CHAPTER 9

Question 1

Calculating profit, going concern and reporting period

Answer 1

The question of when to calculate profit depends on the needs of the owners. Remember that the Going Concern principle assumes that the life of a business is continuous
or never-ending, so to follow this principle alone means that profit could never be determined. As a result, owners would not have information about the trading activities 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.

Question 2

Calculating profit, reporting period and relevance

Answer 2

Once the length of the Reporting Period is determined, it is important that the calculation of profit includes only revenues and expenses, and only those revenues and expenses that have occurred during the current Reporting Period. This ensures that the reports contain the qualitative characteristic of Re/evance, by including only information that is useful for decision-making. If we included items other than revenues and expenses (such as drawings or loan repayments), or included revenues or expenses that occurred outside the current period (such as last year’s wages), the reports would contain information that would not be useful for decision-making. The information would thus distort decision-making, and probably lead to negative consequences for the business and its owner.

Question 3

Closing the ledger

Answer 3

Transferring balances from revenue and expense ledger accounts to the Profit and Loss Summary account so that profit can be calculated.

Question 4

Profit and loss summary account

Answer 4

The Profit and Loss Summary account is like a funnel that channels all revenue and expenses into one account, with a sole figure - the profit or loss for the current period - produced at the end. In the process, the revenue and expense accounts will be ‘emptied’, or reset to zero in readiness for the next period.

Question 5

2 reasons for closing the ledger

Answer 5

• transfer revenues and expenses to the Profit and Loss Summary account in order to calculate profit for the current Reporting Period
• reset revenue and expense accounts to zero in preparation for the next Reporting Period.

Question 6

Why aren’t asset and liability accounts closed

Answer 6

It is only revenue and expense accounts that are closed, because only revenues and expenses are used to determine profit. In addition, revenues and expenses exist only during a particular Reporting Period, whereas assets and liabilities (and owner’s equity,
for that matter) will exist into the future. That is, Balance Sheet items involve a future benefit or future sacrifice and so should not be reset to zero, but their balances should carry forward into the next - or ‘future’ - Reporting Period.

Question 7

Is the profit and loss summary account ever reported

Answer 7

The Profit and Loss Summary account opens (when the revenues and expenses are transferred in) and closes (when the profit or loss is transferred out) on the same day. The account itself lasts for only as long as it takes to post these three entries; just as
a piece of scrap paper is used to make a calculation and then thrown away when the answer is known. It is never listed in an accounting report, as its function is simply to facilitate the calculation of profit.

Question 8

Transferring drawings, entity and reporting period

Answer 8

It is customary to record drawings by the owner in a separate ledger account so that the owner’s transactions for a particular Reporting Period can be isolated. However, at the end of the Reporting Period, the balance of the Drawings account must be transferred to the Capital account so that the Capital account can reflect the net effect of all transactions with the owner. The Drawings account is transferred to the Capital account in much the same way as the Profit and Loss Summary account is closed, as is shown in Figure 9.7.

Question 9

Why is drawings not closed thorough the profit and loss summary account

Answer 9

Although the Drawings account is transferred to the Capital account, it is not closed through the Profit and Loss Summary account. Transactions with the owner are expressly excluded from the definitions of revenues and expenses, and must not be counted in the calculation of profit. To include drawings in the calculation of profit would be a direct breach of Re/evance.

Question 10

Income statement

Answer 10

An accounting report that details the revenues earned and expenses incurred during the current Reporting Period.

Question 11

Why is an income statement necessary when the profit figure has already been calculated

Answer 11

Obviously the Net Profit reported in the Income Statement should be the same as the figure determined in the Profit and Loss Summary account, but the statement will show the reasons why that profit (or loss) occurred, giving the owner far more information on which to base his or her decisions. This fits with the basic function of all accounting reports: to communicate financial information that will assist the owner in making better decisions.

Question 12

4 uses of the income statement

Answer 12

Aid decision making
Assist planning
Calculation of financial indicators
Assess performance in meeting targets

Question 13

Aid decision making

Answer 13

To aid decision-making about the firm’s trading operations. Specifically, the Income Statement allows the owner to assess:
- the firm’s ability to earn revenue so decisions can be made about the types of stock that are held for sale, the level and/or type of advertising, or the level of selling prices. REVENUE EARNING
- the adequacy of the firm’s mark-up so decisions can be made about adjusting selling prices or controlling cost prices. MARK UP
- the firm’s ability to controlits expenses so decisions can be made about managing staff wages, protecting stock from stock loss, or operating more efficiently to control operating costs. CONTROL EXPENSES

Question 14

Meeting targets

Answer 14

The Income Statement can be compared against budgeted, or expected, performance, as shown in the Budgeted Income Statement, which would have been prepared in advance. This comparison will highlight where performance was better or worse than expected. Corrective action can then be taken.

Question 15

Assist planning

Answer 15

By providing a basis for the next budget, the Income Statement will aid in the setting of targets for the future. This may include stock levels, staffing requirements or advertising expenditure.

Question 16

Financial indicators

Answer 16

To facilitate the calculation of financial indicators for analysis and interpretation. These indicators can be used not only to uncover what has happened, but to help explain why.

Question 17

During November the business paid $400 plus GST for November cleaning expenses and they paid another $400 plus GST for cleaning expenses in December. The owner forgot to close the cleaning expenses account at the end of November but remembered at the end of December.
c. Explain the most likely consequences of the owner’s actions on profit determination for November and then December. Your answer should include reference to one accounting
principle and one qualitative characteristic of the reports.
4 marks

Answer 17

Expenses would be understated $400 in November thus overstating profit $400.
The information provided to stakeholders for November would not be 100% relevant (qualitative characteristic of relevance) for that reporting period (accounting principle).
In December, expenses would be overstated by $400 (since $800 would be counted) thus profit would be understated by $400. The information provided to stakeholders for December would not be 100% relevant (qualitative characteristic of relevance) for that reporting period (accounting principle).

Question 18

Explain the difference between the cost of sales and the cost of goods sold

Answer 18

Cost of goods sold, $48 000 in the example above, is the cost of sales $45 600, plus any additional cost to get the stock into a condition and position ready for sale, such as cartage inwards, $2 400 used in the above example. Thus cost of goods sold includes cost of sales. Cost of sales, $45 600, is the cost of the stock sold and represents the balance of the cost of sales ledger account for the reporting period.

Question 19

Referring to a qualitative characteristic explain the possible benefits of preparing a classified balance sheet

Answer 19

Provides stakeholders with more understandable information to better assess the performance of the business. In particular, by classifying liabilities into current and non current liabilities, stakeholders can more clearly see which obligations are more urgent than others. This may provide useful information about the liquidity of the business.

Question 20

Using the example of prepaid insurance (an asset) and insurance (an expense), briefly explain the difference between assets and expenses.

Answer 20

Prepaid insurance is an asset because it represents a resource under the control of the business, as a result of past events, that will provide future economic benefits. Insurance is an expense because it decreases owner’s equity. It represents that part of the economic benefit, prepaid insurance, that has been consumed or used-up in the current reporting period. Prepaid insurance, the asset, is converted to an expense over time as the benefit is used-up.

Question 21

Explain the consequences on profit determination of not closing these expense accounts on:
… the current reporting period:

Answer 21

Expenses would not be counted thus expenses understated $60 950 and profit overstated $60 950 for the current reporting period.

Question 22

Explain the consequences on profit determination of not closing these expense accounts on:
… the next reporting period assuming accounts are closed

Answer 22

Expenses for both the March and June quarters would be counted as expenses in the June quarter thus expenses would be overstated $60 950 and profit understated $60 950 in the June quarter.

Question 23

How would you classify the P AND L Account

Answer 23

The Profit and Loss Summary account is not an element (asset, liability, owner’s equity, revenue or expense). It could be classified as a calculation account, to calculate net profit or loss, or a collection account as it collects the revenue and expenses to calculate net profit or loss.

Question 24

With reference to one accounting principle, explain the importance of closing the ledger

Answer 24

Profit is determined on a periodic basis for a specific period of time known as the reporting period. In order to measure profit accurately, revenue and expense accounts must be closed at the end of each reporting period. They are therefore closed to the Profit and Loss Summary account to determine profit for the current reporting period. Also, it is important to reset the revenue and expense accounts back to zero balances so that the accounts can also be accurate for the next reporting period. This avoids double-counting revenues or expenses over two reporting periods.

Question 25

What happens when an owner transfers a debt to the business

Answer 25

The debt is recorded on the debit side of the capital ledger