1. MEASURING AND REPORTING FINANCIAL PERFORMANCE
Chapter 3
MEASURING AND REPORTING FINANCIAL PERFORMANCE

2. Discuss the nature and purpose of the income statement
LEARNING OUTCOMES
You should be able to:
Prepare an income statement from relevant financial information and interpret the information that it contains
Discuss the nature and purpose of the income statement
Explain the main accounting conventions underpinning the income statement
Discuss the main recognition and measurement issues that must be considered when preparing the income statement

3. Arsenal’s revenue for the year ended 31 May 2013
Property development 13%
Gate and other match day revenues 33%
Commercial 16%
Retail 6%
Broadcasting 31%
Figure 3.1 Arsenal’s revenue for the year ended 31 May 2013 Source: Based on information in Arsenal Holdings plc, Statement of Accounts and Annual Report 2012/13, p. 44.

4. Profit (or loss) for the period
Measuring profit
Total revenue for the period less Total expenses incurred in generating that revenue
Profit (or loss) for the period =

5. Relationship between the income statement and the statement of financial position
Profit (Loss)
Assets
Equity
Liabilities
+ (−) = +
The above equation can be extended to: +
Sales revenue
Expenses
Liabilities −
Assets
Equity =

6. The layout of the income statement
less
equals
plus
Operating expenses
Interest receivable
Operating profit
Interest payable
Gross profit
Cost of sales
Sales revenue
Profit for the year
Figure 3.2 The layout of the income statement

7. Better-Price Stores Income statement for the year ended 31 October 2014
Sales revenue
232,000
Cost of sales
154,000
Gross profit
78,000
Salaries and wages
(24,500)
Rent and rates
(14,200)
Heat and light
(7,500)
Telephone and postage
(1,200)
Insurance
(1,000)
Motor vehicle running expenses
(3,400)
Depreciation – fixtures and fittings
Depreciation – motor van
(600)
Operating profit
24,600
Interest received from investments
2,000
Interest on borrowings
(1,100)
Profit for the year
25,500

8. Calculating gross profit for Better-Price Stores
Sales revenue
232,000
Cost of sales:
Opening inventories
40,000
Goods bought
189,000
Closing inventories
(75,000)
(154,000)
Gross profit
78,000

9. Profit measurement and the recognition of revenue
It is probable that the economic benefits will be received
The amount of revenue can be measured reliably
Basic criteria that must be met before revenue is recognised:
Additional criterion is to be applied where the revenue comes from the sale of goods:
Ownership and control of the items should pass to the buyer

10. Accounting for sales commission
Sales commission expense £6,000
Income statement
Statement of financial position at year end
Cash £5,000
Accrual £1,000
Statement
of cash flows
Figure 3.3 Accounting for sales commission

11. Accounting for rent payable
Rent payable expense £16,000
Statement of financial position at year end
Cash £20,000
Prepaid expense £4,000
Statement
of cash flows
Income statement
Figure 3.4 Accounting for rent payable

12. Accounting conventions and the income statement
Accruals
Materiality

13. Profit measurement and the calculation of depreciation
The useful life of the asset
Residual value (disposal value)
The cost (or fair value) of the asset
To calculate a depreciation charge for a period, four factors have to be considered:
Depreciation methods

14. Graph of carrying amount against time using the straight-line method
Asset life (years) 20 40 60 80 1 2 3 4
Figure 3.5 Graph of carrying amount against time using the straight-line method

15. Straight-line method – an example
Cost of machine
£78,124
Estimated residual value
£2,000
Estimated useful life
4 years
Annual depreciation charge =
£76,
= £19,031

16. Reducing-balance methodP =
Where:
P = the depreciation percentage
n = the useful life of the asset (in years)
R = the residual value of the asset
C = the cost, or fair value, of the asset
(1− R/C × 100%) n
Deriving the fixed percentage

17. Graph of carrying amount against time using the reducing-balance method
Asset life (years) 20 40 60 80 1 2 3 4
Figure 3.6 Graph of carrying amount against time using the reducing-balance method

18. The reducing-balance method – an example
Cost of machine
78,124
Year 1 depreciation expense (60% of cost)
(46,874)
Carrying amount
31,250
Year 2 depreciation expense (60% of carrying amount)
(18,750)
12,500
Year 3 depreciation expense (60% of carrying amount)
(7,500)
5,000
Year 4 depreciation expense (60% of carrying amount)
(3,000)
Residual value
2,000

19. Calculating an annual depreciation expense
Year 1
Year 3
Year 2
Year 4
Depreciation
less
Residual value
equals
Cost (fair value)
Depreciable amount
Asset life (Number of years)
Figure 3.7 Calculating the annual depreciation expense

20. Profit measurement and inventory costing methods
Last in, first out (LIFO)
Weighted average cost (AVCO)
First in, first out (FIFO)
Common assumptions used are:

21. FIFO and LIFO treatment of the inventories in Example 3.8
21,000 tonnes Closing inventories
FIFO
LIFO
20,000 £13 per tonne
10,000 £10 per tonne
9,000 tonnes Cost of sales (inventories used)
Purchases
Figure 3.8 FIFO and LIFO treatment of the inventories in Example 3.8

22. Reduce trade receivables
Bad debts written off
Increase expenses
Reduce trade receivables

23. Uses of the income statement
How effective the business has been in generating wealth
Helps in providing information on:
How the profit was derived