Chapter 3 - Measuring & Reporting Financial Performance

Question 1

How is the income statement linked to the balance sheet?

Answer 1

The profit for the period found in the income statement is recognised as a part of equity in the balance sheet

Question 2

What are the typical lines in the standard layout of an income statement (retail company)?

Answer 2

• Gross profit = Revenues for selling goods - COGS
• Operating profit = Gross profit - operating expenses (overheads)
• Profit for the period = Operating profit + non-operating income (interest received) - non-operating expenses (interest paid)

Question 3

What are two different ways to identify Cost of goods sold?

Answer 3

• For each individual item at the time of sale. This is often the case in large retailers with point-of-sales checkout systems that identify the cost of the particular sale.
• After the reporting period has ended. We then need to know the opening and closing balances of inventory and the cost of goods bought during the period.

Question 4

When should revenue be recognised?

Answer 4

When the control of the product has been transferred to the customer, since the business has satisfied its obligations. Some indicators for determining when control has passed are:

• physical possession passes
• the business has the right to demand payment
• the customer has accepted the product
• legal title passes to the customer
• significant risk/reward of ownership passes

Question 5

When might revenue be recognised over time?

Answer 5

When it is possible to measure progress toward complete fulfilment of obligations, the total revenue can be spread across the reporting periods covered by the contract. This may arise when:

• The customer enjoys the benefits as the obligations are carried out (accounting services)
• The business creates, or improves, an asset held by the customer (renovating a building)
• The business creates an asset with no alternative use and the customer has agreed to pay for work carried out (custom-made furniture)

Question 6

How should expenses be recognised?

Answer 6

Expenses should be matched to the same period as the revenue it helped generate.

• If the expense is larger than the cash paid during the period, the remaining amount is shown as an accrued expense in the balance sheet.
• If we have paid more than the full expense for the period, the excess amount should be shown as a prepaid expense in the balance sheet.

Question 7

What are the four factors we need to consider when calculating the depreciation expense?

Answer 7

• The cost (revalued amount at fair value) of the asset
• The useful life
• The residual value
• The depreciation method

Question 8

What are the two most commonly used depreciation methods?

Answer 8

• Straight-line depreciation

- Reducing-balance method (percentage rate)

Question 9

How do we account for selling an asset with a finite life at a higher/lower price than its book value?

Answer 9

We show it as “profit/loss on disposal of a non-current asset” in the income statement for the period in which it was disposed. The book value is at the same time written down to 0 in the balance sheet.

Question 10

What are three assumptions of how products flow through the company, to determine how to cost inventories?

Answer 10

• FIFO: first in, first out
• AVCO: weighted average cost
• LIFO: last in, first out

Question 11

At what value should inventory be valued at?

Answer 11

The lower of cost and net realisable value (estimated sales price - estimated completion cost - estimated sales cost)

Question 12

When can a bad debt be recognised and how to we account for it in the financial reports?

Answer 12

When it becomes reasonably certain that a customer will not pay. We reduce the trade receivables with the full amount in the balance sheet, and increase the expenses with a line called “bad debts written off”.

Question 13

When do we recognise doubtful debts and how do we account for it in the financial reports?

Answer 13

When there is doubt among some trade receivables, but not reasonably certain that they are bad debts. The amount can be determined by examining individual receivables or by taking a proportion of the total outstanding. The amount is deducted from the trade receivables in the balance sheet and recognised as an expense called “allowance for trade receivables” in the income statement.

Question 14

In what ways can the income statement be useful for users?

Answer 14

• Provides information on how effective the business has been in generating wealth = profit
• Provides information on how profit was derived