Topic 6 - Revenues And Expenses: Statement Of Changes In Equity

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This article is a topic within the subject Accounting 1B.

Contents

Required Reading

Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 523-544.

Determining Profit

The only way to accurately determine profit is to wait until the end of the enterprise’s life. Though it is reliably, it is not timely or decision relevant. Hence we create ‘periodic profit’ by dividing lifetime into periods to make the information timely & decision relevant. However, there is greater uncertainty & judgement required. (Reliability - relevance trade-off)

Income And Revenue

[1] Income refers to increases in economic benefits during the accounting period that results in increases in equity, other than those relating to contributions from owners & encompasses both revenue (ordinary activities) & gains (disposals of NCA). Income is recognised if:

  • Increases in future economic benefits are probable (increases in assets or decreases in liabilities)
  • Cost or Value can be measured with reliability

Revenue Recognition Criteria

[2] Accountants choose a critical event that most closely matches the following criteria:

  1. Provision of most of the G/S
  2. Most of the costs have been incurred (or those remaining can be measured with reasonable accuracy)
  3. Dollar amount of the revenue can be measured
  4. Receipt of an asset (cash/receivable) (& can be measured with reasonable accuracy)

Revenue Recognition Methods – Customer Driven or Push Product?

  • Point of Sale or Delivery (most common)
    • Legal title of G&S changes, risks/rewards associated with ownership transferred to the buyer
    • Risk of credit/warranties/returns are estimated & deducted from revenue (bad debts, provisions)
  • During Production (% of completion method) – determining the proportion of project completion by total cost
    • Requires judgement – reasonable estimations/(certainty) of total cost & revenue (assurance of payment)
    • DR Account Recievable, CR Revenue & DR COGS expense, CR Construction in Process Inventory
    • Franchises
  • On Completion of Productionrevenue recognised after production (e.g. when construction completed)
  • When Cash is Received – if there is significant risk to the collectability of cash from a revenue generating event
    • E.g. Instalment sales – substantial uncertainty
  • At some point After Cash Has Been Received (right of return – guaranteed deposit refund policy
    • DR Cash, CR Unearned Revenue (deposits received liability) & DR UR, CR Revenue (after refund expiration)

Percentage of Completion Method Example

Contract worth $21,000,000 constructed over 3 years, with 7m paid in cash each year. Costs are 15,000,000 (2011: 8m, 2012: 5m, 2013: 2m). 2013 Revenue = $2.8 million, 2013 Profit = 800,000 (2/15 * 6 million)

Completion of Production Method

2013 Profit = $21m - $2m = $19m (Revenue = $21 million)

Expenses

[3] Expenses are decreases in economic benefits, during the accounting period in the form of outflows or depletions of assets or incurrence’s of liabilities that result in a decrease in equity other than those relating to distributions to owners. Expenses are recognised if:

  • It is probable that the consumption or loss of future economic benefits resulting in a reduction in assets or an increase in liabilities has occurred (possible uncertainties – wear & tear & commercial impairment )
  • Cost or Value can be measured with reliability (usually certain except for provision estimates)

In deciding whether to capitalise or expense, if it is not an asset it is an expense.

Losses do not arise from the ordinary activities of the entity. It includes losses from disasters (fires), NCA disposals (& unrealised losses e.g. FOREX losses)

The matching principle states that a company must ‘match’ expenses with the revenues produced during the current period. Thus expenses are recognised on direct association between costs incurred & earnings of specific items of income.

Expense Classification

  • Nature Of Expense Method – not allocated according to function
    • Expenses are aggregated according to their nature (e.g. depreciation, purchases of materials, advertising)
  • Function of Expense (Cost of Sales) Method
    • Classifies each expense according to their function as part of cost of sales (e.g. cost of distribution or administrative activities)

Income Statement

[4] The income must disclose revenue, expenses, financing cost expense, share of P/L of associates & JV’s, post tax P/L of discontinued operations & fair value less costs to sell on the disposal of relevant assets, income tax, P/L (attributable to outside equity interests & to members of the parent entity)

Significant Items

When a revenue/expense from ordinary activities is of such size, nature or incidence that its disclosure is relevant in explaining financial performance, its nature & amount must be separately disclosed in the income statement or notes. E.g. inventory write-down. Significant items may also include litigation settlements, disposals, restructuring etc.

Statement of Changes in Owners’ Equity

[5] This statement summarises transactions affecting owners’ equity during the accounting period. It “bridges the gap” between income statement & equity on the balance sheet by showing total comprehensive income & amount attributable to owners of the parent & to non controlling interests.

Reconciliation between beginning & ending balances of equity shown disclosed via the changes of/from:

  • Profit or Loss
  • Additional Comprehensive Income Items
  • Transactions with Owners (contributions & distributions) & changes in ownership interests in subsidiaries that does not result in a loss of control.

What If Analysis

[6] Analysts often ask what would happen if accounting policies were adjusted (e.g. LIFO or FIFO or depreciation life adjustment) & check the impact on net profit & other accounting numbers.

End

This is the end of this topic. Click Accounting 1B to go back to the main subject page for Accounting 1B

References

Textbook refers to Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning

  1. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 523-524
  2. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 524-530
  3. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 531-534
  4. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 535-539
  5. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 539-540
  6. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 540-544
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