Lecture 5

Unit 4 - Financial Performance

The Income Statement

Income Expenses = Profit or Lo

The purpose of the income statement is to measure and report how much profit (wealth) the business
has generated over a period.

Profit (or loss) is the difference between Income and Expenses

Income is made up of Revenue (from operating activities) and Gains (usually from non-operating
activities)
Expenses are outflows of resources to generate income

Relationship between the Income Statement and the Balance Sheet:

The two are closely related, but NOT substitutes for each other in any way
The income statement can be viewed as linking the balance sheet at the start of a period with the
balance sheet at the end of the period
The accounting equation can thus be extended as:

Assets = OEbeg + Profit (or - Loss) +/- Other OE adj + Liabilities

or further extended to:

Assets = OEbeg + (Income - Expenses) +/- Other OE adj + Liabilities

Remember: this is an extension of the basic accounting equation of A = OE + L

As a result of the relationship between the income statement and two consecutive balance sheets,
profit and loss can be calculated for a period based on the stock approach
The stock approach computes profit and loss by adjusting the change in net assets (A-L) for the
period by other changes in owners equity in the period

The equation for the stock approach is:

Profit (or Loss) = (Aend - Abeg) - (Lend - Lbeg) - New contributions + Owners distributions +/- Other
changes in owners equity

The stock approach can be used to check the accuracy of the transaction approach where income less
expenses is used to calculate profit. It can also be used where there are incomplete records and may be
used by insurance assessors or the Australian Taxation Office.

NOTE: you will not be required to calculate profit using the stock
approach. You will need to be aware of the theoretical aspects of the stock
approach.
Format of the Income Statement
In practice, there are at least three forms of income statement:
Simple listings of accounts (small organisations)
Classified reports (larger organisations)
Regulatory presentations (companies)

Simple reports:
For smaller organisations, the income statement may be just a listing of income and expenses in
alphabetical or financial magnitude order

Example: page 145 of textbook for Newlands Soccer Club and reproduced in lecture notes.

Newlands Soccer Club

Income statement for the year ended 31 October 2008
$ $
Income
Ticket sales 9,200
Fundraising 5,700
Members fees 3,500
Government grant 2,700
Interest 600 21,700
Expenses
Players payments 8,300
Ground fees 2,900
Insurance 2,100
Travel costs 1,900
Uniforms 1,500
Repairs and maintenance 900
Telephone and postage 600
Sundries 400 18,600
Period profit (surplus) 3,100

Classified reports:
Relate to larger organisations and often called the classified financial report. Income and expenses
are not simply listed, but grouped into categories

Income would normally be broken down into sales, and other revenues

Expenses are often broken down into four categories:

1. Cost of sales
2. Selling and distribution
3. Administration and general
4. Financial

Example: page 147 of textbook for Hi-Price Stores (reproduced in lecture notes)

Hi-Price Stores
Income Statement for the year ended 31 October 2008
$ $
Sales 432,000
Less Cost of sales 254,000
 Gross profit 178,000
Other revenue
Interest from investments 2,000
Rent from properties 5,000 7,000
185,000
Less Expenses
Selling and distribution
Advertising 5,000
Commissions 4,000
Delivery 3,000
Display 2,000
Salary and wages 37,000 51,000
Administration and general
Salary and wages 41,000
Rates 2,000
Heat and light 3,000
Telephone and postage 2,000
Insurance 1,000
Repairs and maintenance 5,000
Motor vehicle running expenses 4,000
Depreciation plant and equipment 1,000
Depreciation motor vehicles 2,000
Depreciation buildings 3,000 64,000
Financial
Interest 3,000
Bad debts 7,000 10,000
Total expenses 125,000
Net profit 60,000

Regulatory reports:
Required to be produced by companies and other entities in accordance with statutory standards
AASB 101 Presentation of Financial Statements requires that the income statement should
classify expenses according to their nature or function
Refer to page 149 for a list of AASB 101 requirements
For external reporting, the reporting cycle is normally one year
For internal functions, it is common for profit figures to be prepared on a monthly basis
Example: page 150/151 of textbook

Cash versus Accrual Transaction Recognition

Distinguish between accrual and cash-based transaction recognition:

Cash-based accounting recognises income when it is received and expenses when they are paid
Accrual-based accounting recognises income on the basis that it has been earned irrespective of
whether the cash receipt is in arrears or in advance and expenses are recognized on the basis that
the expense has been used up/incurred/consumed by the business

Profit Measurement and Recognition of Income

Income should only be recognised in the accounts when it has been realised
Realisation is considered to have occurred when:
Activities necessary to generate the revenue are substantially complete
The amount of the revenue can be objectively determined
Reasonable certainty that amounts owing will be received
Any other outstanding items can be determined with reasonable certainty
The Accrual Basis for Recognising Revenue
It is common for adjustments to be made to accounting information prior to it being published in the
financial reports. These adjustments are known as balance day adjustments. The adjustments are
required to ensure that revenue earned is reflected in the Income Statement for the period rather than
revenue received when using the cash basis for revenue recognition. The need for such adjustments
arises where:
1. Revenue earned for the period is greater than the cash received for the revenue
2. The amount received for the revenue is greater than the revenue earned for the period

1. Revenue earned for the period is greater than the cash received for the revenue
(accrued revenue)
For example, a business earns rental income from renting out part of their premises but there
is an amount of rental income that relates to the current financial period but has not been
received. Hence, the revenue has been earned but has not been received so it should be
recognised as revenue in the current financial period. That is, included in the Income
Statement as revenue.
In this case, the revenue account is increased (and shown in the Income Statement) and a
temporary asset is created for the amount that is owed to the business. This temporary asset
appears in the balance sheet as effectively it is an asset at the date of the balance sheet.

2. The amount received for the revenue is greater than the revenue earned for the period
(prepaid / unearned revenue)
For example, a business earns rental income from renting out part of their premises and the
tenant has paid rent in advance. Part of this amount relates to the next financial period. In
 this case, the revenue account is decreased and a temporary liability is created for the unused
amount. The temporary liability appears in the balance sheet as effectively it is an amount
that has been received but not earned at the date of the balance sheet.
In the next period, the prepayment will cease to be an liability and become revenue in the
income statement in the period it relates to.

Profit Measurement and Recognition of Expenses

Expenses measure the outflow of assets (such as cash) or the increase in liabilities that result from
trading and generating revenues

The Matching Principle and Common Basis for Recognition

The Matching principle dictated that expenses should be matched to the income they helped to
generate. More recently, there have been moves away from matching in favour of a common basis
for recognition of income and expenses. The common basis is that if an item satisfies recognition
criteria, it will be recognised if its occurrence is probable, and it can be reliably measured

The Accrual Basis for Recognising Expenses

It is common for adjustments to be made to accounting information prior to it being published in the
financial reports. These adjustments are known as balance day adjustments. The adjustments are
required to ensure that expenses incurred are reflected in the Income Statement for the period
rather than expenses paid when using the cash basis for expense recognition. The need for such
adjustments arises where:
1. An expense incurred for the period is greater than the cash paid for the expense
2. The amount paid for an expense is greater than the expense incurred for the period.

1. An expense incurred for the period is greater than the cash paid for the expense
(accrued expense)
For example, the wages account may show the total wage expense however the next pay
period occurs in the new financial year. However, we are aware that a portion of the wages to
be paid next financial year have actually been used up in the current financial year and
therefore should appear as wages expense in the current year.
In this case, the wages account is increased (and shown in the Income Statement) and a
temporary liability is created for the unpaid amount. This temporary liability appears in the
balance sheet as effectively it is an expense at the date of the balance sheet that has been used
up but not paid for.

2. The amount paid for an expense is greater than the expense incurred for the period
(prepaid expense)
For example, some expenses may be paid in advance (such as insurance, advertising) but not
all of the amount paid may have been used up/consumed by the end of the financial year.
In this case, the expense account is decreased and a temporary asset is created for the unused
amount and appears in the balance sheet as effectively it is an amount that has been paid but
not used up at the date of the balance sheet
 In the next period, the prepayment will cease to be an asset and become an expense in the
income statement in the period it relates to.
Summary:

Adjustment Explanation Impact on Impact on Balance

Income Sheet
Statement
Prepaid expenses Prepaid expenses relate to expenses Decrease Create asset
paid in advance but not yet consumed expense (eg.Prepaid Expense)
item
Accrued expenses Accrued expenses are where the Increase Create liability (eg.
expense has been incurred but expense Accrued Expense)
payment has not yet been made item
Accrued revenue Accrued revenue relates to revenue Increase Create asset (eg.
earned but not received at the end of revenue Accrued Revenue)
the financial year item
Prepaid revenue Prepaid revenue occurs where revenue Decrease Create liability (eg.
has been received but has not been revenue Prepaid Revenue or
earned item Unearned Revenue)

Profit and Cash:

It is important to note that profit and cash (liquidity) are not the same. Profit is a measure of
achievement, or productive effort rather than of cash generated

Profit measurement

In the next lecture, we will look at two common assets and how they impact on expense recognition:
Non-current tangible assets (depreciation expense)
Accounts receivable (bad and doubtful debts)

Lecture 6

Unit 4 Measuring and Reporting Financial Performance (continued)

Non Current Tangible Assets

Profit Measurement and the Calculation of Depreciation on Non-Current Tangible Assets

Depreciation is a measure of that portion of the cost (less residual value) of a fixed asset which has
been consumed during an accounting period

Four factors are considered:

The cost (or other value) of the asset
The useful life of the asset
The estimated residual value of the asset
The depreciation method

The cost of the asset - includes all costs incurred by the business to bring the asset to its required
location and make it ready for use e.g. delivery, installation, legal title, alterations, improvements etc.
The useful life of the asset - the economic life of the asset determines the expected useful life of the
asset for the purpose of calculating depreciation. The economic life of an asset ends when the cost of
operating or holding the asset exceeds the benefit derived from it. Economic life may be shorter than
physical life in many cases. That is, the business will estimate what they believe the estimated useful
life of the asset will be to the business usually where the cost exceeds the benefit provided by it.
This might not be the same as the physical life of the asset. For example, a business may determine
that the estimated useful life of a delivery vehicle is 6 years. After the 6 years have passed, the
delivery vehicle is still likely to be operational and work. However it has reached its useful life from
the business perspective and is likely to be sold (or disposed of) or traded in.
Estimated residual value (disposal value): defined as the likely amount to be received on disposal
(or sale) of the asset. Like useful life, estimated residual value can be difficult to predict.

Depreciation method: Once the depreciable amount (the cost of the asset) has been estimated, it
must be allocated over the useful life of the item. The three common methods of calculating
depreciation expense are:

Straight line method

Accelerated depreciation (reducing balance) method
Units of production (output) method

How Does Depreciation Impact on the Income Statement and the Balance Sheet?
Prior to the preparation of reports, and when adjustments are being undertaken for accrual accounting,
an accounting entry will be used to record depreciation for a non current asset.

The amount of depreciation allocated for a particular year is shown as an expense in the Income
Statement for that year.

The other part of this accounting entry (remembering that there is always a dual effect) is the use of an
account called Accumulated Depreciation. You will find this account in the Balance Sheet. It is
listed underneath the non current asset that the accumulated depreciation relates to. As the name
suggests, accumulated depreciation shows the total amount of depreciation that has accumulated
since the business has had the asset. In terms of transaction analysis, accumulated depreciation on an
asset is considered a negative asset as it reduces the value of assets but is still shown in the non
current assets section of the Balance Sheet. An example of how accumulated depreciation would be
shown in a Balance Sheet is shown below:

Balance Sheet

Non Current Assets $

Property, plant and equipment 100,000
Accumulated depreciation property, plant and equipment (25,000)
75,000
Note that:
$100,000 represents the original cost of the non current asset
$25,000 represents the amount of depreciation that has accumulated so far
The accumulated depreciation is subtracted from the original cost of the asset
$75,000 is the written down value/book value/carrying value of the non current asset. This
amount does not represent market value. It is simply the value of the non current asset according
to historical cost accounting

We will now look at each of the depreciation methods mentioned earlier.

Straight Line Method

This method allocates the same amount of depreciation each year over the assets useful life. It is
calculated using the following formula:

Total cost of the asset less estimated residual value of asset

Estimated useful life of asset

Accelerated depreciation (reducing balance) method

This method allocates a greater portion of the cost of the asset to the earlier years of the assets life
and therefore, less as the asset gets older. It is calculated using the following formula.

Fixed percentage rate x written down value of the asset

The written down value of the asset = cost of the asset less any depreciation that has accumulated so
far. Both of these figures are obtained from the Balance Sheet.

The fixed percentage rate is calculated using the following formula:

R
P (1 n ) x 100%
C

where P = the depreciation percentage, n = the useful life (in years), R = the residual value, and C =
the cost of the asset

NOTE: you will not need to use the above formula to calculate the
depreciation percentage in the exam. If you are asked to use the accelerated
depreciation method, the depreciation percentage (P) will be provided to you.
Units of production (output) method
This method calculates depreciation based on the productive capacity of the asset and its use over
time. It is calculated using the following formula.

Cost of the asset estimated residual value x units of output in the period
Total estimated units over life of the asset

Which method do I choose?

Depreciation methods should be selected to be appropriate to the particular assets and to their use
in the business.
Accounting standard AASB 116 - Property, Plant and Equipment reinforces this view
Depreciation does not provide funds for asset replacement, it is used to calculate net profit
Depreciation is an example of an accounting process that requires a lot of judgement

Accounts Receivable

Profit Measurement and the Problem of Bad and Doubtful Debts

Bad and doubtful debts are associated with income derived from selling goods on credit (credit sales).
When selling goods on credit there is a risk that the customer (debtor/account receivable) will not pay
the amount due. This can result in a bad debt if the amount is not paid. Bad debts are classified as an
expense. When a business is certain that a debt will not be received, it must write the debt off. The
writing off of a bad debt results in an increase in expenses and a decrease in accounts receivable.
Simply cancelling the sale is not the correct action to take. Writing off a bad debt can have
implications for how the granting of credit applications is managed in the future and can impact on the
evaluation of management.

There may also be uncertainty about the collection of some debts as well. Recognition of this
uncertainty results in the debts being doubtful debts. The item Doubtful Debts is recognized in the
Income Statement as an expense. The amount of doubtful debts requires estimation and this can be
done by using either the percentage of credit sales or the aged debtors listing as the basis for the
calculation.

Recognition of doubtful debts also results in the recognition of a further item that is shown in the
Balance Sheet an Allowance/Provision for Doubtful Debts. This item is a negative asset that is
subtracted from Accounts Receivable in the Balance Sheet, as shown below:

Balance Sheet

Current Assets $
Accounts receivable 40,000
Allowance for doubtful debts (5,000)
35,000

Approaches to Recording Bad and Doubtful Debts

There are three alternative approaches to recording bad and doubtful debts observed in practice:
1. Write off bad debt when it is known to be bad. Recognise only on basis of realised
uncollectable amount (customer is bankrupt, deceased etc and business is certain that the
debt will not be paid). This method results in the writing off of a bad debt when the
business knows the debt will not be paid. There is no recognition given to doubtful debts.
2. Recognise bad debts and doubtful debts separately. The bad debt expense is always
written off against accounts receivable. The doubtful debt recognition results in the use
of a doubtful debt account in the Income Statement and an Allowance for Doubtful Debts
account in the Balance Sheet. Adjustments are made to the Allowance for Doubtful Debts
account each year to represent the estimated debts in doubt of collection.
3. A combined bad and doubtful debts expense account is used. The value of doubtful
debts can be calculated on either the percentage of credit sales or the aged debtors listing
approach. When a bad debt is written off, accounts receivable in the Balance Sheet is
reduced and the amount is applied to the Allowance for Doubtful Debts account.

An overall impairment test under AASB 132 may mean changes to the terminology within the
reporting for bad and doubtful debt expenses

Interpreting the Income Statement

How the final net profit figure was derived can be found by:
analysing sales levels - against history and planned sales for the current/future periods
examining the nature and amount of expenses incurred
comparison against history and future
indicator of efficiency of business operations
investigating gross profit levels in relation to sales in similar businesses
helpful in assessing profitability and margins
analysing net profit levels, for example against previous periods and also in relation to sales.

Dividend is A distribution of profit to shareholders.