1 Help session to students with little or no accounting or finance background ´Income and Cash Flow Statementsµ by Binam Ghimire
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1
Help session to students with littleor no accounting or finance
background
´Income and Cash Flow Statementsµby Binam Ghimire
8/3/2019 2 Income N CashFlow Statements Help Session1
http://slidepdf.com/reader/full/2-income-n-cashflow-statements-help-session1 2/31
Example:
On Day 1 Anne starts a business with £1 cash
On Day 2 all the cash is used to buy inventory
Balance Sheet as at Day 1 £
Current Assets
Cash 1
TOTAL ASSETS 1
Equity (Anne¶s Capital)
Capital Introduced 1
EQUITY AT END OF DAY 1 1
Balance Sheet as at Day 2 £
Current AssetsInventory 1
TOTAL ASSETS 1
Equity (Anne¶s Capital)
At end of Day 1
No changes during Day 2
1
EQUITY AT END OF DAY 2 1
The Income Statement (Profit &
Loss Account)
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Example (cont.):
On Day 3 all the inventory is sold for £1.50 cash
Note:
The ASSETS involved in this example are CASH and INVENTORY
PROFIT is a REASON why the assets have increased
Profit is NOT an asset, it is part of EQUITY
The Income Statement (Profit &
Loss Account)
Balance Sheet as at Day 3 £
Current Assets
Cash 1.50
TOTAL ASSETS 1.50
Equity (Anne¶s Capital)
At end of Day 2
Add Profit earned during Day 3
1.00
0.50
EQUITY AT END OF DAY 3 1.50
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Dave starts a taxi business at the beginning of year 1, introducing£15,000 of his own cash which is all used immediately to buy a taxi.
The taxi is estimated to last for 3 years and then be worthless andDave plans to cease trading.
Income from fares amounts to £25,000 each year.
Running expenses, such as fuel costs, amount to £11,000 eachyear.
Discussion:1. How much total profit does the taxi business make during its
lifetime?
2. How useful is this information?
3. What additional financial information would be useful?
The Income Statement (Profit &
Loss Account)
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Answers:
1 - Daves business starts with £15,000
During whole life of business (3 years):Fares = £25,000 x 3 years = +75,000
Running Expenses £11,000 x 3 years = -33,000Taxi = -15,000Net INCREASE (PROFIT) = +27,000
Business ends with original £15,000 + £27,000 = 42,000
i.e. £27,000 MORE than it started with WITHOUT the owner putting more
in and WITHOUT borrowing
Profit over WHOLE life of business = £27,000 for 3 years
2 - Of limited use
The Income Statement (Profit &
Loss Account)
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4. What is the net cash flow for each year, assuming all transactions are forcash?
The Income Statement (Profit &
Loss Account)
Cash Flow Statementfor.
Year 1 Year 2 Year 3 Total
(3 Years)
Cash inflows:
Capital IntroducedFares
Total Cash Inflows
Cash outflows:
New Taxi
Running Expenses
Total Cash Outflows
Net Cash flow
Opening Cash 0 0
Closing Cash
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Answers (cont.): 4
The Income Statement (Profit &
Loss Account)
CASH FLOW 1 2 3 TOTAL
Inflows:
Cap. Introduced
Fares
15,000
25,000
0
25,000
0
25,000
15,000
75,000
Total Cash In 40,000 25,000 25,000 90,000
Outflows
New Taxi
Running expenses
15,000
11,000
0
11,000
0
11,000
15,000
33,000
Total Cash Out 26,000 11,000 11,000 48,000
Net Cash Flow 14,000 14,000 14,000 42,000
Opening Cash 0 14,000 28,000 0
Closing Cash 14,000 28,000 42,000 42,000
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5. Discuss how much profit should Dave recognise each year?
The Income Statement (Profit &
Loss Account)
Income Statementfor
Year 1 Year 2 Year 3 Total
(3 Years)
Income from fares
Expenses:Fuel etc.
Taxi depreciation
Profit for the year
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Answers (cont.): 5 Profit MIGHT be calculated as follows:
The Income Statement (Profit &
Loss Account)
Income Statement 1 2 3 TOTAL
Income (earned)
Fares25,000 25,000 25,000 75,000
Expenses (used up)
Fuel etc.
Depreciation
11,000
5,000
11,000
5,000
11,000
5,000
33,000
15,000
Profit 9,000 9,000 9,000 27,000
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6. Discuss what should appear on the Balance Sheet of the business as at the end of each year:
The Income Statement (Profit &
Loss Account)
Balance Sheet as at end of.. Year 1 Year 2 Year 3
Non-Current AssetsTaxi (net book value)Current AssetsCash
TOTAL ASSETS
Equity
Opening Capital b/f from last
yearCapital Introduced during year
Profit for year
Drawings by owner during year
Closing Capital at end of year
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Answers (cont.): 6
The Income Statement (Profit &
Loss Account)
Balance Sheet at end of 1 2 3
Non-Current Assets
Taxi (net book value)
Current AssetsCash
10,000
14,000
5,000
28,000
0
42,000
TOTAL ASSETS 24,000 33,000 42,000
Equity
Opening Capital b/f
Capital intro in year
Profit for year
Drawings
0
15,000
9,000
0
24,000
0
9,000
0
33,000
0
9,000
0
Capital at end of year 24,000 33,000 42,000
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Answers (cont.): 6 Notes: Daves equity has gone up from the initial capital
introduced of £15,000 to £42,000 by the end of Year 3 dueto.
Cash flow and profit are NOT the same thing (see accrualsconcept below).
Dave can choose how he wishes to depreciate his taxi. Heshould apply whichever method he choosesCONSISTENTLY so his profits can be compared from year
to year. Other taxi businesses, however, may chooseother methods of depreciation. This makes the comparisonof results between different businesses (inter firmcomparison) difficult.
The Income Statement (Profit &
Loss Account)
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7. Discuss - why might accounts preparers wish to overstate profits and assets? Answer: - Management looks good
- Bonuses based on profits
- Increase equity value if current owners wish to sell business (or shares in business)
8. Discuss - why might accounts preparers wish to understate profits and assets? Answer: - Tax avoidance
- Low profits this year may enable better profits to be declared next year
9. What safeguards should prevent the manipulation of accounting information? Answer: - Audits by independent accountants
- Accounting concepts
- Accounting standards
10. Are these safeguards effective? Answer: - Accounting scandals would suggest safeguards not effective enough!!
- Accounting and financial reporting continue to develop
The Income Statement (Profit &
Loss Account)
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The Calculation of ProfitThe calculation of profit is the subject of much debate. As profit is the
most important measure of the success or otherwise of a business,there may be an incentive for managers to manipulate the figureswhen calculating profit for an accounting period. The CONSISTENT
application of the relevant accounting CONCEPTS is, thereforeessential when calculating profit.
Consistency Concept - Calculated on a consistent basis
Going Concern Concept - Business assumed to continue for foreseeable
future
Periodicity Concept - Calculated at regular intervals
Accruals Concept - Accruals Accounting used to calculate profit (Matchingconcept).
The Income Statement (Profit &
Loss Account)
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GOING CONCERN CONCEPT (Continuity )Unless there is evidence to the contrary, it assumed that the business will
continue to operate indefinitely as a going concern. This is important when placing values on assets. E.g. At the end of years 1 & 2 Daves taxiwas valued on the assumption that it would still be used by the business inthe future i.e. the business would not be forced to sell the taxi before the
end of its useful life.
PERIODICITY CONCEPT (Cut-Off ) During the life of a business, profit will be calculated periodically, usually at
least once a year. This is known as the PERIODICITY CONCEPT (orTIME INTERVAL CONCEPT) i.e. for reporting purposes the life of thebusiness is cut up into separate periods.
Period 1s profit will be calculated separately from period 2s etc.
The periodicity concept creates the problem of deciding which transactionsrelate to this year as opposed to next year i.e. which side of the CUT-OFFpoint do they occur?
The Income Statement (Profit &
Loss Account)
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ACCRUALS CONCEPT ( Accruals Accounting )Profit is calculated in accordance with the ACCRUALS CONCEPT All income and charges relating to the
financial period should be taken into account WITHOUT regard to the date of payment or receipt of cash.
Profit is calculated by matching:(i) Income earned during the period (whether received or not)with(ii) Expenses relating exclusively to the period/used up (whether paid for or not)
NoteThe accruals concept results in profit NOT being equal to net cash flow for the accounting period.
So, to calculate profit:Match..Income earned (date cash is received NOT relevant)
withExpenses incurred/used (date cash paid NOT relevant)
e.g. Income for year 3Less Expenses for year 3= Profit for year 3
The Income Statement (Profit &
Loss Account)
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Required: Fill in the missing information concerning the followingtransaction, assuming the financial year ends 31st December.
Goods are sold for £600 on 2 months credit in November, year 3
a) £600 sales income will be recognised in the Income Statement forthe year ended 31st December Year Answer: Year 3
b) The Cash will be received in the month of Year Answer: January Year 4
c) The Balance Sheet as at 31st December Year 3 will show £600 as a, under the heading
Answer: Trade receivable £600, Current Assets
The Income Statement (Profit &
Loss Account)
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The Income Statement
To calculate the profit or loss for an accounting period aseparate Income Statement (Profit and Loss Account)is drawn up.
The Income Statement shows the detail of how profit iscalculated, usually starting with the gross profit, whichis the difference between the selling price of goods and
services sold and the cost of buying or making thosegoods.
The Income Statement (Profit &
Loss Account)
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Example:
Neil buys and sells one type of article only.
Month 1: Purchases 5 articles @ £1.00 each
Sales 3 articles @ £1.50 each
Required:
a. Calculate the Gross Profit for Month 1
b. Prepare the final accounts for Neils business for Month 2 from the following details:
The Income Statement (Profit &
Loss Account)
Trial Balance as at end of Month 2 Dr
£
Cr
£
Month 2 Purchases 7 articles @ £1.00 each
Month 2 Sales 8 articles @ £1.50 each
Inventory at start of Month 2
Interest Received
Wages
Office expenses
Cash at Bank
Neil¶s Capital (equity) at end of Month 1
Trade Receivables
Trade Payables
7
2
1
3
100
6
12
1
101
5
119 119
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Answers : a
The Income Statement (Profit &
Loss Account)
Income Statement for Month 1 £ £
Sales (3 units @ £1.50)Less Cost of sales:Purchases (5 @ £1)Less Closing inventory (2 @ £1)
5.002.00
4.503.00
Gross Profit (33.33%) 1.50
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Answers : b
The Income Statement (Profit &
Loss Account)
Income Statement for Month 2 £ £
Sales (8 units)Less Cost of sales:Opening Inventory (2 units)
Add Purchases (7 units)
27
12
(Available for sale 9 units)Less Closing Inventory (1 unit)
9
1 8Gross Profit (33.33%)
Add Other Income
Interest received etc.
4
1
Less Overhead ExpensesWagesOffice Expenses
13
5
4
Net Profit 1
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Answers : b The following statement may be used by Sole Traders to explain why the Equity in the business has
changed from that shown the Balance Sheet at the end of the previous period. This statement isNOT used by limited companies.
NOTE: NOT used by Limited Companies
The Income Statement (Profit &
Loss Account)
Capital Movements during Month 2 £
Net profit for period
Less Drawings during period
1
0
Retained Profit for period
Add Capital at start of period + Cap Int.
1
101
Closing Capital 102
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Answers : b
Assessment Notes:
The incorporation of end of period adjustments into the ledger accounts will not be assessed.
You will be provided with pro-formas in the coursework assessment test in November.
You will NOT be provided with pro-formas in the end of semester examination in December.
The Income Statement (Profit &
Loss Account)
Balance Sheet as at end Month 2 £ £Non-Current AssetsCurrent AssetsInventoryTrade Receivables
Cash & Bank
16
100
0
107TOTAL ASSETS 107
EquityNeils CapitalNon-Current Liabilities
Current LiabilitiesTrade Payables
1020
5TOTAL EQUITY & LIABILITIES 107
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Gross Profit Margin: Neil
1 unitGross Profit 50pSelling Price 150p
Gross Profit Margin50 x 100 = 33.3%
150
i.e.1/3rd of selling price is profit£33.3p out of every £100 is profit
3 unitsGross Profit Margin150 x 100 = 33.3%
450
8 unitsGross Profit Margin
400 x 100 = 33.3%1,200
The Income Statement (Profit &
Loss Account)
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What Gross Profit will Neil make if his sales total.
I. £1,200
Answer: £1,200 x 33.3/100 = £400
II. £3,000
Answer: £3,000 x 33.3% = £1,000
The Income Statement (Profit &
Loss Account)
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Inter-relationship between final
accounts
and accounting records
Final accounts Double entry rules
Debit Credit
Income statement Expenses USED Income EARNED
Balance sheet Assets owed Liability owed + equity
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Inter-relationship between final
accounts
and accounting records
Income Statement
Income: what is earned
Expenses: what is used up
.during accounting period
Balance Sheet
Assets: what is owned
Liabilities: what is owed
at end of accounting period
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Multiple Choice Questions(i) Gross Profit is:
(a)Sales less purchases
(b)Cost of goods sold less closing stock
(c) Excess of sales over cost of sales
(d)Net profit less expenses for the period
Answer: c
(ii) What is the Gross Profit Margin of a business that records the following for anaccounting period:
Sales £30,000; Purchases £18,000; Cost of Sales £20,000
(a)10%
(b) 33.3%(c)40%
(d)£10,000
Answer: b
£30,000 20,000 = gross profit £10,000
£10,000/£30,000 x 100 = gross profit margin of 33.3%
Self Assessment Questions
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True - False Questions: Are the following statements true or false?
(i) Profit reduces both capital and net assets.
False. Trading at a Profit INCREASES net assets and capital.
(ii) Inventory is a current liability.False. Inventory (stock) is a current asset.
(iii) Drawings are a business overhead.
False. Drawings are NOT a business expense so do NOT influencebusiness profits. They are business assets taken for personal use ofthe owner.
(iv) If a Sole Trader pays himself wages, this is treated as an overhead.
False. The reward of the owner of the business is profit NOT wages.Whenever the owner withdraws money or other assets from thebusiness it is treated as drawings.
Self Assessment Questions
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Thank You
Note : Images were downloaded between 28th April to 2nd May 2011
Examples are from Atrill and McLaney, 2011 and others. detail references can be provided on request