INCOME STATEMENT
Cost by nature and cost by
function
Expenses
Definition:
An expense is the cost of an asset used by a company in
its operations to produce revenues. In other words, an
expense is the use of assets to create sales.
◼ Notice that I didn’t say it’s the amount of money spent to
generate sales. Expenses are created when an asset is used
up, not when cash is paid out. Take depreciation expense for
example.
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Expenses (cost) and expenditure (cash outflow)
◼ Expense and outflow have different economic and accounting
interpretation.
◼ An expense is reported on the income statement. An expense is a
cost that has expired, was necessary in order to earn the
revenues during the time period indicated in the heading of the
income statement, decreases in economic benefits or service,
consumptions of assets
◼ For example, the cost of the goods that were sold during the period are
considered to be expenses along with other expenses such as advertising, salaries,
interest, and so on.
◼ An expenditure is a payment or disbursement. The expenditure
may be for the purchase of an asset, a reduction of a liability, a
distribution to the owners, or it could be an expense.
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Expenses (cost) or cash flow ?
1. Expenses that do not
represent cash outflows from A. Accrued interest on bank loans
entity and will never do.
B. Purchase of goods for resale
2. Expenses that are not outflows (cash payment)
at the moment of expense
recognition, but will result in C. Repayment of bank loan
cash outflow in the future
3. Outflow that never bring D. Depreciation charges
expense.
4. Outflow that can bring cost in
future.
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Expenses (cost) or cash flow
1. Expenses that do not represent cash outflows from entity and will
never do
Depreciation charges
2. Expenses that are not outflows at the moment of expense
recognition, but will result in cash outflow in the future
Accrued interest on bank loans
3. Outflow that never bring expense
Repayment of bank loan
4. Outflow that can bring cost in future
(Cash) purchase of goods for resale – expense appears in the moment
of resale of these goods
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Revenues
Revenue / income
◼ a received or expected to be received inflow of money
usually relating to sale of goods and services
◼ increases in assets resulting in increase of inflow of economic
benefits to the entity
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Revenues and cash inflow
◼ Revenues that do not represent cash flow to the entity and will
never do receipt
◼ Revenues that are not inflows at the moment of reenues
recognition but will result in cash inflow in the future
◼ Inflow that never brings revenues
◼ Inflow that can bring revenues in future
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Revenues and cash inflow
◼ Revenues that do not represent cash flow to the entity and will
never do receipt
materials free of charge
◼ Revenues that are not inflows at the moment of reenues
recognition but will result in cash inflow in the future
sale with deffered payments
◼ Inflow that never brings revenues
repayment of loan granted
◼ Inflow that can bring revenues in future
prepayment received on acccount connected with future sale
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Revenues Expenses
1. Salaries
2. Interest earned on
deposits
3. Depreciation calculate
4. Interest paid on debt
5. Loan Fees (paid)
6. Bank Charges
7. Rent received
8. Donation (received)
9. Losses from disposal of
tangible fixed assets
[Link] and conservation
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The Income Statement
◼ The income statement reports the results of a company’s
activities for a specified period of time.
◼ It identifies the major sources of income and the different
costs incurred in running the business.
◼ The bottom line that summarizes revenues minus expenses is
net income
◼ In the income statement we identify the expenses and
revenues according accrual rule, matching principle
◼ Two version of Income statement:
◼ presenting expenses by nature
◼ presenting expenses by function
Presentation of activity in income statement
◼ Operating activity - reflecting expenses/revenues of main
activities
◼ Other operating activity - reflecting expenses/revenues from
activities not related to central operations and not regularly
recurring
◼ Revenues/Value of sold of non-financial fixed (non-current)
assets
◼ Compensation penalities fines
◼ The financial activity – expenses/revenues relating to financial
activity of the entity
◼ accrued interest on loans
◼ The extraordinary losses specific arise as result of events which a
difficult to predict outside the entity operating activities and not related
to general risk
Extraordinary items are gains or losses that meet both of the following criteria:
1) Unusual in nature, and 2) Not expected to recur in the foreseeable future.
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Operating activity: Cost by nature
◼ Classification on the basis of inputs – what the money was spent
on (e. g., salaries, amortization)
◼ Amortization
◼ Materials and Energy used
◼ External services
◼ Taxes and fees
◼ Wages and salaries
◼ Social incurance
◼ There is no reallocation of these expenses to different functions
of the entity.
◼ This method of disclosure of expenses is usually employed by
small businesses due to its simplicity. However there is drawback
in this method that it cannot be used to calculate gross profit
within the income statement.
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Operating activity: Cost by function
◼ Output-based classification – what money was used for, based on
their use in the operating and investment cycle, classified
according to their role in the determination of income
◼ Manufactoring cost/Cost of goods sold - direct costs attributable to
goods produced and sold by a business (manufacturing or
merchandizing). It includes material costs, direct labour, and overhead
costs
◼ Selling expenses - represent expenses needed to sell products
(e.g., salaries of sales people, travel expenses, advertising, freight,
shipping, depreciation of sales store buildings and equipment)
◼ General and administrative expenses - represent expenses to manage
the business (salaries of officers / executives, legal and professional
fees, utilities, insurance, depreciation of office building and
equipment, office rents, office supplies)
◼ Cost are broken down in each of functions, depending on whether
the employee works in production, sales or administration.
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Classification Exercise
Classify the following cost items. Use cost by function:
1. Depreciation on factory building
2. Depreciation on office equipment
3. Property tax on finished goods warehouse
4. Wages paid to forklift operator in finished goods warehouse
5. Wages paid to forklift operator in factory
6. Paper used in textbook production
7. Paper used in central office computer
8. Wages paid to assembly line workers
9. Maintenance cost for machines
Financial activity:
◼ Dividends and participation in profits,
◼ interest earned on bank deposits, notes receivable, and interest-bearing
investments
◼ Interest on bank loan, note payable
◼ Gains/loss on disposal of investments
◼ Revaluation (remeasurement) of investments
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Prepare operating expenses acording cost by function for the companies
(manufactoring, selling, administrative expenses)
◼ Wozzie Wiggits Ltd. produces and sells gaming software.
◼ Eastern Cycles Ltd. produces and sells bicycles and cycling equipment to
the public.
◼ Overnight Auto Service, a small auto repair shop
◼ Quantum Clinic, Inc., diagnostic company
◼ Baxter, Claxter, and Stone, architectural firm
◼ Environmental Services, Inc., performs various tests on wells and septic
systems
◼ Aerial Views, provide aerial photography services.
◼ Dr. Schekter, DVM, a veterinary clinic
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Net Sales
◼ Revenue from the sale of principal goods or services sold to
customers
◼ Shown net of
◼ Discounts
◼ Returns
◼ VAT
Alternative formats in Europe and US in top 30
listed industrial groups
◼ Formats in practice is highly variable across countries.
◼ While the U.S. and Canada, for example, have adopted a ‘by
function’ income statement format, Italy and Spain prefer the
‘by nature’ format, and several others (e.g., Germany) leave
the choice up to the firms themselves.
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