Open Stock 15,000
(163,000)
Gross Profit 12,000
Operating Expenses
Depreciation –Assets (Note: 8) (2,300)
(2,300)
Operating Profit 9,700
Interest – Bank loan (Note: 9) (1,176)
Profit before tax (or net reported profit) 8,524
Taxation (Note: 10) (2,120)
Profit after tax 6,404
Dividends (0)
Profit retained 6,404
Please Note:
The brackets for outflows are listed as outflows.
Assumptions:
- Stock Value – Cost of the stocks have been reduced by £10k (£25k – 10K) therefore saving is reflected in the income statement.
Background calculations for the Income Statement
Note: 6 Cash Sales working:
Sales Total for the year: £175,000
80% paid cash
80/100 * £175,000 = £140,000
Note: 7 Account Sales working
Sales Total for the year: £175,000
20% pain non cash (on account)
20/100 * £175,000 = £35,000
Note: 8 Depreciation – Assets working:
Fixed assets = £23,000
Yearly Depreciation = 1/10
Therefore 1/10 * £23,000 = £2,300
Note: 9 Interest – bank loan working:
Bank interest 7%
Long term loan: £21,000
£21,000/10 = £2,100 * 2 = £4,200
£21,000 - £4,200 = £16,800
£16,800 * 7% = £1,176
Note 10: Taxation working:
Profit before tax = £6424
Tax = 33%
£6,424 * 33% = £2120
Balance Sheet -Vertical Format
Liz & Sophie Balance Sheet for the year ending at 31st Dec 2008
£ £ £
Fixed Assets
Net book value (Note: 11) 16,100
Current Assets
Debtors (Note: 12) 35,000
Stock year end 25,000
Cash 891
60,891
Current liabilities
Less
Taxation-payable (2,120)
Creditors (Note: 13) (16,667)
(18,787)
Net working capital 42,104
Net Assets 58,204 =====
Shareholders’ funds
Owners capital 35,000
Retained profit 6,404
41,404
Long term liability
Bank Loan (Note: 14) 16,800
58,204 =====
Please Note:
The brackets for outflows are listed as outflows.
Assumptions:
- Long term loan £2,100 - I take this to mean that loan took out on year 2006 and first payment due in 2007 second payment in 2008 and third will be in Jan 2009. Therefore the long term liability is still £16,800.
-
Assumed fixed asset was purchased on 1st Jan 2006
Background calculations for the Balance Sheet
Note 11: Fixed Assets Working:
Based on the assumption fixed asset was purchased on 1/01/06
Fixed assets original value = £23,000
Depreciation 1/10*£23,000 = £2,300
Note 12: Debtors working:
Sales Total for the year 2008: £175,000
20% pain non cash (on account)
Therefore 20/100 * £175,000 = £35,000
Note 13: Products purchased working:
Products purchased year 3: £100,000
Paid for year 3: 10/12 months
10/12*£100,000 = £83,333
Therefore creditors paid for next year: 2/12 months
2/12*£100,000 = £16,666 – current liabilities
Note 14: Long Term Liability working
Long term loan: £21,000
£21,000/10 = £2,100 * 2 = £4,200
£21,000 - £4,200 = £16,800
This is also represented in table format.
Main difference between a Cash flow Statement and an Income statement using four example:
The cash flow statement shows, what is actually flow in and out of the organisation during the relevant period, for example one year. Cash flow statement is nothing to do with profit.
The income statement for Liz and Sophie show a positive figure £6,404 as a profit retained for the accounting period year end 2008. It shows that business made profit in terms of cash due to the fact that income statement is made by assumptions. For example income statement shows that taxation is paid £2,120 paid hence the profit figure will be different where as in the cash flow statement the transaction will be recorded after this event taken place.
The essential features of the cash flow statements are:
- Only deals with cash payments and receipts
- Only record when they happen during that period
- Only takes accounts of transactions during the relevant period rather than original transactions took place or will take place.
- It shows actual cash available for the organisation at given time, and answer the question, can we pay the bills today and what is the bank balance today?
One of the most common reason there is a difference over cash flow and profit is the difference in timing between the making of a sale and actually receiving the money.
On other hand the income statements try to match the organisation’s costs with the sales revenue which it generates. Therefore the cost of the sales and other expenditure should match the sales revenue for the given time. In other words the costs only recognised when sales contact is agreed and in place and the amount of costs recognised is proportion to the amount of sales.
Example one:
Account sales for year 2008 in Liz and Sophie, sales recognised for the 12 months as £175,000 but only £140,000 reflected in the cash flow statement. Whereas in the income statement reflected the total sales as £175,000.
Account sales working:
Sales Total for the year: £175,000 – Income Statement
80% paid cash £140,000 – Cash flow statement
The income statement is prepared based on the accruals/matching concept. Whereas cash flow show actual moment of the cash into and out of the organisation during the particular period of time.
Example two:
Account purchases for year 2008 in Liz and Sophie, income statement shows the materials cost related to sales is £100,000. Whereas the cash flow statement shows £83,333.
Product purchased working:
Products purchased year 3: £100,000 – Income Statement
Paid for year 3: 10/12 months
10/12*£100,000 = £83,333 – Cash flow Statement
Paid for next year: 2/12 months
2/12*£100,000 = £16,666 – Outstanding
Again income statement based on accruals/matching concepts. Whereas cash flow shows actual movement of the cash out flow. As £16,666 is outstanding but not reflected in the cash flow statement but this is included in the income statement because of the accruals concept.
Example three:
Taxation is used for year 2008 in Liz and Sophie, is recognised in the income statement but not in the cash flow statement as it will paid next year.
Taxation working:
Profit before tax = £6424
Tax = 33%
£6,424 * 33% = £2120 – Income Statement
Whereas the cash flow statement only takes accounts of transactions during the relevant period rather than transactions that will take place.
Example 4:
The depreciation used for the fixed assets in Liz and Sophie is included in the income statement, because the income statement includes non cash items such as depreciation. Whereas in the cash flow statement will not show the depreciation because it is a non cash item.
Depreciation – Assets working:
Fixed assets = £23,000
Yearly Depreciation = 1/10
Therefore 1/10 * £23,000 = £2,300 – Income Statement
Accounting Treatment (conventions/standards_ effect on the profit figure
There are several important of fundamentals of accounting concepts and conventions. The most fundamental concepts are Prudence, Accruals, Going concern, consistency, and materiality and there are others. These concepts are important and must take into consideration when preparing accounts. This is because treatment of accounting is different from one another.
Going Concern Concept:
The going concern means that business must have intention to run at least for more than one year and there is no intention to put the company into liquidation. For example when preparing for the accounts for Liz and Sophie, accounting always assumes that business will continue to operate for longer period of time. This means you must do account preparation to continue the business as normal.
Unless if the Liz and Sophie cloths trading was going to be sold for whatever reason. Suppose for an argument say Liz and Sophie trading was treated as their business going to be closed after their financial records produced for 2008 then the value of the asset will be relevant than the going concern concept. The important factor of going concern concept is asset of Liz and Sophie business should not be valued at their breakup value which is the value it will fetch if the business gone into liquidation.
In actual fact Liz and Sophie write off their fixed assets each year. This is shown after the gross profit as a operating expenses as depreciation in the Income statement before tax paid. This expense called depreciation but it is not an actual cost although this is a provision to reduce the book value of the asset.
An example of going concern concept can be used as Liz and Sophie fixed assets are depreciated over the ten years and the original cost of the asset were £23,000. The yearly deprecation is 1/10 of the original cost.
Fixed assets original value = £23,000
Depreciation 1/10*£23,000 = £2,300 normal write off value
Therefore deprecation cost of £2,300 will be charged. Applying the going concern concept assumes that Liz and Sophie will continue their trading and asset will be used for the full 10 years. Therefore net book value of this asset is shown its cost less of the accumulated amount of depreciation charged up to year 2008 as shown below.
As far as Going concern concept means asset will be used throughout the life of ten years and will not be sold for the foreseeable feature.
Prudence Concept:
The prudence concept means that if you are not realised the profit then you cannot apply this on the accounts. Basically you will state actual selling cost rather than predicted selling cost. It is important to show accounts records lower amount or actual amount rather than higher amount. This is to record all the losses on the account rather than recoding the predictable profits on accounts.
An example in Liz and Sophie accounts records indicates that it has £35k of debtors. It is possible that some of debtors may not pay all of the money and therefore Liz and Sophie may make a provision for bad debts. This can be shown on the account records as irrecoverable costs. This sort of bad debts must reflect on the income statement as matter of prudence.
Example: Liz and Sophie sell cloths for £175K and outstanding debts are £35K. Assume is doubtful if £15K will be ever paid. The Liz and Sophie make a Provision for bad debts of £15K. However, the full value of sales £175k will be shown in the income statement although the provision for bad debts will be charged at £15K. Therefore the uncertainty of the sales not being realised in the prudence concept and this suggest that £15k should not be included in the profit of the year.
The consistency concept
Different account procedures can affect the income statement depending on the accounting conventions/standards we use. Therefore consistency concept suggests same treatment should be applied from period to another for same items. This would enable to make a value comparison from one period to another. Constantly changing profits will lead to an invalid account records for the business. Therefore in the consistency is important concept for the accounts for a business to flow a standard method.
For example, in Liz and Sophie the method of depreciation is used as straight line method for the asset they purchased in year 2006 as shown below:
Example of calculating straight line depreciation
Fixed assets original value = £23,000
Depreciation 1/10*£23,000 = £2,300
Therefore in business they cannot suddenly decide to change this method to reducing balance method, as this will directly impact the account records as shown below.
Example of calculating reducing balance method depreciation
Fixed assets original value = £23,000
Depreciation 1/10*£23,000 = £2,300
This shows that deprecation is higher in 2006 and lower in the later year.
The both example shows different profit figures on depending on the method of accounting conventions/standards for calculating the depreciation.
Another example to show where consistency is rather important:
The calculation for the bank interest payment is based on information provided in Liz and Sophie that interest is only paid after two years of repayment. Therefore the treatment of calculating the bank interest will vary depending on the agreement with lenders thus the profit figure will be different in the income statement.
Interest – bank loan working:
Bank interest 7%
Long term loan: £21,000
£21,000/10 = £2,100 * 2 = £4,200
£21,000 - £4,200 = £16,800
£16,800 * 7% = £1,176
The above workings shows that interest calculated after two years of repayment. The interest rate we choose on the loan will effect on the profit figure. For example Liz and Sophie used 7% of the loan whereas if the rate is different for example 11% of the value then this would make difference to the profit figure.
The above working is based on the residual loan which is the standard was chosen. However the interest could have been calculated based on the original loan and this would affect the profit figure.
