Accounting theory and practice, Volume 2 (of 3)

by Roy B. Kester

Cost of Goods Sold—Trading Concern

For a trading business, i.e., a business which buys its commodity for resale, the first deduction from sales is likewise the cost of goods sold as determined by a “cost of goods sold” formula as follows: To the goods on hand at the beginning of the period is added the full cost of the net goods purchased, and from the sum of these two items is deducted the cost of the goods on hand at the end of the period. In the case of both the industrial and the trading enterprise, when the cost of the commodity sold is deducted from the sales the result is the first significant figure as to profits known usually as “Gross Profit.” Among public carriers the first deduction from sales is the “Cost of Services Sold or Rendered”; this is usually carried under the title “Costs of Operation” or “Operating Expenses,” giving the figure of net earnings.

For the other types of business mentioned—agency and commission concerns, and financial enterprises of various sorts—the allocation of the direct costs of the service rendered is much more difficult and is seldom attempted. The so-called general and administrative expense and the expense of selling are usually so inextricably merged with the direct cost of rendering the service that a separate showing of the items is seldom attempted. However, where any expenses are directly applicable to the service rendered, they should be deducted first, before the general administrative and selling expense.

Further Differentiation of Terms

Before going into a detailed explanation of the elements of the profit and loss summary, it may be wise to make a further differentiation of terms sometimes employed, such as: Income and Expenditures, Receipts and Disbursements, Receipts and Payments, etc. All three terms are often met and are frequently misused as titles for the profit and loss summary. Their proper use should limit them to cash transactions or activities only. It is true that in some instances the profit and loss summary is mistakenly made up on a so-called cash basis, cognizance being taken of the income and expense items only when realized in cash. It would hardly seem necessary to convince the modern business man that sales made on credit and not yet realized in cash are part of his income as much as the items of income realized in cash, the chief difference being that provision must be made in the one case for uncollectible items, while in the other case no such provision is necessary. Yet even today it is sometimes difficult to convince the proprietor of a small business of the necessity, from the standpoint of accurate accounting, of taking cognizance of accrued and deferred expense items. Instances may sometimes, though rarely, arise in which all income has been received in cash at the end of the fiscal period and all expenses applicable to that period have been met in cash and that no deferred items need to be taken into account. Where such is the case, a statement of cash receipts and disbursements might give a fair indication of the profit and loss for the period. In the case of clubs, churches, and other institutions, practically all that is required of the managing officers in accounting for their trusteeship is a statement of trusteeship of cash, i.e., a statement of receipts and disbursements. The point of this discussion is merely that the terms, “Receipts and Disbursements,” “Receipts and Payments,” and, to a less extent, “Income and Expenditure,” should be limited to a statement of cash activities and never applied to the profit and loss summary.

Desirability of Uniformity in Terms Used

So far as the standardization of the sections of the profit and loss summary is concerned, much the same remarks are applicable as to the general title of the “Temporary Proprietorship Summary.” Such terms as Gross and Net Profit, Gross Revenue or Income, Net Revenue or Income, Gross Trading Profit, Net Trading Profit, Net Profit or Profit from Operation, or simply Business Profit, are used with little uniformity by the business world at large and even by the accounting profession. While it is never desirable to lay down many hard and fast rules or definitions because any statement or method of showing results should always be flexible and adapted to the conditions met, still the use of the same terms for different purposes and the use of different terms for the same purpose or section of a statement are, to say the least, confusing to the student. The committee of the Federal Reserve Board which drew up tentative forms for the profit and loss account and balance sheet, has done a good work in the interest of uniformity in accounting terminology. Their suggested form is applicable, however, only to the business of a manufacturer or merchant. In the case of public carriers the regulation of their accounting systems by the Interstate Commerce Commission has brought about a very desirable uniformity of terminology. Other regulating bodies in various states have performed a similar service in the case of public utility concerns, although because of divided authority their rulings lack uniformity.

Profit and Method of Showing

In general it may be said that the term “Gross Profit” is properly applicable to what is left after deducting from the main income the cost of that income. In a merchandising concern this figure is sometimes called “Gross Trading Profit,” though the term “Gross Profit” serves the purpose equally well and does not introduce a confusing adjective. When, from this gross profit, the two groups of selling expense and general administrative expense are deducted, there remains what is termed “Profit from Operation” or “Net Operating Profit.” One occasionally finds the group of selling expenses deducted by itself from the figure of gross profit, leaving what is termed the “Net Trading Profit.” Such a method of presentation serves no useful purpose and shows a figure which has little or no significance. The net trading profit merely represents what is left after deducting one group of expenses, and gives no essential information which the total of selling expenses would not give equally as well.

There is some difference of opinion as to whether the figure of net operating profit should be arrived at before considering any of the items of financial management, i.e., as to whether such items as interest income and expense, cash discount items, bad debts, etc., which are more or less common to every business, should be included before determining net operating profit or should be set up separately after its determination. The best practice seems to be to use the term “Net Operating Profit” as indicated above, and to show the financial management items in a separate section. In public service utility statements and also in those of some manufacturing concerns, such terms as “Gross and Net Earnings” and “Gross and Net Income” are met. Where these terms are used the gross earnings correspond approximately to sales and indicate the amount of the main income before any deductions are made. After the deduction of the direct cost of securing this income, the item is frequently called “Net Earnings.” Alternative terms for these two are “Total Operating Revenue” and “Total Net Revenue.” When, to the item of the net earnings or net revenue, income from other sources is added, the figure of total Gross Income is arrived at. When, from this figure of total income the “Charges Against Income” are subtracted, which are roughly the financial management expenses, we arrive at the figure of net income which corresponds to the figure of net profit. The use of the terms “Earnings” and “Income” in this restricted way is illogical, and must be regarded as the outgrowth of custom—a custom which is, as stated above, fairly uniform in the case of public utilities.