1,600 × $25 = $40,000.
NRV = $40,000 − $4,800 = $35,200.
If the inventory originally cost $37,000, the lower figure is NRV, so the inventory would be valued at $35,200. If its cost had been $33,000, the lower figure would instead be the cost of $33,000.
Why inventory valuation matters to profit
Cost of sales relationshipCost of sales = Opening inventory + Purchases − Closing inventory
A lower closing inventory valuation raises cost of sales and therefore lowers gross profit, all else equal. A higher closing inventory valuation has the opposite effect.
Evaluation: inventory valuation can materially alter both the statement of financial position and profit. The significance is greatest where inventory is a large proportion of current assets or where market values change rapidly.
Depreciation
Meaning and purpose
Depreciation is the reduction in the value of a non-current asset over time. It applies to capital expenditure such as machinery, vehicles and equipment. The decline may reflect wear and tear, technological obsolescence, age or poor maintenance.
Accurate asset values
Keeping an old purchase price on the statement of financial position can overstate the current value of an ageing asset.
More accurate annual profit
Depreciation spreads the cost of using an asset across its useful life instead of charging the whole purchase cost to one year.
Important: depreciation is a non-cash expense. Recording depreciation reduces accounting profit, but no cash payment is made at the moment the depreciation expense is recorded.
Straight-line depreciation
Annual straight-line depreciation(Cost of asset − Residual value) ÷ Useful working life
Residual value is the amount expected when the asset is sold or disposed of at the end of its useful life.
Worked example
A machine costs $96,000, is expected to last 6 years and have a residual value of $12,000.
Annual depreciation = ($96,000 − $12,000) ÷ 6 = $14,000 per year.
Carrying value using straight line
| End of year | Carrying value |
|---|---|
| Purchase | $96,000 |
| 1 | $82,000 |
| 2 | $68,000 |
| 3 | $54,000 |
| 4 | $40,000 |
| 5 | $26,000 |
| 6 | $12,000 |
Strength and limitation of straight-line depreciation
Strength
It is simple to calculate, easy to understand and spreads the depreciable amount evenly over the asset's useful life.
Limitation
Many assets do not lose value evenly. Vehicles and technology may fall in value faster in the early years, so straight line can overstate their value at some points.
What happens if depreciation is too high or too low?
| Too much depreciation | Too little depreciation | |
|---|---|---|
| Statement of financial position | Non-current assets may be understated. | Non-current assets may be overstated. |
| Statement of profit or loss | Expenses are higher and profit lower. | Expenses are lower and profit higher. |
| Possible wider effect | The business may look less profitable or valuable than it really is. | The business may appear stronger than it really is and may report higher taxable profit. |
Links between the two financial statements
Statement of profit or loss
Records profit, interest, depreciation expense and cost of sales during the accounting period.
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Statement of financial position
Records retained earnings, loans, the carrying value of non-current assets and closing inventory at the period end.
Profit and retained earnings
Profit not distributed to owners adds to retained earnings/reserves in equity.
Borrowing and interest
A loan appears as a liability; interest on the loan appears as a finance cost and reduces profit.
Depreciation
Depreciation reduces the carrying value of a non-current asset and is also recognised as an expense.
Inventory
Closing inventory is a current asset and also enters the cost-of-sales calculation, so its valuation affects gross profit.
Common exam traps
- Do not confuse cash with profit.
- Do not treat depreciation as a cash payment.
- If sales volume changes, consider the likely effect on cost of sales too.
- Use the lower of cost and NRV when applying the inventory rule described in this topic.
- A statement of financial position is a snapshot; it does not directly show profitability over the year.
Evaluation: depreciation improves the usefulness of financial statements only if the useful life and residual value assumptions are sensible. Straight line is convenient, but convenience does not guarantee an accurate market value.
10.1 revision checklist
Questions open in a pop-up. Each answer is marked immediately, with an explanation so you know why it is correct or incorrect.