F1 Statement of comprehensive income
• Purpose and use.
• Completion, calculation and amendment to include gross profit (revenue, opening inventories, purchases, closing inventories, cost of goods sold), calculation of profit/loss for the year (expenses, other income).
• Adjustments for depreciation (straight-line and reducing balance).
• Adjustments for prepayments, accruals.
• Interpretation, analysis and evaluation of statements.
This calculates whether a firm has made a profit or loss by deducting all expenses from sales revenue. If produced correctly, it will give an accurate calculation showing how much profit or loss the business has made. It records sales, costs and profit over a period of time (normally a year).
The first part of the statement of comprehensive income is made up of three components.
Sales revenue is the money coming into the business from providing a trade it is sometimes referred to as revenue- for example selling goods, manufacturing goods or providing services.
Sales Revenue (Turnover)=quantity sold x selling price
Cost of goods sold includes the costs directly linked to providing that trade, for example, the cost of buying in goods or the raw materials used to manufacture goods. To work out the cost of goods sold, a simple calculation is done to ensure that the figure recorded for cost of goods sold can be directly linked to the goods actually sold and not just all the materials purchased. If, for example, you bought 12 balls of wool and knitted a jumper, is the cost of the wool for that jumper 12 balls? What if you had three left over? Or two extra to start with. If we have closing inventories left over we take them away.
Cost of goods= opening inventories+purchases (- closing inventories)
Gross profit is the amount of money left or the surplus after the costs of goods sold has been deducted from the sales turnover. This is not, however, the business's final profit as there are still other expenses to deduct in the next part of the account.
Gross Profit= sales turnover- cost of goods sold
Opening inventory is the value of inventory at the start of a financial year, while closing is the value of inventory at the end of a year.
Profit is the money left after all other expenses have been deducted from gross profit and any other revenue income has been added.
Revenue income is non-capital income that is received by the business from sources other than sales, for example, discounts received and interest on positive bank balances.
Depreciation appears as an expense in the statement of comprehensive income, as this is a way that accountants can spread the cost of a fixed asset over it's lifetime. Depreciation will be explained in more detail under the fixed asset heading when you look at a balance sheet.
The calculation for profit for the year is:
gross profit - expenses + other revenue income
gross profit=sales revenue-cost of goods sold
cost of goods sold=opening inventory + purchases - closing inventory
profit or loss for the year=gross profit-expenses + other income
Tax is to be deducted from the profit: this is a percentage of the profit that is to be paid to HMRC. This then gives the profit after tax.
The business then has to decide how to use this profit. In the case of a company, a proportion of it may be issued to shareholders in the form of dividends. For a sole trader or partnership, it could be taken out of the business as drawings. Either some or all of it is likely, however, to be ploughed back into the business-this is called retained profit. Retained profits are transferred from the statement of comprehensive income to the statement of financial position.
The value of most assets decrease over time, depreciation is an accounting concept designed to take account of this. This is an accoutancy concept used to spread the cost of an asset over its useful life. It is important that when fixed assets are shown in the statement of financial position, they are given a realistic value
For this reason they are depreciated on an annual basis. The annual amount by which the assets are depreciated is therefore included as an expense in the statement of comprehensive income.
If, for example, a business bought a delivery van for £30000 and three years later still showed its value as £30000, this would be unrealistic and inaccurate accounting. The statement of financial positions should therefore show the historic cost of an asset, the amount by which it has depreciated over it's life and then a current value for the asset.
This final figure is called the net book value and this represents what the asset is thought to be worth at that moment in time.
There are two ways in which depreciation can be calculated:
1)Straight line depreciation: An asset is depreciated by a set amount each year.
This involves reducing the value of an asset from the price paid (historic cost) by a fixed amount each year. To do this we need two values:
1) The expected life of the asset (How long it will be useful)
2) Residual value of the asset (How much it might be worth if sold at the end of it's expected life)
The formula we use is (Historic Value-Residual Value)/expected life
If therefore a Ford transit van cost £16000 and was expected to be used for 4 years with a resale vale of £4000, the calculation of depreciation would be shown as follows.
Historic value =£16000
Residual Value=£4000
Expected life= 4 years
=£16000-£4000/4
=£12000/4
=£3000 depreciation each year
£3000 would be shown as an expense on the statement of comprehensive income.
2)Reducing balance depreciation: An asset is depreciated by a set % of it's remaining value each year. Each year the asset is therefore depreciated by a smaller amount as it ages.
If a Ford transit van was purchased for £16000 and a decision was made to depreciate it by 20% per year the depreciation would be calculated as follows.
Historic cost =£16000
Year 1 depreciation =£16000 x 0.20= £3200
Net Book Value= £16000-£3200=£12800
Year 2 depreciation= £12800 x 0.20= £2560
Net Book Value=£12800-£2560 =£10,240
Year 3 depreciation=£10,240 x 0.20=£2048
Net Book Value= £10,240-£2048= £8192
The advantages of reducing balance depreciation isn't necessarily on the spec but it did come up in an exam.
Advantages
• Gives a more realistic valuation of assets as they lose most value in the first few years.
• Prevents overstating the assets value so would comply with accounting concepts (avoids window dressing)
• Prevents understating the expense / overstating profits so would comply with accounting concepts
• Gives greater tax benefit in early years which would help grow the business
Disadvantages
• Harder to calculate than the straight-line method as you will need to recalculate the expense each year figure based on the net book value at the end of the previous year
• It is harder to work out what percentage to use to depreciate over the asset’s lifetime
• Will produce lower profit figures in the early years in the life of the asset
It is also worth noting in a badly worded question on depreciation they asked us to calculate straight line depreciation but only gave us a %. In this case we calculate the % for the first year and multiply it by the number of years. I believe this was a mistake in the exam and is unlikely to happen again.
It is important that the financial records are a true and fair record of the business's activities. For this reason, adjustments will be made to a statement of Comprehensive Income so that the expenditure shown matches the period in which the good or service is used.
For example, if rent is paid quarterly in advance, the expense may be incurred in one financial year but the premises are actually used in the next financial year. To take account of such timing differences, two types of adjustment are made. These are outlined below.
Prepayments
A prepayment is when an expense is made in advance of the periods to which it relates.
The expense is therefore taken out of expenses in the statement of comprehensive income and shown as a current asset in the statement of financial position.
An example would be rental on a phone line paid quarterly in advance.
Accruals
An accrual is when an expense is paid after the periods to which it relates.
The expense is therefore added as an expense in the statement of comprehensive income and shown as a current liability in the statement of financial position.
An example would be electricty paid quarterly in arrears (after it's been used).
Once produced, the statement of Comprehensive Income can be used internally by management to help measure the performance of the business and inform future decision making. It can also be used externally by potential investors and creditors. A creditor, for example might look at the business Statement of Comprehensive Income when deciding whether or not to offer trade credit.
The statement of comprehensive income may be analysed in a number of ways including making:
Comparisons between figures within the statement of comprehensive income, e.g. profit as a percentage of sales revenue.
Comparisons between years, i.e. gross profit this year as compared to gross profit last year.
Intrafirm comparisons to see how different aspects of the business are performing. e.g. revenue for one product or branch compared with another profit or branch.
Interfirm comparisons to see how the business is performing in relation to the competitors.
When interpreting and analysing a statement of comprehensive income, it is also useful to consider profit quality. Profit quality is how sustainable the profit is. If profits have increased, but this is because of a one-off event, such as selling an asset, then this cannot be repeated the following year and profit quality may therefore be seen as poor. However, if the increase in profit is a result of increased sales or lower costs, then this may be seen as achievable in future years and therefore profit quality is seen as good.
Profit quality can be used to evaluate the statement of comprehensive income. Anyone looking at the accounts may also want to consider the accuracy of the information. Accounts must be accurate to meet legal requirements but it is possible to manipulate data to make it look more favourable. This is called window dressing.