What you'll learn
The income statement measures performance over a period: it starts with revenue, subtracts the cost of what was sold to produce gross profit, then subtracts the running expenses to give profit for the year. The statement of financial position — still widely called the balance sheet — measures position at a single date: what the business controls, what it owes, and what the owner's stake in it is worth. One is a film of the year; the other is a photograph taken at midnight on the last day of it.
The two are joined at the hip. Profit for the year, calculated in the income statement, is added to the capital account in the statement of financial position, and drawings are subtracted from it. If you prepare both statements and the statement of financial position does not balance, the error is almost always in that link or in an adjustment that was put through one statement and not the other.
By the end of this topic you should be able to prepare both statements from a trial balance with adjustments, in the vertical format CXC expects, calculate cost of sales and gross profit correctly, classify every item as current or non-current, and explain what each statement does and does not tell a user.
Key terms and definitions
Revenue (sales) — the value of goods sold or services provided in the period, net of returns inwards.
Cost of sales — opening inventory plus purchases plus carriage inwards, less returns outwards, less closing inventory.
Gross profit — revenue less cost of sales. It measures trading margin before any running costs.
Profit for the year (net profit) — gross profit plus other income, less all expenses.
Non-current asset — an asset held for use in the business over more than one accounting period.
Current asset — an asset expected to be turned into cash within one year: inventory, receivables, prepayments, bank, cash.
Current liability — an obligation due within one year: payables, accruals, bank overdraft.
Non-current liability — an obligation due after more than one year, such as a long-term loan.
Working capital (net current assets) — current assets less current liabilities.
Capital employed — capital plus non-current liabilities; equivalently, non-current assets plus working capital.
Core concepts
Building cost of sales
Cost of sales is not the same as purchases, and the difference is where most marks are lost. The figure needed is the cost of the goods that were actually sold, not the cost of the goods that were bought.
Start with opening inventory — goods on hand at the start that could be sold this year. Add purchases. Add carriage inwards, because the cost of getting goods into the warehouse is part of what they cost. Deduct returns outwards, because goods sent back were never available to sell. Deduct closing inventory, because those goods are still on the shelf and will be sold next year.
Two items are commonly misfiled here. Carriage inwards belongs in cost of sales; carriage outwards is a distribution expense and belongs below gross profit. Goods taken by the owner are deducted from purchases and debited to drawings — they were not sold, so they must not sit in cost of sales.
The structure of the income statement
The vertical format runs: revenue, less returns inwards, giving net revenue. Less cost of sales, giving gross profit. Plus other income — discount received, rent received, commission received. Less expenses, giving profit for the year.
Expenses are usually presented in groups: selling and distribution, administrative, and finance costs. At CAPE level a clear list is acceptable, but grouping reads better and occasionally earns a presentation mark.
Note what is not an expense. Drawings are not an expense; they are a withdrawal of capital. Repayment of loan principal is not an expense; only the interest is. Purchase of a non-current asset is not an expense; only its depreciation is.
The structure of the statement of financial position
Assets are listed with non-current first, at cost less accumulated depreciation, giving carrying amount. Then current assets, in increasing order of liquidity: inventory, receivables less any allowance for doubtful debts, prepayments, bank, cash.
Current liabilities are deducted from current assets to give working capital, which is added to non-current assets to give net assets. Below that sits the financing section: opening capital, plus profit for the year, less drawings, giving closing capital, plus any non-current liabilities.
Net assets must equal capital plus non-current liabilities. That is the accounting equation restated, and it is why the statement balances.
Why the two statements must agree
Every year-end adjustment touches both statements. An accrual of $3,000 for unpaid wages increases the wages expense in the income statement and creates a $3,000 current liability in the statement of financial position. Depreciation of $12,000 is an expense and also increases accumulated depreciation, reducing the carrying amount of the asset.
If you make the income statement entry and forget the position statement entry, the statement will be out by exactly the amount of the adjustment. When a statement fails to balance, list the adjustments and check each has been made twice before looking anywhere else.
What the statements do not tell you
The statement of financial position is not a valuation of the business. Assets are at historical cost less depreciation, not at what they would fetch. Internally generated goodwill, brand strength and the skill of the workforce are absent entirely because they cannot be measured reliably in money.
The income statement is a single period on a chosen basis. A change of depreciation method or inventory valuation changes the profit without changing anything real about the business. This is the material for the evaluation marks in a Paper 02 question, and it is worth having two or three of these limitations ready to deploy.
Worked examples
Example 1 — Cost of sales and gross profit (6 marks)
Sookram's Dry Goods, year ended 31 December. Opening inventory $48,000; purchases $310,000; carriage inwards $9,000; returns outwards $14,000; closing inventory $52,000; revenue $520,000; returns inwards $8,000.
Net revenue = $520,000 − $8,000 = $512,000.
Cost of sales = $48,000 + $310,000 + $9,000 − $14,000 − $52,000.
Working: $48,000 + $310,000 = $358,000; + $9,000 = $367,000; − $14,000 = $353,000; − $52,000 = $301,000.
Gross profit = $512,000 − $301,000 = $211,000.
Gross margin = $211,000 ÷ $512,000 = 41.2%. One mark each for net revenue, the two inventory figures, carriage inwards treated as cost of sales, returns outwards deducted, and the gross profit.
Example 2 — From gross profit to profit for the year (5 marks)
Continuing: expenses were wages $96,000, rent $24,000, carriage outwards $7,000, insurance $11,000, depreciation $18,000, loan interest $5,000. Other income: discount received $4,000.
Total expenses = $96,000 + $24,000 + $7,000 + $11,000 + $18,000 + $5,000.
Working: $96,000 + $24,000 = $120,000; + $7,000 = $127,000; + $11,000 = $138,000; + $18,000 = $156,000; + $5,000 = $161,000.
Profit for the year = $211,000 + $4,000 − $161,000 = $54,000.
Note that carriage outwards sits here, not in cost of sales. Moving it would leave profit for the year unchanged but would misstate gross profit by $7,000 and distort the margin, which is exactly what an examiner is testing.
Example 3 — Completing the statement of financial position (7 marks)
At 31 December, Sookram's had: premises at cost $400,000 with accumulated depreciation $60,000; equipment at cost $90,000 with accumulated depreciation $34,000; inventory $52,000; receivables $71,000; prepaid insurance $3,000; bank $18,000; payables $44,000; accrued wages $6,000; bank loan repayable in five years $120,000. Opening capital was $351,000 and drawings for the year were $35,000.
Non-current assets: premises $400,000 − $60,000 = $340,000; equipment $90,000 − $34,000 = $56,000. Total = $396,000.
Current assets = $52,000 + $71,000 + $3,000 + $18,000 = $144,000.
Current liabilities = $44,000 + $6,000 = $50,000.
Working capital = $144,000 − $50,000 = $94,000.
Net assets = $396,000 + $94,000 = $490,000.
Financing: closing capital = $351,000 + $54,000 − $35,000 = $370,000. Add the non-current loan of $120,000: $370,000 + $120,000 = $490,000.
That equals net assets, so the statement balances. Notice that the profit figure came straight from Example 2 — the link between the two statements is the profit line, and it is the first thing to check if the totals disagree. If it had come out $35,000 short, the likely cause would be drawings deducted twice; if it were $70,000 over — twice the drawings — the cause would be drawings added instead of deducted. An error equal to a figure in the question, or to twice one, almost always identifies itself.
Example 4 — Classifying items (4 marks)
Classify: (a) a three-year bank loan, (b) rent received in advance, (c) a motor vehicle held for use, (d) inventory of unsold goods.
(a) Non-current liability — due after more than one year. (b) Current liability — the business owes a service it has been paid for, due within the year. (c) Non-current asset — held for use over more than one period. (d) Current asset — expected to be sold within the year.
Rent received in advance is the one candidates misclassify. Money has come in, but it is not yet income; it is an obligation.
Common mistakes and how to avoid them
Treating purchases as cost of sales. Always adjust for opening and closing inventory, carriage inwards and returns outwards.
Putting carriage outwards in cost of sales. Inwards is a cost of buying; outwards is a cost of selling.
Treating drawings as an expense. Drawings never touch the income statement. They are deducted from capital.
Adding drawings to capital instead of deducting. This produces an error of exactly twice the drawings figure — a useful diagnostic when a statement is out by an even amount.
Forgetting to deduct the allowance for doubtful debts from receivables. Receivables are shown net in the statement of financial position.
Showing non-current assets at cost only. Show cost, accumulated depreciation and carrying amount; the mark scheme usually rewards all three.
Making an adjustment once. Every accrual, prepayment and depreciation charge appears in both statements.
How this links to your Internal Assessment
The Internal Assessment normally requires a full set of final statements for the business you have chosen, prepared from the records you have kept. Prepare them in the vertical format used throughout this topic — it is what the moderator expects and it makes the working capital and capital employed figures visible without extra calculation.
Two things lift an Internal Assessment above a competent set of statements. The first is a short reconciliation showing how the trial balance and your adjustments produced the final figures, which proves the statements came from the records rather than from nowhere. The second is interpretation: state the gross margin and the net margin, compare them with the prior period or with what the owner expected, and say what the difference means for the business.
If the business is small and largely cash-based, say so and explain what that means for the reliability of your figures. Acknowledging a limitation you cannot remove is stronger than pretending it is not there.
Exam technique for the income statement and statement of financial position
Paper 02 questions in this area are long and generously marked, and they reward method. Read the adjustments note first, before you write anything, and mark each adjustment on the trial balance so none is missed.
Lay out your workings separately and label them — W1 depreciation, W2 accruals, W3 cost of sales. Mark schemes award working marks even when the final figure is wrong, and a labelled working is the only way the examiner can give them to you.
Watch the command words. Prepare means produce the statement in proper format with a heading naming the business, the statement and the period or date. Calculate means show the arithmetic. Comment on or assess means interpret the figure, not restate it: a gross margin of 41% is a number, whereas a gross margin that has fallen from 48% because purchase prices rose faster than selling prices is an answer.
If the statement does not balance, do not abandon it. Complete it, state the difference and say where you would look. Many mark schemes carry marks for correct presentation and for the items that are right.
Quick revision summary
- Income statement covers a period; statement of financial position is at a date.
- Cost of sales = opening inventory + purchases + carriage inwards − returns outwards − closing inventory.
- Gross profit = net revenue − cost of sales; net revenue = revenue − returns inwards.
- Carriage inwards is in cost of sales; carriage outwards is an expense below gross profit.
- Profit for the year = gross profit + other income − expenses.
- Drawings, loan principal and asset purchases are not expenses.
- Current assets are listed in increasing order of liquidity; receivables are shown net of the allowance for doubtful debts.
- Working capital = current assets − current liabilities; net assets = non-current assets + working capital.
- Closing capital = opening capital + profit − drawings; net assets = capital + non-current liabilities.
- Every adjustment appears in both statements — that is the first place to look when it will not balance.
- The statements do not value the business: historical cost, no internally generated goodwill, and policy choices affect reported profit.