Understanding

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Understanding Managing Finance

• Seminar 5

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Seminar 5 - Activities

• Activities to prepare for the seminar
• From Week 4 M A Ex 2.6
• For this week
• P L Activity Spreadsheet
• M A ex. 3.8

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M A 2.6 Original Balance Sheet
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M A 2.6 Trans-actions
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M A 2.6 Revised Balance Sheet
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The Profit (or Loss) Equation
Explain each of the three different elements.
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The P L Account Headings

• Normally a Profit Loss Account will consist
  of
• Sales (Turnover)
• Less Cost of Sales
• Gross Profit
• Less Overheads
• Net profit
• Less Interest on Loans
• Profit Before Tax
• Less Tax
• Profit after Tax
• Less Dividends
• Retained profit for the year

What is meant by each heading?
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Some Issues

• Capital Revenue Costs
• Cost of Sales
• Valuation of Stocks
• Depreciation
• Bad Debt Provision
• Prepaid Expenses
• Accrued Expenses

Give a brief explanation of each of these issues.
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Capital Revenue Costs

• Capital Costs are incurred in purchasing assets
• Revenue Costs are incurred in delivering the
  goods or services and operating the company
• Capital Costs are not charged directly to the
  Profit Loss Account. They are reflected in a
  depreciation charge over their useful life.
• Accounting profit Revenue Income less Revenue
  Expenditure - Capital expenditure is only
  deducted from Accounting profit through
  depreciation
• To capitalise an item means to treat it as
  capital expenditure

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Cost of Sales (1)

• This is the cost of goods sold over a period.
• For retail and manufacturing companies this will
  mainly be the amount of stock throughput, and can
  be calculated by

• Opening stock level for the Period
• Amount of stock purchased during the period
• - Closing stock level for the Period
• Cost of materials during the Period

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Cost of Sales Example

• At the start of January, a small furniture
  retailer held 35,000 worth of stock. During the
  month, a further 12, 000 was bought in, and at
  the end of the month, the stock level was
  27,000.
• Calculate the cost of Sales for January.

Opening stock 35,000
Purchases 12,000 Total 47,000 less
Closing stock 27,000 Cost of
materials 20,000
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Cost of Sales (2)

• In service and some manufacturing industries, The
  cost of sales may also include other Direct
  Costs. These are costs directly incurred as a
  result of making the sale, manufacturing the
  item, or in carrying out the service.

• Direct Costs
• Cost of Materials
• Labour costs incurred
• Transportation costs
• Fuel other costs

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Stock Valuation

• Opening and Closing Stocks must be taken into
  account when calculating Direct Costs to in order
  to keep to the matching convention
• Where sales volume is high (or prices are
  standard) an average price may be used
• Manufacturing Companies may incorporate cost of
  manufacture into stock value (e.g. materials,
  power, labour)

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Stock Valuation Conventions

• Where stock is bought in at different times, from
  different suppliers and at different prices, the
  valuation of stock may be an issue.
• There are basically three conventions
• FIFO (First In First Out)
• LIFO (Last In First Out)
• AVCO (Weighted Average Cost)

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Stock Valuation Methods
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Stock Purchases and Sales

• Opening Stock Level 200 items _at_ 10 each
• Purchase 1 100 items _at_ 12 each
• Purchase 2 200 items _at_ 15 each
• Sales 400 items _at_ 20 each

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FIFO Stock Valuation Example

• Opening Stock Level 200 items _at_ 10 each
• Purchase 1 100 items _at_ 12 each
• Purchase 2 200 items _at_ 15 each
• Sales 400 items _at_ 20 each
• FIFO First in, First Out
• Items will be sold in the order in which they
  were bought.
• The 400 items sold will be made up of
• 200 items _at_ 10 each 2000 (prev. stock)
• 100 items _at_ 12 each 1200 (purch. 1)
• 100 items _at_ 15 each 1500 (purch. 2)
• Total Cost of Sales 4700

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LIFO Stock Valuation Example

• Opening Stock Level 200 items _at_ 10 each
• Purchase 1 100 items _at_ 12 each
• Purchase 2 200 items _at_ 15 each
• Sales 400 items _at_ 20 each
• FIFO First in, First Out
• Items will be sold in the reverse order of
  purchase.
• The 400 items sold will be made up of
• 200 items _at_ 15 each 3000 (purch. 2)
• 100 items _at_ 12 each 1200 (purch. 1)
• 100 items _at_ 10 each 1000 (prev. stock)
• Total Cost of Sales 5200

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AVCO Stock Valuation Example

• Opening Stock Level 200 items _at_ 10 each 2000
• Purchase 1 100 items _at_ 12 each 1200
• Purchase 2 200 items _at_ 15 each 3000
• Sales 400 items _at_ 20 each
• AVCO Weighted Average Cost
• An average cost will be calculated.
• All items sold will be charged at that cost.
• Total value of stock 2000 1200 3000
  6200
• Total no. of items 200 100 200 500
• Average value of stock 6200/500 12.40 per
  item
• Total Cost of Sales 400 _at_ 12.40 4960

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Depreciation

• Depreciation is the method used to spread the
  cost of a purchase (normally of a fixed asset)
  over a number of time periods (usually years)
• This is a way of charging to the business the
  cost of the asset, in a way which accounts for
  the wear and tear of the asset, and the fact
  that over time it is reducing in value.
• Depreciation is shown in the Profit Loss
  Account as an Overhead

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Calculating a depreciation charge

• The depreciation charge is calculated as a
  result of these four factors
• Initial Cost
• How long it will be used for
• What it will be worth at the end
• Calculation method

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Calculating an annual depreciation charge
Whatever method is used, the procedure is the
same
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Depreciation Methods

• There are two main methods used
• Straight-line depreciation Cost of item divided
  by number of years over which it is to be written
  off
• Reducing balance Current value x Depreciation

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Graph of written-down value against time using
the straight-line method
The same amount is used to reduce the asset
value each year.
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Graph of written-down value against time using
the reducing balance method
The amount used to reduce the asset value
decreases year on year.
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Depreciation calculation

• Purchase of a piece of equipment costing 10,000
• Straight-line over 5 years
  Reducing balance at 30
• Written down
  Written down
• Depreciation Value
  Depreciation Value
• Year 1 2,000 8,000
  3,000 7,000
• Year 2 2,000 6,000
  2,100 4,900
• Year 3 2,000 4,000
  1,470 3,430
• Year 4 2,000 2,000
  1,029 2,401
• Year 5 2,000 0
  720 1,681
• Year 6 0 0
  504 1,176

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The Problem of Bad Doubtful Debts

• Many businesses sell goods on credit. The revenue
  generated is recognised in accounts as soon as
  the goods are passed to the customer.
• As soon as this happens, the sale is recorded,
  and the amounts appear as Turnover on the P L
  account, and as Trade Debtors on the Balance
  Sheet.
• There is a risk that the customer will not, or
  cannot pay. If this occurs then this is called a
  bad debt and must be written off.
• This involves reducing debtors on the Balance
  Sheet, and creating an expense in the Overheads
  section for Bad Debt.

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Provision for Doubtful Debt

• In some enterprises the problem of bad debt is
  endemic, and it may not be possible to identify
  with certainty the amount of debt which is bad,
  or which will not be retrieved.
• In this case, the business will use past
  experience to estimate the amount of debt which
  might be lost in the accounting period.
• The Provision for Doubtful Debt is calculated as
  an estimate and this will be used to reduce
  debtors on the Balance Sheet, and create an
  expense in the Overheads section called
  Provision for Doubtful Debt.

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Prepaid Expenses

• Pre-paid expenses - goods or services which have
  been paid for in advance.
• When you eat in MacDonald's, they require you to
  pay up front before you get the food. At the
  point at which you have paid, before you get your
  meal. This is a prepaid expense.
• Prepaid expenses are things like rent rates
  paid in advance, as well as some consultancy
  fees.

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Accrued Expenses

• Accrued expenses - any amount which the
  organisation owes for expenses already consumed
  but for which a bill has not been yet received or
  paid
• When you eat in a posh restaurant they
  normally provide you with the food, then present
  you with the bill at the end. At the point at
  which you have eaten the meal, but not paid, this
  is an accrued expense.
• Accrued expenses are things like tax, dividends,
  wages and fuel bills.

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P L Example Spreadsheet
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P L Example Solution Part 1
January Stock Take figure
Total of all Purchases for February
February Stock Take figure
Opening Stock Purchases - Closing Stock
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P L Example Solution Part 2
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P L Example Solution Part 2
Total of all Sales for February
Total of Wages, Gas/Electric, Rent/Rates,
Petrol for February
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M A Ex 3.8 P L Account
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M A Ex 3.8 Points to note
Increase in Sales Value Gross profit
Increase in Salaries Distribution Costs
Increase in Bad debts
Decline in Net Profits
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M A Ex 3.8 Analysis

• There has been an increase in turnover Gross
  profits
• There has not been a corresponding increase in
  net profits because
• There has been a significant rise in overheads
• Increase in sales achieved only through greater
  marketing effort
• Increase in bad debt suggest that sales being
  offered to poor credit risk customers
• This seems to mark a sales policy shift from the
  previous year, and has not been successful.