CHAPTER 6 Income Statement & Statement of Changes in Equity

Purpose & importance of measuring financial performance

Entities aim to CREATE VALUE. Companies listed on securities exchange value creation (or lack thereof) is generally evidenced by movements in the companys share price. Entities w/o share price value creation is realized when the business is sold.

The definition of income encompasses o o Revenue arising in the ordinary course of activities (e.g. sales, fees & dividends) Gains (e.g. gains on disposal of non-current assets, and unrealized gains on revaluing assets)

An entity cant remain viable in the long term if it continually generates operating losses

Reporting period concept

The reporting period period of time to which the FS relate

Accrual accounting vs. cash accounting

Accrual accounting = transactions & events are recorded in the periods they occur, rather than in the

periods the cash is received or paid. o The entity doesnt have to receive cash associated w/ a transaction for it to be regarded as income o Purpose to better reflect the performance of the entity, timing of cash payments & cash receipts has the potential to distort performance in a period if a cash basis of accounting is used to measure financial performance o o Accrued income amounts not yet received for G+S that have been provided Accrued expenses amounts not yet paid for eco benefits used/consumed.

Cash accounting = transactions are recorded in the period the cash is received or paid

Depreciation

Depreciation allocation of the depreciable amount of a depreciable asset (tangible) over its estimated useful life.

Amortisation allocation of the cost of an intangible asset over its estimated useful life. Straight line depreciable method same depreciation expense being recorded each year for the assets useful life: o

CHAPTER 6 Income Statement & Statement of Changes in Equity Diminishing balance depreciation method assumes that the benefits of using the asset will decrease over its useful life o Calculated by applying a constant % to the assets carrying amount @ the start of each reporting period Units of production method charges depreciation expense based on activity or output Accumulated depreciation = total depreciation charges for a particular asset Contra account (Accumulated depreciation account) an account that is offset against another

Accounting policy choices, estimates & judgements

Many entities are required to prepare there is using accrual accounting. Depreciation an entity can select straight-line, diminishing balance or units of production depreciation method. Method selected should be representative of the pattern in which the assets benefits are expected to be consumed. Estimates need to be made in relation to assets useful life & residual value. o E.g. Consider an asset that is purchased for $20,000 @ start of reporting period & has an estimated life of 4 years, with 0 residual (salvage) value Straight-live depreciation an expense $5000 would be recognised in the income statement for each of the next 4 reporting periods. Diminishing Balance depreciation if the asset was depreciated by 25% each year, the depreciation expense for the next 4 reporting periods would be $5000 (25% of $20,000), $3750 (25% of $20,000-$5000), $2813 (25% of $20,000-$5000-$3750) & $2109 Unit of production method assume the car travels 60,000km, 40,000km, 30,000km, 20,000km in year 1-4.The depreciation expense would be $8000 (60,000km/150,000km x $20,000) etc.

Quality of earnings o Earnings management managers use of accounting discretion via accounting policy choices and/or estimates to report a desired level of profit o Reported profits are used in entities contractual arrangements & to value entities an important financial number o Managers choices determined by their desire to portray the eco reality of the entity or self interest. A particular profit range may be desired to avoid breaching loan covenants, to maintain share price/to max salary bonuses.

Measuring financial performance

Profit or loss for a reporting period is measured as the income during the reporting period less the expenses in the reporting period. If income exceeds expenses in a particular reporting period, a profit results. If expenses

CHAPTER 6 Income Statement & Statement of Changes in Equity exceed income, the entity reports a loss for that reporting period.

CHAPTER 6 Income Statement & Statement of Changes in Equity Income = increases in eco benefits in the form of inflows or enhancements of assets/decreases of liabilities Income (revenue) recognition There must be an increase in future eco benefits Does an agreement for the provisions of G&S exist between the entity & an external party? Has cash been received; or does the entity have a claim against an external party that is for a specified consideration is unavoidable w/o penalty? Have all acts of performance necessary to establish a valid claim against the external party been completed? Is it possible to reliably estimate the collectability of debts?

Expenses = decreases in eco benefits in the form of outflows or depletion of assets or incurrences of liabilities

resulting in a decrease in equity. Doesnt include distribution to owners. Cost of sales (inventory @ beginning of period + purchases inventory @ end of period) o Imagine that an entity purchases goods on credit from a supplier on 15 June. For the reporting period ended 30 June, the purchases would be included in the cost of sales determination, even though no cash has been paid to the supplier by 30 June. Accounts payable is increased, thereby reducing equity. When supplier is paid, the accounts payable is reduced & cash is also reduced, with no reduction in equity the payment isnt recognize as an expense Other expenses include advertising, sales staff salaries, investing & financing activities, utility charges etc. Acquisition of certain assets e.g. PPE, is not an expense since theres no reduction in equity When the value of an asset is lower than its carrying amount asset is impaired must be written down to its recoverable amount (an impairment expense) o Impairment = when an assets carrying value exceeds its recoverable amount

CHAPTER 6 Income Statement & Statement of Changes in Equity

Presenting the income statement Material income & expenses

Separate disclosures of material items are required helps users to identify permanent vs. transitory earnings charges & thereby better predict future earnings E.g. disposals of PPE, assets impairments

Format for entities not required to comply w/ accounting standards

Presentation & classification of items can exhibit great diversity. More detailed & less aggregated as info is prepared more for internal users

Cost of sales

For retailers it is the opening stock value + purchases closing stock value For manufacturing operation opening value of finished goods + cost of goods manufactured closing value of finished goods

Financial performance measures Differentiate alternative financial performance measures

Gross profit = revenue less cost of sales, reflects % by which a entity marks up cost of its products for sale o An entity cant be sustainable unless it has positive gross profit

Profit = gross profit all other expenses AKA income expenses o Profit pre- & post-tax tax is an expense Owners are more interested in profit after tax since tax obligations must be satisfied before profits can be distributed Financial analyst would be interested in profit pre-tax reflects the outcomes of the entitys investing & financing activities w/o the affect of variable determined by external forces o Profit pre- & post-interest Earnings before interest & taxation (EBIT) profit before net interest & tax Net finance costs interest income interest expense (including finance lease charges)

CHAPTER 6 Income Statement & Statement of Changes in Equity

Profit pre- & post-depreciation & amortisation EBITDA measure of the raw operating earnings of an entity, excludes asset diminution, tax + financing charges ^ used for financial statement analysis & credit analysis

Profit pre- & post-material items Maintainable earnings income MINUS expense from ordinary activities Exclusion of material items from profit better reflection of the trend & sustainability of profit

Profit from continuing & discontinued operations Separation assist users to better predict future profits

Pro forma earnings earnings to in accordance with GAAP earnings Selective reporting allows entities to include items of their choosing to determine profit Usual for pro forma to be higher than GAAP

Statement of Comprehensive Income = statement showing all items of income & expense during reporting

period, including items recognised in determining profit/loss + items of other comprehensive income Other comprehensive income all changes in equity during reporting period OTHER than profit or loss and those resulting from transactions with owners as owners
Statement of changes in equity = statement showing the changes in an entitys equity b/w 2 reporting periods

E.g. if CCS commenced 2013 with $50 000 equity, reported profit of $50 000 for the year, and Leyton Cash withdrew $15 000 during the year, the change in equity would be an increase of $35 000. Equity at the end of 2013 would be $85 000 comprising equity at the start of 2013 ($50 000) plus the increase in equity ($35 000).

Entities complying with GAAP has to present this statement Purpose: provide users with better info by requiring aggregation of items w/ similar characteristics & separation of items w/ different characteristics.

CHAPTER 6 Income Statement & Statement of Changes in Equity

Relationship between income statement, balance sheet, statement of comprehensive income & statement of changes in equity

The income statement reports the P/L generated in the reporting period that belongs to owners. It is added to the retained earnings from prev. periods to determine the pool of retained earnings available for distribution. Retained earnings is included in the equity section of the BS as at the end of the period. The statement of comprehensive income details the profit / loss for the period (i.e. income statement) as well as items of I+E not recognised by P/L. These items of I+E bypass the income statement & are recorded in the equity section of the BS. The statement of changes in equity explains the change in equity from start to end.