Lesson 2

Question 0

What do Accounting Statements do?

Answer 0

They present the bookkeeping information we have recorded in such a way that it displays a business’s profitability or lack of profitability in it’s trading activities over a period of time.

Present bookkeeping information
Business’s profitability or lack of profitability
Trading activities
Period of time

Question 1

What are Accounting Statements?

Answer 1

Profit and Loss Account and Balance Sheet

Question 2

What are a business’s Annual Accounts?

Answer 2

A Profit and Loss account and a Balance Sheet drawn up at the end of a year’s trading.

Question 3

What are Annual Accounts required for?

Answer 3

For the owner’s use but also for the a Inland Revenue, which charges tax on business profits on an annual basis.

Question 4

How can profit be defined?

Answer 4

The total income or revenue earned by a business less the total expense incurred over a period of time.

Question 5

How can a trading loss be defined?

Answer 5

If the total expense exceeds the total income or revenue, the excess of expense over revenue is termed a loss. The business has made a trading loss on it’s activities rather than a profit.

Question 6

Why is the period at which income is EARNED important rather than just when that income is RECEIVED?

Answer 6

Income may have been EARNED during a period which must be incorporated in determining the total profit or loss on a business’s activities for the period, but it may not have been RECEIVED during that period.

Question 7

Why is the period of time for which accounts are prepared important in relation to expenses?

Answer 7

Expenditure may be INCURRED during a period although not actually PAID.

Question 8

Which type of expenses will be charged against income or revenue earned to determine profit or loss?

Answer 8

Revenue Expenditure

NOT Capital Expenditure

Question 9

What is Capital Expenditure?

Answer 9

Expenditure incurred in acquiring and improving FIXED ASSETS.

e.g. The purchase of buildings and the legal costs incurred when doing so / improvements to buildings / purchase of machinery or office furniture and fittings etc

Question 10

What is Revenue Expenditure?

Answer 10

Expenditure incurred in the normal day to day running of the business.

i.e. All expenditure other than for the purchase or improvement of fixed assets.

Question 11

Why are normal repairs to assets regarded as revenue items?

Answer 11

Because they don’t improve the asset from its original state and therefore don’t increase it’s value. They just make good the deterioration brought about by use.

Question 12

If a new extension to the business premises is built by a joiner who is an employee of the business, how will the costs be treated? As capital expenditure or revenue expenditure?

Answer 12

The value of the materials used is capital expenditure as it creates an asset to be used for some time by the business.

The cost of the joiner’s time must also be identified as part of the cost of the asset as treated as capital expenditure.

Question 13

In the example of the employee joiner building an extension to the business premises, how would the cost of his time be ‘capitalised’?

Answer 13

By a journal entry debiting Office Buildings account and crediting Wages account.

The joiner’s wages are normally a revenue expense but by charging their value to the Office Buildings account which is a fixed asset account, we are converting it into a capital expense.

Question 14

What is Capital Income?

Answer 14

Finance invested in a business

either by the owner or

from an outside source such as a bank.

It is not income arising from the trading activities of the business and should not therefore be included in calculating the profit or loss arising from from trading activities for any particular period.

Question 15

What is Revenue Income?

Answer 15

Income earned from

the normal

trading or profit making activities

of a business.

Question 16

Calculation of profit or loss only takes account of REVENUE INCOME and REVENUE EXPENDITURE.

What, therefore, can the definition of profit can be stated as?

Answer 16

Profit is the total Revenue Income earned by a business less the total Revenue Expenditure incurred over a period of time.

Question 17

Where in the Annual Accounts are Capital Income and Capital Expenditure reflected?

Answer 17

In the balance sheet in the relevant asset and liability balances.

Question 18

Why do Capital Income and Capital Expenditure not affect the business’s profit or loss on it’s trading activities for a period of time?

Answer 18

Because Capital Income is not derived from the profit-making activity of the business and Capital Expenditure is expected to last for more than one year.

Question 19

Why do ‘drawings’ by the owner not affect the calculation of profit or loss?

Answer 19

The ‘drawings’ account is effectively debited against the capital account in the balance sheet and does not represent a revenue expense.

‘Drawings’ are the withdrawal of assets of the business by the owner for their personal use.

Question 20

Why must capital expenditure not be included in the profit and loss calculation?

Answer 20

Because it relates to a fixed asset which will be used over a period of years, rather than expended in the year in question.

Question 21

Whilst it is wrong to charge the cost of a machine lasting several years as revenue expenditure relating to one year’s profit, some of the value of the asset will be used up in the first year.

Answer 21

It is reasonable to treat as revenue expense that part of value of the asset which is used up in a year.

Question 22

If a piece of machinery could be expected to have a useful working life of ten years, then we could charge one tenth of the cost of the machine as a revenue expense.

Answer 22

This is on the assumption that, during the first year, the machine decreases in value by 10%, so that this value of assets has been used up in generating profit for that year.

Question 23

How can depreciation be defined?

Answer 23

An annual charge against profits

for the use of an asset

in the business.

Question 24

How is the annual depreciation charge determined?

Answer 24

In relation to the working life of the asset and it’s initial cost to the business.

Question 25

What are the most common methods of estimating depreciation?

Answer 25

Fixed instalment method

Reducing instalment method

Question 26

Explain the Fixed Instalment Method of depreciation.

Answer 26

This method takes a fixed or equal instalment each year for the depreciation charge on an asset.

In it’s simplest form, it is the cost of the asset divided by the number of years of estimated working life it has.

Each year the annual revenue charge would be charged in the P&Ln account and the value of the asset shown in the balance sheet would be reduced by that amount.

Question 27

Define depreciation.

Answer 27

An annual revenue charge

against profits

for the use of an asset

in the business.

It is related to the working life of the asset and it’s initial cost to the business.

Question 28

Explain the Reducing Instalment Method of depreciation.

Answer 28

The charge for depreciation

is expressed as a percentage of the book value of the asset at the beginning of each accounting year.

At the end of the first year the depreciation % would be charged in the profit and loss account

and the asset would be shown in the balance sheet at a value of the same % less.

e.g. 10% of £5000 = £500 revenue charge in the P&L. Therefore, £4500 asset value in the balance sheet and so on each year.

Question 29

What is the Fixed Instalment Method also sometimes referred to as and why?

Answer 29

The Straight-Line Method because the amount charged is the same each year.

Question 30

What is the Reducing a Instalment Method also sometimes referred to as and why?

Answer 30

The Reducing Balance Method because, although the rate of depreciation remains the same, it is calculated on a continually reducing balance based on the value of the asset at the time.

Question 31

How does the scrap value of an asset affect the depreciation charge when using the Fixed Instalment Method?

Answer 31

When using the Fixed Instalment (or Straight-line) Method, the amount estimated as the likely scrap value of the asset has to be deducted from cost before the depreciation is calculated.

Question 32

How does the scrap value of an asset affect the depreciation charge when using the Reducing Instalment Method?

Answer 32

Any estimate of scrap value is ignored.

Question 33

What is the main argument in favour of the Reducing Instalment Method of Depreciation?

Answer 33

The total charge of depreciation and maintenance tends to be spread more evenly over the life of the machine.

This method charges more for depreciation in the early years of an asset’s working life and less in the years when it’s running down.

The likelihood is that machinery will require more maintenance and repair work towards the end of it’s life. The cost of this tends to counteract the smaller depreciation charge at this time.

Question 34

How and when is depreciation recorded?

Answer 34

• in the ledger
• at the end of each accounting year
• using a journal entry.

Question 35

Debits and Credits

Answer 35

Debit
Expenses
Assets
Drawings

Credit
Liabilities
Income
Capital