ACTIVITY: Income Statement Quiz

Research has shown that active recall, pushing yourself to recall new information rather than simply going over it again, has a big positive impact on learning and long-term memory. Also by trying to answer questions, you gain new insights and expose gaps in your knowledge.

So here is a short active recall activity. Click on the  heading to check your answer.

The Income Statement, often referred to as the Profit and Loss account, is a record of a business’s trading performance over a period of time. It has the basic structure:

sales less cost of sales less expenses = profit

There are several profit calculations. In the trading income statement, expenses such as interest and depreciation are ignored. To get to the final profit figure, retained earnings, tax and dividends are deducted.

COS (Cost of Sales) and COGS (Cost of Goods Sold) are the costs associated directly with sales. The main categories of costs included are:

  • Direct materials
  • Direct labor
  • Factory overhead
  • Production supplies

Only the direct materials cost is a variable cost that fluctuates with revenue levels, and so is an undisputed component of the cost of goods sold. Direct labor can be considered a fixed cost, rather than a variable cost, since a certain amount of staffing is required in the production area, irrespective of production levels. Nonetheless, direct labor is considered a part of the cost of goods sold. Factory overhead is a largely fixed cost, and is allocated to the number of units produced in a period.

Selling and administrative costs are not included in the cost of goods sold; instead, they are charged to expense as incurred.

Earnings Before Interest Tax Depreciation and Amortization (EBITDA) is the operating profit – in other words the money that the company makes from its normal operations. It is sometimes known as the manager’s profit line because it excludes costs beyond the manager’s control – interest, tax, depreciation and amortization.

Depreciation is the method by which the cost of a capital asset is spread over the asset’s life.

For example, if a vehicle is purchased for $15,000 in year one and is expected to be retained for five years, it would present a distorted picture of the firm’s financial status if the whole $15,000 was taken off the profit for year one. If this were the case, years two to five would have the use of the vehicle at no cost – and that would violate the matching principle (costs should be tied to the sales to which they relate).

There are four factors to consider:

  • the cost of the asset
  • its useful life
  • expected residual value – the estimated amount that could be obtained when disposing of an asset after its useful life has ended
  • method of depreciation

In our example, an asset is bought for £100,000 and it is anticipated that it will be sold in 5 years’ time for a price of £20,000. The three most common depreciation methods are shown:

  • straight line depreciation is generally adopted where time is the key element; for example, leases and patents. The value of the asset, less expected residual value, is divided by the useful life to give the annual depreciation figure. Thus: £100,000 – £20,000 = £80000; £80,000/5 = £16,000 depreciation per year.
  • reducing balance is used for assets such as automobiles and others where the greatest loss in value occurs in the first years. Annual depreciation is a fixed percentage of the residual value for each year. In our example, the depreciation for each year is 27.52% of the remaining value of the asset, taking into account the depreciation of previous years. The Goal Seek capability in a spreadsheet can be used to elicit the appropriate percentage.
  • sum of years – similar to reducing balance, this is an accelerated depreciation method where the asset loses value most quickly in the early years. The calculation has a number of stages:
    • add up the digits of the years for the asset’s expected life; for an asset life of 5 years this is: (5+4+3+2+1) = 15
    • calculate the depreciation for each year by multiplying the total depreciation (£100,000 – £20,000 = £80,000) by 5/15 in year one, 4/15 in year 2, 3/15 in year 3, 2/15 in year 4 and 1/15 in year 5

Amortization is the depreciation of an intangible – that is, an asset that doesn’t have a physical presence. Examples include patents, copyrights and goodwill.

The company may have

  • delayed invoicing to delay paying tax
  • ‘channel-stuffed’ – pushed customers to buy more to inflate current sales. They may have offered discounts, given sale-or-return promises or promised promotional spend in the next period. These tactics have pulled sales from the next period into the current period, making the company’s trading performance look better than it is.
  • long-term projects which have not recognised revenue in accordance with IFRS 15