Topic 3 Accounting For Managers

Accounting for
Managers
Week 3 (Ch 3)
MEASURING AND
REPORTING
FINANCIAL
PERFORMANCE
The statement of financial performance –
its nature and purpose, and its
relationship with the statement of
financial position
• The purpose of the income statement or statement of
financial performance is to measure and report how much
profit (financial progress or wealth) the business has generated
over a period
• Profit (or loss) is the difference between the increases in
owners’ equity (capital), 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
Copyright © 2018 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781488612589/Atrill/Accounting for Non-Specialists/7e
financial position
• The two main accounting statements are closely linked, but they
perform different functions
• The statement of financial position (Chapter 2) shows a
‘snapshot’ of the wealth of a business at a point in time
• The statement of financial performance shows the generation of
wealth over a period of time
 Links the financial position at the beginning of a period to the
financial position at the end of that period
financial position
• The accounting equation can show the link between the
statements of financial position and performance
Example
• At the opening of a new business, its financial position is
represented by the accounting equation:
financial position
Example (continued)
• At the end of the first period, an income statement will show the
wealth generated over that period:
• At the end of the period, a revised statement of financial position

will be prepared to incorporate the changes in wealth that have
occurred since the beginning of the period:
The format of the income statement
Example 3.1
The format of the income statement
• Varies according to:

 The entity structure (e.g. non-profit, sole proprietorship,
partnership, corporation)
 The nature of its operations (e.g. manufacturing, retail,
service)
The format of the income statement –
Key terms
• 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 the profit for the year after a reasonable
estimate of tax likely for the year
• Cost of sales (or cost of goods sold) is the cost attributable to
the sales revenues
 Each business’s approach to cost of sales depends on the type
and scale of its business
Example 3.2
Example 3.3
• Inventory calculations are sometimes shown on the face of the

income statement:
Classifying expenses
• How income and expense items are classified on the income

statement involves judgement
• Normally expenses are classified under four main headings:
 cost of sales
 selling and distribution
 administration and general
 financial
The reporting period
• For external reporting, the reporting cycle is normally one year

• For internal functions, it is common for profit figures to be
prepared on a much more frequent basis
• It is common for income statements to be prepared on a
quarterly, monthly, weekly or even daily basis depending on
need, in order to show how things are progressing
Recognition of revenues
• 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:
 at the time that the order is placed by the customer?
 at the time that the car is collected by the customer?
 at the time that the customer pays the dealer?
• The point chosen can have a major impact on the amount of
revenue and profit recognised in a period
• The main criteria for recognising revenue are that:

 the amount of revenue can be measured reliably
 it is probable that the economic beneﬁts will be received
• For sales of goods (as opposed to services) also that:
 ownership and control of the items should pass to the
buyer
Long-term contracts
• Some contracts, such as construction contracts, often extend over a long period
of time
• The may be broken down into stages to facilitate revenue recognition

throughout the contract
• This is provided that the outcome of the contract as a whole can be estimated
reliably
Services
• Some services may also take years to complete
• Similarly, these may be broken into stages and revenue is recognised as each
stage is completed
• If such a breakdown is not possible, then revenue will not usually be recognised
until the service is fully completed
Cash versus accrual revenue recognition
• The application of the revenue recognition criteria means that

revenue is often recognised before the related cash is
received
• Alternatively, cash may be received in advance of revenue
being recognised, e.g. a cash deposit
• This approach is called ‘accruals accounting’
• Revenue is recognised on the basis that it has been earned
irrespective of whether the cash receipt is in arrears or advance
• Revenue is deemed to be earned when it is realised; realisation
being closely linked to probability of occurrence and reliability of
measurement
• ‘Cash accounting’ means recognising transactions at the time
when cash flows take place
Recognition of expenses
• The matching convention states that expenses should be

matched to the revenue that they helped generate
• This gives rise to three possibilities when recognising expenses in
a period:
 the cash payments are the same as the expenses incurred
(benefits used up or consumed)
 the cash payments are less than the expenses incurred, or
 the cash payments exceed the expenses incurred

• The challenges of the second and third possibilities are illustrated
in Examples 3.4, 3.5 and 3.6
Example 3.4
Example 3.5
Example 3.6
Profit, cash and accruals accounting – 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
Profit measurement and the calculation
of depreciation
• Depreciation is an attempt to measure that portion of the cost (or
fair value) of a non-current asset that has been depleted in
generating the revenue recognised during a particular period
• Depreciation is a cost allocation process – not an estimate of an
asset’s current fair market value
• Four factors have to be considered:
 the cost (or other value) of the asset
 the useful life of the asset

 the estimated residual value of the asset
 the depreciation method
Calculating depreciation
The cost (or fair value) of the asset

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

Estimated residual value (disposal value)
• Expected value at the end of the useful life of a non-current asset
Example 3.7
Example 3.7 continued
Depreciation methods
Straight-line depreciation – Allocates the amount to be

depreciated evenly over each year of the useful life of the asset
Accelerated/reducing-balance depreciation – Applies a fixed

percentage rate of depreciation to the written-down value of an
asset each year
Units of production based depreciation – the depreciation

expense allocated to each period reflects the portion of the asset’s
total available capacity that has been ‘used up’ in the current period
The useful life of the asset is measured in terms of its output (e.g.
kilometres travelled, hours of operation) rather than time elapsed
See Example 3.8 (page 104) for Straight Line

depreciation Figure 3.3
See Example 3.9 (page 106) for Reducing Balance

method Figure 3.4. And comparison of both methods on
page107
Profit measurement and the calculation
of depreciation
Written-down value
• The cost or value of an asset less the accumulated amount
written off as depreciation to date can be referred to as its:
 written-down value
 net book value, or
 carrying amount
Depreciation and the replacement of
fixed assets
Depreciation does not provide funds for asset replacement; it is
used to calculate net profit
Where an asset is to be replaced, the depreciation expense in the

income statement will not ensure that liquid funds are set aside
specifically for this purpose
• RETAINED EARNING
• RESERVES
Depreciation and judgement
Depreciation is an example of an accounting process that requires

judgement
Different judgements will produce different patterns of

depreciation expense over the lives of assets and, therefore,
different patterns of reported profits
Any under- or over-estimations made in this context will be adjusted

for in the final year of an asset’s life (as a gain or loss on disposal)
Profit measurement and the
valuation of inventory
What is inventory?
• Finished goods, raw materials, stores or supplies and work-in-
progress
What is the cost of inventory?
• Includes all costs directly related to bringing the inventory
into a saleable state (ready to sell):
 cost of purchase
 costs of conversion
 other costs (e.g. storage, security, display)
What is the basis for transferring the
inventory cost to cost of sales?
• First in, first out (FIFO) – the earliest inventories held are the
first to be used
• Last in, first out (LIFO) – the latest inventories held are the
first to be used
• Weighted average cost (AVCO) – inventories entering the
business lose their separate identity and go into a ‘pool’; any
issues with inventories then reflect the average cost of the
inventories that are held
• See pages 111 and 112 for calculation and comparison of the
mothods
• IMPACT WILL BE ON COGS AND VALUE ENDING BALANCE OF FG
Example 3.10
Perpetual inventory system
• Maintains continuous records of all inventory movements at

both cost and selling price
• At any point in time the business knows what inventory should
be on hand and what the cost of sales for the period to
date has been
• Physical inventory counts are still undertaken to confirm the
inventory balances and to assess inventory losses
Physical/periodic inventory system
Much simpler than perpetual, does not maintain records of the

cost of inventory sold,
The inventory (asset) account remains unchanged during the year
and is updated at the end of the period following a stock
count
HENCE END OF FINANACIAL YEAR SALES!!!!!!!!!!!!!
The net realisable value (NRV) of
inventory
• The estimated selling price less any further costs necessary
to complete the goods and any costs involved in selling and
distributing those goods
• Accounting standards require valuing inventory on the basis of the
lower of cost and net realisable value on an item-by-item
basis
• International Financial Reporting Standards (IFRS) require that,
for external reporting, the cost of inventories should normally be
determined using either FIFO or AVCO, and also requires the
“’lower of cost and NRV’ rule to be used
• The LIFO assumption is not acceptable for external reporting
The net realisable value (NRV) of
inventory
Consistency convention
• Holds that when a particular method of accounting is selected to
deal with a transaction, this method should be applied
consistently over time
• Inventory valuation and depreciation provide two examples of
where the ‘consistency convention’ should be applied
Profit measurement and the problem of
bad and doubtful debts
• The recognition of bad and doubtful debts is associated with
accruals accounting in general and specifically the matching principle
• The risk of credit sales is that the customer will not pay the amount
due
• A bad debt is an amount owed to a business that is considered to be

irrecoverable, and must be ‘written-off’, which increases
expenses and reduces accounts receivable
• Doubtful debts (those not known with certainty to be bad) are

estimated using either a percentage of credit sales or the aged
listing of accounts receivable, and recorded as an expense on the
income statement and as a deduction from accounts receivable,
called ‘allowance for doubtful accounts’ on the statement of
financial position
Example 3.11
Uses and usefulness of the income
statement
• Analysing sales levels – against history and planned sales for
the current/future periods
• Examining the nature and amount of expenses incurred
 comparison against history and future
 indicator of efficiency of business operations
• Investigating gross profit levels in relation to sales in similar
businesses
 helpful in assessing profitability and margins
• Analysing net profit levels; for example, against previous
periods and also in relation to sales
Example 3.12
Example 3.12 continued
Online resources
• Financial Statement Ratios: Determining Company Performance,

video, Education Portal (7:32)
• Income statement, Accounting Coach
• Bank profits explode as bad debts reduce, New Zealand Herald

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Accounting for

• At the end of the period, a revised statement of financial position

• Varies according to:

• Inventory calculations are sometimes shown on the face of the

• How income and expense items are classified on the income

• For external reporting, the reporting cycle is normally one year

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

• The main criteria for recognising revenue are that:

• The may be broken down into stages to facilitate revenue recognition

• The application of the revenue recognition criteria means that

• The matching convention states that expenses should be

 the cash payments exceed the expenses incurred

 Total expenses are not the same as cash paid

 the useful life of the asset

The cost (or fair value) of the asset

• Economic life may be shorter than physical life

Straight-line depreciation – Allocates the amount to be

Accelerated/reducing-balance depreciation – Applies a fixed

Units of production based depreciation – the depreciation

See Example 3.8 (page 104) for Straight Line

See Example 3.9 (page 106) for Reducing Balance

Where an asset is to be replaced, the depreciation expense in the

Depreciation is an example of an accounting process that requires

Different judgements will produce different patterns of

Any under- or over-estimations made in this context will be adjusted

• IMPACT WILL BE ON COGS AND VALUE ENDING BALANCE OF FG

• Maintains continuous records of all inventory movements at

Much simpler than perpetual, does not maintain records of the

HENCE END OF FINANACIAL YEAR SALES!!!!!!!!!!!!!

• A bad debt is an amount owed to a business that is considered to be

• Doubtful debts (those not known with certainty to be bad) are

• Financial Statement Ratios: Determining Company Performance,

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