Topic 3 Financial Statements - Income Statement Solutions PDF

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Topic 3 Financial Statements – Income statement Solutions: Comprehension questions 6.4

Describe the users who would be interested in the financial position and performance of an entity and explain their interest.

Users who would be interested in the financial position and performance of an entity include both internal and external users: a. internal users (i.e. management) are interested in ascertaining whether the entity’s strategic directions, investing and financing decisions, and product lines are profitable. b. external users such as:   

6.5

shareholders are interested in the profit generated by the entity as the profit will influence return on equity, future dividends and capital returns. creditors (e.g. banks) are interested in ascertaining if borrowers can generate sufficient cash to service debt obligations when they fall due. parties performing a review or oversight function (e.g. government, labour union). Examples include: regulators who are interested in knowing whether entities are complying with the relevant regulations and satisfying reporting requirement; labour unions can use reported accounting numbers to support their wage demands; and government can use reported accounting numbers to determine the need for increasing or decreasing government assistance for various activities and industries.

Explain if the following statements true or false for an entity using the accrual method of accounting. a.

Income statements are used only by users external to the entity.

False. Internal users such as management also need the income statement to assess the profitability of their investment decisions and the appropriateness of their financing decisions. b.

Revenue from sales is included in the income statement when it is received, not when it is earned.

False. Since financial statements are prepared on the basis of accrual accounting rather than cash accounting, it is not necessary for cash to have been received for an item to be recognised as sales revenue. Under accrual accounting, revenue from sales is recognised when it is earned.

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True. Based on the accrual basis of accounting, all expenses incurred in the reporting period are recognised in the income statement. Expenses incurred but unpaid at balance date are included as an expense with a liability recognised in the balance sheet. d. At the end of the reporting period, revenue received for services not yet provided needs to be excluded from the profit or loss determination. True. Under the accrual accounting, revenue should be recognised when the earning process is complete. If the services have not been rendered or provided, irrespective of the cash being received, the earnings process is incomplete and the revenue should not be recognised in the current period.

6.6

Discuss the difference between profit or loss and comprehensive income.

Profit is a measure of accounting return and is determined as income less expenses. The profit figure is not a measure of the change in entity value from the beginning to the end of the reporting period because not all value changes result in income or expenses that are recognised in the income statement. For example, if the entity is fair valuing property, plant and equipment, any increment in value bypasses the income statement and is directly credited to a revaluation reserve account. Other comprehensive income, on the other hand, refers to items that result in changes in equity and are required or permitted by accounting standards to be taken directly to equity rather than recognised in the income statement as part of profit or loss. Examples of such items are:  revaluation of non-current assets;  net exchange differences associated with translating foreign currency denominated accounts of a subsidiary into the reporting currency of the group; and  adjustments to equity allowed pursuant to the operation of a new accounting standard. 6.11 Describe the items that are likely to be present in a statement of changes in equity. A statement of changes in equity shows the changes in an entity’s equity between two reporting periods. Items that are likely to be present in a statement of changes in equity include:  opening balance of the entity’s equity (which could consists of capital, reserves, and retained earnings) in the beginning of reporting period;  additional capital contributed by owners during the period (for sole traders and partnerships), or shares issued (for companies);  profit or loss for the period;  distributions to owners during the period, in the form of drawings (for sole traders and partnerships) or dividends (for companies);  changes in reserves, such as from foreign exchanges or asset revaluation;  closing balance of the entity’s equity at the end of reporting period.

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6.12 Items of income and expenses may be included in the income statement only if they can be measured with certainty. Discuss. The Conceptual Framework specifies two requirements that must be satisfied for an item to be recognised as income or expense. Firstly the increase (decrease) in the future economic benefits must be probable (more likely than less likely), and secondly it must be able to be measured reliably. The term ‘reliably’ does not necessarily mean with certainty, because in practice there are many transactions involving estimations that cannot be measured with certainty. For example, in determining the depreciation expense, the useful life of the asset needs to be estimated. The term ‘reliably’ then means the item can be objectively determined, and the reason behind the estimation (if any) can be justified. Therefore, for income or expenses to be included in the income statement they must meet the probability criteria and secondly, they have to satisfy the reliable measurement criterion.

6.14 Explain the difference between income and revenue. The definition of income includes both revenue arising in the ordinary course of activities (e.g. sales, fees, dividends) and gains (e.g. gains on disposal of non-current assets). Therefore, revenue is a subset of income.

6.15 Explain the difference between profit or loss, gross profit and EBIT. The term ‘profit or loss’ refers to the residual (net) income remaining after deducting all expenses incurred by an entity for the reporting period, including finance costs (i.e. interest expense) and income tax. Gross profit, on the other hand, is the remaining revenue after deducting cost of sales. Subsequently, gross profit is calculated as sales revenue less cost of sales. Afterwards, all other expenses (such as wages, sales and administration, interest, etc.) are deducted from gross profit to arrive at the entity’s profit or loss for the period. EBIT (i.e. ‘Earnings Before Interest and Taxation’) refers to profit before net interest and income tax expense. It is the relevant figure to analyse returns associated with investment decisions only. To calculate EBIT, income tax for the period is added to the entity’s profit to give profit before tax figure. If the entity has net finance income (costs), then the net finance income (costs) is deducted (added) from (to) profit before tax to give EBIT.

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Exercises 6.16 Consider each of the following transactions and examine whether they satisfy the income definition criteria: a. Received cash for services to be provided in the next reporting period b. Borrowed money from a bank c. Credit sale of goods d. Receipt of deposit for future work to be performed e. Obtained a bank loan and received $20 000 f. Received a grant from a government body to assist with an export program. To satisfy the income definition criteria there must be:  an increase in economic benefits during the reporting period via an increase in assets or reduction in liabilities;  resulting in an increase in equity;  which must not be related to contributions from equity participants (i.e. owners). a.

Received cash for services to be provided in the next reporting period This does not satisfy the income definition, because the services have not been provided. There is an increase in assets (i.e. cash), but there is no increase in equity. Rather, the corresponding entry is an increase in liabilities in the form of unearned revenue. Therefore, revenue received in advance is not recognised as income in the current reporting period.

b.

Borrowed money from a bank This does not satisfy the income definition, because although there is an increase in economic benefits through an increase in assets (cash), there is no increase in equity. Instead, the increase in assets results in the increase of liabilities (bank loan).

c.

Credit sale of goods This satisfies the income definition, because it results in increase in an entity’s assets (its accounts receivable) that increases equity and does not relate to contributions from equity participants.

d.

Received cash for goods sold This satisfies the income definition, because it results in increase in an entity’s assets (cash) that increases equity and does not relate to contributions from equity participants (i.e. the cash is from customers).

e.

Owner contributed $20 000 to fund a new product line This does not satisfy the income definition, because although there is an increase in economic benefits through an increase in assets (cash) that increases equity, the $20 000 relates to contributions from equity participants (i.e. owner).

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f.

Received a grant from a government body to assist with an export program

This satisfies the income definition, because unlike a loan, a grant results in an increase in assets but no change in liabilities. This presumes that the grant is received in the period in which the export program is conducted. Consequently, there will be an increase in equity. Accounting standards require that government grants must be recognised as income, on a systematic basis over the periods necessary to match them with the related costs which they are intended to compensate.

6.17 Consider each of the following transactions and examine whether they satisfy the expense definition criteria: a. Paid wages owing from the previous reporting period b. Owner withdrew money for a holiday c. Owed money to telephone company for phone charges this reporting period d. Purchased inventory on credit e. Paid a supplier for goods that had been purchased on credit f. Purchased a computer system to computerise the accounting records. To satisfy the expense definition there must be:  a decrease in economic benefits during the reporting period via a decrease in assets or an increase of liabilities;  resulting in a decrease in equity;  which must not be related to distributions to equity participants (i.e. owners). a.

Paid wages owing from the previous reporting period This does not satisfy the expense definition. Although there is a decrease in economic benefits via a decrease in assets (cash), there is no corresponding decrease in equity. Rather, the decrease in assets is offset by a reduction in liabilities (accrued wages/wages payable). Under accrual accounting, an expense would have been recognised through an adjusting entry in the previous reporting period when it is incurred (i.e. in the previous period, wages expense would have been increased and wages payable would have been increased).

b.

Owner withdrew money for a holiday This does not satisfy the expense definition, because it is relates to a distribution to equity participants (the owner) in the form of owner’s withdrawal of money.

c.

Money owed to Telstra for phone charges this reporting period This satisfies the expense definition, because the phone has been used in the period and there is an obligation for the entity to pay Telstra in the future. Thus, there is a decrease in economic benefits for the entity via an increase in liabilities (accrued phone expense) which decreases equity, and payment for the phone charges does not relate to distributions to equity participants.

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d.

A property asset is impaired An asset is impaired when the asset’s carrying amount exceeds its recoverable amount. In that case, AASB 136 Impairment of Assets prescribes that the asset’s carrying amount shall be reduced to its recoverable amount. This reduction, known as impairment loss, satisfies the expense definition. Impairment loss results in a decrease in economic benefits in the form of decrease in asset (e.g. carrying amount of property) which decreases equity, and the loss does not relate to distribution to equity participants.

e.

Paid a supplier for goods that had been purchased on credit This does not satisfy the expense definition. Although there has been a decrease in economic benefits via the reduction of cash at bank, there is no decrease in equity. The decrease in assets is offset by the reduction of a liability (accounts payable).

f.

Purchased a computer system to computerise the accounting records This does not satisfy the expense definition because the decrease in cash is offset by the increase in another asset class, namely property, plant, and equipment. Overall, equity remains the same.

6.19

Solve the missing items for each independent case. The cost of sales is 60 per cent of sales revenue for each case.

Sales Revenue

Cost of Sales

-

180 000 170 000 d. 204 500 875 000 110 000 m.

108 000 102 000 122 700 525 000 66 000

Other Expenses

+ a.

32 000 30 000 115 000 255 000 32 000

g. j.

=

Profit 40 000 38 000 - -33200 h. 95 000 12 000 n.

b. e. k.

Total

Retained =

Assets

+

Share Capital

+

Total Liabilities

Earnings

864 000c.

589 000

250 000

25 000

621 000 180 000 645 000 615 000o.

195 000f. 75 000 450 000 186 000

225 000 80 000 145 000l. 400 000

201 000 25 000i. 50 000 29 000

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Profit = Sales Revenue – (Cost of Sales + Other Expenses), where Cost of Sales is 60 per cent of Sales Revenue Total Assets = Total Liabilities + Share Capital + Retained Earnings a) b) c) d) e) f) g) h) i) j) k) l) m) n) o)

Cost of Sales = 60% * 180 000 = 108 000 Other Expenses = 180 000 – 108 000 – 40 000 = 32 000 Total Assets = 589 000 + 250 000 + 25 000 = 864 000 Sales Revenue = 102 000 * (100/60) = 170 000 Other Expenses = 170 000 – 102 000 – 38 000 = 30 000 Total Liabilities = 621 000 – (225 000 + 201 000) = 195 000 Cost of Sales = 60% * 204 500 = 122 700 Profit = 204 500 – (122 700 + 115 000) = -33 200 Retained Earnings = 180 000 – 75 000 – 80 000 = 25 000 Cost of Sales = 60% * 875 000 = 525 000 Other Expenses = 875 000 – 525 000 – 95 000 = 255 000 Share Capital = 645 000 – 450 000 - 50 000 = 145 000 Sales Revenue = 66 000 * (100/60) = 110 000 Profit = 110 000 – 66 000 – 32000 = 12 000 Total Assets = 186 000 + 400 000 + 29 000 = 615 000

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8 6.22 You have just completed the income statement for the reporting period. The CEO (who has no accounting background) is reviewing the statement you have prepared, and asks you to explain why the profit is relatively low compared to the increase in the cash at bank during the reporting period. Prepare a report for the CEO offering some suggestions that would explain this.

To: From: Date: Subject:

Joe Blogg, CEO Accountant XX/XX/XXX Accrual and cash accounting

Dear Mr. Blogg, I am writing to you in response to your query as to why profit for this reporting period is relatively low compared to the increase in the cash at bank. In trying to understand the difference between profit and cash, it is important to remember that profit is calculated as income earned less expenses incurred for the reporting period, irrespective of whether cash has been paid/received. Profit may not equate to cash partly due to using accrual accounting. This is because accrual accounting recognises expenses when they are incurred and income when it is earned. In this case, our company might have received deposits for future works to be performed resulting in an increase in cash at bank. However, since the works have not been performed, the deposit received is not recognised as income. Instead, it is recognised as a liability owed by the company to its client. This is one possible explanation why the profit is relatively low compared to the increase in the cash at bank. Another plausible reason for the difference is that expenses have been incurred (and deducted from income in the calculation of profit) but the expenses have not been paid. The payment will occur in a future period. Another reason why profit does not equate to cash is that not all items involving cash flows are income or expense items and affect profit. For example, money raised via a share issue will increase cash at bank but has no impact on profit determination. Further, the calculation of profit involves non cash expenses such as depreciation and amortisation. Depreciation charges will reduce reported profits but have no impact on cash balances. Please do not hesitate to contact me should you have further questions. Yours sincerely, Accountant

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6.23 Categorise each of the following expenses into one of the expense types listed at the top of the columns:

Purchases Depreciation of office equipment Sales commission Interest expense Lease charges Sales staff salaries General staff salaries Advertising Freight charges on purchases Bank charges Utility expenses

Cost of sales √

Selling & distribution

Administratio n and general

Finance

√ √ √ √ √ √ √ √ √ √

6.24 In its first year of operations, Benson Pty Ltd earned $160 000 in services revenue, $24 000 of which was on account and still outstanding at the end of the reporting period. The remaining $136 000 was received in cash from customers. The company paid expenses of $40 000 in cash. Included in the $40 000 paid is $15 000 for insurance coverage that will not be used until the second year. Additionally, there is $22 000 still owing on account at the end of the reporting period. a. Apply cash accounting to calculate the first year profit of Benson Pty Ltd. Income = $136 000 ($24 000 is not recognised as it has not been received in cash) Expenses = $40 000 (the $22 000 balance of expenses is not recognised as it has not been paid) Cash-based profit = $136 000 – $40 000 = $96 000 b. Apply accrual accounting to calculate the first year profit of Benson Pty Ltd. Income = $160 000 (the whole revenue is recognised as services have been rendered) Expenses = $40 000 - $15 000 + $22 000 = $47 000 (The $15 000 for prepaid i...