Lectures 9

BA606 FINANCIAL BA606 FINANCIAL ACCOUNTINGACCOUNTING

Professor Garry CarnegieProfessor Garry Carnegie

Lectures 9 & 10Lectures 9 & 10

Lecture 9: The income statementLecture 9: The income statement

IntroductionIntroduction

Measurement of profitMeasurement of profit

Accounting standardsAccounting standards


The income statement is one of four The income statement is one of four financial statements resulting from the financial statements resulting from the financial reporting processfinancial reporting processThe statement is often known as the profit The statement is often known as the profit and loss statement or statement of and loss statement or statement of financial performancefinancial performanceThe use of income statement is The use of income statement is inconsistent with use of “profit and loss inconsistent with use of “profit and loss statement” in the Corporations Act 2001statement” in the Corporations Act 2001


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

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

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


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

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


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

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

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


IncomeIncome

The definition of income comprises both The definition of income comprises both revenue and gainsrevenue and gains

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


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

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


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

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


ExpensesExpenses

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

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


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

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


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

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


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

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


There are three possible approaches to There are three possible approaches to measuring periodic profit:measuring periodic profit:

- Operating-profit approach- Operating-profit approach

- All-inclusive approach- All-inclusive approach

- Comprehensive income approach- Comprehensive income approach


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

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


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


Under the comprehensive income Under the comprehensive income approach, profit for the period includes all approach, profit for the period includes all income and expenses as defined in the income and expenses as defined in the frameworkframeworkIn other words, all changes in net assets In other words, all changes in net assets (i.e. all recognised changes in the carrying (i.e. all recognised changes in the carrying amount of assets and liabilities), other amount of assets and liabilities), other than transactions with owners, are than transactions with owners, are included in the measurement of profitincluded in the measurement of profit


The approach adopted in AASB 101 is the The approach adopted in AASB 101 is the comprehensive income approachcomprehensive income approach


““Total comprehensive income is the change in Total comprehensive income is the change in equity during a period resulting from transactions equity during a period resulting from transactions and other events, other than those changes and other events, other than those changes resulting from transactions with owners in their resulting from transactions with owners in their capacity as owners” (para. 7)capacity as owners” (para. 7)Total comprehensive income comprises all Total comprehensive income comprises all components of:components of:Profit or loss, andProfit or loss, andOther comprehensive incomeOther comprehensive income


““Profit or loss is the total income less expenses, Profit or loss is the total income less expenses, excluding the other components of excluding the other components of comprehensive income” (para. 7)comprehensive income” (para. 7)““Other comprehensive income comprises items Other comprehensive income comprises items of income and expense (including of income and expense (including reclassification adjustments) that are not reclassification adjustments) that are not recognised in profit or loss as required or recognised in profit or loss as required or permitted by other Australian Accounting permitted by other Australian Accounting Standards” (para. 7)Standards” (para. 7)Examples of components of other Examples of components of other comprehensive income are provided in this paracomprehensive income are provided in this para


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


Para. 81 states:Para. 81 states:““An entity shall present all items of income and expense An entity shall present all items of income and expense recognised in a period:recognised in a period:(a) in a single statement of comprehensive income; or(a) in a single statement of comprehensive income; or(b) in two statements: a statement displaying (b) in two statements: a statement displaying components of profit or loss (separate income components of profit or loss (separate income statement) and a second statement beginning with profit statement) and a second statement beginning with profit or loss and displaying component of comprehensive or loss and displaying component of comprehensive income (statement of comprehensive income)”income (statement of comprehensive income)”The standard does not define income and expensesThe standard does not define income and expenses


The information to be presented. “as a The information to be presented. “as a minimum”, in the statement of comprehensive minimum”, in the statement of comprehensive income is specified in para. 82income is specified in para. 82Para 83 deals with disclosing the proportions of Para 83 deals with disclosing the proportions of profit that are attributable to “minority interest” profit that are attributable to “minority interest” and to “owners of the parent”and to “owners of the parent”Additional line items, headings and sub-totals Additional line items, headings and sub-totals are to be presented where they are “relevant to are to be presented where they are “relevant to an understanding of the entity’s financial an understanding of the entity’s financial performance” as per para. 85performance” as per para. 85


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


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


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


““When items of income and expense are When items of income and expense are material, an entity shall disclose their material, an entity shall disclose their nature and amount separately” (para. 97)nature and amount separately” (para. 97)““An entity shall present an analysis of An entity shall present an analysis of expenses recognised in profit or loss using expenses recognised in profit or loss using a classification based on either their a classification based on either their nature or their function within the entity, nature or their function within the entity, whichever provides information that is whichever provides information that is reliable and more relevant” (para. 99)reliable and more relevant” (para. 99)


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


Accounting for revenue (AASB 118 “Revenue”)Accounting for revenue (AASB 118 “Revenue”)- Definition of “revenue” and “fair value” (paras. 7 - Definition of “revenue” and “fair value” (paras. 7 & 8)& 8)- Measurement of revenue (paras. 9-12)- Measurement of revenue (paras. 9-12)- Identification of the transaction (para. 13)- Identification of the transaction (para. 13)- Sale of goods (paras. 14-19)- Sale of goods (paras. 14-19)- Rendering of services (paras. 20-28)- Rendering of services (paras. 20-28)- Interest, royalties and dividends (paras. 29 -34)- Interest, royalties and dividends (paras. 29 -34)- Disclosure (paras. 35-36)- Disclosure (paras. 35-36)The Appendix is not part of the standardThe Appendix is not part of the standard

Lecture 10: EquityLecture 10: Equity


Components of equityComponents of equity



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

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


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

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


Equity consists of share capital, retained Equity consists of share capital, retained earnings and reserves:earnings and reserves:

- share capital is issued by a company to - share capital is issued by a company to its shareholdersits shareholders

- retained earnings are the accumulated - retained earnings are the accumulated profits of a companyprofits of a company

- reserves represent the balance of equity - reserves represent the balance of equity and arise from two sourcesand arise from two sources


Some reserves arise directly from the Some reserves arise directly from the application of the Corporations Act 2001 application of the Corporations Act 2001 and accounting standards, while others and accounting standards, while others arise from transfers from retained earningsarise from transfers from retained earningsTwo reserves arising under the former are:Two reserves arising under the former are:- revaluation reserve arising under AASB - revaluation reserve arising under AASB 116116- translation reserve arising under AASB - translation reserve arising under AASB 121121


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

By implication, such reserves are set aside By implication, such reserves are set aside for other purposesfor other purposes


Share buy-backsShare buy-backs

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

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

Such conditions are necessary are necessary to Such conditions are necessary are necessary to protect creditors and shareholdersprotect creditors and shareholders


Options granted to employeesOptions granted to employeesShare-based employee benefits, such as share Share-based employee benefits, such as share options, are covered by AASB 2 “Share-based options, are covered by AASB 2 “Share-based Payment”, which deals with:Payment”, which deals with:- equity-settled share-based payment - equity-settled share-based payment transactionstransactions- cash-settled share-based payments - cash-settled share-based payments transactionstransactions- transactions whether there is a choice of - transactions whether there is a choice of whether the company settles the transactions in whether the company settles the transactions in cash or by issuing equity instruments cash or by issuing equity instruments


AASB 2 has been effective from 1 January 2005AASB 2 has been effective from 1 January 2005

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

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


There are two types of share option schemes:There are two types of share option schemes:

- Non-compensatory plans (see H, P & H, Example 17.2)- Non-compensatory plans (see H, P & H, Example 17.2)- Compensatory plans (see H, P & H, Example 17.3)- Compensatory plans (see H, P & H, Example 17.3)

AASB 2 does not distinguish between the two types of AASB 2 does not distinguish between the two types of plansplans


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


Preference sharesPreference shares

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

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

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


Compound financial instrumentsCompound financial instrumentsThe most common instrument of this kind are The most common instrument of this kind are convertible financial instrumentsconvertible financial instrumentsConvertible notes are (legally) debt instruments Convertible notes are (legally) debt instruments (liabilities) that include an option to convert them (liabilities) that include an option to convert them to equity under certain conditionsto equity under certain conditionsUnder AASB 132 “Financial Instruments: Under AASB 132 “Financial Instruments: Disclosure and Presentation”, notes are to be Disclosure and Presentation”, notes are to be separated into equity and debt components separated into equity and debt components (para. 28; also see AASB 139 and H, P & H, (para. 28; also see AASB 139 and H, P & H, Example 17.5)Example 17.5)


AASB 101 AASB 101

AASB 2AASB 2

AASB 132AASB 132

AASB 139AASB 139


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

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


In respect to “notes”, para 112 states: “The notes shall:”In respect to “notes”, para 112 states: “The notes shall:”(a) present information about the basis of preparation of (a) present information about the basis of preparation of the financial statements and the specific accounting the financial statements and the specific accounting policies used in accordance with paragraphs 117-124;policies used in accordance with paragraphs 117-124;(b) disclose the information required by Australian (b) disclose the information required by Australian Accounting Standards that is not presented elsewhere in Accounting Standards that is not presented elsewhere in the financial statements; andthe financial statements; and(c) provide information that is not presented elsewhere in (c) provide information that is not presented elsewhere in the financial statements, but is relevant to an the financial statements, but is relevant to an understanding of any of them”understanding of any of them”


AASB 101 also deals with the disclosure of AASB 101 also deals with the disclosure of accounting policiesaccounting policies

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

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

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

Documents

Lectures 9