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)
for the
= less
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

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
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:

Sales
Assets = Equity + revenue
− Expenses + Liabilities
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 end
Cash £5,000

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
price expenditures
needed to
Acquisition prepare the
Cost asset for its
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
Depreciation Depreciation × Units 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 Produced = $0.25 × 7,000 = $1,750
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 amount) (18,750)
Carrying amount 12,500
Year 3 depreciation expense (60% of carrying amount) (7,500)
Carrying amount 5,000
Year 4 depreciation expense (60% of carrying amount) (3,000)
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 o Copyrights
cost, including
purchase price, o Leaseholds
legal fees, and filing o Leasehold Improvements
fees.
o Franchises and Licenses

o Goodwill

o Trademarks and Trade Names

o Other Intangibles
 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 o Copyrights
cost, including
purchase price, o Leaseholds
legal fees, and filing o Leasehold Improvements
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
Ø When the physical count
Ø 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, Last-In,

Average First-Out First-Out

Ending inventory Better matches

Smoothes out approximates current costs in cost
price changes. current of goods sold with
replacement 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
individual item.
(not 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
 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
individual item.
(not 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
 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
2.6 2.7
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)

 More detailed items

Group accounts
Performance of the company and its subsidiaries
Non-controlling interests
Part of profit due to minority interests
Associates and joint ventures
Percentage of profit earned in associates is shown
Dividends receivables
Receivable on small investments
Acquisitions, discontinued operations, continuing operations
Changes that have occurred in business operations
Segmented reporting
Aids in assessing performance of major categories of business
Exceptional items
One-off items
 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