True/false QUIZ

 Trade receivables are a liability

 Equity is an asset of the business
 The business entity convention treats the
business and its owner as separate entities
 The prudence convention introduces bias into
financial statements
 Football players can be shown as assets on
the statement of financial position
1
 Trade receivables are a liability
 False
 Trade receivables are the amounts owed by
debtors (customers) to the company for goods
that have been bought on credit
 Trade receivables are an asset

2
 Equity is an asset of the business

 False
 Equity is a claim on the business
 It represents the investment that the owner
has made in the business

3
 The business entity convention treats
the business and its owner as separate
entities

 True
 For accounting purposes, a business and its
owner are treated as entirely separate
 This is why the owner is treated as a claimant
(under Equity) of the business

4
 The prudence convention introduces
bias into financial statements
 True
 The prudence convention says that we should
exercise caution when making accounting
judgements
 We should do this by recording losses at once and in
full; but by only recognising profits when they
actually arise
 This means there is a potential bias towards
understatement of financial position
5
 Football players can be shown as
assets in the statement of financial
position

 Sort of true
 Who read pages 54 to 57 in the textbook?
 This says that whilst football clubs cannot own players,
they can own the rights to the players’ services
 Where a transfer fee has been paid for a player, then
that amount can be shown as an asset in the
statement of financial position

6
 S20-AC125
Fundamentals of Financial Reporting

Topic 3: The Income Statement (I)

Lecturer: Zainab Mehmood

7
Measuring and reporting Financial Performance
Required Reading – Chapter 3, A&M textbook

LEARNING OUTCOMES

After lectures 7 and 8 you should be able to:

Discuss the nature and purpose of the

income statement

Prepare an income statement from relevant

financial information and interpret the information
that it contains

Discuss the main recognition and measurement

issues that must be considered when preparing
the income statement

Explain the main accounting conventions

underpinning the income statement 8
 Structure of Lecture

1. The Income Statement - layout and Basic Terms

2. Elements of income statement
3. Preparation of income statement
4. Link between Income Statement & Balance
Sheet
5. The accounting equation revisited
6. The matching convention
7. Practice questions to be completed at home
9
 1. Income Statement - Basics
• Measures the Profit or Loss that the company
has made over the accounting period (i.e. over
1 year)

• How do we measure Profit (or Loss)?

PROFIT = Revenue - Expenses

10
Simple Income Statement Format
INCOME STATEMENT for Company X
for the year ending 31/12/2012

Sales Revenue To memorise it

(-) Cost of goods Sold easier, try to
break it down
= GROSS PROFIT into the 3 profit
figures (Gross,
(-) Operating Expenses Operating, Net)
e.g. Rent
Salaries
Electricity
= OPERATING PROFIT
(+) Non-operating Income
(-) Non-operating Expenses
= NET PROFIT 11
 What is Revenue?
• Income generated by the business from its normal
operations. Also known as sales or turnover.
• Includes the value of all sales, both:
– Cash sales, i.e. sales where cash is received immediately
after the sale
– Credit sales or sales made on credit, i.e. sales where cash
will be received at a future date. NOTE: Credit sales are
recognised in the Income Statement when the sale occurs,
NOT when the cash is received.
• Non-operating Income: Profit from disposal of non-current
assets (such as buildings etc) or through investments (e.g.
interest earned on bank deposits). Appears separately in
the Income Statement at the end. 12
What are the criteria for recognising Revenue?

Basic criteria that must be met before revenue

is recognised:
• The amount of revenue can be measured
reliably
• It is probable that the economic benefits will
be received.
• Ownership and control of the items should
pass to the buyer.

13
 What are Expenses?
• In accounting, the term “Expenses” is used
differently to how people normally use it in their
daily lives.
• In our daily lives, we talk about EXPENSES every time
we spend money on something! In accounting, this is
NOT TRUE.
• In accounting, Expenses are costs incurred in the
process of generating revenue. These costs may not
always involve direct cash payments.

14
 Examples of Expenses
• The cost of the goods that are sold during the year
• Running Costs of the business:
– Rent, Insurance, telephone/water bills
– Salaries, petrol
– Purchases of consumables (e.g. office supplies)
• Depreciation (a non-cash expense)
– A proportion of the value of non-current assets that is
matched to the revenues these assets helped generate in a
given period. More on this later.
• Bad debts /Allowances for trade receivables
• Loss from disposal of non-current assets (non-operating
“expense”)
• Interest expense on loans (non-operating “expense”)
15
 What are NOT classified as expenses?
• Purchase of assets, for example:
– Purchase of a non-current asset, e.g. a building
(an expense will be recorded gradually through
depreciation -> more on this later)
– Purchase of inventories (only when these inventories
are sold do they become an expense called “Cost of
goods sold”)
• Paying for liabilities, for example:
– Repaying a bank loan (the interest charged is an
expense, but not the principal amount of the loan)
– Paying back suppliers for past purchases made on
credit (trade payables)
16
Simple Income Statement Format
INCOME STATEMENT for Company X
for the year ending 31/12/2012

Sales Revenue To memorise it

(-) Cost of goods Sold easier, try to
break it down
= GROSS PROFIT into the 3 profit
figures (Gross,
(-) Operating Expenses Operating, Net)
e.g. Rent
Salaries
Electricity
= OPERATING PROFIT
(+) Non-operating Income
(-) Non-operating Expenses
= NET PROFIT 17
2. Elements of the Income Statement
 Gross profit
 The difference between revenue and cost of sales
 Operating profit
 Gross profit less expenses (overheads) incurred in operating
the business
 Represents the wealth generated from operating (trading)
activities
 Profit for the year
Operating profit
+ any non-operating income
- Costs of financing the business and/or losses from non-current
asset disposal
18
Simple Income Statement Format
INCOME STATEMENT for Company X
for the year ending 31/12/2012

Sales Revenue WE WILL NOW

LEARN HOW
(-) Cost of goods Sold TO CALCULATE
= GROSS PROFIT THIS PART

(-) Operating Expenses

e.g. Rent
Salaries
Electricity
= OPERATING PROFIT
(+) Non-operating Income
(-) Non-operating Expenses
= NET PROFIT 19
 Calculating the GROSS PROFIT
• GROSS PROFIT = Sales Revenue – Cost of Goods
Sold
• Sales Revenue includes both Sales made on
credit (i.e. we don’t get paid immediately) & Cash
Sales (sales for which we get paid immediately)
• Cost of goods Sold (also called Cost of Sales): We
need to find how much it cost the business to buy
or produce the products that it sold.

20
 How do we find the Cost of Goods Sold?
• Most of the times, we don’t have that information
directly.
• We can calculate it, though, if we know:
– Cost of goods (inventory) at the beginning of the
period
– Cost of purchases made during the period
– Cost of goods (inventory) at the end of the period

Cost of Goods Sold = Opening Inventory + Purchases –

Closing Inventory

21
 Calculating Gross Profit: Example
FACTS:
Sales during 2012 £200,000
1 Jan 2012: Inventory £20,000
Purchases during 2012 £140,000
31 Dec 2012 Inventory £45,000
Q: Calculate the Gross Profit made during 2012
Extract from Income Statement for year ended 31 Dec 2012
Sales Revenue £200,000
Less Cost of Sales
Opening Inventory £20,000
(+) Purchases £140,000
(-) Closing Inventory (£45,000) (£115,000)
GROSS PROFIT £85,000 22
3. Activity: Prepare an Income Statement

 The adjacent £’000

Sales 210
information relates Purchases 109
to Sankey Ltd Inventory: 1.10.11 9
 Prepare an income Salaries & Wages 42
Motor expenses 2
statement for the Rent 7
year ended 30.9.12 General expenses 3
 N.B. Not all the Motor vehicles 14
information is Cash at bank 5
Loan interest expense 2
relevant Loan 20
Inventory: 30.9.12 11
23
Simple Income Statement Format
INCOME STATEMENT for Company X
for the year ending 31/12/2012

Sales Revenue We just

learnt how to
(-) Cost of goods Sold work through
= GROSS PROFIT this part

(-) Operating Expenses

e.g. Rent Deduct all
Salaries Operating
Expenses
Electricity
= OPERATING PROFIT
(+) Non-operating Income Add/ Deduct
(-) Non-operating Expenses non-operating
revenue/expenses
= NET PROFIT 24
 Sankey Ltd
Income statement for year ended 30.9.12

£’000 £’000

Sales 210
Cost of sales
Opening inventory 9
Purchases 109
Closing inventory ( 11) (107)
Gross profit 103
Operating Expenses
Salaries & Wages (42)
Motor expenses ( 2)
Rent ( 7)
General expenses ( 3)
Operating profit 49
Loan interest ( 2)
Profit for the year 47 25
 4. LINK between Income Statement &
Balance Sheet
• Balance Sheet (BS): Measures the Financial Position of the
company (i.e. the value of Assets, Liabilities, Equity) at a
particular point in time.
• Income Statement (IS):
– Measures the Financial Performance of a Company during the past 1
year period.
– Informs us about whether the company’s wealth has
increased/decreased during that period.
• LINK: The Income Statement links the balance sheets at the
beginning and at the end of an accounting period.
– Opening wealth position (in Equity part of BS at beginning of
period) + New wealth generated during period (in IS) = Closing
wealth position (in Equity part of BS at the end of period) 26
 How the IS links to the BS
INCOME STATEMENT BALANCE SHEET for
• Do you know how – 31/12/2012 31/12/2012
the IS links to the
Sales … ASSETS
BS? -Cost of Sales … Non-Current
GROSS PROFIT …
Current
• The Net Profit Oper Expenses
Salaries … Total Assets
figure that we find Telephone … YY
from the IS is then Petrol …
Other expenses … CLAIMS
added to the Equity
section of the BS, OPERATING PROFIT … Equity
Original Capital
in particular it is + Interest Inc. …
Retained Profits
added to Retained NET PROFIT XX
(original amount + XX)
Profits.
Liabilities
27
 The Income Statement thought of as an
“appendix” to the Equity Section of the B/S

• In theory, it would be possible to calculate the profit/loss

for the period, by making all adjustments for revenues and
expenses in the Equity section of the Balance Sheet.
– Expenses would decrease wealth  so Equity would
decrease
– Revenues would increase wealth  so Equity would
increase
• However, it would be too cumbersome to do it in the
Balance Sheet. That is why the revenues and expenses are
recorded separately in the Income Statement and the
profit/loss figure is derived. Then the profit/loss figure is
added to the Equity part of the Balance Sheet. 28
5. Revisiting & Expanding the ACCOUNTING EQUATION

ASSETS = EQUITY + LIABILITIES

The above equation can be extended to:

PROFIT/LOSS
Assets = OPENING + Liabilities
for the +
EQUITY (–) period

The above equation can be FURTHER extended to:

Assets = OPENING + Revenues – Expenses + Liabilities

EQUITY

29
 Expanded Accounting Equation
ASSETS = OPEN. EQUITY + (REVENUES – EXPENSES) + LIABILITIES

If we re-arrange the Equation above, we get:

ASSETS + EXPENSES = (Open) EQUITY+ REVENUES + LIABILITIES

- We will be using this Equation for exercises that involve

recording accounting transactions and preparing Financial
Statements
EXAMPLE – Expanded Accounting Equation

During the year, the company made sales on

credit for £31,000. The goods sold had originally
cost £20,000.

How should we record this transaction?

31
EXAMPLE – Expanded Accounting Equation
Sales on credit of £31,000. Cost of goods sold £20,000.
How should we record this transaction?

USING ACCOUNTING EQUATION:

ASSETS = EQUITY + LIABILITIES
+£31,000(trade receiv.)
-£20,000 (inventory) = +£11,000 (profit)

USING EXPANDED ACCOUNTING EQUATION:

ASSETS + EXPENSES = (OPEN) EQUITY +REVENUE +LIABIL.
+£31,000(Trade Rec.) = +£31,000(sales)
-£20,000 +£20,000 =
(Invent.) (cost of sales)
NOTICE THAT THESE TWO APPROACHES ARE EQUIVALENT! 32
 6. The Matching Convention

• MATCHING CONVENTION: Revenues generated during

the year must be matched with the expenses incurred
during the year that helped generate those revenues.

KEY WORDS:
– Revenue Generated  i.e. ALL sales, even if we have not
received cash for them yet
– Expenses Incurred  i.e. we may not have paid for them
yet, but the business has received the benefit of their
service (e.g. work by employees for which the business
pays later)
– During the year  only revenue generated during the
current year & expenses incurred during the current year
should be included in the current year’s Income Statement
33
 Why is the Matching principle so
important?
• If we are interested in finding the Profit made during a
year, we need to compare revenues and expenses
that occurred during the same period. We don’t want
to be comparing revenues and expenses that relate to
different periods (i.e. comparing pears and apples).
• Cash paid for expenses and cash received from sales
don’t necessarily have to coincide time-wise with the
period during which revenues were generated and
expenses were incurred.

• Any examples?
34
 REMINDER: Prepayments
(= prepaid expenses)
• Prepayments: These are payments made for
expenses before the service we pay for is enjoyed
by the company.

• Example: Paying rent today for the next 3 months

prior to actually using the premises for the next 3
months.

• Any other examples?

35
 ALWAYS REMEMBER!

• PREPAID EXPENSES are NOT expenses!!!

• PREPAID EXPENSES are Current ASSETS

and appear on the BALANCE SHEET.

36
 EXAMPLE 1: How to record Expenses
involving Prepayments
Look at the following transaction:

The insurance expense for the year to 31 January 2009 was

£1,800. Insurance paid during this year amounted to £2,000.
Part of this amount relates to insurance for the period
01/02/2009 to 31/03/2009.

How would you record this transaction using

the Expanded Accounting Equation?

37
 EXAMPLE 1: How to record Expenses
involving Prepayments
The insurance expense for the year to 31 January 2009 was
£1,800. Insurance paid during this year amounted to £2,000. Part
of this amount relates to insurance for the period 01/02/2009 to
31/03/2009.

ASSETS + EXPENSES = (Open) + REVENUE + LIAB.

EQUITY
-£2,000 + +1,800 = 0 0 0
(cash) (insurance
+£200 expense)
(prepaid
expense)
-1,800 38
 EXAMPLE 2: How to record Expenses
involving Prepayments
• Imagine a slightly more complicated scenario. You
are now told that:

On the BS dated 31/01/2008 prepaid expenses relating to

insurance were £400. During the period 01/02/08 to
31/01/2009 (i.e. the current accounting period) the company
paid £3,800 for insurance. £500 of this amount relates to
insurance for the 1st quarter of the next accounting period.

How would you record this transaction using the

ACCOUNTING EQUATION?
(Hint: you first need to calculate the Insurance Expense)

39
 EXAMPLE 2: How to record Expenses
involving Prepayments
On the B/S dated 31/01/2008 prepaid expenses relating to insurance
were £400. During the period 01/02/08 to 31/01/2009 (i.e. the
current accounting period) the company paid £3,800 for insurance.
£500 of this amount relates to insurance for the 1st quarter of the
next accounting period.

Insurance Expense = Prepayment from last year +

Insurance paid this year – Amount paid this year
that relates to the next period

Insurance Expense = £400 + £3,800 - £500 = £3,700

40
 EXAMPLE 2: How to record
Expenses involving Prepayments
Recording the transaction using the Expanded
Accounting Equation:

ASSETS + EXPENSES = (Open) + REVENUE + LIAB.

EQUITY
-£3,800 + +£3,700 = 0 0 0
(cash) (insurance
-£400 expense)
(prepaid
expense)
+£500
(prepaid
expense)
-3,700 41
 ADVICE for dealing with
Expenses involving Prepayments
• It is very important to remember what the current
accounting period is, in order to figure out which
amounts don’t relate to it!

• It may help you if you draw a TIMELINE to try and

figure out which payments refer to which periods.

• Look at last year’s BS to see if there are any PREPAID

EXPENSES. This year, these prepaid expenses will be
removed from the BS and instead they will become
part of the Expense and will appear on the IS.
42
 REMINDER:
Accruals (= Accrued Expenses)
• Accrued Expenses: These are amounts owed
for expenses, even though we have received
the benefits relating to the expense. Accruals
are the opposite of Prepayments.

• Example: Business may pay their staff 1

month “in arrears”(=late); i.e. the staff works
in January, but only gets paid January’s wages
at the end of February.
43
 ALWAYS REMEMBER!

• ACCRUED EXPENSES are NOT expenses!!!

• ACCRUED EXPENSES are Current

LIABILITIES and appear on the BALANCE
SHEET.

44
 EXAMPLE 1: How to record
Expenses involving Accruals
Consider the following transaction:

Wages totalling £35,500 were paid during the year

relating to current period wages. At the end of the
year, the business owed £2,200 of wages.

How would you record this transaction using the

Expanded Accounting Equation?
(Hint: Try to first calculate the Wages Expense for the
current period)
45
 EXAMPLE 1: How to record
Expenses involving Accruals
Wages totalling £35,500 were paid during the year relating to
current period wages. At the end of the year, the business owed
£2,200 of wages.

Wages Expense = Cash paid for current period wages + Amount

owed for current period wages
= 35,500 + 2,200 = 37,700

ASSETS + EXPENSES = (Open) + REVEN + LIAB.

EQUITY UE
-35,500 + +37,700 = 0 0 +2,200
(cash) (wages (accrued
expense) expense)

46
 EXAMPLE 2: How to record
Expenses involving Accruals
• Let us complicate the previous transaction a bit
more. You are now told that:

On the B/S dated 31/01/2008 accrued expenses relating to wages

were £3,500. During the period 01/02/08 to 31/01/2009 (i.e. the
current accounting period) the company paid £35,500 for wages. At
the end of the current period, the business owed £2,200 of wages.

How would you record this transaction using the

ACCOUNTING EQUATION?
(Hint: You first need to calculate the Wages Expense)

47
 EXAMPLE 2: How to record
Expenses involving Accruals
On the B/S dated 31/01/2008 accrued expenses relating to wages
were £3,500. During the period 01/02/08 to 31/01/2009 (i.e. the
current accounting period) the company paid £35,500 for wages. At
the end of the current period, the business owed £2,200 of wages.

Wages Expense = (Amount paid for wages during

this year – Amount paid for wages during this year
used to repay owed wages from last year) + Amount
owed for current period wages

Wages Expense = (£35,500 - £3,500) + £2,200

= £34,200

48
 EXAMPLE 2: How to record
Expenses involving Accruals
Recording the transaction using the Accounting
Equation:

ASSETS + EXPENSES = (Open) + REVEN + LIAB.

EQUITY UE
-35,500 + +34,200 = 0 0 -3,500
(cash) (wages (accrued
expense) expense)
+2,200
(accrued
expense)

49
 ADVICE for dealing with
Expenses involving Accruals

• Similar advice as with prepayments regarding:

– How important it is to remember what the current
accounting period is, and
– Drawing a timeline

• Also, look at last year’s B/S to see if there are any

ACCRUED Expenses in the Liabilities section. These will
need to be considered when calculating the current
period’s Expense.

50
 Current Tasks
• Check Blackboard for updates
• Complete required reading:
– Chapter 3 (until page 86), A&M textbook
• Complete relevant Topic 3 homework questions

DON’T FORGET:
Attempt the Workshop 1 Questions
(available on Blackboard) BEFORE the
workshop next week and bring your
answers with you to the workshop
51
 7. Practice Questions

(to be completed at home)

52
 Carnaby Ltd – Recording expenses involving
accruals and prepayments
 Carnaby Ltd’s year end (i.e. accounting period end) is 30
September.
1. It has paid electricity bills for £5,000 for the period 1 October
2010 to 31 July 2011. It estimates the bill for August and
September will be £1,000.
2. It pays insurance on 31 March and 30 September half yearly in
advance of £4,000. There is a prepayment in last year’s balance
sheet for insurance of £3,500.

Show the expense extracts for the income statement for the
year ended 30 September 2011 and the accrual/prepayment
extracts from the statement of financial position as at 30
September 2011.
53
 Notes/Workings
ASSETS + EXPENSES = (Open) + REVEN + LIAB.
EQUITY UE
1. -£5,000 (cash) +6,000 = 0 0 +1,000
(electricity) (accrual)
2. -£8,000 (cash) +7,500 = 0 0 0
-£3,500 (prep) (insurance)
+£4,000 (prep)

NOTES:
1. Electricity Expense = £5000 (paid) + £1,000 (owed) = £6,000
Electricity accrual in B/S: £1,000; Cash decrease in B/S by £5,000
2. Insurance Expense = £3,500(prepayment) + £4,000 (payment for March to
September) = £7,500
Prepaid insurance decrease in B/S: £3,500 (remove last year’s prepayment)
and add new prepaid insurance of £4,000 (prepayment made on
30/09/2011) 54
 Carnaby Ltd - Solution
Extract from Income statement for year ending 30 Sept 2011
Expenses £
Electricity [5,000+1,000] 6,000
Insurance [3,500+4,000] 7,500

Extract from Statement of financial position as at 30

September 2011
Current Assets £
Prepayments [3,500-3,500+4,000] 4,000
Current Liabilities
Accruals [0+1,000] 1,000

55
 Nita – Practice Question
Nita had the following transactions for June 2011:
1. Bought goods on credit for £700
2. Paid rent in advance of £120 for the quarter June-August
3. Made credit sales of £1,400. No cash sales were made in June. She
had inventory of £200 on 1 June and £350 on 30 June.
4. Paid monthly (June) salary to assistant of £500
5. Paid general expenses of £50
6. At the end of June, she estimated that she owed £50 for June’s
electricity consumption

 Draw up an income statement for Nita for month ended 30

June 2011
 Show the statement of financial position extracts for her
prepayments and accruals

56
 NITA Question: Notes/Workings
ASSETS + EXPENSES = (Open) +REVENUE +LIAB.
EQUITY
1. +700 (inven) 0 = 0 0 +700
(Tr. Payab)
2. -120 (cash) +40 (June’s = 0 0 0
+80 (prepaym) rent)
3a. +1,400 (tr. Receiv) 0 = 0 +1,400 0
(sales)
3b. -550 (invent) +550 = 0 0 0
(cost of sales)
4. -500 (cash) +500 (salary) = 0 0 0
5. -50 (cash) +50 (gen. exp) = 0 0 0
6. 0 +50 (electr) = 0 0 +50
(accrual)
SUM +960 +1,190 = +1,400 +750
Transaction 2: Rent expense: 1/3 x 120 = 40, Prepayment: 2/3x120=80
Transaction 3: Cost of Sales = £200 (open inv) + £700 (purchases) -£350 (clos inv) = 550 57
 Nita: Income statement for month
ended 30 June 2011
£ £
Sales revenue 1,400
Less Cost of sales
Opening Inventory 200
(+) Purchases 700
(-) Closing inventory (350) 550
Gross profit 850
Operating Expenses
Rent 40
Salary 500
General expenses 50
Electricity 50 (640)
Operating profit 210

Net Profit 210

58
Nita: SOFP extracts as at 30 June 2011

Current assets
Prepayment [rent 120 x 2/3] 80

Current liabilities
Accrual (electricity) 50

59