Financial Reporting – Income Statements Part 1
November 1, 2009 1 Comment
Income Statements Part 1
Some quick concepts / refreshers
- Trade receivables are an asset. A trade receivable is money owed to the company for goods that have been bought from them on credit.
- Capital is a claim on the business, as it represents the investment the owner had made in it.
- The business entity convention means that the business and owner are treated as separate entities. This is why the owner is a claimant of the business with their capital.
- The prudence convention says that when making accounting judgements we should be cautious, by recording losses straight away in full, but only recording profits when they actually occur. This puts a bias on understating your financial position.
- A football player can be shown as an asset. The player’s services are controlled by the business (the football club) and when a transfer fee is paid then that amount can be shown as an asset
Balance Sheet – Meet the income statement
Assets = Capital + Profit + Liabilities
We can extend it to this:
Assets = Capital + (Sales revenue – Expenses) + Liabilities
Income statement example
See the table below for a sample income statement from a made up company.
Important things from the income statement
- Gross profit is the difference between revenue and cost of sales
- Operating profit is the gross profit minus the expenses (aka overheads) that are incurred from operating the business. This is a representation of the wealth generated from trading activities.
- Profit for the year is the operating profit plus any non trading income, like interest, minus the costs of financing the business, like interest payments
Cost of sales
- Cost of goods sold by the business during the accounting period
- Part of the goods bought during the accounting period may be left over unsold so will remain as inventory
- To get the cost of goods sold, we need to know the amount of any opening and closing inventories, plus any purchases made
Cost of sales example
At the start of the year there is £20,000 worth of inventory. During the year a further £140,000 of it is bought. At the end of the year £45,000 worth remains.
The income statement for that year will look like this:
Opening inventory: £20,000
(Current total: £160,000)
Minus the closing inventory: £45,000
Cost of sales = £115,000
- A lot of the time the company makes a judgement on whether to list certain expenses. It depends on how useful the information is to users.
- If something is large it should be shown separately. This is called the concept of materiality
- Finance costs are shown below the operating profit
- A limited company must follow company law when they classify expenses
Now we are going to make another example of an income statement. Below is some information about a company. We will be making a statement for the year ended 30.9.09. The catch it that not all of the the information here is relevant!
Let’s work out the cost of sales first. Remember from earlier that this is ‘opening inventory + purchases – closing inventory’. Therefore in this case it is ‘9+109-11’, which is 107.
Now we work out the gross profit, which you will remember is ‘sales – cost of sales’, so in this case is ‘210-107’, which makes 103.
Now we move on to the operating profit. This is calculated as the gross profit minus expenses, which is ‘103 – 42 – 2 – 7 – 3’, which comes out as 49.
To get the profit for the year, now we just need to deduct the costs of financing the business, which in this case is the loan interest, so we minus 2 from the operating profit, meaning the profit for the year is 47.
Notice the irrelevant information in the table. ‘Cash at bank’, ‘Loan’ and ‘Motor vehicles’ aren’t relevant to the income statement so we can ignore them.
Profit measurement and recognising revenue
Before we recognise revenue it must meet some basic criteria:
- Revenue amount must be measured reliably
- There must be a high probability that economic benefits will be received
When the revenue comes from the sale of good then this criteria also applies:
- Ownership and control of the item should pass to the buyer
(Have a quick read of this first)
- Expenses should be matched to the revenue that they helped generate
- For example, an income statement should include ALL expenses incurred when generating the reported revenue
- Meaning that an expense item reported in the income statement could be different to the amount of cash paid for that item during the period
What if expense paid is MORE than cash paid during the period?
A company pays their electric bill quarterly. So far for the year ending 30th Sept 2009 they have paid £7,600 in bills, but they haven’t been billed for the final quarter yet. However they estimate that this final bill will be £2,000. So when we put it in the income statement as an expense, what do we put?
Answer: Put £9,600. The electric bill relates directly to sales revenue generated during the year.
The outstanding amount (£2,000) represents a liability at the balance sheet date, so must be recorded as a current liability on the balance sheet (also known as an accrual).
Treating it like this is reflecting the dual aspect of the item, and also it makes sure that the balance sheet equation is maintained.
What if expense paid is LESS than cash paid during the period?
Things like rent and insurance are normally paid in advance. A company pays £4,000 rent every quarter in advance. On the last day of the accounting year, they pay rent of £4,000.
This means that they have paid 5/4’s of rent over the year. We must apply the matching convention to remove the surplus amount from the current year’s expenses. We do this by showing it as a Prepayment (a current asset) on the balance sheet.
On the income statement we show rent as a payable expense of £16,000, but on the cash flow statement we show that £20,000 was paid for rent, and on the balance sheet we show that £4,000 of that £20,000 is a prepaid expense.
Accruals and prepayments example
A company’s accounting year ends on 30th September. They have paid £5,000 in electricity bills for the period 1st Oct to 31st July. They estimate the bill for August and September will be £1,000.
They pay insurance every 6 months in advance, £4,000. They pay it on 31st March and 30th September. There is a prepayment of £3,500 for insurance in last year’s balance sheet.
Let’s see how this will make the income statement and balance sheet look on 30th September.
Here are the expenses for the year (that we know of):
Electricity: £5,000 + £1,000 = £6,000
Insurance: £3,500 + £4,000 = £7,500
The expense for insurance needs explaining: £3,500 was prepaid which would take the company up to the next payment date on 31st March, so they pay another £4,000. This will only pay enough insurance to last until the 30th Sept though, so they need to pay another £4,000. However the final £4,000 will go down as a prepayment as it exceeds the amount needed for the remainder of the year.
Assets: £4,000 prepayment
Liabilities: £1,000 accrual (the part of the electricity bill they haven’t paid yet)
- Most non current assets have a ‘shelf life’ as they get used up in the process of generating wealth for the business
- Depreciation is how we attempt to measure the proportion of the asset that is used up to generate the revenue recorded for the current accounting period
- We record it as an expense of the period. This applies to both tangible and non tangible current assets.
Must consider 4 factors to work out the depreciation
- The cost or value of the asset
- The useful life of the asset
- The residual value
- The method of depreciation
The business needs to choose a suitable method of allocating the amount to be depreciated. The two most common methods are:
- Straight line
- Reducing balance
This is just a linear graph where the amount depreciates over time. It’s late and I can’t be bothered making my own graph, so here’s a really bad one I found on google images:
A curved version of the straight line graph. Here is another appallingly plain image:
A company buys a car for £10,000. They are going to keep it for 4 years then sell it for £256. We are going to calculate the depreciation under both methods.
Straight line method
The same amount is charged each year. We work out the depreciation expense as:
(Cost – Residual Value) ÷ No of years expected life
So in this case it is (10000-256)/4 = £2,436 every year
In an income statement we would list the figure calculated for the year under expenses as ‘depreciation’.
On the balance sheet it would be shown as the accumulated depreciation taken away from the current cost, which leaves the Net Book Value
It would look like this:
Asset: Car: £10,000
minus the depreciation: £2436
Reducing balance method
A fixed percentage is deducted from the cost in the first year, and then from the reduced balance in subsequent years. This means that there are higher depreciation charges in earlier than later years.
P = (1 – n√R/C) × 100%
P = depreciation percentage
n = useful life of asset (years)
R = residual value of asset
C = Cost of asset
Extra note: The ‘n’ isn’t n times the square root, it’s the nth root. So if it was 3 years you would get the cubed root, and so on
So in the example it is:
1 – 4√(256/10000), which comes out as 60%.
If we apply this depreciation to all 4 years:
1st year: £10,000 – 60% = £4,000
2nd year: £4,000 – 60% = £1,600
3rd year: £1,600 – 60% = £640
4th year: £640 – 60% = £256
There is another example in the notes that covers every concept covered here that I recommend you have a look at, although I may update this post to put it in sometime.