Financial Reporting – Income Statement Part 2
November 14, 2009 Leave a comment
Income Statement Part 2
Measuring profit in the income statement
- The income statement measures the profit generated by the business over a period
- The previous section showed that it isn’t always easy as we have to apply our own judgement a lot, like what method of depreciation to use
Here is some data on a company, we’ll call it Shaun Ltd.
Bank interest received: £140
Closing stock on 30th Sept 2008: £6200
Light and heat: £533
Opening stock on 1st July 2007: £5640
General expenses: £2710
Wages and salaries: £47,300
Notes: Insurance was prepaid by £1000, that has been included in general expenses. Light and heat of £600 is to be accrued.
- How long do we set the life of the asset as?
- What do we think the residual value will be?
- What method of depreciation should we use?
- What happens when a non current asset gets sold?
Calculating profit/loss when we dispose of an asset
When we sell an asset the sale value probably won’t be the same as the net book value
Let’s say that a company called Cardigans R Us sell a car for £4,000. It cost £12,000 and the accumulated depreciation was £7,000. Cardigans R Us had an operating profit that year of £20,000.
They made £4,000 from the sale. But the net book value was £5,000 (£12,000 – £7,000), so they have actually made a loss of £1,000.
Because of this £1,000 loss the income statement changes, and the net profit for the year is now £19,000.
Valuation of inventories/stock
There are 3 methods:
- FIFO: Gives the highest profit and inventory value
- LIFO: Gives the lowest profit and inventory value
- AVCO is inbetween
Stock is usually valued at cost although sometimes it needs to be valued at ‘Net Realisable Value‘, which is the estimated selling price minus any further costs. You might do this when goods have deteriorated or become obsolete.
Allowances for trade receivables
Revenue is recognised at the point when the sale is made, even if the customer isn’t going to pay immediately.
There is ALWAYS a risk thought that the customer won’t pay. If this happened then it means that assets have been overstated on the balance sheet, as trade receivables are a current asset.
Bad romance debts
You might find out about something bad about a specific customer, like read in the news that they have gone bankrupt. What do you do?
Answer: Decrease trade receivables by the amount owing, and then increase expenses (call it bad debts) by that amount.
You don’t just cancel the sale because including it will give more information on management performance.
Past experience says that some proportion of trade receivables are never going to be paid, so what you need to do here is make a provision for ‘doubtful debts’. To do this, you:
- Decrease trade receivables by the required provision
- Increase expenses (call it an ‘allowance for trade receivables) by that amount
In the year ending on 30th Sept 2009, ‘cattle castle ltd’ has trade receivables of £90,000. They have recently heard that one of their customers has gone bankrupt, but they still owe cattle castle £3,000. After checking it’s other customers, they consider other trade receivables totalling £1800 to be doubtful.
Show the extracts from the income statement and balance sheet for that year.
Income statement extract:
Bad debts written off: £3000
Allowances for trade receivables: £1800
Balance sheet extract:
Trade receivables: [90,000 – 3000] = £87,000
Allowances for trade receivables: [£87,000 – £1800] = £85,200