Arab Open University

Faculty of Business Studies

B203-B

Business functions in context II

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Chapter 3:
Measuring and Reporting Financial
Performance

Accounting and finance

Atrill & McLaney
The Income Statement
The uses and usefulness of the income statement
The main purpose of the income statement – or profit
and loss account – is to measure and report how
much profit (wealth) the business has generated
over a period.
It also helps users to gain some impression of how that
profit was made.
Profit (or loss) for the period =
Total Revenue (for the period) – Total Expenses
(incurred in generating that revenue)

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The Income Statement
In order to calculate profit, we need to know
 Revenue: is the economic inflow arising from the ordinary
operations of a business.
 Sales of goods,
 fees for services, etc..
 Expenses: is the economic outflow arising from the ordinary
operations of a business
 The cost of buying or making the goods that are sold during the
period concerned: Cost of Goods Sold or COGS
 Salaries and wages
 Rent and rates
 Motor vehicle expenses
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The Income Statement
The uses and usefulness of the income statement :
Helps in providing information on:
1. How effective the business has been in generating
wealth: since wealth generation is the primary reason
for most businesses to exist, assessing how much
wealth has been created is an important issue.
2. How the profit was derived: to evaluate business
performance effectively, it is important to discover
how the profit figure was derived. Thus, the level of
sales revenue, the nature and amount of expenses
incurred, and the profit in relation to sales revenue
are important factors in understanding the
performance of the business over a period.
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Different Roles for The Income Statement
and The Balance Sheet
The income statement links the balance sheets at the beginning and
the end of the a reporting period.
At the start of a new reporting period, the balance sheet shows the
opening wealth position of a business.
After an appropriate period, an income statement is prepared to
show the wealth generated by the business.
A new balance sheet need to be prepared to show the new wealth
position of the business at the end of the period.
Assets (at the end of the period) = Equity (at the end of the
period) + Liabilities (at the end of the period)
 Equity (at the end of the period) = (Equity at beginning of the
period + profit - Withdrawals)
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The Layout of The Income Statement

Sales revenue
less
Cost of sales (Goods Sold)
equals
Gross profit
less
Operating expenses
equals
Operating profit
less
Non Operating Expenses
plus
Non Operating Income
equals
Profit for the period
 Income Statement
Sales Revenue 100,000
(-) (-)
Cost of Goods Sold(cost of sales) 70,000
Gross Profit 30,000
(-) (-)
Operating Expenses 20,000
Operating Profit 10,000
(-) (-)
Non operating expenses 2,000
+ +
Non operating revenues 1,000
Profit for the period 9,000
Cost Of Goods Sold (COGS)
Also called cost of sales
It represents the cost of goods that were sold by the business
during the period rather than the cost of goods that were
bought by the that business during the period.
Part of the goods that were bought during a particular period
may remain in the business, as inventories, at the reporting
period end. They will be sold in the next period (s).
To derive the cost of the sales for a period, we need to know:
 The amount of opening inventories for the period
 The amount of closing inventories for the period
 The cost of goods bought during the period

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COGS

COGS = Opening Inventories + Purchases – Closing Inventories

Cost of goods available for sale

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Example 3.2
You were given these information: Opening inventories $ 40,000 ,
Purchases $ 189,000 , Closing inventories $ 75,000

Required: Calculate the cost of goods sold

$
Opening inventories 40,000
+ +
Purchases (Goods bought) 189,000
Cost of Goods available for sale 229,000
(-) (-)
Closing inventories 75,000
Cost of sales (or COGS) 154,000

COGS = Opening Inventories + Purchases – Closing Inventories

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Gross Profit
The first part of the income statement is concerned
with calculating the gross profit.
Gross profit = Revenue – COGS (Cost of goods sold)
It represents the profit from buying and selling goods,
without taking into account any other revenues or
expenses associated with the business.

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 Operating profit
Operating profit = gross profit – overhead(operating Expenses)
Overhead are all operating expenses (electricity, wages, rent,
etc..)
Operating profit represents the wealth generated during the
period from the normal activities of the business.
It does not take account of any income that the business may
have from activities that are not included in its normal
operations.
Costs for financing the business are also ignored in the
calculation of operating profit.

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Profit for the period
Profit for the period = operating profit + non
operating income – interest payable on borrowings
This is the income that is attributed to the owner(s) of
the business and which will be added to the equity
figure in the statement of financial position (balance
sheet)

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Example 3.1 Better-Price Stores
Income statement for the year ended 31 October 2011
£
Sales revenue 232,000
Cost of sales 154,000
Gross profit 78,000
Operating expenses
Salaries and wages (24,500)
Rent and rates (14,200)
Heat and light (7,500)
Telephone and postage (1,200)
Insurance (1,000)
Motor vehicle running expenses (3,400)
Depreciation – fixtures and fittings (1,000)
Depreciation – motor van (600)
Operating profit 24,600
Interest received from investments 2,000

Interest on borrowings (1,100)

Calculating gross profit for Better-Price Stores

£ £

Sales revenue 232,000

Cost of sales:

Opening inventories 40,000

Goods bought 189,000

Closing inventories (75,000)

(154,000)
Gross profit 78,000
Activity 3.2
Prepare an income statement for the year ended 30 April 2013.
Page 81

Activity 3.3
(Hint: Not all items listed should appear on this statement)
Page 84

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Recognizing revenue
The main criteria for recognizing revenue are:
The amount of revenue can be measured reliably; and
It is probable that the economic benefits will be received;
and
Ownership and control of the items should pass to the
buyer.

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Recognizing expenses
The matching convention states that expenses should
be matched to the revenue that they helped to generate.
In other words, The expenses associated with a particular
item of revenue must be taken into account in the same
reporting period as that in which the item of revenue is
included.
This means that a particular expense reported in the
income statement for a period may not be the same
figure as the cash paid for that item during the period.
The expense reported might be either more or less than
the cash paid during the period.

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Accrued Expenses
When the expense for the period > the cash paid during the period

Example 3.4 page 89

The business should pay £6,000 as commission to
employees.
The business paid only £ 5,000 during the year to the
employees. The remaining £ 1,000 will be paid during
the next reporting period.
But it should be expensed during the year during
which the revenue was made.

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The problem is overcome by dealing with the
commission payment as follows:
Sales commission expense in the income statement will
include the amount paid plus the amount outstanding
(£6,000 = £5,000 + £1,000)
The amount outstanding £1,000 represents an
outstanding liability at the end of the year. It will be
treated as a current liability.
The cash will already have been reduced to reflect the
commission paid (£5,000) during the period.

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 Accounting for Sales Commission

Income statement

Statement Sales commission Statement

of cash expense of financial
flows £6,000 position
at year
Cash £5,000 end

Accrual (Accrued Expense)

£1,000 (liability)
Matching expenses to the period
In principle, all expenses should be matched to the
period in which the sales revenue to which they relate
is reported.
However, it is sometimes difficult to match certain
expenses to sales revenue in the same precise way that
we have matched sales commission to sales revenue in
the previous example.
For example, electricity or rent charges cannot be
linked to particular sales, but to the period in which
they were incurred.

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Prepaid Expenses
When the expense for the period < the cash paid
during the period
Example 3.6 page 91
Rent is paid on:
Jan 1, April 1, July 1, Oct 1
On Dec 31, the business paid the next quarter’s rent (£
4,000) to the following 31 March, which was a day
earlier than required.
This means that the business had made 5 payments
during the previous year instead of 4.

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The problem is overcome by dealing with the rental
payment as follows:
Show the rent for four quarters as the appropriate
expense in the income statement (4 x £4,000 = £16,000)
The cash (5 x £ 4,000 = £ 20,000) would already have
been paid during the year.
Show the quarter’s rent paid in advance (£ 4,000) as a
prepaid expense under assets in the statement of
financial position. (Current asset)

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 Accounting for Rent Expense

Income statement

Statement Statement
Rent expense
of cash of financial
£16,000
flows position at
year end
Cash £20,000

Prepaid expense £4,000

(current asset)
Profit, cash and accruals accounting
Within a particular period:
 total revenue does not usually represent total cash received,
 total expenses are not the same as total cash paid.

As a result, the profit figure (total revenue – total expenses)

will not normally represent the net cash generated during
that period.
It’s important to distinguish between profit and liquidity.
Profit is the measure of achievement, or productive effort,
rather than a measure of cash generated.
Although making a profit will increase wealth, cash is only
one possible form in which that wealth may be held.

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Depreciation
Most non-current assets have limited or finite lives.
They are eventually ‘used up’ in the process of
generating revenue for the business. This ‘using up’
may relate to physical deterioration or obsolescence.
Depreciation is an attempt to measure that portion of
the cost of a non-current asset that has been depleted
in generating the revenue recognized during a
particular period.

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Depreciation
To calculate a depreciation expense for a period, four factors
have to be considered:
 The cost (or fair value) of the asset: this will include all costs
incurred by the business to bring the asset to its required location and to
make it ready to use.
 The useful life of the asset: how long the asset will serve the business
 The residual value of the asset (at the end of its useful life): or
disposal value is the payment received when the asset is sold at the end of its
useful life
 The depreciation method: the business must select a method of
allocating this depreciable amount between the reporting periods covering
the asset’s useful life.

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Depreciation: Activity 3.8
Andrew Wu Ltd bought a new motor car. The invoice
received from the car dealer as follows:
What is the total cost of the new car to be treated as part
of the business’s property, plant and equipment?
New BMW 325i £26,350
Delivery Charge 80
Alloy Wheels 660
Sun Roof 200
Petrol 30
Number Plates 130
Road fund licence 120
£27,570
Part exchange – (old car) (1,000)
Amount Outstanding £26,570
Answer of Activity 3.8
Total cost of the asset =

New BMW 325i 26,350

Delivery Charge 80
Alloy Wheels 660
Sun Roof 200
Number Plates 130
Total Cost 27,420
Depreciation – Straight-line method

Annual Cost of the Asset - residual Value

Depreciation =
Useful Life of the asset

# The total amount to be depreciated = cost of the asset – residual value

# The carrying amount at

the end of each year = Cost of The Asset – Accumulated Depreciation

# Accumulated Depreciation = Annual Depreciation × No of years

 Depreciation – Straight-line method (Example 3.7, page 96)
Cost of machine = £ 78,124
Estimated residual value at the end of its useful life = £2,000
Estimated useful life = 4 years

STEP 1: Calculate the total amount to be depreciated =

£ 78,124 - £2,000 = £76,124

STEP 2: Calculate the annual depreciation:

£76,124 / 4 = £19,031

STEP 3: Calculate the residual value of the asset at the end of each year:
Residual value at the end of year 1: £ 78,124 - £19,031 = £ 59,093
Residual value at the end of year 2: £ 59,093- £19,031 = £ 40,062
Residual value at the end of year 3: £ 40,062- £19,031 = £ 21,031
Residual value at the end of year 4: £ 21,031- £19,031 = £ 2,000

Question: Can you calculate the residual value at the end of year 3 in a different way?
Uses and usefulness of the income statement
The income statement help in providing information on:
How effective the business has been in generating wealth
 Since wealth generation is the primary reason for most businesses to
exist.
How the profit was derived
 For some users, the only item of concern may be the final profit
figure.
 In addition, it helps to evaluate the business effectively by
discovering how the profit figure was derived. So, the level of sales
revenue, the nature and amount of expenses incurred, and the profit
in relation to sales revenue are important factors in understanding
the performance of the business over a period of time.

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Question:
The following information has been taken from ABC Company for the year
2014. Calculate gross profit for the year ended 31, December 2014.

Item Amount
Opening inventories $40,000
Purchases during the $70,000
year
Closing inventories $30,000
Sales revenue $120,000

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Question:
The following information relates to the activities H&S Retailers for the year
ended 31 December 2015
Prepare an income statement for the year ended 31 December 2015.
Motor Vehicle running
expenses $ 1,400 Heat and light $ 500
Closing inventories $ 7,000 Sales revenue $ 90,000
Motor vans – cost less
depreciation $ 20,000 Purchases $ 47,000
Annual depreciation – $ 2,000 Loan interest $ 450
motor vans expenses
Insurance $ 700 Salaries and wages $ 10,500
Balance at bank $15,000 Opening $ 6,000
inventories
Rent payable $ 6,000 Telephone and $ 400
postage
Question:
Activities of ABC company for the year ended 31 December 2015
£
Motor vehicle running expenses 3,000
Annual depreciation (motor vans) 1,500
Motor vans (cost less depreciation) 9,000
Loan interest 2,000
Heat and light 500
Salaries and wages 20,000
Telephone and postage 400
Sales revenue 90,000
Insurance 750
Rent payable 6,000
Balance at bank 17,000
Cost of sales 30,000
Prepare an income statement for the year ended 31 December
2015.
Question:
On January 1, 2015 ABC company acquired a new production equipment at a cost
of $165,000. The machine has an expected life of four years and estimated residual
value of $25,000. Calculate the book value of the machine at the end of 2015, 2016,
2017, and 2018.