Upon hearing your concern and difficulty in understanding for the draft profit & loss account for the year 31 December 2000, I am please to attach the following information to assist you in understanding the draft. Firstly, as a director you must be able to identify & classify the differences in income and expenses. Income is classified into two types and they are Capital Income and Revenue Income. Capital income is not from business activity, it’s gain and extra value is automatic as no direct effort is involve. Examples will be increase in property prices.
On the other hand, revenue income is income made by the company from business activities with human efforts. Examples will be income from sales, discount received and rent received. Expenditure is also classified into two types and they are Capital Expenditure and Revenue Expenditure. Capital Expenditure is investments in fixed assets or anything that is done to increase the value of the fixed assets. Examples will be land and buildings, furniture and fittings, all legal costs of buying land and building, cost of carriage inwards on machinery and all other costs needed to get the fixed assets ready for use.
Revenue Expenditure has a different nature compare to capital expenditure as revenue expenditure is related to; day-to-day running of business in making revenue and it will not increase the value of fixed assets. Examples are salary, rental and property cleaning expenses. Secondly, the understanding of accounting concepts are equally important as accounting itself have a set of principles, custom and practice set as rules and conventions which have been adopted as a general guide by professional accountants.
Accounting concepts is vital and useful to maintain consistent standards in the future because they would be built on the same foundation. Different accounting concepts are mention as below. Accruals concept: The concept that profit is the difference between revenue and expenses. (Wood’s and Sangster, 1999, p. 94) Accountants using this concept will take all income and related charges in the financial period to which the accounts relate will be taken into account regardless to the date or payment. Example: Revenues – Expenses = Profit
Business entity concept: Assumption that only transactions that affect the firm, and not the owner’s private transactions, will be recorded. (Wood’s and Sangster, 1999, p. 94) This concept implies that there is a clear line drawn between all business activities and the owner’s personal activities, both the owner and the firm are treated as two different separated issues. Consistency concept: Keeping to the same method of recording transactions. (Wood’s and Sangster, 1999, p. 94) This concept implies that the basic accounting concepts practise in the firm should not be change as and when the firm feel like.
Accounting concepts must be consistent, as any non- consistency of accounting concepts will show misleading profits being calculated from accounting records. Cost concept: Assets are normally shown at cost price. (Wood’s and Sangster, 1999, p. 94) The price paid to acquire an asset is recorded in the book but do not necessarily reflect the current value of the asset that is bought previously. The costs are valued at the point of purchase and origin, for those costs that have expanded will be shown in the balance sheet. Dual aspect concept: The concept of dealing with both aspects of a transaction. (Wood’s and Sangster, 1999, p.
94) Double entry is also known as the name given for recording the transaction for the dual aspect concept. This concept state that for all business transaction will involves two entries, a debit entry and a credit entry and these two entries will be at all time equal in the total. Going concern concept: Assumption that a business is to continue for a long time. (Wood’s and Sangster, 1999, p. 94) The concept implies that the business will continue trading and operate for as long as the firm wants to. Materiality: Recording something in a special way only if the amount is not a small one. (Wood’s and Sangster, 1999, p. 94)
This concept implies that accounting practices should be flexible and logical in terms that time shouldn’t be wasted on the elaborate recording of trivial items. In this case strict accounting practices and procedures is unpractical to be applied to items of small importance. Money measurement concept: The concept that accounting is concerned only with facts measurable in money, and for which measurements can obtain general agreement. (Wood’s and Sangster, 1999, p. 94) This concept implies that accounting uses money to express facts of a business. Objectivity: Using a method that everyone can agree to. (Wood’s and Sangster, 1999, p.
94) This concept implies that accounting need to seek objectivity, even with one common method it can be agree upon everyone rather than everyone using their own methods. Prudence concept: Ensuring that profit is not shown as being too high, or that assets are shown at too high a value. (Wood’s and Sangster, 1999, p. 94) This concept implies that the accountant will have to use their judgement and made decisions on the side of safety, usually the accountant will understate the figure rather than overstate. Realisation concept: The concept of profit as being earned at a particular point. (Wood’s and Sangster, 1999, p. 94)
The realisation concept holds to the view that profit can only be taken into account when the buyer accepts liability to pay for the goods or services provided. Separate determination concept: The amount of each asset or liability should be determined separately. (Wood’s and Sangster, 1999, p. 94) This concept is able to differential potential gains and potential losses as the amount of each individual asset or liability should be determined separately from all other assets and liabilities. Subjectivity: Using a method that other people may not agree to, derived from one’s own personal preferences. (Wood’s and Sangster, 1999, p.94)
In accounting concepts and practises accountants always seek objectivity, as there are rules, which have long been known and used by accountants rather that subjectivity which accountant will have their own private practises. Time interval concept: Final accounts are prepared at regular intervals. (Wood’s and Sangster, 1999, p. 94) This concept implies that final accounts should be prepare and adopt to a regular interval for normally once every year or even more frequently but keeping in mind that the period must be regular. Thirdly, you will need to understand how the valuation of stocks affects profit.
The concept of consistency must be applied to stock valuation method. Once the method is adopted the same basis should be used in the annual accounts until a valid reason arises to change it. If stock valuation method is frequently change, the profit will also change and it will affect the profit and loss statement and results from such statements will not be accurate. There are three different methods on the valuation of stocks and they are mention as below First in, first out method: This is usually known as FIFO, this method says that the first goods to be received are the first to be issued. (Wood’s and Sangster, 1999, p.267)
Last in, first out method: This is usually known as LIFO. As each issue of goods is made they are said to be from the last lot of goods received before the date. Where there is not enough left of the last lot of goods, then the balance of goods needed is said to come from the previous lot still unsold. (Wood’s and Sangster, 1999, p. 267) Average cost method: This is also known as AVCO, when using the AVCO method, with each receipt of goods the average cost for each item of stock is recalculated. Further issues of goods are then at that figure, until another receipt of goods means that another recalculation is needed.
(Wood’s and Sangster, 1999, p. 268) Lastly, you will also need to understand the differences in Profit & loss account and cash flow statement. The main purpose of preparing a profit and loss account is to show weather the firm is making a profit or loss over a period of time. To an accountant profit means the amount by which revenues are greater than expenses for a set of transactions. The term revenues mean the sales value of goods and services that have been supplied to customers. The term expenses means the value of all the assets that have been used up to obtain those revenues.
On the other hand, it could also be possible that our expenses may exceed our revenues for a set of transactions. In this case the result is a loss. The basic purpose of a statement of cash flows is to provide information about the cash receipts and cash payments of a business entity during the accounting period. (Bettner, Haka, Meigs and Williams, 1999, p. 554) Cash flow statement has the ability to show different sources of cash generated and how the firm is using the cash during the accounting year. Ensuring that the business has sufficient profits to finance and enough cash are available as and when firm needs.
Thus a cash flow statement can also show whether the company have the ability to generate cash flows in the future, meet its obligations and pay dividends. Whether the company need external financing, shows all the related net cash flows from operating activities and also the cash and noncash aspects of company’s investment and financial transactions for the accounting period. The understanding of cash flow statement is very important as it helps users to evaluate a company’s ability to have sufficient cash on a short- run and long- run basis, it basically shows the company’s financial health.