Corrections Required in Income Statement Preparation - Management Accounting

This report analyses the true financial position of a newly set-up company and the corrections required in its income statement. Learn about fixed assets, depreciation, operating expenses, and manufacturing expenses.

Running Head: Income Statement Preparation
Management Accounting

Income Statement Preparation 1
Corrections required to be made in Income Statement of the firm
This report has been prepared to analyse the true financial position of the newly set-up
company which has initiated its business of manufacturing and selling of outdoor play gym
for the children. As this being the first year of business of Bob Earl where the business is set
up on 1st January of this year, it is quite obvious to expect that there will more of cash
outflows than its inflows. This is so because of the requirement to invest in the purchase of
various fixed assets and inventories for the subsequent periods of the business. Fixed assets
are those assets which are generally not held to be sold as a part of normal business activities
and hence it is considered as the capital expenditure (Foster, 2004). The cost incurred to
acquire such assets must not be treated as an operating expense of the business. Rather, the
cost must be taken to the statement of final position with proper adjustments of yearly
depreciation on such assets. The income statement of the company must be charged for the
depreciation on the fixed assets held by the company for its business. Therefore, in the
present case, where Bob has charged the purchasing cost of fixed assets such as factory
equipment, office equipment and the sales vehicle, the recording of such assets is incorrect in
the income statement. The cost of purchase of these three fixed assets must be shown in the
Balance sheet of the company after making the adjustment of current year’s depreciation.
Depreciation on any fixed asset is started to be charged from the year in which such asset is
actually put to use (Radu & Marius, 2011). Assuming that in the present case, the company
has started using its fixed assets, the depreciation on such assets will be calculated in this
particular year using the straight line method. The said depreciation will be taken to the
current year’s income statement account as a debit item (Garrison et. al., 2010). Further, the
operating expenses and manufacturing expenses of the business must be shown separately as
there is a clear difference in such expenses. Manufacturing expenses are those expenses that
are directly related to the production process of the company. These expenses could be

Income Statement Preparation 2
variable or fixed in nature. In the present case, the raw material purchases, direct labour
(wages of factory employees) must be shown separately under the heading Cost of goods
sold. However, the other expenses which are not directly linked to the manufacturing process
must be recorded as the operating expenses as they are incurred to undertake to operate the
business. It will include manager’s salary, office staff salary, rent, electricity expenses,
advertisement, cleaning, advertisement cost and sales staff salary. The rent must be bifurcated
among the factory cost, office cost and selling department cost in the proportion of space of
building occupied for each of the above purpose. Even the factory manager’s cost must be
clearly classified among the factory cost and operating cost in the proportion of time devoted
by him with each department. The income statement must be prepared by deducting cost of
goods sold from the sales to calculate the gross profit of company (Zimmerman & Yahya-
Zadeh, 2011). The cost of goods sold must be determined taking into account the closing
balances of raw material, inventories and finished goods. Thereafter, the operating expenses
must deducted to reach at the net profit of the company.

Income Statement Preparation 3
References:
Foster, G., 2004. Financial Statement Analysis, 2/e. Pearson Education India.
Garrison, R.H., Noreen, E.W., Brewer, P.C. and McGowan, A., 2010. Managerial
accounting. Issues in Accounting Education, 25(4), pp.792-793.
Radu, D. and Marius, D., 2011. Issues related to the accounting treatment of the tangible and
intangible assets depreciation. Annals of the University of Oradea: Economic Science, 1(2),
pp.498-502.
Zimmerman, J.L. and Yahya-Zadeh, M., 2011. Accounting for decision making and
control. Issues in Accounting Education, 26(1), pp.258-259.