Week 4 - Income and expenses, accruals and prepayments (FINISH OFF)

Question 1

What is the income statement?

Answer 1

1. it records the entity’s income and expenses
2. calculates whether the entity has made a profit or loss for the year
3. provides a summary of the entity’s trading activities during the accounting period/ year
4. prepared from the trial balance
5. aim is to enable users to evaluate the financial performance of the business over a period

Question 2

What are the other names for the income statement?

Answer 2

the Statement of Profit or Loss or the Statement of Financial Performance

Question 3

What is the basic format of the income statement?

Answer 3

1. put the name of the company
2. put income statement for the year ended 20XX
3. first show revenue
4. then less:cost of sales/ goods sold
5. then gross profit
6. then other income (income received not directly to the business eg stock dividend)
7. then less:other costs and expenses ->
8. selling and distribution costs
9. administrative expenses
10. finance costs (interest from borrowing
11. then profit/ loss for the period

Question 4

what is income?

Answer 4

an increase in economic benefits during the accounting period in the form of inflows or the enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants

Question 5

How is revenue generated?

Answer 5

arises in the course of the ordinary activities of an entity and is referred to by a variety of different names including sales, fees, interest, dividends, royalties and rent

Question 6

What are gains?

Answer 6

are changes in asset values which are recorded in the accounts

for example, the change in values of some types of investments

Question 7

What is the income equation?

Answer 7

income = revenues + gains

Question 8

What is revenue?

Answer 8

income earned in the period from normal trading activities (called operating activities)

Question 9

What is gross profit?

Answer 9

the profit after only subtracting cost of sales

Question 10

What is operating profit

Answer 10

the profit arising from the business’ operations after deducting other expense related to operating activities

Question 11

What is other income?

Answer 11

when an entity has income from activities that are not its core business, such as receiving interest then this is disclosed separately

Question 12

What are expenses?

Answer 12

yearly running costs. they are used up in the period being reported on

eg electricity used to generate heat and light, rent for the period

Question 13

What is profit or loss?

Answer 13

the total income made by the entity in the period less the total expenses incurred by the entity in the period

Question 14

What is the first part of the income statement for a sole trader

Answer 14

Trading Account, details of calculation of Cost of Sales are presented
4 lines:
1. sales revenue
2. opening inventory
3. purchases
4. closing inventory
5. cost of sales
6. Gross profit

Question 15

What is after the trading account in the income statement for sole traders?

Answer 15

1. Interest recieved
2. General expenses
3. Salaries and Wages
4. Heating and light
5. Depreciation
6. Increase/ decrease in provision for doubtful debts
7. Bad debts expense
8. Profit/ loss on disposal of non-current asset
9. Profit for the year/ profit before tax

Question 16

What is the difference between a sole trader and comanys income statement?

Answer 16

Sole traders has more details about expenses than for a company

Question 17

What is the income statement for a company?

Answer 17

1. Sales revenue
2. Cost of sales
3. Gross profit
4. Administrative expenses
5. Sales and distribution expenses
6. Other expenses
7. Operating profit
8. Finance income
9. Finance costs/ expenses
10. Profit for the year/ Profit before tax

Question 18

What are examples of administrative expenses?

Answer 18

wages paid for receptionists
wages paid for managers
hidden light/ electricity bills

Question 19

What is the first stage in determining the profit for the year?

Answer 19

calculating gross profit

Question 20

How do you calculate gross profit?

Answer 20

Gross Profit = Cost of goods sold - Revenue

Question 21

What separate account is gross profit sometimes calculated in?

Answer 21

the trading account

Question 22

How do you compute costs of goods sold in the trading account?

Answer 22

using the closing inventory formula

Question 23

What is the closing inventory formula?

Answer 23

Closing inventory = Opening Inventory + Net purchases - Cost of Sales

Question 24

What is cost of sales?

Answer 24

the costs directly incurred in selling the goods

Question 25

When do purchases of inventory in a period need to adjust purchase returns and transport (carriage) inwards?

Answer 25

if any three:
1. purchase returns reduce purchases. we deduct purchase return
2. transport (carriage) inwards increase the cost, we add carriage inwards
3. so the number of purchases of inventory in a period in the formula is actually ‘net purchase’

Question 26

Why do cost of sales not equal purchases

Answer 26

because not all purchases are sold in the period (application of the matching concept), and the profit is calculated using only the inventory used for goods that were sold in the period.

Question 27

What are the accounting concepts relevant to the income statement (all linked together)?

Answer 27

1. Recognition
2. Realisation
3. Accruals concept

Question 28

What is recognition?

Answer 28

revenue is recognised by the entity when the sale/ service has been carried out

Question 29

What is realisation?

Answer 29

the entity has received cash for the sale/ service (realised) or if it has received other assets

eg receivables, is reasonable certain of receiving the cash (realisable)

Question 30

What is the accruals concept?

Answer 30

Revenues and expenses must be recorded in the period where they arose. Associated with matching - expenses should be matched to the revenues they helped generate

Question 31

How do we recognise the revenue?

Answer 31

we need to test with two criteria (rules for revenue recognition)

Question 32

What are the rules for revenue recognition?

Answer 32

Revenue is recognised when:
1. the performance obligations in the contract are performed
2. there is an increase in cash or trade receivables as a result of the transaction (realisation criteria)

once these two criteria have been met, then we can recognise the revenue

Question 33

How are expenses classified?

Answer 33

1. Two main types of expenses

Question 34

What are the two main type of expenses?

Answer 34

1. Product/ direct/ traceable costs (direct cost)
2. Period costs (indirect cost)

Question 35

What are product/ direct/ traceable costs?

Answer 35

• costs which can be matched directly with revenue
• they are directly related to the production of a product or service intended for sale
  (eg raw materials for manufacturing firms/ costs of goods bought for resale for a non-manufacturing firm. eg wages for workers who manufacture the product)
• product costs are included in Costs of Goods Sold/ Cost of Sales (when sales happen)

Question 36

How may product costs be carried forward?

Answer 36

because product costs are matched with revenues, these costs/ expenses may be carried forward to be matched with the revenues they generated

Question 37

What happens to product costs if there are no sales or before sales happen?

Answer 37

product costs will be included in the amount of inventory

Question 38

What are period costs?

Answer 38

costs which generate revenue but arent directly traceable to the sale of a specific firm

Question 39

How are period costs allocated?

Answer 39

on a time basis and are therefore expensed in the period in which they occur
eg electricity bills for managers office and stationary costs

(but machinery electricity would count as a product cost because it has contributed to the production of the product directly)

Question 40

How are period costs linked to accruals and prepayments?

Answer 40

some period costs are carried forward or back to other accounting periods (these are called accruals and prepayments)

these arise where an expense is paid for before it is used (prepayments) or after it is used (accruals). the expense must always be included in the period it is used regardless of when it is paid for

Question 41

What are examples of period costs?

Answer 41

1. Administration costs
2. Distribution/ selling costs
3. Finance costs

Question 42

What examples of administration costs?

Answer 42

salaries of accounting staff, office overheads, heat and light, insurance, rent, rates, cleaners wages, depreciation on office fixtures and fittings and office manager’s motor vehicle, stationary

Question 43

What are examples of distribution/ selling costs?

Answer 43

salesman salaries, credit control staff salaries, sales commission, advertising and marketing, depreciation on salesmen’s motor vehicles and delivery trucks, carriage outwards

Question 44

What are examples of finance costs?

Answer 44

loan interest, bank charges, discounts allowed

Question 45

What is the accruals concept?

Answer 45

states that costs/ expenses should be included in the period they are incurred (ie used), not the period they are paid for (ie cash out)

Question 46

What do accountants need to work out with the accruals concept?

Answer 46

need to work out how much of an expense has been used in the period and compare this to how much (cash) has been paid for, and then adjust the accounts to show the used amount

Question 47

What is the accrued expense?

Answer 47

are payables for services received that havent been paid for at the end of the accounting year
(not an expense, a liability in the balance sheet)

Question 48

When do accrued expenses arise?

Answer 48

where expenses are paid in arrears (after use)

Question 49

What do accrued expenses help calculate in the income statement?

Answer 49

the correct expense number

Question 50

What is the prepaid expense?

Answer 50

are receivables in respect of services that have been paid for but not received at the end of the accounting year

(not an expense, an asset in the balance sheet)

Question 51

When do prepaid expenses arise?

Answer 51

where expenses of the services are paid for in advance

Question 52

What do prepaid expenses help calculate in the income statement?

Answer 52

the correct expense number

Question 53

How do we trace a prepaid expense if the payment has already been recorded as an expense in the accounts?

Answer 53

We may have not received the services, so this expense has not incurred

So we need to take this part of the expense out of the income statement and record the prepayment
-> Dr Prepayment (Current Asset in the Balance Sheet)
-> Cr Expense (reduce expense in Income Statement

So taking the unused part of the payments out of the expenses, so the remaining expense only shows the amount used for this year

Question 54

How do we trace a prepaid expense if the payment has not yet been recorded as an expense in the accounts?

Answer 54

We have spent some cash and will receive some services in the future we:
-> Dr Prepayment (Current Asset in Balance Sheet)
-> Cr Cash (in the Balance Sheet)

Question 55

What costs are accrued and the prepaid expenses related to?

Answer 55

period costs only

Question 56

How are the accrued and the prepaid expenses linked to the trial balance?

Answer 56

we need to adjust the expense numbers in the trial balance because in the trial balance the expense numbers related to period costs are only recording the actual cash paid