The Profit and Loss Account (2)

Aims & Objectives Aims: To look further at the construction of the profit and loss account. To introduce partnership accounts, and manufacturing and service sector accounts. Learning Outcomes: On completion of this section you should be able to: 1. Understand the need for provisions against certain current assets. 2. Understand the effect of the following on financial statements: carriage in and out, sales and purchases returns, discounts received and given. 3. Construct more complex financial statements including the effects of the above items 4. Describe and explain the differences between the profit and loss account layouts for manufacturing, trading and service businesses. 5. Understand the differences between sole trader and partnership accounts

Further adjustments to transactions to construct and profit and loss account The recognition of bad and doubtful debts The application of the prudence principle requires us to account for possible bad and doubtful debts. Bad debts are expensed to the income statement/profit and loss account in the period they become known and the balance sheet debtor figure is reduced by same amount Doubtful debts are accounted for by establishing a ‘provision for doubtful debts’ (a provision is an amount written off/retained to provide for a known liability of which the amount and or timing cannot be determined with substantial accuracy) An estimate is made of the % of debtors (after taking account of bad debts) who will not pay. The period change in this amount is expensed to the income statement/profit and loss account. The balance sheet debtors figure is reduced by the total of the provision.

Example 1 As at 31 July 20X1 Ash’s debtors total £397,700. Included in this is a debt of £17,000 owed by King. King has recently ceased trading and the debt will not now be paid. As a response to this situation Ash has also decided to make a general provision for doubtful debts of 3% of debtors. He has never previously made a provision against debtors. What will be the effect of the above on Ash’s income statement/profit and loss account for the year ended 31July 20X1 and balance sheet as at that date? Debtors £397,700 minus bad debts £ 17,000 - expense p&l = £380,700 minus closing provision required (x .03) £ 11,421 - expense p&l = £369,279 - final debtors balance sheet figure

Example 2 As at 31 July 20X2 Ash’s debtors total £436,000. He wishes to maintain the provision for doubtful debts at 3% of debtors. What will be the effect of the above on Ash’s income statement/profit and loss account for the year ended 31July 20X2 and balance sheet as at that date? Debtors £436,000 minus closing provision required (x .03) £ 13,080 = £422,920 final debtors balance sheet figure closing provision £ 13,080 minus opening provision 11,421 = increase in provision £ 1,659 = expense p&l

Further items in final accounts Carriage in Where the business pays for the carriage in (transport costs) of purchases made Recorded as an increase in the cost of purchases Carriage out Where the business pays for the carriage out (delivery costs) of sales made Recorded as an expense

Further items in final accounts Sales returns (returns in) Where goods sold by the business are returned Recorded as a reduction in the sales figure Purchases returns (returns out) Where goods purchased by the business are returned Recorded as a reduction in the purchases figure Discounts received Where the business is offered a discount on purchases made Recorded as other income received Discounts allowed Where the business offers a discount on sales made Recorded as an expense

How does all this fit together, then? Note: this information is set out as a ‘trial balance’. The trial balance ‘balances’ in the following manner: Left column = where the money has gone to e.g. assets, expenses/losses, distributions Right column = where the money has come from e.g. capital, liabilities, revenue/gains, introductions Further information as at 30 June 20X5 not yet taken into account in the above: Stock was valued at £11,517 Motor vehicle expenses owing £55 Rent prepaid £275 A bad debt of £85 is to be provided for. The provision for doubtful debts is to be equal to 2.5 per cent of debtors

Changing a Provision - Example 2004 2005 Provision 750 710 Effect in P&L Account Expenses Decrease in Provision (40) Provision 750 810 Increase in Provision 60

Partnership Accounting What differences are there between sole traders and partnerships? A sole trader business is a owned by a single person, whereas a partnership involves more than one person -(generally) between 2-20 partners How do these differences affect accounting for partnerships? Partnership accounting requires a recording of each partners’ share of the profit and capital of the business: The profit and loss account has an additional account – the appropriation account – which ‘shares out’ the year’s profits between the partners The balance sheet capital section includes A capital account which represents the long-term capital invested into the partnership by the individual partners, and a current account which represents the partners’ share of the profits of the business, minus their drawings.

Example King & Cooper have both invested £25,000 into their partnership. Their salaries for the year are £15,000 and £7,500 respectively and their current accounts stand at £20,000 and £10,000 respectively. They share residual profits in King’s favour 2:1. Their accounts for the year are as follows

Manufacturing and Service business accounts What differences are there between trading, manufacturing and service business? Trading businesses buy-in and re-sell various goods Manufacturing businesses make and re-sell various goods Service businesses do not make or buy-in goods for re-sale

How do these differences affect accounting for manufacturing business? Manufacturing businesses will have specific costs relating to the manufacture of the product. These are summarised in a separate ‘Manufacturing Account’ before being transferred to the trading account There are likely to be three different types of stock recorded on the balance sheet: raw materials, work-in-progress and finished goods The accounts record certain expenses (those of production/manufacture) as part of the cost of goods, rather than recording all expenses in the profit and loss account

For cost of manufacture – Think Purchases Cost of Goods Sold = Opening Stock + Purchases - Closing Stock In a manufacturing company’s accounts Purchases is replaced with Cost of Goods Produced