accounting lecture 20

8/6/2019 Accounting Lecture 20

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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008

Slide 3.1

Learning outcomes

You should be able to:

Prepare an income statement

Discuss the nature and purpose of the

income statement.

Explain the main accounting principles related to the

income statement.

Discuss the main measurement issues that must be

considered when preparing an income statement.

Lecture 2: Measuring and reporting financial performance


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Slide 3.2

The income statement

The purpose of the income statement(or profit and loss account) is to

measure and report how much profit/lossthe business has generated over a period.

Profit (loss) for the period=

Total revenue for the period - Total expenses

incurred in generating the revenue.


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Slide 3.3

Revenue

Revenue is a measure of the inflow of economicbenefits arising from the ordinary activities of abusiness.

These benefits will result in an increase in current assets(cash or easily convertible to cash Trade Receivables).

Examples:

- Sales for goods (by a manufacturer)- Fees for services (of a solicitor)

- Subscriptions (of a club)

- Interest received (on an investment fund).


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Slide 3.4

The recognition of revenue

It is probable that the economic benefits will be

received.

The amount of revenue can be measured reliably.

Basic criteria that must be met before revenue is

recognised:

An additional criterion to be applied where the revenue comes

from the sale of goods:

Ownership and control of the item should pass to

the buyer.


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Slide 3.5

Expenses

Expenses represent the outflow of economic benefits arising from the

ordinary activities of a business.

These benefits will result in either a decrease in asset (cash) or anincrease in liabilities Trade Payable.

Examples:

- Cost of sales or cost of goods sold.

- Salaries and wages.

- Rent and rates.- Motor vehicle running expenses

- Insurances

- Printing and stationery

- Heat and light

- Telephone and postage


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Slide 3.6

To summarise

Revenues do not necessarily represent cash receipts.

Also, not all the expenses are paid in cash.

Therefore, profit is a measurement of achievement, rather than ofcash generated.

These are the concepts ofAccruals Accounting.

Balance sheet and income statements are prepared on the basis ofaccruals accounting.

Cash flow statements follow Cash Basis of Accounting.


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Slide 3.7

What Does Accrual Accounting Mean?

An accounting method that measures theperformance and position of a company byrecognizing economic events regardless of

when cash transactions occur.

The general idea is that economic events

are recognized by matching revenues toexpenses (the matching principle) at thetime in which the transaction occurs ratherthan when payment is made (or received).


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Slide 3.8

The matching principle

Expenses should be matched to the revenue they help to

generate.

For example: an income statement should include allexpenses incurred in generating the reported revenue.

This means that the expense reported may not be the

same as the cash expended on that expense in an

accounting period.


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Slide 3.9

When the expense is more than the cash paid

A firm pays 2% sales commission to staff.

Total sales for year are 300,000

Commissions to be paid = 0.02 x 300,000 = 6,000

However, at year end, only 5,000 has been paid


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Slide 3.10

Recognizing expenses:

Accounting for sales commission

Sales commissionexpense

6,000

Income statement(profit and loss account)

Balancesheet

at year end

Cash 5,000

AC Payable 1,000

Cash - ,5000

Cash flowstatement


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Slide 3.11

When the amount paid during the year is

more than the full expense of the period

A firm pays its rent quarterly in advance (1st Jan;

1st April, 1st July and 1st Oct).

On the last day of its accounting year (31

st

December), it pays the next quarters rent (4,000)

to the following 31 March, which was a day earlier

than required.

To summarise Rent for 4 quarters = 4 X 4,000 = 16,000.

Cash payments = 5 X 4,000 = 20,000.


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Slide 3.12

When the amount paid during the year is more than the

full expense of the period:Accounting for rent payable

Rent payable expense16,000

Income statement

Balance

sheet

at year end

Cash 20,000

Prepaid expense 4,000

Cash - 20,000

Cash flowstatement


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Slide 3.13

Income statement layout

25,500Profit for the year

(1,100)Loan interest

2,000Interest received from investments

24,600Operating profit

(600)Depreciation motor van(1,000)Depreciation fixtures and fittings

(3,400)Motor vehicle running expenses

(1,000)Insurance

(1,200)Telephone and postage

(7,500)Heat and light

(14,200)Rent and rates

(24,500)Salaries and wages

78,000Gross/Trading profit

154,000Cost of sales

232,000Sales revenue


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Slide 3.14

What is Depreciation?

Depreciation is a non-cash expense that reduces thevalue of an asset over time. Assets depreciate for tworeasons:

Wear and tear. For example, an auto will decrease invalue because of the mileage, wear on tires, and otherfactors related to the use of the vehicle.

Obsolescence. Assets also decrease in value as theyare replaced by newer models. Last year's car model isless valuable because there is a newer model in themarketplace.


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Slide 3.16

Calculation of depreciation

The cost of an asset

Includes all costs incurred by the business to bring theasset to its required location and to make it ready for use.

Includes cost of asset, delivery costs and installation costs.

The useful life of the asset

Physical life and economic life.

Economic life is affected by technological progress.

Economic life may be much shorter than physical life.

For charge of depreciation, economic life is considered.

The residual value of the asset

Disposal value of the asset at the end of its economic life.


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Slide 3.17

Depreciation methods

There are a number of depreciation methods.

Once a depreciation method is adopted, it can not be changedwithout a valid reason (consistency and comparability).

Methods:

1. Straight line method (the same amount is deducted each year)

2. Reducing balance method (a high annual depreciation charge inthe early years of an asset's life but the annual depreciationcharge reduces progressively as the asset ages).


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Slide 3.18

Depreciation methods

Expense recognised depends on:

Cost (C)

Useful life (N)

Scrap or residual value (S)

Depreciation method:

1. Straight-line Method

DepreciationCharge = (C S)

N

2. Reducing Balance Method

DepreciationCharge = constant percentage on the decreasing balance, beginningwith the original cost and reducing it to scrap value.


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Slide 3.19

Straight-line method

Equipment

Purchase 75,000 (C)

Life 5 years (N) Scrap value 5,000 (S)

Depreciation Charge = (75,000 5,000)/5= 14,000

Reduce fixed asset, and increase expenses


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Slide 3.20

Depreciation as a period cost

Cash Equipment Rev-Exps

Jan 1 (75,000) 75,000

Year 1 (14,000)

61,000

(14,000)

Year 2 (14,000)

47,000

(14,000)

Year 3 (14,000)

33,000

(14,000)

Year 4 (14,000)

19,000

(14,000)

Year 5 (14,000)

5,000

(14,000)

Sale 5,000 (5000)

Total (70,000) (70,000)


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Slide 3.21

Reducing balance method

Applies a fixed percentage of depreciation on thedecreasing balance, beginning with the original costand reducing it to scrap value.

Higher annual depreciation charges in the initialyears, and lower charges in later years

Depreciation n

C

Sr ! 1


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Slide 3.22


Cost of machine 40,000. Useful life 4 years.

Estimated residual value at the end of 4years is 1,024

Depreciation % =60% every year


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Slide 3.23


Cost at the beginning Depreciation % Dep charge Cost at the end

40000 0.6 24000 16000

16000 0.6 9600 6400

6400 0.6 3840 2560

2560 0.6 1536 1024


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Slide 3.24

Selection of deprecation method

The most appropriate method is the one that best matchesexpense to economic benefits.

For assets evenly consumed over time (e.g. buildings),straight-line method may be applicable.

For assets that lose their efficiency over time (e.g.machinery), reducing balance method may be applicable.

Tax implications


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Slide 3.25

Costing inventories

Inventory (stock) comprises: raw materials, workin progress and finished goods.

Importance

Affect pattern of profit.

Information Cost of sales P&L.

Unsold and unused stock Balance Sheet.


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Slide 3.26

Calculation of cost of sales

Case (1): Prices are NOT changing:

Cost of sales (COS) or cost of goods sold (COGS) in aperiod =

opening stock + purchases closing stock

Example: A firm has 2,000 of stock at 1st

January2009; it buys 14,000 of stock over the year and has3,000 of stock left at 31st Dec.

COGS = 2,000 + 14,000 - 3,000 = 13,000


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Slide 3.27

Last in, first out (LIFO)

Weighted average cost (AVCO)

First in, first out (FIFO)

Common assumptions used are:

Case (2): Inventory costing when prices are changing?


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Slide 3.28

Example

Calculate cost of sales and closing stock given theinformation below:

1 Jan No stock

1 Feb Buy 1,000 @ 15 = 15000

1 Mar Buy 500 @ 18 = 9000

1 May Sell 500 @ 30 = 15000

1 July Buy 1,000 @ 20 20000

1 NovSell 400 @ 35 = 140002,500 44000

900 = 29000


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Slide 3.29

FIFO

Closing stock =100@15 + 500@18 + 1000@20 = 30,500

Purchase

Cost

Cost of

Sales

Balance

StockA/C

1Feb 1000@15 15,000 15,000

1 Mar 500@ 18 9,000 24,000

1 May (500) @ 15 7,500 16,500

1 July 1000@20 20,000 36,500

1 Nov (400) @15 6,000 30,500

1600 44,000 13,500


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Slide 3.30

LIFO

Closing stock = 1000@15+600@20= 27,000

Purchase

Cost

Cost of

Sales

Balance

Stock A/C

1Feb 1000@15 15,000 15,000

1 Mar 500@ 18 9,000 24,000

1 May (500)@18 9,000 15,000

1 July 1000@20 20,000 35,000

1 Nov (400)@20 8,000 27,000

1600 44,000 17,000


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Slide 3.31

AVCOClosing stock = 1,600@18 = 28,800

Purchase

Cost

Cost of

Sales

Balance

Stock A/C

1Feb 1000@15 15,000 15,000

1 Mar 500@ 18 9,000 24,000

1 May (500)@16 8,000 16,000

1 July 1000@20 20,000 36,000

1 Nov (400)@18 7,200 28,800

1600 44,000 15,200


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Slide 3.32

AVCO:Notes

On 1st MarchCost of stock = 24,000Stock units = 1,000 + 500 = 1,500

AVCO = 24,000 / 1,500 = 16

On 1st JulyCost of stock = 36,000

Stock units = 1,000 + 500 500 + 1000 =2,000AVCO = 36,000 / 2,000 = 18


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accounting lecture 20

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