Measuring and Reporting Financial Performance

The measurement of profit is probably the most important function of accounting. Investors, managers, bankers and others are interested in knowing how well a business is doing. The profit and loss account (income statement) shows the results of the flow of activity and transactions and is designed to report the profit performance of a business for a specific period of time, such as a year, quarter or month.

The purpose of income statement is to measure and report how much profit the business has generated over a period.

The measurement of profit requires that the total revenues of the business generated during a particular period, be calculated.

Revenue is simply a measure of the inflow of assets (cash or amounts owed to a business by debtors) or the reduction in liabilities which arise as a result of trading operations.

It is not necessary for a business to receive cash before recognizing that revenue has been earned. The accruals concept recognizes revenue which arises from the sale of goods or services on credit.

The total expenses relating to the period must also be calculated. An expense represents the outflow of assets (or increase in liabilities) which is incurred as a result of generating revenues.

Expenses are goods and services consumed in operating a business or other economic unit.

The income statement for a period shows the total revenue generated during a particular period and deducts from this the total expenses incurred in generating that revenue. The difference between the total revenue and total expenses will represent either profit (if revenues > expenses) or loss (if expenses > revenues).

Where revenues and expenses are equal for the period, the business is said to break even.

Profit (loss) = total revenue --- total expenses incurred to generate the revenue

The income statement and the balance sheet (B.S.) are closely related.

The profit and loss account can be viewed as linking the B.S. at the beginning of the period with the B.S. at the end of the period. Thus, at the commencement of business, a B.S. will be produced to reveal the opening financial position. After an appropriate period, an I.S. will be prepared to show the wealth generated over the period. A B.S will also be prepared to reveal the new financial position, at the end of the period covered by the I.S.

The B.S. will incorporate the changes in wealth which have occurred since the previous B.S. was drawn up.

The effect of making profit (loss) on the B.S. means that the B.S. equation can be extended as follows:

assets = capital + (--) profit (loss) + liabilities

(equity)

assets = equity + (revenues – expenses) + liabilities

2. Classification of expenses and revenues

Expenses and revenues are classified into three categories:

a) operating expenses and revenues;

b) financial expenses and revenues;

c) extraordinary expenses and revenues.

Expenses may be classified into 2 categories:

٭ by type operation or by function

٭ by type of expenditure or by nature.

Accordingly, there may be distinguished 2 formats for Income Statement (function, nature)