In this article we take a look at the other elements of financial statements, which are income and expenses. These are used to report the financial performance of an entity.
Income
The financial performance of an entity is measured by profit or loss.
Profit is whatever is left from income once expenses are deduced.
Income includes both revenue and gains, which is recognised in the statement of profit or loss and other comprehensive income when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably.
Revenue:
- is income that arises in the course of ordinary activities of an entity and is comes from a number of sources including sales, fees, interest, dividends and royalties.
Gains:
- represent other items that meet the definition of income, and may or may not include items arising in the normal course of business.
- represent increases in the future economic benefits, and as such are no different in nature from revenue.
- Realised gains are those where an asset has been sold for more than its carrying amount.
- Realised gains are often reported in the financial statements net of related expenses.
- Gains might also be unrealised. Unrealised gains occur whenever an assets value increases, but is not disposed of.
- For example, an unrealised gain occurs when marketable securities owned by the entity are revalued upwards.
Expenses
Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or other liabilities, which arise.
They include:
- Expenses which arise in the normal course of activities, such as the cost of sales and operating costs, including depreciation of non-current assets. These result in the outflow of assets and increase in liabilities.
- Losses include for example, the loss on disposal of a non-current asset, and losses arising from damage caused to assets. Losses are usually reported as net of any related income.
- Losses may also be unrealised. Unrealised losses occur when an asset’s value decreases but is not disposed of. For example, and unrealised loss occurs when property owned by the entity is revalued downwards, but kept.
Expenses are recognised in the statement of profit or loss and other comprehensive income when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably.
This means, in effect, that recognition of expenses occurs at the same time as recognition of an increase in liabilities or a decrease in assets (for example, the accrual of employee entitlements or the depreciation of equipment.)
Matching Principle
Expenses are recognised in the statement of profit or loss and other comprehensive income on the basis of a direct association between the costs incurred and the earning of specific items of income this is commonly referred to as the matching principle.
This process involves the simultaneous recognition of revenues and expenses that result from the same transactions or other events.
For example, when we recognise the revenue received from the sale of goods, the various components of expense making up the cost of goods sold are recognised at the same time.
Depreciation or amortisation
When economic benefits are expected to arise over several accounting periods and the association with income can only be broadly determined, the expenses are recognised on a systematic or rational allocation basis.
This is often necessary in recognising the expenses associated with using up of assets such as property, plant, equipment, goodwill, patents and trademarks.
In these cases, the expense is referred to as depreciation or amortisation.
These allocation procedures are intended to recognise expenses in the accounting periods in which the economic benefits associated with these items are consumed or expire.
In cases of prepaid expenses, these are not recognised as expenses in the period they are paid, but as assets in the statement of financial position, as they will provide future benefits to the entity.
An example of this is when rent is prepaid, the cost of the rent will be taken from the prepaid rent account.