General purpose financial statements – further consideration of the income statement, the statement of changes in equity, and the statement of cash flow

Question 1

The income statement

Answer 1

The income statement provides details of the income and

expenses of an organisation.

Question 2

Income

Answer 2

Increases in economic benefits during the accounting
period in the form of inflows or enhancements of assets or
decreases of liabilities that result in increases in equity,
other than those relating to contributions from equity
participants.

Question 3

Expenses

Answer 3

Decreases in economic benefits during the accounting
period in the form of outflows or depletions of assets or
incurrences of liabilities that result in decreases in equity,
other than those relating to distributions to equity
participants.

Question 4

Difference between income and expenses

Answer 4

The difference between income and expenses is profit (or
loss).
• Profit (losses) increases (decreases) owners equity, as:
OE = OE + (Income – Expenses) + C - D

Question 5

The use of accrual accounting - income statement

Answer 5

Financial statements are typically prepared on an ‘accruals
basis’. This means that income is recognised when it is earned
and expenses are recognised when the expense is
incurred.

Question 6

Many judgements required in the preparation of the income statement

Answer 6

• Depreciation: judgement on useful life and residual value).
• Income and expenses: judgement based on ‘probability’
and ‘measurability’.
• Revalue PP& E to fair value will increase depreciation
expense, and therefore decrease profits.

Question 7

Implications of judgements

Answer 7

very unlikely that different accountants would derive the same ‘profits’.

Question 8

Accounting rules change over time

Answer 8

• New accounting standards can also impact the profit calculation.
• For example a new accounting standard might be issued that:
• prohibits goodwill amortisation.
• Requires research expenditure do be expensed rather than
capitalised.
• The rules of financial accounting are not static.
• it is problematic to compare current period reported profits with
previous year.
• the ‘rules of the game’ might have changed.

Question 9

The statement of changes in equity

Answer 9

• Equity is the residual interest in the assets of the entity after
deducting its liabilities.
• For a company, equity might be made up of number of
components, for example, JB Hi-Fi includes the following
accounts:
• Contributed equity
• Reserves
• Retained earnings

Question 10

Income receivable

Answer 10

This arises when an organisation performs a service but has not been paid for it.

Question 11

Prepayment

Answer 11

Occurs when a payment for a good or service is made in
advance of receiving the good or service.
• Is considered to be an asset as it provides us with a right to
a future economic benefit.

Question 12

Income received in advance

Answer 12

• An organisation is paid for a good or service in advance.
• For example, a lawn mowing business might be paid 6
months mowing fees in advance of actually doing the
mowing.
• This would be considered to be a liability.

Question 13

Accrued expenses

Answer 13

• Accrued expenses
• expenses have been incurred but not yet paid.
• examples include: Accrued wages; Accrued electricity;
Accrued interest.

Question 14

The statement of cash flows

Answer 14

• The purpose of the statement of cash flows is to provide
details of the cash inflows and outflows of an organisation.
• It provides information that is not directly available from the
balance sheet or the income statement.

Question 15

Purpose of the statement of cash flows

Answer 15

Assists in assessing the ability of the company or economic
entity to:
• generate cash flows
• meet financial commitments
• fund changes in the scope and/or nature of its activities
• obtain external finance

Question 16

Items that might cause a difference between profits and cash flows include:

Answer 16

• depreciation and amortisation
• increases/decreases in various receivable and payable
accounts, accrued and prepaid expenses etc.
• loss/gain on sale of plant and equipment

Question 17

The statement of cash flows is divided into three kinds of

activities:

Answer 17

• Operating Activities
• Investing Activities
• Financing Activities

Question 18

Cash flows from operating activities

Answer 18

The principal revenue-producing activities of the entity and
other activities that are not investing and financing activities.
Cash flows from operating activities include:
• receipts from customers
• payments to suppliers and employees
• cash generated from operations
• interest paid
• income taxes paid

Question 19

Cash flows from investing activities

Answer 19

The acquisition and/or disposal of long-term and other
investments.
Cash flows from investing activities include:
• purchase of property, plant and equipment
• proceeds from sale of equipment
• dividends received

Question 20

Cash flows from financing activities

Answer 20

Relating to changing the size and/or composition of the
financial structure of the entity.
Cash flows from financing activities include:
• proceeds from issue of shares
• proceeds from borrowings
• repayment of borrowings
• dividends paid

Question 21

Why report

Answer 21

Both internal and external users need information about financial performance. Investors need the information in order to determine such things as likely dividend payments. Managers need to know profits being generated from activities so as to determine if various facets of the organisation are viable. Lenders want to know whether an organisation is likely to be able to repay amounts due. Employees and unions might be interested in knowing whether it appears that an organisation is likely to be able to keep paying wages and also if it could pay more to employees. For many organisations, it is a legal requirement to report profits.

Question 22

To whom are we reporting

Answer 22

From the above, we can see that there are many different stakeholders who might have an interest in an organisation’s profitability – investors, creditors, employees, employee unions, customers, government, news media, and so on.

Question 23

What are we reporting

Answer 23

We will be reporting various items of income and expense (together with comparatives for prior periods) which we will discuss shortly.

Question 24

How/where are we reporting

Answer 24

For larger organisations, the information will generally be prepared in accordance with accounting standards and the information will often be provided within an ‘annual report’ which also provides a balance sheet (also called a statement of financial position), a statement of cash flows, a statement of changes in equity, and supporting notes.

Question 25

However, a profit objective is not relevant for all organisations – for example, not-for-profit entities.

Answer 25

Such entities might be more concerned with other objectives such as fulfilling particular social and or environmental needs (nevertheless they would need to monitor some aspects of financial performance including cash flows).

Question 26

Also, we need to appreciate that even for ‘for profit’ organisations, there are also many important aspects of performance that are not financial:

Answer 26

That is, we must always remember that financial measures such as ‘profits’ are not comprehensive measures of organisational performance.

Question 27

The reporting period

Answer 27

• ‘Profit’ is calculated for a period of time.
• Even though an organisation might be expected to last indefinitely (it is a ‘going concern’) financial accounting breaks the life up into discreet (and somewhat artificial) time periods.
• This requires various items of income and expense to be allocated to the time periods which in itself often requires a deal of professional judgement.
• Organisations typically report their results for a year. They can also do it for six month periods, or even monthly.
• In Australia the financial year is typically from July 1 to June 30 whereas in other countries it is typically January 1 to December 31. Other financial years are allowed.

Question 28

Other comprehensive income

Answer 28

Other comprehensive income comprises items of income and expense (including reclassification adjustments) that are not recognised in profit or loss as required or permitted by other Australian Accounting Standards.
• So just be aware that we have a measure called profits, another measure called ‘other comprehensive income, and the total of the two which is referred to as ‘total comprehensive income’.

Question 29

Note on operating activities

Answer 29

Across time it would be hoped that cash flows from operations provides a large proportion of the total cash being required by the organisation.
• In the early years the cash flows from operations might be negative as the organisation establishes itself, but a business organisation cannot persist with negative cash flows from operations.
• This is an important measure of financial performance.

Question 30

Note on investing activities

Answer 30

An organisation in a ‘growth phase’ might be expected to have negative cash flows from ‘investing activities’. Positive cash flows from investing activities might be reflective of an organisation ‘selling down’ its assets.