Profit (loss) for the period = Revenues - Expenses

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1 ADDITIONAL NOTES FOR TEI MBA (CHAPTER ) THE PROFIT and LOSS ACCOUNT (INCOME STATEMENT) Measures and reports the profit or loss generated during a period. Profit (loss) for the period = Revenues - Expenses REVENUES a. inflows of economic benefits arising from the ordinary activities of a business b. these benefits will result in increase in assets or c. decreases in liabilities. EXPENSES a. outflows of economic benefits arising from the ordinary activities of a business b. this loss of benefits will result in decrease in assets or c. increases in liabilities. Even though we can compute profit and loss by adjusting the capital section of the balance sheet, an appendix to capital, the Profit and Loss Account, is prepared, and the net profit is transferred to capital on the balance sheet. JAB Legal Services Profit and loss account For the Year Ended December 31, 2013 Revenues Legal Services Earned 3,500 Expenses Equipment Rental Expense 1,000 Wages Expense 400 Utilities Expense 300 Total Expenses 1,700 Net Profit 1,800 Net profit is a residual amount. For a P &L account of a trading company see page.., in the notes. 1

2 COST OF SALES or COST OF GOODS SOLD during the period. Represents the cost of goods that were sold during the period, not the cost of goods purchased during the period. Inventory accounting systems a. Perpetual This system provides and records, not only the sale, but also the cost of the item sold, immediately after sale. This is done by large retailers and other big companies that use computerized accounting systems or required for other reasons. With this system we know, perpetually, the goods (quantity and cost) we have sold and the goods (quantity and cost) we have in stock. b. Periodic This system provides and records, only the sale, and not the cost of the item sold, immediately after sale. This is done by small size companies. THESE companies identify the cost of sales amount at the end of an accounting period. With this system we do not know, the goods (quantity and cost) we have sold and the goods (quantity and cost) we have in stock. This information is obtained after we take a physical stock count (closing stock) and do the following computation: Cost of sales = Opening stock + Purchases Closing stock See example page., notes. INVENTORY COSTING METHODS Profit and the financial position of a business will be affected by the way we measure the cost (value) of the closing stock, especially in periods of price changes. a. Specific identification (used by companies that sell specific, limited quantity, high value items). b. First in, First out (FIFO), the earliest stocks held are the first to be sold. c. Last in, First out (FIFO), the latest stocks held are the first to be sold. d. The weighted average cost (AVCO) EXAMPLE Based on example below (or page notes), apply the above methods (except a) and compute the gross profit under each method if sales (9000 at 15). Assume a business had the following inventory transactions during May: Units Cost/ Unit Total cost 1 May Opening stock 1, ,000 2 May Purchased 5, ,000 3 May Purchased 8, ,000 Total stock Available for sale 14, ,000 6 May Sold (9,000) Closing Stock 5,000 2

3 FIFO Cost of Sales Closing Stock Units Cost/unit Total Units Cost/unit Total 1 May 1, ,000 2 May 5, ,000 3 May 3, ,000 5, , ,000 60,000 LIFO Cost of Sales Closing Stock Units Cost/unit Total Units Cost/unit Total 3 May 8, ,000 2 May 1, ,000 4, ,000 1 May 1, , ,000 54,000 AVCO a. Compute total cost of stock available for sale. b. Compute average cost per unit Average cost = 161,000/14,000 = 11,5 per unit c. Multiply closing stock and units sold by average sost. Cost of Sales Closing Stock Units Cost/unit Total Units Cost/unit Total 9,000 11,5 103,500 5,000 11,5 57,500 GROSS PROFIT CALCULATION VALUATION EFFECTS FIFO LIFO AVCO Sales revenue 135, , ,000 Cost of Sales 101, , ,500 Gross profit 34,000 28,000 31,500 Rising prices -FIFO will give the highest gross profit and LIFO the lowest closing stock and profit. Falling prices -The position of FIFO and LIFO is reversed. 3

4 PROFIT MEASUREMENT - RECOGNITION OF REVENUE/EXPENSES When is revenue recognized? The Realization Convention: Revenue should be recognized when it has been realized (earned). (For a trading company this is when the title of ownership passes to the buyer, for a service company when the service is rendered). TIMING difference between the recognition of revenue and the receipt of cash. Under accrual accounting revenue is recognized when realized, regardless if collected or not. In other words, revenue in the profit and loss account would be different than total cash received. The difference will appear as an asset Debtors or Receivables from customers. However, there are occasions when it is the other way around; usually because business demands payment before providing the service. When is expense recognized? The Matching Convention: Expenses should be matched to the revenue that they helped to generate. TIMING difference between the recognition of expense and the payment of cash. Under accrual accounting expenses are recognized when occured, regardless if paid or not. In other words, expenses in the profit and loss account would be different than total cash paid. The difference represents an outstanding liability at the balance sheet date and will be included under the heading Accrued Expenses or Accruals (a current liability). Examples: However, there are occasions when it is the other way around; usually because business demands payment before providing the service, or other reasons. Examples: prepayment of rents, of insurance etc.. Since the amount paid refers to more than one accounting period, the amount that refers to future accounting periods, is treated as a Prepaid Expense on the asset side in the balance sheet, and will become an expense in the next year. The Prepaid Expense is treated as a current asset. (notes pg: ) 4

5 PROFIT MEASUREMENT CALCULATION OF DEPRECIATION DEPRECIATION: Is the allocation of the cost of a fixed asset to expense over its estimated useful life in years or units of production. Depreciation relates to tangible (except land) non-current and to intangible non-current assets. Factors considered calculating depreciation (amortization for intangibles): a. The depreciable cost (or fair value) of the asset. Cost includes all expenditures needed to put the asset in operational use. b. The estimated useful life of the asset. The economic value is estimated and not the physical life (could be longer). c. The residual (scrap or salvage or disposal) value of the asset. d. The depreciation method. DEPRECIATION METHODS EXAMPLE: January 1 of Year 1 Company X purchased a machine, cost 40,000 with useful life 4 years and residual value 1,024. a. Straight-line Depreciation is an equal amount for each year the asset is held. Depreciation per year= (Cost Residual Value)/ Estimated useful life Annual depreciation = (40,000-1,024) / 4 = 9,744 would show on the Profit and Loss Account. The amount of depreciation relating to the asset will be accumulated for as long as the asset is owned by the business. The accumulated depreciation will increase each year. The accumulated amount will be deducted from the cost of the asset on the balance sheet. For Year 2 the presentation on the balance sheet: Machine at cost 40,000 Less Accumulated depreciation 19,488 20,512 The amount 20512: book value or carrying value of the asset. b. Accelerated or reducing balance method. Results in relatively large amounts of depreciation in the early years of an asset s life and smaller amounts in later years. Depreciation is computed by multiplying the remaining carrying value of the asset by a fixed percentage; assume 60%, and 50%. The double-declining-balance method is a form of the declining-balance method; it uses a fixed percentage that is twice the straight-line depreciation percentage. Book Value Rate Depreciation Book Value Y 1 40,000 60% 24,000 16,000 Y2 16,000 60% 9,600 6,400 Y3 6,400 60% 3,840 2,560 Y4 2,560 60% 1,536 1,024 Regardless of the method, the total amount of depreciation will be the same. (notes: p. ) 5

6 c. Units of production method (units, hours, miles etc.) Depreciation expense will be proportionately to the units of production. d. Diminishing Balance method and other methods PROFIT MEASUREMENT BAD/DOUBTFUL DEBTS BAD DEBTS : when customers do not pay from sales on credit a. Irrecoverable Write 0ff customer, in the period the sale is recognized: - reduce the debtors and - increase expenses (bad debts written off) b. Doubtful Since at the end of the year is not possible to identify customers who are not going to pay, companies try to estimate the possible loss from bad debts and create a Provision for doubtful debts, by: - examining individual accounts of debtors (aging analysis) - taking a proportion of total debtors outstanding based on past experience - taking a proportion on total credit sales of the period, based on past experience The Provision for doubtful debts will be: Shown as an expense in the P & L account Deducted from the total debtors amount in the balance sheet (so the balance will show the net realizable value. Balance sheet as at December 31, 2013 Debtors (Accounts Receivable) 340,000 Less Provision for doubtful debts 30, ,000 After a provision has been created, any customers who become irrecoverable will be written off the debtors and the Provision. If the company over-provides, any unused provision should be taken back to income. Example: notes pages., CONSISTENCY CONVENTION: When a particular method of accounting is selected to deal with a transaction, this method should be applied consistently over time. 6

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