3. Statement of Profit and Loss (Income statement) Flashcards
What is the income statement (statement of profit and loss)?
A financial report showing the income that a firm has earned and expenses it has incurred during an accounting period. It is prepared on the basis of the accrual principle rather than cash flows. It measures the change in owners’ wealth over an accounting period.
Why is the income statement needed to produce a meaningful value for profit?
To produce meaningful values for profit over a certain period, revenue and expenses need to be brought together. This cannot be achieved using cash flows. The timing mismatch between payments for sales and payments for their related costs makes it impossible to produce a meaningful value for profit for an accounting period based on cash flows. The accrual principle is used to overcome this problem.
What is the accrual principle?
Transactions are recorded when they happen, irrelevant of timing of cash flows.
Revenue should be recognised when earned and expenses should be recognised when incurred regardless of when paid for.
This principle focuses on the commercial substance of transactions rather than the payment means/timing of cash flows.
Under IFRS, firms may only recognise revenue as being ‘earned’ when…
- The rights to all economic benefits from a product or a service, and responsibilities for any risks, have been transeferred to the buyer (i.e. when the firm has discharged its contractual obligations with the good or service to the buyer). For products this is usually the point of delivery (when the customer receives the product).
- The amount of revenue and associated costs have been measured reliably (this prevents overstating or understating of profits).
What is the matching principle?
An extension of the accrual principle. Costs associated with revenues should be recognised in the same periods in which the revenues are recognised.
This is needed to report meaningful value for profit.
Recognition of product costs is therefore driven largely by revenue recognition considerations.
What are product costs?
All the costs expended on a good or service that are needed to generate the revenue from selling the goods or service. For example:
- direct costs such as raw materials and labour.
- fair share of the manufacturing overheads.
What are manufacturing overheads?
Overhead expenses that are incurred in production. They are allocated to products in some systematic way and incorporated into product costs. When the products are sold, these manufacturing overheads are then matched against revenues.
What are corporate overheads?
The period costs associated with running the business. It is part of “other operating expenses” (expenses excluding product costs).
Period costs are costs that cannot be easily matched with revenues (e.g., head office rental costs). When it is not possible to match costs with related revenues, expense recognition is based on recognising costs in the period in which their associated benefits are received or the service consumed.
What is the difference between capital expenditure and revenue expenditure?
Capital expenditure is money spent by a company to acquire non-current assets.
Revenue expenditure is money spent on things used to create goods for sale, to run the business or on things a firm intends to trade in the short-term.
