Professional Documents
Culture Documents
Current assets and liabilities generally have book values and market values
that are very close. This is not necessarily the case with the other assets,
liabilities and equity of the firm.
Assets are listed at historical costs less accumulated depreciation this
may bear little resemblance to what they could actually be sold for today.
The balance sheet also does not include the value of many important
assets, such as human capital. Consequently, the Total Assets line on the
balance sheet is generally not a very good estimate of what the assets of
the firm are actually worth.
Liabilities are listed at face value. When interest rates change or the risk of
the firm changes, the value of those liabilities change in the market as well.
This is especially true for longer-term liabilities.
Equity is the ownership interest in the firm. The market value of equity
(stock price times number of shares) depends on the future growth
prospects of the firm and on the markets estimation of the current value of
ALL of the assets of the firm.
The best estimate of the market value of the firms assets is market value
of liabilities + market value of equity.
Market values are generally more important for the decision making
process because they are more reflective of the cash flows that would occur
today.
Shareholders are the ones that benefit from increases in the market value
of a firms assets. They are also the ones that bear the losses of a
decrease in market value. Consequently, managers need to consider the
impact of their decisions on the market value of assets, not on their book
value. Here is a good illustration:
Suppose that the MV of assets declined to $700 and the market value of
long-term debt remained unchanged. What would happen to the market
value of equity? It would decrease to 700 500 = 200.
The market-to-book ratio, which compares the market value of equity to
the book value of equity, is often used by analysts as a measure of
valuation for a stock. It is generally a bad sign if a companys market-tobook ratio approaches 1.00 (meaning market value = book value) because
of the GAAP employed in creating a balance sheet. It is definitely a bad
sign if the ratio is less than 1.00.
GAAP does provide for some assets to be marked-to-market, primarily
those assets for which current market values are readily available due to
trading in liquid markets. However, it does not generally apply to longterm assets, where market values and book values are likely to differ the
most.
Accounting Conservatism
Accounting income or loss does not incorporate unrealized gains and
losses because of the convention of accounting conservatism. When
accountants confront uncertainty in regard to method or procedure, they
conventionally choose the option that is least likely to overstate income or
asset value. In the case of realized versus unrealized gains and losses, it is
more conservative from an accounting perspective to exclude increases or
decreases in value that have not yet been actualized.
INCOME STATEMENT
Step 1.
Cost of goods sold is subtracted from net sales to arrive at the gross profit.
Step 2.
Operating expenses are subtracted from gross profit to arrive at operating income.
Step 3.
The net amount of nonoperating revenues, gains, nonoperating expenses and losses is
combined with the operating income to arrive at the net income or net loss.
CASH FLOW
Example
Following is an illustrative example of an Income Statement prepared in accordance with the format
prescribed by IAS 1 Presentation of Financial Statements.
2012
USD
USD
Notes
Revenue
16
120,000
100,000
Cost of Sales
17
(65,000)
(55,000)
55,000
45,000
Gross Profit
Other Income
18
17,000
12,000
Distribution Cost
19
(10,000)
(8,000)
Administrative Expenses
20
(18,000)
(16,000)
Other Expenses
21
(3,000)
(2,000)
Finance Charges
22
(1,000)
(1,000)
(15,000)
(15,000)
40,000
30,000
(12,000)
(9,000)
28,000
21,000
Income tax
Net Profit
23
Basis of preparation
Income statement is prepared on the accruals basis of accounting.
This means that income (including revenue) is recognized when it is
earned rather than when receipts are realized (although in many
instances income may be earned and received in the same accounting
period).
Conversely, expenses are recognized in the income statement when they
are incurredeven if they are paid for in the previous or subsequent
accounting periods.
Income statement does not report transactions with the owners of an
entity.
Hence, dividends paid to ordinary shareholders are not presented as
an expense in the income statement and proceeds from the issuance of
shares is not recognized as an income. Transactions between the entity
and its owners are accounted for separately in the statement of changes
in equity.
Components
Income statement comprises of the following main elements:
Revenue
Revenue includes income earned from the principal activities of an entity.
So for example, in case of a manufacturer of electronic appliances,
revenue will comprise of the sales from electronic appliance business.
Conversely, if the same manufacturer earns interest on its bank account,
it shall not be classified as revenue but as other income.
Cost of Sales
Cost of sales represents the cost of goods sold or services rendered during
an accounting period.
Hence, for a retailer, cost of sales will be the sum of inventory at the start
of the period and purchases during the period minus any closing
inventory.
In case of a manufacturer however, cost of sales will also include
production costs incurred in the manufacture of goods during a period
such as the cost of direct labor, direct material consumption, depreciation
of plant and machinery and factory overheads, etc.
You may refer to the article on cost of sales for an explanation of its
calculation.
Other Income
Other income consists of income earned from activities that are not
related to the entity's main business. For example, other income of an
entity that manufactures electronic appliances may include:
Distribution Cost
Distribution cost includes expenses incurred in delivering goods from the
business premises to customers.
Administrative Expenses
Administrative expenses generally
management and support functions
directly involved in the production
offered by the entity.
Examples of administrative expenses
Other Expenses
This is essentially a residual category in which any expenses that are not
suitably classifiable elsewhere are included.
Finance Charges
Finance charges usually comprise of interest expense on loans and
debentures.
The effect of present value adjustments of discounted provisions are also
included in finance charges (e.g. unwinding of discount on provision for
decommissioning cost).
Income tax
Income tax expense recognized during a period is generally comprised of
the following three elements:
Change in gross profit margin, operating profit margin and net profit
margin over the period