1. The Income Statement and the Statement of Cash Flows
CHAPTER 8
The Income Statement and the Statement of Cash Flows

2. Overview Revenue definition and recognition criteria
Expense definition
Determination of cost of goods sold
Gross profit / margin and ratio
Operating expenses
Income from ordinary activities
Earnings per share (EPS) calculation
Income statement alternative presentation models
Unusual items on the income statement
Statement of cash flows
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3. Revenue
Revenue is generated when a firm sells a product or provides a service to a client or customer and receives cash, creates an account receivable, or satisfies an obligation.
Revenue is generally measured by the amount of cash received or expected to be received from a transaction.
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4. Revenue
Revenue is realised when the product or service has been exchanged for cash, claims to cash, or an asset that is readily convertible to a known amount of cash.
Revenue is earned when the entity has completed, or substantially completed, the activities it must perform to be entitled to the revenue benefits.
These criteria are usually satisfied when the product is delivered or service provided.
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5. determine the period in which revenue will be recognised.
From a legal perspective, the sale of a product involves the passing of title. This is usually specified by the contract terms.
This is important as it will:
determine the period in which revenue will be recognised.
determine who suffers any loss or damage to merchandise while it is in transit.
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6. The effect of a sale on the financial statements is:
Revenue
The effect of a sale on the financial statements is:
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7. Revenue
Misstated revenue can lead to significantly misleading financial statements.
Management and internal auditors often design internal control procedures to help promote the accuracy of the revenue recognition process of the firm.
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8. Sales Revenue Service firms – revenue labelled appropriately,
Revenue from sale of product
Sometimes called turnover
Due to return of merchandise
Service firms – revenue labelled appropriately,
e.g. leasing company: rental and service revenues.
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9. Revenue may be recognised using the percentage of completion method.
Sales Revenue
Long-term Construction Projects
Revenue may be recognised using the percentage of completion method.
Unusual revenue recognition methods should be disclosed in the notes to the financial statements.
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10. Expenses
Outflows or other using up of assets or incurrences of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing central operations.
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11. Expenses
Some expenses are recognised concurrently with the revenues to which they relate (matching principle).
Some expenses are recognised in the period in which they are incurred (administrative salaries).
Some expenses result from an allocation of the cost of an asset to the period that is expected to benefit from the asset’s use (depreciation).
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12. Cost of Goods Sold
Most significant expense for many manufacturing and merchandising companies.
Affected by inventory cost flow assumptions – FIFO, specific identification, weighted average.
Excludes inventory shrinkage (loss due to theft or obsolescence) – where identifiable.
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13. Cost of Goods Sold
When an item is sold its cost is transferred from the inventory asset to the cost of goods sold expense with the following effect on the financial statements:
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14. Internal control procedure
Cost of Goods Sold
Perpetual inventory system
Cost of inventory is determined when the item is sold.
Internal control procedure
Regular counts of inventory items will be made on a cyclic basis during the year, and compared to perpetual record of inventory on hand.
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15. Cost of Goods Sold Periodic inventory system
Inventory on hand is counted periodically, and the cost is determined using the relevant cost flow assumption. Cost of goods sold may then be calculated.
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16. Cost of Goods Sold Periodic inventory system Known
Determined from stocktake
Calculated
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17. Gross profit ratio = gross profit / sales
Gross Profit / Margin
Gross profit is the excess of net sales revenue over cost of goods sold.
Gross profit ratio = gross profit / sales
Sometimes called gross margin ratio
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18. Gross Profit / Margin
Gross profit ratio is an important statistic used by managers for such things as:
1. Estimating level of sales to achieve profitability
2. Estimating cost of goods sold and ending inventory
3. Setting selling prices
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19. Operating Expenses
Expenses from ordinary activities are usually reported in the following functional categories on the income statement:
distribution expenses
marketing expenses
occupancy expenses
administrative expenses
research and development expenses
other expenses
borrowing costs
Expenses may also be classified by nature (of the input).
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20. Income from ordinary activities
Borrowing costs -
Associated with financial leverage
Profit from ordinary activities before tax:
most appropriate measure of management’s ability to utilise the firm’s operating assets
excludes income tax and results of significant items.
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21. Net Profit or Loss
Sometimes called the BOTTOM LINE
Net profit is also reported on a per ordinary share basis
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22. Earnings Per Share (EPS)
Net profit less preferred share dividends
Basic
EPS =
Profit attributable to ordinary shareholders
Weighted-average number of shares
Takes into account the number of days different blocks of shares have been held
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23. Earnings per share
When a firm has options or convertible securities, there is the potential for the dilution of basic earnings per share. When any of these securities are present, a second earnings per share known as diluted earnings per share, is reported.
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24. Income Statement Alternatives
Single-Step
Multiple-Step
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25. Unusual Items Reported in Income
Unusual items are reported separately from the results of recurring transactions to facilitate users’ interpretation of the accounts:
Discontinued operations
Significant items
Cumulative effect of a change in accounting principle
Outside equity interest in earnings of subsidiaries
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26. Statement of Cash Flows
Provides relevant information about the cash receipts and cash payments of an enterprise during the accounting period. The statement shows why cash and cash equivalents changed during the period by reporting net cash provided or used by:
Operating activities 
Investing activities 
Financing activities 
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27. Statement of Cash Flows
Cash outflows
Cash inflows
Cash received from customers
Cash paid to suppliers and employees, and for taxes and interest
Operating activities
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Slides prepared by Sandra Chapple
Copyright  2005 McGraw-Hill Australia Pty Ltd

28. Statement of Cash Flows
Cash outflows
Cash inflows
Sale of non-current assets and investments
Acquisition of assets, investments in securities
Investing
activities
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Copyright  2005 McGraw-Hill Australia Pty Ltd

29. Statement of Cash Flows
Cash outflows
Cash inflows
Issuance of shares and long-term debt
Payment of dividends, repayment of loans
Financing activities
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Slides prepared by Sandra Chapple
Copyright  2005 McGraw-Hill Australia Pty Ltd

30. Statement of Cash Flows
In Australia, the operating activities section of the statement of cash flows is presented according to the direct method.
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
Net increase/ decrease in cash
Cash balance opening
Cash balance closing
Reconciliation of net profit and net cash provided by operating activities
xxx
Refer next slide
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31. Statement of Cash Flows
Reconciliation - shown in notes to financial statements
Income statement
Cash flow statement
Linked by reconciliation
Net profit
Adjust for:
revenues and expenses that do not affect cash (depreciation, amortisation)
income tax not currently payable
changes in non-cash operating accounts.
Net cash provided by operating activities.
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32. Interpreting the Statement
A business entity should have positive cash flows from operating activities. If operating activities do not generate cash, the entity must look to outside parties for funds to meet its day-to-day activities.
The cash flow statement will also reveal if the entity is generating enough cash to finance growth (investing activities).
The cash flow statement will provide details of the liquidity situation of the entity.
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Slides prepared by Sandra Chapple
Copyright  2005 McGraw-Hill Australia Pty Ltd