1. Introduction to Accounting IM51005B Lecture 3 Principle and Measurement to Financial Performance: The Income Statement
Dr Sarah Lauwo

2. Lecture Outline: The income statement and the accounting equation
Format of the income statement
Recognition of revenue & expenses
Cost of sales
Depreciation
Accruals and prepayments

3. Ownership Interest (capital)
The Income Statement and the Accounting Equation
Profit (Loss)
Assets
Ownership Interest (capital)
Liabilities
+ (-) = +
The above equation can be extended to: +
Revenue
Expenses
Liabilities -
Assets
Ownership Interest (capital) =

4. The Income Statement (Profit and Loss Account)
The Income Statement measures and reports how much profit the company has generated over a period.

5. The Income Statement (Profit and Loss Account) …….
Profit earned during period
= Revenue Expenses
Revenue = Increases in Ownership Interest
Expenses = Decreases in Ownership Interest
The Income Statement measures changes in ownership interest between two balance sheets

6. Format of the Income Statement
Sales revenue x
Less Cost of sales
(x)
Gross profit
Less expenses (salaries, rent, heat and light, insurance, annual depreciation..etc)
Operating profit (or loss)
Add Other income (e.g., investment income)
Less Interest payable
Profit (or loss) before taxation
Less Taxation for the year
Profit (or loss) for the year

7. Recognition of Revenue
For revenue to be recognised in current period, the following criteria must be satisfied:
The amount of revenue can be measured reliably
Goods/services must have passed to customer
Exchange of resources between buyer and seller
Resources must have high probability of being collected. That is, it is likely that economic benefits will be received .
Hence, revenue may be recognised before cash is received.

8. Example 1 – Sales revenue
BDP Plc sells a pool table to bar on December 31 for
£ 5,000. The pool table was not paid for until January 15th and it was not delivered to the bar until January 31.
At which date BDP Plc has to recognise the revenues arising from the pool table sale?

9. Example 2 – Sales revenue
BE PLC is an electricity firm. During December, BE PLC supplied electricity for a value of £2,000 to one of its clients. The client does not pay for the energy consumed until the following January.
At which date BE PLC has to recognise the revenues arising for energy supplied?

10. Expenses recognition
According to the matching convention, in order to report a company's profitability during a specified time interval, a company is required to match expenses with the revenues they helped to generate The expensed associated with a specific item of revenue must be taken into account in the same reporting period as that in which the item of revenue is included.

11. Matching Convention and the Recognition of Expenses
When the amount paid during the year is more than the full expense for the period
PREPAID EXPENSE
When the expense for the period is more than the cash paid during the period
ACCRUED EXPENSE 8

12. Accrual principle
The accrual principle is the concept that you should record accounting transactions in the period in which they actually occur, rather than the period in which the cash flows related to them occur. An "accrual" is an expense which has been incurred but not yet paid for.

13. Accrued Expenses
They refers to expenses which have been Incurred by the business for good or services that have been delivered (provided) by the suppliers but which have not yet been billed and paid.
Adjustment:
Companies must recognize the Expenses incurred but not yet paid for.
Companies must recognize a Liability for the amount that the company owe to the suppliers for the services provided/good delivered for which the company hasn’t yet paid.

14. Example : Sales Commission
At the end of the year you owe £1,000 for sales commission.
The accounting equation entries with respect to the accrued commission will be:
Assets = Liabilities Owners’ Equity , , (accruals) (sales commission expense)

15. Example – Accrued sales commission ….
Sales commission expense £6,000
Income statement
Balance sheet at year end
Cash £5,000
Accrual £1,000
Cash flow statement

16. Accrued Expenses
Example. On March 1st, 2017 a company rented a building. The rent is £36,000 for one year. Bills are sent and paid after one semester. Show the adjustments that should be done at December 31st , 2017
Rent
01/09
Bank
18,000
31/12
Accrued Expenses c/d*
12,000
Profit and loss
30,000
01/01
Accrued Expenses b/d
All the expenses occurred during the year are transferred to the Profit and loss statement
The Accrued expenses represent a liability to be transferred to the Balance Sheet
*Expense incurred= (36,000/12)*10 = 30,000
*Accrued expense to be recognized = (36,000/12)*4 = 12,000
*Expense paid = (36,000/12)*6 = 18,000

17. Accrued expenses: Taxation
Total taxation for the year should be deducted from profit after interest in the income statement regardless of whether it has been paid or not
If the total taxation for the year has not been paid:
total should be included as an accrued expense under current liabilities in the balance sheet
If part of the taxation has been paid during the year:
only unpaid amount is included as an accrued expense under current liabilities in the balance sheet

18. Accrued Expenses: taxation
Example. The taxes for the year 2014 amount £ 25,000. The companies has paid 5,000 on November 15th. Show the adjustment that should be done at December 31st , 2014
Tax
15/11
Taxes
5,000
31/12
Accrued Expenses c/d
20,000
Profit and loss
25,000
01/01
Accrued Expenses b/d
All the expenses occurred during the year are transferred to the Profit and loss statement
The Accrued expenses represent a liability to be transferred to the Balance Sheet

19. Accrued expenses :Interest Payable on Loans
The total interest for the year should be deducted from the operating profit in the income statement regardless of whether it has been paid or not
If the total annual interest has not been paid yet:
the total unpaid appears as a current liability in the balance sheet
If part of the interest has already been paid:
the difference only (the unpaid amount) appears as a current liability in the balance sheet
If all the annual interest has been paid during the year:
nothing will appear in the balance sheet

20. Accrued Expenses: Interest Payable on Loans
Example. ABC PLC pays loan interest for the month of December of £10,000 on 3rd January Show the adjustment that should be done at December 31st , 2014
Interest expense
31/12
Accrued Expenses c/d
10,000
Profit and loss
01/01
Accrued Expenses b/d
All the expenses occurred during the year are transferred to the Profit and loss statement
The Accrued expenses represent a liability to be transferred to the Balance Sheet

21. Depreciation of Tangible Non-Current Assets
Depreciation is the cost of wear and tear of assets.
It used to estimate the cost of non- current assets that have been consumed in generating the revenues recognised during a particular period
Consumption includes:
Wear and tear from using the asset
The asset becoming obsolete
Passage of time

22. Depreciation in the financial statements
Annual depreciation is an expense and appears in the income statement
Accumulated depreciation (the aggregate amount of annual depreciation from previous years plus this year’s annual depreciation) is deducted from the asset in the balance sheet

23. Annual
Depreciation
Accumulated
from year to
year
Income
Statement
(Expense)
Balance
Sheet
(Deduction
from Asset)

24. Example of depreciation
At July 31, A company bought an equipment valued £ 50,000.
At December 31, 2013 the annual depreciation is estimated as £5,000.
At December 31, 2014 the annual depreciation is estimated as £10,000.
Reports the value in the Equipment Account, Depreciation Account and Accumulated Depreciation Account at December 31, 2014

25. Example of depreciation
Equipment
31/07/13
50,000
Depreciation
31/12/14
10,000
Accumulated Depreciation
31/12/13
Depreciation
5,000
31/12/14
10,000
The £50,000 debit balance in Equipment minus the £15,000 credit balance in Accumulated Depreciation equals £35,000. This net amount of £35,000 is referred to as the carrying value of the equipment. As follows:
Equipment Ac
31/07/14
50,000
Accumulated depreciation
15,000
Balance c/d ,000
31/07/13
50,000

26. Prepayments
A "prepayment" is an amount which has been paid for in one accounting period but which relates to the following accounting period.
Adjustments:
Companies must recognize only the Expenses incurred in P&L and record an Asset in the BS for the amount that has been prepaid.
Example: At end of year, rent of £4,000 is paid in cash in advance.
The accounting equation entries with respect to the prepaid rent will be:
Assets = Liabilities Owners’ Equity
-4,000 (cash)
+4,000 (prepayment)

27. Prepaid Expenses (Prepayments)
Example. On October 31st, 2014 a company pay £6,000 relating to an annual car insurance premium. Show the adjustment that should be done at December 31st , 2014
Car insurance
31/10
Bank
6,000
31/12
Prepaid c/d*
5,000
Profit and loss
1,000
01/01
Prepaid b/d
The prepaid expenses represent an asset to be transferred to the Balance Sheet
Only the expenses occurred during the year are transferred to the Profit and loss statement
*Amount prepaid = (6,000/12)*10 = 5,000

28. Practice Question Question 3.6 Atrill and Mclaney (TT & CO)
Please bring copy of the question for
discussion