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The income statement or the profit and loss account as it is also called measures reports how much profit (wealth) has the business generated over a period of time.
To measure profit the total generated revenue over a period must be identified. Revenue is a measure of inflow of economic benefits arising from the operations of the business. These benefits will either result in an increase of assets such as cash or amounts owed to the business by the customers or a decrease of liabilities.
The total expenses must also be identified. Expenses are obviously the opposite of revenue. It represents the outflow of economic benefits.
The profit is then easily calculated by taking the generated revenue over a particular period of time and from it deduct the total expenses incurred in generating that revenue. The final result form the mathematical equation will be either a profit or a loss. If the revenue is more than the expenses = profit and if the expenses are more than the profit = loss.
The period over which profit or loss is calculated is called reporting period but it is sometimes referred to as accounting period or financial period.
The income statement and the statement of financial position have different roles. The statement of financial position gives us information about the financial status(position) of the business at a particular time and the income statement gives us information about the amount of profit (wealth) generated by the business. The two statements are closely related.
The income statement links the statement of financial position at the beginning and the end of the reporting period. At the beginning of the reporting period the statement of financial position shows the opening wealth position of the business at that time. After an appropriate period an
income statement is then prepared to reveal the wealth generated at that period. A statement of financial position is then prepared to reveal the new wealth position at the end of the period. The extended equation would look like this:
Assets = Equities + Profit or loss + Liabilities
An appendix presents users with a more detailed and informative view of performance.
Income statement layout
The layout of the income statement will vary according to the type of business that is being related
The first part of the income statement is where we calculate the so-called gross profit which is calculated by taking revenue of the goods that were sold by the business and from the revenue is deducted the cost of those goods. In other words the gross profit represents the profit or loss from buying the goods and selling the goods.
Operating expenses (overheads) incurred in running the business (salaries, rents, rates and so on) are deducted from the gross profit. The resulting figure from the equation is known as the Operation profit.
Profit for the period
Having established the operating profit, we add any non-operating income (such as interest receivables) and deduct any interest payables on borrowings to arrive at the Profit for the period(or net profit).
Having set out the main principles involved in making the income statement we need to consider some further points.
Cost of sales
The cost of sales (or cost of goods being sold) can be identified in different ways. In some businesses the cost of sales for each individual sale is identified during the time of transaction. Each item of sales is matched up with the relevant cost of that item during the transaction. Big retailers, for instance, (supermarkets) have checkouts where the machines not only record each item that was sold but they also simultaneously pick up the cost of the goods. Businesses that sell relatively small number of high-valued equipment prefer to use this method. But small retailers prefer identifying the cost of sales at the end of the reporting period.
We must remember that cost of sales is the cost of goods sold and not the cost of goods being bought during the period. Part of the goods bought during the period may remain as inventories at the end of the period. These will normally be sold in the next period.
The classification of expense items is often a matter of judgement. Such decisions are normally based on how useful a particular classification will be to the users.
To sum up this is what the income statement layout would look like: Sales revenue – Cost of sales = Gross Profit – Operation expenses = Operation profit – Non-operating expense + Non-operating income = Profit for the period (Net profit)
A key issue in the measurement of profit concerns the point at which revenue is recognized.
For example a motor car dealer can recognize revenue in three different ways: 1. At the time that the order is placed by the customer
2. At the time that the car is received by the customer
3. At the time that the customer pays the dealer.
The point choise can have a profound impact on the total revenues reported for the reporting period and this in return may have a profound impact on profit.
The main criteria for recognizing revenue from the sale of goods or services are that:
– The amount of revenue can be measured reliably
– It is probable that the economic benefits will be received
And an additional criterion must be made in the situation of recognizing revenue when it comes from the sale of goods which is:
– Ownership and control of the items should pass to the buyer
As we can see revenue can be identified in the statement of income long before the items was sold which basically means that there will be a difference between the total cash of the business and the revenue of the business at the end of the accounting period. For cash sales (sales where cash is payed as the goods are being transferred) there will be no difference between the total cash and revenue of the business at the end of the reporting period.
Some contracts for goods or services make take longer than one reporting period to complete. A misleading impression may be given if a business waits until the completion of a long-term contract before recognizing revenue. In such a situation it is possible to recognize the revenue before the contract of the goods or services is completed, provided that work can be broken down into different stages and each stage can be measure reliably. Each stage can be awarded a separate price with the total of all stages being equal to the total price for the entire contract. This means that as each stage is completed the supplier of goods or services can recognize the price of the stages as revenue and bill the customer accordingly.
Construction contracts often extend over a long period of time and so staged approach to recognizing revenues tends to be applied.
Suppose that a customer signs a contract with a builder to have a new factory built that will take approximately 3 years to build. Let us assume that building the factory can be broken down into the following stages:
– Stage 1 – Clearing and leveling the land and putting in the foundations
– Stage 2 – Building the walls
– Stage 3 – putting on the roof
– Stage 4 – putting in the windows and completing all the interior work.
As each stage is complete the builder will bill the customer for the agreed price of that stage. The builder will treat the revenue for the stage as that of the reporting period in which the stage is completed.
There are also certain kinds of service that may take years to complete. One example is where a consultancy business installs a new computer system for a client. This approach tends to be taken with any contract no matter for what purpose (product or service) that takes a long time to complete.
In some cases a continuous service may be provided to a customer For example a telecommunications business may provide access to internet for subscribers. Here, the benefits from providing the service are usually assumed to arise evenly over time and so revenue is recognized evenly over the subscription period.
Where it is not possible to break down a service into different stages and calculate revenue from there or to assume that benefits from providing the service accrue(Натрупваt) evenly over time, revenue is normally recognized after the service is completed.
TV broadcasting services for instance have a bunch of different ways of recognizing revenue: Pay per view
Subscribtion services – as the services are provided
Advertising revenues – when the advert is broadcast
Installation, hardware and service revenue – when the goods and services are activated.
Revenue of providing a service is often recognized before the cash is received there are occasion,however, when businesses demand cash before providing the service.
The matching convention provides guidance to this. This convention states that expenses should be matched to the revenue that they helped to generate. In other words expenses associated with a particular item of revenue must be taken into account in the same reporting period as that in which the item of revenue is included. Applying this convention we must remember that it might be different from the total cash (just the same way as the profit) In other words the expenses might more or less than the total cash during the reported period.
When the expense for the period is more than the cash paid during the period The example with the sale staff that receive a 2% commission form sales. 6000 is the commission but only 5000 gets payed in cash the other 1000 will be counted as a liability in the statement of financial position and will be payed through the next 12 months. The processes would look like this: £6000 in income statement, £5000 in statement of cash flow and £1000 as a liability in statement of financial position. When the amount paid during the period is more than the full expense for the period. The Example given here is the one with the advertisement company that pays rent every quarter of the year = £4000. The company pays £4000 in advance at the end of the period. The extra 4000 pounds will be counted as prepaid expenses in the statement of financial position under assets. It would like this: £16000 in income statement, £20000 in statement of cashflow, and £4000 as a prepaid expenses in statement of financial position.
In practice the treatment of accruals and prepayments(prepaid expenses) will
be a subject to the materially convention. This convention states that, where the amounts involved are immaterial, we should consider only what is expedient (Изгоден) This would usually mean treating an item as an expense in the period in which it is acquired rather than strictly matching it to the revenue to which it relates. For instance a business may find that at the end of a reporting period it holds £2 worth of unused stationery. The time and effort taken to record this as a prepayment would outweigh the negligible effect on the measurement of profit or financial position. As a result it would be treated as an expense of the current period and ignored in the following period.
Profit, Cash, and Accruals accounting
We have seen that it is normally the case that for a particular reporting period total revenue does not match the total cash received and that the total expense is not equal to the total cash paid. As a result the profit for the period (the revenue minus the expenses) will normally not represent the net cash generated during that period. As a conclusion we can come to defining the meaning of profit which is measure of achievement or productive effort rather than a measure of cash generated. The statement of cash flow cannot be based on accruals accounting!
This “using up” may relate to physical deterioration (for instance a motor vehicle) or it may be linked with obsolescence (as with some IT software that is no longer useful) or the mere passage of time (as with a purchase patent, which has a limited period of validity). In the case of depreciation with intangible products we refer to the expense as armotisation rather than depreciation.
Calculating the depreciation expense
To calculate the depreciation expense for a period four factors have been considered:
The cost of the asset
The cost will include all costs incurred by the business to bring the asset
to its required location and to make it ready for use. This means that in addition to requiring the asset any delivery costs, installation costs, and legal costs incurred in the transfer of legal title will be included as part of the total cost of the asset.
The useful life of the asset
A non-current asset has a both a physical and economic life. The physical life of the asset will be exhausted through the effects of wear and tear and/or passage of time. The economic life is decided by the effects of technological progress, by changes in demand or changes in the way that the business operates. The benefits of an assets soon become outweighed by the costs as it becomes unable to compete with newer assets. The economic life of an asset may be much shorter than the physical life. For instance the physical life of a computer may be 7 years but the economic life 3
Residual value (disposal value)
When a non-current asset is used up it can still have value for someone and some revenue might be found from it. The residual value must be deducted from the cost of the asset. For instance if the asset costed us 50 pounds and the residual value was 5 pounds the ending cost for the asset would be 45 pounds.
There are mainly two methods that have been used in practice the straight-line method and the reducing balance method.
Straight-line method this method simply allocates the amount to be depreciated evenly over the useful life of an asset. In other words there is an equal depreciation expense for each year that the asset is help: asset costs 100,000 after 2 years it would be 50,000 and 4 years it would be 25,000
Reducing balance method – this method applies fixed percentage of depreciation to the carrying amount of the asset each year.
Selecting a depreciation method
The appropriate depreciation method to choose is the on that reflects the consumption of the economic benefits of an asset. Where the economic benefits are consumed evenly over time (with building, for an example) we would use the straight-line method. Where the economic benefits consumed decline over time (for instance certain types of machinery that lose their efficiency) the reducing-balance method would be appropriate. Where the pattern of economic benefits consumed is vague the straight-line method is used.
There is an international financial reporting standard to deal with the depreciation property.
In practice the use of different depreciation methods may not have such a serious impact on profits.
Impairment and depreciation
Depreciation expenses for future reporting periods should be based on the impaired value of that asset.
Depreciation and asset replacement
Some people appear to believe that the purpose of depreciation is to to provide funds for the replacement of a non-current asset when it reaches the end of it’s life. However, this is not the case. The depreciation rate for a particular reporting period is used to calculate the profit for that period. If the depreciation rate is excluded from the income statement the information provided would not have a fair measure of financial performance of the business. Where an asset is to be replaced the depreciation expense in the income statement will not ensure that liquid funds are set aside specifically for this purpose.
Depreciation and judgement (repeat read afterwords)
Accounting is not as prices and objective as it is portrayed as being. There are areas where subjective judgement is required.
Making different judgements on these matter result in a different pattern of
depreciation expenses over the life of the asset and therefore in a different pattern of reported profits. However, underestimations or overestimations that are made in relation to above will be adjusted for in the final year of an asset’s life. As a result the total depreciation rate and total profit will not be affected by estimation errors.
The final adjustment for under-depreciation of an asset is often referred to as loss or deficit on disposal of a non-current asset as the amount received is less than the residual value. Similarly the adjustment for over-depreciation is often referred to as profit or surplus on disposal of a non-current asset.
The cost of inventories is important for determining financial performance and position. The cost of inventories sold will affect the calculations of profit and the cost of inventories held at the end of the reporting period will affect the portrayal of assets held.
To calculate the cost of inventories an assumption must be made about the physical flow of inventories through the business – It is concerned only with providing useful measures of performance and position.
– First in, first out (FIFO) in which it is assumed that the inventories acquired the earliest are the ones to be used the first.
– Last in, first out (LIFO) in which it is assumed that the inventories acquired the latest are the ones to be used first.
– Weighted average cost (AVCO) in which it is assumed that inventories acquired lose their separate identity and go into a pool. Any issues of inventories from this pool will reflect the weighted average cost of inventories held.
During a period of changing prices, the choice of assumption used in costing inventories can be important.
There is an Financial Reporting Standard that deals with inventories. It
states that when preparing financial statements for external reporting the cost of inventories should normally be determined using either FIFO or AVCO. LIFO is not suitable for external reporting. The standard also requires the “lower of cost net realizable value” rule to be used and so endorses the application of the prudence convention.
Costing inventories and deprecation provide two examples where the consistency convention should be applied. This convention holds that as soon as an accounting method is selected it should be applied consistently over the years. It is not acceptable to, say, change from FIFO to AVCO between periods (unless, of course, the circumstances make it appropriate).
Trade receivables problem
When businesses sell goods or services on credit revenue will usually be recognized before the customer pays the amount owing. Recording the dual aspect of a credit sale will involve increasing sales revenue and increasing trade receivables by the amount of the revenue from the credit sale. With this type of sale there is always the risk that the customer will not pay the amount due. Where it become reasonably certain that the customer will not pay the amount owed is considered as bad debt which must be taken into account when preparing the financial statements.
To provide a more realistic picture of financial performance and position the bad debt must be “written off”. This will involve reducing the trade receivables and increasing expenses by the amount of the bad debt. The bad debt is written off in the same period as the sale which generated the bad debt in the first place.
When a debt is bad the accounting response is not simply to cancel the original sale – the income statement would not be informative. Reporting the bad debt as an expense can be extremely useful in assessing management performance
At the end of the reporting period it may not be possible to identify with
certainty all bad debts that incurred during that period. The business must try to determine the amount of trade receivables that, at the end of the reporting period, are doubtful (there is a possibility that they may eventually prove to be bad).
Once a figure has been derived and expense known as an allowance for trade receivables should be recognized. This will be shown as an expense in the income statement and deducted from the total trade receivables figure in the statement of financial position.
Dividends are payed from the collected revenue of the business (retained earnings) but only from the cash pool. Shareholders are often given an annual dividend which may be in two parts:
– Interim dividend being payed half way through the year
– Final dividend shortly after the year end
Dividends that are declared but not paid at the end of the year might appear as a liability in the statement of financial position.
Only 50% of a company’s tax of a company’s tax liability is due for payment during the year concerned the other 50% will appear in the end-of-year statement of financial position as a current asset.
In conclusion the layout of the Income statement would look like this
Companies are taxed with the corporation tax
Revenue (minus) cost of sales = Gross Profit
Gross Profit (minus) operation expenses = Operation profit
Operation profit (minus)Non-operational expenses (interest payables) or (plus) non-operational income (interest receivables) = Profit Before taxation Profit Before Taxation (minus) tax = net profit for the period
Reserves are profits and gains that were achieved by the company that are still part from the shareholder’s equity (shareholders’ funds)