ACCT1200(18) Lecture and Tutorial 6 Profit and Loss Account PDF

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LaiACCT1200/18 (lecture 6) ADA University, School of Business ACCT1200 Principles of Financial Accounting, Spring Semester 2018 Lecture 6 – Profit and Loss Account o Recollection – after preparation of the trial balance and making end-of-the-period adjustments, the next stage in the accounting cycle is the closing of certain accounts (predominantly but not exclusively revenue and expense accounts) followed by the preparation of the profit and loss account (P&L Account). o Actually the two stages (closing of accounts and the preparation of the profit and loss account) are done simultaneously. The profit and loss account is part of the double -entry system, thus entries made in the profit and loss account will have to comply with the double-entry / debit and credit rules. o For example, the sales account will be closed by debiting it and crediting the P&L account. o For example, the purchases account will be closed by crediting it and debiting the P&L account.

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Formats: o The format used in preparing the P&L account as discussed in the previous paragraph is known as the T-account or horizontal format. The profit and loss account is more commonly prepared in vertical format. As a matter of fact, virtually all companies use the vertical style to prepare their published financial statements for inclusion in the annual reports or for external use - the reason being the external users find it easier to comprehend the P&L Account and balance sheet in vertical than in horizontal format. Thus, we will only be “focusing” on the vertical style of preparing the P&L account in this lecture. o There are several versions (formats) in which the financial statements can be prepared. For example, in the UK, the Companies Act allows 4 formats which can be used to prepare the P&L Account. In addition, FRS3 (Financial Reporting Standard 3) – Reporting Financial Performance, requires a slightly different format to those permitted in the Companies Act. The format indicated below is a “hybrid” of the formats required by the UK Companies Act and FRS3 and should be acceptable for internal use and “examination purposes”.

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Reminder: o The basis for preparation of the profit and loss account is the matching principle which requires relevant costs to be matched with relevant revenues to determine the profit or loss of the accounting period: Revenue – expenses = profit (loss).

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LaiACCT1200/18 (lecture 6) For internal or management use General Ltd Profit and Loss Account for the year ended 31 December 2015 $ Sales Less: Returns Inwards (Sales Returns) Opening stock at 01.01.2015 Add: Purchases Less: Returns outwards (purchases returns) Add: Carriage inwards Less: Closing stock Cost of sales Gross profit Less: Distribution costs Wages and salaries (sales staff) Motor expenses (distribution) Rent, rates and insurance (distribution) General distribution expenses Advertising and sales promotion Depreciation – motor vehicles Carriage outwards Sales / marketing director’s remuneration Hire of motor vehicles Less: Administrative expenses Wages and salaries (office staff) Motor expenses (administration) Rent, rates and insurance (administration) General administrative expenses Bad debts Provision for bad and doubtful debts (increase) Or: Provision for bad and doubtful debts (decrease) Discounts allowed Auditors remuneration / fees Directors’ remuneration Depreciation - buildings / premises - motor vehicles - fixtures and fittings - equipment Discounts received

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X X (X) X X (X) X

$ X (X) X

(X) X

X X X X X X X X X

(X)

X X X X X X (X) X X X X X X X (X)

(X)

Add:

Other operating income Rent receivable Royalties / commissions receivable Operating Profit Add: Dividends receivable Bank deposit interest receivable Interest receivable from government / corporate securities Profit Before Interest and Tax (PBIT) Less: Bank overdraft interest payable Debenture interest payable Loan interest payable Profit on ordinary activities before tax (profit before tax) Less: Taxation Profit on ordinary activities after tax (net profit after tax) Less: Profit & Loss Appropriations: Ordinary share dividends - interim paid - proposed Preference share dividends - interim paid - proposed Transfer to General Reserve Retained profits for the year Add:

Profit and loss account (retained profits) as at 31.12.2014 b/f Profit and loss account (retained profit) c/f

X X

X X

X X X_ _________X X X X X (X) X (X) X X X X X X

(X) X X X

For publication / shareholders

Less: Less: Add:

Add:

Less: Less:

General Ltd Profit and Loss Account for the year ended 31 December 2015 $ $ Turnover X Cost of sales (X) Gross profit X Distribution costs X Administrative expenses X (X) Other operating income Rent receivable X Royalties / commissions receivable X X Operating profit X Dividends receivable X Interest receivable X_ _________X Profit Before Interest and Tax X Interest payable (X) Profit on ordinary activities before tax (profit before tax) X Taxation (corporate tax) (X) Profit on ordinary activities after tax (net profit after tax) X

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Less: Profit & Loss Appropriations: Ordinary share dividends - paid and proposed Preference share dividends – paid and proposed Transfer to General Reserve Retained profits for the year Add:

Profit and loss account (retained profits) as at 31.12.2014 b/f Profit and loss account (retained profit) c/f

X X X

(X) X X X

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Main sections of the P&L account: The P&L account of a trading company can be divided into 3 main sections: (a) Trading account – to calculate the gross profit (excess of sales over the cost of goods sold). (b) P&L account – to calculate the net profit (excess of gross profit and other revenues over all other expenses) (c) Profit and Loss Appropriation account – shows how the net profits are to be appropriated, used or distributed.

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Comments: o The items / accounts indicated above is not exhaustive, but are what can be commonly found in P&L accounts. o Some of the items that are to be classified as either distribution costs or administrative expenses may be obvious from their descriptions (example, salespersons’ commissions, administrative salaries). o Others are either less obvious or based on generally accepted conventions. For example, bad debts, provision for bad and doubtful debts, discounts allowed can be classified as either distribution or administrative expenses (depending on the locus of responsibility for each of these items). Warehouse expenses can be classified either under cost of sales or distribution (depending on their function – to make the goods into saleable condition or merely for distribution expenses). o Thus, there are no rigid rules about the format of the P&L account. o Frequently, examination questions require some items to be apportioned between distributive costs and administrative expenses (for example motor expenses, depreciation on motor vehicles, machinery or equipment). o If it is not possible to classify the expenses as either distributive or administrative, then just use the general classification “expenses” as in the example given below.

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LaiACCT1200/18 (lecture 6)

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Example: The following trial balance is extracted from the books of Seven Oceans Ltd as on 31 December 2015: Dr ($) Cr ($) 10% preference share capital 20,000 Ordinary share capital 70,000 10% debentures (repayable 2019) 30,000 Buildings at cost 95,000 Equipment at cost 8,000 Motor vehicles at cost 17,200 Provision for depreciation (accumulated depreciation) as on 01.01.2015: equipment 2,400 motors 5,160 Stock 01.01.2015 22,690 Sales 98,200 Purchases 53,910 Carriage inwards 1,620 Salaries and wages 9,240 Directors’ remuneration 6,300 Motor expenses 8,120 Rates and insurance 2,930 General expenses 560 Debenture interest 1,500 Debtors 18,610 Creditors 11,370 Bank 8,390 General reserve 3,000 Share premium account 10,000 Interim ordinary dividend paid 3,500 Profit and loss account 31.12.2014 7,440 257,570 257,570 The following adjustments are needed : (a) Stock at 31.12.2015 was $27,220. (b) Depreciate motors $3,000, equipment $1,200. (c) Accrue debenture interest $1,500. (d) Provide for preference dividend $2,000 and final ordinary dividend of 10 per cent. (e) Transfer $2,000 to general reserve. (f) Authorized share capital is $20,000 in preference shares and $100,000 in ordinary shares. (g) Provide for corporation tax $5,000.

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Required: Prepare a profit and loss account for the company for the year ended 31 December 2015 for internal use in vertical format. LaiACCT1200/18 (lecture 6) Reminder: a useful rule to remember when preparing the financial statements is that those accounts (appearing in the trial balance and after adjustments) which are revenue and expense accounts will be used for the preparation of the P&L account while asset, liabilities and capital accounts will be used in the preparation of the balance sheet For internal use only, not for publication Seven Oceans Ltd Profit and Loss Account for the year ended 31 December 2015 $ $ $ Sales 98,200 Less Cost of goods sold: Opening stock 22,690 Add Purchases 53,910 Add Carriage inwards 1,620 78,220 Less Closing stock (27,220) (51,000) Gross profit 47,200 Less Expenses Salaries and wages 9,240 Motor expenses 8,120 Rates and insurances 2,930 General expenses 560 Directors’ remuneration 6,300 Depreciation - motor vehicles 3,000 - equipment 1,200 (31,350) Operating Profit (Profit Before Interest and Tax) 15,850 Less: Debenture interest (3,000) Profit on ordinary activities before tax 12,850 Less: Corporation tax (5,000) Profit on ordinary activities after tax 7,850 Less: Profit & Loss Appropriations: Ordinary share dividends - interim paid 3,500 - proposed 7,000 10,500 Preference share dividends - proposed 2,000 Transfer to General Reserve 2,000 (14,500) Retained profits for the year (6,650) Add: Profit and loss account (retained profits) as at 31.12.2014 b/f 7,440 Profit and loss account (retained profit) c/f 790 Readings:  Sangster, A; Frank Wood’s Business Accounting 1, 13th edition, 2015, Pearson, chapters 7, 9, 45. 6

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Leiwy, D and Perks, R; “Accounting: Understanding and Practice”, 4th edition, 2013, McGraw-Hill Education, chapter 2. LaiACCT1200/18 (lecture 6)

Glossary of terms used in this lecture:  Ordinary shares – holders of ordinary shares are entitled to vote and to a share of the profits in the form of dividends if these are declared by the directors. Dividends on ordinary shares are not fixed in advance, they normally vary according to the profits made by the company, in years of losses no dividends will normally be paid.  Preference shares – holders of preference shares have no voting rights, but their dividends must be paid first before any dividend can be paid on ordinary shares. Dividends on preference shares are fixed in advance, but their payment is still subject to the decision of the directors.  Dividends - both the dividends of ordinary and preference shares are commonly expressed as a percentage of the par or nominal values of the shares. For example, 8 % preference shares with a par value of $1 per share carry an annual dividend of 8 cents per share if they are paid. 8 % preference shares with a par value of $0.50 per share carry an annual dividend of 4 cents per share if they are paid. o Companies pay dividends twice a year – an interim and a proposed final dividend.  Interim dividends are paid based on the results of the first 6 months of the financial year and would already have been paid by the balance sheet date (thus it will appear in the trial balance).  The final dividend is proposed based on the results of the full financial year, thus it would normally still be outstanding at the balance sheet date and will appear as a current liability in the balance sheet.  Par value – the nominal or paper or face value of the shares (this is to be distinguished from the market value of the shares. The par value of shares can be any value ($0.52 for example) but the more common are $1.00 and $0.50. In the balance sheet, shares must be recorded at par or nominal values. Companies often issue shares at prices exceeding the par values. Any payment in excess of par value made by shareholders will be recorded under a different account called the share premium account.  Authorized share capital – the maximum nominal value or number of shares which the company is allowed to issue to shareholders.  Allotted or issued share capital – the total nominal value of the number of shares that have actually been issued at the date of the balance sheet. Will equal authorized share capital if all of the authorized share capital has been issued.  Paid-up capital – the amount of share capital which has been paid for by shareholders.  Debentures or loan stocks – loans to a company which carry a fixed rate of interest based on the nominal value. For example, 10 percent debentures with a nominal value of $1,000 each carry an annual interest of $100 per debenture certificate.  Bonds / secured debentures – these are debentures which are “secured” against specific fixed assets owned by the company, that is, in the event the company cannot pay back the principal, the bondholders possess the “rights of ownership” to the fixed assets which can then be disposed off to settle the amount owing to the lenders.

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o Unlike dividends, interest on debentures and bonds must be paid. Another difference is interest on debentures and bonds is an expense charged against profit, whereas dividends constitute an appropriation of profit. LaiACCT1200/18 (lecture 6)

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o Common nominal values for debentures / bonds are £100 or USD1,000. Turnover – sales minus returns inwards. Reserves – these are transfers from the retained profit to be reserved or earmarked for specific uses in the future such as the replacement of fixed assets (in this case an amount would be transferred to the fixed assets replacement reserve account. The reason of the transfer may not be specific, in this case an amount would be transferred to a general reserve account. Reserves may also have been transfers from the capital of the company (for example the share premium account) or created by statutory requirement. Reserves may be classified into distributable (revenue) or non-distributable (capital) reserves. Distributable or revenue reserves – these are reserves which can be used to pay dividends to shareholders such as the profit and loss account (retained profits) or the general reserve account. Non-distributable or capital reserves – these are reserves which cannot be used to pay dividends to shareholders such as the share premium account or the fixed assets replacement reserve account. Revaluation reserve – this is a reserve created when fixed assets such as land and buildings are revalued at a value exceeding historical cost. At cost – at historical cost. At valuation – at the revalued amount. Listed investments – company’s investments in the shares of other companies listed on the stock exchanges (shown as a current asset in the balance sheet).

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LaiACCT1200/18 (Tutorial 6)

ADA University, School of Business ACCT1200 Principles of Financial Accounting, Spring Semester 2018 Tutorial 6 – Profit and Loss Account

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Issue 1: The trial balance of Tamurlane Co. as at 31 December 2013 is as follows: Dr. ($) Cr.($) Preference share capital: $1 shares 50,000 Ordinary share capital: $0.50 shares 60,000 Share premium 13,600 General reserve 45,000 Profit & Loss account as on 31.12.2012 19,343 Stock: 31.12.2012 107,143 Sales 449,110 Return inwards 11,380 Purchases 218,940 Carriage inwards 5,571 Wages and salaries: sales staff 28,161 Wages and salaries: administrative staff 74,500 Motor expenses (see note ii) 16,400 General distribution expenses 8,061 General administrative expenses 7,914 Debenture interest 10,000 Commissions receivable 4,179 Directors’ remuneration 18,450 Bad debts 3,050 Discounts allowed 5,164 Discounts received 4,092 Plant & machinery at cost (see note iii) 175,000 Accumulated depreciation: Plant & machinery 58,400 Motor vehicles at cost (see note ii) 32,000 Accumulated depreciation: motor vehicles 14,500 Goodwill 45,820 Trade debtors 78,105 Trade creditors 37,106 Bank overdraft 10,329 Debentures (redeemable in 5 years) 80,000 845,659 845,659

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LaiACCT1200/18 (Tutorial 6) Notes: (i) Closing stock on 31 December 2013: $144,081. (ii) Motor expenses and depreciation on motors to be apportioned: Distribution ¾, Administrative ¼. (iii) Plant and machinery depreciation to be apportioned: Distribution 3/5th ; Administrative 2/5th (iv) Motor vehicles to be depreciated 25 percent and plant & machinery 20 percent straight-line. (v) Accrued corporation tax on profits of the year is $14,150, payable 1 October 2014. (vi) A preference dividend of $5,000 is to be paid and an ordinary dividend of $10,000 is to be proposed. (vii) Goodwill will not be amortized. Required: Prepare the profit and loss account for Tamurlane Co. for the year ended 31 December 2013 in vertical format and for internal use. 

Issue 2: The following is the trial balance of Silk Road Ltd as on 30 June 2015: Dr ($) Authorized and issued share capital: 25,000 ordinary shares of $1 each 25,000 10 per cent preference shares of $1 each Stock as at 30 June 2014 Trade debtors / creditors 10 per cent debentures Fixed assets replacement reserve

76,590 53,780

General reserve

Cr ($) 25,000 25,000

24,620 40,000 20,000 12,000

Profit and loss account as at 30 June 2014 Interest on debentures Equipment at cost Motor vehicles at cost Bank Cash Purchases / Sales Returns inwards Carriage inwards Wages and salaries

7,928 2,000 70,000 57,000 7,286 360 82,700 2,300 480 20,720

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199,000

Rent, rates and insurance Discounts allowed Directors’ salaries Accumulated depreciation at 30 June 2014: Equipment Motor vehicles

10,340 2,492 5,000 16,800 _ 20,700 391,048 391,048 LaiACCT1200/18 (Tutorial 6)

Further information : (a) Stock at 30 June 2015 is valued at $98,742. (b) The preference share dividends are outstanding at the end of the year and a final dividend of 20 per cent (or 20 cents per share) has been proposed on the ordinary shares. (c) Accrued rent $1,400; directors’ salaries $5,000. (d) Debenture interest ½ year’s interest owing. (e) Depreciation on cost: equipment 10 per cent; motor vehicles 20 per cent. (f) Corporation tax is 20 per cent. (g) Transfers to reserves: general reserve $4,000; fixed assets replacement reserve $2,000. Required: Prepare the profit and loss account of Silk Road Ltd for the year ended 30 June 2015 in vertical format and for internal use.

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