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B. The income statement

 

The income statement aka P&L account (Profits & Losses account) represents the wealth created by the company during a given fiscal exercise. Every item shown on an income statement is thus impacting the profits realized during the period. Reciprocally, those operations which do not impact the profits are not recorded on the income statement. For instance, when borrowing an amount D of money, the company is not realizing profits (since it will have to pay back D in the future); therefore, this operation won’t appear on the income statement (but will be recorded on the balance sheet, since this affects the financing structure of the company). Similarly, when paying back the nominal amount D, the company is not posting losses (since it is merely paying back the amount that was borrowed in the past): therefore, this operation won’t show on the income statement (but will impact the balance sheet).

 

Income statement (aka P&L account)

 

 

Let’s now explain the different fields of the income statement.

 

Goods purchased, Sales of goods purchased: “goods purchased” records the cost of goods purchased for trade. This means that only those finished products which are purchased by the company with the sole purpose of being resold at a profit are recorded in this field. Obviously, “sales of goods purchased” records the value at which those goods were eventually sold.

 

Variation of inventories in goods purchased: records the variation in the value of the inventories in goods purchased. If this quantity increases, then this means that some of the goods purchased for resale were actually not sold during the period. Consequently, they must not penalize the income statement since they were not “consumed” by the company and therefore must be added back to (Sales of goods purchased – Goods purchased) in order to get the commercial profit realized by the company during this period.

 

Sales of finished products and services: records the sales of those finished products which were produced by the company, and of those services which were performed by the firm. The difference with the previous fields is that “sales of goods purchased” deals only with trading activity, while “Sales of finished products” deals with those products which are both manufactured and sold by the firm.

 

Variation of inventories and work in progress: records the variation in the value of the inventories in finished products and in the value immobilized within work in progress (those products which are being manufactured but are not finished yet). The same reasoning as above applies here: when this quantity increases, this means that some of the finished products were actually not sold during the period. Consequently, they must not penalize the income statement since they were not “consumed” by the company (similarly, work in progress cannot be considered as having been consumed by the company since it represents products which have not been finished yet).

 

Production for the company: records the value of those products or services which have been produced for the company for itself, that is to say for its own consumption.

 

Raw materials purchased: records the value of the raw materials which have been purchased for the manufacturing of finished products.

 

Variation of inventories in raw materials: records the variation in the value of the inventories in raw materials. The same reasoning as above applies: when this quantity increases, this means that some of the raw materials were actually not consumed by the production process during the period. Consequently, they must not penalize the income statement for that period.

 

Other purchases and external costs: regroups some other expenses linked to the production process, for instance wages paid to contract workers or marketing expenses.

 

Production subsidies: records the subsidies received by the government or other organizations.

 

The few following fields are self-explanatory, with the exception of “wages”, which records only those wages paid to the regular workers of the company (wages paid to contract workers are recorded within the field “other purchases and external costs” because they are considered as “closer” to the production process).

 

Depreciation & Amortization (D&A): records the depreciation of tangible assets and the amortization of intangible assets during the period. When purchasing an asset (be it a building for its headquarters or a patent in order to be able to produce a special drug), the company must accounts for the gradual loss in value of this asset in time. Indeed, since this asset appears on the balance sheet of the company, it reflects the wealth that the company owns at a certain point in time, and whenever this asset loses value, this must be accounted for and recorded as a loss for the period (note that this loss is actually non-cash, i.e. it won’t be materialized by a cash flow; also note that if it happens that the same asset appreciates in value, this won’t be recorded at all: in other words, when an asset is depreciated and loses value, it cannot take it back).

 

There are several methods available to companies in order to record D&A expenses:

 

-          the straight-line method: assume that the asset is initially purchased at t=0 at price P (the historical price), and assume that it has a salvage value of R (the salvage value is the value that will have the asset once it has been fully depreciated). The straight-line method consists in depreciating the asset over n years in a linear fashion, meaning that every year the asset’s value will decrease (P-R)/n. At the end of year n (and for all the following years), the asset will thus be worth its salvage value R. The Net Asset Value (NAV) at time t* represents the historical price at which the asset was purchased minus the cumulated depreciation of this asset until time t*. Let’s 5now take an example of an asset with historical price 100, salvage value 2 and to be depreciated over 5 years:

 

Example of straight-line depreciation

 

Book Value at the beginning of the year	Depreciation expense	Cumulated depreciation	Book value at the end of the year
$100	$15	$15	$85
$85	$15	$30	$70
$70	$15	$45	$55
$55	$15	$60	$40
$40	$15	$75	$25

 

-          the double-declining method: the interest of this method is to model the fact that the asset will lose more value during the first few years after its purchase. Once again, assume that the asset is initially purchased at t=0 at price P (the historical price), and assume that it has a salvage value of R. The asset will be depreciated by twice the linear rate (starting with the historical price, that is to say notwithstanding the salvage value; an example of this will be provided below). For the last step of the depreciation, one must make sure that the value of the asset does not fall below its salvage value. Let’s now take an example of an asset with historical price 100, salvage value 10 and to be depreciated over 5 years:

 

Example of double-declining depreciation

 

 

-          activity depreciation: this method consists in depreciating the asset according to how it is actually used by the company. Imagine that your company builds a $100,000 factory which is to be depreciated over 3 years, with salvage value $20,000. In this factory, you project to manufacture 1,000 finished products on the first year, 100 on the second year and another 1,000 on the third year. You will therefore depreciate $80,000 x 1000/(1000+100+1000) = $38,095 on the first year, $80,000 x 100/(1000+100+1000) = $3810 on the second year, and another $38,095 on the third year.

 

Example of activity depreciation

 

 

 

Provisions and writebacks on provisions: every time a new provision is recorded by the company, it has a negative impact on the income statement, since provisions are anticipated losses. Since these losses are only anticipated (but not effectively realized), provisions are also recorded on the balance sheet as negative assets or positive liabilities. In the future, if it happens that the losses anticipated by such provisions are not incurred (e.g., the customers eventually pay their debts), the value of the provision which was written to that effect will be recovered by the company (i.e. added back to the income statement, within the field “writebacks on provisions”).

 

Financial income: records the financial income earned by the company during the period (proceeds from financial investments in associates, for instance).

 

Financial expenses: records the financial expenses recorded by the company during the period, for instance interest payments on debt.

 

Non-recurring items: records those revenues and expenses which are not supposed to recur in the future, for instance an exceptional divestiture (your company, which was operating three factories, decides to sell one of them in order to cut production; since such a divestiture is exceptional and will not be likely to happen again in the near future, it is recorded as a non-recurring item).

 

Corporate tax: records the corporate tax paid by the company on its profits before tax for the current period. The corporate tax rate will be depending on the country in which the company is operating (but generally speaking, this rate will hover between 20% and 40%, even though there exist some tax havens where there is little or no taxation).