Unit 2

Features of the P&L

* Summarizes the revenues, costs and expenses occurred during a specific period
* Uses accrual accounting methods
* Ignores when and why cash is received or paid

Three sections of the P&L

* Operating result
* Profit before interest and tax (EBIT)
* Financial result
* Operating + financial = Profit before tax
* Net profit

Operating result (P&L)

Results from company’s operating activities, irrespective of their financing, with only operating expenses being accounted for.

What does EBIT measure

Core operating performance

Use of EBIT

Comparison of companies in one and different industries

European way to present expenses

Expenses by nature

Expense by nature

Expenses are accounted by their type (ex: raw material, wages, depreciation)

Anglo-Saxon way to present operating expenses

Expense by function

Expenses by function

Expenses are accounted by the activity that they were assigned to and bundled into the ****cost of goods****

Financial result

Interest income - interest expense

Interest income

Dividend income from investments and cash holdings

Profit before tax (PBT)

EBIT + financial result

Use of PBT

Used to compare profitability with companies with similar financings structures, but in different tax jurisdictions

Net profit

Total revenue - total costs

Total costs and tax on income

Total costs include tax on income

Net profit definition

Wealth generated by the company and is available for shareholders, but can also be retained for future investing

Accruals

Revenues or expenses incurred that have impacted company's net income, even though the **cash still has not exchanged hands**

Deferral

Means of recording an expense or an income that was paid in one accounting period, but not accounted for until a later one

Revenue recognition

Revenue is recognized when it is earned (incurred), which implies a certain degree of performance on the part of supplier

IFRS 15

Establishes that a company will get its revenue from the goods and services they provided

IAS 2

Treatment of inventories, including definition of COGS

Treatment of revenues

Inventories are expensed when the goods are actually sold and the **revenue is recognized**

COGS

Opening inventory + purchases during the period - closing inventory

Gross profit

Sales - Cost of goods sold

Difference between gross profit and EBIT

Gross profit subtracts only COGS from the sales, while the EBIT also has to account for the operating costs

Considerations through inventory managment

Inventory managment should not overstate or understate value of the inventory, which is especially a risk, when prices fluctuate rapidly. And some of the value might be there, but not realisable in a realistic situation

Cost calculation approach allowed by the IFRS

FIFO and Individual costs

Individual costs

Cost are calculated for the products/services

The effect of Accruals on statements

Changes in net income on income and the balance sheet, as they involve non-cash assets and liabilities

In-depth effect of accrual of expenses

Equity goes down, since the expenses are accrued as liability

In-depth effect of defferal of expenses

Expenses are deferred (+E), as an asset (+A), Equity is increased through profit to “delete the expense” and the expense is seen as an asset, since it will be used in future

In-depth effect of deferral of revenue

Revenue is accrued (+E), as an Asset (+A), because it will be used in future to earn profit, equity and profit both go up

In-depth effect of accrual of revenue

Revenue deferred (-E), as a Liability (+L), profit goes down, which leads to lower equity

Fair value approach

Market-based measurement that is not entity specific

Principles of a fair value price:

* It’s an exit price
* Not a force sale
* From market-based view
* Current price at the measurement date

Difficulty with the fair value approach

There is a need to make assumptions regarding a market even where there is no active market

IAS 16

Concerned with fixed assets and their valuation principles

Initial valuation of fixed assets

Historical or acquisition cost, which includes all expenditure to get the asset ready for use

Addition of subsequent expenditure to the initial costs

Only added to the cost if it will produce economic benefits beyond it’s originally assessed performance

Depreciable amount of the asset

Acquisition cost minus the residual value of the asset

Depreciation schedule factors

Depreciable amount of the asset, the useful life of the asset, depreciation methods

Straight-line depreciation method

Depreciation as a function of time

Diminishing balance depreciation method

allocates a high proportion of the expense in the early life of the asset

Units of production depreciation method

Non-current asset is expensed according to physical capacity usage

Impact of depreciation on the balance sheet

Lowers the net value of the asset (aka: carrying amount/book value) through lowering the gross acquisition costI

Impact of depreciation on a P&L account

Increase in depreciation expense of the current year

Asset impairment when does it occur

Occurs if the economic value of the asset **drops below its carrying amount (net book value)**

IAS 36

Asset impairment

How does asset impairment occur

The book value of the asset is adjusted downwards for an impairment loss, reducing profit

Carrying amount

The book value of an asset

Bad debts

Specific receivables that are not likely ever to be paid on the available evidence, should be written off quickly

Doubtful receivables

May or may not be repaid in the future, so possibly becoming bad debt

Allowance for doubtful receivables

Expensed in P&L and is entered in the balance sheet as credit balance

Ways to create hidden reserves

Creation of excessive provisions, excessive asset write-down/impairment, adjustments of accrued/differed expenses/revenues

Capital structure of companies

Mix of equity capital and debt capitalQ

Equity capital

funds owned by shares and consists of: contributed funds and Internally generated funds

Contributed funds

Money that shareholders originally invested in the company in exchange for shares

Internally generated funds

Profits that have not been distributed to shareholders, retained by the company in order to finance future operations and expansion

Retained earnings

Profits that are eligible to be paid over to shareholders, but have not been distributed

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Reserves

Appropriation of retained profits, such as legal/statutory reserves, directly included in equity

Debt capital

Borrowed funds