246 Accounting: Business Reporting for Decision Making
Summary of learning objectives
6.1 Explain the purpose and importance of measuring financial performance.
It is important to measure financial performance periodically so that users, both internal and external, can
assess the profitability of the entity. The primary objective of preparing financial statements is to provide
information that is useful for decision making. Knowledge of the profit or loss is crucial in assessing past
performance and forming an opinion as to expected future performance for a for-profit entity.6.2 Explain the reporting period concept and the difference between accrual accounting and
cash accounting.
The fundamental concepts underlying the preparation of the statement of profit or loss are the
accounting or reporting period, accrual accounting and generally accepted accounting principles. Gen-
erally accepted accounting principles (GAAP) are the accounting rules that determine the recognition,
measurement and presentation of financial information. The financial performance of an entity is meas-
ured over a period of time — the life of the entity is arbitrarily divided into reporting periods. The profit
measurement for a reporting period should include all transactions affecting profit in that reporting
period. Accrual accounting, as distinct from cash accounting, means that the profit determination is
independent of whether cash is received or paid in relation to profit items during the reporting period.
6.3 Outline the effect that accounting policy choices, estimates and judgements can have on
the financial statements.
Even when preparing financial statements in compliance with approved accounting standards, preparers
are provided with choices and are required to use estimations and judgements. Therefore, users of finan-
cial statements need to appreciate that accounting flexibility and discretion exist, consider the incentives
that may affect the choices, estimations and judgements being made, and be aware of the impact of the
choices, estimations and judgements on the financial information reported.
6.4 Describe and calculate the measurement of financial performance.
Profit or loss for a reporting period is measured as the income during the reporting period less the
expenses in the reporting period. If income exceeds expenses in a particular reporting period, a
profit results. If expenses exceed income, the entity reports a loss for that reporting period.6.5 Discuss the definition and classification of income.
Income is defined as increases in economic benefits — in the form of inflows or enhancement of
assets or decreases of liabilities of the entity — that result in increases in equity during the reporting
period. Contributions by owners are not regarded as income. Income comprises revenue and gains.6.6 Discuss the definition and classification of expenses.
Expenses are decreases in economic benefits — in the form of outflows or depletions of assets or
increases of liabilities — that result in decreases in equity during the reporting period. Distributions
to owners are not expenses. Expenses can be classified according to their nature or function.6.7 Apply the recognition criteria to income and expenses.
The term recognition refers to recording items in the financial statements with a monetary
value assigned to them. Therefore, ‘income recognition’ or ‘expense recognition’ means that the
income or expense is recorded and appears in the statement of profit or loss. It is recognition that
links the elements in financial statements — assets, liabilities, equity, income and expenses — and
hence the financial statements. The linkage between the statements arises because the recognition of
one element (or a change in one element) requires the recognition of an equal amount in one or more
other elements (or changes in one or more other elements) as per the accounting equation. There are
no definitive rules to assist the decision of whether an item should be recognised. The recognition
decision requires judgement. The overarching considerations when deciding to recognise an asset
or a liability (and any related income, expenses or changes in equity) are whether the recognition
provides financial statement users with relevant information about the asset or the liability and about