MANG6079 Accounting and Control
Lecture 2
Topic 2 – Financial Statements
Topic 2.2 – Measuring and Reporting
Financial Performance
Topic 2.2 Learning Outcomes
After successfully completing Topic 2.2, you should:
•
be able to demonstrate knowledge and understanding of the:
2.2.1 Nature and purpose of an income statement;
2.2.2 Accounting conventions and adjustments underpinning an income statement;
2.2.3 Main recognition and measurement issues that must be considered when
preparing an income statement;
2.2.4 Usefulness and limitations of an income statement;
•
be able to:
2.2.5 Prepare an income statement from relevant financial information and interpret
the information that it contains; and
2.2.6 Properly apply the relevant accounting conventions and adjustments in
preparing an income statement.
2
Topic 2.2 Study Activities
No.
Name
Format/Resource
Purpose
Study
Wk
Panopto video
(Micro Lecture)
Watch, Listen
2
2.2
Measuring and recognising revenue
2.3
Measuring and recognising expenses
“
“
2
2.4
Accounting conventions for an income
statement
“
“
2
Profit measurement and end-of-year
accounting adjustments
“
“
2
YouTube video
“
2
2.5
(a, b, c)
2.6
Usefulness and limitations of an income
statement
2.7
Topic 2 Review Questions
Questions
Practice, Discuss
2&3
2.8
Topics 2 Practice Questions [Income
Statement & Statement of Financial
Position]
Questions
Collaborate,
Practice
3
3
Topic 2.2 Essential |Recommended Reading List
Textbook chapters:
1. Atrill and McLaney (2019)
• Chapter 3, 4
2. Weetman (2019)
• Chapter 2, 3, 4, 5, 6
4
Study Activity 2.2
Name
Measuring and recognising revenue – Based on IFRS 15
Format
Video (Micro Lecture)
Purpose
Watch, Listen
Resource
Panopto video - micro lecture
5
Concepts of measurement and recognition
in financial accounting
• Measurement:
–
–
–
An act or process or system or model of quantifying, in monetary value, the elements of financial
statements. For example:
Historical cost: amount paid/incurred for an asset or agreed for a liability on the date the transaction
first occurs.
Fair value: price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date.
• Recognition:
–
–
An act or a process or a model of identifying items/elements to be included in a financial statement.
Occurs when the elements such as revenue, expenses, assets, liabilities and equity are brought into
the financial statements.
• More on measurement and recognition principles and adjustments underpinning an income
statement is covered in:
– Accounting conventions and adjustments underpinning the income statement.
6
Relationship between the income statement
and the statement of financial position
Assets
=
Accounting
Equation
+
Equity
Liabilities
The accounting equation can be extended to:
Assets
Assets
=
=
Equity
Equity
+
(−)
+
Profit
(Loss)
Sales
revenue
+
Liabilities
− Expenses +
Liabilities
7
Measuring business profit
Profit
(or loss)
for the
period
=
Total revenue for the period
−
Total expenses incurred in generating that revenue
Revenue: Definition and Forms
• Revenue:
– Also known as turnover
–
–
A measure of the inflow of assets, or a reduction in liabilities, arising as a result of
trading (ordinary) operations of a business.
Increase in the ownership interest (i.e. increase in net assets).
• Forms of revenue:
–
–
–
–
Sales of goods (e.g., by a manufacturer);
Fees for services (e.g., of a solicitor);
Subscriptions (e.g., of a club); and
Interest received (e.g., on an investment fund).
8
Example 1 – Recognising Revenue
A manufacturer produces and sells a standard product on credit, which is
transported to customers using the manufacturer’s delivery vans.
Managers believe there are four points in the production/selling cycle at
which revenue might be recognised:
1. when the goods are produced;
2. when an order is received from a customer;
3. when the goods are passed to, and accepted by, the customer; and
4. when the cash is received from the customer.
Required:
At which of these points do you think the manufacturer should
recognise revenue? (Before continuing to watch the video, please
answer this question as a quiz)
9
Example 2 – Recognising revenue over time – Answer
Control of goods or services may be transferred to a customer over time rather than as a
single ‘one-off’ event.
Required:
(a) Can you think of, and write down, two examples of where this situation may arise?
(b) In the situations you have identified in (a), how will the revenue be recognised in
your business income statement?
-
=================================================================
(a) This situation may arise where:
– the customer enjoys the benefits as the business performs its obligations –
e.g., service contracts, such an accounting firm undertakes employee
payroll services for a large business;
– the business creates, or improves, an asset held by the customer – e.g.,
building contracts, such as a builder undertakes the refurbishment of a shop
owned by a retailer;
– the business creates an asset with no alternative use and the customer has
agreed to pay for work carried out – e.g., special orders, an engineering
business produces specially designed equipment for a manufacturer.
(b) In this case – the total revenue will be spread (recognised) across the
reporting periods covered by the contract.
10
Revenue Measurement & Recognition
Revenue – the amount agreed for the
transfer of goods/services
Recognition – when control of the
goods/services passes to the customer
11
Study Activity 2.3
Name
Measuring and recognising expenses
Format
Video (Micro Lecture)
Purpose
Watch, Listen
Resource
Panopto video - micro lecture
12
Expenses: Definition and Forms
• Expenses:
– A measure of the outflow of assets, or an increase in liabilities, arising as a result of
trading (ordinary) operations of a business.
– Decrease in the ownership interest (i.e. decrease in net assets).
– Cost of providing services and supplying goods to a customer
• Typical forms business expenses:
– Cost of premises: rental, business rates, insurance, etc.
– Selling and distribution costs: haulage, delivery services, sales staff salaries and
commission.
– Administration costs: phone, stationery, administrative staff salaries, computer costs.
– Finance costs: bank charges, interest.
13
Accounting conventions and adjustments
underpinning the income statement
• Accounting conventions for an income statement
– Matching convention: Accruals & prepayments
– Materiality convention
– Accruals convention: Profit, cash and accruals accounting
• Profit measurement and end-of-year accounting adjustments
– Accruals & prepayments
– Depreciation
– Bad debts write-off & provision for doubtful debts
– Inventory movements & costing
– Measuring cost of sales (goods sold) & gross profit
14
Name
Format
Study Activity 2.4
Accounting conventions for an income statement
Video (Micro Lecture)
Purpose
Resource
Watch, Listen
Panopto video - micro lecture
15
Accounting conventions and the income statement
Matching
Materiality
Accruals
16
Matching & Accruals Conventions
• Matching:
– Revenue and expenses must be matched with each:
▪ Revenue is matched up with the expenditure that gives rise to the revenue.
– Effects of transactions and other events:
▪ Are recognised when they occur (i.e. amount is agreed & control passes to customer) and not
as cash/its equivalent is received/paid.
▪ e.g. Credit sales are recognized when goods are dispatched (which may be several weeks
before cash is received).
• Accruals:
– Profit is the excess of revenue over expenses, not the excess of cash receipts over cash
payments.
– Net profit for an accounting period ≠ Net cash generated during the same period.
– Accruals accounting system (v/s Cash accounting system).
17
Accrued expenses: Expense incurred for the period
is more than the cash paid during the period
Income statement
Statement
of cash
flows
Sales commission
expense
£6,000
Cash £5,000
Accrual expenses £1,000
Statement
of financial
position
at year
end
Atrill and McLaney (2019, p. 84, Figure 3.3 – Accounting for sales commission)
18
Prepaid expenses: Cash paid during the period is
more than the full expense incurred for the period
Income statement
Statement
of cash
flows
Rent payable expense
£16,000
Cash £20,000
Prepaid expense £4,000
Statement
of financial
position at
year end
Atrill and McLaney (2019, p. 87, Figure 3.4 – Accounting for rent payable)
19
Materiality Convention
• In practice, the treatment of accruals and prepayments is subject to the
materiality convention.
– Where the amounts involved are trivial, we should consider only what is
expedient/convenient/practical.
– Treating an item as an expense in the period in which it is first recorded, rather
than strictly matching it to the revenue to which it relates.
– e.g., a large business, at the end of a reporting period holds £2 worth of unused
stationery.
▪ The time and effort taken to record this as a prepayment would outweigh
the negligible effect on the measurement of profit or financial position.
▪ Treated as an expense rather than an asset (prepaid expense)
20
Profit Measurement and
End of Year Accounting Adjustments
Accruals and Prepayments
Depreciation
Bad debts write-off &
provision for doubtful debts
Inventory movements & costing methods
Measuring cost of sales (goods sold) &
gross profit
21
Name
Study Activity 2.5 (a)
Profit measurement and end-of-year accounting
adjustments
Format
Video (Micro Lecture)
Purpose Watch, Listen
Resource Panopto video - micro lecture 2.5(a) - Depreciation
22
Depreciation
• Let’s buy a van for our business:
o Cost £20,000.
o Expected useful life 4 years.
o Estimated book value at end of 4 years £5,000.
Non-current asset
• Briefly, try to discuss/answer the following questions:
What should our income statement and balance sheet show?
Should we charge the £20,000 as an expense in the first year?
Surely the van will be helping to generate revenues over the four years, if we charge
£20,000 in the first year, is this a fair comparison of revenue and expenses?
? What if the cost was many millions, would your answers to the above questions be
different?
?
?
?
• As you discuss/answer the above questions, think about the following
accounting conventions:
– Historical (original) cost.
– Matching.
– Accruals.
23
Profit measurement and
the calculation of depreciation
• What is depreciation?
✓ Systematic allocation of the depreciable amount of an asset over its useful life.
✓ Depreciable amount is the cost of the asset less its residual value.
✓ Residual value is the estimated amount the entity would obtain from disposal of the asset.
• To calculate a depreciation charge (expense) 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
24
Depreciation Methods & Assumptions
• Straight-line method
▪
Assumes equal amount of an assets economic benefits are consumed
each year.
• Reducing/Declining balance method
▪
Assumes the asset provides greater benefits in the earlier years than in
the later years.
• Other methods includes:
▪
▪
▪
Double-declining balance method
Units-of-production method
Sum-of-years digits method
25
Example 1: Straight-line method
•
A business buys a van to be used in its operations:
o
o
o
•
Cost £20,000 (incurred on 1-1-20)
Expected useful life 4 years.
Estimated book value at end of 4 years £5,000.
Required: Use the above information and the SLM to determine the depreciation
charges and book values at the end of each of the four accounting years.
•
Workings & Solution: Depreciation expenses using SLM:
✓ SLM
= Depreciable Amount/Useful life
✓ Dep. Exp. = £20,000 – £5,000 = £3,750 per year
4 years
Expected Useful life
Cost (Van)
1-1-20
31-12-20
31-12-21
31-12-22
Balance Sheet
Impact of
Depreciation
on FS
Balance/
Account
£20,000
£5,000
Est. BV end of 4 years
Income Statement
31-12-23
£3,750
£3,750
£20,000
£20,000
£20,000
NCA (Van-Cost)
£3,750
£7,500
£11,250
£15,000
Accumulated
Depreciation
£16,250
£12,500
£8,750
£5,000
Net BV
£3,750
£20,000
£3,750
Dep. Expenses
26
Graph of carrying amount (net book value) against time
using the straight-line method
Carrying amount
20,000
16,250
12,500
8,750
5,000
0
1
2
3
4
Asset life (years)
Adapted - Atrill and McLaney (2019, p. 92, Figure 3.5)
27
Reducing-balance method
The formula for deriving the
fixed depreciation percentage:
P
=
n
(1 − R/C × 100%)
Where:
P = the depreciation percentage
n = the useful life of the asset (in years)
R = the estimated residual value of the asset
C = the cost, or fair value, of the asset
28
Example 2: Reducing-balance method (1)
The formula for deriving the
fixed depreciation percentage:
P
=
(1 −
4
5,000/20,000 × 100%)
Where:
P = the depreciation percentage = 29.3%
n = the useful life of the asset (in years) = 4
R = the estimated residual value of the asset = £5,000
C = the cost, or fair value, of the asset = £20,000
29
Example 2: Reducing-balance method (2)
£
Cost of Van (1-1-20)
20,000
Year 1 (31-12-20) depreciation expense (29.3% of cost)
(5,860)
Carrying amount (NBV) – 31-12-20
14,140
Year 2 depreciation expense (29.3% of NBV)
(4,143)
Carrying amount (NBV) – 31-12-21
Year 3 depreciation expense (29.3% of NBV)
Carrying amount (NBV) – 31-12-22
Year 4 depreciation expense (29.3% of NBV)
Estimated residual value (NBV) – 31-12-23
9,997
(2,929)
7,068
(2,071)
4,997
30
Graph of carrying amount (net book value) against time
using the reducing-balance method
Carrying amount
20,000
14,140
9,997
7,068
4,997 0
1
2
3
4
Asset life (years)
Adapted – Atrill and McLaney (2019, p. 93, Figure 3.6)
31
Calculating the annual depreciation expense - SUMMARY
Cost (or fair value)
less
Residual value
equals
Depreciable amount
Year 1
Depreciation
Year 2
Year 3
Year 4
Depreciation
Depreciation
Depreciation
Asset life (Number of years)
Atrill and McLaney (2019, p. 96, Figure 3.7)
32
Self Test 1
A business buys a machine for £100,000 on 1 January
2020. The estimated useful life of the machine is 5
years, and at the end of that period the machine can be
sold for £15 000.
Required: What is the annual depreciation charge for
each of the five years?
(i) Using the straight line method.
(ii) Using the reducing balance method.
33
Self Test 2
ABC Company Limited purchased a new vehicle on 1 April
2018 for £18,000. ABC intends to use the vehicle for three
years before disposing it at the estimated carrying amount
at the end of the third year. For this type of vehicles, the
company’s depreciation policy is to use the reducing
balance method to calculate depreciation expenses at an
annual rate of 25%.
Required: According to the company’s depreciation
policy:
(i) What is the annual depreciation expense for each of
the three years?
(ii) What is the estimated carrying amount (or residual
value) of the vehicle at the end of the third year?
34
Intangible Non-Current Assets and Amortization
• Amortization works in the same way as depreciation but is applied to
intangible non-current assets.
• Examples:
– Brand recognition
– Mineral extraction rights
– Intellectual properties (e.g. legal rights - Patents and licences,
trademarks and copyrights)
– Newspaper titles
35
Example 3: Accounting for Amortization
On 1st January 2019 Bright and Shoesmith, a pharmaceutical manufacturer, buys a
license to manufacture a sleeping pill for £3.6m. The licence is for 4 years and will
then expire with £0 residual value.
Required: Show the amortization expenses and the carrying amount of the
licence for each of the four years.
2019
2020
2021
2022
£m
£m
£m
£m
Licence at cost
3.6
3.6
3.6
3.6
Amortisation expenses
0.9
0.9
0.9
0.9
(0.9)
(1.8)
(2.7)
(3.6)
2.7
1.8
0.9
0
Less: Accumulated amortization
Carrying amount (NBV)
36
Land and Buildings
• In almost all cases, land is not subject to depreciation because it does not
normally wear out.
• There are some exceptional cases, e.g. mining, where land value is
affected by the amount of minerals extracted from it – in such cases
accounting for depreciation or “depletion” would be appropriate.
• Some buildings last a long time, but accounting assumes that they all
wear out eventually and so depreciation is charged.
37
Name
Study Activity 2.5(b)
Profit measurement and end-of-year accounting
adjustments
Format
Video (Micro Lecture)
Purpose Watch, Listen
Resource Panopto video - micro lecture 2.5b – Bad & Doubtful Debts
38
Problems with Trade Receivables
• Risk that customers will not pay the amounts due.
• Accounting adjustments to measure and recognise the trade receivables value facing this
risk are required for:
• Bad trade receivables (will not be paid):
• Virtually no chance of receiving the amount from a credit customer, the amount is
‘written off’:
– Remove the amount from the balance sheet – no longer an asset.
– Charge the amount as an expense – reduces profit & equity/capital.
• Doubtful trade receivables (may not be paid):
• Amounts due from credit customers where there is concern that the customer may be
unable to pay.
– Amount may yet be received, so it remains in the balance sheet;
– But an allowance/provision is made against it that is charged as an expense.
39
Bad debts written off and
provision for doubtful debts
Reduce trade receivables
Increase expenses
40
Example 1: Accounting for Bad & Doubtful Debts
At the end of Year 1 the Garden Pond Company has a balance sheet comprising £2,000 trade
receivables, £7,000 other assets and £9,000 ownership interest that consists of £1,800
ownership interest at the start of the period and £7,200 profit of the period. On the date of the
financial year-end the manager of the company reviews the trade receivables list and decides
that debts amounting to £250 are doubtful because there are rumours of a customer not paying
other suppliers in the trade. The manager also noticed a debt amounting to £100 from a
customer known to be certainly bankrupt, which she decides to treat it as a bad debt.
Required: Show how the manager’s decision to treat the amounts £250 and £100 as doubtful
and bad debts, respectively, affects the:
(i)
Profit of the period;
(ii) Book value of trade receivables at the end of Year 1; and
(iii) Ownership interest at the end of Year 1.
41
Example 1: Accounting for Bad & Doubtful Debts - Answer
The effect on the:
(i) Profit of the period (Income statement)
Income statement:
Profit before adjustment
Less Bad debt
Provision for doubtful debt
Profit after adjustment
£
7,200
(100)
(250)
6,850
(ii) & (iii) Book value of asset and Ownership interest (Balance sheet)
Balance sheet:
Before Adjust
After
Other
7,000
7,000
Trade receivables
2,000 (less 350) 1,650
Total Assets
9,000
8,650
Ownership interest/equity (start)
1,800
1,800
Profit of the period
7,200 (less 350) 6,850
Total equity
9,000
8,650
42
Preparing an Income Statement
• An income statement reports on the financial performance of a
business to, for example, investors, potential investors, lenders, employees
and government revenue authorities such HMRC.
• NB: income statement is often referred to as ‘profit and loss account’ in the
UK.
• The income statement (profit and loss account) reflects that part of the
accounting equation which defines profit.
• Profit equals Revenue minus Expenses
43
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
44
Atrill and McLaney (2019, p. 79, Figure 3.2)
Calculating gross profit for Better-Price Stores
£
£
Sales revenue
232,000
Cost of sales:
Opening inventories
Goods bought
40,000
189,000
Closing inventories
Gross profit
(75,000)
(154,000)
78,000
Atrill and McLaney (2019, p. 78, Example 3.3)
45
Better-Price Stores
Income statement for the year ended 30 June 2018
£
Sales revenue
232,000
Cost of sales
(154,000)
Gross profit
78,000
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
Operating profit
(600)
24,600
Interest received from investments
2,000
Interest on borrowings
(1,100)
Profit for the year
25,500
Atrill and McLaney (2019, pp. 75-76, Example 3.1)
46
Income Statement in a Service Business
•
A service business may not need to prepare a trading account
(no inventory movements where there is no inventory).
•
Income statement for service business therefore tends to be much
simpler:
– Revenue less expenses.
47
Week 3 Study Activity: Review Questions
Name
Topic 2 Review Questions
Format
Questions & answers, Discussion Board/Forum
Purpose
Practice, Discuss
Resource
Topic 2 Review Questions available on Blackboard
Notes
Give you the opportunity to revise and assess, mainly, your conceptual knowledge and
understating of the topics covered in a study week. These questions are for weeks 2 and 3.
Week 3 Study Activity: Practice Questions
Name
Topic 2 Practice Questions [Income Statement & Statement of Financial Position]
Format
Questions
Purpose
Collaborate, Practice
Resource Topics 2 Practice Questions (PQ) available on Blackboard
Notes
Students attempt PQ and collaborate in self-formed groups.
48
Week 2 Study Activity: Topic 2 Review Questions
RQ2.2 “Although the income statement is a record of past achievement, the
calculations required for certain expenses involve estimates of the future.”
(i) What does this statement mean?
(ii) Can you think of examples where estimates of the future are used?
49
RQ 2.3: “The statement of financial position shows how much a
business is worth.”
(a) Do you agree with this statement?
(b) Explain the reasons for your response.
50
RQ 2.4: The statement of financial position is sometimes seen as the
least important of the three major financial statements discussed in
this chapter (Topic 2).
Can you see why this might be the case?
51
Week 2 Study Activity: Topic 2 Review Questions
RQ 2.5 “An asset is similar to an expense.” Do you agree?
52
Week 2 Study Activity: Topic 2 Review Questions
RQ 2.6 Briefly explain the key accounting conventions and end-of-year
accounting adjustments for an income statement with appropriate
examples.
53
End of Topic 2.2
Measuring and Reporting
Financial Performance
Next - Topic 2.3
Measuring and Reporting
Financial Position
54