M B A

F I N A N C I A L
A C C O U N T I N G
DR. HADY OMAR
 CHAPTER 3

MEASURING
AND REPORTING
FINANCIAL
PERFORMANCE
LEARNING OUTCOMES
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
Arsenal’s revenue for the year ended 31 May 2015

Property Player
development trading Gate and other
4% 1% match day revenues
Commercial 29%
23%

Retail
7%

Broadcasting
36%
 Measuring profit

Profit Total revenue for the period

(or loss) = less
for the Total expenses incurred in generating that revenue
period
Reasons for Profit Measurement
• Measure performance
• Decide on dividend policy
• Decide on performance related pay
• Measure efficiency
• Measure effectiveness
• Assess the financial strength of company
• As a guide for taxation
• For pricing decisions
• Employees for career planning purposes
Functions of Profit Measurement
Profit figures are useful for several reasons:
• As a guide for dividend decisions
• Generally more profit, more dividend
• Dividends paid out of profit; capital is maintained
• To indicate cash generated
• Profit and cash flow are not the same thing
• Eventually profit does turn into cash
• How successful has management been?
• Aim of financial management is to maximize shareholders
wealth
Functions of profit measurement
• As a basis for taxation
• To guide investors in deciding to buy or sell shares
• Investors are main users of financial statements
• Profit performance provides some information about future
performance
• To guide creditors
• Mainly interested in liquidity
• Profit as an indicator of survival (Z-scores)
• Guide of economic efficiency
• Efficiency is the input/output relationship
• Effectiveness is the achievement of objectives
Relationship between the income statement and the
statement of financial position

+ Profit
Assets = Equity
(−) (Loss)
+ Liabilities

The above equation can be extended to:

Assets = Equity + Sales

revenu
− Expenses + Liabilities
e
 The income statement: terminology and format
• Summarises financial performance for a defined period
• How well the organization has used its resources to make profit
• Shows Revenue, Expenses and Profit (or Loss)
• Revenues minus Expenses = Profit
• Revenue: sales, turnover
• Expenses: costs
• Profit is not the same as cash receipts
Statement of changes in equity

• Shows how equity has changed during the year

• Equity increases by amount of profit
• Equity decreases from payment of dividends
• Equity increases through revaluations
The layout of the income statement

Sales revenue
less
Cost of sales
equals
Gross profit
less
Operating expenses
equals
Operating profit
less
Interest payable
plus
Interest receivable
equals
Profit for the period
Income statement under IAS1
 Better-Price Stores
Income statement for the year ended 30 June 2016
£
Sales revenue 232,000
Cost of sales (154,000)
Gross profit 78,000
Salaries and wages (24,500)
Rent (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)
Profit for the period 25,500
 Structure of an Income Statement for a
Trading Company

• Part 1: Shows the calculation for Gross Profit

• Sales minus Cost of Goods Sold

• Part 2: Shows Operating Profit or how much has been made from normal
operations

• Part 3: Shows the calculation for Net Profit before Taxation after deductions
for finance costs

• Part 4: Shows Profit after Taxation which can be used to determine dividends
to be paid to shareholders
Gross Profit and Cost of Sales
What is gross profit?
Gross profit is the excess of sales revenue over the cost
of goods sold in the period.
Note – where the cost of goods sold is greater than the
sales revenue, the result is a gross loss.
The formula is
Sales − Cost of goods sold = Gross profit
How to draw up a trading account
Step 1 – Identify the balance on all accounts and draw up the trial
balance.
Step 2 – Obtain the closing inventory figure by valuing the inventory
at the end of the year.
Step 3 – Calculate the cost of goods sold using the formula:
Opening inventory
+ Purchases
− Closing inventory
= Cost of goods sold
How to draw up a trading account
(Continued)
Step 4 – Calculate the gross profit using the
formula:
Sales
− Cost of goods sold
= Gross profit
Step 5 – Close the accounts that should appear in
the trading account by transferring their
balances to that account.
Calculating gross profit for Better-Price Stores

£ £

Sales revenue 232,000

Cost of sales:

Opening inventories 40,000

Purchases (goods bought) 189,000

Closing inventories (75,000) (154,000)

Gross profit 78,000

 Activity, using Exhibit 14.1
Step 1 – completed.
Step 2 – assume the value of closing inventory is £3,000.
Step 3 – Cost of goods sold calculation
Opening inventory 0
+ Purchases 29,000
− Closing inventory (3,000)
Cost of goods sold 26,000
 Activity, using Exhibit 14.1 (Continued)
Step 4 – Gross profit calculation
Sales 38,500
− Cost of goods sold (26,000)
Gross profit 12,500
Drawing up the income statement

• The figures from the trading account and profit and

loss account will now be entered into the income
statement
What is meant by “Revenue”

• Sales: How much has been earned for goods sold during the
period
• Sales revenue; Turnover
• Income for services (rent revenue; fees; subscriptions etc.)
during the period

• Underlying principle : “Realization concept”

• Has the service been provided during the period

• cash may be received earlier or later
• service provision capable of yielding cash
• sales includes “credit sales”
Profit measurement and the recognition of 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

Additional criterion is to be applied where

the revenue comes from the sale of goods:

Ownership and control of the items

should pass to the buyer
Other income
• Profit on sales of non-current
assets
• Investment income
• Interest receivables
What about “Expenses”?

• Accruals concept
• An expense is not the same as the amount of cash spent
• Matching concept
• Expenses are amounts used in providing the sale or service
during the period
• Trading businesses have significant expenses “Cost of Sales“ or
“Cost of Goods Sold” expenses
• Cost of goods used up in making the sale
 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 £1,000
 Accounting for rent payable

Income statement

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

Prepaid expense £4,000

Accounting conventions and the income statement

Materiality

Accruals
Profit measurement and the calculation of depreciation

To calculate a depreciation charge for a

period, four factors have to be considered:

The cost (or fair value) of the asset

The useful life of the asset

Residual value (disposal value)

Depreciation methods
Plant Assets
Tangible in Nature

Actively Used in Operations

Expected to Benefit Future Periods

Called Property, Plant, & Equipment

Plant Assets
Cost Determination
Purchase All expenditures
price needed to
prepare the
Acquisition asset for its
Cost intended use

Acquisition cost excludes

financing charges and
cash discounts
Land
Title insurance premiums
Purchase Delinquent
price taxes

Real estate Surveying

commissions fees

Title search and transfer fees

Land is not depreciable.

Land Improvements

Parking lots, driveways, fences, walks, shrubs,

and lighting systems.

Depreciate
over useful life of
improvements.
Buildings
Cost of purchase or Title fees
construction

Brokerage Attorney fees

fees

Taxes
Machinery and Equipment

Purchase
price Taxes

Transportation
charges

Installing,
assembling, and Insurance while
testing in transit
Depreciation

Depreciation is the process of allocating the cost

of a plant asset to expense in the accounting
periods benefiting from its use.

Balance Sheet Income Statement

Acquisition Cost
Expense
Cost Allocation
(Unused) (Used)
Factors in Computing Depreciation

The calculation of depreciation requires

three amounts for each asset:
1. Cost
2. Salvage Value
3. Useful Life
Depreciation Methods
1. Straight-line
2. Units-of-production
3. Declining-balance
Asset we will depreciate in future screens
Straight-Line Method
 Straight-Line Method

For year ended December 31 As of December 31

Balance Sheet Presentation

Machinery $ 10,000
Less: accumulated depreciation 3,600 $ 6,400
Straight-Line Depreciation Schedule
Units-of-Production Method
Step 1:
Depreciation = Cost - Salvage Value
Per Unit Total Units of Production

Step 2:
Number of Units
Depreciation Depreciation × Produced
=
Expense Per Unit in the Period
 Units-of-Production Method
Assume that 7,000 units were
inspected during 2011.
Depreciation would be
calculated as follows:
Step 1: Cost - Salvage Value
Depreciation
Per Unit = Total Units of Production
=
$9,000
36,000 = $0.25/unit
Step 2:
Number of Units
Depreciation Depreciation = $0.25 × 7,000 = $1,750
×
Produced
Expense = Per Unit in the Period
Units-of-Production
Depreciation Schedule

Units produced and sold during the period.

Double-Declining-Balance Method
Double-Declining-Balance Method
Comparing Depreciation Methods
Double-
Straight- Units of Declining-
Period Line Production Balance
2011 $ 1,800 $ 1,750 $ 4,000
2012 1,800 2,000 2,400
2013 1,800 2,250 1,440
2014 1,800 1,750 864
2015 1,800 1,250 296
Totals $ 9,000 $ 9,000 $ 9,000

$4,000
$3,500
$3,000
$2,500
$2,000
$1,500
$1,000
$500
$-
2011 2012 2013 2014 2015

Straight-Line Units-of-Production Double-Declining-Balance

Graph of carrying amount against time using
the straight-line method
80

Carrying amount (£000)

60

40

20

0 1 2 3 4
Asset life (years)
 Straight-line method – an example

Cost of machine £78,124

Estimated residual value £2,000

Estimated useful life 4 years

£76,124 = £19,031
Annual depreciation charge =
4
 Reducing-balance method

Deriving the fixed percentage

n
P = (1− R/C × 100%)

Where:
P = the depreciation percentage
n = the useful life of the asset (in years)
R = the residual value of the asset
C = the cost, or fair value, of the asset
Graph of carrying amount against time using the
reducing-balance method
80

Carrying amount (£000)

60

40

20

0 1 2 3 4
Asset life (years)
 The reducing-balance method – an example

£
Cost of machine 78,124
Year 1 depreciation expense (60%* of cost) (46,874)
Carrying amount 31,250
Year 2 depreciation expense (60% of carrying (18,750)
amount)
Carrying amount 12,500
Year 3 depreciation expense (60% of carrying (7,500)
amount)
Carrying amount
5,000
Year 4 depreciation expense (60% of carrying (3,000)
amount)
Residual value
2,000
Calculating the annual depreciation expense

Cost (fair value)

less

Residual value
equals

Depreciable amount

Year 1 Year 2 Year 3 Year 4

Depreciation Depreciation Depreciation Depreciation

Asset life (Number of years)

Change in Estimates for Depreciation
Predicted Predicted
salvage value useful life

Depreciation
is an estimate

Over the life of an asset, new information may

come to light that indicates the original estimates
were inaccurate.
Change in Estimates for Depreciation
Let’s look at our machinery from the previous examples and
assume that at the beginning of the asset’s third year, its
book value is $6,400 ($10,000 cost less $3,600 accumulated
depreciation using straight-line depreciation). At that time, it
is determined that the machinery will have a remaining useful
life of 4 years, and the estimated salvage value will be revised
downward from $1,000 to $400.
Revenue and Capital Expenditures
Type of Capital or
Expenditure Revenue Identifying Characteristics
1. Maintains normal operating condition.
Ordinary 2. Does not increase productivity.
Revenue
Repairs 3. Does not extend life beyond original
estimate.
Betterments 1. Major overhauls or partial
and replacements.
Extraordinary Capital
Repairs 2. Extends life beyond original estimate.
Revenue and Capital Expenditures
Type of Capital or
Expenditure Revenue Identifying Characteristics
1. Maintains normal operating condition.
Ordinary 2. Does not increase productivity.
Revenue
Repairs 3. Does not extend life beyond original
estimate.
Betterments 1. Major overhauls or partial
and replacements.
Extraordinary Capital
Repairs 2. Extends life beyond original estimate.
Natural Resources
Total cost,
Extracted from
including
the natural
exploration and
environment
development,
and reported
is charged to
at cost less
depletion expense
accumulated
over periods
depletion.
benefited.

Examples: oil, coal, gold

Cost Determination and Depletion
Let’s consider a mineral deposit with an estimated 250,000 tons
of available ore. It is purchased for $500,000, and we expect
zero salvage value.
Depletion of Natural Resources
Depletion expense in the first year would be:

Balance Sheet presentation of natural resources:

Plant Assets Used in Extracting

Specialized plant assets may be required to

extract the natural resource.
These assets are recorded in a separate account
and depreciated.
Intangible Assets
Noncurrent assets Often provide
without physical exclusive rights
substance. or privileges.

Intangible
Assets

Useful life is Usually acquired

often difficult for operational
to determine. use.
Cost Determination and Amortization

Record at current
o Patents
cash equivalent
cost, including o Copyrights
purchase price, o Leaseholds
legal fees, and o Leasehold Improvements
filing fees.
o Franchises and Licenses
o Goodwill
o Trademarks and Trade Names
o Other Intangibles
Profit measurement and inventory costing methods

Common assumptions used are:

First in, first out (FIFO)

Last in, first out (LIFO)

Weighted average cost (AVCO)

Determining Inventory Items
Merchandise inventory includes all goods that a
company owns and holds for sale, regardless of where
the goods are located when inventory is counted.

Items requiring special attention include:

Goods
Goods in
Damaged or
Transit
Goods on Obsolete
Consignment
Goods in Transit
FOB Shipping Point
Public
Carrier

Seller Buyer

Ownership passes
to the buyer here.

Public
Carrier

Seller FOB Destination Point Buyer

Goods on Consignment
Merchandise is included in the inventory of the
consignor, the owner of the inventory.
Thanks for selling my
inventory in your
store.
Consignee

Consignor
Goods Damaged or Obsolete
Damaged or obsolete goods are not counted in
inventory if they cannot be sold.

Cost should be reduced to net realizable

value if they can be sold.
Determining Inventory Costs
Include all expenditures necessary to bring an item to a
salable condition and location.

Minus Invoice Plus

Discounts and Insurance
Allowances Cost

Plus Import Plus

Duties Plus Storage
Freight
 Internal Controls and Taking a
Physical Count
➢When the physical count
➢Most companies take a does not match the
physical count of Merchandise Inventory
inventory at least once account, an adjustment
each year. must be made.

Good internal controls over count include:

1. Pre-numbered inventory tickets.
2. Counters have no inventory responsibility.
3. Counts confirm existence, amount, and
quality of inventory item.
4. Second count is taken.
5. Manager confirms all items counted.
Inventory Costing under
a Perpetual System
Inventory
affects . . .
Balance Income
Sheet Statement

The matching
principle requires
matching costs
with sales.
Inventory Cost Flow Assumptions
Management decisions in accounting for inventory
involve the following:
1. Items included in inventory and their costs.
2. Costing method (specific identification, FIFO, LIFO,
or weighted average).
3. Inventory system (perpetual or periodic).
4. Use of market values or other estimates.
Inventory Cost Flow Assumptions
First-In, First-Out Assumes costs flow in the order
(FIFO) incurred.

Last-In, First-Out Assumes costs flow in the

(LIFO) reverse order incurred.

Weighted Assumes costs flow at an

Average average of the costs available.
Inventory Costing Illustration
Here is information about the mountain bike inventory of Trekking
for the month of August.
First-In, First-Out (FIFO)
Oldest Cost of Goods
Costs Sold

Recent Ending
Costs Inventory
First-In, First-Out (FIFO)
First-In, First-Out (FIFO)
Last-In, First-Out (LIFO)
Recent Cost of Goods
Costs Sold

Oldest Ending
Costs Inventory
Last-In, First-Out (LIFO)
Last-In, First-Out (LIFO)
Weighted Average

When a unit is sold, the average cost of each

unit in inventory is assigned to cost of goods
sold.
Units on hand
Cost of Goods
Available for Sale ÷ on the date of
sale
Weighted Average
Weighted Average
Weighted Average
Financial Statement Effects
of Costing Methods
Because prices change, inventory methods nearly always
assign different cost amounts.
Financial Statement Effects
of Costing Methods

Advantages of Methods

Weighted First-In, First- Last-In, First-

Average Out Out

Ending inventory Better matches

Smoothes out approximates current costs in cost
price changes. current replacement of goods sold with
cost. revenues.
Consistency in Using Costing Methods

The consistency principle requires a company

to use the same accounting methods period
after period so that financial statements are
comparable across periods.
Lower of Cost or Market
Inventory must be reported at market value
when market is lower than cost.

Defined as current Can be applied three ways:

(1) separately to each
replacement cost (not
individual item.
sales price).
(2) to major categories of
Consistent with assets.
the conservatism (3) to the whole inventory.
principle.
Lower of Cost or Market
A motor sports retailer has the following items
in inventory:
Per Unit
Units on Total
Inventory Items Hand Cost Market Total Cost Market
Cycles:
Roadster 20 $ 8,000 $ 7,000 $ 160,000 $ 140,000
Sprint 10 5,000 6,000 50,000 60,000
Off-Road
Trax-4 8 5,000 6,500 40,000 52,000
Blazer 5 9,000 7,000 45,000 35,000
Totals $ 295,000
Lower of Cost or Market
Here is how to compute lower of cost or market
for individual inventory items.
LCM Applied
to
Units on Total
Inventory Items Hand Total Cost Market Items
Cycles:
Roadster 20 $ 160,000 $ 140,000 $ 140,000
Sprint 10 50,000 60,000 50,000
Off-Road
Trax-4 8 $ 40,000 $ 52,000 40,000
Blazer 5 45,000 35,000 35,000
Totals $ 295,000 $ 265,000
 Financial Statement Effects of Inventory Errors

Income Statement Effects

Inventory Error Cost of Goods Sold Net Income
Understate ending inventory Overstated Understated
Understate beginning inventory Understated Overstated
Overstate ending inventory Understated Overstated
Overstate beginning inventory Overstated Understated
 Financial Statement Effects of Inventory Errors

Balance Sheet Effects

Inventory Error Assets Equity
Understate ending inventory Understated Understated
Overstate ending inventory Overstated Overstated
FIFO and LIFO treatment of the inventories in Example 3.8

Purchases 10,000 tonnes 20,000 tonnes

@ £10 per tonne @ £13 per tonne

9,000 tonnes
FIFO 21,000 tonnes
Cost of sales
Closing inventories
(inventories used)

9,000 tonnes
LIFO 21,000 tonnes
Cost of sales
Closing inventories
(inventories used)
Bad debts written off

Reduce trade receivables

Increase expenses
 Average bad debt loss percentage
for European businesses

4.0

3.5
3.0 3.1
2.8
3.0 2.7
2.6
Bad debt loss %
2.4
2.5
1.9 2.0 2.0 1.9 2.0
2.0

1.5

1.0

0.5

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Uses of the income statement

Helps in providing information on:

How effective the business has

been in generating wealth

How the profit was derived

Impairment of Goodwill
• Goodwill is the excess amount over net
assets that is paid for the purchase of a
business
Business A

Cash paid to buy £45m

Net Assets £30m

Goodwill £15m Recorded as a non

current asset

• Goodwill is recorded as a non-current

asset
• The value of goodwill is assessed yearly
• Impairment test
• Where value has declined an impairment
charge is recognized
Classification of expenses in published accounts

• Cost of sales
• Selling and administrative expenses
(salaries, training, telephone)
• Finance expenses (interest charges)
Subjective measures and creativity problems
• There is subjectivity in measuring profit and performance
• Grey areas include:
• Capital expenditures and revenue expenditures
• Depreciation
• Valuation of inventories
• Timing and recognition of revenue

• All impact on the level of reported profit

Role of income statements
• Measure financial performance
• Shows how and where profits might be increased
• Financial control
• Last year as compared to this year
• Actual as compared to budgets
• Monitoring
Limitations of income
statements
Limits on the use of income statements derive from:
• What explanations underpin performance ?
• Scope for creative accounting
• Different accounting policies
• Profit not the same as cash flows
Thank
You!