Sourced from: http://www.clipartpanda.com/categories/income-clipart Presentation of Financial Performance Module 2 Topic 3
Learning Objectives Explain the purpose and importance of measuring financial performance Explain the reporting period concept and the difference between accrual accounting and cash accounting Describe the measurement of financial performance Discuss the definition and classification of income Discuss the definition and classification of expenses Apply the recognition criteria to income and expenses Identify presentation formats for the statement of profit or loss Explain the nature of the statement of comprehensive income and statement of changes in equity Explain the relationship between the statement of profit or loss, the balance sheet, the statement of comprehensive income and the statement of changes in equity
Financial performance Profit or loss, a measure of financial performance, is an important item in financial statements. Profit reflects the outcome of an entity s investment and financing decisions. An entity should periodically report its performance to enable internal and external users to make informed decisions. The profit or loss will inform internal decisions such as the entity s pricing of goods and services and the need to review cost structures. The profit or loss will inform external decisions such as whether or not to invest in, or lend to, the business. Sourced from: http://printersadvisor.blogspot.com.au/2013/11/10- ways-to-financially-improve-your.html
Sourced from: https://www.cpacanada.ca/en/the-cpa-profession/aboutcpa-canada/cpa-canada-annual-report-2014-2015 Sourced from: https://www.linkedin.com/pulse/best-practicefinancial-performance-management-you-bruce-claassen An entity that generates losses rather than profits is not sustainable. The statement of profit or loss reflects the accounting return for an entity for a specified time period. Periodic determination of an entity s profit or loss is necessary because users need to assess the profitability of an entity throughout its life. Users rely on periodic profit or loss figures to evaluate past decisions, revise predictions and make future decisions.
Accrual accounting vs. Cash accounting Accrual accounting is a system in which transactions are recorded in the period to which they relate, rather than in the period the entity receives or pays the cash related to the transaction. This means that the reported profit or loss based on the accrual system is the difference between income and expenses for the period. An entity required to comply with accounting standards must prepare its financial statements on an accrual basis. A cash accounting system, in contrast, would determine cash profit or loss as the difference between the cash received in relation to income items and the cash paid for expenses for the period. Entities not required to comply with accounting standards, such as many small businesses, may prepare their financial statements on a cash basis. Sourced from: http://blogqpot.com/images/credit%20cards%20cash%20basis%20accounting
Measuring financial performance Profit or loss is not formally defined in the Conceptual Framework, but instead is identified as being measured as the difference between income and expenses in a reporting period. To measure the profit or loss of an entity, it is therefore necessary to identify and measure all income and expense items attributable to the reporting period.
Income Sourced from: http://www.beaconhilladvisory.com/2016/05/25/why -guaranteed-income-for-life-doesnt-always-offerthe-best-retirement-options/ Income is defined in the proposed Conceptual Framework (para. 4.48) as: increases in assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from holders of equity claims. Income encompasses both: Revenue arising in the ordinary course of activities (for example, sales, fees, dividends) Gains; all other inflows (for example, gains on disposal of non-current assets)
Recognition of income Revenue should be recognised only when: The increases in assets or reduction of liabilities have probably resulted from inflows of economic benefits and these movements can be reliably measured. Or can be more simply stated when the earning process is substantially complete and measurable and when the receipt of payment for the goods and services is reasonably certain.
Classification of income By income-generating activities By income types Sourced from: http://raywhiteelizabeth.com.au/news/tip-ofthe-week-40/ Sales, fees, commissions, interest, royalties, rent, non-reciprocal transfers Sourced from: http://simplesalesadvice.com/2017/01/its-allabout-top-10-sales-tips/ Sourced from: http://hackingdistributed.com/2015/12/23/bitcoin-feemarket/ Sourced from: http://www.clipartpanda.com/categories/commiss ion-clip-art
Expenses Expenses are defined in the proposed Conceptual Framework (para. 4.49) as: decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. Or put simply, a money sacrifice or the incurring of a liability in the pursuit of business objectives. Sourced from: http://www.clipartpanda.com/categories/expenses-clip-art
Cost of sales expense is the main expense incurred by a retailer in order to sell goods and generate income, the entity must purchase goods for resale. Sourced from: https://www.123rf.com/clipartvector/electricity_bill.html Sourced from: https://www.iconfinder.com/icons/533560/ban king_costs_delivery_price_transportation_tru ck_van_icon Sourced from: http://communicationsclipart.com/design/communic ation-clipart-of-a-dollar-bill-mascot-cartoon- character-holding-a-red-telephone-by-toons4biz- 489 Other expenses include wages and salaries, depreciation, rent, telephone, electricity, delivery costs, advertising. Note: drawings taken by owners (or dividends paid to shareholders) are not expenses.
Recognition of expense An expense should be recognised in the current period if:- It is probable that the decrease in economic benefits has occurred The amount can be reliably measured. Examples of expenses are, payment of wages, payment of electricity bill, purchasing a machine or other asset type, purchase of goods for resale.
Classification of expenses There is some choice as to how to display and classify expenses in the income statement. Smaller entities: often list all their expenses in the income statement Larger entities: aggregate their expenses into certain classes for reporting purposes Reporting entities: required to classify their expenses by nature or function
Decision tree for classifying assets and expenses
Gross profit and cost of goods sold GROSS PROFIT = REVENUE COST OF SALES Not all businesses have COGS (cost of goods sold), generally service businesses do not (e.g. a law firm, or a tax accounting firm). Cost of Sales Beginning Inventory Purchases Ending Inventory
Timing is important Sourced from: https://leapafrica.wordpress.com/2015/03/04/the-lawof-timing-when-to-lead-is-as-important-as-what-to-doand-where-to-go/ Deciding when (i.e. in which accounting period) costs should be recognised as expenses: If an item or service is acquired during that year (or accounting period) and consumed during that year (period), therefore the expenses are recognised in that same accounting period. Whether or not the item has been paid for is not relevant.
Format of the income statement Format of the income statement will be affected by the following factors: Size of the organisation Type of the organisation Types of users who will read the income statement
Income Statement format for a non-reporting entity For sole traders and partnerships, there are virtually no regulations covering the format. No prescribed reporting format for income statements prepared by non-reporting entities. Although presentation and classification of items may show great diversity, the purpose of the income statement does not change: to report the profit for the entity for the reporting period. The profit objective is not necessarily relevant for all entities.
Income Statement format for a non-reporting entity
Prescribed format for reporting entities The accounting standard governing the presentation of the statement of profit or loss requires the following to be presented on the statement of profit or loss: Revenue Cost of sales (if revenue from sales is disclosed) Finance costs Share of profit or loss of associates and joint ventures if equity accounted Tax expense Profit or loss.
Prescribed format for reporting entities
Material income and expenses must be disclosed separately via either the income statement or the notes. The determination of whether an item is material is based on: The size and/or nature of the item Whether its non-disclosure could influence users decision making
Revenue Less Cost of Sales Gross Profit Less Distribution Costs Administration Expenses Finance Costs Other Expenses Profit (Before Tax) Less Income Tax Expense Profit (After Tax) Victory Ltd Statement of Profit and Loss for the year ended 30 June 2014
Statement of Comprehensive Income Reporting entities can elect to present all items of income and expense in a reporting period in a single statement of comprehensive income or in two statements: An Income Statement that shows the income and expenses associated with the determination of profit (or loss) for the reporting period. A statement beginning with profit or loss and displaying components of other comprehensive income is Statement of Comprehensive Income.
The Statement of Comprehensive Income shows all items of income and expense during the reporting period, including those items recognised in determining profit or loss, as well as items of other comprehensive income taken directly to equity. Comprehensive income items that may be added or subtracted from net profit to arrive at total comprehensive income for the period.
Comprehensive Income Items Increase in Fair Value of Property Gain or Loss related to Superannuation Benefit Plans Gain or Loss from Revaluation of Financial Assets Gain or Loss from Foreign Currency Transactions
Other comprehensive income (positive or negative) is added to the profit (or loss) this shows all non owner changes that have occurred in assets and liabilities that have occurred in the period. Examples: Unrealised gain (loss) on revaluation of properties Unrealised gain (loss) for the year on available for sale financial assets Gain (losses) on foreign currency translation of investments in foreign operations
Victory Ltd Statement of Profit and Loss and Other Comprehensive Income for the year ended 30 June 2014 Revenue Less Cost of Sales Gross Profit Less Distribution Costs Administration Expenses Finance Costs Other Expenses Profit (Before Tax) Less Income Tax Expense Profit (After Tax) Add Other Comprehensive Income Profit and Loss and Other Comprehensive Income
Statement of Changes in Equity The purpose of the statement of changes in equity is to report all owner changes to equity that are taken directly to the equity section of the balance sheet, together with the comprehensive income for the period. This, therefore, shows the total changes to the equity for the period. It enables users to observe the overall change in equity during a period.
Link between financial statements It is important to understand the relationships between the financial statements, rather than viewing each statement in isolation. The Income Statement presents the profit or loss made by the entity during the reporting period. The Statement of Comprehensive Income reports the profit or loss and other comprehensive income. The Statement of Changes in Equity explains the changes in equity from the start to the end of the reporting period.
The Balance Sheet shows the financial position of the entity as at the end of the reporting period. The profit or loss for the reporting period is added to the retained earnings as at the start of the period. The entity can make distributions from retained earnings (i.e. dividends or drawings) and transfers to or from retained earnings. The balance of the retained earnings as at the end of the reporting period is included as an equity item in the balance sheet.
Deferrals and Accruals Sourced from: Beattie, C., Chalmers, K., Edwards, L., Hellmann, A., Hoggett, J., Medlin, J., Maxfield, J. (2015). Accounting (9 th ed.). Milton, Qld: John Wiley & Sons.
Prepaid Expenses - Prepayments They are payments made in advance. The portion of the payment relating to the unexpired portion of the benefit (e.g. insurance) is reflected as a current asset in the balance sheet of the business. The portion that has been expired (or used up) is expressed as an expense in the period to which it relates (e.g. January 20X4).
Accrued Expenses - Accruals Expenses that have been incurred but are not yet recorded in the accounts. A good example is an electricity invoice because these invoices are based on usage they are received in the next accounting period. Estimated value has to be accrued using following entries: Expense (Income Statement) Accrued Expense (Balance Sheet - Current Liability) The entry is usually reversed at the beginning of the next accounting period and exact value is recorded under Payables once the invoice is received.
Debtors Sourced from: http://www.investopedia.com/video/play/whats-debtor/ Commonly known as Accounts Receivable, however the terms are interchangeable and mean the same thing. Debtor occurs when a business sells goods or services to a third party on credit terms, i.e. when the goods or services are sold on the understanding that payment will be received at a later date. The amount will be recognised as an Accounts Receivable (Debtors) on the Balance Sheet under the heading Current Assets to be received within a year. At the same time it will be recognised as a Sale on the Income Statement.
Bad Debts In reality, most businesses will not collect all money owed to it. There are some debtors who will not/cannot pay. When payment cannot be collected the amount is referred to as a bad debt, some reasons for bad debts could be: Debtors bankruptcy Death of the debtor Disagreement regarding the contract for goods/services provided Sourced from: https://www.jantoo.com/cartoons/keywords /bad-debts
Allowance for Doubtful Debts A common method in medium to large businesses is to provide or allow for an amount every month for doubtful debts, not specifically relating to any debtor, but for the purpose of creating an allowance account for the amount that we expect debtors not to pay. Allowance for doubtful debt is recorded as a contra asset account and expensed under Bad Debt Expense on the Income Statement.
Trade Creditors Established businesses find it more convenient to establish accounts with suppliers and pay for their purchases after they have received the goods or services. The amount will be recognised as an Accounts Payable (Creditors) on the Balance Sheet under the heading Current Liabilities which are payable within a year. The amount of time the business has to pay will depend on the credit terms established by the supplier.
Exercise Items to be categorised Accrued Interest Accumulated Depreciation Depreciation Expense Cost of Sales Drawings Goodwill Interest Expense Sales Prepaid Rent Telephone Wages Motor Vehicle Fees received Income Statement Balance Sheet
Items to be categorised Accrued Interest Accumulated Depreciation Depreciation Expense Cost of Sales Drawings Goodwill Interest Expense Sales Prepaid Rent Telephone Wages Motor Vehicle Fees Received Income Statement Depreciation Expense Cost of Sales Interest Expense Sales Telephone Wages Fees Received Balance Sheet Accrued Interest Accumulated Depreciation Drawings Goodwill Prepaid Rent Motor Vehicle
References Birt, J., Brooks, A., Chalmers, K., Maloney, S., Oliver, J. (2017). Accounting: business reporting for decision making (6 th ed.). Milton, Qld: John Wiley & Sons. Beattie, C., Chalmers, K., Edwards, L., Hellmann, A., Hoggett, J., Medlin, J., Maxfield, J. (2015). Accounting (9 th ed.). Milton, Qld: John Wiley & Sons. Birt, J., Brooks, A., Chalmers, K., Maloney, S., Oliver, J. (2014). Accounting: business reporting for decision making (5 th ed.). Milton, Qld: John Wiley & Sons.