Chap 8 Flashcards
Why do we have to calculate profit
The most basic function of any small business is to earn a pro t for the owner, so from
time to time the owner must calculate whether a pro t or loss has been generated.
Revenue
an inflow of an economic benefit (or saving in an out flow) in the form of an increase in assets (or decrease in liabilities) that increases owner’s equity (except for capital contributions)
Expense
an outflow or consumption of an economic benefit (or reduction in an inflow) in the form of a decrease in assets (or increase in liabilities) that reduces owner’s equity (except for Drawings)
The reporting period and relevance in terms of calculating profit
The question of when to calculate profit depends on the needs of the owner. Remember, the Going Concern principle assumes that the life of the business is continuous or never- ending, so to follow this principle alone means that profit could never be determined! As a result, the owner would not have information about the performance of their firm until it was too late to do anything about it. This is why the Reporting Period principle is so important: it allows us to divide the life of the business into arbitrary periods in order to determine profit.
Note that the length of these reporting periods is arbitrary (or subjective) – it is up to owners to decide how often they want pro t to be determined. Some owners will want profit calculated every month; others will be satisfied with seasonal or quarterlypro t reports. In fact, the length of the reporting period can be as short or as long as the owner desires (although taxation requirements mean that the reporting period must be no longer than one year) and the length of the reporting period will determine how frequently pro t is calculated.
Once the length of the reporting period is determined, it is important that the calculation of pro t includes only revenues and expenses. This ensures Relevance in the reports by including only information that is useful for decision-making about pro t. If we were to include items other than revenues and expenses (like Drawings or loan repayments), our reports would contain information that would not be useful for decision making, but would actually distort decision-making (and probably lead to negative consequences for the business and its owner).
Income statement
The information about profit or loss must be reported to the owner in a formal accounting report known as an Income Statement. It is an accounting report which details the revenues earned and expenses incurred during the reporting period
Earning a net profit but suffering a cash deficit
Many business owners assume that earning a pro t means that the business will have more cash on hand. However, this is not always the case. It is possible for a business to earn a Net Pro t but still suffer a cash de cit due to:
• Drawings
• a loan repayment
• a cash purchase of a non-current asset
• a GST settlement.
These items will have no effect on Net Pro t as they are not expenses. However, each is a cash payment, and as a consequence will decrease Bank. Therefore a business which earns a Net Pro t could still nd itself with less cash in the bank at the end of the period.
Generating a cash surplus while suffering from a net loss
It is also possible for a business to incur a loss, and yet still see its bank balance increase, if it receives:
• a loan
• a capital contribution from the owner
• a GST refund.
These items will have no effect on Net Pro t as they are not revenues. However, all are cash receipts, and will increase Bank.
Uses of the income statement
An Income Statement must be prepared in order to provide information for the business owner. By highlighting the revenue and expense items, and identifying whether the business achieved a Net Pro t or Loss, the report is useful as a decision making tool.
The speci c bene ts of preparing an Income Statement are to:
1 aid decision-making about the rm’s operations by measuring the rm’s performance. Detailing revenues and expenses (and ultimately pro t) allows the owner to identify
where changes may be necessary.
2 assess whether the business is meeting its revenue and expense targets by
comparing the Income Statement against budgeted (or expected) performance.
3 assist in planning for future service activities by providing a basis for the next budgeted Income Statement, which will set targets for the future. This may include setting targets to achieve a certain level of fees, staf ng requirements, or advertising
expenditure.
4 assess the performance of management in operating the business, primarily relating
to generating sales and controlling expenses.
