FFMA Week 2 - Measuring and Reporting Financial Performance

Question 1

FFMA-029: What is the purpose of the income statement in financial reporting?

Answer 1

The income statement is one of the main financial statements and is used to determine how much wealth has been generated by the business over a specific accounting period, primarily through the measurement of profit.

Question 2

FFMA-030: How is profit calculated in the income statement?

Answer 2

Profit in the income statement is calculated by subtracting expenses from sales revenue, where profit represents the measure of wealth generated.

Question 3

FFMA-031: What role does the income statement play in relation to owners’ equity?

Answer 3

The income statement provides a link between the owners’ equity at the start of the period and at the end of the financial period, showing how business operations have impacted equity through profit or loss.

Question 4

FFMA-032: How is the relationship between assets, equity, and profit expressed in accounting terms?

Answer 4

In accounting, the relationship is expressed as Assets = Equity + (Sales Revenue - Expenses) + Liabilities, where sales revenue minus expenses represents the profit.

Question 5

FFMA-033: What key questions are raised when recording profit in the income statement?

Answer 5

Key questions include what constitutes revenue, how expenses are identified, and in which accounting period revenue and expenses are recognized.

Question 6

FFMA-034: What are the accounting conventions underlying the preparation of the income statement?

Answer 6

The accounting conventions underlying the income statement include revenue recognition, expense matching, and the accrual concept, ensuring accurate and consistent reporting of financial performance.

Question 7

FFMA-035: What is the main objective of a commercial entity?

Answer 7

The main objective of a commercial entity is to create wealth for the owners through profitable trading activities.

Question 8

FFMA-036: What is the income statement and what does it report?

Answer 8

The income statement, often called the profit and loss account, is one of the three main accounting reports in a set of financial statements. It reports on the profitability of a business over a set period, typically 12 months.

Question 9

FFMA-037: Why is profitability crucial for a business?

Answer 9

Profitability is vital to a business’s long-term survival and is critically important to all stakeholders, including funders, shareholders, investors, and managers, as it indicates the success of the business’s trading activities.

Question 10

FFMA-038: How does the income statement contribute to understanding a business’s financial health?

Answer 10

The income statement measures profit and provides a link between the owner’s equity at the start and end of the accounting period, showcasing how wealth is generated and used.

Question 11

FFMA-039: How is profit generally calculated in the income statement?

Answer 11

Profit is generally calculated in the income statement by subtracting total expenses incurred from all the revenue earned during the period.

Question 12

FFMA-040: What are the three common measurement points for profit in the income statement?

Answer 12

The three common measurement points for profit in the income statement are gross profit, operating profit, and profit for the period (net profit). These measurements assess management’s effectiveness in running the business.

Question 13

FFMA-041: Why is the income statement important for stakeholders?

Answer 13

The income statement is important for stakeholders as it provides insights into the financial performance of the business, influencing their future decision-making regarding the company.

Question 14

FFMA-042: What is the matching or accruals concept in accounting?

Answer 14

The matching or accruals concept in accounting is the principle of recording transactions in the year they occur, rather than the year in which any related payments are made.

Question 15

FFMA-043: What are accruals in the context of financial accounting?

Answer 15

Accruals in financial accounting refer to expenses that have been incurred but not yet paid by the end of the financial year, like an electricity bill relating to the current year but received after the year-end.

Question 16

FFMA-044: How are accruals treated in financial statements?

Answer 16

Accruals are added as expenses in the financial statements of the year they relate to, ensuring expenses are matched with the revenues they helped generate.

Question 17

FFMA-045: What are prepayments in accounting?

Answer 17

Prepayments in accounting occur when a payment is made in advance for services or goods to be received in a future period, like paying a year’s rent in advance.

Question 18

FFMA-046: How are prepayments accounted for in financial statements?

Answer 18

Prepayments are accounted for by removing the portion of the expense that pertains to the next financial year from the current year’s accounts and recognizing it in the next year’s accounts.

Question 19

FFMA-047: What is the matching principle in accounting?

Answer 19

The matching principle states that expenses should be matched to the revenue they help generate. This means expenses associated with a specific revenue should be recognized in the same reporting period as the revenue.

Question 20

FFMA-048: Can expenses reported in the income statement differ from actual cash outflow in the same period?

Answer 20

Yes, expenses reported in the income statement for a period can differ from the actual cash outflow for that period due to the application of the accruals accounting system.

Question 21

FFMA-049: What is the accruals accounting system and how does it apply the matching convention?

Answer 21

The accruals accounting system applies the matching convention by matching the recognition of revenues with the expenses incurred in generating those revenues, regardless of the timing of the associated cash flows.

Question 22

FFMA-050: How does the accruals concept affect the reporting of revenue and expenses?

Answer 22

Under the accruals concept, total revenue reported for a specific period usually differs from total cash received, and total expenses differ from total cash paid. Consequently, profit for the period (total revenue minus total expenses) often varies from net cash generated.

Question 23

FFMA-051: How does the accounting treatment of profitability differ from liquidity?

Answer 23

In accounting, profitability and liquidity are different concepts; profit is the excess of revenue over expenses for a period, not the excess of cash receipts over cash payments. Profit measures productive effort or wealth creation, while liquidity is concerned with cash flows, addressed in the statement of cash flows.

Question 24

FFMA-052: What is revenue in financial accounting?

Answer 24

Revenue in financial accounting is the inflow of economic benefits resulting from a company’s trading and operational activities. It typically manifests as cash or near-cash assets (like credit sales) and leads to an increase in assets or a decrease in liabilities.

Question 25

FFMA-053: How does revenue vary across different industry sectors?

Answer 25

Revenue varies across different industry sectors, with each sector generating distinct types of income streams.

Question 26

FFMA-054: What are some common forms of revenue in various industries?

Answer 26

Common forms of revenue include retail sales (e.g., supermarkets, clothing retailers), sale of goods (e.g., manufacturers), sale of services (e.g., cleaning, gardening, hairdressing), fee income (e.g., accountants, lawyers), commissions (e.g., estate agents), investment income (e.g., dividends, interest), subscriptions (e.g., golf clubs, gyms, internet streaming services), and rental income (e.g., car rentals, equipment rental, storage facilities).

Question 27

FFMA-055: How do income streams vary in businesses, especially larger ones?

Answer 27

Many businesses, particularly larger ones, have a combination of income streams rather than just a single source. This diversity in income streams is a common characteristic of complex business operations.

Question 28

FFMA-056: Why is revenue recognition a key issue in financial accounting?

Answer 28

Revenue recognition is crucial in financial accounting because the timing of when a business records revenue in their accounts significantly impacts reported revenue and, consequently, profits.

Question 29

FFMA-057: At what points can revenue from the sale of goods or services be recognized?

Answer 29

Revenue from the sale of goods or services can be recognized at various points, such as at the time of placing an order, when the order is dispatched to a customer, or when a contract is fulfilled (e.g., a house sale by an estate agent).

Question 30

FFMA-058: What are the basic criteria for revenue recognition?

Answer 30

The basic criteria for revenue recognition include: 1) The amount of revenue can be measured reliably, usually the agreed price or contract value; 2) It’s likely that the economic benefits will be received by the customer; 3) In the case of goods, ownership and control should pass to the buyer.

Question 31

FFMA-059: How is the transfer of ownership and control relevant to revenue recognition from the sale of goods?

Answer 31

For revenue from the sale of goods, a key aspect is the transfer of ownership and control (or passing title) to the customer, as per relevant law such as English law. This transfer is a critical factor in recognizing revenue.

Question 32

FFMA-001: What are expenses in the context of trading and operational activities?

Answer 32

Expenses arise from the outflow of economic benefits due to trading and operational activities, typically involving cash outflow or the creation of liabilities.

Question 33

FFMA-002: What are typical expenses for many types of businesses?

Answer 33

Typical business expenses include wages and salaries, rent, insurance, utilities, telephone, business rates, advertising, and depreciation.

Question 34

FFMA-003: Are purchases of non-current assets considered expenses in the income statement?

Answer 34

No, purchases of non-current assets like manufacturing equipment or vehicles are not included in the income statement as they are considered capital expenditure, not operating expenditure.

Question 35

FFMA-004: What is the cost of sales or cost of goods sold in manufacturing or retail organizations?

Answer 35

In manufacturing or retail organizations, the cost of sales or cost of goods sold is the cost of producing or purchasing goods sold during the period.

Question 36

FFMA-005: How can you recognize expenses in an income statement?

Answer 36

Expenses are recognized by applying the matching convention to the income statement, where they should be matched to any revenue generated in the same period.

Question 37

FFMA-006: What is an example of an accrued expense?

Answer 37

An example of an accrued expense is electricity charges for a business that may be billed quarterly but the business has been using power over the past three months. Accrued expenses are shown as current liabilities on the statement of financial position.

Question 38

FFMA-007: What are prepayments and how are they shown in the statement of financial position?

Answer 38

Prepayments, often resulting from timing issues like receiving goods at the end of an accounting period but being invoiced later, are payments made in advance. They are shown as a current asset on the statement of financial position.

Question 39

FFMA-008: What is the principal format of an income statement and does it vary by industry?

Answer 39

Yes, the income statement layout can vary by industry, such as between a football club and a car manufacturer. However, all follow the same principal format but differ in detail.

Question 40

FFMA-009: Does the income statement for a sole trader include tax, and why or why not?

Answer 40

No, the income statement for a sole trader or a partner in a partnership does not include tax because, for them, income tax is a personal liability.

Question 41

FFMA-010: How is gross profit calculated on an income statement?

Answer 41

Gross profit is calculated as sales revenue less cost of sales. It excludes overheads or operating expenses that are not directly involved in providing goods or services.

Question 42

FFMA-011: What is operating profit and how is it different from gross profit?

Answer 42

Operating profit is the profit a company makes after deducting the cost of sales and overheads such as rent, insurance, and wages from the total sales revenue. It differs from gross profit in that it also subtracts overheads and operating expenses.

Question 43

FFMA-012: What does net profit represent and how is it calculated?

Answer 43

Net profit, also known as profit for the period, is the final profit figure after adjusting for non-operating income and expenses. It is calculated by taking the operating profit, adding non-operating income, and subtracting finance costs and tax charges.

Question 44

FFMA-013: How does the income statement reflect the financial performance of a business?

Answer 44

The income statement provides a measure of financial performance through various profit calculations such as gross profit, operating profit, and net profit, indicating the efficiency and effectiveness of the business in generating wealth.

Question 45

FFMA-014: What can the retained or residual profit indicate for a business?

Answer 45

The retained or residual profit indicates the total wealth generated for the owners during the accounting period and reflects an increase in the value of their equity. It is the ultimate measure of wealth creation for a business.

Question 46

FFMA-015: How is the cost of sales calculated on the income statement?

Answer 46

The cost of sales is calculated by adding opening inventory to purchases and then subtracting the closing inventory.

Question 47

FFMA-016: What is the formula to derive gross profit from the income statement?

Answer 47

Gross profit is derived by subtracting the cost of sales from sales revenue.

Question 48

FFMA-017: How are total expenses calculated in the income statement?

Answer 48

Total expenses are calculated by summing up all individual expense items such as wages, motor expenses, insurance, and general expenses.

Question 49

FFMA-018: What does operating profit represent on the income statement?

Answer 49

Operating profit represents the profit made from the business’s core operations after subtracting all operating expenses from gross profit.

Question 50

FFMA-019: How do you determine the profit or loss for the period from the income statement?

Answer 50

Profit or loss for the period is determined by taking the operating profit, adding any interest received, and subtracting any interest paid on loans.

Question 51

FFMA-020: What does the cost of sales, also known as cost of goods sold, reflect?

Answer 51

The cost of sales reflects the direct costs incurred in selling goods or providing services, not just the cost of goods purchased.

Question 52

FFMA-021: How do large retailers use technology to calculate the cost of sales?

Answer 52

Large retailers use point-of-sale computer systems to match the sale of each item with its cost, allowing for accurate cost of sales calculations.

Question 53

FFMA-022: Is it always practical to match costs to sales for all businesses?

Answer 53

No, many businesses, such as small retailers, find it impractical to match costs to each sale and instead identify the cost of sales at the end of the reporting period.

Question 54

FFMA-023: How do we calculate the cost of sales?

Answer 54

The cost of sales is calculated by taking the opening inventory, adding purchases during the period, and subtracting the closing inventory.

Question 55

FFMA-024: Why does the cost of unsold inventory not appear in the income statement?

Answer 55

Unsold inventory is not included in the income statement’s cost of sales because it has no revenue to match to at that point, following the matching principle.

Question 56

FFMA-025: What costs do manufacturing companies include in their cost of sales?

Answer 56

Manufacturing companies include all identifiable direct costs of production such as factory labor, raw materials, and related production overheads in their cost of sales.

Question 57

FFMA-026: What is the manufacturing account used for?

Answer 57

The manufacturing account is used to calculate the cost of goods sold in a manufacturing company.

Question 58

FFMA-027: How does a manufacturer’s inventory differ from a retailer’s inventory?

Answer 58

A manufacturer’s inventory includes raw materials, work-in-progress (partially completed products), and finished goods, unlike a retailer whose inventory consists only of goods for resale.

Question 59

FFMA-028: Can you give an example of a manufacturer’s inventory?

Answer 59

An example is Top Tables Limited, a company that makes hand-made oak tables for high-end furniture retailers, which would have an inventory consisting of raw materials, work-in-progress, and finished goods as of a certain date.