TOPIC 1: Measuring and Reporting Financial Performance Flashcards
Lecture 4, Chapter 3 (38 cards)
Define ‘Income Statement’.
Shows the profit or loss generated over a specific period; therefore, it is also known as a ‘Profit and Loss Statement (P&L)’.
A key financial statement used by companies to report their financial performance over a specific period, typically a month, quarter, or year.
What is the purpose and use of an income statement.
To define profit or loss for a period.
Purpose: To measure of a company’s financial performance over a specific period (e.g. quarter or year).
- It records revenue and expenses to calculate the net profit or loss for that period.
- A part of financial accounting, where variable costing is used externally, and absorption costing is used internally, and is presented to the bank.
Use: Analysing profitability, assessing effectiveness, and comparing performance to e.g. aid decision-making.
But it does not reflect cash flows, which are handled by the cash flow statement.
Describe the link between the income statement and the statement of cashflows.
The income statement reports the profit (or loss) of a business over a period, while the statement of cash flows shows how that profit translates into actual cash.
The statement of cash flows adjusts the net income from the income statement for non-cash items and changes in working capital to show the net cash generated or used in operating activities.
Explain the financial reporting cycle (accounting period).
A financial reporting cycle of one year is the norm.
Some large businesses produce a half-yearly or interim report (on a quarterly, monthly, weekly, or even daily basis) to provide more frequent feedback on progress to show how things are progressing.
Remember! Not the same as a budget.
What are the main components of an income statement?
- Revenue: Earnings from main business activities, e.g., sales
- COGS: Direct costs tied to goods/services sold (material, labour and overhead)
- Gross Profit = Revenue – COGS
- Operating Expenses: Ongoing business costs like rent, wages, utilities
- Operating Profit (EBIT) = Gross profit – operating expenses
- Other Income/Expenses: Financial gains/losses, e.g., interest or investment income
- Net Profit (Net Income): Final profit after all expenses and taxes
Define the order in which key elements appear in an income statement.
1. Revenue (total revenue, COGS, and gross profit)
2. Expenses (operating income/loss)
3. (EBIT and) Net income/loss
Define the two formats of income statements.
1. Single step format: Two measures of profitability = pre-tax income (EBIT) and net income.
2. Multi-step format: Four measures of profitability = gross income, operating income, pre-tax income and net income.
How is profit calculated (formula)?
Profit = Revenue – Cost of Goods Sold
Define ‘Revenue’ in an income statement.
A section including all the earnings by the company from its primary business activities, such as sales of goods or services.
Explain the recognition (recording) of revenue and the problem hereof.
Revenue recognition refers to the accounting rule that determines when revenue is recorded in the income statement.
Core principle: Revenue is not always recognised when cash is received, since revenue can be both cash and trade receivables (credit), but instead when it is earned.
Problem: Trade receivables have to be recorded when it is earned, which can happen at various points:
- The time the order is placed by the customer.
- The time the order is received by the 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 organisation’s bank account.
How should revenue generally be recognised?
Generally, it is important to define the point where one wants to recognise a sale (revenue).
Revenue is recognised when ownership and control transfer from seller to buyer, not when cash is received. Here, risks and rewards are transferred to the buyer.
This keeps reported profit aligned with the actual business activity, not cash flow timing.
For long-term projects (>1 year), revenue may be recognised in phases (periods), and each phase should have a price to ensure revenue for each financial year.
Explain the recognition (recording) of trade receivables and the risk hereby.
When businesses sell goods or services on credit, revenue will usually be recognised before the customer pays the amounts owing.
Risk: Some customers may never pay = bad debt.
So, to provide a more realistic picture of financial performance and position, the bad debt must be ‘written off’.
Define bad debt and explain how they are “written off”.
Bad debt = When it becomes reasonably certain that the customer will never pay, the debt owed is considered to be a bad debt.
Should be:
- Recognised as an expense
- Written off in the same period as the related revenue
Explanation:
Writing off a bad debt involves reducing the trade receivables and increasing expenses (by creating an expense known as ‘Bad debts written off’ and ‘Allowance for doubtful debts’) by the amount of the bad debt.
The matching convention requires that the bad debt be written off in the same period as the sale that gave rise to the debt is recognised.
What is meant by “Bad debts written off” and “Allowance for doubtful debts”?
Bad debts written off = These are debts definitely known to be uncollectible.
Allowance for doubtful debts = These are debts that may not be collected (based on estimation).
Define ‘Cost of Goods Sold (COGS)’ in an income statement.
A section including 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.
COGS = Opening Inventory + Purchases − Closing Inventory
Define ‘Inventory Valuation’ related to the COGS.
Costing inventory.
Three approaches used for costing:
1. First in, first out (FIFO): The earliest inventories held are the first to be used.
2. Last in, first out (LIFO): The latest inventories held are the first to be used (not permitted under IFRS).
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.
Explain the FIFO approach.
First-In First-Out = The oldest inventory items (the first bought) are sold first.
This doesn’t mean the physical goods are sold in that order, but that costs are accounted for in that order.
For example, if 900 units are sold, this is withdrawn firstly from the opening inventory of 100 units, then from any inventory bought during the period of 1300 units, resulting in a closing inventory of 500 units (valued at the latest price of purchase).
So, the oldest inventory costs are used for calculating the cost of sales, and the newest costs remain in the closing inventory.
In times of rising prices, FIFO results in:
- Lower COGS
- Higher profit
- Higher ending inventory value
Explain the LIFO approach.
Last-In, First-Out = The most recently purchased inventory is assumed to be sold first.
This doesn’t mean the physical goods are sold in that order, but that costs are accounted for in that order.
For example, if 900 units are sold, this is withdrawn first from the latest inventory bought during the period of 1300 units, then from the opening inventory of 100 units, resulting in a closing inventory of 500 units (valued at the earliest price of purchase).
So, the newest inventory costs are used first when calculating the cost of sales, and the oldest costs remain in the closing inventory.
In periods of rising prices, LIFO leads to:
- Higher COGS
- Lower profit
- Lower ending inventory value
Explain the AVCO approach.
Average Cost or Weighted Average Cost = All units of inventory are valued at the average cost per unit, regardless of when they were purchased.
Method:
- Step 1: Calculate the weighted average Cost = toal cost / total amount
- Step 2: Cost inventory sold based on the weighted average cost
So, the same average cost is applied to all inventory, no matter when it was bought. This gives a balanced view during times of price changes.
AVCO results in:
- Moderate COGS
- Moderate profits
- Stable inventory valuation
Define ‘Net Realisable Value (NRV)’ in relation to inventory valuation.
Inventory has a net realisable value.
The estimated selling price of inventory.
NRV = Selling price – Estimated costs to complete/sell
It considers 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.
Define ‘Gross Profit’ in an income statement.
The revenue a company earns from its sales, minus the direct costs associated with producing those goods or services.
Gross Profit = Revenue - Cost of Goods Sold
What is another way to express the gross profit?
As a margin: The percentage of revenue remaining after deducting the cost of goods sold (COGS) from total revenue.
Gross Profit Margin = (Gross Profit ÷ Revenue) × 100
Define ‘Operating Expenses’ in an income statement.
A section including 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.
Explain the recognition (recording) of expenses.
Expense recognition refers to the accounting principle that determines when an expense should be recorded in the financial statements.
This is guided by two key conventions:
- Matching convention
- Materiality convention
So, deciding when and how much of an expense to report, based on:
- Whether it helps earn current period revenue (Matching), and
- Whether it’s worth tracking precisely (Materiality).
