Lecture 4 notes

Question 1

So what have we done so far in the lectures?

Answer 1

What is accounting? Basic terminology 2nd lecture we looked at all the 3 financial statements ( what information they convey and how to prepare a basic SOFP) 3rd lecture we went behind the scenes, we looked at are the steps before the preparations of the financial statements ( debits and credits, T accounts and Trial balance)

Question 2

What will we learn in these notes today?

Answer 2

We look at a trial balance and ask ourselves, how do we create an income statement and statement of Financial position from this trial balance. We will also learn adjusting entries

Question 3

What will the 2 halves of this lecture contain?

Answer 3

Income statement then Asset management and Profit measurement.

Question 4

What is the income statement?

Answer 4

Tells you how much wealth was generated ( Profit and loss statement)

Question 5

To find Profit or loss how will be laid out our income statement( ie formula for profit?

Answer 5

Profit = Revenue - Expenses.

Question 6

Now lets look at that formula in depth. What is revenue?

Answer 6

It is an increase in owners equity from providing a good and service ( the thing you sale, the money is the owners.

Question 7

What is the revenue recognition citeria?

Answer 7

It is earned ( goods and services are delivered) It is realised or realizable ( payment is received in cash or something that can be converted into cash)

Question 8

Why do we have this regulation on revenue being realised?

Answer 8

If you didn’t firms could dispatch products to customers homem and claim it as revenue, even though the customer didn’t order it. In the short term profits go up, so investors think company is doing well, but in long term customers return the goods and profits go down. So if you are ensure about payment coming in you cannot note it down as revenue.

Question 9

When exactly is revenue recognised?

Answer 9

From the sale of goods ( sales revenue) when goods are delivered and accepted by customers. Services: when services are rendered e.g. a consulting company provides services to goldman sachs, for 3 years, you recognise the revenue, every accounting period e.g. every one year.

Question 10

When exactly do you recognise revenue for long term projects?

Answer 10

As each distinct stage is completed. e.g. a construction company building an apartment complex, revenue is realised at each distinct stage, e,g, laying foundation.

Question 11

ABC company receives a contract from GE for 3 years on 1/1/2016 for an amount of 300,000£. GE pays the cash upfront. How much revenue does ABC recognise at the end of 2016?

A) 0

B) 100,000

c) 200000
d) 300000

Answer 11

B. 100000

Question 12

What are expenses?

Answer 12

These are things that decrease owners equity that arise when generating revenue ( e.g. buying raw materials)

Question 13

What are two types of expenses

Answer 13

Product costs: Directly related to products they help generate. Eg: direct labour, materials used. r.g. shoe company, the expense here would be the fabric on the shoe

. Period costs: Indirect costs not directly associated with a product, also related to time period costs e.g. rent, advertising expense.

Question 14

For expenses and the income statement what are 2 underlying principles?

Answer 14

Matching ( You match the expense to the revenue generated) ACCURALS ( you dont track cash, you track the transcation)

Question 15

For product costs how does Matching principle work?

Answer 15

It is easy e.g. say you made 5000 shoes and you sold 4,000 shoes, you note down raw materialss e.g. ( product costs of 4000 shoes.

Question 16

For period costs how does Matching principle work?

Answer 16

e.g. rent for the next year 2 years, 1 Jan 2019, pay rent for entire 2019 and the next year, however 31 dec 2019 On this date you ask what is the period cost which is matched to the revenue at the periods In terms of rent you will only be first years rent, which is matched to the revenue generated at that period, The extra you pay is a prepaid asset.

Question 17

In December of 2019, ABC buys materials worth £100,000. How much expense is recognised in this 2019’s financial statements? (Hint: Product cost)

Answer 17

There have been no sales, you have nothing to match it against. so expense is 0

Question 18

In December of 2019, ABC uses £8,000 of materials to produce these shoes. It sells all of these shoes at £14,000. How much expense is recognised in 2019’s financial statements?

Answer 18

£8000 because sale has happened, the cost of producing that good you note that down.

Question 19

ABC pays a consultant £40,000 for services for 2019 and 2020. How much expense is recognised for consulting services by ABC in the 2019 financial statements?

Answer 19

£20,000 ( matching of period costs ( this is based on the assumption though that it is equally distrubted for 2 years.

Question 20

how do you create an income statement?

Answer 20

You start with sales revenue- CoS = Gross profit Then you subtract operating expenses ( e.g. rent, deprecation and electricity) from Gross profit giving you operating income After you take away Interest to get pre tax income then minus Income tax payable to get net income.

Question 21

Remember Funny sun Trial balance, What is the income statement? ( We use bottom half of that trial balance)

Answer 21

Question 22

Where does the net income go from the Income statement?

Answer 22

To the statement of financial position in the RE part ( remember at the start is was 0 but now because of sales it is now £3000.

Question 23

What is the statement of financial position for Funny sun?

Answer 23

Question 24

Why is the PPE 55,000? and not 60,000?

Answer 24

Because there was Accumlated deprication which is a contra asset ( it reduces a value of an asset) so 60,000- 5,000= 55000. Which is net PPE.

Question 25

So far what have we looked at when we make entries?

Answer 25

We have looked at unadjusted entries.

Question 26

What is adjusting entries?

Answer 26

Adjusting entries, also called adjusting journal entries, are journal entries made at the end of a period to correct accounts before the financial statements are prepared. This is the fourth step in the accounting cycle.

Question 27

What are some adjusting entries that are not noted by the bookepping software?

Answer 27

Non- cash transcations ( no cash coming in or out) ( accounting software only notes cash coming in and out) Internal transcations Implementation of Accural princple.

Question 28

Give an example of adjusting entry for wages that have not been paid?

Answer 28

As cash is not been exchanged the bookkeeping software might, not write it down on the statements, but the adjusting entry would make it a payable expense for that period. So you note that down.

Question 29

What are 2 broad catogeries of adusting entries that we see in the income statement?

Answer 29

Expenses ( Prepaid expense & Accured Expense ( Payable) Depriecation.

Question 30

Why is depriecation an adjusting entry?

Answer 30

The value of the asset has reduced, due to usuage, there is no cash transcation, so it becomes an adjusting entry.

Question 31

What is a prepaid expense and how would it look on SOFP using matching princple?

Answer 31

Expense paid in advance ( the extra you pay is noted down as a prepaid expense using matching convention. ( current asset), it is however only a current asset depending on time period e.g. if the time period is 3 years, it would be a non-current asset, as supposed to 3 months which is a current asset.

Question 32

What is the journal entry? ABC corp has fiscal year from Jan 1 – 31 Dec. On Dec 1, ABC pays £4000 for 4 month’s rent. What will be the entries on 1 Dec (DUMB BOOKEEPING SOFTWARE) and 31 Dec?

Answer 32

Dec 1: Dr Rent Expense (+E) 4000 Cr cash(-A) 4000 ) Bookkeeping software asks what has cash been used for? December 31: Dr Prepaid Rent (+A) 3000 Cr Rent expense (-E) 3000 However as smart accountants we use matching princple , and realised you have paid £3000 extra and used £1000. It is wrong to classify next years expense in the current period.

Question 33

Mr Joseph Bent rents office premises on a quarterly basis and makes his payments in advance. The rental agreement commenced 1/3/2018. He pays £6000 per quarter (£2000 per month)  His latest payment of £6,000 was made on 1/12/ 2018 covering the period to 28 February 2019.  Assuming that Mr Joseph’s year end is 31 December, what should be charged for year 2018 for rent expense and prepayment?

Answer 33

2018 Initial payment of rent on 1/12/2018 is Dr Rent expense £6000 Cr Cash £6000 (Bookkeeping software says this) The smart accountant however would adjust this so Dr Prepaid rent £4000 Cr Rent expense £4000

Question 34

What would go on income, SOFP and Cash flow statement for Mr Joesph renting a premise?

Answer 34

Income statement : rent expense £20000 Cash flow statement : 6000X 4 = £24000 SoFP at the end: Prepayment £4000

Question 35

What is an Accured expense?

Answer 35

Payable ( the expense is more than cash paid) which is another type of adjusting entry. ( Current liability)

Question 36

What is the Journal entry? ABC corp has fiscal year from Jan 1 – 31 Dec. For the month of December employees need to be paid salary of £25000. The salary is paid only on Jan 5th next year. What is the entry on 31st December?

Answer 36

Dec 31: Dr Salary expense (+E) 25000 Cr Accrued expense(+L) 25000 (Or Salary payable) Jan 5 (Next year): Dr Accrued expense (-L) 25000 Cr Cash (-A) 25000

Question 37

Here is an example of matching and Accured expense Harry Potter Ltd starts trading on 1/1 /2009 and incurs telephone charges of £200 per month (i.e. £ 600 per quarter). Its year-end date is 31 December and its next quarterly telephone bill is due on 10/1/ 2010. By 31 December 2009 three telephone bills totalling £1,800 were received, paid and charged to the income statement. What is the telephone bill at December 2009 and point in 2010

Answer 37

This means that he has paid 3 invoices quartely which is 3x600 = £1800 When next bill is due he has still used the telephone so by 31st december 2009 : Dr telephone expense £600 Cr Accured payable £600 At point of payment in 2010 it would be : Accured expense £600 Cr Cash £600

Question 38

Harry Potter Ltd starts trading on 1/1 /2009 and incurs telephone charges of £200 per month (i.e. £ 600 per quarter). Its year-end date is 31 December and its next quarterly telephone bill is due on 10/1/ 2010. By 31 December 2009 three telephone bills totalling £1,800 were received, paid and charged to the income statement. What would go on Balance sheet, Income statement and Cash flow statmeent?

Answer 38

Telephone expenses recorded and paid = 600 x 3 = 1800 Add accured expense( payable) = 600 Total = 2400 £2400 ( income statement) Accured expense = £600 Cash flow statement = £1800

Question 39

Firm ABC bought insurance for 3 years on 1.1.2019 for £3000. What will be the correct balances in the SOFP and I/S as on 31/12/2019 after adjusting entries? A. Prepaid insurance = £3000 (SOFP) Insurance expense = £3000 (I/S) B. Prepaid insurance = £2000 (SOFP) Insurance expense = £1000 (I/S) C. Prepaid insurance = £3000 (SOFP) Insurance expense = £1000 (I/S)

Answer 39

B. Prepaid insurance = £2000 (SOFP) Insurance expense £1000 (I/S) using matching princple

Question 40

Firm XYZ’s water bills get generated on 10th of July (for period Jan-June) & 10th of Jan (for period June-Dec). The bill on 10-Jul-2018 was £400 and was paid in cash & on 10-Jan-2019 was £500. Which of the following is correct as on 31.12.2018? A. Water Expense (I/S) = £900 Accrued expense (SOFP) = 400 B. Water Expense (I/S) = £400 Accrued expense (SOFP) = 500 C. Water Expense (I/S) = £900 Accrued expense (SOFP) = 500

Answer 40

C. Water expense ( I/S) = £900 Accured Expense ( SOFP) = £500 Expense for this year = £400 (paid) + £500 (unpaid) = £900 Accured payable = £500

Question 41

If you have a fixed asset ( car $14000) and it depricates annually by $3000 for 4 years what is the value of the car in 4 years? What would be the double entry each year of this annuall depriecation?

Answer 41

$2000 Dr Depriceation expense £3000 Cr accumlated depriecation £3000 ( reduces the value of an asset thats why it is a contra asset, you increase this by Cr)

Question 42

If you have a fixed asset ( car $14000) and it depricates annually by $3000 for 4 years the value of the 4th year would be $2000

Answer 42

So income statmenet in that year the expenses would include Depreciation expense £2000 And on SOFP would be Assets: Cars 14,000 - Accumulated depreciation (2,000) Cars (net) 12,000

Question 43

So for all 3 adusting entries ( Depreciation, Prepaid expense and accured expense ( payable) what key convention should we always use?

Answer 43

You need to match the expense to the period in which the revenue was generated.

Question 44

What have you noticed till now about inventory?

Answer 44

Previously we are always been told the closing inventory. e.g. a firm sold £8000 worth of goods for £14000? , but how was this number created?

Question 45

What is inventory?

Answer 45

Products held for sale; a current asset in the SOFP.

Question 46

What is Cost of sales?

Answer 46

When goods are sold their cost becomes an expense, which is known as COS in the income statement.

Question 47

What is the formula to calclulate COS?

Answer 47

Opening inventory + Purchases (= Goods avaliable to sell) - Closing inventory (Cost of sales)

Question 48

A shoe reseller,, this company already has 100 shoes at the beginning of the year, it purchased 500 shoes from the manfuacter. At the end of the year he calclaltess that there are 200 shoes remaining, so what is Cost of sales?

Answer 48

Opening inventory = 100 Purchases = 500 = 600 avaliable to sell - Closing inventory = 200 so you sold £400

Question 49

What happens if you have a purchase return?

Answer 49

You subtract this from purchases ( so you are returning back to supplier)

Question 50

What is COS always noted down in?

Answer 50

Historic cost

Question 51

What is it called if you cannot sell at Historic cost e.g. .6000 BUT CAN ONLY SELL £4000? What does Prudenance princple tell you do about it?

Answer 51

This is called Net realising value ( this is the estimated selling price less than any costs involved in selling and distrubting the goods so cost price was £6000, you think you can sell at £400, it is an estimated loss.) Prudence princple tells you that you should note down the estimated or anticptated loss.

Question 52

Why might the net realizing value occur?

Answer 52

Changing consumer trends Inventory get damaged by earthequake Seasonality If firm is about to go bankrupt, they need to sell urgently.

Question 53

When the Net realising occurs what is the write off it is a regular expense ( e,g, firm knows they will sell at discount in summer) or a one time thing ( earthquake) on ana income statement?

Answer 53

If it is a regular expense it is incorporated into the cost of sales. If it is not a regular expense, you write it as a separate expense on the income statement.

Question 54

On the Statement of Financial position how is the write off written when there is a Net realising value?

Answer 54

You deduct the write off from total inventory.

Question 55

What is the cost called when there is not net realising value?

Answer 55

Carrying amount: initial cost (using FIFO or AVCO)

Question 56

How would you double entry the Net realising value?

Answer 56

You reduce value of inventory and you are going to be increasing the CoS. DR Write down of inventory CR inventory

Question 57

Marathon plc – producer of sports goods • The cost of inventory on 30 September 2011 was £1,100. Included in this total is men’s sportswear costing £150 whose colour has faded. It has been decided to sell these clothes at 30% of their cost.Beginning inventory = £1,050 • Purchases = £6,520 What is Cost of sales?

Answer 57

COS = Beginning inventory (1,050) + 6520 - 995 = 6525 1100- (70% X 150) = 995

Question 58

ABC had a beginning inventory of £1000. They purchased £250 of goods during the year. The closing inventory was £500 of which they had to sell goods worth £75 for £25. The COS is: A. 800 B. 750 C. 500 D. 250

Answer 58

A. 800 = £1000 + 250 - 500 - ( 75-25) = 800

Question 59

When customers don't pay there receivables what are 2 ways we can catogrise them?

Answer 59

Bad debt and Doubtful debt.

Question 60

What is Bad debt?

Answer 60

You know for certain the customer will not pay e.g. goes bankrupt.

Question 61

What is doubtful debt?

Answer 61

You don't know whether they are going to pay or not.

Question 62

What is the double entry for bad debt?

Answer 62

If receivables are never going to come back then you reduce value of your receivable and you create a bad debt expense DR bad debt expense Cr Receivables

Question 63

After investigating its debtor balances at its Trial Balance (31.12.2008) of £32,000, Winsor Ltd considered that £2,000 was likely to prove irrecoverable What is the double entry and what will it look like on the I/S and SOFP.

Answer 63

Double entry Dr Bad debt write-off (I/S) £2,000 Cr Trade receivables £2,000 So on income statement (31.12.2008) you will have a bad debt expense of £2000 On statement of financial position you find net receivables so 32,000- 2000= 30000

Question 64

What does the Income statement and SOFP look like after After investigating its debtor balances at its Trial Balance (31.12.2008) of £32,000, Winsor Ltd considered that £2,000 was likely to prove irrecoverable.

Answer 64

I/S Sales Cos Gross Profit (One of the operating expenses is bad debt) Bad debt expense (2000) Balance sheet Asset Liability CASH 125 ( made up) Inventory 45000 (made up) Rec 32000- 2000 = 30000

Question 65

For doubtful debt ( we use what is the double entry?

Answer 65

Dr Doubtful debt expense ( we use prudenance princple and still note it down) Cr Provision for doubtful debt ( as you decrease value of asset

Question 66

What is provision of doubtful debt?

Answer 66

It is a contra asset, you are not going to directly reduce the receivable, as it might not come, so you will create a contra asset, that will reduce the value of a receivable.

Question 67

Winsor Ltd also considered that some of the remaining debts were doubtful and decided to establish a 5% provision against doubtful debts. Previously it was £32000

Answer 67

The remaining is key, from previous question it was £30000 remianing so now you find 5% which is £1500 So you Dr Doubtful debt expense 1,500 Cr Provisional for doutbul debt 1500

Question 68

What would the I/S and SOFP look like after Winsor Ltd also considered that some of the remaining debts were doubtful and decided to establish a 5% provision against doubtful debts. Previously it was £32000

Answer 68

I/S ## Footnote Sales COS GRoss profit Bad debt expense --- (2000) Doubtful debt expense ( 1500) SOFP Asset Liability Cash 125 made up Inventory 45000 made up Rec - 30,000 Provisional for doubtful debt - (1500) So net receivables is 28500

Question 69

During the subsquent accounting period (ending 31.12.2009) another £1000 was considered to be irrocervable, the new debtors balance was £41000 and Winsor LTD decided to maintain proivison for doubtful debts?

Answer 69

Recevables 41000 Bad debt (1000) Net = 40000 (DR bad debt expense 1,000 Cr Trade receivables 1,000) 1500 from previous year what he saved (5% of 40000 =2000) - 1500 = (500) Dr doubtful debt expense = 500 Cr Provision for doubtful debt. 500

Question 70

During the subsquent accouting period 31.12.2010 there was no bad debt. The new debtors balance was £22000 and winsdor LTD decided to maintain the 5% provision for doubtful debt?

Answer 70

Trial balance Cash 500 inventory 20400 Receivables - 22000 Provision for doubtful debt = 2000 Doubtful debt = 5% of 22000 = 1100 ( there has been a decrease in doubtful debt so you debt it, it is a contra asset) 2,000 - 1100 = 900 I/S. Dr Provision for doubtful debts 900 Cr Doubtful debt expense 900 I/S Sales COs . . . Doubtful debt - 900 Statement of financial position Trade reveivables = 22000 Provison of doubtful debt = 1100 Net receivables = 20900

Question 71

What is the difference between Profit Margin and Profit Markup?

Answer 71

Profit Margin : Profit is expressed as a proportion of its selling price. Profit / selling price Profit Markup: Profit is expressed as a proportion of cost Profit/ cost

Question 72

Calculate profit Markup and Margin

Answer 72

An easy way to remember is profit margin is usually revenue minus cost of sales ( gives profit margin)

Question 73

The selling price is 150 and the mark up is 50% calculate the profit

Answer 73

Question 74

What does it mean if a company has marked up its costs?

Answer 74

The mark-up added to the cost price usually equals retail price.

Question 75

To what extent can the choice of depreciation method be used as an earnings management tool?

Answer 75

By choosing a depreciation method that leads to a higher (lower) depreciation charge in a given year, managers can manage earnings downwards (upwards). However, any attempts by firms to manage earnings cannot be sustained over the long -run

Question 77

When there is a decrease in provision of doubtful debt, and you put it in the income statement, what do you do with it?

Answer 77

You decrease it from the total operating expenses or you put it in brackets.