Income Statement Part 2 Notes

2) Income Statement – Part 2

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Definition

A financial statement of an organization which measures the financial performance of the business for a specified accounting year.

In other words

The income statement is also known as the profit and loss statement, P&L, statement of income, and the statement of operations.

Why is it important?

The income statement is a very important document for the users. Income statement shows the revenues and expenses of a company for the year. Users can find a plenty of important information on the income statement including the entity's sales, productivity, gross profit and net profits for their future decision making

Lecture Notes

Expense Recognition

Expenses are defined as decreases in monetary benefits during the year in the form of outflow of resources or incurrence of liabilities that result in decreases in equity, other than dividends to shareholders.

The matching principle

This concept states that the revenues and the expenses incurred to earn that revenues must belong to the same accounting period.

For e.g. If annual rent expense (Jan-Dec) is $1000. and the accounting period is from July to June, according to matching concept $500 will be recognised in the income statement (1000 x 6/12).

Examples of Expenses recognition

Following are some major expenditures an entity recognises in the income statement

1. Cost of goods sold (Inventories):

Formula: COGS = opening inventory + purchases - closing inventory

There are certain costing methods of inventory

1. First in First out (FIFO)

2. Last in First out (LIFO)

3. Weighted average cost

2. Provision for bad debts (Provision for doubtful debts)

The provision for bad debt expense is basically calculated out of the current year’s debtors. It is an estimation of future loss based on the past experiences and the credit ratings of the debtors.

The provision is made on the debtors after deducting the bad debt expense, the whole provision will be recognised as an expense in the income statement in the first year.

For subsequent years Increase in the provision for bad debt will be recorded as an expense and decrease in the provision for bad debt as an income to be shown in the income statement.

3. Warranties:

Some businesses may have a warranty policy, means they promises customers to repair or exchange specific types of damage to their products within a certain period of time after sales. If the company can reasonably estimate the amount of warranty claims, it should recognised an expense in the income statement that suggests the cost of these estimated claims within the accounting period..

4. Depreciation

Depreciation is the systematic allocation of the asset’s cost less scrap value over its useful life

Following are some methods of providing Depreciation in the financial statements

• Straight Line Method:

Under this method fixed percentage on original cost is deducted from the asset every year. Means every year same amount of depreciation expense.

The amount of depreciation is calculated as follows.

Annual Depreciation = Cost of the Asset - Scrap Value

Useful life

• Reducing Balance Method:

This method is also known as Diminishing balance method. Under this method depreciation is charged at a fixed rate on the reduced balance every year. Depreciation expense is high in earlier years and lower in the later years.

5. Amortization

Intangible assets with a definite life decreases in value over time and is calculated in a process called amortization. Amortization is like depreciation of intangible assets and recorded as an expense in the income statement

However, goodwill or brand names, which are also intangible assets, are exempted from amortization because its useful life is indefinite. They are annually test for impairment

6. Unusual or Infrequent Items

In this category there are items that are either rare or unfamiliar in nature but cannot be both.

Examples of unusual or infrequent items:

• Profit / loss as a result of the tempering of a company's business segment such as cost of cessation of the business unit or a manufacturing plant

• Profit / loss as a result of a litigation

• Loss of business operations due to a natural disaster

7. Extraordinary Expenses

Events that are both rare and unfamiliar in nature are known as extraordinary expenses.

Example of extraordinary items:

• Profit / loss from early departure of debt

• Loss from seize of assets

8. Discontinued Operations

Sometimes management decides to dispose of certain business units but either has not yet done so or did it in the current year after it had generated Profit / loss. To be accounted for as a discontinued operation, the business must be...

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