HANDOUT FOR WEEK 3 UNDERSTANDING THE INCOME STATEMENT Introduction (Profit and loss statement) The financial account system generates and important report that captures the financial performance of the company called as the Income statement or the Statement of profit and loss. Income statement is measured with reference to a period of time. This period of time is usually for a year. Performance reports are also prepared for periods less than a year when firms provide interim reports for quarters or half years. For internal purpose this statement can be prepared every month as well. It depicts the financial performance of the firm in terms of incomes earned and expenses incurred. This is very similar to the flow of water into and out of a dam measured with reference to a period of time. An income statement presents the revenue earned during the period and the expenses incurred in generating that revenue. Net Income represents the excess of revenue over expenses over a period of time. Net Income = Revenue Expenses The income statement presents a summary of the operating and financial transactions, which have contributed to the change in the owners' equity during the accounting period. Revenues are transactions that augment owners' equity and expenses are transactions that diminish owners' equity. Income: Income is defined in the standards as: Income is the increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity (Retained earnings) other than those relating to contributions from equity participants. Income comprises both the operating income as well as the non-operating income. Operating income constitutes the revenue generated from the core activities of the business, i.e. it can be either sale of goods or rendering of services. Apart from the primary income, a company can generate income from other sources like generating income from sale of assets, interest income and other income from non-operating activities. All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial
Operating expenses are incurred to run the core business of the firm. It comprises of items like the cost value of goods or services sold and general administrative, selling and distribution expenses. Non-operating income /gain comprises of income generated from sources other than the core activities of the firm and can be further broken down into income and gains. For example, for a firm engaged in tourist taxi service, income earned from investment will be considered as a non-operating income (other income) and profit earned on sale of cars will be non-operating gains. Non-operating expense/loss comprises of the losses or and expenses are relatable to sources other than the core business. For a tourist taxi firm, examples of non-operating expenses will be loss on sale of equity shares held as investment will be a non-operating loss. Revenue: The term Revenue means the price charged to customers for goods sold or services rendered. It is the inflow of economic benefits (cash, receivables, other assets) arising from the ordinary operating activities of an entity To illustrate, a retail store generates revenue by selling the goods. A service enterprise gets revenue by charging fees for the services provided. When goods are sold or services performed, the resulting revenue is in the form of cash or accounts receivable. Revenue is not necessarily cash flowing into a business within same Accounting year. Rather, it is the amount earned during the period. It can be in cash or kind. Expenses: Expenses in general terms mean the costs incurred for generating revenue. They are the cost incurred in the normal course of business operations. The expenses can range from acquiring raw materials, production costs, administrative expenses like employee salaries, utilities expenses; other overhead expenses used are the common examples of business expenses. There are 3 important concepts related to the income statement. These are Realisation, Accrual and Matching Concept. The Realization Concept An important concept, the realization concept, indicates the amount of revenue that should be recognized from a given sale. Revenue should be recognised only when the goods are sold and when the services are provided. According to the realisation principle, a revenue is recognised when the transaction generating the revenue takes place and not when the cash for the transaction is received. To illustrate this principle, let us consider an example. Suppose a firm sells goods worth $10,000 on credit to a customer. The revenue is recognised when the sale takes place even though cash may be received later. When the firm receives cash, it will adjust its balance sheet by decreasing the receivables and increasing the cash. The Matching Concept As noted earlier, the sale of merchandise has two aspects: (1) a revenue aspect, reflecting the revenue realized, and (2) an expense aspect, that is incurred to earn the revenue This principle requires that all the costs and expenses incurred should be identified and matched against the related revenue earned during a time period. To summarise, all the All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial
expenses incurred to generate revenue should be recognised in the same accounting period as the related revenue. There has to be a clear matching of the revenue with expenses incurred. For example, if a particular sale has been recorded, then all the costs associated to that sale should also be recorded in the same time period. If a firm sells 10 pens the cost incurred to sell the 10 pens should be included as expenses in the same period. The Accrual concept Accounting transactions generally end up with cash. That is, revenue is ultimately realised and expenses are generally paid. The question is should accounting system wait for the cash part to complete before recording the same. It is not normally treated that way. Accounting transactions are recorded without waiting for cash part to complete. The reason is accrual concept. When it comes to revenue or expenses, accrual concept is consistent with matching concept. If a sale is made, whether expenses on account of sale is paid or not, they are to be recognised. For instance, an advertisement was released on December 25 but the amount was paid on 4 th April. Since the expenses have been accrued, they need to be recognised in the accounts. Similarly, if a loan is taken in January and next interest has to be paid at the end of June, interest expenses for the period of January to March are to be recognised when closing the books of accounts in the month of March. Some Major issues related to the Income Statement 1. Revenue Recognition Most of the activities of the business can be broadly classified into Operating activities Investing activities Financing Activities The main objective of any business is to generate revenue. Businesses generate revenue either by selling goods or services. For example; Retail Store sells food and other household goods, Pharmaceutical companies sells pharma products, banks lend money and sell financial services etc., We can see that the sale of product or service is at the heart of any business, same way correct accounting of revenue is the key to correct disclosure of revenue in financial statements. A number of questions get raised in this regard: When should revenue be recognised? Is it when: The customer places the order, or The goods are manufactured or The invoice is prepared or The goods are delivered or When cash is collected or Maybe later when there is no chance of return of goods by the customer. How do we assign revenue to a particular period? This is really an important issue, which has to be dealt with utmost care and caution. All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial
As per IFRS guidelines, there are set number of conditions that have to fulfil in order to recognize revenue. In simple terms, revenue should be recognised: When the goods or services have been provided or delivered to the customer (i.e. when the risk and reward of ownership is transferred) and There is no uncertainty in collection of consideration from the customers. If these two conditions are met, revenue can be recorded for such items. Revenue recognition can get quite complex for services industry. For example: A company in the IT services gets a contract for development, installation, customer support and providing hardware. The issue arise as to at what point in time, the company should recognise its revenue? Learners can examine the accounting Policy section of the annual report of companies to understand the Revenue Recognition of Companies. Expenses There are several expenses a company incurs to earn the income. For example a manufacturing firm incurs expenses such as: Raw Material expenses, wages, manufacturing overheads, administration expenses such as rent, depreciation interest and other expenses. Tax expense consists of current tax and deferred tax. Current tax is computed by multiplying the taxable income, as reported to the tax authorities, by the appropriate tax rate. Deferred tax, also called future income tax, is an accounting concept that arises on account of temporary difference (also called timing difference) caused by items which are included for calculating taxable income and accounting profit but in a different manner over time. For example, depreciation is charged as per the written down value for the taxable income but as per the straight-line method for calculating the accounting profit. As a result, there are differences in the year-to-year depreciation charges under the two methods, but the total depreciation charges over the life of the asset would be the same under both the methods. Some companies have extraordinary items reported in the income statement. Extraordinary items are material items, which are both infrequent and unusual, and they have to be disclosed separately by virtue of their size and incidence. Examples of extraordinary items are the discontinuance of a business segment, either through termination or disposal, the sale of investments in subsidiary and associated companies etc. One of the important expenses in the income statement is Depreciation. We discuss the same in the next section. Depreciation As we have seen that all the expenses have to be recorded in the Income Statement. Depreciation is one such non-cash expense, which is reported in the Income Statement. All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial
One of the issues in accounting for plant & equipment is the allocation of an asset s cost over its useful life. The matching principle requires that this costs be recorded as expense in the period when the benefits from the use of asset have been enjoyed. This allocation procedure is depreciation and the allocated amount recorded in the closing entry is an expense. Depreciation is the systematic process of allocating the depreciable cost of the asset over the useful life of the asset. Accounting for depreciation is often confusing. People think that depreciation reflects the decline in an asset s value. The concept of depreciation is nothing more than a systematic write off or allocation of the cost of an asset over its useful life. To calculate depreciation for an asset, you need to know: Original cost of the asset Useful life Estimated Salvage value Salvage value is the amount expected to be received when the asset is sold at the end of its useful life. There are several methods for depreciating the costs of assets for financial reporting. Most commonly used method of depreciation is the Straight Line method of depreciation. This method assumes that an asset will benefit all periods equally and the cost of the asset should be assigned equally for all the accounting periods. The formula for calculating straight-line depreciation is; Cost - Salvage Value Expected useful life ( years ) = Annual Depreciation expense For example, ABC purchased a vehicle for $100,000 for its own use. The expected useful life of the asset is 10 years. The estimated salvage value is $20,000. What would be the annual depreciation expense for the vehicle? Annual Depreciation expense will be $100,000 - $20,000 = $8,000 10 There is one exception here. For example land. Land doesn t get depreciated because its assumed to have unlimited useful life. For assets having unlimited life, there is no depreciation charged because they are going to provide future economic benefits to the business forever. All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial
There are other methods of depreciation like accelerated method of depreciation, units of production method of depreciation. Under the accelerated depreciation method, the depreciation expense is higher in the early years of the asset s useful life and lower in the later years. Associated terms in the income statement are amortisation and impairment. Amortisation term is depreciation but associated with certain intangible assets. Impairment of asset An impaired asset is a company's asset that has a recoverable value or future benefits less than the value listed on the company's balance sheet. Accounts that are likely to be written down are the company's goodwill, accounts receivable and long-term assets because the carrying value has a longer span of time for impairment. As per IFRS guidance, Impairment loss is the amount by which the carrying amount (net book value) of an asset exceeds its recoverable amount (its future benefits) The Recoverable amount is measured by the higher of a) The asset's fair value less costs of disposal* (sometimes called net selling price) b) Its value in use How do we measure the value in use? The value in uses is a difficult concept to measure. A running business or a useful asset gives future benefits through production and sale of products. This has to be quantified to measure the value in use. If, and only if, the recoverable amount of an asset is less than its carrying amount, the carrying amount of the asset shall be reduced to its recoverable amount. That reduction is an impairment loss. Statement of Changes in equity It is a detailed statement showing the changes in share capital, retained earnings and reserves during a period of time. Shareholders Equity can increase or decrease as a result of several things, for example: If new shares are issued If the company buys back its shares The company makes a profit or loss during the period It pays out dividends to its shareholders This statement comprises of broad categories, which together make the shareholder s equity for a company. That is: Share Capital Securities Premium or Additional paid in capital Retained earnings Reserves All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial
Statement of comprehensive income Comprehensive income reflects the overall change in a company s wealth during a period. This statement includes items that are not related to the business operations of the company but arise from change in certain market conditions and resulting fair value changes. Therefore these items are excluded from the Income Statement and included in the comprehensive income. Examples of the types of changes captured by other comprehensive income include: Foreign currency transaction adjustments Unrealized gains and losses on Available-for-sale securities. Unrealized gains or losses on derivative instruments Unrealized gains or losses on defined benefit Pension plans. Revenues, expenses, gains and losses appear in other comprehensive income when they have not yet been realized. Thus, if the company has invested in Available for sale securities and the fair value of those changes in the year-end, recognize the difference as a gain or loss in other comprehensive income. On selling them, the gain or loss on sale is realised and it moves to the income Cash Flow Statement The Cash Flow Statement gives information about the cash generated or used by the firm during a financial year. Consider the Balance Sheet of a firm. The status depicted is different in the beginning and end of the year. Can the change in status be attributed entirely to the performance of the company, incomes earned and expenses incurred during the financial year? Not quite. Performance always affects the status of a firm. But all changes in the status cannot be attributed only to performance. The changes in status may also arise due to other activities of a firm such as equity raised, loans repaid and equipment purchased. We need a statement, which explains why the status changed during a period. The causes for the change in the status can be attributed to 3 sources:- Performance (operating) activities Investing activities (i.e., acquisition and disposal of long term assets) Financing activities (i.e., raising and settlement of loans and share capital) The cash generated or used by the firm during a period is categorized under the above three broad activities as given in the following format:- A. Cash generated/(used) from Operating Activities B. Cash generated /(used) from Investing Activities C. Cash Generated/(used) from Financing Activities All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial
D. Net Cash generated during the period E. Opening cash balance F. Closing cash Cash normally means currency (coins, bank notes). But it also includes cheques, drafts, and traveller s cheque. Accountant defines cash to include cash on hand as well as cash at banks and cash equivalents. Cash at banks means money lying in bank accounts, money on deposits in bank, and some cases bank overdrafts also. Companies maintain several bank accounts as well as keep a small amount of cash on hand. Cash equivalents: These are highly liquid investments. These are short-term investments that are readily convertible to known amounts of cash and which have insignificant risk of changes in value. These securities have a low-risk, low-return profile. It presents a summarised view of the cash transactions of the business during a period. Cash flow statement provides relevant information in assessing a company's liquidity and solvency position. It helps in answering questions like: How was cash generated from the main business activity or from its operations How were the assets financed Was there any dividend distribution done by the firm How much money was borrowed during the year Has the company raised further funds by issue of shares etc? Cash Flow Statement helps the users of financial statements to assess various aspects of firm s financial position like The entity s ability to generate future cash flows The entity s ability to pay dividends and meet financial obligations The reason for the difference between the net income and net cash generated from operations The investing and financing transactions of the business Managers in evaluating past operations and in planning future investing and financing activities use the cash flow statement. Others also use it like creditors, investors to assess the company s cash generating potential and ability to pay off its debts. The statement of cash flows report three types of cash flow activities: Cash flow from operating activities Cash flow from investing activities All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial
Cash flow from financing activities Cash flows from operating activities: Cash flows from operating activities are the cash inflow or outflow from a company s day-to-day operations. These consist of the cash flows generated by the company s main or core business activity. The operating activities section shows the cash effects of revenue and expense transactions. This can be cash flow arising from buying and selling of goods for a manufacturing or trading company or it can be from rendering services for a service company. Cash from operating activities doesn t include cash spent on capital expenditures like buying new equipment, buying long-term investments. Since these are not related to the main operations of the company, they are disclosed under the other heads. Example of Cash from operating activities: Cash received from customers Cash paid to suppliers Cash paid for other operating expenses of the business including payment to employees Cash payments for income taxes The operating activities section includes the cash effects of those transactions reported in the income statement. Let us consider the effects of credit sales. Credit sales are reported in the income statement in the period when the sales occur. But the cash effects occur later- when the receivables are collected in cash. If these events occur in different accounting periods, the income statement and the operating activities section of the cash flow statement will differ. In a similar way, it happens for the expenses accounted in the income statement but for which cash has not been paid in the current period. There are again certain expenses, which are non-, cash in nature and which don t involve any cash outflow. Cash flow from operating activities can be made following either direct method or indirect methods The direct method shows each major class of gross cash receipts and gross cash payments. All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial
The operating cash flows section of the statement of cash flows under the direct method would appear something like this: Direct Method Cash receipts from customers Cash paid to suppliers Cash paid to employees Cash paid for other operating expenses Interest paid Income taxes paid Net cash from operating activities The indirect method adjusts accrual basis net profit or loss for the effects of non-cash transactions. The operating cash flows section of the statement of cash flows under the indirect method would appear something like this: Earnings before interest and income taxes (some companies use earnings after tax) 1. Add: Non Cash, Non operating items such as depreciation and impairment losses 2. Add/Less: Interest Income /Interest Expenses and other non operating income and expenses 3. Working capital changes Increase / Decrease in receivables, inventories, payables and other items of operating working capital. Cash flow from Operations Less: Direct taxes paid Net cash from operating activities All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial
Cash flows from investing activities Cash flow from investing activities shows the cash inflows and outflows related to changes in a company s long-term assets. Cash flows from investing activities include cash used in acquiring fixed assets and making investments and cash generated from selling these assets and investments Cash flow from investing activities is related to activities that are intended to generate income and cash flows in future. Examples: Cash from investing activities are Cash paid for purchasing fixed assets, Cash received from sale of fixed assets; Cash invested in financial assets of investments; Cash received by way of dividends, interest Cash flow from financing activities Cash flows from financing activities show the cash inflows and outflows related to changes in long-term liabilities and shareholder s equity. It helps in understanding how the financing structure of the business. Cash flows from financing activities: Cash received form issue of shares, Cash received from borrowings, Cash paid for buy back of shares, Cash paid for repayments of debts or borrowings, Cash paid as dividends. Interest paid ( Some differences as per US GAAP and IFRS ) IFRS: interest and dividends received and paid may be classified as operating, investing, or financing cash flows, provided that they are classified consistently from period to period [IAS 7.31] Interest received or interest paid is usually classifies as cash flow from investing activities except for financial institutions where it is classified as cash flow from operating activities. US GAAPS: Interest paid or received are classified as cash flow under operating activities All Rights Reserved. This document has been authored by and is permitted for use only within the course "Financial