1. Accounting for Management Decisions, 2012 Chapter 6 Income statement and statement of changes in equity

2. 2 PURPOSE AND IMPORTANCE OF MEASURING FINANCIAL PERFORMANCE The income statement reflects the accounting return for an entity over a specified time period: PROFIT = INCOME – EXPENSES

3. 3 PURPOSE AND IMPORTANCE OF MEASURING FINANCIAL PERFORMANCE continued Income encompasses both: – revenue arising in the ordinary course of activities (Ex(s): sales, fees, etc.) – gains (Ex(s): gains on disposal of non-current assets, unrealised gains on revaluing assets, etc.)

4. 4 ACCOUNTING CONCEPTS FOR FINANCIAL REPORTING Preparation of financial statements is subject to generally accepted accounting principles (GAAP). The accounting rules pronounced as accounting standards are legally binding for disclosing entities. An accountant preparing financial statements for a reporting entity has a professional responsibility to comply with accounting standards.

5. 5 THE REPORTING PERIOD The financial statements assume that an entity is a going concern, but the life of the entity is divided into arbitrary reporting periods, also known as accounting periods. For external reports, the convention is that the arbitrary reporting period is yearly, and so the entity prepares financial statements at the end of each 12 months (not necessarily a calendar year).

6. RELATIONSHIP BETWEEN THE INCOME STATEMENT AND THE BALANCE SHEET The two are closely related, but NOT substitutes for each other in any way. The income statement can be viewed as linking the balance sheet at the start of a period with that at the end of the period.

7. EXAMPLE PROBLEM #21 - 6 Which account links the income statement and the balance sheet? Explain.

8. EXAMPLE PROBLEM #22 - 6 A company ’ s profit & loss record has been lost. However, the information below has remained. Use it to calculate the unknown profit (all $) BeginningEnding Accounts payable9,0006,900 Land20,00020,000 Inventory6,4007,500 Bank overdraft07,400 Wages payable1,3001,500 Cash5,3003,700 Prepayments800600 Building60,00068,000 Motor vehicles23,00031,000 Bank loan40,00036,000 Accounts receivable7,9008,700 Equipment18,00016,500 The owner did not make any further contributions during the year but did withdraw cash of $12,000.

9. 9 ACCRUAL ACCOUNTING VS. CASH ACCOUNTING Accrual accounting is a system in which transactions and events are recorded in the periods they occur, rather than in the periods the entity receives or pays the related cash. A cash accounting system would determine profit or loss as the difference between the cash received in relation to income items and the cash paid for expenses. Accounting standards require financial statements to be prepared on the basis of accrual accounting. It is important to note that ‘profit’ and ‘cash’ are not necessarily the same in accrual accounting. Profit is a measure of achievement, or productive effort rather than of cash generated.

10. EXAMPLE PROBLEM #23 - 6 In late December, a leasing company receives 120,000 RMB for 3 months of commercial rent (January – March). When should the revenue from this transaction be recognized? Will there be a difference depending on whether we use accrual accounting or cash accounting? Why do you think accrual accounting is preferred over cash accounting?

11. PROFIT MEASUREMENT AND RECOGNITION OF EXPENSES Expenses measure the outflow of assets (such as cash) or the increase in liabilities that result from trading and generating revenues. The ‘ Matching ’ principle dictates that expenses should be ‘ matched ’ to the income they helped to generate.

12. EXAMPLE PROBLEM #24 - 6 A car company buys a car at a cost of 60,000 RMB in July. It sells the car in October for 75,000 RMB. Which accounts are affected in each transaction? What are the revenues and expenses for July and for October?

13. 13 ACCRUAL ACCOUNTING Under accrual accounting, the following may occur: – Income is recognised without receipt of cash (accrued income) – Cash is received but income is not recognised (income received in advance or deferred income) – Expense is recognised without payment of cash (accrued expense) – Expense is paid but not recognised as an expense (prepaid expense or deferred expense)

14. EXAMPLE PROBLEM #25 - 6 Consider the following accounts: Prepaid rent Interest payable Accounts receivable Unearned insurance income Which one is most closely related to: Accrued expense? Deferred expense? Accrued revenue? Deferred revenue?

15. EXAMPLE PROBLEM #26 - 6 Monthly wages expense for a company are $150,000. However, the company typically pays the former month of wages on the 8 th of the following month. How would the balance sheet be affected on, for example, March 31 st and April 8 th ?

16. EXAMPLE PROBLEM #27 - 6 Given the following scenarios, state whether assets, liabilities, and owners’ equity would be overstated, understated, or correct. 1)An accountant forgets to account for supplies used during the month. 2)An accountant forgets to record revenue earned that was received in advance. 3)An accountant forgets to account for interest on a bank loan. 4)An accountant does not record credit sales as revenue.

17. DEPRECIATION Depreciation - A measure of that portion of the cost (less residual value) of a fixed asset which has been consumed during an accounting period Four factors are considered: 1.The cost (or other value) of the asset 2.The useful life of the asset 3.The estimated residual value of the asset 4.The depreciation method Note: Land is not subject to depreciation.

18. DEPRECIATION continued  The cost of the asset - includes all costs incurred by the business to bring the asset to its required location and make it ready for use e.g. delivery, installation, legal title, alterations, improvements etc  The useful life of the asset - the economic life of the asset determines the expected useful life of the asset for the purpose of calculating depreciation. The economic life of an asset ends when the cost of operating or holding the asset exceeds the benefit derived from it. Economic life may be shorter than physical life in many cases.

19. DEPRECIATION continued  Estimated residual value (disposal value): defined as the likely amount to be received on disposal of the asset. Like useful life, estimated residual value can be difficult to predict  Depreciation method: Once the ‘depreciable amount’ (cost minus residual value) has been estimated, it must be allocated over the useful life of the item, property, plant or equipment. The three common methods of deriving a depreciation expense are detailed on the next slide

20. DEPRECIATION continued There are three different depreciation schedules 1)Straight-line depreciation 2)Unit depreciation 3)Reducing-balance depreciation The following symbols and amounts are used to compare the various depreciation schedules for a $41,000 delivery truck purchased by Keypon Trucking Company on January 1, 2003.

21. DEPRECIATION continued Symbols Amounts for Illustration C = total acquisition cost January 1, 2003 $41,000 R = estimated residual value $1,000 n = estimated useful life (in years or miles) 4 years 200,000 miles D = amount of depreciation Various IMPORTANT: A depreciable asset is never depreciated below its estimated residual value.

22. STRAIGHT-LINE DEPRECIATION Straight-line depreciation – spreads the depreciable value evenly over the useful life of an asset – is by far the most popular method for financial reporting purposes The depreciation expense charged to Keypon ’ s income statement is: D = (C – R) / n

23. EXAMPLE PROBLEM #28 - 6 Show the depreciation schedule using straight-line depreciation.

24. UNIT DEPRECIATION When physical wear and tear determines the useful life of the asset, depreciation may be based on units of service or units of production instead of units of time (years). The same formula is used as before except that n is no longer in years.

25. EXAMPLE PROBLEM #29 - 6 Calculate the depreciation expense that should be on Keypon Trucking ’ s income statement (using unit depreciation) assuming the truck is driven 65,000 miles in the first year. How would assets, liabilities, and owners ’ equity be affected?

26. DIMINISHING-BALANCE DEPRECIATION The reducing-balance (RB) method is an accelerated-depreciation method, meaning that (compared to straight-line depreciation) more depreciation is written off near the start of an asset’s useful life. The formula for the RB method is: 1 - √ n R / C D = Note: This formula cannot be used when the residual value is 0. The depreciation expense is the carrying amount multiplied by the depreciation rate.

27. EXAMPLE PROBLEM #30 - 6 Calculate the depreciation of Year 4 using the reducing-balance method.

28. INCOME STATEMENT FORMATS Two commonly used formats for income statements are the: – Single-step income statement – Multiple-step income statement The single-step income statement: – groups all types of revenue together – lists and deducts all expenses without drawing any intermediate subtotals

29. SINGLE-STEP INCOME STATEMENT

30. MULTI-STEP INCOME STATEMENT Most multiple-step income statements disclose: – Gross profit (gross margin) The excess of sales revenue over the cost of the inventory that was sold – Operating expenses A group of recurring expenses that pertain to the firm’s routine, ongoing operations (Examples: wages, rent, depreciation, telephone, heat, advertising, etc.)

31. MULTI-STEP INCOME STATEMENT continued – Operating income The remainder of gross profit after the deduction of operating expenses. – Other (nonoperating) revenue and expenses Revenues and expenses that are not part of the ordinary operations of selling goods or services (Examples: interest revenue and interest expense)

32. MULTI-STEP INCOME STATEMENT continued

33. EXAMPLE PROBLEM #31 - 6 If Chan declared and paid a dividend of $0.01/share with 200,000 shares outstanding, by how much would net assets increase during the month?

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