Lecture 3 - Undertsanding Financial Performance

What accounting concept links expenses to the revenue they generate?

The matching (accruals) concept.

What is the purpose of the accruals concept in accounting?

To match expenses with the revenue they generate, regardless of when the payment is made.

What method should be used for valuing closing stock of perishable items like fresh flowers?

FIFO (First In, First Out) method.

Why does Burberry use the lower of cost and NRV for stock valuation?

To reflect the reality of stock use, especially in the high fashion industry where items go out of fashion quickly.

What impact did the Covid-19 pandemic have on Burberry's closing stock valuation?

An adjustment of £169.5 million was made as a provision where NRV was considered lower than cost.

What is 'creative' accounting?

The use of accounting choices/techniques to produce an overly positive view of a company's financial position.

What are some objectives of creative accounting?

Management compensation, tax considerations, competitive considerations, conceal poor management decisions, and satisfy investor demands.

What is the role of prepayments in financial statements?

Prepayments decrease the expense recorded and are classified as current assets.

How do you calculate the insurance expense for a 15-month policy costing £30,000?

Monthly cost is £30,000/15 = £2,000, so for 12 months, it is £2,000 x 12 = £24,000.

What are accruals in accounting?

Expenses owed for services used but not yet paid for, which increase the expense recorded.

How is the electricity expense calculated if £9,000 is paid up to September 30, 2019, and an estimate for the last 3 months is needed?

Monthly estimate is £9,000/9 = £1,000; accrual for 3 months is £3,000.

What happens to trade receivables when debts go bad?

Bad debts are written off, removed from trade receivables, and recognized as an expense in the income statement.

How do you calculate the gross profit if 1,000 stock items are bought for £5 each and 700 are sold at £12 each?

Gross profit = (700 x £12) - (700 x £5) = £8,400 - £3,500 = £4,900.

What is the depreciation policy for buildings in Uma Ltd?

2% per year on the historic cost of £102,000.

What is the depreciation method for machinery in Uma Ltd?

20% reducing balance on the historic cost of £65,000.

What is the depreciation policy for computers in Uma Ltd?

5-year life with a residual value of £2,250.

What is the accumulated depreciation for buildings as of 30/09/19?

£8,000.

What is the accumulated depreciation for machinery as of 30/09/19?

£6,500.

What is the accumulated depreciation for computers as of 30/09/19?

£2,700.

What is the formula for calculating the expense owed for electricity at the end of the financial year?

Total electricity expense = paid amount + estimated accrual.

What is the significance of the lower of cost and NRV in stock valuation?

It ensures that stock is not valued above the amount that can be realized from its sale.

What is the impact of regular stock line changes in the fashion industry on stock valuation?

It necessitates using methods like FIFO to accurately reflect stock value and turnover.

What is the relationship between management compensation and creative accounting?

Creative accounting may be used to meet profit targets that influence management bonuses.

What is the accounting treatment for bad debts?

They are derecognized from trade receivables and recorded as an expense in the income statement.

What is the importance of the matching concept in financial reporting?

It ensures that expenses are recorded in the same period as the revenues they help generate.

What does the Income Statement show?

The Income Statement shows financial performance, indicating how much profit or loss has been made over an accounting period.

What is the accruals concept in accounting?

The accruals concept states that incomes and expenses are recognized when earned or used, not when paid, matching expenses to the incomes they generate.

What is revenue according to the IASB Framework?

Revenue is defined as increases in economic benefits during the accounting period before expenses are deducted.

What are examples of revenue income?

Examples include sales (turnover), fees, interest, dividends, royalties received, and rent received.

What are gains in the context of revenue?

Gains are income arising from activities that are not part of the ordinary operations of an entity, such as gains on disposal of non-current assets.

What is IFRS 15?

IFRS 15 sets out the approach to revenue recognition, stating that revenue should be recognized when goods/services are transferred to the customer.

What is the prudence principle in accounting?

The prudence principle requires that revenue is recognized only when it is certain and reflects the consideration the company expects to receive.

What is the formula for Cost of Sales in retail?

Cost of Sales = Opening Inventory + Purchases - Closing Inventory.

How is closing inventory valued?

Closing inventory is valued at the lower of cost or Net Realizable Value (NRV), which is the selling price less further costs before sale.

What does FIFO stand for in inventory valuation?

FIFO stands for 'First In, First Out,' meaning the oldest inventory items are sold first.

What does LIFO stand for in inventory valuation?

LIFO stands for 'Last In, First Out,' meaning the most recently purchased inventory items are sold first; this method is not acceptable under international accounting standards.

What is AVCO in inventory valuation?

AVCO stands for 'Average Cost,' which calculates the weighted average cost of inventory items.

What was the outcome of the Tesco revenue recognition scandal?

In 2017, Tesco agreed to pay a £129 million fine and £85 million in compensation to investors due to the scandal.

How does the choice of inventory valuation method affect profit?

The choice of inventory valuation method can change the reported profit, as different methods yield different closing inventory values and cost of sales.

What is the impact of the Covid-19 pandemic on Burberry's closing stock valuation?

The impact is discussed in Note 17 of Burberry's financial report, reflecting changes in inventory valuation due to the pandemic.

What is the relationship between the Income Statement and the Statement of Financial Position?

The Income Statement links the Statements of Financial Position at the beginning and end of a reporting period, showing the changes in financial position.

What is the purpose of recognizing revenue in accounting?

The purpose is to accurately reflect the income earned by an entity during a specific accounting period.

What are multi-part sales in revenue recognition?

Multi-part sales involve transactions where goods or services are sold in multiple components, such as mobile phone contracts.

What is the significance of matching expenses to income?

Matching expenses to income ensures that financial statements reflect the true profitability of an entity during a specific period.

What does NRV stand for?

NRV stands for Net Realizable Value, which is the estimated selling price of an asset minus any costs expected to incur for its sale.

What is the effect of using different inventory valuation methods?

Different inventory valuation methods (FIFO, LIFO, AVCO) can lead to different reported profits and cost of sales.

What is the closing inventory valuation for Lara's flower business using FIFO?

Using FIFO, the closing inventory is valued at £8,800 for 1,100 unsold roses.

What is the closing inventory valuation for Lara's flower business using LIFO?

Using LIFO, the closing inventory is valued at £5,800.

What is the closing inventory valuation for Lara's flower business using AVCO?

Using AVCO, the closing inventory is valued at £7,370.

What is the basic rule for valuing inventory?

The basic rule is to value inventory at the lower of cost or Net Realizable Value (NRV).

What are the three major financial statements?

The income statement, balance sheet, and cash flow statement.

What accounting concept underpins the statement of financial performance?

Accruals.

What are two key accounting conventions?

Consistency and prudence.

What is the difference between revenue and capital expenditure?

Revenue expenditure is for day-to-day operations, while capital expenditure is for acquiring or improving long-term assets.

How do you calculate gross profit?

Gross Profit = Turnover - Cost of Sales.

What is the formula for calculating cost of sales?

Cost of Sales = Opening Inventory + Purchases - Closing Inventory.

If 1,000 items are bought for £5 each and 700 are sold for £12 each, what is the turnover?

Turnover = 700 x £12 = £8,400.

What is the cost of purchases if 1,000 items are bought at £5 each?

Cost of Purchases = 1,000 x £5 = £5,000.

How is closing inventory valued when the cost is £5 and net realizable value is £12?

Closing inventory is valued at £1,500 (300 units x £5).

What happens to gross profit if the net realizable value falls to £3 per unit?

Gross profit decreases; new gross profit is £4,300.

How do you calculate depreciation for buildings valued at £102,000 with a 2% rate?

Depreciation = £102,000 x 2% = £2,040.

What is the depreciation charge for machinery valued at £65,000 with a 20% rate?

Depreciation = (£65,000 - £6,500) x 20% = £11,700.

How is the depreciation for a computer valued at £9,000 calculated?

Depreciation = (£9,000 - £2,250) x 1/5 = £1,350.

What is the total depreciation charge for Uma Ltd's income statement?

Total depreciation = £2,040 (buildings) + £11,700 (machinery) + £1,350 (computer).

What is the significance of the distinction between revenue and capital expenditure?

It affects how expenses are recorded and impacts financial statements.

What is the impact of closing inventory on gross profit?

Closing inventory reduces cost of sales, thus increasing gross profit.

What is the formula for calculating gross profit when closing inventory is considered?

Gross Profit = Turnover - (Opening Inventory + Purchases - Closing Inventory).

What is the net book value (NBV) of non-current assets?

NBV = Cost - Accumulated Depreciation.

How do you determine the lower of cost and net realizable value for inventory?

Compare the cost price with the expected selling price and use the lower value.

What is the effect of a decrease in net realizable value on closing inventory?

Closing inventory is valued at the lower of cost or net realizable value.

What is the purpose of the income statement?

To summarize revenues and expenses to determine net income or loss.

What is the role of consistency in accounting?

To ensure financial statements are comparable over time.

What does prudence in accounting entail?

To recognize expenses and liabilities as soon as possible, but revenues only when they are assured.

What is the importance of understanding financial performance?

It helps stakeholders make informed decisions about the financial health of an organization.

What does the Statement of Financial Position (SoFP) represent?

A snapshot of the business's assets, liabilities, and equity at one point in time.

How is depreciation charged for buildings valued at £102,000 with a rate of 2%?

Depreciation charge = £(102,000 x 2%) = £2,040.

What is the depreciation charge for machinery valued at £65,000 with a residual value of £6,500 at a rate of 20%?

Depreciation charge = £(65,000 - 6,500) x 20% = £11,700.

How do you calculate the depreciation for a computer valued at £9,000 with a residual value of £2,250?

Depreciation charge = £(9,000 - 2,250) x 1/5 = £1,350.

What is an accrual in accounting?

An amount owing at the accounting period end for an expense incurred but not yet paid for.

What is a prepayment in accounting?

An amount paid by the accounting period end for an expense that the business has not yet benefited from.

What is the impact of a bad debt on financial statements?

It reduces profit and decreases trade receivables.

What is the formula for calculating total assets after taking out a long-term bank loan of £25,000?

Total assets = Previous total assets + £25,000.

How does issuing new ordinary shares affect the equity section of the Statement of Financial Position?

Increases cash, share capital, and share premium.

What is the total dividend paid if 21,000 shares are issued at 10p each?

Total dividend = 21,000 x 10p = £2,100.

How does revaluing non-current assets from £5,750 to £7,500 affect the financial statements?

Increases non-current assets by £1,750 and creates a revaluation reserve of £1,750.

What are the limitations of financial statements?

Includes revenue recognition issues, historic cost basis, estimates and judgments, and subjective accounting choices.

What are the different methods of inventory valuation?

FIFO (First In, First Out), LIFO (Last In, First Out), and AVCO (Average Cost).

What is creative accounting?

Techniques used to create an overly positive view of a company's activities and financial position.

What is the net book value (NBV) of buildings after accounting for depreciation?

NBV = Cost of buildings - Accumulated depreciation.

What is the effect of paying a dividend on cash and retained profits?

Decreases cash and retained profits by the total dividend amount.

What happens to current liabilities when an electricity expense accrual of £200 is recorded?

Current liabilities increase by £200.

How is the insurance expense adjusted for a prepaid amount of £300?

Decreases the insurance expense in the Income Statement.

What is the total equity after issuing new shares and paying dividends?

Total equity = Ordinary shares + Share premium + Retained profits after dividends.

What is the formula for calculating retained profits after paying dividends?

Retained profits = Previous retained profits - Total dividends paid.

How does a long-term bank loan affect the Statement of Financial Position?

Increases total assets and non-current liabilities by the loan amount.

What is the impact of a customer becoming bankrupt owing £500?

Increases bad debts by £500 and decreases trade receivables by the same amount.

What is the significance of the nominal value of shares?

It represents the minimum price at which shares can be issued.

What is the total assets calculation after all adjustments for Gerry Ltd?

Total assets = 43,000 + 25,000 + 2,000 - 2,100 + 1,750 - 500 = 69,150.