3 Income Statements

Question 1

What is the link between balance sheets and income statements?

Answer 1

The balance sheet at the beginning and the end of the accounting period are linked by the income statement for the period.

Through retained earnings account in the owner’s equity section of the balance

Question 2

Define dividends

Answer 2

The distribution of earnings to owners (cash) - they reduce retained earnings.

Question 3

Define retained earnings

Answer 3

The sum of company’s net income to date, less dividends, if any paid to the owners.

Question 4

Retained earnings, net income and dividends

Answer 4

Retained earnings: beginning balance

+ net income (or net loss)

• dividends

= retained earnings: ending balance.

Question 5

What changes retained earnings?

Answer 5

Net income (loss) for the period.

Dividends paid - not an expense, instead a distribution of capital.

Question 6

Define income

Answer 6

Increases in assets (or decreases in liabilities) ultimately, an increase in equity, other than those in relation to contributions from holders of equity claims.

Question 7

Define expenses

Answer 7

Decreases in assets (or increases in liabilities) ultimately, a decrease in equity, other than those in relation to contributions from holders of equity claims.

Question 8

What is the matching principal?

Answer 8

Revenue and expenses that result directly and jointly from the same transactions or other events should be recognised simultaneously.

Question 9

Equation linking revenue, expenses and income

Answer 9

Revenues - expenses = income

Question 10

Two ways of classification in income statements

Answer 10

Classification by nature and classification by function.

Question 11

How is timing important for income statements?

Answer 11

Timing is important - expenses should be recognised in the same period as the relevant revenues recognised.

Question 12

When are costs related to this period’s activities but which are not directly related to products and services sold expensed?

Answer 12

This period.

Question 13

Requirements for the income statement

(6)

Answer 13

The income statement should include:

• revenue
• gains and losses arising from the de-recognition of financial assets measured at amortised cost
• finance costs
• share of the profit or loss of associates and joint ventures accounted for using the equity method
• tax expense
• a single amount for the total of discontinued operations

Question 14

What expenses are not recognised on the income statement?

Answer 14

• revaluation gains and losses
• re-measurements of defined benefit plans
• gains and losses arising from translating financial statements of a foreign operation
• for particular liabilities designated as at fair value through profit and loss, the amount of the change in fair value that is attributable to changes in the liability’s credit risk
• items relating to hedging instruments

Question 15

The pinciple underlying income statements

Answer 15

Financial statements are based on accruals concept (income is recognised when underpinning transaction occurs and in the period to which it relates).

Question 16

What is a performance obligation?

Answer 16

A promise to transfer to the customer either:

• a good or service (or a bundle of goods or services) that is distinct; or
• a series of distinct good or services that are substantially the same

Question 17

What is a contract?

Answer 17

An agreement between two or more parties that creates enforceable rights and obligations.

Question 18

What is a customer?

Answer 18

A party that has contracted with an entity to obtain goods or services.

Question 19

What is transaction price?

Answer 19

The amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer.

Question 20

5-step approach to recognising revenue of a contract

Answer 20

1. Identify the contract with the customer
2. Identify the separate performance obligations
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations
5. Recognise revenue when a performance obligation is satisfied.

Question 21

What does it mean for a contract to be ‘unbundled’?

Answer 21

Essentially breaking the contract down into separate parts.

Question 22

When are performance obligations satisfied?

Answer 22

Performance obligations are satisfied when the goods or services are transferred to the customer.

Question 23

Indicator of satisfied performance obligations

Answer 23

When the customer obtains control of the goods or services i.e. the customer has the ability to direct the use of and obtain benefits from the goods or services.

Question 24

When is satisfaction over time?

(3)

Answer 24

Over time if one or more of the following are met:

• Customer simultaneously receives and consumes the benefits of the company’s performance (e.g. service contract).
• The company’s performance creates or enhances an asset that the customer controls (e.g. construction contract).
• The company creates an asset of no alternative use to itself and it has the right for payment for the performance to date (e.g. specific consultancy work)

Question 25

What is satisfaction at a point in time?

Answer 25

Indicators:

Company has right to payment

Customer has legal title

Customer has risks and rewards of ownership

Question 26

Example: a company enters into a contract with a customer to construct a building for £15 million over 2 years. The company estimates the total costs of the construction at £12 million.

What can be said about this performance obligation?

Answer 26

All the promised goods and services in the contract are highly interrelated so we assume the contract is a single performance obligation.

Question 27

Example: a company enters into a contract with a customer to construct a building for £15 million over 2 years. The company estimates the total costs of the construction at £12 million.

What can be said about revenue recognition?

Answer 27

The company’s performance is creating and/or enhancing an asset that the customer controls

• Revenue is recognised over time

A method needs to be chosen to reflect the company’s progress towards complete satisfaction of the performance obligation.

Question 28

What methods could we use to measure performance obligation in a construction contract?

Answer 28

Input methods - measure progress on the basis of the company’s effort (resources consumed, hours of labour, costs)

Output methods - measure progress based on the basis of value to the customer (survey of work completed to date, units produced and delivered)

Question 29

How is transaction price often determined?

Answer 29

Often it is simply the contract price (when fixed at time of sale)

Question 30

What is and isn’t adjusted for in transaction prices?

Answer 30

Transaction price adjusted for the time value of money when a contract contains a significant financing component.

Transaction price not adjusted for collectability (no changes in accounting for irrecoverable and doubtful debts)

Question 31

How is transaction price allocated?

Answer 31

Usually done in proportion to the stand-alone selling price of the goods or services underlying each performance obligation.

The stand-alone selling price may have to be estimated.

Question 32

Incremental costs incurred to fulfil a contract are recognised as an asset provided???

(3)

Answer 32

The costs relate directly to a contract

Costs enhance the resources that will be used to satisfy the contract’s performance obligations in the future

Costs are expected to recovered

Question 33

How are costs amortised?

Answer 33

Costs are amortised on a systematic basis that is consistent with the transfer of the goods or services to the customer – over time or at a point in time.

Question 34

Is a warranty a distinct service and therefore a separate performance obligation?

Answer 34

If it provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications.

If warranty required by law - not a separate performance obligation.

The longer the warranty period, the more likely it is a separate performance obligation.

Question 35

What is breakage?

Answer 35

Any type of service that is unused by a customer that has already been paid for in full.

Question 36

When do we recognise breakage on financial statements?

Answer 36

Recognise revenue from breakage when the likelihood of the customer exercising its rights becomes remote.

Question 37

Reporting conservatism

Answer 37

Revenues should be recognised only when reasonably certain, but expenses should be recognised as soon as reasonably possible.

Question 38

!!

How are income statements formatted/arranged?

Answer 38

Revenue (or turnover, or sales)

Cost of goods sold (cost of sales

Gross profit (sometimes expressed as a percentage gross margin)

Operating expenses

Operating profit

Interest expense

Profit before tax

Tax

Profit after tax (net income)