“The very earliest accounting records date to 7500 BC, when cities in the Middle East traded coins made of clay for livestock, grains, and fabric. Papyrus scrolls dating from 3000 BC still survive to this day, showing financial and trade transactions from ancient Egypt, including inventory of property owned by Pharaohs as well as detailed building records and payroll reports. It wasn't until the first century AD, however, that the Greeks developed dome of the first banking systems, accounting records of which still exist” (Beach 2017).
In the modern economy, it is crucial to provide reliable and comparable financial information to investors and other stakeholders, so they can better make decisions. Hence, most countries have implemented the International Financial Reporting Standards (IFRS) guidelines and frameworks across their businesses to interpret performance using a mutually agreed global structure.
Welcome to Topic 8: Financial Statement Analysis – Income Statement. In this topic, you will learn about:
- Organisational forms and characteristics
- History of IFRS
- Basic accounting principles
- Annual reports
- Revenue and expenses
- Financial statement ratios.
These relate to the Subject Learning Outcomes:
- Understand the role of the finance and accounting functions in an organisation.
- Identify the terminology and concepts that underlie the preparation of general-purpose financial reports.
- Prepare and summarise financial statements to support business decision making.
- Apply mathematics of finance to determine risk, return, evaluation of investment, financing, working capital and distribution decisions.
- Develop analytical skills drawing from key finance theories, concepts and techniques.
Welcome to your pre-seminar learning tasks for this week. Please ensure you complete these prior to attending your scheduled seminar with your lecturer.
Click on each of the following headings to read more about what is required for each of your pre-seminar learning tasks.
Read Chapter 13 of the prescribed text - Melicher, RW & Norton, EA 2017, Introduction to finance: Markets, investments, and financial management, 16th edn., John Wiley & Sons, Inc. In particular, take note of p. 392, Section 13.4 Income Statement.
Read the following journal articles:
- Danzi, J & Boom, M 1998, Fundamentals of financial statement analysis for academic physician managers, Academic Medicine, 73(4):363-9.
- Adiloglu, B 2019, Income Statement vs. Comprehensive Income Statement, European Journal of Business and Management, 11(35):35-40.
Identify the key ideas from each article and add these to your reflective journal. You can access the reflective journal by clicking on ‘Journal’ in the navigation bar for this subject. If you are unsure of any concepts, reach out to your lecturer.
Read the following web articles:
- Stobierski, T 2020, How to read and understand an income statement, blog post.
- Morris, J 2021, How do I read and analyze an income statement?, Investopedia.
Identify the key ideas from each article and add these to your reflective journal. If you are unsure of any concepts, reach out to your lecturer.
Read the case study, 13.2: Forms of Business Organization in the United States, on pp. 384-388 of the prescribed text.
Then, consider Discussion question 1 on p. 388. Make note of your answers in your reflective journal and be ready to share your reflections with the class during the scheduled seminar.
- If you are going to start a business, what organisational form would you select? Why?
- What drawbacks might you face in organising a business this way?
This topic has discussion forum activities, which will enhance your knowledge and give you the opportunity to interact with your peers. You can access the activities by clicking on the following links. You can also navigate to the forum by clicking on 'FIN100 Subject Forum' in the navigation bar for this subject.
Read and watch the following content.
Organisational forms and characteristics
The income statement is one of the essential financial documents that every company prepares to measure its financial performance within a set time period. When the income (or the revenue) exceeds the costs (or the expenses) within the period, the business will profit, which ultimately contributes to increasing the owner's wealth. To maximise profits, every business needs to plan its strategies.
Failure to plan is planning to fail(Melicher & Norton 2017, p.382)
Successful businesses prepare financial plans. According to Melicher & Norton (2017), financial planning is one of the most important parts of any business plan. Financial planning also helps outline a pathway from the current business financial position towards future financial goals. Financial planning includes hiring staff, buying equipment and expanding to new markets. Ultimately, financial planning processes will influence existing organisational structures to redesign business activities and internal processes to better align with new business and financial goals.
Organisational structures help develop and support efficient internal business processes, which allow the business to minimise costs and maximise revenue-generating activities to earn profits. Planning for and deciding on the organisational structure that is best suited for the company requires careful consideration of the characteristics of the business and matching them to the most appropriate structure. Choosing the organisational structure of a business can be one of the most critical decisions a business owner can make.
The following table names some of the organisational forms and outlines their key characteristics.
| Organisational form | Number of owners | Owner's liability | Equity capital sources | Ease of startup | Taxation | Liquidity of ownership | Life span |
|---|---|---|---|---|---|---|---|
| Proprietorship | 1 | Unlimited | Self, friends, relatives | Simple | Personal taxation | Difficult to sell | Linked to owner |
| Partnership (general) | >1 | Unlimited, jointly and severally | Partners, friends, relatives | Not difficult | Personal taxation | Difficult to sell | Linked to owners |
| Limited partnership | At least one (1) general, any number of limited partners | Limited partners' liability is limited to partners' investment | General and limited partners | More difficult | Personal taxation | Usually poor | Linked to general partner |
| Corporation | Unlimited | Limited to shareholders' investment | Common stock offerings | Difficult | Corporate taxation but dividends are taxed twice, both as corporate and personal income | Can be very liquid | Unlimited |
| Subchapter S corporation | <35 | Limited to shareholders' investment | Sub S equity investors | Difficult | Income flows to shareholders for taxation at personal rates | Usually poor | Unlimited |
| Limited liability company (LLC) | Unlimited | Limited to owners' investment | Common stock offerings | Difficult | Income flows to shareholders for taxation at personal rates | Poor | Linked to current shareholders |
History of IFRS
The globalisation phenomenon following World War II, with the rise of many multinational corporations, demanded a globalised accounting language (Zeff 2012). The International Financial Reporting Standards (IFRS) were created as a business performance interpretation language to be used worldwide. The reasoning behind introducing the IFRS was to provide a framework for all businesses to present their financial information in a manner that makes it easier for everyone to understand and compare (Sutrisno & Djashan 2017). Especially for global organisations, there is a considerable advantage in using the IFRS as the reporting base because it means that stakeholders from any part of the world will correctly interpret their financial information.
In 1973, the International Accounting Standards Committee (IASC) was established through an agreement between ten (10) professional accounting bodies from around the world, namely:
- Australia
- Canada
- France
- Germany
- Ireland
- Japan
- Mexico
- The Netherlands
- The United Kingdom
- The United States of America (Mendoza 2005).
The IASC commenced issuing 41 International Accounting Standards (IAS), which they amended or replaced over time.
Transition from IAS to IFRS
Originating in London in 2021, the International Accounting Standards Board (IASB) is an independent, private enterprise established to replace the IASC structure but with the same intention of producing high-quality global accounting standards (Mendoza 2005). In the beginning, the IASB continued using the old IAS but has gradually developed the new accounting standards – the IFRS – which are still in use today.
In the beginning, businesses in countries that voluntarily adopted the IFRS showed lower earnings levels as compared to businesses in countries where the IFRS was not adopted (Barth et al. 2008). The reduced earnings were due to the initial cost to implement the new standards.
More and more countries and capital markets around the world started to implement the standards and made the IFRS a listing requirement after the International Organization of Securities Commission (IOSCO) recommended its members to follow at least ten (10) main principles of the IAS (Whittington 2005). Following the IOSCO recommendation, the European parliament decided to incorporate the IFRS into all listed companies within the European Union (EU), and the rest of the world began to follow suit.
Gradually, the IFRS became a standard requirement for businesses operating in many countries such as Australia, Canada, Brazil and Korea (Saini 2012). As of recently, about 70 % of the listed companies worldwide follow the IFRS reporting guidelines. To be exact, “144 jurisdictions now require the use of IFRS Standards for all or most publicly listed companies, whilst a further 12 jurisdictions permit its use” (IFRS n.d.), which means IFRS is now the default global financial language for reporting purposes.
Basic accounting principles
Basic accounting principles are the general assumptions, rules and concepts used in accounting as guidelines to prepare financial reports and interpret their information. Similar to the Australian Accounting Standards Board (AASB), governing bodies around the world used these basic principles to create more advanced, complex and legalistic accounting rules to manage their businesses.
Basic accounting principles can be grouped into three (3) main categories:
- Accounting assumptions
- Accounting concepts
- Accounting constraints.
Accounting assumptions
Accounting assumptions are conditions that are believed to be true at all times. They need to be upheld to ensure the financial information is consistently accurate and reliable.
The four (4) accounting assumptions are as follows:
- Money unit principle – the assumption that all business transactions and events need to be recorded in some sort of monetary unit form.
- Economic unit principle – the assumption that business finances need to be kept separate from the personal transactions of its owners, partners and shareholders.
- Going concern principle – the assumption that all business decisions need to be made with a mindset that the business will continue to run for the foreseeable future.
- Time period principle – the assumption that a business should maintain its reporting within standard time periods.
Accounting concepts
Accounting concepts are the plans or intentions created to streamline the reporting process of accounting.
The four (4) accounting concepts are as follows:
- Historical cost principle – business assets need to be recorded at their cost at the time of purchase.
- Revenue recognition principle – a business should record its revenue when it is earned, not when the payment is received.
- Matching principle – a business should record all its expenses and revenue in the period they occur.
- Full disclosure principle – a business should declare all the information that could affect its stakeholders' understanding of the business.
Accounting constraints
Accounting constraints are the limitations created to maintain relatively similar financial reports in different businesses.
The four (4) accounting constraints are as follows:
- Cost-benefit principle – the cost of providing information through financial statements should not overreach the benefits they provide to the stakeholders of a business.
- Conservatism principle – a business should recognise its gains only once they are realised. However, even if they are only probable, all losses need to be recognised as a contingent liability.
- Consistency principle – A business should follow the same accounting principles adopted to maintain its ability to compare reporting periods accurately.
- Objectivity principle – A business's financial statements and information should be built upon verifiable data.
Annual reports
Annual reports exist to deliver the financial information about a business to its stakeholders to help them make better decisions. Current and future investors, suppliers, customers, management, board of directors, employees and government departments such as the Australian Tax Office (ATO) are some of the other parties interested in business performance for various reasons.
Revenue and expenses
Revenue and expenses are two (2) critical aspects of a business's performance that are regularly reported. The way they are reported depends on the type of financial statement and the time period the report covers.
Revenue
Revenue can also be considered as income. Revenue, or income, can be defined in several ways including:
- Revenue is an increase in economic benefits during the accounting period in the form of inflows or enhancements of assets.
- Revenue, or decreases of liabilities, results in increases in equity, other than those relating to contributions from equity participants.
- Income can also exist through reducing liabilities that increase the entity's equity.
Income recognition: there must be an established likelihood of increasing future economic benefits that can be accurately and reliably measured.
In other words, to recognise an income, the business must establish the likelihood of receiving payment via transferring the risk and rewards associated with the goods or services to the buyer. The amount of income needs to be accurately measured according to the cost incurred, the services rendered or the stage of completion.
The following two (2) videos explain how a transaction is recognised as revenue, and the difference between accrued revenue and deferred revenue.
Expenses
The International Accounting Standards Board (2018, 4.69) defines expenses as "decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims." Expenses have the following key characteristics:
- Are decreases in economic benefits
- Are in the form of outflows or depletions of assets or incurrences of liabilities
- Result in reductions in equity
- Are decreases in addition to those relating to distributions to equity participants.
Expense recognition: there must be an established likelihood of a decrease in future economic benefits that can be accurately and reliably measured.
The following two (2) videos further explain what expenses are, as well as the differences between accounts payable and accrued expenses.
Revenue and expenses according to accounting versus finance
As we already know, financial information is vital to both internal and external stakeholders of a business. However, depending on the requirements and focus, there are many ways of interpreting the information.
For example, stakeholders, who are focused on the financial situation of a business, tend to be interested in identifying transactions that just relate to cash inflows and outflows. Whereas an accounting-focused individual will be keen to see the entire revenue for the period earned by the business as a combination of both cash and credit (accrued) in total.
The following table outlines the key differences in accounting and finance perspectives.
| Accounting focus | Finance focus |
|---|---|
| Matching revenue and expenses (accrual concept) | Identifying cash inflows and outflows |
| Use of different accounting principles can lead to manipulation of financial statements | Track the cash flows to assess the "quality" of reported assets and earnings |
| Seek to measure business profitability | Measure cash usage |
| Emphasis is historical | Looks forward |
| Attempts to track assets and depreciate them | Market value of assets |
Income statement ratios
An income statement is a document prepared by a company to show its performance within a given period, by offsetting its revenue and expenses to measure the profit or the loss for the period.
Ratio analysis is one of the most effective ways of analysing company performance compared to its own past performance and industry benchmark figures. The following are some of the most commonly used income statement ratios:
- Gross margin – the amount of sales revenue left after taking out direct costs.
$$\mathsf{Gross\;margin}=\frac{\mathsf{gross\;profit}}{\mathsf{sales\;revenue}}$$
- Profit margin – measures the profitability of the business.
$$\mathsf{Profit\;margin}=\frac{\mathsf{after\;tax\;net\;income}}{\mathsf{net\;sales}}$$
- Operating margin – gives you the leftover revenue after deducting the variable cost of the business.
$$\mathsf{Operating\;margin}=\frac{\mathsf{operating\;income}}{\mathsf{net\;sales}}$$
- Earnings per share – helps to determine the company share price.
$$\mathsf{Earnings\;per\;share}=\frac{(\mathsf{net\;income}\,-\,\mathsf{dividends\;on\;preferred\;shares})}{\mathsf{ordinary\;shares}}$$
Key takeouts
Congratulations, we made it to the end of the eighth topic! Some key takeouts from Topic 8:
- The IFRS were created as a mutual business performance interpretation language for use worldwide.
- Basic accounting principles are categorised into three (3) main groups:
- Assumptions
- Concepts
- Constraints.
- Proprietorship, one (1) type of organisational form, is easier to set up than a company. However, the liabilities are unlimited.
- Ratio analysis for the income statement is the best way of comparing a business performance with its industry results and its results from the previous appropriate time period.
Welcome to your seminar for this topic. Your lecturer will start a video stream during your scheduled class time. You can access your scheduled class by clicking on ‘Live Sessions’ found within your navigation bar and locating the relevant day/class or by clicking on the following link and then clicking 'Join' to enter the class.
Click here to access your seminar.
The following learning tasks will be completed during the seminar with your lecturer. Should you be unable to attend, you will be able to watch the recording, which can be found via the following link or by navigating to the class through ‘Live Sessions’ via your navigation bar.
Click here to access the recording. (Please note: this will be available shortly after the live session has ended.)
In-seminar learning tasks
The in-seminar learning tasks identified below will be completed during the scheduled seminar. Your lecturer will guide you through these tasks. Click on each of the following headings to read more about the requirements for each of your in-seminar learning tasks.
Watch the video, Income statement explained.
Working in a breakout room team assigned by your lecturer during the scheduled seminar, discuss the following questions with your teammates. Your lecturer will request that you present the findings back to the class.
- Describe the importance of an income statement.
- What does top-line and/or bottom-line growth mean?
- Are operating expenses categorised under fixed or variable costs of a business? Explain your answer.
Access the Accounting Coach's Income Statement (Practice Quiz).
Individually attempt all the multiple-choice questions. You may attempt each question as many times as you like. Working in a breakout room team assigned by your lecturer during the scheduled seminar, discuss the answers with your teammates. Note down any questions that you are unclear about to discuss with your lecturer.
Welcome to your post-seminar learning tasks for this week. Please ensure you complete these after attending your scheduled seminar with your lecturer. Your lecturer will advise you if any of these are to be completed during your consultation session. Click on the following heading to read more about the requirements for your post-seminar learning task.
Complete the Topic 8 Worksheet and save it to your journal. This learning task can be completed during the consultation session.
A list of account balances for TG Group of Hotels at the end of 30th June 2021 is provided as follows. Prepare the Income Statement for the period and save it to your reflective journal.
| $'000 | |
|---|---|
| Cash | 26 000 |
| Receivables | 14 000 |
| Office supplies | 1 200 |
| Prepaid insurance | 650 |
| Plant and equipment | 125 000 |
| Accumulated depreciation – plant and equipment | 29 300 |
| Accounts payable | 20 600 |
| Salaries payable | 6 000 |
| Rent received in advance | 12 000 |
| Share capital | 75 000 |
| Retained earnings | 16 000 |
| Service revenue | 178 000 |
| Rent revenue | 14 000 |
| Supplies expense | 17 500 |
| Rent expense | 29 500 |
| Insurance expense | 2 100 |
| Depreciation expense | 20 650 |
| Salaries expense | 114 300 |
Start preparing an income statement for the client in Assessment 3. You can access the instructions by clicking “Assessment 3” in the navigation bar for this subject.
Each week you will have a consultation session, which will be facilitated by your lecturer. You can join in and work with your peers on activities relating to this subject. These session times and activities will be communicated to you by your lecturer each week. Your lecturer will start a video stream during your scheduled class time. You can access your scheduled class by clicking on ‘Live Sessions’ found within your navigation bar and locating the relevant day/class or by clicking on the following link and then clicking 'Join' to enter the class.
Click here to access your consultation session.
Should you be unable to attend, you will be able to watch the recording, which can be found via the following link or by navigating to the class through ‘Live Sessions’ via your navigation bar.
Click here to access the recording. (Please note: this will be available shortly after the live session has ended.)
- Business Australia, n.d., How to understand and analyse financial statements
- Masson, DJ 2018, 6 Steps to an Effective Financial Statement Analysis, Association for finance professionals
References
- Adiloglu, B 2019, Income Statement vs. Comprehensive Income Statement, European Journal of Business and Management, 11(35):35-40 https://iiste.org/Journals/index.php/EJBM/article/view/50736/52429
- Averkamp, H n.d., Financial Statements (Practice Quiz), Accounting Coach, https://www.accountingcoach.com/financial-statements/quiz
- Barth, ME, Landsman, WR & Lang, MH 2008, International Accounting Standards and Accounting Quality, Journal of Accounting Research (Wiley-Blackwell), 46(3):467–498
- Beach, E 2017, About the History of Financial Accounting, Bizfluent, https://bizfluent.com/about-4740398-history-financial-accounting.html
- Counttuts 2021, Accounting Expenses | Explained with Examples, streaming video, YouTube, https://www.youtube.com/watch?v=bSI7n5yVlgU
- Danzi, J & Boom, ML 1998, Fundamentals of financial statement analysis for academic physician managers. Academic Medicine, 73(4):363-9. https://journals.lww.com/academicmedicine/abstract/1998/04000/fundamentals_of_financial_statement_analysis_for.8.aspx
- The Finance Storyteller 2020, Accounts payable vs accrued expenses, streaming video, YouTube, https://www.youtube.com/watch?v=-JcpFoQQJ1o
- The Finance Storyteller 2020, Accrued revenue vs deferred revenue, streaming video, YouTube, https://www.youtube.com/watch?v=m-BRH3CQj28
- The Finance Storyteller 2020, Income statement explained, streaming video, YouTube, https://www.youtube.com/watch?v=Hq-44PHgAiU
- The Finance Storyteller 2020, Revenue recognition explained, streaming video, YouTube, https://www.youtube.com/watch?v=816Q6pOaGv4
- IFRS n.d., Why Global Accounting Standards?, IFRS https://www.ifrs.org/use-around-the-world/why-global-accounting-standards/
- Indonesia wiki n.d., , "Indonesia", wiki article, https://en.wikipedia.org/wiki/Indonesia
- International Accounting Standards Board 2018, Conceptual Framework for Financial Reporting, IFRS Foundation, https://www.ifrs.org/content/dam/ifrs/publications/pdf-standards/english/2021/issued/part-a/conceptual-framework-for-financial-reporting.pdf
- Melicher, RW & Norton, EA 2017, Introduction to finance: Markets, investments, and financial management, 16th edn., John Wiley & Sons, Inc.
- Mendoza, RR 2005, International Accounting Standards: Historical and Rational Perspectives, The Accountant's Journal, 54(1):23-30
- Morris, J 2021, How Do I Read and Analyze an Income Statement?, Investopedia, https://www.investopedia.com/ask/answers/100715/how-do-i-read-and-analyze-income-statement.asp
- Saini, JS 2012, Financial Reporting under IFRS: A Topic Based Approach, Journal of International Accounting Research, 11(2):83–85
- Stobierski, T 2020, How to Read & understand an Income Statement, blog post, https://online.hbs.edu/blog/post/income-statement-analysis
- Sutrisno, P & Djashan, IA 2017, The Effect of IFRS Convergence on Earnings Quality: Empirical Evidence from Indonesia, Accounting & Finance Review (AFR), 2(4):21–31
- Zeff, SA 2012, The Evolution of the IASC into the IASB, and the Challenges it Faces, Accounting Review, 87(3):807–837
