Week 4 - Income Statement

Question 1

What is the income statement often referred to as?

Answer 1

Profit and loss account

Question 2

How is profit (or loss) measured using the income statement?

Answer 2

Revenue minus expenses

Question 3

Describe the layout of the Income Statement

Answer 3

Sales revenue
less
Cost of sales
equals
Gross profit
less
Operating expenses
equals
Operating profit
less
Interest payable
plus
Interest receivable
equals
Profit for the period

Question 4

What are some of the reasons for measuring profit?

Answer 4

• Measure performance
• Decide on dividend policy
• Decide on performance related pay of managers
• Measure efficiency (inputs (i.e. costs) compared to outputs (i.e. sales))
• Measure effectiveness (outputs and objectives)
• Assess the financial strength of company (a profitable company is more able to pay its liabilities)
• As a guide for taxation
• For pricing decisions
• Employees for career planning purposes

Question 5

Sample income statement for Simple Company Ltd.

Answer 5

Week 4 page 6 notes

Question 6

What does the income statement always begin with?

Answer 6

Revenue

Question 7

What is revenue also referred to as?

Answer 7

Sales or turnover

Question 8

What is revenue?

Answer 8

Revenue includes how much has been earned for goods sold and income for services (rent revenue;
fees; subscriptions etc.) during the period

Question 9

Outline the revenue recognition principle

Answer 9

Realisation Concept

– revenue is recognised when a sale has been made, even if the money for the sale is not received until a later period

Question 10

In practice, when is a sale legally recognised?

Answer 10

A sale is usually recognised when the invoice is sent out, signifying ownership of goods has been transferred or that services have been delivered

Question 11

What is included as revenue in the income statement?

Answer 11

• Sales
• Profit on sales of non-current assets
• Investment income
• Interest receivables

Question 12

What is included as expenses in the income statement?

Answer 12

• Cost of sales
• Selling and administrative expenses (e.g. salaries, training, telephone and other utilities)
• Finance expenses (interest charges)

Question 13

What two accounting principles is the recognition of expenses based on?

Answer 13

Accruals Concept

Matching Concept

Question 14

What is the accruals concept?

Answer 14

An expense is not the same as the amount of cash spent; it is the amount incurred in earning the revenue

Question 15

What is the matching concept?

Answer 15

• Expenses are amounts used in providing the sale or service during the period
• After recognising the turnover for a period, we match against it those expenses that have been incurred in earning that turnover

Question 16

What is the first expense on the income statement?

Answer 16

Cost of sales

Question 17

What is ‘cost of sales’ on the income statement often referred to as?

Answer 17

Cost of goods sold (i.e. cost of goods

used up in making the sale)

Question 18

What is included and excluded from the cost of sales figure?

Answer 18

•The cost of sales figure includes: the costs of
buying, or producing goods and services; an
appropriate share of production overheads
•The cost of sales figure does not include: the
general administration costs, or the selling and
distribution costs

Question 19

How is the cost of sales calculated?

Answer 19

Opening inventory plus
Purchases less
Closing inventory

Question 20

How is gross profit calculated?

Answer 20

Sales minus cost of sales

Question 21

Give the formula for gross profit margin

Answer 21

Gross profit margin = Gross profit/Sales x100

Question 22

Give the formula for markup

Answer 22

Markup = Gross profit/Cost of sales x100

Question 23

Give the formula for net profit

Answer 23

Net profit = Sales - cost of sales - other expenses

Question 24

Challenge
£m
Revenue 250
Cost of Sales 100
Gross Profit?
Other Expenses 50
Net Profit?

Calculate the gross profit, gross profit margin, markup, and net profit using the above information

Answer 24

Gross profit = Sales minus cost of sales
Gross profit margin = Gross profit/Sales x100
Markup = Gross profit/Cost of sales x100
Net profit = Sales - cost of sales - other expenses

Gross profit = 250 - 100 = 150
Gross profit margin = 150/250 x 100 = 60 %
Markup = 150/100 x100 = 150%
Net profit = 250 - 150 - 50 = 100

Question 25

What is the useful economic life of a long-term asset?

Answer 25

The period of time for which the asset contributes to making profit

Question 26

How is depreciation shown on the income statement?

Answer 26

Each year a portion of the cost of long-term assets is shown in the income statement as an expense

Question 27

What four factors must be considered when calculating the depreciation charge for a period?

Answer 27

The cost (or fair value) of the asset
The useful life of the asset
Residual value (disposal value)
Depreciation methods

Question 28

State the two methods of depreciation

Answer 28

Straight line depreciation

Diminishing (or reducing) balance method

Question 29

What is the straight line method of depreciation?

Answer 29

Same depreciation expense each year

Question 30

How is the yearly depreciation expense calculated using the straight line method?

Answer 30

(Cost – Scrap value at end of useful life)/Expected useful life in years

Question 31

What is the diminishing (or reducing) balance method of depreciation?

Answer 31

High depreciation early years, reducing over time

Question 32

Draw a simple graph of carrying amount against

time using the straight-line method

Answer 32

Week 4 page 24
x axis = Asset life (years) 0-1-2-3-4
y axis = Carrying amount (£000) 0-20-40-60-80
Straight line downwards from (0,80)

Question 33

Draw a simple graph of carrying amount against

time using the reducing balance method

Answer 33

Week 4 page 25
x axis = Asset life (years) 0-1-2-3-4
y axis = Carrying amount (£000) 0-20-40-60-80
Exponential decay shape (straight lines from one year to the next, however,)
Higher depreciation in the early years
Lower depreciation in the later years

Question 34

Depreciation - Examples
• An asset was purchased for £150,000 and has a
depreciation rate of 5%. What will be the depreciation charge for the first three years under the straight line and reducing balance methods?
• What will be the income statement and statement of
financial position entries?

Answer 34

• Straight line – years 1, 2 and 3 will each be £150,000*0.05 = £7,500

• Reducing balance – year 1 = £7,500
• This is then taken off the original value of the asset
to work out the depreciation for year 2, thus
(£150,000 - £7,500) * .05 = £142,500 * .05 = £7,125
• Year 3 will be (£142,500 - £7,125) * .05 = £6,769

• Straight line – in years 1, 2 and 3 £7,500 will be an
expense on the income statement

• Reducing balance, the income statement entries are
the following expenses – year 1 = £7,500, year 2 =
£7,125 and year 3 = £6,769

• On the statement of financial position, the original
value is shown, from which the accumulated
depreciation is taken off: Table available week 4 page 29

Question 35

Why does bad debt occur?

Answer 35

Not all trade receivables pay what is due as some are declared bankrupt

Question 36

If a trade debtor goes bankrupt and cannot pay what is due, how will this affect the company income statement and statement of financial position?

Answer 36

• The amounts they owe can be deducted from the trade receivables figure and counted as an expense in the income statement
• However, some businesses also set up an allowance
for doubtful debts provision, which is normally a
percentage of net trade receivables
• Any increase or decrease in this allowance would
appear on the income statement

Question 37

Bad Debts - Example
• A company has trade receivables of £920,000
• The company learns that a number of these have gone bankrupt and will not pay what is due – these amount to £82,000
• Moreover, the company has set up an allowance for doubtful debts provision, which is equivalent to 3% of net trade receivables
• This allowance currently stands at £26,000
• What are the income statement and statement of financial position entries following the bad debts of £82,000 being recognised?

Answer 37

• The trade receivables figure is now £920,000 - £82,000 = £838,000
• 3% of £838,000 = £25,140
• Therefore the company needs to reduce its allowance for doubtful debts provision (which currently stands at £26,000) by £860
• Income statement entries: bad debts of £82,000 written off as expenses; and the £860 reduction in the allowance would be equivalent to income
• Statement of financial position: trade receivables = £920,000 – (£82,000 + £25,140) = £812,860

Question 38

Accruals and Prepayments

• Example:
• A company is yet to pay its final quarter electricity bill; the charge for the first three quarters amounts to £1,500
• A company’s rent bill for the year is £39,000, but this includes one month paid in advance

What are the income statement and statement of financial position entries?

Answer 38

• Income statement entries:
• Electricity - £2,000 (assume an average of £500 per quarter)
• Rent - £36,000 (£39,000 = 13 months, thus take off one month’s rent of £3,000)
• Statement of financial position entries:
• Under Current Liabilities there will be an entry of £500 under the heading of Accruals
• Under Current Assets there will be an entry of £3,000 under the heading of Prepayments
• How does the statement of financial position balance?
• Accrual – profit is down by £500, but this is balanced by the accrual entry of £500
• Prepayment – the bank is down by £3,000, but this is balanced by the prepayment entry of £3,000

The statement of financial position always balances

Question 39

Why does creative accounting occur?

Answer 39

As there is subjectivity in measuring profit and performance

Question 40

What are some factors which influence creative accounting?

Answer 40

1. Capital expenditures versus revenue expenditures
2. Depreciation
3. Valuation of inventories
4. Timing and recognition of revenue and
   expenses

Question 41

Explain why capital expenditure versus revenue expenditure is a factor which influences creative accounting

Answer 41

• There may be a temptation to treat normal expenses
as long-term investments
• Rather than declaring the full cost on the income statement immediately, the company only reports the depreciation amount and spreads the cost over several years

Question 42

Explain why depreciation is a factor which influences creative accounting

Answer 42

There is subjectivity over:
• the useful life of the asset;
• the value at the end of the useful life; and
• the choice of depreciation methods

Question 43

Explain why valuation of inventories is a factor which influences creative accounting

Answer 43

• The company has to value the amount of goods that it has not sold yet
• They could overestimate the value

Question 44

Explain why timing and recognition of revenue and

expenses is a factor which influences creative accounting

Answer 44

• The company could report sales as having occurred this year even though they will not receive any cash yet
• The company could say that expenses have not occurred this year, even though they have already paid them

Question 45

What are some of the uses of the income statement?

Answer 45

1. Measure financial performance
   • The profit a business has made during the period
   • The profits and losses from various business activities
2. Shows how and where profits might be
   increased
   • Monitoring exercise
   • Gross profit as a proportion of sales and various expenses as a proportion of sales
3. Financial control
   • Last year as compared to this year (vertical analysis)
   • Comparing one company’s results with another (horizontal analysis)
   • Actual results as compared to budgeted (planned) income statements

Question 46

What are some of the limitations of the income statement?

Answer 46

• Scope for creative accounting
• Different accounting policies can lead to different profits
• Profit is not the same as cash flows
• Making profits is not enough. The main financial accounting statements should be taken as a whole
- E.g. The calculation of the return on capital employed (ROCE) requires figures from both the income statement and the statement of financial position

Question 47

What is the income statement, at its most simplistic level?

Answer 47

A list of all the statement of financial position entries made during a particular period which affect retained profit, we summarise these entries and show different ‘levels’ of profit (gross profit, operating profit, profit before tax, profit after tax)

Question 48

Typical Exam Question
• You will be presented by what is known as a trial balance (see next slide)
• Then there will be a number of items that have come to light since the trial balance was drawn up
•You will then be asked to compile an income statement and a statement of financial position using both lots of information

The Trial Balance ££ ££
Sales 18,614
Purchases 11,570
Inventory 1 May 2016 3,776
Carriage outwards 326
Carriage inwards 234
Returns inwards 440
Returns outwards 355
Salaries and wages 2,447
Motor expenses 664
Rent 576
Sundry expenses 1,202
Motor vehicles 3,400
Fixtures and fittings 600
Trade receivables 4,577
Trade payables 3,045
Cash at bank 3,876
Cash in hand 120
Drawings 2,050
Capital 13,844
35,858 35,858

Extra Information
• The closing inventory at 30th April 2017 is £2,500
• An electricity bill estimated to be £220 has not yet arrived for the final quarter.
• The motor expenses include a prepaid service plan for the following two years worth £80 per year.
•Depreciation has not been charged on the motor vehicles or fixtures and fittings. The motor vehicles are depreciated at 20% per annum, whereas the fixtures and fittings are depreciated at 10% per annum. The straight line method is used in both cases.
• A debtor who owes the company £120 has gone bankrupt and will be unable to pay what they owe

Draw up the income statement and statement of financial position using the trial balance and extra information

Answer 48

Income Statement for the year ending
£ £
Sales 18,614
Less Cost of Goods Sold
Opening inventory 3,776
Purchases 11,570
Carriage in 234
15,580
Less Returns out 355
Less Closing inventory 2,500 12,725
Gross Profit 5,889
Less Expenses
Carriage out 326
Returns in 440
Salaries and wages 2,447
Motor expenses* 504
Rent 576
Sundry expenses* 1,422
Bad debt* 120
Depreciation - Motor vehicles* 680
Depreciation - F & Fittings* 60 6,575
Net Loss -686

Statement of Financial Position as at
£ £ £
Non-current assets Cost Acc Dep WDV
Motor vehicles 3,400 680 2,720
Fixtures and fittings 600 60 540
3,260
Current assets
Inventory 2,500
Trade receivables 4,457
Prepayment 160
Cash at bank 3,876
Cash in hand 120 11,113
Total assets 14,373

Capital and reserves
Capital 13,844
Less Drawings 2,050
Less Loss for year 686 11,108
Current liabilities
Trade payables 3,045
Accruals 220 3,265
14,373