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FINM 7409 Financial Management for
Decision Makers
Lecture 3: Statement of Profit or Loss
Ref. Chapter 6, Birt et al., 8e
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1. Explain the purpose and importance of measuring financial performance
2. Explain the reporting period concept and the difference between accrual accounting and cash
accounting
3. Outline the effects that accounting policy choices, estimates and judgements can have on financial
statements
4. Describe the measurement of financial performance
5. Discuss the definition and classification of income
6. Discuss the definition and classification of expenses
7. Apply the recognition criteria to income and expenses
8. Identify presentation formats for the statement of profit or loss
9. Differentiate between alternative financial performance measures
10.Explain the relationship between the statement of profit or loss, the statement of financial position,
the statement of comprehensive income, and the statement of changes in equity.
Learning objectives
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But profit or loss is NOT
 a measure of the change in an
entity’s value over the reporting
period
 a measure of the cash that the
entity has generated during the
period
 Profit or loss is an important item in financial statements
 Profit reflects the outcome of an entity’s investment and financing decision
 The statement of profit or loss reflects the accounting return for an entity over a specified period
 Users need profit/loss information from this report to make informed decisions, e.g., to evaluate past
decisions and revise future predictions
 The accounting return here refers to the profit or loss of the entity
 How to define profit or loss?
Purpose and importance of measuring financial performance
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Profit = Income − Expenses
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Triple Bottom Line – 3 P’s:
1. Profit
2. People
3. Planet
Page 14 of Birt Profit maximisation is often the goal for many entities, but the
importance of sustainable business practices should never be
underestimated
 With sustainable business practices, business decisions are made
that are not necessarily profit-maximising but beneficial for the
environment or the community
 Nowadays, many entities report not only financial performance but
also environmental, social, and governance performance (ESG)
 Such reporting is often known as triple bottom line reporting or
ESG reporting
 Triple bottom line? ⇒ https://online.hbs.edu/blog/post/what-is-the-
triple-bottom-line
 Recently, integrated reporting – how an entity’s strategy, governance,
performance, and prospects are leading to the creation of value
Purpose and importance of measuring financial performance
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 Why so?
 In accounting, income and expense recognition is not contingent on cash
being received or paid
 E.g., sold products on credit, recognized revenue even though cash has not
been received
 Income here encompasses:
1. Revenue from ordinary course of operations, e.g., sales, fees, etc.
2. Gains, e.g., gains on disposal of non-current assets and unrealized gains
on revaluing assets
But profit or loss is NOT
 a measure of the change in an
entity’s value over the reporting
period
 a measure of the cash that the
entity has generated during the
period
Purpose and importance of measuring financial performance
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We’ve said earlier (a few
slides back) that…
Revenue ⊆ Income
“Gains”?
 Bought JB Hi-Fi shares for $50. Two months later, price goes up to $70.
 If still holding the share ⇒ Unrealised gain of $20.
 If sold ⇒ Realised gain of $20
Gain ≠ Profit
Gain ⇒ Non-core/non-
recurring/peripheral/incidental activities
Profit ⇒ Recurring, much wider concept
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 The reporting period (also “the accounting period”) is the period of time to which the financial statements
relate
 For external reporting purposes, the convention is that a reporting period is yearly, i.e., prepare the
report at the end of each 12 months
 E.g., Australian companies report for a 12-month period starting from July 1st (previous calendar
year) to June 30th (current calendar year)
The reporting period
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SepJun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug
Previous calendar year Current calendar year
Reporting period
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 Accounting standards require that financial statements be prepared on the basis of accrual accounting
 What is accrual accounting?
 A system in which transactions and events are recorded in the period to which it relates rather than
in the period in which cash is received or paid
 It recognizes the income and expense transactions when they occur, not when cash is paid or
received
 ⇒ Implications!
 Reported profit or loss based on the accrual system is the difference between income and expenses
for the period
 It better reflects the performance of the entity for a reporting period
Accrual accounting vs. Cash accounting
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See Page 200, Birt et al., 8e for detailed examples
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 What is cash accounting?
 A system that determines profit or loss as the difference between cash received (from income items)
and cash paid (from expense items) for the period
 Transactions are recorded in the period in which cash is received or paid, i.e., recognise profit/loss
when and only when cash is received/paid
 Entities not required to comply with accounting standards, such as small businesses, often prepare their
financial statements on a cash basis
Accrual accounting vs. Cash accounting
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 Income is recognised without receipt of cash ⇒ called “accrued income”
 ⇒ Income has been earned, but payment is still owing (i.e., has not received $payment$ yet)
 Cash is received but income is not recognised ⇒ called “income received in advance”
 ⇒ Cash has been received (e.g., payment received) but the entity has not fully delivered the
services/goods yet
 It creates a liability for the entity until the income is earned (i.e., until the goods/services have been
fully delivered)
 Expense is recorded without cash payment ⇒ called “accrued expense”
 ⇒ Expense is incurred but payment has not been made yet
 Expense is paid but not recognised as an expense ⇒ called “prepaid expense”
 ⇒ Paid in advance and the expense is recorded only when the benefits are consumed/used up
 E.g., paid fortnight rent at the beginning of the period
Accrual accounting effects
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Incomed “earned”??? ⇒ say
“earned” when the entity has
completed the delivery/provision of
goods or services, regardless of
whether it has received payment
Expense “incurred”??? Say “incurred”
when the entity has received the
goods/services, regardless of
whether it has paid for it
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Example – Accrued income
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Example – Income received in advance
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Example – Accrued expense
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Example – Prepaid expense
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Summary
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 Under accrual accounting, there are expenses that are recognized but do not involve cash flows (i.e.,
non-cash expenses)
 What are they?
 Depreciation – tangible assets
 Amortization – intangible assets
 What is depreciation (amortization)?
 Is the systematic allocation of the cost of a tangible (intangible) asset over its useful economic life
 It does not involve cash flows
 It does not represent the loss in the asset’s value during the reporting period
 Just a way to recognize how much the economic benefits of the asset has been used up in the
reporting period
 “Accumulated depreciation” is an account that captures the total depreciation that has been charged to
the statement of profit or loss for a particular asset
Depreciation
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 Same information as above, but now assume a 50%
depreciation rate
 Purchased equipment for $30,000 at the start of the
reporting period
 Estimated useful life = 3 years
 Expected residual value = $3,000
Depreciation expense = Asset cost − Residual valueEstimated useful life = 30,000−3,000
3
= $9,000
Year Depreciation Expense
1 $15,000
2 $7,500
3 $3,750
Note: Book value at the end of
Year 3 is equal to the cost
price less accumulated
depreciation
Straight-line depreciation
Diminishing-balance depreciation
 Straight-line depreciation allocates a
constant amount $ to the book value
of the asset at the start of each
reporting period over the useful life of
the asset
 Diminishing-balance depreciation
allocates a constant percentage % to
the book value of the asset at the start
of each reporting period over the
useful life of the asset
Depreciation – Example
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 Same information as previous, but now assume the machine
has a useful life of 100,000 units of production and # units
produced each year shown as follows:
Year # Units produced Depreciation Expense
1 50,000
2 30,000 $8,100
3 20,000 $5,400
 Units-of-production depreciation
charges depreciation expense on the
basis of the activity or output in the
reporting period relative to the asset’s
total expected activity or output
 Formula:
Depreciation – Example
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Depreciation expense = $Asset cost – $Residual value#Total estimated units × #Units in the period
How?
Year 1: [(30,000 – 3,000) / 100,000] ×
50,000 = $13,500
Similarly for Year 2 & 3
$13,500
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Useful terminology
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 Written-down value = The cost or value of an asset less the accumulated
depreciation written off as depreciation to date
 Other terms used interchangeably:
 Net book value
 Carrying amount
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Summary/comparison of depreciation methods
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 GAAP permits choices when transactions are being recorded and require estimations by the preparers
 Users of financial statements need to be aware of the existence of this flexibility and discretion in
accounting
 ⇒ Important to consider the potential impacts of such flexibility and discretion on the quality of
reported financial information
 Reported profit or loss figures are affected by the entity’s discretion over the following:
 Accounting policy choices (e.g., can choose straight-line or declining-balance depreciation)
 Accounting estimates (e.g., % estimates for bad debts, etc.)
Effects of accounting policy choices, estimates, and
judgements on financial statements
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 Method of depreciation
 Method of inventory costing
 Method of valuing PPE
 Capitalising or expensing development
expenditure
 Etc.
Examples of accounting policy choices and estimates
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 Useful life of depreciable assets
 Residual value used in depreciation
calculations
 Impairment of assets
 Employee benefits (e.g., long-service
leave)
 Etc.
Accounting policy choices Accounting estimates
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 Discretion in choosing accounting policies and estimates ⇒ need to consider the quality of profit or loss
figures – often called the “quality of earnings”
 Does such a reported earnings reflect the financial performance of the entity?
 Reported profits are an important number because they are used in contractual arrangements and to
value entities
 If driven by self-interest, managers may choose estimates or policies that best serve their interests
rather than those that portray the entity’s economic reality
 Managers may use such discretion to portray a desired level of earnings
 E.g., to avoid breaching loan covenants, to maintain the share price, to maximize salary and
bonuses, etc.
 Earnings management is a term that refers to managers’ use of accounting discretion to portray a
desired level of profit in a particular reporting period
 EM often occurs via the accrual process
Quality of earnings – “Earnings management”
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 To measure the profit or loss of an entity, it is necessary to identify and measure all income and
expense items attributable to the reporting period
 This requires an understanding of what attributes a transaction must have in order to be classified as an
item of income or an item of expense
 Income and expenses are integrally linked with assets and liabilities
Measuring financial performance
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 Income is defined as an increase in an asset or a decrease in a liability that results in an increase in
equity other than those relating to equity-holders’ contributions
Income
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INCOME
Increase in equity
that’s not from
owners’
contributions
Increase
in asset
Decrease
in liability
OR
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 Recall that income comprises both revenue and gains:
 Revenue? ⇒ arises from the ordinary course of an entity’s activities
 Gains? ⇒ also represents increases in economic benefits but may or may
not arise in the ordinary course of the entity’s activities
 E.g., non-operating events such as gains from asset sales, lawsuits,
changes in market values, etc.
 To repeat, income must be associated with an increase in assets or a decrease
in liabilities
 Recall the duality principle: An increase in an asset or a decrease in liability
must be accompanied by an increase in equity ⇒ Thus, income increases
equity
Income
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FINM7409  Gains ⇒ Peripheral, non-
core, non-recuring,
incidental, non-
operating…
 Revenue ⇒ Central, core,
on-going, recurring,
major, operating,…
$$
$Income$
$Gains$$Revenue$
See Page 206, Birt et al., 8e for an example of
how to identify income
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Income classification
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 providing goods/services
 investing/lending
 receiving contributions from parties
other than owners
 etc.
 sales
 fees
 commissions
 interest
 rent
 etc.
Income-Generating Activities Income Types
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 Expenses are defined as a decrease in an
asset or an increase in a liability that results
in a decrease in equity other than those
related to equity-holders’ distributions
Expenses
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EXPENSES
Decrease in equity
that’s not from
owners’
distributions
Decrease
in asset
Increase
in liability
OR
“Distributions”? ⇒ Pay dividends, return of capital to
owners ⇒ NOT an expense, even though it results in a
decrease in equity
AASB = “Australian Accounting Standards Boards”
https://aasb.gov.au/pronouncements/accounting-standards/
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 Cost of sales is the main expense incurred by an entity
 i.e., to sell goods to generate income, the entity must purchase goods for resale, e.g., JB Hi-Fi
purchases iPhones from Apple Inc. to resell
 Due to accrual accounting, the cost of sales expense comprises purchases during the reporting period
and the change in the inventory balance during the period
 Other expenses:
 Wages, salaries, depreciation (non-cash), selling, general, and administrative expenses (SG&A),
borrowing expenses
 Periodic expenses include depreciation expenses and/or impairment losses
 BUT the acquisition of certain assets like PPE is not an expense for the period because there is no
reduction in equity associated with the acquisition transaction
Expenses – Example
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Cost of Sales = Opening Inventory + Purchases - Closing Inventory
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 Entities have a choice in how to display and classify expenses in the statement of profit or loss
 Smaller entities often list all expenses in the statement of profit or loss
 Larger entities aggregate expenses into certain classes for reporting purposes
 Entities required to comply with accounting standards must classify expenses by nature or function
 E.g., by nature ⇒ employee benefit expense, depreciation/amortization expenses, etc.
 E.g., by function ⇒ distribution, marketing, borrowing costs, etc.
Expense classification
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Expense classification by function – JB Hi-Fi Ltd.
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 Recall (from last week):
 Recognition refers to the recording of items in the financial statements with a $monetary value$
assigned to them
 ⇒ Income/expense recognition is the recording of income/expense items on the statement of profit or
loss
 Important here: Items be measured in $monetary terms$ - the “$monetary concept$”
 Also recall (from last week) the following factors to consider when making a recognition decision:
Recognition criteria for income and expenses
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1. Uncertainty
2. Probability
3. Measurement uncertainty
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 Customer 1: Made 50% non-cancellable
deposit for goods worth $5,000
 Customer 2: Made 10% cancellable deposit for
goods worth the same amount
 Which one would you be likely to recognize as
income of $5,000?
 To recognise income requires knowing when an
increase in assets or a decrease in liabilities has
occurred
 Income recognition can be difficult and requires the
consideration of relevance assessed with
reference to the factors mentioned earlier – (1)
uncertainty, (2) probability, and (3) measurement
uncertainty
 As a result, it is difficult to be prescriptive as to the
appropriate point in time when income should be
recognized
Income (revenue) recognition
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Factors to consider in income recognition
 Is there an agreement for provision of goods/services
between the parties?
 Has cash been received?
 Is it possible to reliably estimate the collectability of
debts?
 Have all acts of performance that are necessary to
establish a valid claim been completed?
 Etc.
CRICOS code 00025B
 Expense recognition is based on whether a decrease in assets or an increase in liabilities has occurred,
paying due attention to the relevance with respect to the factors mentioned earlier:
1. Uncertainty
2. Probability
3. Measurement uncertainty
 Expense recognition can be
 Straightforward: when goods with a known value have been sold or an invoice has been received,
etc.
or
 Tricky: when there’s much uncertainty about the occurrence/measurement of the outflow of
resources, e.g., employee benefits, asset impairment, etc.
Expense recognition
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Income and expense recognition – Summary
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 The matching principle requires matching the income earned with expenses incurred in a reporting
period
 Items of income and expenses result directly and jointly from the same transaction
 E.g., the concurrent recognition of sales and cost of sales
 E.g., sold goods, inventory down, recognised revenue and cost of sales
 Income is matched with progressive performance
 E.g., a borrower recognizes the interest expense associated with a loan throughout the loan’s life
even if all the interest is to be paid at the loan’s maturity
 Expenses are matched with the entity’s productivity
 E.g., the recognition of depreciation on a systematic basis according to the asset’s useful life is
allocating the depreciation expense according to the asset’s productivity (e.g., see the units-of-
production method for depreciation, where # units produced by the machine are estimated for each
year over its useful life)
Matching principle
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 Accounting standards require the following items be presented in the statement of profit or loss
Prescribed format for general-purpose financial statements
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Revenue
Cost of sales
Finance costs
Impairment losses
Share of profit/loss of associates and joint ventures
accounted for using the equity method
Tax expenses
Profit or loss (separated for continuing and discontinued
operations, if applicable)
CRICOS code 00025B
 Applicable to manufacturing and retail operations
 An entity cannot be sustainable unless it has a +positive+ gross profit.
 Why? ⇒ If gross profit < 0, it is selling goods/services at a price that is below their cost
 Thus, gross profit reflects the percentage % by which an entity marks up the cost of its products to sell
to its customers
 It also reflects the entity’s relationship with suppliers and its purchasing power
Financial performance measures
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Gross Profit = Revenue − Cost of Sales
Terminology:
“Gross Profit Margin”
⇒ Gross Profit divided
by Revenue
Gross Profit
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 Profit before and after tax, also called profit on a pre- and/or post-tax basis
 Tax expense is based on taxable income, calculated by applying taxation rules, but the profit reported in
the statement of loss or profit is measured by applying accounting rules
 Implications?
 ⇒ If taxation and accounting rules differ, the tax expense of an entity will not simply the pre-tax
accounting profit multiplied by the applicable tax rate
 Taxation and accounting rules may differ due to the following:
1. Income not being assessable for taxation purposes
2. Expenses not being deductible for taxation purposes
Financial performance measures
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Profit pre-tax and post-tax
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 Profit seen so far reflect the effects of an entity’s investing and financing decisions and their taxation
consequences
 What about the return associated with investing decisions only? ⇒ Profit before interest and tax –
commonly called EBIT (Earnings Before Interest and Taxes)
 Net finance costs:
 Net lender (e.g., a bank) with interest income > interest expense ⇒ subtract the net interest from the
profit-before-tax figure to calculate EBIT
 Net borrower with interest income < interest expense ⇒ add the net interest to the profit-before-tax
figure to calculate EBIT
Financial performance measures
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Profit pre-tax and post-interest
Net finance costs = Interest income − Interest expenses
(including finance lease charges)
See Figure 6.6 from Birt et al., 8e (Page 216) for
an example of EBIT calculation for JB Hi-Fi Ltd.
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 Depreciation and amortization are non-cash expenses included in the statement of profit or loss
 EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) reflects the profit before
interest, taxes, and depreciation/amortization expenses
 It is a measure of the raw operating earnings because it excludes
1. asset diminution, i.e., actual or perceived loss in market or resale value of the asset
2. tax and
3. financing charges
Financial performance measures
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Profit pre- and post-
depreciation/amortization
Asset
dim
inutionFi
na
nc
in
g
E B I T D A
Ta
x
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 Income and expense items can be labelled as “material” or “significant” on the basis of their size or
nature
 E.g., many users are interested in an entity’s “maintainable” earnings, which is taken to be income less
expenses from “ordinary” activities, excluding the material items
 Why exclude the material items?
 Excluding the material items would provide a better reflection of the trend and sustainability of an
entity’s profit
 Despite this, material items should still be given due consideration
Financial performance measures
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Profit pre- and post-
material items
Telxtra Co. had revenue of $100m last year. That
year, it sold a business unit in Brisbane, which led
to a gain of $10,000. This amount – $10,000 –
was not treated as “material”
St Lucia Fruit Juice is a fruit juice stall on UQ
campus. Its profit for last year was $5,000. That
same year, it also earned royalty of $5,000 for
selling fruit juice to a big conference organised by
UQBS. This amount – $5,000 – would be treated
as “material” for this business
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 Discontinued operations:
 If an entity has sold or plans to sell a part of its business during the reporting period, then it must
disclose that information so that users can evaluate the financial effects of the discontinued
operations
 This is to help users better predict future profits
Financial performance measures
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Profit from continuing and
discontinued operations
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 The recognition of income occurs simultaneously with the increase in assets
or decrease in liabilities
 The recognition of expense occurs simultaneously with the decrease in
assets or increases in liabilities
 Profit (loss) for the reporting period is added to retained earnings at the start
of the period
 The entity can make distributions from retained earnings and transfers
to/from retained earnings
 The balance of retained earnings at the end of the period is included as an
equity item in the statement of financial position
The link between the financial statements
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Terms:
Retained earnings/Retained
profits/Accumulated profits ⇒
Undistributed profits from
previous periods
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The link between the
financial statements
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Thank you