MEASURING AND REPORTING FINANCIAL PERFORMANCE Chapter 3 MEASURING AND REPORTING FINANCIAL PERFORMANCE

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

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.

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 =

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 =

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

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

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

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

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

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

Accounting conventions and the income statement Accruals Materiality

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

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

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

Reducing-balance method P = 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

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

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

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

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

FIFO and LIFO treatment of the inventories in Example 3.8 21,000 tonnes Closing inventories FIFO LIFO 20,000 tonnes @ £13 per tonne 10,000 tonnes @ £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

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

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