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Module 2ModuleModuleModule 222 The Profit and Loss AccountThe Profit and Loss Account Omar ElKheshen – kheshen@gmail.com 1
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Learning Objectives By the end of this module you should understand: 1. The role of the profit and loss account in the measurement of corporate accomplishment and effort 2. The timing of revenue and expense and the role of accounting conventions 3. The impact on profit of different stock valuation methods and depreciation methodsmethods 4. The principal features of depreciation 5. The distinction between product costs and period costs 6. The implications of ‘gross profit’ and ‘net profit’ Omar ElKheshen – kheshen@gmail.com 2
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Agenda 2.1 Introduction 2.2 What Is Profit? 2.3 The Measurement of Accomplishment 2.4 Another Reason for Opting for ‘Ship and Invoice’ 2.5 Conventions Underlying Measurement of Sales Accomplishment 22..66 The Measurement of EffortThe Measurement of Effort 2.7 Task One: Determining the Consumption of the Means of Production 2.8 Task Two: Determining the Value of Closing Work-in-Progress and Inventories 2.9 Types of Inventory in a Manufacturing Company 2.10 Inventory Valuation Methods 2.11 Valuation of Work-in-Progress and Finished Goods 2.12 Interpreting Profit Review Questions Omar ElKheshen – kheshen@gmail.com 3
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Over the next two modules we shall be examining the 3 financial statements in greater depth You Will Become Aware of: Where the underlying information in these statements comes from The conventions employed by accountants in constructing the statements The various techniques used to measure aspects of business activity Omar ElKheshen – kheshen@gmail.com 4
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We will use the profit and loss account and balance sheet of the sole trader encountered in Module 1 to further explain those three concepts Profit and Loss Account For the Period Actions 1–7 Sales € 750 Fixed assets Less: Cost of sales Materials € 500 Plant and equipment at cost € 12,000 Labour 20 Less: Depreciation 50 € 11,950 Depreciation 50 570 Current assets Gross Profit 180 Inventories 5,500 Less:Less: Selling and administrative costsSelling and administrative costs Debtors 750 Advertising 10 Cash 4,960 Salaries 10 20 11,210 Net Profit € 160 Less: Current liabilities Creditors 3,000 8,210 Net assets of the company 20,160 Represented by: Capital introduced 20,000 Profits earned € 160 Owners’ equity 20,160 Omar ElKheshen – kheshen@gmail.com 5
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Agenda 2.1 Introduction 2.2 What Is Profit? 2.3 The Measurement of Accomplishment 2.4 Another Reason for Opting for ‘Ship and Invoice’ 2.5 Conventions Underlying Measurement of Sales Accomplishment 22..66 The Measurement of EffortThe Measurement of Effort 2.7 Task One: Determining the Consumption of the Means of Production 2.8 Task Two: Determining the Value of Closing Work-in-Progress and Inventories 2.9 Types of Inventory in a Manufacturing Company 2.10 Inventory Valuation Methods 2.11 Valuation of Work-in-Progress and Finished Goods 2.12 Interpreting Profit Review Questions Omar ElKheshen – kheshen@gmail.com 6
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Profit is the difference between the sales that were made and the sum of costs which have been incurred to bring the goods sold ready for sale Profit = Sales - Costs Direct costs of manufacture Indirect costs Raw materials Advertising Wages of workforce involved Salaries of service support in the transformation process staff Depreciation (costs of using up the equipment) Profit serves as the prime indicator of overall effectiveness Omar ElKheshen – kheshen@gmail.com 7
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The main purpose of the profit and loss account is to show the results of the transformation process over a given period of time Transformation Process The functions that are necessary to convert raw materials into a saleable product. Accomplishment: Sales Revenue Storage less TransformationTransformation Efforts:Efforts: Costs Storage equals Purchase Profit Figure 2.1 Accomplishments less Efforts Is the difference between a measure of accomplishment (what has been Profit achieved in sales) and a measure of effort (what these sales have cost). Omar ElKheshen – kheshen@gmail.com 8
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Agenda 2.1 Introduction 2.2 What Is Profit? 2.3 The Measurement of Accomplishment 2.4 Another Reason for Opting for ‘Ship and Invoice’ 2.5 Conventions Underlying Measurement of Sales Accomplishment 22..66 The Measurement of EffortThe Measurement of Effort 2.7 Task One: Determining the Consumption of the Means of Production 2.8 Task Two: Determining the Value of Closing Work-in-Progress and Inventories 2.9 Types of Inventory in a Manufacturing Company 2.10 Inventory Valuation Methods 2.11 Valuation of Work-in-Progress and Finished Goods 2.12 Interpreting Profit Review Questions Omar ElKheshen – kheshen@gmail.com 9
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Products must be SHIPPED and INVOICED to a customer before they are included in the measurement of accomplishment Example What can be considered as a measure of accomplishment in the transformation process in an accounting period? Total production for one accounting period of Product ABC: 300 units. Number of Product ABC shipped and invoiced to customers: 250 units. The difference between both: Products which have been Producedproduced but not soldNot Sold at the end of the period These products are to be stored in the warehouse. The shipped and invoiced products (250 units) are considered as the measurement of accomplishment Omar ElKheshen – kheshen@gmail.com 10
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The events of shipping and invoicing the products are more critical in measuring accomplishment than total production Shipped & Invoiced Products Total Production X Business is certain that: Business is uncertain that: Customers accepted Customers will accept the productsthe products finished products in thefinished products in the warehouse thus: thus: They are liable to Selling price is pay for them still uncertain Omar ElKheshen – kheshen@gmail.com 11
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Measurement of Accomplishment differs from one company to another according to each one’s operation South African Gold Mine Ice Cream Seller Occurs at the point when: Occurs at the point when: The gold is extracted from the rock He receives money for ice cream cone They can be assured of selling it Uncertainties about making an within a predictable price range earlier recognition of accomplishment World demand for gold is so buoyant Omar ElKheshen – kheshen@gmail.com 12
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Accomplishment is generally measured at the first point in the operating cycle at which the 3 following conditions are satisfied The principal revenue-producing service has been performed, i.e. the 1 product has been made and delivered against a firm order. All costs that are necessary to create the revenue have either been 2 incurred or accurately predictable TheThe amount collectableamount collectable in cash can bein cash can be estimatedestimated within an acceptablewithin an acceptable 33 range of error Shipping and invoicing is the most popular measure of accomplishment because: In most cases it is the first point in the cycle at which all three criteria are met Omar ElKheshen – kheshen@gmail.com 13
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Three other methods for measuring accomplishment exist – the first is time of sale orders in which sales are recorded as soon as orders are received… Time of Sales Orders Useful in situations where: Example 1 A knitwear company received an order to The goods which areThe goods which are ordered are inordered are in inventoryinventory supply high-quality sweaters to the when the order iswhen the order is Britain/ Europe Ryder Cup golf team for receivedreceived their next match against the USA. 22 A firm order? Yes. All majorAll major costscosts havehave already been incurredalready been incurred A customer who will pay? Yes. Certain production costs? No. 3 The world price of cashmere is The number and timingThe number and timing volatile and may change of cancelled orders doof cancelled orders do significantly between order and notnot vary significantlyvary significantly delivery. Omar ElKheshen – kheshen@gmail.com 14
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…The second measure of accomplishment is time of production where sales are recorded as soon as products have been produced… Time of Production Consider this manufacturing company: Period 1 Period 2 Builds up inventories No manufacturing Makes no sales Sells the entire inventory Recognizing accomplishment in period 1 X Inventory of finished goods in the balance sheet for period 1 Cost of sales in the profit and loss account for period 2 Note In some industries like shipbuilding, civil engineering and construction, the time of production is acceptable when sales are certain following production Omar ElKheshen – kheshen@gmail.com 15
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Using the timing of production method of measuring accomplishment allows some companies to record profits when they occur Example Solution XY Construction plc is in the process of building a bridge linking two Scottish Year 1 Hebridean islands. The job will take two P&L Account years. Sales - Costs = Profit At the end of the first year, one-third of €4 Mio €3 Mio €1 Mio the contract of €12 million had been Balance Sheet completed, although the client had paidcompleted, although the client had paid only one-sixth, namely, €2 million. Debtors + €2 Mio The company expected to make €3 million profit on the bridge and at the Year 2 end of Year 1 costs were being incurred P&L Account on a predictably even basis. Sales - Costs = Profit How many sales and profits should XY €8 Mio €6 Mio €2 Mio recognize at the end of Year 1? Omar ElKheshen – kheshen@gmail.com 16
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A third method is time of collection in which accomplishment is recognized only when payment has been collected Why Is Time of Collection Sometimes a Critical Point in Measuring Accomplishments? It is a critical when: •The likelihood of receiving payment cannot be predicted accurately •There is a relatively high risk of reclaims of the merchandise because of non-payment. Companies that sell their products on installment plans Payment period is long Relatively small down Seller retains conditional payment is required title to the goods Here, revenue is recognized as the cash is collected Costs of the merchandise Inventory in Carried the balance Then transfer paid Cost of sales in the sold on installment To Amounts to P&L account sheet Omar ElKheshen – kheshen@gmail.com 17
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Accomplishments are conveniently measured when the products are invoiced unless there is a likelihood that the customers would not pay When Is a Sale a Sale? 6. Cash received 1. Enquiry Unnecessarily late unless there is Too early – order may not emerge. evidence that customer won't pay for goods. 2. Order 55. Invoice. Invoice Too earlyToo early –– costs too uncertain;costs too uncertain; About right – goods are normally customer may walk away before invoiced at the time of shipment. delivery. 4. Ship 3. Inventory of finished goods Too early – unsold goods may never sell. Also, the ultimate sales price may be unknown. Figure 2.2 A typical manufacturing cycle Omar ElKheshen – kheshen@gmail.com 18
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Agenda 2.1 Introduction 2.2 What Is Profit? 2.3 The Measurement of Accomplishment 2.4 Another Reason for Opting for ‘Ship and Invoice’ 2.5 Conventions Underlying Measurement of Sales Accomplishment 22..66 The Measurement of EffortThe Measurement of Effort 2.7 Task One: Determining the Consumption of the Means of Production 2.8 Task Two: Determining the Value of Closing Work-in-Progress and Inventories 2.9 Types of Inventory in a Manufacturing Company 2.10 Inventory Valuation Methods 2.11 Valuation of Work-in-Progress and Finished Goods 2.12 Interpreting Profit Review Questions Omar ElKheshen – kheshen@gmail.com 19
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Let’s go back and take a look at the example from module 1 Sales € 750 Fixed assets Less: Cost of sales Materials € 500 Plant and equipment at cost € 12,000 Labour 20 Less: Depreciation 50 € 11,950 Depreciation 50 570 Current assets Gross Profit 180 Inventories 5,500 Less: Selling and administrative costs Debtors 750 Advertising 10 Cash 4,960 SalariesSalaries 1010 2020 11,21011,210 Net Profit € 160 Less: Current liabilities Creditors 3,000 8,210 Net assets of the company 20,160 Represented by: All sales were on credit, he received Capital introduced 20,000 NO CASH for them at the time of sale Profits earned € 160 and until the end of the period. Owners’ equity 20,160 Omar ElKheshen – kheshen@gmail.com 20
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