Financial Accounting

LECTURE 6

LECTURER: MD. REZAUL KABIR E-MAIL: mrkabir@iba-du.edu

Learning objectives
After this lecture you should be able to:
A. Understand the nature and purpose of income statement B. Understand the implications of main profit measurement issues C. Interpret the information contained within a income statement.

Reading
Atrill & McLaney (2005) Financial Accounting for Decision Makers, Chapter 3.

Objective 1
EXAMINE THE NATURE AND PURPOSE OF INCOME STATEMENT

A. UNDERSTAND THE NATURE AND PURPOSE OF INCOME STATEMENT

1. What is income statement?

to measure and report the profit or loss during a particular accounting period.

2. Relationship between Income Statement and Balance Sheet

B/S shows financial position at a particular moment in time P & L statement shows the flow of wealth over an accounting period.
4

2. Relationship between Income Statement and Balance Sheet

The following equations better explain the relationship:
Assets - Liabilities = Capital + (Revenues Expenses) (1) Assets - Liabilities = Capital + (-) Profit (Loss) (2)

3. Format of income statement

XYZ Limited Income Statement for the year ended 30th September 2007.
Sales Cost of goods sold: Opening stock Purchases Less: Closing stock Gross profit Less: Expenses: Salaries and wages Rent and rates Heat and light Loan interest Depreciation Net profit 7000 2000 4000 6000 1000 5000_ 2000

700 500 200 100 100 1600 400

6

Objective 2
UNDERSTAND THE IMPLICATIONS OF MAIN PROFIT MEASUREMENT ISSUES

1. Revenue Recognition
Revenues are recognised:
when the goods or services are delivered to, and accepted by, the customer. not until the realisation of revenue in cash.

However, revenue recognition criteria could vary from business to business. For example, construction business.
8

2. Accruals and Prepayments

The general rule is: All expenses of a particular accounting period must be matched with the relevant income of that period
irrespective of the matter whether theyre paid or received in cash.
9

Accrued Expenses
Outstanding expenses at the end of accounting period. Example:
outstanding rent 100 already paid rent 900.

Treatment:
P&L: 1000 (900+100) B/S: current liability 100.
10

Prepaid Expenses
Expenses paid in the current year for the next year. Example: Annual rent is 1200. But 1400 is paid in the current year. Treatment:
P&L: 1200 as current years expenses B/S: 200 as current asset.
11

Outstanding Income
Income earned but not received within the current period. Example:
fees outstanding 200. fees already received 1800

Treatment:
P& L: under income (1800+200=2000) B/S: outstanding fees 200 under current asset.
12

Income received in advance

You received next years revenue in this year. Example:
Youve received both current (2000) and next years fees (2000) together.

Treatment:
P& L: Only 2000 as current years income. B/S: The balance 2000 as current liability.
13

Progress Check 1
For the accounting period 1st January to 31st December 2006 a trader paid 2800 as rent. The traders monthly rent is 200 only. Calculate how much rent should be shown in the P& L Statement for the year ended 31st December, 2006.
a. b. c. d. 2800 2400 2600 3000
14

3. Depreciation Accounting
Basis of calculation: It is calculated on the basis of costs less residual values. Residual values are the minimum nominal value that you would receive at the end of useful life of an asset. Calculation methods:
straight line method and reducing balance method.

Which method to choose?

Remember the purpose here is to choose the method that best matches the depreciation expense with the benefits or income that the related asset would help to generate.

15

Depreciation Methods
A. Straight line depreciation: Annual Depreciation = Cost - Residual value Useful economic life (in years) B. Reducing balance method:

Depreciation Rate = (1 - nR/C) x 100%

Annual Depreciation = Depreciation Rate x Cost/book value

Book value = Cost less accumulated depreciation.

16

Example
Plant and machinery was bought on the 1 January 2007 Cost: 1,000 Expected useful economic life of 3 years Estimated residual value of 343.

17

Example
1. Straight line method: (1,000 - 343) z 3 = 219 p.a. 2. Reducing balance method: ____ Rate = (1 - 3343 z 1,000) x 100 = 30% 2007: 30% x 1,000 = 300 2008: 30% x (1,000 - 300) = 210 2009: 30% x (1,000 - [300 + 210]) = 147 Under this method book value/written down value of the asset at the end of 2007 would be 700 (1000-300).
18

Example of Corporate Practice

Tangible fixed assets are stated at cost less a provision for depreciation. Depreciation is calculated to write off the cost of tangible fixed assets, excluding freehold land, in equal annual instalments over their expected useful lives. (Extract from Glaxo Annual Report, 2002, P.84)
19

Progress Check 2
A machinery was purchased on 1st Jan. 2005 at a cost of 10,000. Depreciation was charged @ 10% following the reducing balance method. What will be the annual depreciation charge for the year ended 31st December, 2006?
a. b. c. d. 1000 900 810 100
20

4. Stock Valuation 1
Cost of Goods Sold = Opening Stock + Purchases Closing Stock. Main Valuation Rule:
It is normally valued at cost or net realisable value (NRV) whichever is lower. It needs to be done on an item by item basis

Example: if cost of stock is 100 and NRV is 80 itll be valued at 80. NRV = estimated selling price less estimated expenditures required to complete and sell the stock item.
21

Progress Check 3
The stock of Cher Ltd at the end of its accounting year was composed of the following three items: Cost 1,000 2,000 3,000 6,000 Net realizable value 1,200 2,300 2,400 5,900

Product A Product B Product C

This stock would be shown in the balance sheet at an amount of: A. B. C. D. 5,400 5,900 6,000 6,500

22

Stock Valuation 2
Determination of cost depends on the following assumptions:
First in, first out (FIFO) - earlier stocks held are the first to be sold. Last in, first out (LIFO) the latest stocks held are the first to be sold. Weighted average under this method new unit price are calculated every time a new stock item arrives in the store.
23

Example (Atrill & McLaney, 2005)

1 October 2 October 3 October 6 October opening stock 1000 units @ 10 purchased 5000 units @ 11 purchased 8000 units @ 12 sold 9000 units @ 20

Required: Find the value of closing stock.

24

FIFO
1000X10 = 10000 5000X11 = 55000 3000X12 = 36000 101,000 5000x12 = 60,000

Cost of sales Closing Stock

25

LIFO
1000X11 = 11000 8000X12 = 96000 107,000 Cost of sales 4000x11 = 44,000 1000x10 = 10,000 54,000 Closing Stock
26

WEIGHTED AVERAGE
1000X10 = 10000 5000X11 = 55000 8000X12 = 96000 14,000 161,000/ 14,000 = 11.5 per unit 9000x11.5 = 103,500 Cost of sales 5000x11.5 = 57,500 Closing stock

27

Impact on Profits
FIFO
Sales (9000x20) Cost of goods sold Gross Profit 180,000 101,000 79,000

LIFO
180,000 107,000 73,000

WA
180,000 103,000 76,500

Impact on balance sheet Closing stock 60,000

54,000

57,500

28

Corporate Practice
Stocks are included in the financial statements at the lower of cost (including manufacturing overheads, where appropriate) and net realisable value. Cost is generally determined on a first in, first out basis. (Extract from Glaxo Annual Report, 2002, P.85)
29

5. Provision for bad and doubtful debts

Not all customers to whom you sell on credit will pay. Youre required to make some provisions for bad and doubtful debts. Realistically we can assume that a proportion of them will default.
30

Example
Trade debtors 300,000 at 30th June, 2003. Out of them 10,000 was found to be irrecoverable (bad) on investigation. To be on the safer side, management decided to make another provision for doubtful debts at 10%.

31

Solution to Example
Profit and Loss Bad debts written off Provision for doubtful debts (300,000 10,000) x 10% Balance Sheet Trade debtors Less: Bad debts written off Recoverable debt Less: Provision for doubtful debts 300,000 10,000 290,000 29,000 261,000 ======
32

10,000 29,000

6. Capital and Revenue Expenditure

Capital Expenditures:
The benefits go beyond one accounting year. It is long-term in nature and non-recurrent. Examples: fixed assets Treatment: balance sheet.

Revenue expenditures:
are incurred to run day to day business. short-term and recurrent in nature. Example: heating and lighting. Treatment: income statement.
33

Objective 3
INTERPRET THE INFORMATION CONTAINED WITHIN AN INCOME STATEMENT

34

P & L Analysis 1
Comparisons:
Yearly with budget with competitor industry average.
35

P & L Analysis 2
Gross Profit Ratio = Gross Profit/Sales x 100.
XYZ limited: 28.5% (2000/7000 x100).

Net Profit Ratio = Net Profit/Sales x100.

XYZ: 5.7% (400/7000 x 100).
36