3- Statement of Profit and Loss

Question 1

What does Statement of Profit and Loss Show?

Answer 1

• Income of a firm- revenue earned by firms minus its expenses.

Question 2

3 types of payment methods

Answer 2

• Cash on delivery
• Paid in arrears
• Paid in advance

Question 3

Cash on delivery

Answer 3

Services and goods paid at the time the services are consumed or goods received.

Question 4

Examples of cash on delivery

Answer 4

Goods from supermarket, takeaway food.

Question 5

Paid in arrears

Answer 5

Services consumed and goods delivered and paid for at a later time.
May be invoiced at the time of delivery (typical for goods) or at a later time (common for services).

Question 6

Examples of payments in arrears

Answer 6

Goods sold by one firm to another (invoiced at the time), electricity consumed (invoiced at a later date).

Question 7

Paid in advance

Answer 7

Services and goods ordered and paid for in advance.

Question 8

Examples of payments in advance

Answer 8

Rent on commercial premises, tickets for a flight.

Question 9

Why Can’t We Use Cash Flows for Profit?

Answer 9

The timing mismatch between payments for sales and payments for their related costs makes it impossible to produce a meaningful value profit for an accounting period based on cash flows.

Question 10

The Accrual Principle

Answer 10

Revenue should be recognised when earned regardless of when paid for. Expenses should be recognised when incurred regardless of when paid for.

Question 11

IFRS Revenue Recognition Requirements

Answer 11

• the rights to all economic benefits from a product or a service, and responsibilities for any risks, have been transferred from the seller to the buyer without recourse (or returns can be reliably estimated)
• and the amount of revenue and associated costs can be measured reliably.

Question 12

Different expenses

Answer 12

• Product costs
• Costs of running the business
• Selling and distribution costs

Question 13

Problem with reporting expenses

Answer 13

• IFRS is not very proscriptive in terms of reporting
• US GAAP/ SEC Reporting
• Wide variation in terms of level of reporting and presentation
• Creates comparability problems

Question 14

Product costs

Answer 14

Comprise all of the costs expended on a goods or service that are needed to generate the revenue from selling the goods or service.

Question 15

Examples of product costs

Answer 15

• Direct costs such as raw materials and labour
• Fair share of the manufacturing overheads.

Question 16

Matching Principle

Answer 16

Costs associated with revenues should be recognised in the same periods in which the revenues are recognised.

Question 17

Reason for the matching principle

Answer 17

Needed to report meaningful value for profit

Question 18

Gross/ Trading Profit

Answer 18

Revenue minus cost-of-sales

Question 19

Period costs

Answer 19

Costs that cannot be easily be matched with revenues.

Question 20

Corporate overheads

Answer 20

The costs of running the business

Question 21

Manufacturing overheads

Answer 21

Transformed into product costs

Question 22

Application of the Accrual Principle to Period Costs

Answer 22

Costs incurred for services received or things consumed that cannot be directly associated with revenues should be recognized in the same periods in which the benefits from the service were received or consumption took place.

Question 23

Examples of corporate overheads

Answer 23

• Head office itself (building, staff)
• Marketing
• Data centres, call centres and IT network
• May include selling and distribution costs- Reported as “Other operating expenses” or “Selling, General and Administrative (SG&A) expenses”

Question 24

Core Operating Profit

Answer 24

Gross profit - other operating expenses

Question 25

Operating Profit (PBIT)

Answer 25

• Core operating profit + other income
• Other income may include rental income and dividends from equity investments
• Profit before interest and tax (PBIT)
• The operating profit on the firm’s operating assets

Question 26

What do the Operating Profits Go To?

Answer 26

• Financial creditors- for loan expenses, bonds etc.
• Tax authorities- Tax expenses towards infrastructure, security and legal system on which firm depends, education and health of its employee
• Minority interests Claims of profits from minority shareholders in one or more of a firm’s subsidiaries
• Profit attributable to owners

Question 27

Credit sales

Answer 27

Firms transact most of their business with one another on credit terms, typically of 30-60 days.

Question 28

Reasons and pitfalls of credit sales

Answer 28

• Free financing for customer
• Have credit risk for supplier
• People in credit control want to keep payment terms short
• People working in sales and marketing want generous payment terms

Question 29

Credit sales- trade receivables

Answer 29

• Used to record invoices issued by the company to its customers for goods and services it has sold to them on credit.
• Represents amounts owed to the firm due for payment (normally within 12 months).
• Value of gross trade receivables is shown in the notes to the accounts.

Question 30

Credit sales: trade payables

Answer 30

• Used to record the value of invoices received by the company from its suppliers for goods and services it has bought from them on credit.
• Represents amounts owed by the firm due for payment (normally within 12 months) and its value shown in the statement of financial position.

Question 31

Accrued income

Answer 31

Value of revenue earned that has not yet been invoiced.

Question 32

Accrued expenses

Answer 32

Value of expenses incurred for which an invoice has not yet been received (e.g. estimated electricity consumption.

Question 33

Unearned income at end of period

Answer 33

Unearned income at start of period
‒ Revenue from advance sales
+Payments received from customers

Question 34

Prepayments at end of period

Answer 34

Prepayments at start of period
‒ Expenses consumed / goods received
+Payments made to suppliers

Question 35

Trade receivables at end of period

Answer 35

Trade receivables at start of period
+Revenue from credit sales
‒Payments received from customers

Question 36

Revenue from credit sales

Answer 36

Trade receivables at end of period
‒ Trade receivables at start of period
+Payments received from customers

Question 37

Working capital

Answer 37

• Concerns a firm’s trading assets and liabilities
• Defined as working capital = current assets – current liabilities
• Working capital represents the portion of current assets which must be funded by long-term financing
• Can be positive and negative

Question 38

When positive what does working capital represent?

Answer 38

Working capital represents the portion of current assets which must be funded by long-term financing.

Question 39

When negative what does working capital represent?

Answer 39

it represents the portion of current liabilities that are available to fund a firm’s non-current assets.