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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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
Slide 3.22
Reducing balance method
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
Slide 3.23
Reducing balance method
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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Peter Atrill and Eddie McLaney, Financial Accounting for Decision Makers, 5th Edition, Pearson Education Limited 2008
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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