MONASH

BUSINESS
SCHOOL

ACC/ACF5903 Accounting for Business

Lecture 3
Measuring & Reporting Financial
Performance
Dr. Karen Zhang

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 Learning Objectives / Lecture Outline

1. The introduction of Income Statement

2. Understand and recognize revenue and expense
3. Adjusted entries: why, what, and how
4. Why depreciation and how to depreciate
5. Inventory cost
6. Bad debt
7. Summary
 Statement of Financial Performance

• The purpose of the income statement or statement of

financial performance is to measure and report how much
profit (wealth) the business has generated over a period
• Profit (or loss) is the difference between the increases in
owners’ equity, known as income, and the decreases in
owners’ equity, known as expenses.

• Income is made up of revenue (from operating activities) and

gains (usually from non-operating activities)

• Expenses are outflows of resources to generate income

 Relationship Between
Financial Performance & Financial Position

• The two main accounting statements are closely linked but

perform different functions

• Statement of financial position (Chapter 2) shows ‘snapshot’

at a point in time

• Statement of financial performance shows generation of

wealth over a period of time

o Links financial position at beginning of period to financial

position at end of period
• Artificially divide the life of a company into
annual periods is for the purpose of financial
reporting
• Why is there a demand for periodic
performance measures?
– Valuation (e.g., short term pressure from market)
– To evaluate management performance
• Reward management (managerial labor market)
 Relationship Between
Financial Performance & Financial Position

Links financial position at beginning of period to financial

position at end of period:

Assuming no Contributions or Drawings/Dividends:

Assets = Liabilities + Opening Equity + Income – Expenses

• Explained on Income Statement

• Equals Profit
 Format of the Income Statement

• Varies depending on:

o Entity structure (e.g. non-profit, sole trader, company)
o Nature of operations (e.g. manufacturer, retail, service)

• Gross profit refers to the difference between the revenues

from sales and the cost of those sales

• Operating profit refers to the increase in wealth for a period

that is generated from normal operations

• Profit for the period is Operating profit plus/minus non-

operating income/expenses and an allowance for tax
Format of the Income Statement

Note the use of

(brackets) to
indicate a
number that is
subtracted.
Minus signs are
not used.
Different forms of revenue
 Practice
• Consulting firm - > fees for services
• Sports club - > subscriptions fees, court fees
• Newspapers - > sales, advertising
• Finance company - > interest received
Cost of Sales / Cost of Goods Sold

Cost of sales (expense) is the main expense incurred by many

entities – in order to sell goods and generate income

Cost of Inventory at Inventory at

–sales =
Inventory beginning of periodat +costPurchases
Cost of sales price – end of period

Available Inventory
Supplies expense calculated in a similar way to Cost of Sales:
i.e. Supplies expense = Supplies asset at beginning of period + purchases
of supplies during period – Supplies asset at end of period
Physical flow of manufacturing
Example 3.3

Cost of Sales calculation sometimes shown on the face of the

income statement:
 Classifying Income and Expense

• How income and expense items are classified on the income

statement involves judgement
• Normally expenses are classified under four main headings:
o Cost of Sales (or Cost of Goods Sold for a manufacturer)
o Usually refers to inventory, but service businesses (e.g. a restaurant)
may also categorise some expenses this way

o selling and distribution

o administration and general
o financial
Cash versus Accrual Revenue Recognition

Under ‘accrual accounting’:

• The revenue recognition criteria mean revenue is often

recognised before the related cash is received

• Also, cash may be received before revenue is recognised, e.g.

a customer makes a prepayment of cash

• This is in contrast to ‘Cash Accounting’ in which revenue is

recognised at the time when cash flows take place
 Recognition of Income

• A key issue in the measurement of profit concerns the point

at which income (revenue) is recognised

• Consider when a motor car dealer would recognise revenue

on a customer sale. Would it be:

o at the time that the order is placed by the customer?

o at the time that the car is collected by the customer?

o at the time that the customer pays the dealer?

• Point chosen can have major impact on amount of revenues

and profit recognised in a period
 Recognition of Income

• Main criteria to recognise revenue are:

o the amount of revenue can be measured reliably

o it is probable that the economic benefits will be received

• For sales of goods (as opposed to services) also:

o ownership and control of the items should pass to the buyer

o The significant risk and reward pass to the customer

o The business has the right to demand the payment

 Recognition of Income
Long-term contracts

• Some contracts, such as construction contracts, often extend

over a long period of time

• Broken down into stages to facilitate revenue recognition

throughout the contract

Services

• Some services may also take years to complete

• Similarly, these are broken into stages and revenue is

recognised as each stage is completed

• E.g. the work done by a lawyer on a house purchase for a client

has been years
 Another example: Research and Development
expenses (R&D)

• The treatments of R&D expenses under different jurisdiction:

• AACSB (1983): (1) Research costs and development costs
should be charged to expense as incurred; (2) costs incurred
during the R&D projects should be deferred to future period
only when future benefits from R&D projects are expected.
• China (2007): the successful R&D project shall be identified as
assets in a given year financial report, otherwise, reported as
expenses in the same financial year.
Before producing financial statements

• Financial statements are produced at a point in time, i.e. the

end of a reporting period

• “Balance day” adjustments

• update account balances to take account of events that
are known but not yet reflected in the accounts: adjusting
entries
• Adjusting entries include “accruals”

• At the start of the next reporting period, some adjusting

entries are reversed in order to avoid double-counting:
”reversing entries”
Entries required under Accrual Accounting

INCOME RECOGNITION
▪ When the goods are sold or the services but cash not
receive yet
▪ accounts receivable

▪ Before producing financial statements, adjusting entries

are necessary if there is:
▪ income earned but not yet billed (Accrued income)
▪ cash received but income not earned (Unearned
income)
▪ Subject to the materiality convention, i.e. what is
expedient given the significance of the adjustment
 Typical Examples of adjusting entries

• A company shipped goods on credit, but the company's sales invoice was
not processed as of the end of the accounting period
• A company received some goods from a vendor but the vendor's invoice
had not been processed by the company as of the end of the accounting
period
• A company that prepares monthly income statements paid for 6 months of
insurance coverage in the first month of the insurance coverage.
• A company's customer paid in advance for services to be provided over
several accounting periods. Until the services are provided, the unearned
amount is reported as a liability. After the services are provided, an entry
is needed to reduce the liability and to report the revenues.
 Accrued income
(income earned but not yet billed)
Architect produces plans for a client and passes the plans to the
client in early June. As at the end of June, the architect hasn’t yet
issued an invoice for the $1000 fee and the client hasn’t paid the
cash

Q. Can income be recognised? Has income been earned?

The adjusting entry:

A = L + E (Income - Expenses)
accrued income Services income
+ $1000 A + $1000 I
 Unearned income
(cash received but not earned)
Midway through a year, a magazine company receives $336 in
subscriptions for 24 monthly issues of a food magazine, i.e. $14
per issue.
The income statement must be prepared at the end of the same
year, i.e. 6 months later.
Q. Has income been earned at end of reporting period, i.e. after 6
months?

There are 2 ways that this transaction could initially have been
recorded:
1. Initially as subscription revenue (income)
2. Initially as unearned subscription revenue (liability)
1. Initially recorded as subscription revenue

When receive cash

A = L + E + (I - E)
cash subscriptions
+ $336 (A) + $336 (Income)

Adjusting entry at year end to reflect income not being earned

A = L + E + (I - E)
unearned income subscriptions
+ $252 (L) - $252 (I)

The effect of this adjusting entry will be to show unearned

income of $252 and subscription revenue of $84

‘Unearned income’ aka ‘income in advance’ or ‘deferred

revenue’
2. Initially recorded as a liability

When receive cash

A = L + E + (I - E)
cash unearned income
+ $336 (A) + $336 (L)

Adjusting entry at year end to reflect portion of income

earned
A = L + E + (I - E)
unearned income subscriptions income
- $84 (L) +$84 (I)

The effect of this adjusting entry will be to show unearned

income of $252 and subscription revenue of $84
• Same as before
Expense Recognition

Expenses are included in the income statement when they are

incurred rather than when they are paid for.
– accounts payable, interest payable, wages payable, etc
The matching convention holds that expenses should be matched
to the revenue that they helped generate
• Before producing financial statements, adjusting entries are
required if there are:
– expenses paid for but not incurred in the period (Prepaid
Expenses)
– expenses incurred but not yet recognized, e.g. the invoice
has not yet been received (Accrued expenses)
– Some expenses don’t involve cash at all, e.g. depreciation

– Subject to the materiality convention, i.e. what is expedient

given the significance of the adjustment
 Prepaid expense
(cash paid but no expense incurred yet)

On 1 March, a retailer took out a new insurance policy for paying

an annual premium of $4800. Preparing accounts at June end:
• Has cash been paid?
• Has expense been incurred?

There are 2 ways that this transaction could have been recorded
on 1 March:
1. As an expense
2. As a prepaid expense (an asset)

This way in Assignment 1

1. Initially recorded as an expense

A = L + E + (I - E)
cash insurance
- $4800 (A) + $4800 (E)

Adjusting entry at reporting year end to reflect expense not

incurred:
A = L + E + (I - E)
prepaid ins insurance
+$3200 (A) - $3200 (E)

The effect of this adjusting entry will be to show, at the end of

June, a prepaid expense of $3200 and an insurance expense of
$1600.
2. Initially record as a prepaid asset
A = L + E + (I - E)
cash
- $4800 (A)
prepaid ins
+$4800 (A)

Adjusting entry at year end to reflect expense incurred

A = L + E + (I - E)
prepaid ins insurance
- $1600 A +$1600 (E)
The effect of this adjusting entry will be to show, at the end of
June, a prepaid expense of $3200 and an insurance expense of
$1600.
• Same as before!
 Accrued expense
(expense incurred but expense not yet recognised)

An entity last paid its workers on 20th June. The wages owing
at reporting date (30th June) is $5000
Q. Has cash been paid?
Q. Has expense been incurred?

Adjusting entry to reflect expense incurred

A = L + E + (I - E)
accrued wages wages
+ $5,000 (L) + $5000 (E)
 A review
• It is important to remember that:
❑ Total revenue does not usually represent cash received
❑ Total expenses are not the same as cash paid
❑ The profit figure (revenues minus expenses) does not
normally represent the net cash generated from
operations during a period
❑ Profit is a measure of achievement, or productive effort,
rather than a measure of cash generated
 Depreciation

• A measure of that portion of the cost (less residual value) of

a fixed asset which has been consumed during an accounting
period

• Four factors are considered:

o the cost (or other value) of the asset

o the useful life of the asset

o the estimated residual value of the asset

o the depreciation method

 Depreciation

Useful life of the asset

• The economic life of the asset determines the expected
useful life of the asset for the purpose of calculating
depreciation
• Economic life may be shorter than physical life
Cost of the asset
• Includes all costs incurred by the business to bring the asset to its
required location and make it ready for use, e.g. delivery,
installation, legal title, alterations, improvements, etc.

Residual value (disposal value)

• Expected value at the end of the useful life of a non-current asset
• The “depreciation” of intangible assets we call
it impairment, such as goodwill, the licence to
operate a mobile phone business
 Accounting for depreciation

Each year:
• Record Depreciation Expense in Income Statement (reduces
Profit)
• Add Depreciation amount to Accumulated Depreciation
account in Balance Sheet.
• represents the cumulative amount of depreciation
expense on the asset
• Accumulated Depreciation account is a contra account.
• It is deducted from the asset account in the Balance
Sheet
 Depreciation Methods

1. Straight-Line Method (% of cost)

Assumes equal consumption each accounting period over
useful life of asset.
Depreciation pa = (Cost – Residual Value) ÷ Useful life

2. Reducing Balance Method

Assumes fixed proportion of consumption based on a
percentage of economic benefits used during a period

3. Units of production Method

Consumption depends on percentage of total capacity used in
the period
 Example (straight line depreciation)
Equipment is purchased for $47 000 with an estimated
useful life of 5 years and expected residual value of
$11,000
Annual depreciation expense = Cost of asset – Expected residual value
Asset’s expected useful life

= $47 000 – $11 000 = $7,200 p.a.

5 years
Year 1 Book Value:
Equipment $47,000
Less Acc Dep’n ( 7,200)
$39,800
Example (Reducing Balance depreciation)

Equipment is purchased for $47 000 with an estimated

useful life of 5 years and expected residual value of $11,000
• Reducing balance rate: 25.2%
Depreciation expense:
• Year 1: 25.2% x $47,000 = $11,844
• Year 2: 25.2% x $35,156 = $ 8,860

Year 1 Book Value: Year 2 Book Value:

Equipment $47,000 Equipment $47,000
Less Acc Dep (11,844) Less Acc Dep (20,704)
$35,156 $26,296
Example (Units of Production method)
Equipment is purchased for $47 000 with an estimated
useful life of 50,000 hours and expected residual value
of $11,000
• First year usage: 12,000 hours

Depreciation expense:
12,000 x $36,000 / 50,000 = $8,640
Book value:
Equipment $47,000
Less Acc Dep (8,640)
$38,360
 Effect of Accounting choice on profit:

Straight-line depreciation Reducing Balance dep’n

Income $36,000 Income $36,000

Cash expenses 25,000 Cash expenses 25,000

Depreciation 7,200 Depreciation 11,844

Profit/(Loss) 3,800 Profit/(Loss) (844)

Similarly, profit also affected by estimates of residual value, life, etc.
 Profit Measurement and the
Valuation of Inventory
Inventory
• Finished goods, raw materials, stores or supplies and work-
in-progress

Cost of inventory
• Includes all costs directly related to bringing the inventory
into a saleable state:
o cost of purchase
o costs of conversion
o other costs
 Basis for Transferring the
Inventory Cost to Cost of Sales (COS)

First in, first out (FIFO)

• the earliest inventory held is the first to be sold

Last in, first out (LIFO)

• the latest inventory held is the first to be sold

Weighted average cost

• a weighted average cost is determined, to derive cost of sales
and cost of remaining inventory held
 Example. 1,000 tonnes are sold …

On May 6, 1,000 tonnes are sold. What is Cost of Goods Sold?

First in, first out (FIFO): COGS = 1,000 x $10 = $10,000

Last in, first out (LIFO): COGS = 1,000 x $12 = $12,000

Weighted average cost:

Total cost of 14,000 tonnes: $10,000 + $55,000 + $96,000=$161,000
Weighted average cost: $161,000 ÷ 14,000 = $11.50 per tonne
COGS = 1,000 x $11.50 = $11,500
 Effect of Accounting choice on profit:

Let’s extend the example by assuming the coal was

sold for $13 per tonne:

FIFO Weighted Average

Income $13,000 Income $13,000

COGS 10,000 COGS 11,500
Gross Profit 3,000 Gross Profit 1,500
GP Margin 23.1% GP Margin 11.5%

Accounting choices make a difference!

 Inventory

Perpetual inventory system

• maintains continuous records of all inventory movements,
records both cost and selling price, and volume

Physical/periodic inventory system

• much simpler than perpetual, does not maintain records of
cost of inventory sold, the inventory (asset) account remains
unchanged during the year and is updated at end of period
following a stock count
 Inventory

Net realisable value (NRV)

• The estimated selling price less any further costs necessary to
complete the goods and any costs involved in selling and
distributing the goods
• Accounting standards require valuing inventory on the basis of the
lower of cost and net realisable value on an item-by-item basis
• Inventory valuation and depreciation are good examples of where
the ‘consistency convention’ should be applied

Consistency convention
• Holds that when a particular method of accounting is selected to
deal with a transaction
• Should be applied consistently over time
 Profit Measurement and the
Problem of Bad and Doubtful Debts
• The risk of credit sales is that the customer will not pay the
amount due, thus ‘bad debts’ are created and ‘doubtful debts’
when collection is uncertain. Bad debts must be ‘written-off’ which
increases expenses and reduces profit

• Allowance for doubtful debts estimated using either the

percentage of credit sales or the aged debtors listing approach
(increase doubtful debt expense, increase allowance)

• Bad debt is considered to be irrecoverable :

• Increase “bad debt expenses” or “bad debts written off”

• Reduce “accounts receivable”

• When uncertain debts raise:
– An expense labelled ‘doubtful debts expenses’ to
be included in the income statement
– A deduction from the accounts receivable account
labelled ‘allowance for doubtful debts’ to be
include in the balance sheet
 From lecture 2 Example 2.
B. Beetle – Sole Trader
In January, Beetle:
1 Jan. Bought a van for $4 000
4 Jan. Received a bank loan of $12 000 (9 month term)
5 Jan. Bought some furniture for $8 000 on credit
8 Jan. Delivered $5,000 services to a customer on credit
12 Jan. Paid rent on premises of $1 000 cash
15 Jan. Paid salaries to sales staff of $1 400 cash
24 Jan. Banked cash received in payment for services $6 000
30 Jan. Received and paid electricity bill for $400

Required:
1. Analyse the transactions and enter them in the worksheet
2. Prepare (unadjusted) Income Statement and Balance Sheet
 Example 2 solution

BALANCE SHEET INCOME STATEMENT

Date ASSETS LIABILITIES EQUITY INCOME EXPENSE Notes

Vehicle Office Office Acc

Cash Prepayments Vehicles Acc. Dep'n Supplies Equip't dep'n A/Rec A/Pay Bank loan Capital Drawings

o/balances $20,000 $12,000 $800 $18,000 $6,400 $9,000 $30,000 $18,200

1 Jan -$4,000 $4,000
4 Jan $12,000 $12,000

5 Jan $8,000 $8,000

8 Jan $5,000 $5,000 Services
12 Jan -$1,000 $1,000 Rent
15 Jan -$1,400 $1,400 Wages
24 Jan $6,000 -$6,000
30 Jan -$400 $400 Electricity
$31,200 $0 $16,000 $0 $800 $26,000 $0 $5,400 $17,000 $42,000 $0 $18,200 $0 $5,000 $2,800
 “Balance day” Adjusting entries
BALANCE SHEET INCOME STATEMENT
Date ASSETS LIABILITIES EQUITY INCOME EXPENSE

Vehicle Office Office Acc

Cash Prepayments Vehicles Acc. Dep'n Supplies Equip't dep'n A/Rec A/Pay Bank loan Capital Drawings
Opening
balances $20,000 $12,000 $800 $18,000 $6,400 $9,000 $30,000 $18,200
1 Jan -$4,000 $4,000
4 Jan $12,000 $12,000

5 Jan $8,000 $8,000

8 Jan $5,000 $5,000
12 Jan -$1,000 $1,000
15 Jan -$1,400 $1,400
24 Jan $6,000 -$6,000
30 Jan -$400 $400
Unadjusted
month end
balances $31,200 $0 $16,000 $0 $800 $26,000 $0 $5,400 $17,000 $42,000 $0 $18,200 $0 $5,000 $2,800
Adjusting Entries

Closing
balances $31,200 $0 $16,000 $0 $800 $26,000 $0 $5,400 $17,000 $42,000 $0 $18,200 $0 $5,000 $2,800
Uses & Usefulness of the Income Statement
• Analysing sales levels – against history and planned sales for
the current/future periods
• Investigating gross profit levels in relation to sales in similar
businesses
o helpful in assessing profitability and margins

• Examining the nature and amount of expenses incurred

o comparison against history and future
o indicator of efficiency of business operations

• Analysing net profit levels, for example against previous

periods and also in relation to sales
• Useful? Remember the role of choice: in accounting methods
and in making estimates