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Chapter 4

INCOME STATEMENT
(STATEMENT OF FINANCIAL
PERFORMANCE)

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Learning Outcomes
Able to: -
Describe income statement.
Discuss income and expenses.
Distinguish cash accounting and
accrual accounting.
Describe and apply balance day
adjustments.
Prepare an income statement,
incorporating adjustments.
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RELATIONSHIP OF
BALANCE SHEET AND
INCOME STATEMENT

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Income Statement

What
? Why
? How
?

???
???
??? 4
Income Statement (Contd)
What?
A statement showing the income and expenses of a
business for a particular period of time (usually 12
months period) for the purpose of calculating profit
or loss.
Why?

It provides information about the


financial performance of a business.
How?

Income Expenses = Profit or Loss


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Income Statement (Contd)

Income Expenses = Profit or Loss

Income > Expenses =?

Income < Expenses =?


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Income Statement (Contd)

Income Statement

Dividend A distribution of profit to shareholders!

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Purpose of Income Statement
Purpose is to measure generation of wealth
over a specific period.
Profit (or Loss) is the difference between
Income and Expenses.

Income:
Revenue (usually from operating
activities) primary
Gains (usually from non-operating
activities)
Expenses:
Outflow of resources to generate income
Atrill,Mclaney, Harvey, Jenner: Accounting 3 Ed 2008 Pearson Educ Australia 8
Usefulness of Income Statement

1. Evaluate the past performance of the


enterprise.
2. Provide a basis for predicting future
performance.
3. Help assess the risk or uncertainty of
achieving future cash flows.

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Income
Statement

Income What?

Why?
How?
Income are amounts earned by the
business.
Income

Sales / Turnover / Revenue Other income


(generated from (E.g. Gain on disposal
principal activities) of machinery)

Income are recognised when they are earned,


incurred and realised or realisable.
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Income

Expenses
Statement
What?

Why?

Expenses are amounts spent by the business How?


and consumed immediately or in short period.
Expenses are costs incurred in earning that income.

Expenses are recognised when they are incurred.

Expenses

COS / Operating Interest


COGS expenses Taxation
expense
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Income

Expenses (Contd)
Statement

Relationship?
Opening Closing
Inventory Inventory
Cost of
Goods
Available
for Sale

Cost of
Purchases
Goods Sold

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Income

Expenses (Contd)
Statement

Opening inventory + Purchases Closing inventory =

COS / COGS

Sales - COS / COGS

= Gross profit/(loss)
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HOW DO WE MEASURE Net PROFIT?

Recognising
(recording)
INCOME and
EXPENSE

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INCOME
Income is only recognised (recorded) in the
accounts when it has been realised.

In other words you can only claim the income


in your financial records when you are very
sure that it has been earned.

Very sure
Probability
Reliability

Atrill,Mclaney, Harvey, Jenner: Accounting 3 Ed 2008 Pearson Educ Australia 15


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

The Matching principle is applied and shifts


recognition from cash to accrual

A business is likely to incur many expenses


cost of buying goods for resale, salaries, insurance,
electricity, postage, telephone, petrol for motor
vehicles, rent

Atrill,Mclaney, Harvey, Jenner: Accounting 3 Ed 2008 Pearson Educ Australia 16


MATCHING PRINCIPLE which allows
Revenue Earned to be matched with Ex
penses incurred within a particular acco
unting period.

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Format and Presentation of
Income Statement
How to draft an
Income Statement?

Depends on the type of business entity.


Depends on the type of business activity.

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HCMC Ltd.
Income Statement for the year ended 31 December 2007

2007 2006

million Dong million Dong


Sales 6,000 1,000

Less: Cost of Sales (3,000) (1,500)


Gross Profit/(Loss) 3,000 (500)
Add: Other Income 500 100
3,500 (400)
Less: Operating Expenses & Interest (1,500) (200)

Profit/(Loss) Before Taxation 2,000 (600)


Less: Taxation (600) -
Profit/(Loss) After Taxation 1,400 (600) 19
Less: Dividends (400) -
When is it prepared?

Income Statements are normally provided on


an annual basis, however it is common for
shorter periods to be adopted
known as interim reporting eg. half-yearly,
quarterly or monthly reports
provides more frequent feedback on progress
helps to provide timely information for decision-
making
Depends on the type of industry and purpose of
the reporting

Atrill,Mclaney, Harvey, Jenner: Accounting 3 Ed 2008 Pearson Educ Australia 20


FORMATS see supplementary notes
The format will depend on:
the structure of the entity (sole proprietor,
partnership, company)
the nature of the operations (merchandising,
manufacturing, service provision)
the size of the organisation and the need for
provision of information

For a simple structure:


A listing of income and expenses
Difference shown as net profit or net loss

Atrill,Mclaney, Harvey, Jenner: Accounting 3 Ed 2008 Pearson Educ Australia 21


Cash versus Accrual Accounting
Transaction or event is recorded
when: -

Cash is received It is earned


or paid or incurred

Cash Accounting Accrual Accounting

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CASH FLOWS
Cash versus Accrual Accounting
VERSUS PROFIT (Contd)

Matching Concept

Revenue and its associated expenses


should be recorded in the
same accounting period.

Accrual Accounting

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Accrual Accounting
Revenue is recognised when an inflow
of future economic benefit is: -

can be
probable. & measured
reliably.

Accrual Accounting

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Accrual Accounting
Expense is recognised when an
outflow of future economic benefit
is: -
can be
probable. & measured
reliably.

Accrual Accounting

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CASH and ACCRUAL ACCOUNTING

CASH ACCOUNTING Income and Expense


is recognised when Cash is received

ACCRUAL ACCOUNTING Income and


Expense is recorded when they are EARNED
(for Income) INCURRED (for Expense)

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Example
Year 2005 (Accounting Period Jan 1- 31 Dec)
Revenue Earned 500,000
Expenses Incurred 200,000
Profit 300,000

Current Accounting Period


Revenue Earned
Expenses Incurred
Profit

Jan 1 Dec 31

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However, where the matching process is not exact
because a Receipt or Payment occurs outside the period
but belongs within the period, then there is a need for a
Balance Day Adjustment.

Adjustments are required to correctly match revenue or


expenses items so that the correct profit is reported in
the Statement of Financial Performance or P & L for the
period.

There is also a secondary effect that requires the


creation of an item to go into the Statement of Financial
Position/Balance Sheet.

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Adjustments
Entries made at the end of an accounting period to
ensure that the recognition criteria are followed
for assets, liabilities, revenues and expenses.

Examples: -
Revenue Prepaid
receivable Accrued expenses
expenses
Unearned (Expenses
revenue payable) Bad debts

Closing
inventories Doubtful debts
Depreciation
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Adjustments

Activity

Application Exercise 4.14


Page 172, Textbook

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ILLUSTRATION:
RECOGNISE
(record) REVE
NUE

Revenue Unearned
receivable revenue
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Revenue Receivable
Revenue
receivable

Revenue that has been earned


but money has not yet been received.

Action?

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ILLUSTRATION for REVENUE RECEIVABLE

Classic Catering has received $800,000 for its


services by 30 June 2006.

An amount of $50,000 for function held on the 28


June will be paid by the end of July.

Action?
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HOW?

Rev. Earned and Received $800,000


Rev. Earned but not received $50,000

Rev. Earned $850,000

30 June

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Entries:
Statement of Financial Performance / Profit and Loss
for the year ended 30 June 2006

Revenue $850,000

Statement of Financial Position / Balance Sheet


as at 30 June 2006

Current Assets
Accounts Receivable $50,000 (adjustment)

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Unearned Revenue
Unearned
Revenue
Money received but
revenue has not been earned
by providing goods or services.
OR

Money received in advance Action?


for goods or services
to be provided in future.

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ILLUSTRATION for UNEARNED REVENUE

TNK Tours had received $150,000 from its


clients by 30 June 2006.

Included in this amount was $7,500 of


deposits for tours to be conducted during
July.

Action?
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HOW?
$ 150,000
Cash Received

Rev.Earned $142,500 Unearned Rev. $7,500

30 June

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Entries:
Statement of Financial Performance / Profit and Loss
for the year ended 30 June 2006

Revenue $142,500

Statement of Financial Position / Balance Sheet


as at 30 June 2006

Current Liabilities
Unearned Revenue $7,500

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WHEN DO WE
RECOGNISE E
XPENSES?
Accrued
Prepaid expenses
expenses (Expenses
payable)

Bad debts
Depreciation
Doubtful debts
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Accrued Expenses
Accrued expenses
(Expenses payable)
Expenses used during the period
but not yet paid for.

No invoice/bill received yet.


Action?
Estimation made.
Cash payments are less than
the expenses incurred in a
specified accounting period.
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ILLUSTRATION for ACCRUED EXPENSES

Staff Commission is: $6,000

On 26th June 2006,the company had


paid 5,000 as Sales Commission
and on the 30 June 2006 (end of the
period), the companys owing to the
staff amounted to $1,000 as Sales
Commission.
Action?
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HOW?

Sales Commission Paid $5,000


S.C. Owing $1,000

Sales Commission Expense $6,000

30 June

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Entries:
Statement of Financial Performance / Profit and Loss
for the year ended 30 June 2006

Expenses
Sales Commission Expense $6,000

Statement of Financial Position / Balance Sheet


as at 30 June 2006

Current Liabilities
Accrued Expense $1,000
(Sales Commission Payable)

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Accrued Expenses (Contd)
Exercise
SML Ltd., closes it financial year on 30 June,
paid electricity bills for 11 months of
2007/2008
amounted to 100 million Dong. The bill for
June
2008 amounted to 15 million Dong was only
received on 8 July 2008.
Required:
(a) State the effect of June 2008s bill on
the
Income Statement and Balance 45
Prepaid Expenses
Prepaid expenses
Money paid for goods or services that
have not been received or rendered yet
at that particular accounting period.

Expenses that will be used


in the future accounting period. Action?
Cash payments are more than
the expenses incurred in a
specified accounting period.

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ILLUSTRATION FOR PREPAID EXPENSES

Rent for the use of the office is $400 per quarter,


payable in advance (on 1 January, 1 March, 1 June,
and 1 September). On the last day of the
accounting year, 31 December, the business pays
the next quarters rent on 31 December ($400)
which is a day earlier than required.

Meaning a total of 5 quarters rent were paid during


the year, thus there is a one quarter paid in
advance.

Action?
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HOW?

(1) Cash payment for the rent in a year

5 x 400 = 2,000

(2) Money paid in advance

1 x 400 = 400

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Entries:
Statement of Financial Performance / Profit and Loss
for the year ended 31 December 2006

Expenses
Rent Expense $1,600
(4 x $400)

Statement of Financial Position / Balance Sheet


as at 31 December 2006

Current Assets
Prepaid Rent $ 400
(paid in advance)

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Trade Debtors
Trade debtors (Accounts receivable) are
customers who bought goods on credit and
have not been settled the payments as at
balance sheet date.
Effect on
Income Statement Balance Sheet
Sales on
credit Sales Trade
debtors
Cash receipts
from No Trade
trade debtors effect debtors
Cash
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Bad and Doubtful Debts
When a trade debtor (TD) fails to settle
the outstanding amounts, the debts is
said to be irrecoverable.
TD may not pay
TD cannot pay or unlikely to pay
(e.g. gone into liquidation) (e.g. may go into liquidation)

Bad debt Doubtful debt

Written off!!! Make provision or


allowance!!!
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Bad and Doubtful Debts (Contd)
Effect on
Income Statement Balance Sheet
Bad debts Trade
Bad debts
(Expenses) debtors
(Asset)
Doubtful Doubtful Provision/
debts * debts Allowance
(Expenses) for doubtful
debts
(Contra asset)
* 1st year recognised the doubtful debts.
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Bad and Doubtful Debts (Contd)
Balance Sheet

Trade Debtors million


Dong
Gross amount x
Less: Provision/Allowance
for doubtful debts (x)

xx

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Depreciation
Depreciation is the loss of value of
WHAT? PPE over time. It is a systematic
allocation of the depreciable amounts
of an asset over its useful life.

Matching Match cost of PPE


concept WHY? with revenue they
(expenses with revenues) help to earn.

Depreciation rate
& HOW?
Depreciation method

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Depreciation (Contd)

An example of fixed assets .


PPE
Machinery
Building

Land
Equipment

Freehold Leasehold
land land Furniture
& fittings Vehicles

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Depreciation (Contd)

Cost of PPE is the purchase/acquisition price


plus direct attributable cost incurred to
bring the asset into present location and
condition for its intended use.

Direct
PPE
Cost = Purchase
price + attributable
cost

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Depreciation (Contd)

PPE (except for freehold land) are


depreciable assets because they
have
limited useful lives. Expected physical
due wear & tear.
to
Legal or similar
Technical obsolescence. limits on the use
of the asset.

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Depreciation (Contd)
Depreciation
Effects on Depreciation
Income Statement (Expenses)

Effect on Accumulated Depreciation


Balance (Contra asset)
Sheet to deduct from cost of PPE
and
NBV
reflect NBV in Balance Sheet
Depreciation is only an estimation! 58
Depreciation (Contd)

Reflection of useful life


Depreciation
Rate of PPE.
Expressed in % or years.

Depreciation
(1) Straight line method Method
(2) Reducing balance method

(3) Units of production method

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Depreciation (Contd)
Calculation of Depreciation

Straight Line Reducing Balance


Method Method

NBV x Useful economic life (in %)

Cost RV
Useful economic life (in years)
OR
(Cost RV) x Useful economic life (in %)
Useful economic life is the depreciation rate! 60
Units of Output or Production
Method
Calculates depreciation based on productive capacity
of the asset and its use over time.

Cost of the asset estimated residual value X units of output


Total estimated units over life of the asset in the period

Example:
Cost of machine $22,000
Residual value $2,000
Useful life 4 years
Est. units of total output 200,000
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Depreciation (Contd)

RV Residual value (RV) or Scrap value


or (SV) is the expected net reliasable
SV amount of an asset at the end of its
useful life.
Net book value (NBV) or carrying amount
is the amount at which an asset is recognised
in the balance sheet after deducting any
accumulated depreciation.

NBV
= Cost - Accumulated
Depreciation 62
Depreciation (Contd)
Exercise
A machine acquired for A$50,000 is depreciated
at the annual rate of 20%. Using straight line
method and reducing balance method respectively,
calculate the following:
(1) Annual depreciation for the 1st & 2nd
year.
(2) Accumulated depreciation after
3 years of ownership.
(3) NBV after 4 years of ownership.

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Depreciation (Contd)
Exercise (Contd)

Machine PPE

Depreciation rate: 20% annually

Depreciation method: -
Straight line
Reducing balance

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Depreciation (Contd)
Exercise (Contd) Straight line: 20% pa
Year Cost Accumulated Depreciation NBV
Beginning Current End
Y1

Y2

Y3

Y4

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Depreciation (Contd)
Exercise (Contd) Reducing balance: 20% pa
Year Cost Accumulated Depreciation NBV
Beginning Current End
Y1

Y2

Y3

Y4

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DEPRECIATION
The reduction in the value of NCA
due to use (wear and tear)
effects of time

obsolescence

Depreciation is an attempt of identifying what


proportion of the NCA has been used up to
generate revenue during a given period.

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CONSIDERATIONS:

Cost of Asset cost of acquiring incl.


delivery, installation, transfer of legal title

Useful Life physical and economic life.

Residual Value disposal value

Method of Depreciation
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RECORDING:
In the B/S statement
Machine
Less Accumulated depreciation:
Written down value (book value)

In the P&L statement

Depreciation expense

Note: accumulated depreciation is the accumulated account year by


year

Accumulated depreciation year 1 = depreciation expense year 1


Accumulated depreciation year 2 = accumulated depreciation
expense year 1 + depreciation expense year 2
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Methods of Depreciation

Straight line method

Reducing balance method

Unitsof production based


depreciation
Depreciation based on productive capacity of
asset and its use over time

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Straight Line Method

Total cost Estimated Residual value


Estimated Useful Life

Example:
Cost of Machine: $40,000
Estimated Residual Life: $1,024
Estimated useful life: 4 years

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Reducing Balance Method
%P (1 - n R ) x 100%
C

P = depreciation %
n = Useful life of assets
R = Residual value
C = cost of asset

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Consider the following
Cost of machine C=$40,000
Rate of depreciation P=20%
Amount of depreciation

Year 1 20%* 40,000= 8,000 (WDV=32,000)


Year 2 6,400 (WDV 25600)
Year 3 5,120 (WDV 20480)
Year 4 4,096 (WDV 16384) and so on

Higher amounts in the earlier years


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Which method?
Uses judgment
Depends on the asset
Match the use of the asset with the revenues
generated
For example
Table constant value over time so
SLM is more suitable
Computers lose value over time so

RBM is better suited

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Mini Quiz (Contd)
Question

The following payments were made: -


Insurance A$24,000; and
Wages A$140,000.
Out of the above payments, A$4,000 of insurance was
prepaid and A$2,000 was owing for wages, answer the
following: -

(a) What amount would be shown in the income


statement for insurance?
(b) What amount would be shown in the income
statement for wages?
(c) What figures would be shown in the balance sheet?
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Mini Quiz (Contd)
Choice of answers for Questions 1 & 2
(All amounts are stated in A$)

36,000 4,000

20,000 2,000

12,000 16,000 142,000

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Mini Quiz (Contd) True or False
Question
(a) Income measure the outflow of assets or the increase
in liabilities that result from business operations.

(b) Gross profit is calculated as the difference between


the value of sales and the cost of goods that were
sold.

(c) Income is comprised of both revenue and gains.

(d) Rent paid in advance at the end of an accounting


period should appears as an asset on the Balance
Sheet.

(e) If expenses exceed income for a period then the


business is said to have made a profit.
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Mini Quiz (Contd) True or False
Question (Contd)
(f) While it is possible to prepare an income statement in
horizontal format, the vertical format is most common.
(g) Rent can be an income item as well as an expense
item.
(h) The accrual accounting system records income only
when cash is received.
(i) Payment of accrued expenses in the subsequent
accounting period will reduce that periods profit.
(j) Expenses incurred but unpaid at Balance Sheet date
are treated as current liability and have the effect of
increasing owners equity.

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