ACCT 5011

Accounting for Management M

Topic 4
Financial Statements:
Income Statement &
Statement of Changes in
Equity

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LEARNING OBJECTIVES
1. Understand the purpose and presentation format of
income statement;
2. Understand the basic accounting concepts in preparing
income statement;
3. Understand the definition, recognition and
classification of “income” and “expense”;
4. Understand the alternative financial performance
measures;
5. Understand the nature of the statement of changes in
equity;
6. Be able to describe the relationship between financial
statements.

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 INCOME STATEMENT
 Reflects the accounting return
(profit/loss) for the entity over a specified
time period
 Calculates the difference between total
income and total expenses (i.e. P/L = I – E)
 Assists users to evaluate past decisions and
revise future predictions

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THE FORMAT OF INCOME
STATEMENT
Income
(e.g. sales, fees)
Less Expenses
(e.g. wages, rent, electricity, gas)
= Net Profit (or loss)

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FORMAT FOR REPORTING ENTITIES
The appearance of the income statement differs
depending on whether:
 the preparing entity is a reporting entity (i.e. an
entity with external users who rely on the
financial reports for decision making).
 The accounting standard specifies the form and
content of the income statement for reporting
entities (e.g. must show interest, tax, etc.)
 There is no prescribed reporting format for non-
reporting entities.
 Reporting entities must disclose any item that is
material (i.e. an item could influence a decision by
users)
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FORMAT FOR REPORTING ENTITIES
 Reporting entities must prepare a statement
of comprehensive income (i.e. income
&expenses in determining profit + other
comprehensive income)
 Other comprehensive income - all changes in
equity during the reporting period other than
those resulting from transactions with owners
as owners equity (such as dividends and capital
contributions) – e.g. revaluation reserve;
foreign currency translation differences

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FORMAT FOR REPORTING ENTITIES
 Reporting entities can either present all items
in a single statement of comprehensive income
or in two separate statements as
 (1)An income statement showing the income
and expenses associated with the
determination of profit/loss for the
reporting period;
 (2)A statement beginning with profit/loss
and displaying components of other
comprehensive income.

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ACCRUAL ACCOUNTING CONCEPTS
 The Income Statement is prepared using
accrual accounting (i.e. income is
recognised when it is earned and expenses
when they are incurred)

 In contrast, under cash accounting,

income is recognised when cash is received
and expenses when cash is paid

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ACCRUAL ACCOUNTING EXAMPLES
Accrued income (income)
The entity sold goods to a client and the client was
invoiced $5,000 on 30 June. Cash not received.
30 June Accounts receivable increase 5,000
Sales revenue increase 5,000

When cash is received:

Cash increase 5,000
Accounts receivable decrease 5,000

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ACCRUAL ACCOUNTING EXAMPLES
Accrued expense (liability)
The entity used electricity for a month. At the end
of the month, it has not received or paid the
electricity bill, but the electricity charge is
estimated to be $1,000.
Electricity expense increase 1,000
Expenses payable increase 1,000
(or Accrued expenses)
When cash is paid,
Expenses payable decrease 1,000
Cash decrease 1,000
(What if the bill shows $1,200? or $800?)

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 ACCRUAL ACCOUNTING EXAMPLES
Unearned income/income received in advance
(liability)
The entity received cash payment of $3,000 for
the service to be provided in two weeks.
Cash increase 3,000
unearned income increase 3,000

When the service is rendered in two weeks,

Unearned income decrease 3,000
Service revenue increase 3,000

(what if 50% of the service is provided in two weeks?)

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 ACCRUAL ACCOUNTING EXAMPLES
Prepayment/prepaid expense (Asset)
The entity paid a 24-month insurance of $600 on 1 Jan 2015
Option 1: insurance is initially treated as an expense
1 Jan. 2015 Insurance expense increase 600
Cash decrease 600
30 Jun. 2015 Prepaid insurance increase 450
Insurance expense decrease 450
Option 2: insurance is initially treated as an asset
1 Jan. 2015 Prepaid insurance increase 600
Cash decrease 600
30 Jun.2015 Insurance expense increase 150
Prepaid insurance decrease 150
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 ACCRUAL ACCOUNTING EXAMPLES
Consumption of current asset (expense)
The entity purchased office supplies of $800 on cash on 1
July 2014. A physical count revealed that office
supplies as at 30 June 2015 was $325.
1 Jul. 2014 Office supplies increase 800
Cash decrease 800
30 Jun. 2015 Office supplies expense increase 475
Office supplies decrease 475

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 ACCRUAL ACCOUNTING EXAMPLES
Depreciation (amortisation) of tangible (intangible)
non-current assets (expense)
The entity purchased office equipment at a cost of $20,000
on 1 Jan. 2014, with zero residual value and 20 years
useful life. Straight-line depreciation method is applied.
1 Jan. 2014 Office equipment increase 20,000
Cash decrease 20,000
30 Jun. 2014 Depreciation expense increase 500
- office equipment
Accumulated depreciation increase 500
- office equipment
(calculation: annual depreciation = $20,000/20 = $1,000;
6 months depr. = $1000 x 6/12 = $500)

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 ACCRUAL ACCOUNTING EXAMPLES
Depreciation (amortisation) of tangible (intangible)
assets (expense)

30 Jun. 2015 Depreciation expense increase 1,000

- office equipment
Accumulated depreciation increase 1,000
- office equipment

Balance sheet as at 30 June 2015 shows:

Office equipment(cost) $20,000
Less Accumulated Depreciation $1,500 $18,500

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ACCOUNTING POLICY CHOICES AND ESTIMATES

 Accounting policy allows choices and

estimations (e.g. use different ways to
depreciate assets, estimate allowance for
doubtful debts, etc.)
 Earnings management – managers can use
accounting discretion via accounting policy
choices and/or estimations to portray a
desired level of earnings

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ACCOUNTING POLICY CHOICES AND ESTIMATES –
CONT.

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ACCOUNTING POLICY CHOICES AND ESTIMATES –
CONT.

Examples of Examples of
accounting policy choices accounting estimates
• Method of asset • Useful life of
depreciation depreciable assets
• Method of valuing • Residual value used in
property, plant and depreciation calculations
equipment • Allowance for doubtful
debts
• Employee benefits (e.g.
sick leave, long service
leave)

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ACCOUNTING POLICY CHOICES AND ESTIMATES –
CONT.

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 XEROX REVENUE RECOGNITION FRAUD
• Global document technology
corporation
• Environmental responsibility - Lease
and take back
• Income from equipment (photocopiers) lease
• Lease income recognised was actually future
income (i.e. unearned income)
• Improperly classified over $6 billion (future)
revenue leading to an overstatement of profit
by nearly $2 billion
• 10 million fine by SEC
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 INTERESTING READING

Jackson, S., Liu, X. and Cecchini, M. (2009)

“Economic consequences of firms’ depreciation
method choice: Evidence from capital
investments”, Journal of Accounting and
Economics, 48 pp. 54–68

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MEASURE FINANCIAL PERFORMANCE
 To measure profit, we must correctly identify
and measure ALL income and expense items.

 Matching principle – matching the income

earned with the expenses incurred in a
reporting period (e.g. recognise sales/service
revenue and expenses associated with such
sales/service concurrently)

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 DEFINITION OF INCOME
Under the Framework Income is
defined as:
‘Increases in economic benefits during
the reporting period in the form of
inflows or enhancements of assets or
decreases in liabilities that result in
increases in equity, other than those
relating to contributions from equity
participants’

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CLASSIFICATION OF INCOME
Income includes
 revenue arising in the ordinary course
of activities, e.g.
 providing goods and services (sales, fees, etc.)
 investing or lending (dividends, interest, etc.)
 receiving contributions from parties other than
owners (government grants, etc.)
 Gains, e.g. proceeds from disposal of non-
current assets

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DEFINITION OF EXPENSES
Under the Framework Expenses are
defined as:
‘ Decreases in economic benefits during
the reporting period in the form of
outflows or depletions in assets or
incurrences of liabilities that result in
decreases in equity’, other than those
relating to distributions to equity
participants.’

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CLASSIFICATION OF EXPENSES
 Smaller entities often simply list all
their expenses;
 Larger entities often classify their
expenses by nature (e.g. employee
benefits expenses, depreciation
expenses, etc.) or by function (e.g.
distribution expenses, marketing
expenses, administrative expenses,
etc.).
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EXAMPLES OF CLASSIFICATION BY NATURE

 Cost of goods sold/Cost of sales (COS)

 Beginning inventory + net purchases – ending inventory
 Wages and salaries
 Depreciation expense
 Tax expense
 Interest expense, etc.

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RECOGNITION OF INCOME &
EXPENSES
 Income recognition or Expense
recognition means that the income or
expense is recorded and appears in the
income statement.
 The factors to consider when making a
recognition decision, framed in terms of
whether an asset or liability is recognised
are uncertainty, probability and
measurement uncertainty.

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PROFIT (EARNINGS) CAN BE MEASURED AT
VARIOUS LEVELS

Alternative measures include:

 Gross profit – i.e. revenue less cost of sales

 Net profit – i.e. gross profit less all other

expenses incurred in operating the business
(Earnings after tax and interest)
 Earnings (profit) pre and post tax

 Earnings (profit) pre and post interest

 Earnings before interest and tax (EBIT)

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THE STATEMENT OF CHANGES IN EQUITY
 Required by all reporting entities
 The statement details the changes in
equity from the beginning to the end of
the reporting period:
Owner’s equityt+1= Owner’s equityt + Profit
– profit distribution
+ equity contribution
– equity withdrawal

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AN EXAMPLE OF THE STATEMENT OF CHANGES IN EQUITY
– SMALL BUSINESS

AAA business
Statement of Changes in Equity for the year ended 30 June 201X

Equity at the beginning of the year $66,300

Capital contributions by owner 24,000
Profit 2,300 26,300
92,600
Drawings by owner (10,000)
Equity as at 30 June 201X $82,600

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AN EXAMPLE OF THE STATEMENT OF CHANGES IN EQUITY
XYZ Ltd
Statement of Changes in Equity for the year ended 30 June 201X

Share Capital
at beginning of the year 320 000
Issued share 100 000
Total share capital 420 000  Balance Sheet
Retained earnings
Balance at beginning of the year 132 400
Profit for the period 29 400  Income statement
Dividends paid (4 000)
Transfer to general reserve (4 000)
Balance at end of the year 153 800  Balance Sheet
Reserves
General reserve
Balance at the beginning of the year 2 000
Transfer from retained earnings 4 000
Balance at the end of the year 6 000
Asset revaluation reserve
Balance at beginning of the year 100 000
Revaluation of property 20 000
Balance at end of the year 120 000
Total reserves at end of the year 126 000  Balance Sheet
Total equity 699 800  Balance Sheet
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LINK BETWEEN INCOME STATEMENT, STATEMENT
OF CHANGES IN EQUITY AND BALANCE SHEET
 The Income Statement presents the
profit (or loss) made by the entity over
the accounting or reporting period.
 The Statement of Changes in equity
explains the changes in equity from the
beginning to end of the reporting period
 The Balance Sheet shows the financial
position (assets, liability, equity) of the
entity as at the end of the reporting
period.
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LINK BETWEEN INCOME STATEMENT, STATEMENT
OF CHANGES IN EQUITY AND BALANCE SHEET
 The profit (loss) for the reporting period is
added to the retained profits as at the start
of the period.
 The entity can make distributions from (i.e.
dividends) and transfers to/from retained
profits (e.g. transfer to/from reserve).
 The balances of the retained profits, as well as
other equity items in the statement of changes
in equity as at the end of the reporting period
are included as equity items in the Balance
Sheet.
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 Next Topic:

Cash Flow Statements

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