Finance explained to my mother-in-law. Chapter IV – Documents and principles

The documents that make up the annual statement of a company are 3:

  • Profit and Loss
  • Balance Sheet
  • Cash flow

A financial year covers 12 months: most often it runs from 1 January to 31 December, but it can also be postponed for market or company-specific reasons.

Profit and Loss : this is the compilation of the income for the financial year with the related expenses, i.e. only those actually used to “produce” the income.

In order to “produce” the turnover of a given financial year, it is necessary to purchase raw materials, employ machine and labour hours, incur transport costs, staff salaries, etc. over the twelve months.

The accounting approach classifies these events by “nature” (local sales, European sales, sales outside Europe, purchase of materials, purchase of services, etc.) according to an accounting plan defined by strict numerical codes.

The off-balance sheet approach, on the other hand, consists of reclassifying business events by “destination” (sales of product x or y) with “standard” recipes and formulations for which deviations and waste are checked.

Knowing that accounting is little more than a necessary evil, I will always use the second type of approach for explanations to my mother-in-law.

There is a fundamental principle related to Profit and Loss, which is the deterministic relationship between expenses and income for the financial year.

Everything that does not fall within this relationship is booked to the Balance Sheet.

A rent for the first half of the following financial year will therefore be booked to ?

Balance Sheet ?
Income Statement ?

Balance Sheet: corporate economic events that have an impact that extends beyond the financial year are recorded in the Balance Sheet.

Example Income Statement/ Balance Sheet – Year ended 31/12

  • Sale of 100t of product at 30/12 => Income statement
  • Purchase of 1000Kwh for the production of November => Profit and loss account
  • Expense report of the Chairman of 15/12 => Income statement
  • Purchase of a wagon of raw materials to be used on 03/01 => Balance sheet (stock)
  • Purchase value of new production equipment => Balance sheet (Immo) – because its usefulness extends beyond the financial year, except for the share represented by “depreciation”.
  • Depreciation of a production equipment => Income statement
  • Anticipated quarterly rent (01/01 – 31/03) => Balance sheet (Prepaid expenses)

As double-entry accounting is used, events that have an impact on the Income Statement have also a counterpart on the Balance Sheet.

Each event in the Income Statement is recognised in Equity (under Liabilities in the Balance Sheet) in the form of “Profit (Loss) in progress” while a counter-entry of equal amount but opposite effect will be recognised to balance the Balance Sheet.

Example double-entry

  • Sale of 100t of product at 30/12 => Operating income:
    contributes positively to the current Result of the Income Statement by increasing the Equity on the Liabilities side of the Balance Sheet.
    At the same time, Current Assets will increase by the same amount due to the Receivables.
    Eventually Assets and Liabilities increase by the same amount and remain the same.
  • Purchase of 1000Kwh for production in November => Operating cost:
    contributes negatively to the current result in the Income Statement by decreasing Equity on the Liabilities side in the Balance Sheet.
    At the same time, the Current Liabilities will increase by the same amount because of the Payables.
    The Liabilities will therefore decrease by the same amount and the total will remain the same as Assets.