Measurement of profit

Measurement of profit

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


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


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)


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)


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)


“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


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)


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)


“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


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)


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”


There are three possible approaches to measuring periodic profit:

- Operating-profit approach

- All-inclusive approach

- Comprehensive income approach


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


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


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


The approach adopted in AASB 101 is the comprehensive income approach


“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, andOther comprehensive income


“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


“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


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


“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)


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”


“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)


“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)


“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 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


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


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


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


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


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)


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


“… 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)


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


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)


AASB 101 AASB 2 AASB 132 AASB 139


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


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”


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)

Business

Measurement of profit