AC105 AT W4 - 19/10/26, 12:00

How is gross profit calculated?

Gross profit = Cost of goods sold - Revenue

Operating profit

A profit from business operations (= Gross profit - Operating expenses) before deduction of interest and taxes

Profit before tax

Shows the profit made from the ordinary course of trading, less costs of finance.

How is net profit calculated?

Net profit (AKA Net income) = Total revenue - All company expenses

(basically just = Income - Expenses)

Revenue definition

Revenue is income arising in the course of an entity’s ordinary activities (eg. sales, fees, interest, dividends, royalties, and rent) / Revenue is gross inflow of economic benefits – cash, receivables & other assets -- resulting from its operations such as sale of goods and services

Gains definition

Gains represent other items that meet the definition of income (eg. gains from selling non-current assets)

What makes up income?

Revenue and gains

Revenue - principles for recognition (2)

• Entity has transferred promised goods or services to the customer

• Entity has received or is entitled to receive payment in exchange for promised goods or services

Point at which revenue is recognised (3)

• From the sale of goods (sales revenues): when goods are delivered and accepted by the customer

• Services: when services are provided

• Long-term contracts: as each distinct stage is completed

Expenses definition

Expenses are decreases in owner’s equity that arise when generating revenue. This definition encompasses losses as well as those expenses that arise in the course of the ordinary activities of the entity

What principles apply when recognising expenses? (2)

• Matching principle. Expenses are matched to the revenue that they help generate

• Conservatism or prudence principle. Recognise anticipated losses immediately, recognise anticipated gains only when they arise

What are adjusting entries?

Adjusting entries are accounting journal entries made at the end of the accounting period after a trial balance has been prepared. Accountants record financial transactions throughout the year as they occur. They receive documentation for each transaction, eg. invoices from suppliers. Adjusting entries update the financial records for events that have occurred, but no document for a transaction exists.

What transactions are adjusting entries done for? (2)

• Non-cash transactions – no cash coming in or going out

• Internal transactions

When are adjusting entries done?

At the end of the accounting period, after a trial balance has been prepared

Types of adjusting entries (4)

• Accruals/prepayments: expenses used but not yet billed, or paid but not yet used

• Depreciation: spreads the cost of a non-current asset over the periods that benefit from it

• Bad and doubtful debts: recognises expected losses on receivables in the same period as the related sales, which reflects matching and prudence

• Inventory: only the cost of goods sold becomes an expense, and the rest stays as an asset

  • Inventory write-downs

  • Cost of sales calculation

Cash basis vs. accrual basis accounting

• Cash basis accounting records only transactions with cash: cash receipts and cash payments. When cash is received, revenues are recorded. When cash is paid, expenses are recorded. As a result, revenues are recorded only when cash is received and expenses are recorded only when cash is paid.

• Accrual basis accounting records the effect of each transaction as it occurs—that is, revenues are recorded when earned and expenses are recorded when incurred. Revenues are considered to be earned when the services or goods are provided to the customers. Under accrual basis accounting, it is irrelevant when cash is received or paid.

Accrued expenses (2)

Expenses that have been incurred, but not yet recorded (not invoiced) i.e, services/goods received from suppliers, but payment has not been made yet

Prepaid expenses (2)

Future expenses that have been paid in advance, meaning cash has been paid, but services/goods have not been received yet

In which financial statement and as what do accrued expenses appear?

In the SOFP as current liabilities (as they are expenses which have been incurred but unpaid, therefore not true expenses)

In which financial statement and as what do accrued expenses appear?

In the SOFP as current assets (as they are expenses which have been paid in advance, therefore not true expenses)

Contra accounts

Special accounts that are established to reduce the balance in another account indirectly, which preserves the identity of the primary account

Why are contra accounts used for depreciation?

Contra accounts are used to record depreciation while keeping the value of the primary account at historical cost, in order to follow historical cost convention. This also allows users of the accounts to see both the accumulated depreciation and the original value.

What type of account is the contra account to non-current asset primary accounts?

Accumulated depreciation

What type of account is the contra account to trade receivable primary accounts?

Provision for doubtful debt

What type of account is the contra account to sales revenue primary accounts?

Sales returns

In which financial statement and as what does ‘cost of inventories held’ appear?

In the SOFP as current assets (and is phrased as ‘inventory‘)

In which financial statement and as what does ‘cost of inventories sold’ appear?

In the Income Statement as an expense (and is phrased as ‘cost of sales’)

Types of inventory systems (2)

• Perpetual inventory system

• Periodic inventory system

Perpetual inventory system

In a perpetual inventory system, companies keep detailed records of the cost of each inventory purchase and sale. Under a perpetual inventory system, a company determines the cost of goods sold each time a sale occurs.

Periodic inventory system

In a periodic inventory system, companies do not keep the detailed inventory records of the goods on hand throughout the period. Instead, they record all purchases made between physical inventory counts in a Purchases account, then determine the cost of goods sold (cost of sales) only at the end of the accounting period, by using the cost of sales formula.

Cost of sales formula

Cost of sales = Opening inventory + Purchases - Closing Inventory

Bad debt (3)

• A receivable that is irrecoverable (the customer will definitely not pay the company)

• Written off immediately

• Dr Bad debt expense (+ expense on income statement), Cr Trade receivables (- asset on statement of financial position)

Doubtful debt (4)

• A receivable that may not be paid

• This is an estimate made by the company, usually as a percent of the receivables, which is based off of past experience

• Recorded by creating a ‘Provision for doubtful debts‘ which is a contra account to trade receivables (as it reduces receivables indirectly while leaving the receivables account balance as it originally was)

• Dr Doubtful debt expense (+ expense on income statement), Cr Provision for doubtful debts (+ contra asset OR - asset on statement of financial position)

Doubtful debt expense vs. Provision for doubtful debts (2)

• DDE is a temporary account whereas PFDD is a permanent account

• Therefore DDE only records the movement (eg. increase/decrease) in the provision, whereas PFDD records the entire contra account value against trade receivables

What conventions do bad/doubtful debts link to? (2)

• Matching: the expense for customers who won’t pay belongs in the same period as the sales that created the receivables

• Prudence: you don’t overstate assets, therefore trade receivables shouldn’t be shown at a figure you don’t expect to collect

What type of account is ‘Provision for doubtful debt‘?

A contra asset account (NOT a liability)

Smoothing (in terms of doubtful debt)

When a company sets a high doubtful debt provision on years that it does well so that when they have a low performing year, they can reduce the provision and artificially inflate their income.