Accounting Business Reporting for Decision Making

CHAPTER 6 Statement of profit or loss and statement of changes in equity 229

Income classification

Income arising in the ordinary course of an entity’s activities (i.e. revenue) is generated from various

activities; typically these include providing goods and services, investing or lending, and receiving con-

tributions from parties other than owners. As well as diversity in income-generating activities, there are

diverse income types such as sales, fees, commissions, interest, dividends, royalties, rent and non-reciprocal

transfers. Look at notes 3 and 4 in the 2015 Preliminary final report of JB Hi-Fi Ltd in the appendix to this

text. The company has revenue from the sale of goods and services as its main revenue source. There is also

‘other income’ but no details are provided as to what type of income is included in this category.

6.6 Expenses

LEARNING OBJECTIVE 6.6 Discuss the definition and classification of expenses.

As with income, definition criteria must be satisfied before an expense is recorded in the statement of

profit or loss. The following sections discuss these criteria.

Expense definition

Expenses are defined in the proposed Conceptual Framework (para. 4.49) as:

decreases in economic benefits during the accounting period in the form of outflows or depletions of

assets or incurrences of liabilities that result in decreases in equity, other than those relating to distri-

butions to equity participants.

The word ‘expenses’ refers to expenses arising in the ordinary course of the entity’s activities, as well

as losses (both realised and unrealised). When deciding if the expense definition criteria are satisfied, it is

necessary to ascertain that assets have been reduced or that liabilities have increased. A reduction in an asset

or an increase in a liability must be accompanied by a reduction in equity for the definition to be satisfied.

Thus, expenses decrease equity. The qualification to this definition is that the transaction does not involve a

distribution to owners (i.e. a dividend distribution or return of capital to equity participants). The qualifi-

cation eliminates dividend distributions or capital returns to owners being recognised as expenses.

Consider a retail operation. The main expense incurred by the business is the cost of sales. In order to

sell goods and generate revenue, the entity must purchase goods for resale. Remembering that financial

statements are prepared using accrual accounting, the cost of sales expense comprises the entity’s pur-

chases during the reporting period and the change in the inventory balance from the beginning to the end

of the reporting period (calculated using the equation below).

Cost of sales=

Inventory at beginning

+Purchases–

Inventory at end

of period of period

Imagine that the entity purchases goods on credit from a supplier on 15 June. For the reporting period

ended 30 June, the purchases would be included in the cost of sales determination, even though no cash

has been paid to the supplier by 30 June.

The critical feature of an expense is that an asset has been reduced or a liability increased, with a con-

sequent reduction in equity. In the transaction described, the entity has an obligation to pay the supplier,

so a liability is increased (accounts payable). The dual side of the transaction is that an expense, pur-

chases, increases and thereby reduces equity. When the supplier is paid, the liability account (accounts

payable) is reduced and an asset account (cash) is also reduced, with no corresponding reduction in

equity. Hence, the payment does not involve the recognition of an expense.

Other expenses associated with selling goods include advertising, sales staff salaries, store displays and

wrapping materials. Generally, the expense will arise as a result of the payment of cash (asset reduction)