BST511 - Lecture 3

Fundamentals of Accounting:
Measuring & reporting
financial performance
Chapter 3 Atrill & McLaney
Malcolm Anderson
Cardiff Business School
 Learning Outcomes

discuss the nature and purpose of the income statement (IS)

discuss the main recognition and measurement issues that must
be considered when preparing the IS
explain the main accounting conventions underpinning the IS
explain the matching convention and how it applies to revenue
and expenses
explain how and why revenue and expenses are disclosed in the
IS
illustrate how the statement of financial position and IS are
interrelated
prepare an IS from relevant financial information and interpret
the information that it contains
Relationship between the income statement
and the SOFP

+ Profit
Assets = Equity
() (Loss)
+ Liabilities

The above equation can be extended to:

Assets = Equity + Sales

revenue
Expenses + Liabilities
 Income (revenue)

Revenue is simply a measure of the inflow

of economic benefits arising from the
ordinary operations of a business
e.g. selling goods
e.g. fees for services rendered
 Profit measurement and the
recognition of revenue
Basic criteria that must be met before revenue is
recognised:
The amount of revenue can be measured reliably
It is probable that the economic benefits will be received
Additional criterion is to be applied where the revenue
comes from the sale of goods:
Ownership and control of the items should pass to the
buyer
 Expenses

Really the opposite of revenue

Represents the outflow of economic
benefits arising from the ordinary
operations of the entity
Incurred in the process of earning revenues
e.g. cost of sales, salaries/wages, rent
The Income Statement Gross Profit

Sales X
Less Sales returns (X)
X
Less Cost of Sales:
Opening Inventory X
+Purchases X
Less Purchase returns (X)
+ Carriage Inwards X
- Closing Inventory (X)
(X)
Gross Profit XX
 Accruals Concept
The accruals basis of accounting means that to
calculate the profit for the period, we must include
all the income and expenditure relating to the period,
whether or not the cash has been received or paid or
an invoice received.
Profit is therefore:
Income earned X
Expenditure incurred (X)
Profit X
 A number of issues

What if customers dont pay us?

How do we deal with the loss of value
(depreciation) in non-current assets in earning
revenue?
How do we calculate the cost of sales to then
match with revenues?
What happens when we pay bills over a different
period to the accounting period?
 Irrecoverable Debts

Irrecoverable Debts
An irrecoverable debt should be written off to the income
statement in accordance with the prudence concept.

Allowance for Receivables

Where the recoverability of a receivable
is uncertain an allowance may be set up
to reflect this in accordance with prudence.

The allowance will offset the receivables balance in the

statement of financial position.
 Depreciation

Repair and maintenance does not

remove the need for depreciation.
Depreciation starts when an asset
is complete and ready for use.
Depreciation ceases when an asset is fully depreciated or
derecognised.
Depreciation method used should reflect how the asset is
being consumed.
Method should be reviewed at each year end
 Depreciation Methods

Straight Line Reducing Balance

Reducing amount of
Depreciation charge is
depreciation charged
same each year
each year

Assume benefits
Assume benefits
consumed in earlier
consumed evenly
years

Dep (RB) = RB rate x Net Book Value @ start of year

Dep (SL) = (cost scrap value)/economic useful life
Reducing-balance method

Deriving the RB percentage

n
P = (1 S/C 100%)
where:
P = the depreciation percentage
n = the useful life of the asset (in years)
S = the residual value of the asset
C = the cost, or fair value, of the asset
 IAS 2 Inventories

Inventories are assets:

Held for sale, or
In the process of production for sale, or
Materials or supplies to be consumed in the
production process
Inventories should be measured at lower of cost and net
realisable value.
Inventories = no. of items x cost/value
Methods for arriving at Cost

How do we calculate the cost of sales to then match with

revenues?
We must make assumptions on the flow of goods through
the entity

ACCEPTABLE NOT ALLOWED

FIFO (first in first out) LIFO (last in first out)
Average cost
 What is Cost?

All costs incurred in bringing the product to

its present location and condition:
- costs of purchase purchase price, import
duties, transport &
handling
- costs of conversion direct labour, fixed and
variable overheads
 What is NRV?

Estimated selling price less:

Estimated costs of completion
Estimated costs of making the sale (marketing,
selling and distributing)
Cost may not be recoverable due to:
Damage
Obsolescence
Decline in sales price
Expenses timing issues
Accruals
Expenses charged against profits
for the period even though they
have not yet been paid for.

Prepayments
Payments made in one period but charged against profits
in a later period to which they relate.
 Freds first year of trading
Paid 2,000 into the bank and borrowed a further 2,000 as
a bank loan at 10% interest. He forgot to pay the interest
until just after the end of his first year.
Bought oven (3,000), van (500); thought oven would
last 3 years and van 2 years before needing replacement
Bought 8,000 of supplies for pizza making. Had 400-
worth unused at end of year
Paid wages (6,000), petrol (1,000) and gas bills of
3,000. Owed a further 1,000 for gas at end of year
Sold 40,000-worth of pizzas but only banked 38,000.
Still owed 2,000 for supplying pizzas for events, and
believes he will only receive 1,500.
 Early SOFP
When Fred sets up the business:
Assets: (Cash plus loan proceeds) 4,000
Liabilities: (Loan) (2,000)
Freds Equity: (= what he paid in) 2,000
After buying the van and oven:
Assets: Oven at cost 3,000
Van at cost 500
Cash (4,000-3,000-500) 500
Liabilities: (Loan) (2,000)
Freds Equity: (still = what he paid in) 2,000
What about the van and oven?
We are trying to measure Freds performance in his
first year of trading, but the van is expected to last for
2 years and the oven for 3 years before they need
replacement.
Accounting spreads the cost of long-term investments
across the periods they benefit. It is logical to charge
Freds first years trading with only half the cost of
the van and one-third of the cost of the oven, to reflect
the amount of the original value that has been used
up in the year.
The trading activity

Made sales of 40,000 and paid 8,000 for

ingredients (yeast, flour, tomatoes, salmonella extract
etc).
BUT: had unused stocks of ingredients worth 400 at
year end.
The real cost of making his sales has therefore been
(8,000 - 400) = 7,600. The other items have not
been used this year (but will presumably be used next
year).
Running expenses for the year
The other costs of running the business are:
Wages 6,000
Petrol 1,000
Gas (3,000 plus 1,000 owed) 4,000
Oven depreciation (3,000/3 years) 1,000
Van depreciation (500/2 years) 250
Allowance for receivables 500
Freds Operating Profit - Solution
Sales in the year: 40,000
Less: Cost of sales:
purchases (8,000)
Less closing inventory 400 (7,600)
Trading (gross) profit 32,400
Running costs: Wages (6,000)
Petrol (1,000)
Gas (4,000)
Depreciation (1,250)
Allowance for receivables (500) (12,750)
Operating profit: 19,650
 Interest on the bank loan
Operating profit is calculated without taking the
cost of financing into account. Fred has agreed to
pay 10% interest on his 2,000 bank loan and so
there will be another 200 to deduct from his profit.
This is excluded from the calculation of operating
profit because it is a result of how the business is
financed, not how well or badly it is run.

This makes it easier to compare businesses in the

same field but with different financial structures.
Income Statement for Fred for first year

Sales in the year: 40,000
Cost of sales: purchases 8,000
Less closing stock (400) (7,600)
Trading (gross) profit 32,400
Running costs: Wages 6,000
Petrol 1,000
Gas 4,000
Deprecn 1,250
Allowance 500 (12,750)
Operating profit: 19,650
Interest payable (200)
Net Profit: 19,450
 Freds year-end SOFP
Cost Depreciation NBV
Non Current Assets:
Oven 3,000 (1,000) 2,000
Van 500 (250) 250
2,250
Current assets:
Inventory 400
Receivables(2,000-500) 1,500
Cash 20,500
22,400
TOTAL ASSETS: 24,650
Freds original equity 2,000
Accumulated profit: 19,450
Total equity 21,450
Non-current liabilities - Loan 2,000
Current liabilities: Gas bill 1,000
Interest 200
1,200
TOTAL EQUITY & LIABILITIES 24,650
 Lessons from Fred
1. Increase in net assets = increase in wealth = increase
in profit (but not necessarily in cash!)
2. Cash and profit measure performance differently.
Freds equity has increased by 19,450 but his cash
has only (!) gone up by 18,500.
3. The SOFP shows the financial position of a business
under accounting conventions, not necessarily related
to reality (the current market value of the van and
oven might be more or less than 250 and 2,000
respectively - and, if you were Fred, would YOU sell
up for 21,450, the SOFP value of the business??????
Uses of the income statement

Helps in providing information on:

How effective the business has been in

generating wealth

How the profit was derived

Limitations of the income statement

Items that cannot be measured reliably

are not reported in the income
statement.

Income numbers are affected by the

accounting methods employed.

Income measurement involves

judgment.
 Next lecture......

Fundamentals of Accounting:
Statement of Cash Flows

A&M Reading:
Chapter 6