Ch2 The profit and Loss Account.docx

Module 2 -The profit and Loss Account Objectives: The role of P&L in the measurement of corporate accomplishment and effort the timing of revenue and expense and the role of accounting conventions the impact on profit of different stock valuation methods and depreciation methods the principle features of depreciation the implication of gross and net profit The P&L account is a more detailed picture of everything that effects the owners equity A transformation process is defined as the functions which are necessary to convert raw materials into saleable product. The profit of an entire transformation process over a given period is the difference between: a measure of accomplishment (what has been achieved in sales), and a measure of effort (what these sales had cost) In the P&L, accomplishment is the number of products shipped and invoiced to customers during the period. Accomplishment is the first point in the operating cycle at which: The principal revenue producing service has been performed All costs necessary to create revenue have either been incurred, or are either negligible or can be predicted to a high degree of accuracy. The amount ultimately collectable in cash can be estimated to within an acceptable range of error. sometimes the accomplishment can be: time of sales order – if the between order receipt and shipment is so short that the distinction is of no practical importance time of production – in industries like shipbuilding, this is used when the services required after production are negligible, when the amount of collection is reasonably certain and the time of shipping is more uncertain than the time of production Example: 2 year Contract worth $12M first year: 1/3 of contract completed & $2M received Total profit expected: $3M => cost = $9M or $3M in first year, $6M in second Using Time of Production: Sales would be $4M in first year, $8M in second Actually Paid: $2M in first year, $10M in second 1st Year: 2M Sales, 2M Debtors, 3M Cost => 1M profit 2nd Year: 8M in sales, 0M Debtors, 6M Cost => 2M profit time of collection – installment plans, goods are only including in P&L as they are paid Conventions Underlying Measurement of Sales Accomplishment: The realization expenditure – only products that have been sold are measure as sales, not ones completed or partially completed and not sold The accruals conventions – cash does not have to be received to create value, an obligation from a credit worthy customer is good enough. Accruals describe items where it is appropriate - for revenue/cost matching reasons - to recognize costs in an earlier period than the period in which the cost is actually recorded in the company's accounting records. This means that in terms of revenue or sales, you can count sales to credit worthy customers in the total sales figure Example: A company year-end is 31 December 1997. It receives its quarterly power bill up to 31 January 1998. This bill will be recorded in 1998, but 2/3 of the costs belong to 1997. Therefore, an Accrual will be made in the accounts at 31 December 1997 equal to 2/3 of the power bill costs. Prepayments are the effective opposites of Accruals. They arise where costs relating to a later accounting period are recognized or paid in the current accounting period. Example: A company year-end is 31 December 1997. During December 1997, the company pays its insurance premiums for 1998 insurance. All of the insurance premium paid will be regarded as a Prepayment in the accounts at 31 December 1997. So: Accruals –pay later for now, but recognize it now Prepayments – pay now for later 2.6 The Measurement of Effort: The Matching Convention – profit is arrived at by matching the effort (or costs) with the units shipped and invoiced to the customer during a sales period. So if more units are manufactured than sold, the cost of sales is the cost of manufacturing the units minus the cost of units put back into finished inventory. Efforts are all the costs involved in producing saleable products, and the costs involved in actually selling the products which are recognized in the measurement of sales accomplishment. Costs of production include: raw materials labor depreciation of production plant & machinery overheads directly related to production cycle Typical costs of selling and admin include: advertising & promotion packaging and distribution staff salaries non-production overhead expenditure research & development The Allocation Convention Firstly, how much of each means of production, in money terms, was consumed during the accounting period. That is, the company’s total purchase of means of production (raw material, power, wages to production staff). Secondly, how much of the means of production (in money terms) should be matched with sales revenue and how much should be matched to the closing work in progress (inventory of unfinished goods) and to the inventory of finished goods. This is similar to the matching convention. The Cost Convention Usually accountants use the historical (or acquisition) cost of different means of production, ie the price paid for them by the business when it acquired them. This is not always correct, as sometime the purchase price can fluctuate during the accounting period. 2.7 Task One: Determining the Consumption of the Means of Production Use of Raw Materials: RM used = opening +purchased –closing. Problems start occurring when the price of the raw material varies during the year. How do you price closing RM? Is it the last price paid for RM purchased or an average. However you value the closing inventory will effect how you value the stock consumed. value of closing stock + value of stock consumed = total value (amount spent on raw materials during the year + opening stock). Note : this is the same equation as RM used = opening +purchased –closing Labor: easy, taken from payroll 2.7.3 Depreciation of Fixed Assets – three factors are used: the actual historic cost (inc. installation charges) the estimated net residual amount the company will retrieve upon disposal the estimated useful life of the asset to the present owner the methods of depreciation are used: Straight line: (historic cost – residual value) / useful life. This gives the annual depreciation Reducing Balance Depreciation: this is based on the notion that most the depreciation occurs in the early years of the service life. The annual charge is 1 – nth Sq Root (Scrap cost/Cost), n = life of asset. Consumption Method – (number of running hours of the machine/total running hours) x net cost Depreciation is: the allocation of the cost of assets purchased in one accounting period over the accounting periods in which they are used a cost of production, like raw materials the selection of method influences the amount of cost per period, which in turn effects reported profit it does not provide cash for the assets replacement but lowers profit and so dampens the loss of cash from the business in tax , dividends and perhaps wage demands. 2.8 Task Two – determining the value of closing work in progress and inventories cost of beginning inventory + cost of purchases –cost of closing inv = cost of goods sold charged in P&L so: the higher the closing inventory, the higher the profit, and vice versa. 2.9 Types of Inventory in a Manufacturing Company: Finished goods Work–in-progress inventory Raw Materials and supplies inventory 2.10 Inventory valuation methods: Example: Company starts with opening inventory of 100 units valued @ $1 ($100), they purchased 1200 units (costing $2700) during the year and were left with 300 (valued @ $1000 using FIFO) units at end of year. Hence 1000 units were used. 1000 units sold @$5 each = $5000 in sales cost of sales = $2700 +$100 - $1000 =$1800 profit was $3200 Closing inv = $1000 (200 @ $3.50 and 100 @ $3) Closing inv is now considered obsolete, only worth $100 in scrap – so value of cost of sales is now $1000 - $100 = $900 P&L: Sale: 5000 Cost of sales: 1800 + 900 = 2700 Profit:2300 So you need to include the cost of the obsolete closing inv as a part of cost of sales in the P&L account. Conservatism says: ‘Recognize losses and reductions in value whenever they come to light’. Types of inventory valuations include: First in, First Out (FIFO): The oldest units are the first sold, or the first ones purchased are the first one’s sold. Good because it matches what physically happens, bad because reported income is relatively high in times of rising prices, meaning more taxes etc. Last In first Out (LIFO): Most recently acquired goods are sold first – opposite advantages & disadvantages to FIFO Average Method: A weighted average unit cost of goods available for sales. Then apply this to number of units sold and the number of units in ending inventory. The average cost is taken for all goods in opening inventory and goods purchased during the period. Which one should be chosen? In times of rising prices, LIFO minimizes taxes. Usually inventory bought to replace inventory sold is bought at latest prices - so LIFO matches reality of sales pricing Valuation of Work in Progress and Finished Goods Product costs can be traced directly to the product being manufactured or to the production process. Examples are: raw materials, labor, indirect labor such as supervisors, factory overheads. Product costs can be allocated to goods sold, raw materials, work-in-progress or finished goods. The portion allocated to goods sold goes in the P&L under cost of goods sold. The rest goes to balance sheet under closing inventory and is an asset. Remember : Beginning Inv + Purchases – Closing inv = cost of goods sold so the more ending inv, the less the cost of goods sold and so the higher the profit Period Costs are costs which are incurred so that the goods can be sold and money collected, they are set off against sales revenue in the P&L. Examples are: selling, distribution and marketing costs. Interpreting Profit: Profit should be reported in a consistent manner from one period to another. The gross profit (sales – cost of sales) is a measure of the efficiency of the transformation process Net Profit before interest charges and tax enables the reader to judge overall managerial efficiency against both previous accounting periods and other companies engaged in similar fields (efficiency = minimizing period costs)\ Net Profit after Interest charges shows the company’s financial structure Taxes are irrelevant when judging managerial performance because the taxes shown as being payable in an accounting period bear little resemblance to the actual taxes paid (timing differences). Management have little control over method of determining level of tax paid. Net Profit after interest charges and after tax tells the reader very little about the companys efficiency – more detail required. Appendix 2.1 - The impact of changing Money Values: High inflation requires adjustments to be made to reflect the changing money values Depreciation Replacement of assets is more expensive in times of high inflation. Normally depreciation only sets aside the original cost of the asset being replaced. Example – asset acquisition cost = $1250 3 years life and residual value of $50 Assume 20% / annum inflation over the 3 years Replacement value is then 1500 (120% of 1250) and residual value is $60 (120% $50) at end of first year So first year depreciation amount = $1440, divide this by 3 = $480 depreciation charged in 1st year Similarly 2nd: 1800 – 72 = 1728/3 = 576 Note: 576 is 120% of 480, 3rd: 2160 – 86 = 2074/3= 691 This does not include the fact that the depreciation is inflated as the years go by: Year One : 480 depreciation Year Two: 576 + 120% of 480 = 1152 [the top-up is 20% of 480 and this is charged against undistributed profits ] = Total depreciation up to year two Year Three: 691+ 120% of 1152 = 2073 = total deprecation up to year 3 Cost of Sales: With high inflation, the profit may be artificially high because the cost of replacing sold inventory is much more then it cost to originally buy them. So accounts add a ‘Cost of Sales adjustment’ figure to take this into account. The average method takes the average current cost of opening and closing inventories for the year and subtracts them from the amount actual Ex: Price was $1 at beginning and $3.5 at end, so average price was $2.25 ( (1+3.50)/2 ) So opening inv adjustment is $100 x 2.25/1.00 = $225 closing inv adjustment is $1000 x 2.25/3.50 = $643 so, current cost of goods sold is: Opening Stock: $225 Purchases: $2700 Minus closing stock: 643 Total: 2282 So, the adjustment is 1800 – 2282 = -482 Final P&L: Sales $5000 (taken from the assumption on 2/17 about 1000 X $5) Opening inv. $100 Purchases $2700 $2800 Less Closing $1000 $1800 Plus Adjustment $482 Total Cost of Goods $2882 Profit $2718 The adjusted profit is less, balanced by the gain to the company in holding onto inventory as the price rose. This gain will be reflected in the Balance Sheet. Summary Profit = Accomplishments – efforts Accomplishments = when goods are shipped and invoiced, using realization and accrual conventions Efforts = costs involved in producing saleable products – governed by matching convention – matching costs to sales revenue allocation convention - first, how much money for each method of production (raw materials, labor, depreciation of fixed assets) was consumed in during the accounting period and second, how much of each method of production should be matched with sales revenue cost convention – accountants use the historical cost of the methods of production Review Questions: c b a d c opening inventory – 25 units @ $100 ea. = $2500 March 5 $100 = $500 May 10 $110 = $1100 June 8 $115 = $920 Sept 6 $120 = $720 Nov 12 $125 = $1500 total 41 units $4740 Annual Sales = 52 sets, totaling $9350 Opening + Purchases –closing = total 25 + 41 – closing = 52 Closing = 14 units Ans: b Cost of opening + cost of purchases – cost of closing inv = total cost of sales 2500 + 4740 = total cost of sales+cost of closing inv. = $7240 Ans: c closing = 14 units. 12 @ $125 ea. + 2 @ $120 ea = 1500 + 240 = $1740 ans: a Cost of sales = 7240 – 1740 = $5500; Ans: c 66 units were bought for a total of $7420, hence the avg cost was $109.7/unit. (Ans: a) closing = 14 units 14 @ $100 = $1400 (NOTE: we had 25 in opening stock @$100 – so the closing stock came from opening in the LIFO case). Ans: a Higher cost of sales means lower cost of closing inv. In a time of rising prices, LIFO will mean that closing stock will be valued at the lowest prices. Ans: b d Acquisition cost = $40,000; lifetime = 10 years; residual cost = $6000 Straight line = (40000 – 6000)/10 = $3400 / year Ans: b 40000 – (4 x 3300) = 26400 Ans: c 15% depreciation yearly 1st year : depreciation = 6000 2nd year: dep. is 15 % of (40000-6000) = 5100 Ans: c 3 rd year – 15% of (34000 – 5100) = 4335 book value is 24565 Ans: d II and IV a b c a Original Cost : 110,000; 11,000 depreciation each year, at end of ‘97: 88,000 That implies that it was bought in ’95 for 110,000. 10% of 110,000 = 11,000 => original cost = 121,000 10% of Depreciation = 11,000 x 10% = 1100 = extra dep at ‘96 Ans: a In 97, the depreciation cost is 110% of $(1100+11000) = 13310 Top up is 13310-12100 = 1210 Ans:c Avg inv. = (100+130)/2 = 115 Opening Inv. is $600 x 115/100 = $690 Ans: c 26: Closing inv. = $790 x (115/130) = $699 Current Cost of goods sold is: $690 + $3250 - $699 = $3241 Ans: b 27: Cost of sales adjustement = $3241 - $3060 = $181 Ans: a Case Study 2.1 Closing Stock = 5000 + 29000 –25000 = 9000 units Total purchases = 350000 + 675,000 + 200000 = 1,225,000 Scottish – FIFO => closing stock value = 4000 @ $50 + 5000 @ $45 = $200,000 + $225,000 = $425,000 Scottish P&L Sales 1,750,000 Opening Stock 125,000 Purchases 1,225,000 1,350,000 Less Closing Stock 425,000 Cost of Sales 925,000 Gross Profit 825,000 Less Selling & Distr 575,000 Net Profit 250,000 Canadian LIFO => closing stock value is =5000 @ $25 + 4000 @ $35 = $125,000 + 140,000= $265,000 Sales 1,750,000 Opening Stock 125,000 Purchases 1,225,000 1,350,000 Less Closing Stock 265,000 Cost of Sales 1,085,000 Gross Profit 665,000 Less Selling & Distr 575,000 Net Profit 90,000 Higher valuation of closing stock means lower cost of sales means higher profit means more tax. In times of rising prices companies often want to minimize taxes, wage demands and dividends by dampening profit. Case Study 2.2 Weaving Machine - $64000 Depreciation – 25% reducing balance method Van - $8100 4 years of life, trade in value - $1700 Motor vehicles – straight line Weaving Machine Reducing Balance Depreciation = 1 – nth Sq Root (Scrap cost/Cost), n = life of asset. in this case its given already, 25% Depreciation Expense Accumulated Depreciation Book Value 16000 16000 48,000 12,000 28,000 36,000 9000 37,000 27,000 Van: Depreciation charge = 8100-1700/4 = $1600 per year Depreciation Expense Accumulated Depreciation Book Value 1600 1600 6500 1600 3200 4900 1600 4800 3300 Case Study 2.3 Accounting equation: Assets = Equity + Liability 40,000 (Cash) = 40,000 (Equity) 4th Oct 36000 (Cash) = 40,000 (Equity) - 4000 (Rent PrePaid) 10th Oct 19,000 (Cash) + 10000 (Plant) + 7000 (Van) = 40,000 (Equity) - 4000 (Rent PrePaid) 15th Oct 19,000 (Cash) + 10000 (Plant) + 7000 (Van) + 8000 (RM) = 40,000 (Equity) - 4000 (Rent PrePaid) + 8000 (Creditors) 16th Oct 18,750 (Cash) + 10000 (Plant) + 7000 (Van) + 8000 (RM) = 40,000 (Equity) - 250 (Van Repairs) - 4000 (Rent PrePaid) + 8000 (Creditors) 18th Oct 14,750 (Cash) + 10000 (Plant) + 7000 (Van) + 12,000 (RM) = 40,000 (Equity) - 250 (Van Repairs) - 4000 (Rent PrePaid) + 8000 (Creditors) 31st Oct 11,750 (Cash) + 10000 (Plant) + 7000 (Van) + 6,000 (RM) + 9,000 (FGI) = 40,000 (Equity) - 250 (Van Repairs) - 4000 (Rent PrePaid) + 8000 (Creditors) 6th Nov 11,750 (Cash) + 10000 (Plant) + 7000 (Van) + 4500 (Equip) + 6,000 (RM) + 9,000 (FGI) = 40,000 (Equity) - 250 (Van Repairs) - 4000 (Rent PrePaid) + 12,500 (Creditors) 8th Nov 24,750 (Cash) + 10000 (Plant) + 7000 (Van) + 4500 (Equip) + 6,000 (RM) + 0 (FGI) = 40,000 (Equity) - 250 (Van Repairs) - 4000 (Rent PrePaid) + 4000 (Profits) + 12,500 (Creditors) 15th Nov 18,750 (Cash) + 10000 (Plant) + 7000 (Van) + 4500 (Equip) + 6,000 (RM) + 0 (FGI) = 40,000 (Equity) - 250 (Van Repairs) - 4000 (Rent PrePaid) + 4000 (Profits) + 6,500 (Creditors) 21st Nov 18,750 (Cash) + 10000 (Plant) + 7000 (Van) + 4500 (Equip) + 13,000 (RM) + 0 (FGI) = 40,000 (Equity) - 250 (Van Repairs) - 4000 (Rent PrePaid) + 4000 (Profits) + 13,500 (Creditors) 30th Nov (**** Answer to first part of question) ****) 15,250 (Cash) + 10000 (Plant) + 7000 (Van) + 4500 (Equip) + 8,000 (RM) + 8,500 (FGI) = 40,000 (Equity) - 250 (Van Repairs) - 4000 (Rent PrePaid) + 4000 (Profits) + 13,500 (Creditors) 1st dec 15,250 (Cash) + 10000 (Plant) + 7000 (Van) + 4500 (Equip) + 8000 (RM) + 3200 (FGI) + 8600 (Debtors) = 40,000 (Equity) - 250 (Van Repairs) - 4000 (Rent PrePaid) + 7300 (Profits) + 13,500 (Creditors) 5th Dec 15,250 (Cash) + 10000 (Plant) + 7000 (Van) + 4500 (Equip) + 8000 (RM) + 0 (FGI) + 16300 (Debtors) = 40,000 (Equity) - 250 (Van Repairs) - 4000 (Rent PrePaid) + 11800 (Profits) + 13,500 (Creditors) 6th Dec 9850(Cash) + 10000 (Plant) + 7000 (Van) + 4500 (Equip) + 8000 (RM) + 0 (FGI) + 16300 (Debtors) = 40,000 (Equity) - 250 (Van Repairs) - 4000 (Rent PrePaid) + 11800 (Profits) + 8100 (Creditors) 12th 8850(Cash) + 10000 (Plant) + 7000 (Van) + 4500 (Equip) + 8000 (RM) + 0 (FGI) + 16300 (Debtors) = 40,000 (Equity) - 250 (Van Repairs) - 4000 (Rent PrePaid) – 1000 (Advertising) + 11800 (Profits) + 8100 (Creditors) 15th 8850(Cash) + 10000 (Plant) + 7000 (Van) + 4500 (Equip) + 7500 (RM) + 0 (FGI) + 16300 (Debtors) = 40,000 (Equity) - 250 (Van Repairs) - 4000 (Rent PrePaid) – 1000 (Advertising) + 11800 (Profits) + 7600 (Creditors) 24th 6050(Cash) + 10000 (Plant) + 7000 (Van) + 4500 (Equip) + 3300 (RM) + 7000 (FGI) + 16300 (Debtors) = 40,000 (Equity) - 250 (Van Repairs) - 4000 (Rent PrePaid) – 1000 (Advertising) + 11800 (Profits) + 7600 (Creditors) 31th: 8050(Cash) + 10000 (Plant) + 7000 (Van) + 4500 (Equip) + 3300 (RM) + 7000 (FGI) + 14300 (Debtors) = 40,000 (Equity) - 250 (Van Repairs) - 4000 (Rent PrePaid) – 1000 (Advertising) + 11800 (Profits) + 7600 (Creditors) 54150 = 54150 Wahayyyy Purchases = 8000 (15th Oct) + 4000 (18th Oct) + 7000 (21st Nov) – 500 (15th Dec) = 18500 Closing Stock Profit and Loss a/c for Lowlands from 1st Oct 1997 to 31st Dec 1997 Sales 29,300 Opening Stock 0 Purchases 18,500 Less Closing Stock 10,300 8200 Plant Depreciation 375 (Note: 15% per annum means 3.75% per quarter) Production Wages 9300 17,875 Gross Profit 11425 [All depreciation per annum figures are quartered below] General Expenses: Depreciation of Van 438 Depreciation office Eq. 282 Bad Debts 1100 Advertising 1000 Electricity Bill 480 Rent 2000 (for 3 months) Repairs to Van 250 5550 Net Profit 5875 Balance Sheet Fixed Assets Plant 10000 Less Depreciation 375 9625 Van 7000 Less Depreciation 438 6562 Office Equipment 4500 less Depreciation 282 4218 20405 Current Assets Finished Goods 7000 Raw Materials 3300 Debtors 14300 Less Bad Debts 1100 13200 PrePayments2 2000 Cash in Hand 8050 33550 Current Liabilities Creditors 7600 Accruals 4801 8080 25470 45875 Represented by Capital Introduced 40000 Profit 5875 45875 1 This accrual was taken away from profits so it needs to be taken away here to balance the balance sheet 2 prepayments are include here because the total rent paid effected cash in hand, the portion of rent for last quarter 97 reduced the profits which partially balances the amount removed from cash but to ensure that it balances prepayments are included in current assets ortcaelf calculations required for Cash Flow Statement Net Profit 5875 Add back items that do not effect cash: Depreciation of Van 438 Depreciation office Eq. 282 720 6595 Adjustments to Working Capital Increase in inventory 10300 Increase in debtors (13200) Increase in Creditors 7600 4700 Cash Flow from Operations 11295 Cash Flow Statement Cash Flow from Operations 11295 Returns on Investments - Taxation - Capital Expenditure (17000) Acquisitions - Equity Dividend - Management of liquid resources - Financing - Decrease in cash 5705