Question

(a) What are 3 important parameters, for running a business successfully, that an Income Statement shows you?
(b) A machine with an initial cost of R 25 000 has an expected working life of 5 years. If it is depreciated linearly over this period, what will the ‘book value’ be at the beginning of year 4?

Answer 1

a) Income statement is the statement of expenses and incomes of the business, made during a particular period of time. It basically consists of 3 sections.

1. Gross Profit Section: This section shows the revenues earned from sale of goods less the cost of production of goods. It helps in reaching out a gross profit figure. It helps in determining the pricing policy of the company and also finding out gross margin ratio to its net sales.
2. Operating Expenses Section: It includes expenses which are indirect to production which means they are not directly linked to production activities. It includes salaries, rent, depreciation, etc. They can be both fixed or variable. If it is concluded from this section that expenses are growing more quickly than the company must cut its costs or increase its sales.
3. The Bottom Line: It is the section which helps in calculation of net earnings or net profits at the end of a particular period. It is calculated by subtracting operating expenses from gross profits. It is used to calculate net profit or net loss and also net profit margin to net sales.

So, these are the 3 business parameters provided by an income statement and each section must be analysed properly to run business properly.

b) Linear method of depreciation is nothing else but Straight line method of depreciation. According to this, equal amount of depreciation is provided to asset each year. It can be calculated as:

Straight line depreciation = (Initial cost of asset - Salvage value) / Useful life of asset

In the given case, there is no salvage value. So, depreciation will be calculated as:

= (25,000-0) / 5

= R 5,000 each year

The book value of machine at the beginning of Year-4= Initial cost - Depreciation for 3 years

= 25,000 - 15,000

Book value of machine at the beginning of Year-4 = R 10,000