Contents

Income statement .................................................................................................................................................................. 2 Income statement layout ....................................................................................................................................................... 2 Recognizing revenue ............................................................................................................................................................ 3 Recognizing expenses........................................................................................................................................................... 3 Depreciation.......................................................................................................................................................................... 3 Costing inventories ............................................................................................................................................................... 4 Trade receivables .................................................................................................................................................................. 4

Measuring and reporting financial performance

Income statement
Income statement (or profit and loss account): Is to measure and report how much profit (wealth) the business has generated over a period. It helps users to gain some impression of how that profit was made. Revenue: Is simply a measure of the inflow of economic benefits arising from the ordinary activities of a business. These benefits will result in either an increase in assets(such as cash) or decrease(such as amounts owed to suppliers) in liabilities. (Examples are: sales of goods by a manufacturer, fees for services of a solicitor, subscriptions of a club or interest received on an investment fund) Assets: Is essentially a resource held by a business. For a particular item to be treated as an asset for accounting purposes, it should have the following characteristics: 1. 2. 3. 4. A probable future benefit must exist. The business must have the right to control the resource. The benefit must arise from some past transaction or event. The asset must be capable of measurement in monetary terms.

Liabilities: Represent the claims of all individuals and organizations other than the owner(s). They arise from past transactions or events such as supplying goods or lending money to the business. Expense (The opposite of revenue): It represents the outflow of economic benefits arising from the ordinary activities of a business. This loss of benefits will result in either a decrease in assets (such as cash) or an increase in liabilities (such as amounts owed to suppliers). Expenses are incurred in the process of generating, or attempting to generate revenue. Examples are: 1. 2. 3. 4. 5. The cost of buying, or making, the goods that are sold during the period concerned known as cost of sales or cost of goods sold. Salaries and wages or Rent and rates or Heat and light or Telephone and postage. Motor vehicle running expense. Insurance. Printing and stationery.

The income statement simply shows the total revenue generated during a particular period and deduct from this the total expenses incurred in generating that revenue. The difference between the total revenue and total expenses will represent either profit (if revenue exceeds expenses) or loss (if expenses exceed revenue). Thus we have
Profit (Or Loss) For The Period = Total Revenue For The Period - Total Expenses Incurred In Generating That Revenue.

Reporting period (accounting or financial period): The period which profit or loss is normally measured.

Income statement layout

The layout of the income statement will vary according to the type of business which it relates. Brackets are used to denote when an item is to be deducted, this convention is used by accountants. The income statement provides three measures of profit. 1. Gross profit Revenue which arises from selling the goods is the first item that appears. The cost of sales (cost of goods sold) is for the period deducted from sales revenue.Gross Profit = Sales Revenue Cost Of Sales. 2. Operating profit other expenses (overheads (no assets)) that have been incurred in operating the business (salaries and wages, rent and rates and so on) are then deducted from the gross profit. Operating Profit = Gross Profit - Other Expenses. 3. Profit for the year after operating profit we add any non-operating income (such as interest receivable) and deduct any interest payable on borrowings made by the business, to arrive at the profit for the year. Net Profit = Gross Profit Operating
Profit + Interest Receivable Interest Payable.

Deriving the cost of sales after the end of the reporting period: To derive the cost of sales for a period, we need to know the amount of opening and closing inventories for the period and the cost of goods bought during the period.
Opening Inventories + Purchases (Goods Bought) = Goods Available For Resale Goods Available For Resale Closing Inventories = Cost Of Sales

Recognizing revenue
The main criteria for recognizing revenue: 1. The amount of revenue can be measured reliably. 2. It is probable that the economic benefits will be received. 3. Ownership and control of the items should pass to the buyer. Long-term contracts: Some contracts, both for goods and for services, can last for more than one reporting period. If the business providing the goods or service were to wait until the contract is completely fulfilled before recognizing revenue, the income statement could give a misleading impression of the wealth generated in the various reporting periods covered by the contract. This is a particular problem for business that undertakes major long-term contracts, where a single contract represents a large proportion of their total activities. Example is a construction contract: Stage 1 clearing and leveling the land and putting in the foundations Stage 2 - building the walls Stage 3 putting on the roof Stage 4 putting in the windows and completing all the interior work Each stage can be awarded a separate price with the total for all the stages being equal to the total contract price for the factory. If the builder were to wait until the factory was completed before recognizing revenue, the income statement covering the final year of the contract would recognize all of the revenue on the contract, and the income statements for each preceding year would recognize no revenue. This would give a misleading impression, as it would not reflect the done during each period. Services: Revenue from contracts for services may also be recognized in stages. Suppose a consultancy business has a contract to install a new computer system for the government, which will take several years to complete. Revenue can be recognized before the contract is completed as long as the contract can be broken down into stages and the particular stages of completion can be measured reliably.

Recognizing expenses
Recognizing expenses: Expenses should be matched to the revenue that they helped to generate. In other words, the expenses associated with a particular item of revenue is must be taken into account in the same reporting period. Accrued expenses: An accounting expense recognized in the books before it is paid for. It is a liability, and is usually current. These expenses are typically periodic and documented on a company's balance sheet due to the high probability that they will be collected. Prepaid Expense: A type of asset that arises on a balance sheet as a result of business making payments for goods and services to be received in the near future. While prepaid expenses are initially recorded as assets, their value is expensed over time as the benefit is received onto the income statement, because unlike conventional expenses, the business will receive something of value in the near future.

Depreciation
Calculating the depreciation charge for a period is necessary for the proper measurement of financial performance, and must be done whether or not the business intends to replace the asset in the future. Although the effect of a depreciation charge is to reduce net profit, and therefore to reduce the amount available for withdrawal by the owners, the amounts retained within the business as a result may be invested in ways that are unrelated to the replacement of the specific asset. Depreciation: Is an attempt to measure that portion of the cost (or fair value) of a non-current asset that has been used up in generating the revenue recognized during a particular period. The depreciation charge is considered to be an expense of the period to which it relates. Depreciation tends to be relevant both to property, plant and equipment (tangible non-current assets) and to intangible non-current assets. To calculate a depreciation charge for a period, four factors have to be considered: 1. The cost (or fair value) of the asset; 2. The useful life of the asset; 3. The residual value of the asset; 4. The depreciation method. Fair value: The cost of an asset will include all costs incurred by the business to bring the asset to its required location and to make it ready for use. The useful life of the asset: An asset has both a physical life and an economic life. The physical life of an asset will be exhausted through the effects of wear and tear and/or the passage of time. It is possible, however, for the physical life to be extended considerably through careful maintenance, improvements and so on. The economic life of an asset is decided by the effects of technological progress and by changes in demand. After a while, the benefits of using the asset may be less than the costs involved. Residual value (disposal value):

When a business disposes of a non-current asset that may still be of value to others, some payment may be received. To calculate the total amount to be depreciated with regard to an asset, the residual value must be deducted from the cost of the asset. Depreciation method: Once the amount to be depreciated (that is, the cost, or fair value, of the asset less the residual value) has been estimated, the business must select a method of allocating this depreciable amount between the accounting periods covering the assets useful life. 1. The first of these is known as the straight-line method. This method simply allocates the amount to be depreciated evenly over the useful life of the asset. In other words, an equal amount of depreciation will be charged for each year the asset is held.Straight Line =(Cost of Fixed Asset Residual Value)/ Useful Life of Asset (years). 2. The second approach is known as the reducing-balance method. This method applies a fixed percentage rate of depreciation to the written-down value of an asset each year. The effect of this will be high annual depreciation charges in the early years and lower charges in the later years.Reducing-Balance = Depreciation Rate * Book Value At Beginning Of Year.See example:

Suppose a business has an asset with $1,000 original cost, $100 salvage value, and 5 years useful life. First, calculate straight-line depreciation rate. Since the asset has 5 years useful life, the straight-line depreciation rate equals (100% / 5) 20% per year. With double-declining-balance method, as the name suggests, double that rate, or 40% depreciation rate is used. The table below illustrates the double-declining-balance method of depreciation.
Book value at beginning of year $1,000 (original cost) $600 $360 $216 $129.60 Depreciation rate 40% 40% 40% 40% $129.60 - $100 Depreciation expense $400 $240 $144 $86.40 $29.60 Accumulated depreciation $400 $640 $784 $870.40 $900 Book value at end of year $600 $360 $216 $129.60 $100 (scrap value)

Selecting a depreciation method: The most appropriate method should be the one that best matches the depreciation expense to the economic benefits that are consumed. The business may therefore decide to undertake an examination of the pattern of benefits consumed. Where the assets benefits are likely to be consumed evenly over time (buildings, for example), the straight-line method may be considered appropriate. Where assets lose their efficiency and the benefits consumed decline over time as a result (for example, certain types of machinery), the reducingbalance method may be considered more appropriate. Where the pattern of economic benefits consumed is uncertain, the straight-line method is normally chosen. Depreciation intangible assets (Amortization): Where an intangible asset has a finite life, the approach taken for the depreciation (or amortization as it usually called with intangibles) is broadly the same as that for property, plant and equipment (tangible non-current assets).

Costing inventories
The way in which we measure the cost of inventories (or stock) is important, because the cost of the inventories sold during a period will affect the calculation of net profit, and the remaining inventories held at the end of the period will affect the portrayal of the financial position. A business must determine the cost of the inventories sold during the period and the cost of the inventories remaining at the end of the period. To do this, both of these costs are calculated as if it had been physically handled in a particular assumed manner. The assumption made has nothing to do with how the inventories are actually handled; it is concerned only with which assumption is likely to lead to the most useful accounting information. Two common assumptions used are: 1. first in, first out (FIFO) the earliest inventories held are the first to be sold; 2. Last in, first out (LIFO) the latest inventories held are the first to be sold. 3. Weighted average cost (AVCO), in which it is assumed that inventories acquired lose their separate identity and go into a pool. Any issues of inventories from this pool will reflect the weighted average cost of inventories held.
Weighted Average Unit Cost = Total Cost of Inventory Total Units in Inventory

Trade receivables
Many businesses sell goods on credit. When credit sales are made, the revenue is usually recognized as soon as the goods are passed to, and accepted by, the customer. Recording the dual aspect of a credit sale will involve: 1. Increasing sales revenue. 2. Increasing receivables by the amount of the credit sale. With this type of sale there is always the risk that the customer will not pay the amount due, however reliable they might have appeared to be at the time of the sale. When it becomes reasonably certain that the customer will never pay, the debt is considered to be bad and this must be taken into account when preparing the financial statements.