3: Income Statement

What does the income statement show

The statement explains how revenue and expenses combine to produce profit or loss

• reports profitability over a specific period

• shows profit or loss for the period

Profit or Loss= revenue - expenses

What can profit support in the future

Profit may support dividends or be retained earnings for future growth

Why are income statements useful

Past- evaluate performance

Future- supports forecasts

Risk- assess uncertainty of future cash flows

Efficiency- understand how resources were used

Examples of revenue

• sales of goods

• fees for service

• interest and subscription

→ e.g. Real estate business: revenue is rent (sales of goods)

→ e.g. bank: revenue is interest

→ e.g. accountancy firm: revenue is fees for their service

Examples of expenses

• cost of sales

• selling and administration

• interest and tax

What is the business year divided into

Reporting periods

→ an accounting year does not have to match the calendar year

What reporting periods is the business life divided into and what is each for

Month → Quarter → Year

→ month and quarter is for decision making/ own use

→ year is for legal reasons when submitting accounts to Companies House

How long do plc and ltd get to prepare financial statements

Private (ltd):

They have 9 months from end of own accounting year to prepare financial statements and submit accounts (a regulation)

Public (plc):

They have 6 months to prepare, audit and submit to companies house

Accrual versus cash basis

The timing of recognition can differ from the timing of cash

Accrual basis

• revenue when earned (good leaves business or service is provided)

• expenses when incurred

Cash basis

• revenue when cash is received

• Expenses when cash is paid

The two types of accounting

Accrual basis accounting

Cash basis accounting

Accrual-basis Accounting

Record transactions in the periods in which economic events occur

→ recognition is driven by earning and incurrence, not by cash collection or payment

→ *Accrual is a liability (incurred expense)

Economic event → revenue earned/expense incurred → recognise in profit

Cash-basis Accounting

Recognition occurs only when cash changes hands

• cash received → recognise revenue

• cash paid → recognise expense

*cash basis accounting is not compliant with IFRS (International Financial Recording Services)= use accrual-basis accounting unless small business/ practice

→ prepayment is an asset

What are the main elements of equity

• retained earnings

• revenue - expenses - dividends

Components in an income statement

Cost of sales

= direct costs of the goods or services sold during the period

• costs must relate to the goods or services sold in the period

• unsold goods remain in closing inventory (= opening stock following year)

• cost of sales is deducted from revenue to calculate gross profit (GP= rev - cost of sales)

Opening inventory + purchases - closing inventory = cost of sales

Operating Expenses

= other costs incurred in carrying out trading activities

→ operating expenses are deducted from GP to calculate OP (OP= GP- operating expenses)

Examples:

• salaries and wages

• rent and rates

• utilities

• transport costs

• telephone and postage

• insurance

Detailed income statement

zoom in on cost of sales

Why do assets lose accounting value

Depreciation allocates the depreciable amount over an asset’s useful life

→ focus on fixed assets

• wear and tear

• lower resale value

• obsolescence and ageing

• systematic allocation rather than marketing valuation

What is depreciation

= represents the loss in value of this asset over time

→ depreciation is an expense

Depreciation when purchasing a new asset

When purchasing an asset (e.g. motor vehicle or computer), you should expect its value to not stay the same over the years

• wear and tear

• having a lower resale value

• becoming outdated/ obsolete

• etc.

What are the 2 methods of depreciation

Straight line

Reducing Balance

What are the 4 inputs to the calculating depreciation

*The method determines the pattern of allocation

1. asset cost= initial recorded amount

2. useful life= expected period of use

3. residual value= expected value at disposal

4. method= straight line or reducing balance

What is the straight line method

The same depreciation charge is recognised each year

Reducing balance method

• apply a fixed percentage to the carrying amount brought forward

• the depreciation charge reduces because the carrying amount reduces each year

What is the accounting value

Accounting value is the value left after depreciation and this figure then becomes the opening value for the next year

Comparing the two methods of depreciation

What is it known as when a receivable becomes unrecoverable

Bad debt

Bad debt

= recognised as an expense when a customer balance cannot be collected

→ e.g. someone declares bankruptcy

• credit sales create trade receivables

• a later cash receipts reduces the receivables

• an unrecoverable balance is removed from receivables

• the same amount is recognised as bad-debt expense

Credit sale to a partial payment

→ sale on credit period= increases accounts receivable by same amount

→ cash increases= account receivables decrease by same amount

What happens to the remaining balance (bad debt)

It gets written off

→ after the write-off, no amount remains recoverable from the customer

Income Statement:

• bad debt expense increases by amount unrecovered

Statement of Financial position:

• trade receivables decrease by amount unrecovered