The profit and loss account, and why it looks the way it does


All those of us who have studied double entry bookkeeping will remember their earliest lessons, in which we are told how the balances of the various accounts in the general ledger are taken to one of two statements at the end of the reporting period.  One of these is the balance sheet, which (we were told in lesson one) is like a family photo, a snapshot of your business at one particular point in time, and therefore is “na dzien”, and the other statement is the profit and loss account, which is a story of how the family developed and what happened to them between the last photo, and the current photo.  Put simply, a profit and loss account is the story of how you get from one balance sheet to another.  There are in fact other ways in which balance sheet items can change which don’t involve things passing through the profit and loss account, but international standards of accounting seem to prefer it when as much as possible going on between an opening and closing balance sheet for a reporting period (usually a year) is reflected to the maximum degree possible in the profit and loss account, or as it is now fashionably known, the statement of income and expenditure.

What I wanted to talk about in this article is to let us think I’m at about the order in which things appear in a typical profit and loss account.  This is worth doing as there are many different layouts for the balance sheet as you go around the world (the Americans have theirs, the British have theirs, the continental Europeans have theirs and each of the above look somewhat different) but there is a lot more uniformity as you go around the world in the order in which things are set out in the profit and loss account, or statement of income and expenditure.

Invariably the first thing that it deals with is the issue of turnover.  In most countries which have VAT, but by no means all, the turnover figure in published accounts is shown net of VAT.  That is how it is done in Poland and that is the way in which international standards would also have us do it.  Similarly the expenses, where VAT applies which can be reclaimed by the entity, are shown net.  (This of course is different to the balance sheet, where debtors and creditors are shown gross of VAT and the difference which you would have in the profit and loss account if those items were shown gross ends up in the VAT control account).

The first question that our profit and loss account seek to answer is whether the business is making a profit or loss regardless of how it is financed or tax.  It is also good to show items which are likely to be normal recurring items, and not one-off or extraordinary items in the first part of the profit and loss account.

Hence the top of most people’s profit and loss accounts as you go around the world deals with the question of ordinary sales income and the costs incurred to get to that sales income, giving a basic idea of profit.  Before you add in the cost of selling an administration, while you are still looking at a cost of goods sold or the cost of providing the services of is a service company, the profit figure achieved is known as gross profit.  Exactly what costs and what revenues make up that gross profit actually do differ quite significantly from one firm to another firm depending on the business, and the principles of management accounting have quite a lot to say in how we will classify the costs and revenues going into the gross profit line.

Once we’ve subtracted from the gross profit other operating costs such as the selling and administration costs, we come down to something called profit on ordinary operating activities.  After that it might be a good time to look at the extraordinary activities that happened which were still operational, or “other” activities which are not core, such as sales of fixed assets or unusual write downs, and this gives you the operating profit.

The next question that the profit and loss account will seek to answer is the cost of financing the business.  We are still well before the point at which tax is applied, as finance charges such as interest on business loans are usually tax allowable.  We look in this section of the profit and loss account at the interest received and take off the interest paid.  In Poland we have just about any foreign exchange differences also appearing in this section, where as in most western countries it would be considered correct to examine foreign exchange differences to see whether they really appeared on financing decisions or an operational decisions, and put them in the correct part of the profit and loss account depending on the answer to that question.  In Poland they are automatically considered to be part of the financing decision, which is not always true and therefore sometimes leads to misleading ratio analysis unless this is taken into account by the analyst.

At this point the profit and loss account will show us the profit on all the ordinary activities, and the next question that it starts to answer is what the tax is on that.  If a company is applying deferred tax, then the tax figure shown in the profit and loss account will be normalised tax on the profits to that point.  It takes account of timing differences between operational treatments of transactions and there tax treatments.  This means it probably won’t be the same as the figure on the tax return for the year.  The difference between the figure in the profit and loss account and the figure on the tax return for the year is usually going to be the amount added to or subtracted from the deferred tax assets and liabilities and the balance sheet.

In Poland that is usually the end of the line for the profit and loss account, however in some groups the profit and loss account goes on to answer the question ‘how about minority interest?’ which comes after the tax question because tax falls regardless of who the minorities are, and then questions about dividends are dealt with in the profit and loss account in many countries, but not generally so in Poland.

In order not to get confused the questions which the profit and loss account is trying to answer, it is important to observe the order of information, and also to consider whether an item is needed in order to help is to say the very important question of whether the underlying business is profitable or not, and the more the answer to that is yes, the higher up in the profit and loss account you should show it or expect to find it.

 

What do you want out of business?


The picture shows the typical stakeholders of ...
Some stakeholders, yesterday

Governance and strategy are what this blog is all about, but governance and strategy themselves are actually all about making sure that business delivers its intended objectives.  Objectives, in their turn, derive or ought to derive, from the mission statement of the organisation.  The mission statement is supposed to say what the stakeholders want out of the business.  Therefore even though this may seem to be a post on a lighter note than some of the posts in this blog, nevertheless I believe that this question really gets into the heart of what strategy and governance are actually all about.  Strategy and governance are all about making sure that we want out of the business, we get.

Therefore the starting point needs to be to ask ourselves the question, what is it that we actually want from business? This is a question which I’d like to ask today to anybody who is a stakeholder, please note I didn’t say “shareholder” but “stakeholder” in any business.  Please consider the businesses in which you are a stakeholder, please identify the one which has the greatest importance to you of those businesses, and with regard to that particular business, please put into the poll below all of the answers which you see as being things that you want out of that business.  Things that you are looking for from your stake as a stakeholder in that business.

Hopefully this will show a nice cross-section of the different things which stakeholders are actually looking for from businesses, but if you can see in the list something which you are particularly looking for from your business please feel free to add it in the comments afterwards.

Many thanks for taking part in the poll.

Domain names scam – what to do if affected


World Map Politic 2005 with ccTLDs - LQ version
CCTLD map from Wikipedia

You may have received e-mail (especially from Chinese and Hong Kong companies relating to .cn domains bearing your name if you didn’t register in China, but now more commonly in East Europe also) which says that if you use these people’s services they can prevent your name’s domain in that country from getting blocked.

Now this email gets sent out all over the world to addresses harvested from the internet page and chats and from usenet fora by robots, and of course the people behind the email cannot really afford to block every single domain that they are fishing for.  The one sure fire way of making sure that they do block your domain is if you respond to them, whether with threats or with asking for the help, even in terms of “what it would cost”. I suggest you only do this if you don’t want the domain really and have no intention of buying it, as if you are lucky it will lead the scammers into real cash outlay which they’ll never see any return on. I highly encourage that! Maybe some of these pests will stop it if they see that enough internet users are wise to them and don’t mind leading them up a garden path…

You can always search here on EuroDNS (in the interests of transparency that affiliate link earns 10% of anything you buy after you go there, but it shouldn’t cost you more and it’s the service I use myself) and see what the status is of all of your possible combinations of your name and the country endings or generic endings, as well as check the Whois status of all these countries, both Europe and Asia, all in one place. You will probably find that nobody has blocked your domain at all, and if you are interested in owning the domain you can block it there and then. They are ethical and I never had a problem with them that the owner didn’t solve within a week. If they are not contactable one day you can usually get them the next day. Continue reading “Domain names scam – what to do if affected”

Should your Company have a pro-forma audit?


Mostrador de um relógio Foto de Jose Goncalves
Tempus fugit - is it time for your proforma audit?

For businesses which have never been audited but which are growing up quickly to meet the audit thresholds in a year or two, you may wish to consider having your first audit done while it is still voluntary to do so, and the results, if less positive than expected, can at least be kept private.

Once your business has exceeded the audit thresholds (very typically in Europe this means for a private company about 50 employees, 5 million Euros turnover and 2.5 million Euros of gross assets, and it means 2 out of those three conditions – we just stated actually the Polish ones verbatim, (with the proviso that they also state a set PLN amount to avoid subjectivity for businesses that are on the cusp), but most countries are not far off that – even the Czech Republic which really needs much smaller thresholds)

Clearly this doesn’t apply at all to public limited companies, ie. the “S.A.”, “a.s.”, UK plc or German AG style companies which must be audited regardless of size – in some jurisdictions even if they are dormant – but for private limited liability companies most jurisdictions have size criteria like the ones just given – for Slovakia about 60% of the sizes given, so please note that this is divergent from the Czech ones, which are far too high for that country and result in proportionally fewer audits, which is a bad thing for corporate governance in that country.

While you are under the limits audit is voluntary. And you can have an unofficial audit whereby the audit comes and does for you all the normal work he would do if officially appointed, but it is only pro-forma. “Pro-forma” is Latin for something like the idea of “as if” so the auditor will work and report as if they had been properly appointed, but it is really a dry run for you. You do not appoint them as statutory auditors in the minuted general meeting, you do not have to file the report as the audit was voluntary, and you get all the benefit of the audit without the risk, and on top of all of that, I can get you these pro-forma audits for only 75% of the cost of a statutory audit, because the Firms we associate with want to promote good voluntary governance practice in the economy.

If you wait for your first audit until it is an obligatory one because you’ve outgrown the size criteria – and as we come out of the recession that will happen to some of you next year hopefully sooner than you dare hope for now – then if the auditor finds something wrong then the report of the auditor could be “modified” – I’ll do a separate article on what sorts of “modifications” exist and what they mean in accountancy speak, but it’s not good if you get one.

It will not help if you need a loan, and it will probably trigger a lot of interest on the part of the tax inspector. But you’ll have to publish it anyway, if there isn’t time to do the remedial work a good auditor should outline to you in time for your statutory deadline.

Now auditors get cajoled, encouraged in a friendly way or even outright threatened by desparate managers and owners to overlook things or change to an opinion that doesn’t match the facts, and there is nothing that can be done in those circumstances. Auditors are not generally anywhere near as afraid of their client as they are of their regulator, but more than that we are educated throughout our professional lives to be independent in our outlook, and so the only way to get out of some modified opinions is to do the remedial work the auditor recommends or make the adjustments that they recommend.

There’s no point in changing to another auditor you think will be more pliable – they must write to the old auditor and ask if there are any reasons why they cannot act. The best thing to do, if you are not sure how well your company will stand up to an audit is to have your first one a year or so before you need to. Then if the audit shows up a lot to be desired, you have a whole year to put it right and nobody will ever know because auditors are bound by confidentiality – it isn’t us who even publish our reports, it’s the responsibility of the client. The report is given to its addressee, which is always the shareholder, and some other corporate governance boards if they are in existence.

So it’s well worth thinking about, especially if your business has been growing fast and maybe has outgrown its systems.

Let us know if we can help.

Don’t neglect your inventory count!


This article talks about the seasonal business of inventory counting from a Polish perspective. It is also broadly true, with variations in the details, for most countries in the region.

It’s that time of the year again. Already some businesses with financial years corresponding to the calendar year (which is still the vast majority of businesses in this country) will count their inventories at the end of November just to avoid interrupting their employees Christmas breaks, some however will be pulling in the warehouse staff and others around Christmas and New Year to do their yearly duty. Some businesses, even with material amounts of stocks, will however not be stock-taking at all, as they believe that they can take advantage of  article 26 paragraph 3 point 2 of the Ustawa o Rachunkowosci and only perform this task every two years, and among those who will be doing it this year, a surprising number will not be taking it too seriously.

 

The point of this article is to remind you that the stocktake is one of the most important things that need to be done in order to be sure that the annual report is right, and to urge Quoracy.com readers to think again and invest some time and energy into this process if it has not been given adequate attention in your Company in the past.

 

For many businesses – at least half of the manufacturing ones and also a number of service enterprise performing long-term contract work-in-progress, the figure for stock is the largest asset and the largest item on the balance sheet. It is also one of the more complex to account for, as unlike the monetary items such as debtors and cash, which are simply denominated in value, you need to keep volume and value information and to that end most businesses with sizeable stocks run special warehouse programs to keep track of stocks and manage such matters as goods received notes and goods issued notes, reordering, and these systems often interface with the main accounting system showing the amount of stocks purchased against creditors for the given period and sold against debtors also.

 

For stock accounting an evidential or standard cost is often used, enabling the system to concentrate on the issue of volumes, and a system for allocation of deviations between actual cost and the standard costs.

 

In my experience the area is found difficult to get right by businesses, and where issues do occur in audits or errors appear which are of a size that could entirely upset the usefulness of the financial statement, more often than not it is precisely in the area of stocks, and a properly conducted stock-take could have helped avoid the problem. In many cases, years of sloppy stocktakes failed to spot a problem until it became critical.

 

International Accounting Standards, in particular IAS 2 “Inventories” talk in detail about the principals for the value to be shown for each individual item of stock, but there is no help in IAS for the question of how often and in what way to go about establishing the volume of the stock items actually present. There is no mention of inventory counting or stocktake methodology or frequenct, and there is not even a definition given for these in the glossary to IFRS. This is extremely disappointing, given the importance and centrality of this item for so many businesses, and one is driven to wonder about the practicality of IFRS when one sees a regular “taniec godowy” being made in IFRS about the question of derivatives (instrumenty pochodne) which effects only a minority of businesses and is non-routine in nature for many of them, and then total silence on a matter which actually creates more practical hicoughs in accountancy for more businesses than most others do.

 

So we are thrown back on national law for any kind of realistic guidance in the matter – the requirements of Polish law for businesses accounting under the “Ustawa o Rachunkowosci”. There have been queries coming across my desk from businesses which are accounting under IFRS asking what they should do when they are “not under the UoR, but the IFRS are silent in the matter” – it seems to me that they must also abide by the tenets of Polish law in matters not regulated in IFRS, but is the Polish law actually strict enough?

 

As you can see from the text of the Ustawa, almost all classes of asset must be counted from life (spisem z natury) on the last day of each accounting year. That’s the basic rule from 26.1 and 26.2. And a very fine rule it is. But then we come on the 3rd paragraph, which is where certain relaxations from the main rule are allowed, and we see that on the basis of these rules people are performing stock-takes of very material amounts of inventory where there are systems that do historically allow in errors and where there is rapid movement of stocks, anywhere between 3 months before and 15 days after their financial year end, and also these cases where whole years are skipped (which is only supposed to happen where warehouses are properly guarded and there is a proper stock system, but people take a very subjective interpretation of what that means). And this is where the law as it stands is rather deficient, and we have to rely on the good practice of well trained business managers, such as the people reading this magazine, to make sure they do the right thing anyway.

 

Here then is my advice about stocktaking for this fine magazine’s readership

 

DO give more attention to the stocktake if your stock is:

  • A major asset in the balance sheet
  • Controlled by special laws such as explosives and pharmaceuticals
  • Easily removable and able to be used by employees or sold onwards
  • Not tracked over the reporting period by volume and value (some businesses in Poland whose owners come from countries which have a relaxed system forget the implications of the monthly tax system in Poland and do not realise that if they do not have a full volume-and-value system, they actually need proper stock takes every month in this country)
  • Difficult to count because of being “materialy sypkie” which need special mathematical algorithms to apply depending on the shape of the prism
Sometimes stocktaking pourable solids (materialy sypkie) is a bit like counting sand in the Sahara Desert and looks that way too, although I assure you this is woodchips in West Poland. This looks like a good time to get stock-take help from the “geodeta”!

 

  • Obsolescent, or partly aging or damaged
  • Slow-moving
  • In numerous locations or needs at least several man days to count
  • Extremely varied
  • Known in the past to show up errors at stock take

 

(If you have any of the conditions in this list, then you have high risk stock, and shouldn’t in my view be taking advantage of biennial stock taking even if the Ustawa allows you to. If you have several then you should be ensuring that you have the time and resources allocated to take this exercise seriously, as failure to do so could upset the smooth-running of your business at some stage)

 

In planning the stocktake DO

  • Start planning early, don’t leave it till the last minute
  • Ensure auditors are informed and can attend. (Auditors are well within their rights to qualify your accounts if they are not enabled to attend the stocktake)
  • Consider your stocks held at other locations and stocks at your location that belong to third parties.Certificates may be requested/issued for these items.
  • Ensure that the count sheets do not contain any info on the expected volume of the stocks. This would compromise the count being a proper “count from life”. Counters will blindly accept any suggestion on the sheet about values and save on counting if they can. Count sheets should clearly identify the stock number, description, location and unit of measurement, and should be signed off by the counter and double-checked at least on a sample basis by another team)
  • Ensure BHP training for each participant, especially those not normally working in the warehouse, and proper protective clothing on the day if needed.
  • Ensure that there is an adequate number of teams to do the job in the available time – which ought to be the time over which the business can afford to avoid moving the stock around. Where stocks must be moved during the count, it is necessary to devise some marking system so that all items are counted, and once only.
  • Ensure that the wareouse people who are responsible are all there, and that they are teamed up with people independent, such as bookeepers or other administrative people.
  • Ensure that enough forklift drivers will be on hand if access to stock depends on that
Some stocks are difficult to access – make sure lifting equipment is on hand at the stock take!

 

 

 

  • Take advantage of sensible techniques, such as digital photography, weighing homogenous stocks and the use of dipsticks for liquid tanks.
  • Do try to arrange a stock-take at the time when the company’s stocks are at their annual low. The counting then is at its most accurate, and it is worth doing even if it is not the main stock count of the year. This is the probable origin of why the inwentaryzacja is sometimes known in  informal language in Polish as the “remanent” – it refers to checking the ‘remnant’, the small amount left over at the end of a season.

Some DON’Ts of stock taking:

  • Don’t cut corners – especially if the stock is risky stock as identified in the first list above. All year round you are paying good money to the accounts department to get a good set of financial statements, but if you don’t get this bit right, what chance do they have?
  • Ignore likely weather or lighting conditions in planning. Last year alone I had to abort one count because it was planned after sundown in a poorly lit location and in another case the outside guages were frozen over so the apple juice concentrate involved would  not flow over them. In another case it was hard to tell where the snow stopped and the coal started on one prism.

 

In this case it was hard to tell where the snow stopped and the coal started – a true case of “in-winter-yzacja”. Maybe not the best image for a Christmas card to a member of the stocktake team, despite the seasonal weather!

 

 

  • Don’t try to measure a hałda or prism at a distance or use photography without a proper measurement. For complex shapes of materialy sypkie, don’t try to measure them unless you have specialist resources – get a surveyor in (geodeta).
  • Don’t allow the people who are materially responsible for the stock to be responsible for the count of it, although they should be there at the time to answer questions.
  • Don’t let the counters go from books to life, only from life to the books. Don’t give them access to the volume the system thinks is there
  • Don’t delay in turning the results of the count into an adjustment to the books. You also need to analyse the possible reasons behind any surprising divergences between expacted volumes and actual volumes. This is a cue to check controls, especially access controls to avoid theft and also the correct functioning of the guages and scales that measure the inflow and outflow of stock – have they been checked for accuracy and maintained properly by the producer?
  • Don’t forget to reward the count people with some kind of special thank-you, especially if they have been pulled out of their homes at Christmas time. This job is worth doing well, so it’s worth motivating people to take it seriously. Let it become one of your Company’s traditions that people actually might even start to enjoy and look forward to!

 

I would like to close this article with a story from my casebook about a company who had failed to get their stocktaking right – and this was a company in the heating sector which burned coal. They had had a problem with their weighing apparatus and for some time had been getting very good calorific results for each ton of coal they put into their furnaces, or so they thought. What had actually been happening was that they were reading 1 tonne of coal but putting in in fact 15% more.

Of course they suddenly ran out of coal in the depths of winter when the system was telling them that they had enough to go easily to the end of the season. They then assumed that the coal had been stolen and asked me to do a forensic accounting exercise to discover what had happened. This analysis led to the broken rolling scale and the both good and bad news that no-one had in fact stolen their coal, they had simply been overusing it for the previous six months. This would have showed up on their stock take (and saved them a lot of money not least in not needing to employ a top consultant) had they used the correct manner of measuring the coal, and not relied on two inexperienced children fresh from university sent in by their auditor, one of the largest companies in  the world, who later needed to withdraw their audit opinion and redraft it with the correct figures in.  When I asked what procedures these kids had applied at the stocktake attendance, I was told that they had looked at the coal pile from the third floor (about 300 metres away) as it was rather cold that day and they were young ladies and didn’t want to go outside. Please take your stocktakes a bit more seriously than that!

Some businesses holding large amounts of stock in their balance sheets are going to be audited and so they automatically will get an auditor to look (hopefully more closely than the above mentioned case) at their stock count, but even if your business is too small to fall under obligatory audit, but has relatively a large figure of stock or difficulties with control of stock, remember you can ask an auditor to make an audit style stock-take attendance without doing a full audit, and just report to you on the quality of the stocktake with recommendations for improvements. This shouldn’t cost more than a thousand Euro or two, and has a chance of giving you a good proportion of the value back that you would have had from a much more expensive full audit, if it’s a stock intensive business you are in. This comes under “agreed upon procedures” and auditors will be very pleased to help you with just what you need without making a full audit or review assignment out of it. Many people in business would find it useful, but just haven’t thought of asking an auditor in just for their view on the inventory count.

David J. James

(Photos by the author)