Measuring

financial
performance
Income statement
 Overview on Income statement

Recognising Sales, Revenue,

Depreciation and profit

Outline Costing inventory

Recording Trade Receivables

Final exercise
Income statement

• An Income Statement, also known as a Profit and Loss

Statement (P&L), is one of the key financial statements used
by companies to report their financial performance over a
specific period of time, typically a month, quarter, or year.

• The question answered in an income statement

• How much wealth (that is, profit) was generated, or lost,
by the business over that period? (Profit (or loss) is
defined as the increase (or decrease) in wealth arising
from trading activities.)
Income statement

• An income statement (profit and loss account) is prepared to

show the wealth (profit) generated.

• Wealth (Profit) = Revenue (Sales) – Cost of goods sold

• It provides a summary of a company's revenues, expenses,

gains, and losses, resulting in the net income or net loss for
the period.
Back to the example in your text.
• Recall the problem

Recall: ¾ of the wrapping paper (goods) were so

A recap on income statements

• So
• Cost of goods sold ¾ of £40 = £30
• What is left in inventory is ¼ of £40 = £10
• £10 will be charged against the future sales revenue that they generate.
A recap on income statements

• Revenue: This section lists all the revenues earned by the company from
its primary business activities, such as sales of goods or services.
Revenue is often reported net of any discounts, returns, or allowances.

• Cost of Goods Sold (COGS): This section includes all the direct costs
associated with producing the goods or services sold by the company. It
typically includes costs such as materials, labor, and overhead.

• Gross Profit = Total revenue - cost of goods sold.

• It represents the profit generated from the company's core business
operations before deducting operating expenses.
A recap on income statements

• Operating Expenses: This section includes all the expenses

incurred by the company in the course of its normal operating
activities. Operating expenses may include items such as salaries,
rent, utilities, marketing, and depreciation.

• Operating Income (EBIT): Operating income, also known as

operating profit,
• Operating income (Operating profit) = Gross profit - operating
expenses.
• It represents the profit generated from the company's core
business operations after deducting all operating expenses.
A recap on income statements

• Other Income and Expenses: This section includes any

additional income, or expenses not directly related to the
company's core business operations. This may include gains
or losses from investments, interest income, or interest
expenses.

• Net Income: Net income, also known as net profit or the

bottom line, is the final figure on the income statement. It
represents the total profit or loss for the period after
deducting all expenses, taxes, and other adjustments.
 Income statement layout

Cost of goods sold

Operating expenses
consisting of fixed and
variable costs.
EBIT
Other earnings and income
Net income
Exercise 1
The Accounting Period

• The financial reporting cycle of one year is the norm.

• Some large businesses produce a half yearly, or interim,

(quarterly, monthly, weekly or even daily basis) to provide
more frequent feedback on progress in order to show how
things are progressing.
 Recognising Sales,
Revenue, Depreciation
and profit
Recognising revenue.

• Revenue can be from cash or trade receivables.

• Revenue can be recognized at various points. As examples

• The time that order is placed by customer
• The time the order is received by customer
• The time the customer pays for the goods.
• The time the bank or payment platform clears and transfers the amount paid by the customer to the organizations bank
account.

• A reliable criteria from recognizing revenue is that ownership and control of items should pass from
the seller to the buyer.

• At this point the significant risks and rewards have been transferred from seller to buyer.

• In long term contracts of projects and services that last beyond 1 year, it is advisable to break the
tasks into phases and each phase should have a price.
• This ensures that there is revenue for each financial year.
• In the case of a service, periodic subscription could be an option.
Recognizing expenditure or expenses.

• Approach 1: The matching convention:

• In the matching convention revenue expenditure should be matched to the revenue they create
within the same accounting period.

• Such costs could include, wages, rent, utilities , insurance etc that goes into producing a unit
product that earns revenue.

• Approach 2: The materiality convention

• This convention states that, where the amounts involved are immaterial, we should consider only
what is reasonable.

• This may mean that an item will be treated as an expense in the period in which it is paid, rather
than being strictly matched to the revenue to which it relates.
Recognising Profit and loss.

• Profit is a measure of achievement, or productive effort,

rather than a measure of cash generated.

• The profit figure (that is, total revenue minus total

expenses) does not normally represent the net cash
generated during a period.

• That because revenue does not usually represent cash

received and expenses are not the same as cash paid.
Recognizing Depreciation.

• The depreciation charge is considered to be an expense of

the period to which it relates in the income statement.

• Depreciation tends to be relevant both to tangible

noncurrent assets (property, plant and equipment) and to
intangible non-current assets.
Recognizing Depreciation.

• Depreciation of tangible non-current assets.

• To calculate a depreciation charge for a period, four

factors have to be considered:
• the cost (or fair value) of the asset
• the useful life of the asset
• the residual value of the asset
• the depreciation method.
Recognizing
Depreciation.
• Depreciation of tangible non-current assets.

• The cost (or fair value) of an asset

include:
• costs of acquiring the asset
• any delivery costs
• installation costs
• legal costs incurred in the transfer
of legal title of the asset.
• costs incurred in improving or
altering an asset in order to make it
suitable for its intended use within
the business.

An example of how you cost a fair

value of an asset.
Recognizing Depreciation.

• Depreciation of tangible non-current assets.

• The useful life (or continues usefulness) of the asset

• The useful life of an asset is the estimated number of years over which the asset is
expected to be used before it fully depreciates.

• All tangible non-current assets depreciate or lose their physical and economic value
overtime.

• A tangible non-current asset has both a physical life and an economic life.

• The physical life will be exhausted through the effects of wear and tear and/or the passage
of time.

• The economic life of a non-current tangible asset may be much shorter than its physical life.
Recognizing Depreciation.

• Depreciation of tangible non-current assets.

• The residual or disposal value of an asset

• The residual value is the value at which you decide to sell the asset.

• In other words, the residual value is the knock off price of the asset.

• The residual value is often lower than the fair value and the actual cost of the
asset.

• Depreciation = Historic cost of Asset – residual value

• Or
• Depreciation = Fair value – residual value
Recognizing
Depreciation.
• Depreciation of tangible non-current assets.

• The depreciation method.

• Once the amount to be depreciated (that is, the cost, or fair value, of the asset less any
residual value) has been estimated, the business must select a method of allocating this
depreciable amount between the accounting periods covering the asset’s useful life.

We will consider 2 methods

1. The Straight line method
2. The reducing balance method
 Recognizing
Depreciation.
• Depreciation of tangible non-current assets.

• The depreciation method.

• The straight line method.

• This method simply allocates the amount to be

depreciated evenly over the useful life of the
asset.

• Based on the result

• The balance of £40,062 shown above is referred
to as the carrying amount (sometimes also
known as the written-down value or net
book value) of the asset.
Recognizing
Depreciation.
• Depreciation of tangible non-current assets.

• The depreciation method.

• The reducing-balance method.

This method applies a fixed percentage rate of

depreciation to the carrying amount of the asset
each year.

The effect of this will be high annual depreciation

charges in the early years and lower charges in the
later years.

The fixed percentage is derived from this formular.

Recognizing
Depreciation.
• Depreciation of tangible non-current assets.

• The depreciation method.

• The reducing-balance method.

Let's consider the previous example.

Lets assume that fixed percentage rate of

depreciation to the carrying amount of the asset each
year is 60%.

As seen in the example, the 60% depreciation charges

leads to the erosion of the carrying amount to a
residual value of 2000 after 4 years.
Recognizing
Depreciation.
• Depreciation of intangible non-current assets.

• Where an intangible asset (e.g a patent) has a finite life, the approach taken for the
depreciation (or amortisation as it is usually called with intangibles) is broadly the
same as that for property, plant and equipment (tangible non-current assets).

• However, this rarely occurs as there is usually no active market from which to
establish fair values.
Costing inventory
Costing Inventory

• Inventory is often for homogeneous products.

• Process costing approaches is used such as:

• first in, first out (FIFO) – the earliest inventories held are the
first to be used;
• last in, first out (LIFO) – the latest inventories held are the first
to be used;
• 3 weighted average cost (AVCO) – inventories entering the
business lose their separate identity and go into a ‘pool’. Any
issues of inventories then reflect the average cost of the
inventories that are held.
Costing Inventory

• Last semester, we looked at

process costing from a
production perspective.

• How do we handle these

process costing approaches,
if the goods sold are
purchased?

• Let's take a look at some

examples based on the
transactions presented here.
Costing Inventory

• The FIFO approach

Costing Inventory

• The LIFO approach

Costing Inventory

• The weighted average

 The example I
Exercise 2 presented in the
previous slides
Costing Inventory

• Inventory has a net realizable value.

• Net realizable value = Estimated selling price of inventory - Any further

costs that may be necessary to complete the goods and any costs
involved in selling and distributing the goods.

• The net realisable value may be lower where:

• goods have deteriorated or become obsolete;
• there has been a fall in the market price of the goods;
• the goods are being used as a ‘loss leader’;
• bad buying decisions have been made.
Recording Trade
Receivables
Recording Trade Receivables

• When businesses sell goods or services on credit, revenue will

usually be recognised before the customer pays the amounts
owing..

• With this type of sale there is always the risk that the
customer will not pay the amount due.

• When it becomes reasonably certain that the customer will

never pay, the debt owed is considered to be a bad debt and
this must be taken into account when preparing the financial
statements.
Recording Trade Receivables

• To provide a more realistic picture of financial performance

and position, the bad debt must be ‘written off’.

• Writing off a bad debt involves reducing the trade receivables

and increasing expenses (by creating an expense known as
‘bad debts written off’) by the amount of the bad debt.

• The matching convention requires that the bad debt is

written off in the same period as the sale that gave rise to
the debt is recognised.
Recording Trade
Receivables

• An example on how to write off

bad debts
Exercises
Exercise 3
Exercise 4

Solve exercise 3.7,

Page 112
Optional
Assignment

Solve exercise 3.6,

Page 111