NZDB 500 Accounting Principles AMIA 500 Introduction to

NZDB 500 Accounting Principles AMIA 500 Introduction to Accounting Lesson Four: Income Statement Power. Point's adapted from 2010 Pearson Education New Zealand Ltd

Learning outcomes LEARNING OUTCOME TWO Students will examine and apply accounting concepts and policies to prepare financial statements for a sole trader and/or a small company. The effect of transactions on the expanded accounting equation. Financial statements: • Income Statement Note: These are all examined by the Test

What is an Income Statement? • The Income Statement lists an entity’s revenues earned, and expenses incurred, for a period of time (usually one year), and then calculates the profit or loss for the period. • The profit or loss is equal to total revenues minus total expenses. • Note the alternative names for the Income Statement: – Statement of Financial Performance – Profit and Loss Statement (often abbreviated to P&L Statement, or just P&L) – Revenue Statement (or Revenue and Expense Statement) – Statement of profit or loss and comprehensive income.

What is the purpose of the Income Statement? • The purpose of the Income Statement is to report the revenues earned, the expenses incurred, and the resulting profit (or loss) for the accounting period. • The Golden Chips Takeaways Income Statement follows:

Income Statement (Simplified layout) Golden Chip Takeaways Income Statement for the year to 31/12/20 X 1 • Sales 300, 000 • Less: Cost of Goods Sold • Opening Inventory 2, 000 • Purchases 84, 300 • Closing Inventory (2, 800) 83, 500 Gross Profit 216, 500 Selling & Distribution expenses • Advertising 600 • Depreciation – Vehicle 6, 400 • Packaging 2, 300 • Vehicle expenses 3, 200 12, 500

Example: Income Statement Cont General & Administrative expenses • Accountancy 1, 100 • Bank Charges 300 • Insurance 3, 800 • Kitchen Supplies 10, 800 • Power 12, 300 • Rent 26, 000 • Repairs and Maintenance 4, 300 • Telephone 700 Financial Expenses • Interest 400 72, 200 Net Operating Profit (Before Tax) 59, 300 400 $ 144, 300

Layout of an Income Statement • Refer to the Model in Lesson 4

Why is it important? • The Income Statement summarises the operating activities of the business for the accounting period. • These activities arise from the relationship between planning and management’s operating decisions. • The profit or loss for the period is the result of those decisions. • The information is used by owners, creditors, banks and others to assess how well the managers have managed the business during the accounting period. • By using several consecutive statements, the stakeholders can evaluate management’s performance over several periods.

Why is it important? • External users, such as investors and lenders, use the Income Statement to determine such things as: • investment value – is the business earning a satisfactory return on the assets employed? Golden Chip Takeaways has a profit for the period before tax of $144, 300 – earned on an asset base of $43, 800 – giving a return on assets of 229%! • creditworthiness – is the business earning enough to pay its suppliers and other creditors on time? Because fast-food outlets are basically cash sales, Golden Chip Takeaways appears to be in a very sound position, and suppliers would be happy to provide credit – it had earnings of $300, 000 to cover the expenses incurred of $155, 700 ($83, 500 + $72, 200).

Why is it important? • income success – the Income Statement for 20 X 1 suggests that Golden Chip Takeaways is able to earn significant income for a business of its size. • However, users need to be aware of the shortcomings of the statement (Refer to the Assignment).

Income, expenses and profit for the period • A business earns income by selling goods or by providing services – the income earned is the price the customers pay for these goods or services. • To provide these goods and services, the business must incur costs – the expenses incurred. The Income Statement is therefore based, like the Balance Sheet, on an equation: – Profit (or loss) for the period = Income – Expenses

Income, expenses and profit for the period Income and expenses • The earning of profits underlies the existence of every business. • Therefore a very important function of an accounting system is to produce information about the business’s profitability. • To determine profit for the period, it is necessary to measure: – the price of goods sold and services rendered by the business (income) = SALES – the cost of goods and services consumed by the business (expenses) during the accounting period = COGS

Income, expenses and profit for the period • There are two basic categories of items shown in the Income Statement: – income, which measures the net assets (Assets – Liabilities) that flow into the business when it sells goods or provides services. (Sales and Other Income) – expenses, which measure the net assets that the business consumes in the process of generating income. ( COGS, SD, GA, F expenses)

Income, expenses and profit for the period • Income is defined by the NZ Framework as: – … 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 (para 4. 25(a)).

Income, expenses and profit for the period Expenses • Expenses are defined in the NZ Framework as: – … decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity, other than those relating to distributions to equity participants (para 4. 25(b)). • Expenses are the cost of goods and services consumed in the process of earning income.

Income, expenses and profit for the period Profit or loss for the period • Profit for the period equals income minus expenses, and is the increase in owner’s equity resulting from operating the business. • If expenses are greater than income a net loss will result, and will reduce owner’s equity. • The difference between income and expenses represents a net change in owner’s equity. Thus, the accounting equation can be written as: Assets = Liabilities + (Owner’s equity + Revenue – Expenses) • This equation shows that the Balance Sheet and Income Statement are closely linked. (The profit / loss from the IS goes into the OE section of the BS)

How are items classified in the Income Statement? • The Income Statement has several sections showing the composition of the income and expenses that lead to profit for the period

How are items classified in the Income Statement? The classified Income Statement • Income: – income from sales – income from services * – income from investments*. • (Sales can be subdivided into cash and credit sales, or by major physical products or locations, and so on. ) • As the Assessment One: Test concentrates on a small Trading Sole trader these are not used much and are categorised under other income

How are items classified in the Income Statement? • Expenses: – cost of goods sold (COGS) – selling expenses (sometimes termed selling and distribution expenses) (SD) – administrative expenses (sometimes termed general and administration expenses) (GA) – finance expenses (F). • Cost of goods sold includes all costs incurred in getting goods ready for sale, such as the original purchase price, customs duty, cartage on purchases, freight inwards, and so on.

How are items classified in the Income Statement? • Selling and distribution expenses include all costs associated with selling the goods or services of the business – advertising, marketing, salaries and commissions of salespeople, packaging expenses, storage and delivery costs, service calls, and warranty repairs, etc. • General and administration expenses – office salaries, stationery, postage, telephone rent, rates, repairs to buildings, insurance premiums, and so on. • Finance expenses are those associated with: – financing the enterprise, such as interest on loans and interest on bank overdraft. Refer to the model fully classified income statement in Lesson 4 and for examples in each category

How are items classified in the Income Statement? *(not assessed in Test) • There are variations to these classifications. • Is doubtful debts a finance expense, or a selling expense? • What about discount on sales? • Or rent on a building used for both office space and manufacturing purposes? • Income and expenses must be treated with consistency so that comparisons of one period with those of another period will not be misleading.

How are items classified in the Income Statement? • A company is a separate legal entity, and pays tax on profits. Therefore, it shows net profit before tax, tax expense, and net profit after tax. • Sole traders, not the business, pays taxes, so the tax paid is shown on the individual’s tax return. • The information is much more summarised than for a sole trader. • The numbers in the ‘notes’ column provide reference to further notes to the accounts, which provide more detailed information on each item.

Theory of the Income Statement These are some of the common uses to which the Income Statement may be put: • It will be included in a report to shareholders (owners) and used by them to form an opinion regarding the progress of the business and the effectiveness of the management group. • It may be submitted to banks in support of a request for a loan. The banks use it to judge the earnings prospects of the business. • It may be used by investors in reaching decisions on whether to: – buy, – continue to hold, or – sell securities issued by the business.

Theory of the Income Statement • It may be used by management to: – judge the effectiveness of their past policies and decisions, – to detect unfavourable trends and developments, and – to provide data for decision making on such matters as whether to: – – – expand production change advertising policy introduce a new product alter selling prices merge with another company.

Theory of the Income Statement • Other users of the Income Statement: – the government uses it as a basis formulating tax and economic policy – customers can use it to determine the business’s ability to provide needed goods and services – unions examine earnings closely to establish a basis for salary discussions.

Theory of the Income Statement • Thus, the Income Statement provides: – useful information for evaluating the past performance of the business. – important trends may be determined. – helps users to determine the risk (level of uncertainty) of achieving particular cash flows. – Information on the various components of income – revenue, expenses, gains, and losses – highlights the relationship among these components. • Is the Income Statement the only document used for these purposes? No. The Balance Sheet is also very important, as are directors’ and analysts’ reports.

Recommended reading • Smart et al. : Chapter Six, pages 117 -128, 141 to 143 • Workbook: Lesson Four: Income Statement