Hi, Else here.
And in this video, we'll be learning
about how to report expenses on the statement
of income/comprehensive income.
As noted in my previous video, expenses
are not a required line item under Canadian IFRS.
However, one of the required line items
is profit or loss from all operations.
This can only be calculated when expenses,
such as cost of goods sold or depreciation, are included.
It is, therefore, clear that the line item expenses must
be presented in the statement.
In addition, IAS I, in paragraph 99,
recommends that the statement of income/comprehensive income
include an analysis of the expenses classified
in one of two ways--
by nature or by function.
What does this mean?
By nature means that expenses are grouped based
on the source of the expense.
All similar sources are grouped together.
By function means that expenses are
grouped based on what the business used the expenses for.
This can also be viewed as grouping cost by activity.
Often the whole concept of by nature versus by function
confuses students, so let's do an example
to clarify what by nature and by function actually means.
Assume you work for Greene Inc. The business
has three departments-- production,
sales and marketing, and administration.
Each of these departments have the following costs--
the cost of raw materials consumed during production,
employee benefit costs, including wages, payroll taxes,
health care costs, et cetera, depreciation and amortization
costs with regards to long-lived assets, utility
costs for communication, water, and electricity, and finally,
other expenses, which would include all other costs
incurred to generate revenue.
You can quickly see that total costs for this business
are 3,205,000.
What would show on the face of the statement
of income/comprehensive income if Greene Inc was reporting
their expenses by function?
Cost of goods sold of 2,616,00 to represent the costs
incurred by the production department,
selling expenses of 366,000 to represent the costs incurred
by the sales and marketing departments,
administration expenses of 223,000 to represent
the costs due to the administration department,
and finally, interest expense of 54,000.
Remember from my previous video that IFRS requires financing
costs to be shown separately.
Total expenses for Greene Inc would be 3,259,000.
These expenses are on the face of the statement
of income/comprehensive income.
However, if a business chose a condensed format
they would likely list only two lines
on the face of the statement--
operating costs of 3,205,000 with a reference
to a note and interest expense of 54,000
because this line must always be shown
on the face of the statement.
The breakdown of the operating expenses
would be provided in the nose to the financial statements,
likely in the form of a schedule.
If a condensed format is used, information
must be provided in the notes to the financial statements.
As you can see, expenses by function
can be thought of as expenses by departments
within the business.
For example, cost of goods sold is made up
of all the expenses used or consumed
by the production department when they are producing goods.
Are there any drawbacks to providing expenses by function?
Actually, there is.
When we provide expenses by function,
we have to divide all costs into multiple departments.
For example, amortization or utility costs
may have to be allocated.
This requires professional judgment
because costs are sometimes allocated using cost drivers.
As you may remember from managerial accounting,
the cost drivers used to allocate
costs between departments may not
represent 100% of the costs in the cost pool.
Allocations are, by their very nature, estimations.
This must be understood when you see an income
statement with costs presented by function.
What about presenting expenses by nature?
Let's go back to our example.
If Greene Inc reports their expenses by nature,
they would group expenses that have a similar source together.
For example, employee benefit costs
may be divided by department, but all of these expenses
are from the same source--
employees working for the company.
Depreciation and amortization can also
be divided by department, but all of these expenses
are from the same source, which is
using long-lived assets in the operation of the business.
Expenses by nature means that all expenses
with a similar source are grouped together
on the statement of income/comprehensive income.
Therefore, for Greene Inc, the statement
would present raw materials consumed would be 1,246,000.
Employee benefit costs from all departments would be 1,149,150.
Depreciation and amortization expense for the whole company
would be 529,650.
Utility costs would be 48,200.
And other costs would be 232,000.
Finally, interest expense would be 54,000.
Notice that the total of 3,259,000
is exactly the same as the total expenses by function.
The expenses are simply categorized
using a different method.
By function or by nature, what does IFRS say?
Actually, IFRS states that when an entity chooses
to report their expenses by function,
they must also provide the same information by nature.
At a minimum, businesses reporting their expenses
by function must also disclose the following,
either on the face of the statement
or as a note to the statement--
cost of inventory charge to expenses, employee benefit
costs, depreciation and amortization costs.
This means that information by nature
is required, while information by function is optional.
Note that ASPE does not require expenses
by either function or nature.
Entities using ASPE can choose to disclose what they feel
is relevant to their stakeholders.
So which method is better for the stakeholders?
It depends on what the stakeholders need
to make an informed decision.
For instance, a retailer, such as Walmart reports
by function on the face of their income statement,
because for manufacturers, wholesalers, and retailers,
the focus is on the cost of goods sold and gross profit.
Analysis of gross profit provides important information
with regards to inventory prices and costs.
Other businesses may also prefer by function.
Pfizer Inc. reports by function, because they
have huge expenses related to research and development.
If Pfizer reported by nature, those costs
would be largely hidden within the employee benefit costs.
This is because a large portion of research and development
costs are attributed to payroll costs.
Other businesses provide expenses
by nature on the face of their statement,
because their business model supports this type of grouping.
For instance, Royal Bank of Canada
reports their expenses by nature.
This makes sense, since their business does not
have a cost of goods sold.
Expenses group by nature is more informative
to their stakeholders.
How does all this translate into a question
you may see on a test or exam?
Well, you may get a statement of income/comprehensive income
and be asked, is this by nature or by function?
You may get a listing of accounts which includes both
and then be asked to produce a statement by either function
or nature.
If you include all the expenses on your statement,
then the expenses will be double what they actually are.
The key here is to be able to differentiate
the expenses by function from the expenses by nature.
That way, you can produce the statement requested.
Let's just check your understanding
with regards to these concepts.
Remember to pause the video before I
answer the question for you.
If the line item called distribution costs was included
on an income statement, are expenses
presented by function or by nature?
The answer is B, by function.
Distribution or delivery costs are the costs
incurred by the sales department and are, therefore, considered
a by function presentation.
That's it for the presentation of expenses on the statement
of income/comprehensive income.
Thank you for watching this video.
I hope you found it useful for your learning.