The Income Statement

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<ul><li><p>THE INCOME STATEMENTTHE INCOME STATEMENT</p><p>LECTURE 4</p></li><li><p>LEARNING OBJECTIVESLEARNING OBJECTIVES` Understand what an income statement is` Explain the structure of an income statement` Get familiar with key income statement itemsy` Describe the main revenue and expense categories and </p><p>how to arrive at profit figuresp g` Assess the possibilities for creative accounting in profit </p><p>measurement` Discuss the role and limitations of income statement</p><p>WBS, 2013-14Panagiotis Dontis Charitos2</p></li><li><p>IN TODAYS LECTUREIN TODAY S LECTURE...` Topics` Income statement definition and structure` Income statement items` Revenues, expenses, profits` Detailed analysis of chosen items</p><p>` A i i t fit fi f th ` Arriving at a profit figure for the year` Problem areas and items` Role and limitations of income statements` Role and limitations of income statements</p><p>WBS, 2013-14Panagiotis Dontis Charitos3</p></li><li><p>INCOME STATEMENT: OVERVIEWINCOME STATEMENT: OVERVIEW` Presents the activities of a company for a given period` States revenue, expenses and profit (loss)` Incurred during the specified period` Income statement of Alpha Ltd for the year ended 31 December 2010</p><p>` Summarises financial performance for a defined period` Companys ability to generate profit by increasing revenue </p><p>and/or reducing costs` H ll th i ti h d it t k ` How well the organisation has used its resources to make </p><p>profit</p><p>WBS, 2013-14Panagiotis Dontis Charitos4</p></li><li><p>INCOME STATEMENT: OVERVIEWINCOME STATEMENT: OVERVIEW` Presents amount of:` Revenues earned during period (sales, other income)` Expenses incurred during period (costs)` COGS distribution admin depreciation financing ` COGS, distribution, admin, depreciation, financing </p><p>` Tax to be paid` Distribution of profits to shareholdersp` Dividends</p><p>` Preparation and content underpinned by accounting standards and principles</p><p>` Reminder:f ` Profit is not the same as cash receipts</p><p>` It follows a general form...</p><p>WBS, 2013-14Panagiotis Dontis Charitos5</p></li><li><p>INCOME STATEMENT: EXAMPLE 1INCOME STATEMENT: EXAMPLE 1</p><p>WBS, 2013-14Panagiotis Dontis Charitos6</p></li><li><p>INCOME STATEMENT: EXAMPLE 2INCOME STATEMENT: EXAMPLE 2</p><p>WBS, 2013-14Panagiotis Dontis Charitos7</p></li><li><p>INCOME STATEMENT: STRUCTURE &amp; TERMINOLOGYTERMINOLOGY` Revenues` Total amount of sales for the period` Also known as turnover or sales</p><p>` Cost of Sales` Also known as Cost of Goods Sold` COGS</p><p>` Gross profit` Difference between sales figure and cost of goods that have </p><p>been sold` Excludes inventory` Revenues COGS</p><p>WBS, 2013-14Panagiotis Dontis Charitos8</p></li><li><p>INCOME STATEMENT: STRUCTURE &amp; TERMINOLOGYTERMINOLOGY` Distribution costs</p><p>C l d di ib i f d` Cost related to distribution of products` Administration expenses` Expenses not directly tied to manufacturing/production or sales` Expenses not directly tied to manufacturing/production or sales` Related to the organization as a whole` Senior executive salaries, accountants etc.</p><p>` Depreciation` Operating profit` Difference between gross profit and sum of operating expenses` Shows profit from operations` Also known as earnings before interest and tax (EBIT)` Also known as earnings before interest and tax (EBIT)` Allows comparison of companies with different capital structures </p><p>and tax rates</p><p>WBS, 2013-14Panagiotis Dontis Charitos9</p></li><li><p>INCOME STATEMENT: STRUCTURE &amp; TERMINOLOGYTERMINOLOGY` Finance income` Interest received</p><p>` Financing costs` Interest paid</p><p>` Profit before tax` Operating profit + finance income finance expenses` Also known as earnings before tax (EBT)` Allows comparison of companies in different tax environments</p><p>` Tax` Tax on EBT (i.e. 30%)</p><p>WBS, 2013-14Panagiotis Dontis Charitos10</p></li><li><p>INCOME STATEMENT: STRUCTURE &amp; TERMINOLOGYTERMINOLOGY` Profit after tax` Profit for the period` Difference between EBT and tax payable</p><p>` Determines` Earnings per share (EPS)` Amount of dividend` Retained earnings` Changes in equity` Balance as at 31st December 2010 (Beginning Balance)</p><p> fi f h i d` + profit for the period` - dividends for the year` = Balance as at 31st December 2011 (End Balance)</p><p>WBS, 2013-14Panagiotis Dontis Charitos11</p><p>` Balance as at 31 December 2011 (End Balance)</p></li><li><p>ARRIVING AT THE PROFIT FIGURE: AN EXAMPLEARRIVING AT THE PROFIT FIGURE: AN EXAMPLE</p><p> + 100,000Sales Revenue 100,000</p><p> - 40 000 Find:iCOGS - 40,000</p><p> 10 000</p><p>Find:</p><p>Gross ProfitOperating Profit</p><p>Find:</p><p>Gross Profit: 60,000Operating Profit: 50 000</p><p>Admin expense - 10,000</p><p> 10 000</p><p>Operating ProfitEBITEBT</p><p>Profit for period</p><p>Operating Profit: 50,000EBIT: 50,000EBT: 60,000</p><p>Profit for period: 42,000</p><p>Finance Income - Expense</p><p> + 10,000 Profit for period</p><p>Tax (30%) - 18,000</p><p>WBS, 2013-14Panagiotis Dontis Charitos12</p></li><li><p>INCOME STATEMENT &amp; BALANCE SHEET: REVISITEDREVISITED...` Changes in equity` Balance as at 31st December 2010 (beginning Balance)` Add profit for the period` Deduct dividends for the year` Balance as at 31st December 2011 (end Balance)</p><p>` Or using balance sheet...` Increase (decrease) in equity = profit (loss)` Equity (beginning balance) Equity (end balance)</p><p>` Deduct proceeds of share issue (if applicable)Add d d d d` Add any dividends paid</p><p>` Deduct any amount resulting from revaluation of assets</p><p>WBS, 2013-14Panagiotis Dontis Charitos13</p></li><li><p>DETAILED ITEMS: REVENUESDETAILED ITEMS: REVENUES` Sales: How much is earned for goods sold` Sales revenue; Turnover </p><p>` Income for services rendered (rent revenue; fees; subscriptions etc )subscriptions etc.)</p><p>` Underlying principle : Realisation concept` Invoice has been sent` Invoice has been sent` Incentive to bring sales forward` Practice cannot be perpetuated` Practice cannot be perpetuated</p><p>` Has the service been provided during the period` Cash may be received earlier or latery` Service provision capable of yielding cash` Sales includes credit sales</p><p>WBS, 2013-14Panagiotis Dontis Charitos14</p></li><li><p>DETAILED ITEMS: EXPENSESDETAILED ITEMS: EXPENSES` Amounts used in providing the sale or service during the </p><p>period` Accruals concept` Examples: Wages, Cost of raw materials used, Electricity, Rent ` Not the amount paid during period` Amount incurred in earning revenue</p><p>` Trading businesses have significant Cost of Sales or Cost of Goods Sold expenses` Cost of goods used in making the sale</p><p>WBS, 2013-14Panagiotis Dontis Charitos15</p></li><li><p>DETAILED ITEMS: EXPENSESDETAILED ITEMS: EXPENSES` Cost of Goods Sold` Opening and closing inventory are important` Determine COGS` Profit</p><p>` Overstating closing inventory overstates profit and makes balance sheet look betterbalance sheet look better` Important to value inventories at cost</p><p>` Example 1:` Example 1:Alpha ltd had no inventory at the beginning of the period. In February Alpha buys100 items at 10 each. During the period Alpha sells 70 products at 15 each and30 it i ld i t 30 items remain unsold as inventory.</p><p>Find the Gross Profit for the period</p><p>WBS, 2013-14Panagiotis Dontis Charitos16</p><p>p</p></li><li><p>DETAILED ITEMS: EXPENSES EXAMPLE 1DETAILED ITEMS: EXPENSES...EXAMPLE 1</p><p>Sales Purchases 100x10 1 000</p><p>I </p><p>70x15 1,050</p><p>1,000</p><p>Inventory 30x10 300</p><p>Gross Profit = Sales COGS 1,050 (1,000 300) </p><p>Gross Profit = 350</p><p>WBS, 2013-14Panagiotis Dontis Charitos17</p><p>Gross Profit 350</p></li><li><p>DETAILED ITEMS: EXPENSES EXAMPLE 2 DETAILED ITEMS: EXPENSES...EXAMPLE 2 </p><p>WBS, 2013-14Panagiotis Dontis Charitos18</p></li><li><p>DETAILED ITEMS: EXPENSESDETAILED ITEMS: EXPENSES` Depreciation` Purchase of non-current assets not immediately treated as </p><p>expenseN ib fi i d f i ( f l ` Non-current assets contribute to profit over a period of time (useful life)</p><p>` Each year a portion of cost of non current asset is shown in the y pincome statement as expense</p><p>` Goal is to charge as expense against profit the amount of asset that has been used uphas been used up</p><p>` Accruals and matching principle` Depreciation not paid out of cashp p</p><p>` Cost allocation not asset valuation` Less obvious in standardised income statements</p><p>WBS, 2013-14Panagiotis Dontis Charitos19</p></li><li><p>DETAILED ITEMS: EXPENSESDETAILED ITEMS: EXPENSES` Depreciation methods` Straight line method` Takes into account initial cost, useful life and salvage price</p><p>If i i i l i 10 000 f l lif i 4 d ll f If initial cost is 10,000, useful life is 4 years and expect to sell asset for 2,000 then total amount to be depreciated is 8,000 (2,000 per year)</p><p>` Diminishing balance methodg` Takes into account initial cost, percentage of yearly depreciation Charge 33% depreciation on the assets remaining balance each year. </p><p>10 000(1 33) 6 700(1 33) 4 489(1 33) 3 008(1 33)10,000(1-.33) 6,700(1-.33) 4,489(1-.33) 3,008(1-.33) Balance at end of year 4 is 2,015</p><p>` Leads to higher depreciation in early years and lower depreciation in later years</p><p>` Other methods i.e. amount of miles per annum for car</p><p>WBS, 2013-14Panagiotis Dontis Charitos20</p></li><li><p>DETAILED ITEMS: EXPENSESDETAILED ITEMS: EXPENSES` Impairment of goodwill` Goodwill is a non-current asset` Does not last indefinitely` Its value should be depreciated or amortised</p><p>` Difficult to assess its useful lifeI i h ` Impairment test each year</p><p>` Impairment charge when loss of value is determined` Grey area in accounting` Grey area in accounting...` Dubious value write-off as soon as possible` Current view Goodwill lasts indefinitely (no amortisation)y ( )` Official requirement annual impairment test Subjective: much room for creative accounting...</p><p>WBS, 2013-14Panagiotis Dontis Charitos21</p></li><li><p>PROBLEM AREAS AND ITEMSPROBLEM AREAS AND ITEMS` Capital and revenue expenditures` Capital expenditure is purchase of asset` Spread over useful life through depreciation</p><p>` Revenue expenditure includes maintenance, cost of usage` Possible treatment of maintenance as improvement to asset </p><p>may lead to overstated profitsmay lead to overstated profits</p><p>` DepreciationV l i f i i` Valuation of inventories...</p><p>` Timing and recognition of revenue...All impact on the level of reported profit!</p><p>WBS, 2013-14Panagiotis Dontis Charitos22</p></li><li><p>INCOME STATEMENT: ROLE AND LIMITATIONSINCOME STATEMENT: ROLE AND LIMITATIONS` Role</p><p>S i fi i l f` Summarises financial performance` Reveals areas for profit improvement` Facilitates financial control, comparison` Facilitates financial control, comparison` Monitoring and budgetary control` Time series and cross section</p><p>L` Limitations` Performance differs across firms` Identify capital asset liability structures` Identify capital asset liability structures` Different accounting policies</p><p>` Profit not the same as cash flows` Profit not enough` Should consider profit in relation to investment` ROCE, ROE, ROA</p><p>WBS, 2013-14Panagiotis Dontis Charitos23</p><p>, ,</p></li><li><p>READING LISTREADING LIST` Core reading` Perks and Leiwy` Chapter 2</p><p>` Further reading` Perks and Leiwy` Chapter 3 section 3.7</p><p>WBS, 2013-14Panagiotis Dontis Charitos24</p></li><li><p>REMEMBERREMEMBER...</p><p>` Accounting inevitably ` Accounting inevitably allows some room for cooking the numbers...</p><p>` So be critical when assessing a companys financials</p><p>WBS, 2013-14Panagiotis Dontis Charitos25</p></li></ul>