Accounting The Income Statement Part 2
Dr. Clive Vlieland-Boddy FCA FCCA MBA
The Income Statement • The Income Statement (Profit and Loss account or Income & Expenditure Account), summarises the incomes and expenses of the enterprise for the period stated. • The 4 accounting concepts are essential. Remember… Going Concern, Accruals, Consistency and Prudence. • This statement tells how well management have done in generating profits for the firm. • It is a statement of financial performance.
The Income Statement • It is a statement of what has actually been consumed in the relevant period. • Summaries the activity of the period. • What is not consumed or still exists is taken to the Balance Sheet. • It like a movie picture of the companies activities over the period. • It says how fast the business is going.
Basic Format of the Income Statement Incomes ( Sales or Revenues) Less: Cost of Sales Gross Profit Overheads Net Revenue
Sales and Cost of Sales • Sales - Actual activity. • Cost of Sales - Normally we have Inventories to deal with as we consume these to fulfil sales. Cost of Sales could also include production wages and sales discounts.
Inventories • Take a Pizza Restaurant. • At the first day of the new year, it would have a freezer with unsold pizzas. • During the year, it would sell these but also buy more which again most would hopefully be sold. • On the end of the final day of the year it would have some pizzas to be sold in the next year. • We have to ensure that we only bring into the income statement what has actually been consumed.
Inventories - Accounting • They are recognised in the Income Statement as a deduction as they need to be taken to the next accounting period to be recognised “to be matched” with their actual sale. • This years closing inventories will be next years opening. • And as a Current Asset in the Balance Sheet
Overheads or Operating Expenses These are the costs that a business has to meet to operate even if it does not sell any goods. Examples: • Sales and Marketing • Wages & Salaries • Admin Expenses • General Overheads • Bad Debts • Depreciation ( we will deal with later) • Profit or loss on sale of NCA ( we will deal with later)
Usual Layout Normally grouped together in major categories like: • Sales and Marketing • Admin
Selling & Marketing Expenses • These represent the cost associated with selling items. Normally advertising and marketing , sales commissions. • They are normally included in the Overheads. In certain instances they could be shown as a Cost of Sales. ( e.g. A Mail Order Catalogue Company)
Bad Debts • Some Accounts Receivable become un collectable. Often when the customer goes bankrupt. • The asset is therefore lost and we show this as a bad debt under overheads and reduce Accounts Receivable in Current Assets.
Profit or Loss on sale of Non Current Assets • Whilst you may well depreciate non current assets on an intelligent basis, with the aim to match the consumption of the value over the expected useful life, often there is a difference when the item is actually sold. • Such loss or profit is recognised when incurred.
EBIT PBIT & EBITDA • EBIT = Earnings before Interest & Tax • PBIT = EBIT • EBITDA = EBIT or PBIT plus Depreciation and Amortisation
Post EBIT/PBIT • Interest • Tax • Dividends • Exceptional Items.
Taxation and the Accounts There are two types of taxation. • Firstly Mainstream Taxation which is the amount that the business will pay usually based on a percentage of the net profit. • Secondly, Deferred Taxation. This represents tax not actually payable now but could be payable in the future. This adjustment is made to recognise that the matching concept must apply.
Deferred Taxation Example: • A company has a tax rate of 50%. However, due to accelerated relief for investment onto new plant the actual tax payable this year is only 42%. However, over the next 5 years, this benefit will be reversed. • In order to match the correct tax bill with the profits generated, a deferred tax account is set up for the 8%, and reversed over the next 5 years.
Net Profit ( Net Earnings) • This represents the profit after overheads and expenses have been deducted from the gross profit. • NOTE: Often net profit is taken before Interest an Tax. This is called EBIT or PBIT (Earnings / Profit Before Interest &Tax)
Abnormal & Exceptional Items • Abnormal = Likely to happen again. They should be shown as an overhead. • Exceptional = Unlikely to happen again. They can be shown after EBIT.
Abnormal Vs Exceptional Items • Items that are abnormal but could happen again should be included in the accounts. The should be shown separately if material. • Note that if the item is one that is very unlikely to happen again then it can be shown as a deduction after EBIT/PBIT has been struck.
Restructuring Charges: Employee Severance • Employee severance costs represent the accrual of estimated costs relating to the termination of employees as a result of a restructuring program. • Asset write-downs: restructuring activities that usually encompass closure or relocation of manufacturing or administrative facilities. • Inventory • LT Assets • Goodwill
Examples of non Operating Items • Discontinued Operations • Extraordinary Items • Changes in Accounting Principle
Extraordinary Items • Extraordinary items represent transitory events that are both unusual and infrequent. • Extraordinary items are segregated from the rest of the income statement items and presented separately following income from continuing operations. • The company makes the determination of whether an event is unusual and infrequent.
Examples of Abnormal Items Write-down or write-off of assets Foreign currency gains and losses Gains and losses form disposal of specific assets or business segments Effects of a strike Accrual adjustments related to long-term contracts Costs of defense against a takeover Costs incurred as a result of the September 11, 2001 events.
Change in Accounting Principle • A change in accounting principle results from adoption of a generally accepted accounting principle (GAAP) or IFRS different from the one previously used for reporting purposes. • The effect of this change needs to be reported. Normally it is an extraordinary item. • For comparability the previous years have to be restated adopting the accounting changes so that the consistency principal is maintained
Common Size Statement • See page 115
Earnings Per Share (EPS) • This is a very useful indicator. • It represents the earnings attributable to the ordinary shareholders divided by the total number of ordinary shares. • (We will return to this later)
Coffee Break • 12.4.1
Accruals or Matching Concept • We must match revenue with the relevant expenses. • So if we are selling cars, we have to match the cost of the cars sold and the expenses that flow from those sales. • We need to recognise revenue with the correct expenditure and expenditure with the correct revenue
Financial Accounting The basis of accounting & Inflation
Historic Vs Current Cost • Historic = The original Cost • Current Cost = Current replacement value.
Long Term Contracts • Contracts say for the building of the Channel Tunnel take many years. • The constructors have to deal with the fact that they need to match income and expenditure. • Normally they will interim bill. • They need to match the costs and make any provisions that are appropriate.
Long Term Contracts • Often use % of Completion method • Will have in the contract when invoicing can be made. • Mark to Market or Fair Value accounting. Allowed under IFRS but is now being criticised. After all it was successfully misused and abused by Enron!!!!!
Capital Vs Revenue Expenditure • Essentially we differentiate these expenditures in order to match the income with expenditure. (The accruals concept) • If we expend funds on non current assets then we have to recognise that that investment needs to be matched with the revenues that it generates over several years. We therefore take it to the Balance Sheet. ( We will discuss the issue of depreciation later )
Capitalise Vs Expense • The Balance Sheet shows assets and liabilities. • An assets and an expense represent a resource acquired by the enterprise. • This can either be capitalised and brought in to the Balance Sheet as an asset. OR: • Written off as an expense in the Income Statement.
Revenue Expense Consumed and Still to be Consumed • Consider a restaurant selling pizzas. At the beginning of the day it will have a fridge full of these. Clearly as it sells the pizzas to customers they are consumed. But at the close of the day, there are still some in the fridge. • Essentially we differentiate these types (consumed and unconsumed) in order to match the income with expenditure, also known as the accruals concept. • The consumed will be listed as cost of sales in the Income Statement, but the unconsumed items will represent closing inventories and shown in the Balance Sheet.
Stanley Tools • www.stanleyworks.com
Summary Balance Sheet & Income Statement • Profits or Losses for the year are added or subtracted from the Retained Earnings
Balance Sheet & Income Statement – Optimistic Balance Sheet 31 December 2002 Profit & Loss Year 2003 Balance Sheet 31 December 2003 Liabilities £350,000 Liabilities £350,000 Assets £500,000 Assets £550,000 Revenues £1,000,000 Expenses £950,000 Shareholders Equity £150,000 Shareholders Equity £200,000 Profit £50,000 Profit added to Retained Earnings
Balance Sheet & Income Statement Balance Sheet 31 December 2007 Profit & Loss Year 2008 Balance Sheet 31 December 2008 Liabilities £350,000 Liabilities £425,000 Assets £500,000 Assets £525,000 Shareholders’ Equity £150,000 Revenues £950,000 Expenses £1,000,000 Shareholders’ Equity £100,000 Loss £50,000 Loss – to Reduce Retained Earnings
Quiz Time. Exercise 4 • Where in the income statement would you look for the following?