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Accounting

The Income Statement. Accounting. Dr. Clive Vlieland-Boddy FCA FCCA MBA 2009. Revision – Balance Sheet. Exercise 3. The Income Statement.

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Accounting

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  1. The Income Statement Accounting

  2. Dr. Clive Vlieland-Boddy FCA FCCA MBA 2009

  3. Revision – Balance Sheet Exercise 3.

  4. The Income Statement The Income Statement (Profit and Loss account or Income & Expenditure Account), summarises the incomes and expenses of the enterprise for the period stated. The 4 accounting concepts are essential. Remember… Going Concern, Accruals, Consistency and Prudence. This statement tells how well management have done in generating profits for the firm. It is a statement of financial performance.

  5. The Income Statement • It is a statement of what has actually been consumed in the relevant period. • Summaries the activity of the period. • What is not consumed or still exists is taken to the Balance Sheet. • It like a movie picture of the companies activities over the period. • It says how fast the business is going.

  6. Format of the Income Statement Gross Incomes ( Sales)‏ Less: Cost of Sales Gross Profit Deduct Overheads Net Revenue

  7. Revenues or Sales These represent the value of sales made in the relevant accounting period. Normally net of any sales tax. Example: The annual Statement would show all the sales made in that year.

  8. Cost of Sales Here the matching concept requires you to ensure that the costs matches the sales. Example: A Television manufacturer needs to ensure that the costs of his sales matches the TV’s sold. Materials consumed in the production process along with production wages and other direct costs attached to production.

  9. Manufacturing & Construction Enterprises They will incluse in Cost of sales: • Purchases. • Direct wages • Other direct costs Note that most published accounts will just show Cost of Sales.

  10. Gross Profit (Gross Margin) This represents the contribution generated from the selling of goods after deducting the cost of those goods. It is an important figure and essential in evaluation of accounts. Essentially firms can evaluate their marketing success by looking at the sales generated as well as the gross profit. This discloses total activity as well as the extent that discounting or increased costs have affected the firm.

  11. What does this tell us? This represents the trading activity for a given period. We need to ensure that the sales are matched with the cost of goods sold as well as the overheads relevant to those sales and the accounting period. Remember in any doubt then “prudence” must prevail.

  12. Sales and Cost of Sales Sales - Actual activity. Cost of Sales - Normally we have Inventories to deal with as we consume these to fulfil sales. Cost of Sales could also include production wages and sales discounts.

  13. Purchases & Inventories • Purchases represent the items acquired in the period. • Often all these are not actually consumed. • Some are left over at the end of the period to be sold in the next period. • These remaining items are classified as inventories. • Remember the pizza restaurant…..

  14. Inventories Take a BMW garage. At the first day of the new year, it would have a showroom with vehicles in it and a store with parts. During the year, it would sell these but also buy more cars and parts of which again most would hopefully be sold. On the end of the final day of the year it would have cars in the showroom and parts in the store all to be sold in the next year.

  15. Inventories - Accounting They are recognised in the Income Statement as a deduction as they need to be taken to the next accounting period to be recognised “to be matched” with their actual sale. And as a Current Asset in the Balance Sheet Inventories are the easiest asset to manipulate….. Great Salad Oil Scandal…..

  16. Activity 12.2.1

  17. Overheads These are the costs that a business has to meet to operate even if it does not sell any goods. Examples: Sales and Marketing Wages & Salaries Admin Expenses General Overheads Bad Debts Depreciation ( we will deal with later) Profit or loss on sale of NCA ( we will deal with later)

  18. Selling & Marketing Expenses These represent the cost associated with selling items. Normally advertising and marketing , sales commissions. They are normally included in the Overheads. In certain instances they could be shown as a Cost of Sales. ( e.g. A Mail Order Catalogue Company)‏

  19. Bad Debts • Some Accounts Receivable become un collectable. Often when the customer goes bankrupt. • The asset is therefore lost and we show this as a bad debt under overheads and reduce Accounts Receivable in Current Assets.

  20. Profit or Loss on sale of Non Current Assets Whilst you may well depreciate non current assets on an intelligent basis, with the aim to match the consumption of the value over the expected useful life, often there is a difference when the item is actually sold. Such loss or profit is recognised when incurred.

  21. EBIT PBIT & EBITDA • EBIT = Earnings before Interest & Tax • PBIT = EBIT • EBITDA = EBIT or PBIT plus Depreciation and Amortisation

  22. Post EBIT/PBIT Interest Tax Dividends Exceptional Items.

  23. Taxation and the Accounts There are two types of taxation. Firstly Mainstream Taxation which is the amount that the business will pay usually based on a percentage of the net profit. Secondly, Deferred Taxation. This represents tax not actually payable now but could be payable in the future. This adjustment is made to recognise that the matching concept must apply.

  24. Deferred Taxation Example: A company has a tax rate of 50%. However, due to accelerated relief for investment onto new plant the actual tax payable this year is only 42%. However, over the next 5 years, this benefit will be reversed. In order to match the correct tax bill with the profits generated, a deferred tax account is set up for the 8%, and reversed over the next 5 years.

  25. Net Profit ( Net Earnings)‏ This represents the profit after overheads and expenses have been deducted from the gross profit. NOTE: Often net profit is taken before Interest an Tax. This is called EBIT or PBIT (Earnings / Profit Before Interest &Tax)‏

  26. Abnormal & Exceptional Items • Abnormal = Likely to happen again. They should be shown as an overhead. • Exceptional = Unlikely to happen again. They can be shown after EBIT.

  27. Abnormal vs Exceptional Items Items that are abnormal but could happen again should be included in the accounts. The should be shown separately if material. Note that if the item is one that is very unlikely to happen again then it can be shown as a deduction after EBIT/PBIT has been struck.

  28. Multi Step Income Statement

  29. Common Size Statement • See page 115

  30. Earnings Per Share (EPS)‏ This is a very useful indicator. It represents the earnings attributable to the ordinary shareholders divided by the total number of ordinary shares. (We will return to this later)

  31. Coffee Break • 12.4.1

  32. Revenue Recognition Financial Accounting

  33. Accruals or Matching Concept • We must match revenue with the relevant expenses. • So if we are selling cars, we have to match the cost of the cars sold and the expenses that flow from those sales. • We need to recognise revenue with the correct expenditure and expenditure with the correct revenue

  34. Recognising Revenue on a Sale • Recognise the sale only when the “significant risks and rewards” have been passed to the buyer. • Where the seller has no continual managerial involvement. • Where the revenues can be measured. • That there will be economic benefit. • That the costs incurred in the transaction can be measured.

  35. Coffee Break • 9.2.1

  36. Study Pack 2 • Have a go at this.

  37. The basis of accounting & Inflation Financial Accounting

  38. Historic Vs Current Cost • Historic = The original Cost • Current Cost = Current replacement value.

  39. Historical v Current Cost Inflation can seriously distort financial information. Historical Cost represents the price paid when purchased. Current Cost is the value today. This is less relevant in periods of low inflation like now. Example if you have inflation of say 20% per annum. An asset that costs say $100,000 today will be cost 20% more in one year. To replace it then will cost $120,000.

  40. Long Term Contracts • Contracts say for the building of the Channel Tunnel take many years. The constructors have to deal with the fact that they need to match income and expenditure. Normally they will interim bill. They need to match the costs and make any provisions that are appropriate.

  41. Long Term Contracts • Often use % of Completion method • Will have in the contract when invoicing can be made. • Mark to Market or Fair Value accounting. Allowed under IFRS but is now being criticised. After all it was successfully misused and abused by Enron!!!!!

  42. Capital v Revenue Expenditure Essentially we differentiate these expenditures in order to match the income with expenditure. (The accruals concept)‏ If we expend funds on non current assets then we have to recognise that that investment needs to be matched with the revenues that it generates over several years. We therefore take it to the Balance Sheet. ( We will discuss the issue of depreciation later )‏

  43. Revenue Expense Consumed and Still to be Consumed • Consider a restaurant selling pizzas. At the beginning of the day it will have a fridge full of these. Clearly as it sells the pizzas to customers they are consumed. But at the close of the day, there are still some in the fridge. • Essentially we differentiate these types (consumed and unconsumed) in order to match the income with expenditure, also known as the accruals concept. • The consumed will be listed as cost of sales in the Income Statement, but the unconsumed items will represent closing inventories and shown in the Balance Sheet.

  44. Stanley Tools again... • www.stanleyworks.com

  45. Summary Balance Sheet & Income Statement • Profits or Losses are added or subtracted from the Retained Earnings

  46. Balance Sheet & Income Statement – Optimistic Balance Sheet 31 December 2002 Profit & Loss Year 2003 Balance Sheet 31 December 2003 Liabilities £350,000 Liabilities £350,000 Assets £500,000 Assets £550,000 Revenues £1,000,000 Expenses £950,000 Shareholders Equity £150,000 Shareholders Equity £200,000 Profit £50,000 Profit added to Retained Earnings

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