Understanding & Managing Finance Seminar 5

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

M & A 2.6 Original Balance Sheet

M & A 2.6 Trans-actions

M & A 2.6 Revised Balance Sheet

The Profit (or Loss) Equation Profit (loss) Total expenses incurred in generating the revenue less equals Total revenue Explain each of the three different elements.

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?

Give a brief explanation of each of these issues. 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.

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

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

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

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

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)

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)

Stock Valuation Methods Three methods First in, first out (FIFO) Last in, first out (LIFO) Weighted average cost (AVCO)

Stock Purchases and Sales Opening Stock Level 200 items @ £10 each Purchase # 1 100 items @ £12 each Purchase # 2 200 items @ £15 each Sales 400 items @ £20 each

FIFO Stock Valuation Example Opening Stock Level 200 items @ £10 each Purchase # 1 100 items @ £12 each Purchase # 2 200 items @ £15 each Sales 400 items @ £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 @ £10 each £2000 (prev. stock) 100 items @ £12 each £1200 (purch. #1) 100 items @ £15 each £1500 (purch. #2) Total Cost of Sales: £4700

LIFO Stock Valuation Example Opening Stock Level 200 items @ £10 each Purchase # 1 100 items @ £12 each Purchase # 2 200 items @ £15 each Sales 400 items @ £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 @ £15 each £3000 (purch. # 2) 100 items @ £12 each £1200 (purch. # 1) 100 items @ £10 each £1000 (prev. stock) Total Cost of Sales: £5200

AVCO Stock Valuation Example Opening Stock Level 200 items @ £10 each £2000 Purchase # 1 100 items @ £12 each £1200 Purchase # 2 200 items @ £15 each £3000 Sales 400 items @ £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 @ £12.40 = £4960

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

Calculating a depreciation charge Factors to be considered Cost of the asset Useful life of the asset Residual value of the asset Depreciation method 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

Calculating an annual depreciation charge less Residual value equals Cost Depreciable amount Annual depreciation charge Year 1 Year 3 Year 2 Year 4 and so on Whatever method is used, the procedure is the same:

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%

The same amount is used to reduce the asset value each year. Graph of written-down value against time using the straight-line method Written-down value (£000) Asset life (years) 10 20 30 40 1 2 3 4 The same amount is used to reduce the asset value each year.

The amount used to reduce the asset value decreases year on year. Graph of written-down value against time using the reducing balance method Written-down value (£000) Asset life (years) 10 20 30 40 1 2 3 4 The amount used to reduce the asset value decreases year on year.

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

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.

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.

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.

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.

P & L Example Spreadsheet

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

P & L Example – Solution Part 2

P & L Example – Solution Part 2 Total of all Sales for February Total of Wages, Gas/Electric, Rent/Rates, Petrol for February

M & A Ex 3.8 P & L Account

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

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.