Week 4 - Income and expenses, accruals and prepayments (FINISH OFF) Flashcards
What is the income statement?
- it records the entity’s income and expenses
- calculates whether the entity has made a profit or loss for the year
- provides a summary of the entity’s trading activities during the accounting period/ year
- prepared from the trial balance
- aim is to enable users to evaluate the financial performance of the business over a period
What are the other names for the income statement?
the Statement of Profit or Loss or the Statement of Financial Performance
What is the basic format of the income statement?
- put the name of the company
- put income statement for the year ended 20XX
- first show revenue
- then less:cost of sales/ goods sold
- then gross profit
- then other income (income received not directly to the business eg stock dividend)
- then less:other costs and expenses ->
- selling and distribution costs
- administrative expenses
- finance costs (interest from borrowing
- then profit/ loss for the period
what is income?
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
How is revenue generated?
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
What are gains?
are changes in asset values which are recorded in the accounts
for example, the change in values of some types of investments
What is the income equation?
income = revenues + gains
What is revenue?
income earned in the period from normal trading activities (called operating activities)
What is gross profit?
the profit after only subtracting cost of sales
What is operating profit
the profit arising from the business’ operations after deducting other expense related to operating activities
What is other income?
when an entity has income from activities that are not its core business, such as receiving interest then this is disclosed separately
What are expenses?
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
What is profit or loss?
the total income made by the entity in the period less the total expenses incurred by the entity in the period
What is the first part of the income statement for a sole trader
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
What is after the trading account in the income statement for sole traders?
- Interest recieved
- General expenses
- Salaries and Wages
- Heating and light
- Depreciation
- Increase/ decrease in provision for doubtful debts
- Bad debts expense
- Profit/ loss on disposal of non-current asset
- Profit for the year/ profit before tax
What is the difference between a sole trader and comanys income statement?
Sole traders has more details about expenses than for a company
What is the income statement for a company?
- Sales revenue
- Cost of sales
- Gross profit
- Administrative expenses
- Sales and distribution expenses
- Other expenses
- Operating profit
- Finance income
- Finance costs/ expenses
- Profit for the year/ Profit before tax
What are examples of administrative expenses?
wages paid for receptionists
wages paid for managers
hidden light/ electricity bills
What is the first stage in determining the profit for the year?
calculating gross profit
How do you calculate gross profit?
Gross Profit = Cost of goods sold - Revenue
What separate account is gross profit sometimes calculated in?
the trading account
How do you compute costs of goods sold in the trading account?
using the closing inventory formula
What is the closing inventory formula?
Closing inventory = Opening Inventory + Net purchases - Cost of Sales
What is cost of sales?
the costs directly incurred in selling the goods
When do purchases of inventory in a period need to adjust purchase returns and transport (carriage) inwards?
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’
Why do cost of sales not equal purchases
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.
What are the accounting concepts relevant to the income statement (all linked together)?
- Recognition
- Realisation
- Accruals concept
What is recognition?
revenue is recognised by the entity when the sale/ service has been carried out
What is realisation?
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)
What is the accruals concept?
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
How do we recognise the revenue?
we need to test with two criteria (rules for revenue recognition)
What are the rules for revenue recognition?
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
How are expenses classified?
- Two main types of expenses
What are the two main type of expenses?
- Product/ direct/ traceable costs (direct cost)
- Period costs (indirect cost)
What are product/ direct/ traceable costs?
- 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)
How may product costs be carried forward?
because product costs are matched with revenues, these costs/ expenses may be carried forward to be matched with the revenues they generated
What happens to product costs if there are no sales or before sales happen?
product costs will be included in the amount of inventory
What are period costs?
costs which generate revenue but arent directly traceable to the sale of a specific firm
How are period costs allocated?
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)
How are period costs linked to accruals and prepayments?
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
What are examples of period costs?
- Administration costs
- Distribution/ selling costs
- Finance costs
What examples of administration costs?
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
What are examples of distribution/ selling costs?
salesman salaries, credit control staff salaries, sales commission, advertising and marketing, depreciation on salesmen’s motor vehicles and delivery trucks, carriage outwards
What are examples of finance costs?
loan interest, bank charges, discounts allowed
What is the accruals concept?
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)
What do accountants need to work out with the accruals concept?
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
What is the accrued expense?
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)
When do accrued expenses arise?
where expenses are paid in arrears (after use)
What do accrued expenses help calculate in the income statement?
the correct expense number
What is the prepaid expense?
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)
When do prepaid expenses arise?
where expenses of the services are paid for in advance
What do prepaid expenses help calculate in the income statement?
the correct expense number
How do we trace a prepaid expense if the payment has already been recorded as an expense in the accounts?
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
How do we trace a prepaid expense if the payment has not yet been recorded as an expense in the accounts?
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)
What costs are accrued and the prepaid expenses related to?
period costs only
How are the accrued and the prepaid expenses linked to the trial balance?
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
