Chapter 6

Statement of profit or
loss and statement of
changes in equity

©2020 John Wiley & Sons Australia Ltd

 Learning objectives

After studying this presentation you should be able to:

6.1explain the purpose and importance of measuring
financial performance
6.2explain the reporting period concept and the
difference between accrual accounting and cash
accounting
6.3outline the effects that accounting policy choices,
estimates and judgements can have on financial
statements
 Learning objectives

6.4describe the measurement of financial performance

6.5discuss the definition and classification of income
6.6discuss the definition and classification of expenses
6.7apply the recognition criteria to income and expenses
6.8identify presentation formats for the statement of
profit or loss
6.9differentiate between alternative financial
performance measures
 Learning objectives

6.10 explain the nature of the statement of

comprehensive income and the statement of changes in
equity
6.11 explain the relationship between the statement of
profit or loss, the statement of financial position, the
statement of comprehensive income and the statement
of changes in equity.
 Purpose and importance of measuring
financial performance

• The statement of profit or loss reflects the accounting

return for an entity over a specified time period.
Profit = Revenue – Expenses
• Profit is the difference between the income and
expenses for a reporting period.
 Purpose and importance of measuring
financial performance

• While many entities aim for profit maximisation, the

importance of sustainable business practices means that
decisions may be made that are not necessarily profit
maximising, but are beneficial for the environment or
the community.
• Entities often articulate their governance, environmental
and social policies and report on their environmental
and social performance in addition to their financial
performance. This is referred to as triple bottom line
reporting.
 Purpose and importance of measuring
financial performance

• Revenue is a subset of income.

• Income encompasses both:
– revenue arising in the ordinary course of activities
(e.g. sales, fees, dividends)
– gains (e.g. gains on disposal of non-current assets,
and unrealised gains on revaluing assets).
Accounting concepts for financial reporting

• The reporting period:

– Reporting period (accounting period) is the period of
time to which the financial statements relates.
– For external reports, the convention is that the
arbitrary reporting period is yearly, and so the entity
prepares financial statements at the end of each 12
months (not necessarily a calendar year).
Accounting concepts for financial reporting

• Accrual accounting versus cash accounting:

– Accounting standards require financial statements to
be prepared on the basis of accrual accounting.
– Accrual accounting is a system in which transactions
and events are recorded in the periods they occur,
rather than in the periods the cash is received or paid.
Accounting concepts for financial reporting

• Accrual accounting versus cash accounting:

– A cash accounting system would determine profit or
loss as the difference between the cash received in
relation to income items and the cash paid for
expenses.
– Transactions are recorded in the period the cash is
received or paid.
Accounting concepts for financial reporting

• Accrual accounting versus cash accounting:

– Under accrual accounting, the following may occur
for income:
• Income is recognised without receipt of cash
(accrued income).
– The income has been earned (service provided),
but not yet paid for.
Accounting concepts for financial reporting

• Accrual accounting versus cash accounting:

– Under accrual accounting, the following may occur
for income:
• Cash is received but income is not recognised
(income received in advance).
– Must remain as a liability, until the income is
earned.
Accounting concepts for financial reporting

• Accrual accounting versus cash accounting:

– Under accrual accounting, the following may occur
for expenses:
• Expense is recognised without payment of cash
(accrued expense).
– Yet to pay for an expense that we have
consumed or used.
Accounting concepts for financial reporting

• Accrual accounting versus cash accounting:

– Under accrual accounting, the following may occur
for expenses:
• Expense is paid but not recognised as an expense
(prepaid expense).
– Paid in advance, and only when the expense is
consumed or used up, do we record the
expense.
Accounting concepts for financial reporting

• Accrual accounting example:

Accounting concepts for financial reporting

• Depreciation (amortisation):
– The systematic allocation of the cost of a tangible
(intangible) asset over its useful life.
– It does NOT represent the loss in the asset’s value
during the reporting period.
– It does NOT involve cash flows.
– Accumulated depreciation represents the total
depreciation that has been charged to statement of
profit or loss in relation to an asset.
Accounting concepts for financial reporting

• Depreciation example — straight-line depreciation:

– Equipment is purchased for $40 000 with an
estimated useful life of 4 years and expected residual
value of $8000.
Annual depreciation expense = Cost of asset – Expected residual value
Asset’s expected useful life
Annual depreciation expense
= $40 000 – $8000 = $8000
4 years
Effect of accounting policy choices, estimates
and judgements on financial statements

• GAAP permit choices when transactions are being

recorded, and require estimations by preparers.
• Reported profit or loss figure affected by an entity’s:
– accounting policy choices (e.g. straight-line or
reducing balance depreciation)
– accounting estimations.
Effect of accounting policy choices, estimates
and judgements on financial statements
Examples of Examples of
accounting policy choices accounting estimates
• Method of depreciation. • Useful life of depreciable
• Method of inventory assets.
costing. • Impairment of assets.
• Method of valuing • Employee benefits (e.g.
property, plant and long service leave).
equipment. • Residual value used in
• Capitalising or expensing depreciation calculations.
development
expenditure.
Effect of accounting policy choices, estimates
and judgements on financial statements
• Quality of earnings:
– Earnings management:
• Managers’ use of accounting discretion via
accounting policy choices and/or estimations to
portray a desired level of earnings.
• Reported profits are an important number because
they are used in contractual arrangements and to
value entities.
• Managers’ choices may portray economic reality or
be driven by self-interest.
 Measuring financial performance

• To measure the profit or loss of an entity, it is necessary

to identify and measure all income and expense items
attributable to the reporting period.
• This requires an understanding of what attributes a
transaction requires in order to be classified as an item
of income or expense.
 Income

• Income is defined in the revised Conceptual

Framework (para. 4.68) as an increase in an asset, or
a decrease in a liability, which results in an increase in
equity (other than those relating to equity-holder
claim contributions).
 Income

• Recall that income comprises both revenue and gains,

with revenue arising in the ordinary course of an entity’s
activities.
• Gains also represent increases in economic benefits, but
they may or may not arise in the ordinary course of an
entity’s activities.
• Income must be inflows or enhancements of economic
benefits that increase assets or reduce liabilities.
 Income

• Income classification:
– By income-generating activities.
– By income types:
• sales, fees, commissions, interest, royalties, rent
and non-reciprocal transfers.
 Expenses

• Expenses are defined in the revised Conceptual

Framework (para. 4.69) as a decrease in an asset, or
an increase in a liability, which results in a decrease in
equity (other than those relating to equity-holder
claim distributions).
• Qualification: distribution to owners is NOT an
expense despite it resulting in a decrease in equity.
 Expenses

• Specific examples:
– Cost of sales expense is the main expense incurred
by an entity — in order to sell goods and generate
income, the entity must purchase goods for resale.
Cost of Inventory at Purchases Inventory at
sales = beginning of period + – end of period
– Other expenses include wages and salaries,
depreciation, selling administrative and borrowing
expenses.
 Expenses

• Specific examples:
– The acquisition of certain assets (such as property,
plant and equipment) is not an expense of the period
because there is no reduction in equity associated
with the transaction.
– However there may be related depreciation and/or
impairment expenses.
 Expenses

• Expenses classification:
– There is some choice as to how to display and classify
expenses in the statement of profit or loss.
• Smaller entities often list all their expenses in the
statement of profit or loss.
• Larger entities aggregate their expenses into
certain classes for reporting purposes.
• Reporting entities are required to classify their
expenses by nature or function.
 Expenses

• Expense classification example:

 Applying recognition criteria to income
and expenses

• Recognition refers to recording items in the financial

statements with a monetary value assigned to them.
• ‘Income recognition’ or ‘expense recognition’ means
that the income or expense is recorded and appears in
the statement of profit or loss.
• The factors to consider when making a recognition
decision, framed in terms of whether an asset or liability
is recognised, are uncertainty, probability and
measurement uncertainty.
 Applying recognition criteria to income
and expenses

• Income (revenue) recognition:

– The determination of when an increase in assets or
reduction in liabilities has arisen, and hence when
income can be recognised, can be difficult and
demands consideration of relevance assessed with
reference to uncertainty, probability and
measurement.
– Difficult to be prescriptive as to the appropriate point
in time when income should be recognised.
Income (revenue) recognition
 Applying recognition criteria to income
and expenses

• Expense recognition:
– Determining if a decrease in assets or an increase in
liabilities is required.
– Paying due attention to relevance as assessed
considering the factors of uncertainty.
– Probability and measurement uncertainty.
Applying recognition criteria to income
and expenses
 Presenting the statement of profit or loss

• The appearance of the statement of profit or loss differs

depending on whether:
– the statement is being prepared for internal or
external reporting purposes
AND
– whether the preparing entity is a reporting entity.
 Prescribed format for general purpose
financial statements
• Prescribed format for general purpose financial
statements:
– The following must be presented on the statement
of profit or loss:
• revenue
• cost of sales (if revenue sales is disclosed)
• finance costs
• share of profit of loss of associates and joint
ventures if equity accounted
• tax expense
• profit or loss.
 Prescribed format for general purpose
financial statements
• Prescribed format for general purpose financial
statements:
– Must also segregate profit or loss from continuing
and discontinued operations.
 Prescribed format for general purpose
financial statements
• Material income and expenses:
– Material income and expenses must be disclosed
separately via either the statement of profit or loss or
the notes.
– The determination of whether an item is material is
based on:
• the size and/or nature of the item
• whether its non-disclosure could influence users’
decision making.
 Prescribed format for general purpose
financial statements
• Format for entities not required to comply with
accounting standards:
– No prescribed reporting format for statements of
profit or loss prepared by non-reporting entities.
– Although presentation and classification of items may
show great diversity, the purpose of the statement of
profit or loss does not change: to report the profit for
the entity for the reporting period.
– The profit objective is not necessarily relevant for all
entities.
 Prescribed format for general purpose
financial statements

• Statement of profit or loss format for an entity not

required to comply with accounting standards:
 Financial performance measures

• Gross profit:
– Refers to revenue less the cost of sales, and is
applicable to manufacturing and retail operations.
– The gross profit measures the revenue remaining
after deducting the cost of sales.
– Reflects the percentage by which an entity marks up
the cost of its products to sell to its customers.
 Financial performance measures

• Profit:
– Profit pre- and post-tax:
• Profit performance measures can be referred to on
a pre- and/or post-tax basis.
– Profit pre- and post-interest:
• Earnings before interest and taxation (EBIT): the
profit before net interest and taxation expense.
• Net finance costs: interest income less interest
expense (including finance lease charges).
 Financial performance measures

• Profit:
– Profit pre- and post-depreciation and amortisation:
• Earnings before interest, tax, depreciation and
amortisation (EBITDA): the profit before interest,
taxation and depreciation/amortisation expense.
– Profit pre- and post-material items:
• Items of income and expense can be labelled as
material (or significant) on the basis of their size or
nature.
 Financial performance measures

• Profit:
– Profit from continuing and discontinued operations:
• If an entity has sold or plans to sell a part of its
business during the reporting period, information
must be disclosed that enables users of the
financial statements to evaluate the financial
effects of the discontinued operations.
 Financial performance measures

• Profit:
– Pro forma earnings:
• Earnings that are not in accordance with GAAP
earnings. Unusual items (particularly expense
items) tend to be excluded in the calculation of pro
forma earnings.
 The statement of comprehensive income

• Reporting entities must also prepare a statement of

comprehensive income.
• Other comprehensive income refers to all changes in
equity during the reporting period other than those
resulting from transactions with owners as owners (such
as dividends and capital contributions).
 The statement of comprehensive income

• Reporting entities can elect to present all items in a

single statement of comprehensive income or in two
statements:
(1) A statement of profit or loss showing the income
and expenses associated with the determination of
profit (or loss) for the reporting period.
(2) A statement beginning with profit or loss and
displaying components of other comprehensive
income (statement of comprehensive income).
 The statement of comprehensive income

• Example — JB Hi-Fi Ltd Statement of comprehensive

income for the financial year ended 30 June 2018:
 The statement of comprehensive income

• The statement of changes in equity:

– Required by all reporting entities.
– Details changes in equity from the beginning to the end
of the reporting period.
– It shows:
• Income and expenses as per the statement of profit or
loss.
• Income and expenses recognised directly in equity
(e.g. non current asset revaluations).
• Transactions with equity holders as equity holders
(e.g. shares repurchased, dividends paid).
 The statement of comprehensive income

• Example — JB Hi-Fi Ltd, extract of statement of changes

in equity for the financial year ended 30 June 2018:
 The link between the financial statements

• Profit (loss) for reporting period is added to retained

earnings at start of period.
• The entity can make distributions from retained earnings
and transfers to/from retained earnings.
• The balance of retained earnings at the end of the
period is included as an equity item in the statement of
financial position.
The link between the financial statements
 Summary

• Knowledge of an entity’s financial performance is

essential in order to form an opinion about expected
performance.
• Measurement of financial performance requires
appropriate recognition and classification of income and
expense items.
• The statement of profit or loss reports profit/loss for the
period, with the treatment of this being shown in the
other statements; all financial statements are
interrelated.