CHAPTER 3

Measuring Profit and Income

About This Chapter

Understandably, both users external to a business and the managers working within it are interested in financial performance. One piece of information that is important is whether the business made a profit or loss over the financial period. There are six separate standards that set out the various methods to be applied in establishing a company’s profit or loss for a period. In summary, these are

IAS 1 Presentation of financial statements

IFRS 15 Revenue from contract with customers

IAS 2 Inventories

IAS 16 Property plant and equipment

IAS 11 Construction contracts (now superseded by IFRS 15 from January 1, 2018)

IAS 18 Revenue

It is important to emphasize that we are examining accounting regulations, not tax regulations, which are different. Every country applies its taxation regulations in calculating the amount of tax a company should pay. Industries will have developed their own methods in previous years for accounting for revenue and costs to arrive at their version of “profit.” A change required by a new accounting standard may not be met with enthusiasm. It has been observed that the relevant standards issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have significant differences and that there are also differences with the Internal Revenue Code in many countries (Sedki, Posada, and Pruske 2018).

The calculation of profit or loss begins with the revenue generated in the period. This is not necessarily immediate cash, as we explained with the accruals basis in Chapter 2. Once the amount of revenue is calculated, all the expenses incurred in generating that revenue are deducted. If the amount of revenue is greater than the expenses, we have a profit. If it is lower, we have a loss.

The financial statement that shows the profit for the year has traditionally been named either the profit or loss statement or the income statement. Companies can decide the term they wish to use. The IASB has now expanded the information to be given. We still have the traditional statements, but companies must also disclose other comprehensive income. In this chapter, we explain the meaning of the terms profit, other comprehensive income, and total comprehensive income.

The Calculation of Profit

IAS 1—Presentation of Financial Statements was first issued in 1975 under the title Disclosure of Accounting Policies. There were several amendments to the standard, but here we concentrate on the standards issued in 2007 (IASB 2007a), which came into effect on January 1, 2009, as these illustrate the process. We include in our explanation two amendments made in 2010 that were concerned with comprehensive income.

Profit is calculated by deducting the costs incurred by an entity during the financial period and deducting this amount from the revenue for that period. It has been recognized that profit is not defined, but income and expenses are (Barker 2010). Profit is therefore a balancing figure. If the costs are higher than the revenue for the same period, there will be a loss.

Accounting records will be maintained to record all the revenue generated and expenses incurred in the normal course of business during the financial period. At the end of the period, the records will be summarized to produce a financial statement showing the profit or loss. This statement may be headed Profit or Loss Account or Income Statement. Both give similar information.

A simplified structure for a Profit or Loss Account would be as follows:

Profit or loss account for the year ended December 31, 2017
	$	$
Revenue		10,000
Goods purchased for sale	5,000
Less closing inventory	1,000	4,000
Gross profit		6,000
Employee costs	3,000
Administration costs	1,500
Depreciation on machinery	500	5,000
Net profit		1,000

There is a temptation to concentrate on the preciseness of the monetary “numbers” and forget the reality behind them. All of the above numbers represent an actuality. For example, “closing inventory” is the goods that we have at the year-end that we have not sold. These have to be counted and valued. The counting is the work of the company, and confirming the calculations is the work of the auditors. How the final financial value of closing inventory is calculated is dictated by the standard.

To give some indication of the task, Carnival Corporation, which, among other activities, runs cruise ships, reported that its closing inventory was US$387 million in 2017. Many companies have equally significant closing inventory. There has to be a rigorous method of identifying the actual quantity before putting a “value” on it for the profit statement.

Before looking at the detailed requirements of each standard, we give a summary of each of the standards that are related to the profit or loss statement. This gives you a guideline to the calculation of profit or loss for a financial period. The main standard issued in 2007 introduced the concept of comprehensive income. This takes a much broader view of the wealth created by a company. In addition to profit, there are other events, such as the revaluation of land and property, that increase the financial strength of the company. In this chapter, we first study the profit or loss statement in detail before explaining the statement of profit or loss and other comprehensive income.

IAS 1—Presentation of Financial Statements

This was first issued in 1975, revised in 1997, and again in 2003. The latest revision was in 2007 and requires the disclosure of additional information. The standard identifies the financial statements a company should publish, the minimum information to be disclosed, and the concepts on which the financial statements are based.

IFRS 15 Revenue

This standard was issued in 2014 (IASB 2014) and is effective for periods beginning on or after January 1, 2018. The standard sets out the timing for revenue recognition and the information to be disclosed. In this section, we explain the five-step model contained in the standard and to be applied to recognize revenue. IFRS 15 replaces IAS 18, which was first issued in 1982 and revised in 1993. A brief summary of IAS 18 is included in this chapter for completeness.

IAS 2 Inventories

This standard was first issued in 1975, revised in 1993, and again in 2005 (IASB 2005). It requires inventories to be measured at the lower of cost and net realizable value (NRV). The NRV is the amount estimated to be received less any costs incurred if the inventory were sold. The standard explains the methods companies can apply in determining cost. The correct calculation of the financial amount of inventories is an essential input into calculating profit.

IAS 16 Depreciation

This standard was first issued in 1982 and covers property, plant, and equipment. It was revised in 1993 and further revised in 2003. When a company acquires noncurrent assets, being those expected to last longer than one financial period, such as property, plant, and equipment, they must be first measured at cost. The assets will appear on the balance sheet but will have a useful life of several years. Over that useful life, part of the original cost will be written off (depreciated), and this amount will be shown in the profit or loss account. In this chapter, we explain depreciation, and in Chapter 4 the impact on the statement of financial position.

IAS 11 Accounting for Construction Contracts

This standard was first issued in 1979 and revised in 1993. It was superseded by IFRS 15 on January 1, 2018. We include a brief summary of IAS 11 in this chapter.

IAS 1 Profit and Other Comprehensive Income

The requirements on which financial statements should be made public are in IAS 1 Presentation of Financial Statements. On September 6, 2007, a revised IAS 1 was issued. This became effective for annual periods beginning on or after January 1, 2009, and the standard requires an entity to include in its annual report and accounts a statement of comprehensive income. This has probably been the most contentious requirement introduced by the IASB. It is argued that the statement is a mixture of realized, unrealized, temporary, persistent, and recyclable elements (Hodgson and Russell 2014).

The present IAS 1 requires companies to disclose:

• •one statement of comprehensive income or
• •two separate statements comprising:

1. 1.an income statement displaying components of profit or loss
2. 2.a statement of comprehensive income. This statement begins with profit or loss shown on the bottom line of the income statement. The items of other comprehensive income for the reporting period follow.

The standard allows flexibility in the titles given to statements. In our experience, companies using the two-separate-statement approach give the title profit or loss statement to the first statement and statement of other comprehensive income to the second statement. As there is no rule on this, you should ensure whether you are reading an “Income Statement” that shows only the profit or loss or whether you are viewing the comprehensive income statement.

There is no definition of profit in IAS 1. It is calculated by defining revenue and deducting specific costs. This explains the method of calculating profit or loss for a financial period but does not provide a conceptual framework on the nature of profit. Unfortunately, the terms “profit” and “income” are not defined clearly in either IAS 1 or any other standards. Sometimes, income may refer to profit, although it may be used to mean “sales.” To understand the calculation of profit or loss we need to consider the approach the IASB takes to comprehensive income.

Comprehensive income can be considered to be the difference in the entity’s total wealth at the beginning and at the end of the financial period. The owners’ equity, that is their “share” of the company, is the measure of wealth. A decline in equity indicates a decrease in wealth; an increase in equity indicates an increase in wealth. In making these calculations, it is assumed that there have been no direct transactions with shareholders, for example the payments of dividends during the financial period.

It is argued that the statement of total comprehensive income provides more useful information than just profit because it shows all the gains and losses, both realized and unrealized, that increases or decreases the owners’ equity, that is, wealth. An example of a gain in equity (shareholders’ wealth) not recognized is a revaluation of noncurrent assets. We discuss this issue in Chapter 4, where we examine IAS 16 Property, Plant and Equipment.

Under IAS 1 the statement of comprehensive income includes both profit from revenue and also other gains. The argument put forward is that gains meet the definition of income and may, or may not, arise in the course of the ordinary activities of an entity. Such gains can be realized, such as the disposal of a noncurrent asset, or they may be unrealized, for example, gains on the revaluation of marketable securities and increases in the value of long-term assets such as land.

The decision of the IASB to require a comprehensive income statement gave rise to considerable controversy. Despite the criticisms, the IASB introduced the statement of comprehensive income. However, they made some concession, and entities can continue to publish a profit or loss statement separately from the statement of comprehensive income, or they can publish one combined statement.

In this section, we concentrate on the structure and contents of the first statement that gives the components of profit and loss. In other words, the statement will give the total revenue for the financial period and the expenses that have been incurred in generating that revenue.

In presenting the profit or loss account under IAS 1, a company can choose to use either the function of expense method or the nature of expense method. Both methods will give the same figure of final profit, but there is a distinction with the detailed information that is given.

With the nature of expense method, the expenses incurred by the company are shown according to their nature. For example, purchase of materials, transport costs, employee benefits, and advertising costs. These costs are deducted from the revenue to give the figure of profit.

With the function of expense method, sometimes known as the cost of sales method, expenses are classified according to their function, for example distribution and administration. As a minimum, the company must disclose the cost of the goods that it has actually sold. In doing this, the company will also show its gross profit, which can be relevant information to the users. The following simplified example shows the items that may appear in such a statement and the applicable standards that we discuss in this chapter.

Profit or loss account for the year ended….
	$	$	Standard
Revenue		20	IAS 16
Opening inventory	6
Add purchases	10
	16
Less closing inventory	5	11	IAS 2
Gross profit		9
Administration expenses	3
Distribution expenses	2
Depreciation	2	7	IAS 16
Net profit		2

We are concentrating on the function of expense method as it requires the calculation for “cost of sales,” sometimes referred to as “cost of goods sold.” The rationale of this calculation is that a company makes a profit only on the goods it has actually sold in the financial period. At the end of a financial period, a company will have goods that it has made or bought still unsold. These are known as the closing inventory or closing stock, and IAS 2 applies.

Obviously, the profit for a financial period is calculated on the goods that were sold or consumed in some manner in that financial period. When inventories are sold, the carrying amount of those inventories must be recognized as an expense in the period in which the related revenue is recognized.

The most effective way to calculate the value of goods sold is to take the amount held in stock at the beginning of the financial period, add the costs of goods bought, and finally deduct the value of the goods remaining. It is this last adjustment that is explained in IAS 2 Inventories.

In addition to showing the profit for the period, the comprehensive income statement must also show other comprehensive income. Examples of other comprehensive income are as follows:

Any held investment classified as available for sale, which is a nonderivative asset not intended to be held until maturity and is not a loan or a receivable, may be recognized as comprehensive income.

Foreign currency transactions that create gains or losses. This normally applies only to large companies that are active in many different currencies.

Pension plans, where the value of the plan increases, can be recognized as other comprehensive less any distributions to pension recipients.

In March 2019, the IASB published proposed amendments to IAS 1. The intention is to clarify the criteria for identifying liabilities as current or noncurrent. It aims to finalize the amendments in 2019.

IFRS 15 Revenue from Contracts with Customers

IFRS 15 (IASB 2014) replaces two earlier standards, IAS 11 (1993) Construction contracts and IAS 18 Revenue. We provide brief summaries of these two standards at the end of this chapter. The standard comes into effect for financial periods beginning on or after January 1, 2018. It requires financial statements to give users information on the nature, amount, timing, and uncertainty of revenue and cash flows. Remember that the profit or loss account uses the accruals basis of accounting and does not show movements of cash. IFRS 15 does not apply to other income that is part of the total comprehensive income.

The replacement by IFRS 15 Revenue of two existing standards emphasizes the scope of the new standard. However, it does not encompass all transactions and events. For example, transactions that involve leasing come under IAS 17 Leases, but this standard was replaced by IFRS 16 from January 1, 2016.

The objective of IFRS 15 is to identify the financial period in which a company should recognize revenue and the amount of that revenue. It concentrates on the financial statements of the seller and does not consider the buyer. IFRS 15 does not cover all facets of the financial ­relationship with customers. A transaction may be partially within the requirements of IFRS 15 and partially within those of another standard, and the standard explains the method to separate one or more parts of revenue and measure them.

The main requirements of IFRS 15 Revenue are:

• •A customer is a party contracting for goods or services that are its ordinary activities in exchange for consideration. Any other transaction would not fall under IFRS 15.
• •If the consideration is not cash based, the transaction price is equal to the fair value of the noncash consideration. In these circumstances, IFRS 13 Fair Value Measurement would apply.
• •Where there are arrangements between companies in the same line of business to assist in making a sale to a third party, IFRS 15 does not apply.

The Five-Step Model

A five-step model has been developed to explain the actions that should be taken in determining whether a transaction can be considered to be generating revenue that appears on the profit or loss statement. The steps are:

• •Identify contract
• •Identify performance obligations
• •Determine transaction price
• •Allocate transaction price to performance obligations
• •Recognize revenue when performance obligation is satisfied

The model’s main thrust is that there is an agreement between a customer and the company for identifiable goods or services. The company will supply these, and there will be an identifiable payment made by the customer.

Although the above paragraph appears self-evident, it must be remembered that some revenue transactions are extremely complex. The agreement could be a one-off or it may be that the goods or services are to be provided over a number of months or even years. The price agreed upon may depend on issues such as discounts, performance bonuses, and price concessions. The final price is identifiable with the goods or services, but an amount representing some form of financing may be included in the contract. Poon (2017) illustrates the problems with an analysis of real estate transactions in the United States. The complexities of applying the standard are summarized with a hypothetical standard given by Schmutte and Duncan (2016).

Although the standard addresses these issues and the important matter of when the revenue can be recognized in the financial statements, this depends on whether the direct use and remaining benefits are transferred at one point in time or passed over a period over time. For example, control has passed in one point in time agreement when the entity has a present right to payment for the asset; the customer has legal title to the asset; the entity has transferred physical possession of the asset; the customer has significant risks and rewards related to the ownership of the asset.

In addition to setting out the regulations for recognizing revenue, the standard also explains the procedures to be followed for any additional costs incurred. For example, sales people may spend several months negotiating a contract, legal fees may be incurred, and there may be delivery and installation of equipment costs spread over several years.

In such circumstances, the costs need not be charged immediately in the profit or loss account unless the contract is completed within 12 months. Costs over an extended period can be shown on the balance sheet and written off to the profit or loss statement over an appropriate number of years.

IAS 2 Inventories

Calculating the profit for a retailing or manufacturing company may appear simple. From the amount of sales for the period as calculated under IFRS 15, the company deducts the costs of the goods it is selling or the costs of manufacturing. This can present problems.

The financial records show the costs of all the goods and materials the company has purchased during the period but not the costs of the goods it actually sold. It could be that some goods have been lost, stolen, or damaged. These have not been sold, and therefore no profit has been made, and the company must suffer the loss. The most certain method of calculating the costs of goods actually sold is to make the following calculation.

1. 1.Value of goods at the beginning of the financial period.
2. 2.Add costs of goods purchased during the financial period to the value shown in stage 1.
3. 3.Deduct value of goods held as inventory at the end of the period from the amount calculated in stage 2.

IAS 2 establishes the methods to account for most types of inventory. It requires inventories to be measured at the lower of cost or NRV. The NRV is the expected revenue from the sale of the assets less any costs incurred. It also explains the various methods that can be used to determine cost. This includes:

• •finished goods held for sale
• •work in process
• •raw materials and supplies to be used in production

At the end of a financial period, a company, whether it is a retailer or a manufacturer, will have goods that remain unsold but that it expects to sell in the next financial period. Calculating the closing inventory for a retailer is fairly simple, but for a manufacturing company it can be more complex. Closing inventory could consist of raw materials, work in process, goods ready to dispatch to customers, and finished goods waiting to be sold.

The standard explains the calculation of the cost of inventories by identifying the costs that can be included and also the costs that should be excluded. It also explains the actions a company must take if some of the inventories are now worth less than their original cost. This is known as the NRV.

We need to emphasize that inventory is important and can be a substantial amount. The correct identification of inventory at the end of the financial period can be a significant undertaking. In what follows we show the Note in the financial statements of Vodafone Group plc in the annual report for 2016.

14. Inventory

Our inventory primarily consists of mobile handsets and is presented net of an allowance for obsolete products.

Accounting policies

Inventory is stated at the lower of cost and NRV. Cost is determined on the basis of weighted average costs and comprises direct materials and, where applicable, direct labor costs and those overheads that have been incurred in bringing the inventories to their present location and condition.

	2016	2015
	£m	£m
Goods held for resale	565	482

Inventory is reported net of allowances for obsolescence, an analysis of which is as follows:

	2016	2015	2014
	£m	£m	£m
April 1	(74)	(88)	(89)
Exchange movements	(3)	8	6
Amounts (debited)/credited to the income statement	(22)	6	(5)
March 31	(99)	(74)	(88)
Cost of sales includes amounts related to inventory of £5,427 million (2015: £5,701 million; 2014: £5,340 million).

Source: Vodafone Group plc. Annual Report 2016 Note 11.

The main items to be included in the cost of inventory are the purchase price, which includes taxes, transport, and handling but any trade discounts received must be deducted. With some companies there may be the costs of converting the materials purchased into finished items. These costs, including fixed and variable manufacturing overheads, should be included. Finally, the costs incurred in bringing the inventories to their present location and condition should also be included.

Not surprisingly, some costs cannot be included in the value of inventory and these are:

• •abnormal waste
• •storage costs
• •administrative overheads unrelated to production
• •selling costs
• •foreign exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency
• •interest cost when inventories are purchased with deferred settlement terms.

The standard allows three main methods for valuing closing inventory. These are the FIFO (First In, First Out) method, the weighted average method, and the retail method. It does not permit the Last In First Out method (LIFO), which may be acceptable in those countries not following international accounting standards.

The FIFO method assumes that the items of inventory that were purchased or produced first are sold first. This method means that items remaining in inventory at the end of the period are those most recently purchased or produced. These are up-to-date values.

The weighted average method takes the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. The company can elect to calculate the inventory on a periodic basis, for example each month, or as each additional shipment is received.

If we take a simple example.

On Day 1 a company purchases 80 units of an item at $5.00 per unit

On Day 2 the company purchases another 100 units at $6.00 per unit. The average price per unit is

$400 + $600 = $1,000/180 = $5.55 per unit

The retail method calculates the value of closing inventory using the cost to retail price ratio. The procedure is:

1. 1.Determine the retail value of goods available for sale during the period by adding the retail value of beginning inventory and retail value of goods purchased.
2. 2.Subtract total sales during the period from the retail value of goods available for sale.
3. 3.Calculate the cost to retail price ratio using the formula given below.
4. 4.Multiply the difference obtained in Step 2 and the cost to retail price ratio calculated in Step 3, to obtain the estimated cost of closing inventory.

Cost to retail price ratio is calculated using the following formula:

Cost to retail ratio = Cost of beginning inventory and purchases during the period

Retail value of beginning inventory and purchases during the period.

The situation can arise where a company has acquired inventory, but the amount it could obtain by selling them is less than the original cost. This drop in value can be for a variety of reasons. For example, the inventories may have become obsolete or damaged while in store. The market may have declined, and the current selling price is now less than the original cost. It could also be that the costs of completing production have increased, exceeding the expected selling price.

Where the amount a company can obtain selling its inventory is lower than what it cost them originally, the standard has a strict rule. Any closing inventory must be valued and shown in the financial statements at the NRV, that is, what the company can expect to receive now.

IAS 16 Property, Plant, and Equipment (Depreciation)

For many companies, the total amount of noncurrent assets, such as land, buildings, and machinery, is substantial. It is important that the values are shown in the financial statements in accordance with IAS 16 (IASB 2003b). However, most noncurrent assets have a finite life. They cannot remain on the balance sheet forever. The problem is that the business has the use of the asset to generate profit over several years, but the original cost is not immediately shown in the profit or loss account.

The solution given in IAS 16 is to “depreciate” the original cost of the asset. This involves:

1. 1.realizing the original cost of the asset on the balance sheet
2. 2.estimating the number of years the asset will last
3. 3.estimating the possible payment the company may receive on the disposal of the asset
4. 4.subtracting the disposal value of the asset from the original cost and then dividing by the number of years to calculate the annual depreciation
5. 5.showing the annual depreciation charge on the profit or loss account as an expense and deducting the same amount from the original cost of the asset on the balance sheet.

There are various approaches to depreciation and they are illustrated at the end of this section.

It is important to remember that the depreciation charge for the period appears only in the Income Statement—it is not a flow of cash. The output of paying for the asset, which could be by installments over several years, is shown in the cash flow statement, which we discuss in Chapter 5.

Depreciation is an estimate that allows us to make a charge to the income statement annually for the noncurrent asset and also to show on the balance sheet how much of the original cost of the asset still has to be depreciated. Although IAS 16 sets out the requirements for depreciation of an asset, it is not a new notion and can be traced back to 1399 (Kuter et al. 2018). They argue that comparison with current practice shows that the method has remained relatively unchanged over the centuries.

It is important to note that the amount shown on the balance sheet is not the current value or market price of the asset. This amount is usually referred to the carrying amount of the asset. Some refer to it as the written down value (WDV) of the asset or the net book value (NBV). This can be misleading as the figure does not show the value but merely the original cost less any depreciation charged to date.

Under IAS 16, a company must depreciate property, plant, and equipment on a systematic basis over the asset’s useful economic life. The depreciation charge commences when the asset is available for use and continues until the asset is derecognized regardless of periods of idleness.

The standard explains three main methods for depreciating a noncurrent asset—the straight-line method, the diminishing balance method, and the units of production method. The diminishing balance method is also known as the reducing balance method or declining balance method.

In the straight-line method the calculation for the annual depreciation charge is

Example

A company purchases some machinery for $50,000, and there will be evidence of this transaction. However, estimating the residual value of an asset and its useful life can be difficult. Usually, companies have experience or can draw on advice. For example, the manufacturers of machines and vehicles can usually provide such data.

The annual depreciation charge appears on the profit or loss account as a cost. The accumulated annual depreciation charges are deducted from the cost of the asset to give the “carrying amount” of the asset shown on the balance sheet. Note that this is not the current value or the WDV of the asset. It is a “calculated” amount.

A company estimates that machinery will last for 10 years, and the value at which it can be disposed will be $1,000. The annual depreciation charge will be

As you can see, the depreciation charge is not scientifically specific, but it is important. Not only is the profit or loss account charged with $4,900 depreciation for the year, but there is another issue. The cost of the asset is in the company’s financial records. If the company has managed to get all its estimates right, at the end of the asset’s life, the carrying amount should be the same as what the company will receive on its disposal. Such accuracy is unlikely, but any differences are usually minimal.

The diminishing balance method requires a similar procedure. The company estimates a set percentage that is charged for depreciation over the asset’s useful life. Annually, the percentage rate remains the same, but the actual annual depreciation charge decreases as the set percentage rate is charged on the “diminished balance” of the asset. Assuming the company uses 20 percent as the depreciation charge, the figures would be

Original cost $50,000

Year 1 depreciation 20% = $10,000. Reduced balance is $40,000

Year 2 depreciation is 20% of $40,000 = $8,000. Reduced balance is $32,000.

Year 3 depreciation is 20% of $32,000 = $6,400. Reduced balance is $25,600.

The depreciation charge at 20 percent of the reduced value of the asset continues to be made until the original cost is written off.

One argument for this method is that the asset becomes less productive and costs more in repairs as it ages. Therefore, the depreciation charge to the profit or loss account is decreasing as the charge for repairs is increasing. The assumption is that the combined total of depreciation and repairs is the same each year over the life of the asset.

The following example of a depreciation policy is taken from the Heineken Annual Report for 2016:

Depreciation is calculated on the depreciable amount of an asset, which is the cost of the asset, or other amount substituted for cost, less its residual value.

Land except for financial leases on land over the contractual period is not depreciated as it is deemed to have an infinite life. Depreciation on other P, P & E is charged to profit or loss on a straight-line basis over the estimated useful lives of items of P, P & E, and major components that are accounted for separately, since this most closely reflects the expected pattern of consumption of the future economic benefits embodied in the asset. Assets under construction are not depreciated. Leased assets are depreciated over the shorter of the lease term and their useful lives unless it is reasonably certain that HEINEKEN will obtain ownership by the end of the lease term. The estimated useful lives for the current and comparative years are as follows:

––Buildings 30 to 40 years

––Plant and equipment 10 to 30 years

––Other fixed assets 3 to 10 years.

Where parts of an item of P, P & E have different useful lives, they are accounted for as separate items of P, P & E.

The method chosen by a company can have an impact both on the profit and loss account and on the balance sheet. In the following example, we demonstrate and compare the use of the diminishing balance method and the straight-line method (Table 3.1).

Table 3.1 Depreciation methods

	Diminishing balance method (35%)		Straight-line method
	Annual ­depreciation charge to Income Statement	Written down amount shown on balance sheet	Annual ­depreciation charge, 3,0000	Written down amount on balance sheet
Cost January 1	20,000		20,000
Depreciation December 31, 2014	7,000	13,000	3,000	17,000
Depreciation December 31, 2015	4,550	8,450	3,000	14,000
Depreciation December 31, 2016	2,957	5,493	3,000	11,000
Depreciation December 31, 2017	1,922	3,571	3,000	8,000
Depreciation December 31, 2018	1,250	2,321	3,000	5,000
Depreciation December 31, 2019	812	1,509	3,000	2,000
	528	981	2,000	–

As you would appreciate, the method of depreciation can have a substantial impact on the profit shown by the company and the value of the assets it owns. Companies decide their policy on the depreciation method, but they show in their annual report and accounts the relevant information.

The units of production method is used when the company has an asset that produces measurable output, for example units produced or miles traveled. It is similar to straight-line depreciation, but, instead of the asset’s life being measured in time (number of years), it is measured by an output measure. With some assets this method is extremely useful. It may be that the manufacturer/supplier of the asset will conduct regular maintenance at specific mileage stages. When the total miles have been reached, the asset should no longer be shown on the balance sheet.

IAS 11 Construction Contracts (Summary)

IAS 11 was effective from January 1, 1980, and was superseded by IFRS 15 from January 1, 2018. We have included a brief summary in case you are examining a set of accounts dated prior to that date. The old standard defined a construction contract as one that is for the construction of an asset or a group of interrelated assets. If two or more contracts were jointly negotiated and the work was interrelated, a company could deem that it should be accounted for as a single contract.

The revenue was the amount agreed in the initial contract plus revenue from alterations in the original contract work plus any claims and incentive payments that were deemed collectible and could be reliably measured. Contract costs included costs that related directly to the specific contract plus costs attributable to the contractor’s general contracting activity.

Many construction activities are lengthy in nature and can exceed one financial reporting period. If the results of a construction contract can be estimated reliably, the revenue and costs are recognized in proportion to the stage of completion of contract activity. If the outcome cannot be estimated reliably, no profit should be recognized in the financial period. The only revenue that should be recognized is where the contract costs incurred were expected to be recoverable.

IAS 18 Revenue (Summary)

IAS 18 Revenue became effective on January 1, 1984, was revised in 1993, and superseded by IFRS 15 on January 1, 2018. We include this brief summary in case you are examining a set of accounts dated prior to that date. IAS 18 applied to transactions where it was highly likely that future economic benefits would flow and that those benefits could be measured reliably. The new standard contains different criteria for a transaction that was a sale of goods and one that was a provision of services.

In addition to sale of goods and provision of services, a company may receive revenue from interest, royalties, and dividends. For a company to recognize such revenue, there had to be probable economic benefits and reliable measurement of revenue.

An additional issue addressed by the standard is the practice of some entities, usually selling household items, allowing customers to defer payment for 1 or 2 years. The argument was that this deferred payment was “interest free” for the customer. The standard considered that the fair value the company received for the goods was actually less than the amount of cash the company will receive in 2 years’ time. In such circumstances, the standard required the company to report separately the interest element from the cash received for the sale of goods.

Conclusions

The comprehensive income statement was introduced by the International Accounting Standards Board in IAS 1 Presentation of Financial Statements. It introduces a completely different view of financial statements as it requires an entity to include in its annual report and accounts a statement of comprehensive income.

This is a new departure and requires companies to disclose more than one fairly simple profit figure. Companies must now produce a statement of comprehensive income or two separate statements comprising:

• •An income statement displaying components of profit or loss
• •A statement of comprehensive income. This statement begins with profit or loss shown on the bottom line of the income statement.

In addition to these significant changes, there have also been new standards and amendments to existing ones. The key factors to be aware of are the approach to the recognition of revenue as set out in IFRS 15, the requirements for revenues, and the treatment of depreciation as set out in IAS 16.

Although these changes appear dramatic, for most users of financial statements they are only one aspect of examining a company’s financial statements. In the next chapter we examine the statement of financial position, also known as the balance sheet.

IAS 16 is likely to be amended in the near future. It will require companies that have recently acquired property, plant, and equipment to show any profits from early sales in the profit or loss account.