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Dec 13, 2013 (3 years and 5 days ago)

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BA606 FINANCIAL
ACCOUNTING

Professor Garry Carnegie

Lectures 9 & 10

Lecture 9: The income statement

Introduction

Measurement of profit

Accounting standards

Introduction

The income statement is one of four
financial statements resulting from the
financial reporting process

The statement is often known as the profit
and loss statement or statement of
financial performance

The use of income statement is
inconsistent with use of “profit and loss
statement” in the Corporations Act 2001

Measurement of profit

Profit, as a measure of performance, is the
overriding goal of business entities as opposed
to not
-
for
-
profit organisations

The reported profit figure, otherwise known as
periodic profit, usually attracts the most attention

Accounting standard
-
setters have, not
surprising, set out to improve the measurement
and reporting of profit, sometimes to the
disadvantage of the balance sheet



Measurement of profit

According to the Framework, “information about
the performance of an entity, in particular its
profitability, is required in order to assess
potential changes in the economic resources
that is it likely to control in the future” (para. 17)

“… It is also useful in forming judgements about
the effectiveness with which the entity might
employ additional resources” (para. 17)

Measurement of profit

The elements income and expenses are directly
related to the measurement of profit

It is common practice to distinguish between
items of income and expenses that arise from
the ordinary activities of the entity and those
which do not (Framework, para. 72)

“Items that arise from the ordinary activities of
one entity may be unusual in respect of another
entity” (para. 72)

Measurement of profit

Income

The definition of income comprises both
revenue and gains

“Revenue arises in the course of the
ordinary activities of an entity and is
referred to by a variety of different names
including sales, fees, interest, dividends,
royalties and rent” (para. 74)

Measurement of profit

“Gains represent other items that meet the
definition of income and may, or may not,
arise in the course of the ordinary activities
of an entity” (para. 75)

Gains represent increases in economic
benefits and are no different in conceptual
terms (i.e. in nature) from revenue

Measurement of profit

Gains are usually displayed separately in
the income statement because knowledge
of them is regarded as useful for economic
decision making

“Gains are often reported net of related
expenses” (para. 76)

Measurement of profit

Expenses

The definition of expenses comprises both
losses and also expenses that arise from
the ordinary activities of the entity

“Expenses that arise in the course of the
ordinary activities of the entity include, for
example, cost of sales, wages and
depreciation” (para. 78)


Measurement of profit

“Losses represent other items that meet
the definition of expenses and may, or
may not, arise in the course of the ordinary
activities of the entity” (para. 79)

Losses represent decreases in economic
benefits and are no different in conceptual
terms (i.e. in nature) from other expenses


Measurement of profit

Losses are usually displayed separately in
the income statement because knowledge
of them is regarded as useful for economic
decision making

“Losses are often reported net of related
expenses” (para. 80)


Measurement of profit

Under the Framework, the matching
concept is addressed (para. 95)

As stated in para. 95 “… the application of
the matching concept under this
Framework does not allow the recognition
of items in the balance sheet which do not
meet the definition of assets or liabilities”


Measurement of profit

There are three possible approaches to
measuring periodic profit:


-

Operating
-
profit approach


-

All
-
inclusive approach


-

Comprehensive income approach

Measurement of profit

Under the operating
-
profit approach, periodic
profit is measured and reported as income from
operations less expenses from operations

When applying this approach, adjustments (such
as corrections or revisions) relating to prior
periods, items of an extraordinary nature and
those arising from changes in accounting policy
bypass the income statement

Measurement of profit

Under the all
-
inclusive approach, periodic
profit is measured and reported as the
result of ordinary operations plus
adjustments relating to prior periods and
items of an extraordinary nature and the
effects of some accounting policy
changes.

This approach is broader than the
operating
-
profit approach

Measurement of profit

Under the comprehensive income
approach, profit for the period includes all
income and expenses as defined in the
framework

In other words, all changes in net assets
(i.e. all recognised changes in the carrying
amount of assets and liabilities), other
than transactions with owners, are
included in the measurement of profit

Measurement of profit

The approach adopted in AASB 101 is the
comprehensive income approach

Measurement of profit

“Total comprehensive income is the change in
equity during a period resulting from
transactions and other events, other than those
changes resulting from transactions with owners
in their capacity as owners” (para. 7)

Total comprehensive income comprises all
components of:


Profit or loss, and


Other comprehensive income




Measurement of profit

“Profit or loss is the total income less expenses,
excluding the other components of
comprehensive income” (para. 7)

“Other comprehensive income comprises items
of income and expense (including
reclassification adjustments) that are not
recognised in profit or loss as required or
permitted by other Australian Accounting
Standards” (para. 7)

Examples of components of other
comprehensive income are provided in this para

Measurement of profit

“Reclassification adjustments are amounts
reclassified to profit or loss in the current
period that were recognised in other
comprehensive income in the current or
previous periods” (para. 7)

Accounting standards

Para. 81 states:


“An entity shall present all items of income and expense
recognised in a period:


(a) in a single statement of comprehensive income; or


(b) in two statements: a statement displaying
components of profit or loss (separate income
statement) and a second statement beginning with profit
or loss and displaying component of comprehensive
income (statement of comprehensive income)”

The standard does not define income and expenses

Accounting standards

The information to be presented. “as a
minimum”, in the statement of comprehensive
income is specified in para. 82

Para 83 deals with disclosing the proportions of
profit that are attributable to “minority interest”
and to “owners of the parent”

Additional line items, headings and sub
-
totals
are to be presented where they are “relevant to
an understanding of the entity’s financial
performance” as per para. 85


Accounting standards

“An entity shall recognise all items of
income and expenses in a period in profit
or loss unless an Australian Accounting
Standard requires or permits otherwise”
(para. 88)

Accounting standards

According to para. 89, circumstances may
exist when particular items may be
excluded from profit or loss for the current
period. AASB 108 [“Accounting Policies,
Changes in Accounting Estimates and
Errors’] deals with two such
circumstances: the correction of errors and
the effect of changes in accounting
policies”

Accounting standards

“An entity shall disclose the amount of
income tax relating to each component of
other comprehensive income, including
reclassification adjustments, either in the
statement of comprehensive income or in
the notes” (para. 90)

Accounting standards

“When items of income and expense are
material, an entity shall disclose their
nature and amount separately” (para. 97)

“An entity shall present an analysis of
expenses recognised in profit or loss using
a classification based on either their
nature or their function within the entity,
whichever provides information that is
reliable and more relevant” (para. 99)

Accounting standards

“An entity classifying expenses by function
shall disclose additional information on the
nature of expenses, including depreciation
and amortisation expense and employee
benefits expense” (para. 104)

Accounting standards

Accounting for revenue (AASB 118 “Revenue”)


-

Definition of “revenue” and “fair value” (paras.
7 & 8)


-

Measurement of revenue (paras. 9
-
12)


-

Identification of the transaction (para. 13)


-

Sale of goods (paras. 14
-
19)


-

Rendering of services (paras. 20
-
28)


-

Interest, royalties and dividends (paras. 29
-
34)


-

Disclosure (paras. 35
-
36)

The Appendix is not part of the standard


Lecture 10: Equity

Introduction

Components of equity

Accounting standards

Introduction

In the private sector, equity is described by
various terms, such as owners’ equity,
shareholders’ funds, shareholders’ equity,
share capital, proprietorship and so on.

Under the Framework, equity cannot be
identified, recognised and measured until
assets and liabilities are identified,
recognised and measured

Introduction

Equity is the difference between the amounts of
assets and the liabilities or the residual interest
where, in the case of companies, shareholders
are the holders of the residual rights

In the case of the public sector, the holders of
the residual rights are normally the community,
through its elected representatives in the various
tiers of government

Components of equity

Equity consists of share capital, retained
earnings and reserves:


-

share capital is issued by a company to
its shareholders


-

retained earnings are the accumulated
profits of a company


-

reserves represent the balance of equity
and arise from two sources


Components of equity

Some reserves arise directly from the
application of the Corporations Act 2001
and accounting standards, while others
arise from transfers from retained earnings

Two reserves arising under the former are:


-

revaluation reserve arising under AASB
116


-

translation reserve arising under AASB
121

Components of equity

Other reserves are created by transfers
from retained earnings and may be
established to indicate to shareholders
that such amounts are unavailable for the
payment of dividends

By implication, such reserves are set aside
for other purposes

Components of equity

Share buy
-
backs

Following amendments in 1989 to companies
legislation, companies may now trade in their
own shares

Companies may buy
-
back their own shares
under strict conditions as specified in the
Corporations Act 2001

Such conditions are necessary are necessary to
protect creditors and shareholders






Components of equity

Options granted to employees

Share
-
based employee benefits, such as share
options, are covered by AASB 2 “Share
-
based
Payment”, which deals with:


-

equity
-
settled share
-
based payment
transactions


-

cash
-
settled share
-
based payments
transactions


-

transactions whether there is a choice of
whether the company settles the transactions in
cash or by issuing equity instruments


Components of equity

AASB 2 has been effective from 1 January 2005

Previously, there was no requirement to formally
recognise share options in the financial
statements until the option holders took
-
up
-

that
is, exercised
-

their options

Share
-
based payment transactions are now
required to be recognised as an expense in the
period in which the employees provide services
(para. 8)


Components of equity

There are two types of share option schemes:



-

Non
-
compensatory plans (see H, P & H, Example 17.2)


-

Compensatory plans (see H, P & H, Example 17.3)



AASB 2 does not distinguish between the two types of
plans






Components of equity

“… the entity shall measure the goods and
services received, and the corresponding
increase in equity, directly, at the fair value of
the goods and services received, unless that fair
value cannot be estimated reliably” (para. 10)

Should a reliable estimate on this basis not be
possible, “… the entity shall measure their face
value, and the corresponding increase in equity,
indirectly, by reference to the fair value of the
equity instruments granted
” (para. 10 emphasis
in original; also see paras. 11
-
13 and 14
-
15)

Components of equity

Preference shares

Preference have priority (preference) over
ordinary shares according to the conditions of
issue

Preference shares may also be redeemable and
may be classified as liabilities

Dividend payments must be recognised in
accordance with the balance sheet classification
of preference shares

Components of equity

Compound financial instruments

The most common instrument of this kind are
convertible financial instruments

Convertible notes are (legally) debt instruments
(liabilities) that include an option to convert them
to equity under certain conditions

Under AASB 132 “Financial Instruments:
Disclosure and Presentation”, notes are to be
separated into equity and debt components
(para. 28; also see AASB 139 and H, P & H,
Example 17.5)

Accounting standards

AASB 101

AASB 2

AASB 132

AASB 139

Accounting standards

AASB 101 also requires the preparation of
a “statement of changes in equity” (see
paras. 106
-
107, in particular, for details of
what is to appear on the face of this
statement)

Refer to H, P & H, p. 559 for an illustrative
example


Accounting standards

In respect to “notes”, para 112 states: “The notes shall:”


(a) present information about the basis of preparation of
the financial statements and the specific accounting
policies used in accordance with paragraphs 117
-
124;


(b) disclose the information required by Australian
Accounting Standards that is not presented elsewhere in
the financial statements; and


(c) provide information that is not presented elsewhere in
the financial statements, but is relevant to an
understanding of any of them”

Accounting standards

AASB 101 also deals with the disclosure of
accounting policies

“An entity shall disclose in the summary of
significant accounting policies:


(a) the measurement basis (or bases) used in
preparing financial statements; and


(b) the other accounting policies used that are
relevant to an understanding of the financial
statements” (para. 117)