1. Understanding & Managing Finance
Seminar 5

2. 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

3. M & A 2.6 Original Balance Sheet

4. M & A 2.6 Trans-actions

5. M & A 2.6 Revised Balance Sheet

6. 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.

7. 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?

8. 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.

9. 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

10. 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

11. 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

12. 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

13. 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)

14. 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)

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

16. Stock Purchases and Sales
Opening Stock Level 200 £10 each
Purchase # £12 each
Purchase # £15 each
Sales £20 each

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

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

19. AVCO Stock Valuation Example
Opening Stock Level 200 £10 each £2000
Purchase # £12 each £1200
Purchase # £15 each £3000
Sales £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+ £ £3000 = £6200
Total no. of items = = 500
Average value of stock = £6200/500 = £12.40 per item
Total Cost of Sales = £ = £4960

20. 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

21. 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

22. 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:

23. 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%

24. 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.

25. 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.

26. 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 £ 2, £ 8, £ 3, £ 7,000
Year £ 2, £ 6, £ 2, £ 4,900
Year £ 2, £ 4, £ 1, £ 3,430
Year £ 2, £ 2, £ 1, £ 2,401
Year £ 2, £ £ £ 1,681
Year £ £ £ £ 1,176

27. 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.

28. 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.

29. 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.

30. 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.

31. P & L Example Spreadsheet

32. 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

33. P & L Example – Solution Part 2

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

35. M & A Ex 3.8 P & L Account

36. 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

37. 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.