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Sam Ghosh Founder and SEBI Regd. Investment Adviser at Wisejay Private Limited Bangalore, Karnataka
Basics of Financial Accounting for Entrepreneurs part 4: Profit and Loss Statement
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06:38:55 AM, 12th June, 2019
  • Sam GhoshFounder and SEBI Regd. Investment Adviser at Wisejay Private LimitedBangalore, Karnataka

    Analysts will often start to analyse the economics of a business from the profit and loss Statement (also called an income statement). For entrepreneurs also profit and loss statement can be helpful in analysing operational efficiency.

    A word of caution though – for an early stage company the operations are not stable at all. The operations often go through a lot of changes as the entrepreneur tries to find a market fit often with a lot of experimentations. Also, due to lower negotiating power, an early-stage company often have to extend discounts for customer acquisition. Due to all these, the profit and loss statement will not reflect the true economics of the business for an early stage company.

    Let us discuss some important factors related to profit and loss statements.


    CASH AND NON-CASH EXPENSES

    An important step for an entrepreneur is to separate the cash-expenses from the non-cash expenses. Inventory cost, labour, SG&A, interest, income tax etc. involve cash-flows whereas depreciation, amortisation, stock-based compensation etc. do not involve any cash-flow.

    This is important to analyse the trend in the economics of the business without getting distracted by the accounting entries for non-cash expenses.

    Note: Even though the non-cash expenses can be ignored for short term decision making, they cannot be ignored in the long term. For example, depreciation reflects the cost associated with usage of plants and machinery. It is a reality that without the use of capital assets, the revenue could not be generated. Though the calculation of non-cash expenses depends on the accounting rules which may not completely reflect the real cost, entrepreneurs need to be aware that the capital assets will need to be maintained and replaced when necessary and allocate cash accordingly.


    FIXED AND VARIABLE COSTS

    Variable costs are the costs which vary with the production volume and fixed costs do not depend on the production volume. Example of variable costs are raw material, direct labour, etc. whereas renting expenses, administrative expenses etc. are examples of fixed costs.

    One way to look at it is that to register any profit, the business needs to have net revenue more than the fixed costs. For an early stage company with unstable revenue or companies in cyclical industries, keeping the fixed cost low is an absolute priority in designing the business model.


    INCOME TAX

    At the outset, it may seem that income taxes are very straight forward, you just calculate the tax and pay – right? Unfortunately, things are not that simple. A complication arises due to the difference between the accounting or book income and the taxable income.

    According to AS 22, accounting income (loss) “is the net profit or loss for a period, as reported in the statement of profit and loss, before deducting income tax expense or adding income tax saving”, whereas taxable income (tax loss) “is the amount of the income (loss) for a period, determined in accordance with the tax laws, based upon which income tax payable (recoverable) is determined”.

    The difference between the accounting income (loss) and taxable income (loss) arises mainly from the differences between accounting norms and the income tax laws. Some of these differences are reversible in future accounting periods and some of them are not. The reversible differences are called 'timing differences' and the non-reversible are called 'permanent differences'.

    Current tax is the amount determined to be payable or recoverable in the relevant period calculated based on the tax laws. A deferred tax which can be an asset or a liability which arises due to the aforementioned difference between accounting income (loss) and taxable income (loss) but only for the reversible part i.e. timing differences.

    Any excess payment of income tax as per the tax laws which can be revered is recorded a 'deferred tax asset' on the balance sheet of the company and can be used to reduce the future tax burden. Similarly, any shortfall in the tax payment creates 'deferred tax liability' which the company needs to pay in the future.

    The point is that the income taxes may not be straightforward and may need special attention of the entrepreneur.

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