3 Income Statements Flashcards
What is the link between balance sheets and income statements?
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
Define dividends
The distribution of earnings to owners (cash) - they reduce retained earnings.
Define retained earnings
The sum of company’s net income to date, less dividends, if any paid to the owners.
Retained earnings, net income and dividends
Retained earnings: beginning balance
+ net income (or net loss)
- dividends
= retained earnings: ending balance.
What changes retained earnings?
Net income (loss) for the period.
Dividends paid - not an expense, instead a distribution of capital.
Define income
Increases in assets (or decreases in liabilities) ultimately, an increase in equity, other than those in relation to contributions from holders of equity claims.
Define expenses
Decreases in assets (or increases in liabilities) ultimately, a decrease in equity, other than those in relation to contributions from holders of equity claims.
What is the matching principal?
Revenue and expenses that result directly and jointly from the same transactions or other events should be recognised simultaneously.
Equation linking revenue, expenses and income
Revenues - expenses = income
Two ways of classification in income statements
Classification by nature and classification by function.
How is timing important for income statements?
Timing is important - expenses should be recognised in the same period as the relevant revenues recognised.
When are costs related to this period’s activities but which are not directly related to products and services sold expensed?
This period.
Requirements for the income statement
(6)
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
What expenses are not recognised on the income statement?
- 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
The pinciple underlying income statements
Financial statements are based on accruals concept (income is recognised when underpinning transaction occurs and in the period to which it relates).
What is a performance obligation?
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
What is a contract?
An agreement between two or more parties that creates enforceable rights and obligations.
What is a customer?
A party that has contracted with an entity to obtain goods or services.
What is transaction price?
The amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer.
5-step approach to recognising revenue of a contract
- Identify the contract with the customer
- Identify the separate performance obligations
- Determine the transaction price
- Allocate the transaction price to the performance obligations
- Recognise revenue when a performance obligation is satisfied.
What does it mean for a contract to be ‘unbundled’?
Essentially breaking the contract down into separate parts.
When are performance obligations satisfied?
Performance obligations are satisfied when the goods or services are transferred to the customer.
Indicator of satisfied performance obligations
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.
When is satisfaction over time?
(3)
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)
What is satisfaction at a point in time?
Indicators:
Company has right to payment
Customer has legal title
Customer has risks and rewards of ownership
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?
All the promised goods and services in the contract are highly interrelated so we assume the contract is a single performance obligation.
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?
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.
What methods could we use to measure performance obligation in a construction contract?
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)
How is transaction price often determined?
Often it is simply the contract price (when fixed at time of sale)
What is and isn’t adjusted for in transaction prices?
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)
How is transaction price allocated?
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.
Incremental costs incurred to fulfil a contract are recognised as an asset provided???
(3)
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
How are costs amortised?
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.
Is a warranty a distinct service and therefore a separate performance obligation?
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.
What is breakage?
Any type of service that is unused by a customer that has already been paid for in full.
When do we recognise breakage on financial statements?
Recognise revenue from breakage when the likelihood of the customer exercising its rights becomes remote.
Reporting conservatism
Revenues should be recognised only when reasonably certain, but expenses should be recognised as soon as reasonably possible.
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How are income statements formatted/arranged?
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)
