The Income Statement and the Cash Flow Statement CHAPTER 8 The Income Statement and the Cash Flow Statement Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Learning Objectives Define Income and explain the criteria that permit revenue and income to be recognised. Determine cost of goods sold. Explain the significance of gross profit and calculate the gross profit margin. Explain the principal categories of expenses. Explain what profit before income tax includes. Understand the Earnings Per Share (EPS) calculation. Consider alternative Income statement presentation models. Identify unusual items on the income statement. Explain the purpose and general format of the Cash Flow Statement. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Overview The Income Statement indicates how much profit the firm made for a period. It also shows whether sales are increasing relative to the cost of goods sold. Distinguish between gross profit and net profit. In the second part of this topic we will explore the cash flow statement. The cash flow statement explains the change in the entity’s cash position for the period. The cash flow statement summarises the cash affects of the firm’s operating, investing and financing activities during the period. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Income The AASB defines income as “increases in economic benefits during the accounting period in the form of inflows or decreases in liabilities that result in increases in equity, other than those relating to contributions from owners”. Inflows or increase in assets; or Decrease in liabilities; Other than from owners; That increase equity. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Income is a net concept e.g. gain on disposal of NCA The term Income is also used and is largely interchangeable with the term revenue. Sales Revenue is generated when a firm sells a product or provides a service to a client or customer and receives cash, creates an account receivable, or satisfies an obligation. Revenue is generally measured by the amount of cash received or expected to be received from a transaction i.e. it is a gross concept reported before associated expenses. Income is a net concept e.g. gain on disposal of NCA Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Income Income is recognised when it is probable that the benefits (the sale, the fees, interest etc) will flow to the entity and when it is possible that the benefits can be reliably measured. Two recognition criteria: It must be more likely than not that the benefits will be received; The benefits must be capable of reliable measurement. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Revenue The term Revenue is also used and is largely interchangeable with the term income. Revenue is generated when a firm sells a product or provides a service to a client or customer and receives cash, creates an account receivable, or satisfies an obligation. Revenue is generally measured by the amount of cash received or expected to be received from a transaction. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Revenue recognition point Revenue is realised when the product or service has been exchanged for cash, claims to cash, or an asset that is readily convertible to a known amount of cash. Revenue is earned when the entity has completed, or substantially completed, the activities it must perform to be entitled to the revenue benefits. These criteria are usually satisfied when the product is delivered or service provided. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

determine the period in which revenue will be recognised. From a legal perspective, the sale of a product involves the passing of title. This is usually specified by the contract terms. This is important as it will: determine the period in which revenue will be recognised. determine who suffers any loss or damage to merchandise while it is in transit. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

The affect of a sale on the financial statements is: Revenue The affect of a sale on the financial statements is: Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Revenue Misstated revenue can lead to significantly misleading financial statements eg overstated profit. Management and internal auditors often design internal control procedures to help promote the accuracy of the revenue recognition process of the firm. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

INCOME Misstated INCOME/ REVENUE FROM SALES can lead to significantly misleading financial statements eg overstated profit. Management and internal auditors often design internal control procedures to help promote the accuracy of the revenue recognition process of the firm. See Exhibit 9-2 pg 279 Seven Financial Shenanigans Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Sales Revenue Service firms – revenue labelled appropriately, Revenue from sale of product Sometimes called turnover Due to return of merchandise Service firms – revenue labelled appropriately, e.g. leasing company: rental and service revenues. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Sales Revenue Long-term Construction Projects Revenue may be recognised using the percentage of completion method. Unusual revenue recognition methods should be disclosed in the notes to the financial statements. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Expenses AASB defines expenses as Outflows or depletions of assets or incurrences of liabilities that result in a decrease in equity, other than those involving owners. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Expenses There are again 3 elements: There must either be a decrease in assets; or An increase in liabilities; Not involving the owners. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Expenses Some expenses are recognised concurrently with the revenues to which they relate (matching principle). Some expenses are recognised in the period in which they are incurred (administrative salaries). Some expenses result from an allocation of the cost of an asset to the period that is expected to benefit from the asset’s use (depreciation). Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Cost of Goods Sold Most significant expense for many manufacturing and retailing companies Affected by inventory cost flow assumptions – FIFO, specific identification, weighted average Excludes inventory shrinkage (loss due to theft or obsolescence) – where identifiable. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Cost of Goods Sold When an item is sold its cost is transferred from the inventory asset to the cost of goods sold expense with the following affect on the financial statements: Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Perpetual inventory system Cost of Goods Sold Perpetual inventory system Cost of inventory is determined when the item is sold. Regular counts of inventory items will be made on a cyclical basis during the year, and compared to perpetual record of inventory on hand. Internal control procedure Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Periodic inventory system Cost of Goods Sold Periodic inventory system Inventory on hand is counted periodically, and the cost is determined using the relevant cost flow assumption. Cost of goods sold may then be calculated. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Cost of Goods Sold Periodic inventory system Known Determined from stocktake Calculated Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Gross profit ratio = gross profit / sales Gross Profit / Margin Gross profit is the excess of net sales revenue over cost of goods sold. Gross profit ratio = gross profit / sales Sometimes called gross margin ratio Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Gross Profit / Margin Gross profit ratio is an important statistic used by managers for such things as: 1. Estimating level of sales and sales mix to achieve profitability. 2. Estimating cost of goods sold and ending inventory. 3. Setting selling prices. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Other Operating Expenses Expenses from ordinary activities are usually reported in the following functional categories on the income statement: distribution expenses marketing expenses occupancy expenses administrative expenses research and development expenses other expenses borrowing costs Expenses may also be classified by nature (of the input). Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Income from ordinary activities Borrowing costs = interest expenses (associated with financial leverage) Profit from ordinary activities before tax: Most appropriate measure of management’s ability to utilise the firm’s operating assets. Excludes income tax and results of significant items. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Net Profit or Loss Sometimes called the BOTTOM LINE Net profit is also reported on a per ordinary share basis. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Earnings Per Share (EPS) Net profit less preferred share dividends Basic EPS = Profit attributable to ordinary shareholders Weighted-average number of shares Takes into account the number of days different blocks of shares have been held. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Earnings per share When a firm has options or convertible securities, there is the potential for the dilution of basic earnings per share. When any of these securities are present, a second earnings per share known as diluted earnings per share, is reported. Due the significance of this measure it is reported just below the profit figure. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Income Statement Alternatives Single-Step Multiple-Step Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola