7 5 Chapter 7 Financial Statements for Sole Proprietorships (I) Notes to teachers 1 Start by showing real-life examples of income statements, which can be found from the Internet. 2 Ask students what can b e known about a busine ss entity from its income stat ements and how the information can be used in decision-making. 3 Y ou should then go through with them the common terms found in income statements, such as invent ory, cost of goods sold, gross profit, net profit, other revenues and various types of expenses. 4 It is not difficult for students to understand how an income statement is prepared. But they may have difficulty understanding subtle differences between the income statement and the profit and loss account. 5 Y ou should emphasise that in the pr evious curriculum, both the ledge r account for c losing off expense and revenue accounts at the end of an accounting period and the financial statement for reporting prof its and losses are given the name of ‘profit and loss account’. The termi nology has now changed. The former can still be called the profit and loss account (or the ‘income summary account’ in many American textbooks) while the latter should now be called the ‘income statement’ (or even the ‘statement of comp rehensive income’ according to the revised HKAS 1). However, it should also be pointed out that it is not compulsory for sole proprietorships or partnerships to adopt the new terms used in the revised HKAS 1. This is because sole proprietorships and partnerships do not have external reporting requirement s. 6 Y ou should also point out that c ompared to the pro fit and loss account (a ledger accoun t), the income statement is easier for non-accounting people to understand (especially when the vertical format is used) and more useful for decision-making as it provides additional information such as the major source of revenue (i.e., sales for trading firms) and other revenues, the cost of goods sold, gross profit and other operating expenses. In reality, expenses are further classified and summarised in order to help users better understand the expenditure pattern of a business entity. 7 Although income statement s can be prepar ed in either the horizontal or vertical f ormat, students should be encouraged to adopt the vertical format as this format is more popular in public examinations and in practice. Q1 Firms prepare financial statements to report the financial results of their businesses at the end of an accounting period. The financial statements, consisting of at least an income statement and a balance sheet, are known as final accounts because they are prepared at the end of an accounting period. Q2 There is no absolute answer. The firm determines the length of financial period and it may be a month, a quarter, half a year or a year. o es o
1 Start by showing real-life examples of income statements, which can be found from the Internet.
2 Ask students what can be known about a business entity from its income statements and how theinformation can be used in decision-making.
3 You should then go through with them the common terms found in income statements, such as inventory,cost of goods sold, gross profit, net profit, other revenues and various types of expenses.
4 It is not difficult for students to understand how an income statement is prepared. But they may havedifficulty understanding subtle differences between the income statement and the profit and loss account.
5 You should emphasise that in the previous curriculum, both the ledger account for closing off expense andrevenue accounts at the end of an accounting period and the financial statement for reporting profits andlosses are given the name of ‘profit and loss account’. The terminology has now changed. The former canstill be called the profit and loss account (or the ‘income summary account’ in many American textbooks) while the latter should now be called the ‘income statement’ (or even the ‘statement of comprehensiveincome’ according to the revised HKAS 1). However, it should also be pointed out that it is not compulsoryfor sole proprietorships or partnerships to adopt the new terms used in the revised HKAS 1. This is becausesole proprietorships and partnerships do not have external reporting requirements.
6 You should also point out that compared to the profit and loss account (a ledger account), the incomestatement is easier for non-accounting people to understand (especially when the vertical format is used)and more useful for decision-making as it provides additional information such as the major source of
revenue (i.e., sales for trading firms) and other revenues, the cost of goods sold, gross profit and otheroperating expenses. In reality, expenses are further classified and summarised in order to help users betterunderstand the expenditure pattern of a business entity.
7 Although income statements can be prepared in either the horizontal or vertical format, students should beencouraged to adopt the vertical format as this format is more popular in public examinations and inpractice.
Q1 Firms prepare financial statements to report the financial results of their businesses at the end of anaccounting period. The financial statements, consisting of at least an income statement and a balance sheet,are known as final accounts because they are prepared at the end of an accounting period.
Q2 There is no absolute answer. The firm determines the length of financial period and it may be a month, aquarter, half a year or a year.
Q3 (a) A firm would incur a gross loss if the cost of goods sold is greater than sales. The firm might be sellingits goods below costs.
(b) A firm would incur a net loss if total expenses exceed the sum of gross profit and other revenues. Thismay indicate that the firm should take measures to reduce expenses.
Q4 Net profit = Gross profit + Other revenues – Expenses
So the difference between gross profit and net profit is due to other revenues and expenses.
Gross profit = Sales – Cost of goods sold
As service firms don’t have sales or cost of goods sold, they don’t need to calculate gross profit.
Q5 Brian LeeIncome Statement for the year ended 31 December 2006
$ $
Purchases 34,000 Sales 61,000
Less Closing inventory (6,000)
Cost of goods sold 28,000
Gross profit c/d 33,000
61,000 61,000
Salaries 12,000 Gross profit b/d 33,000
Other expenses 6,200 Deposit interest received 400
Net profit 15,200
33,400 33,400
Q6 The cost of goods purchased in the current period may not equal the cost of goods sold in the same period,because there may be unsold goods at the end of the current period (i.e., closing inventory) or unsoldgoods brought forward from the previous period (i.e. opening inventory).
Cost of goods sold = Opening inventory + Purchases (cost of goods purchased in the current period) –Closing inventory
Q7 The inventory at the end of an accounting period, known as the closing inventory, would be carriedforward to the next period as the opening inventory. Physically, the closing inventory for an accountingperiod and the opening inventory for the following accounting period refer to the same goods. Theirquantities and amounts are the same. However, their accounting treatments are different. The openinginventory will be added to the cost of goods sold for the current accounting period, while the closinginventory will be deducted from current period’s cost of goods sold.
Q8 Brian LeeIncome Statement for the year ended 31 December 2006
$ $
Sales 61,000
Less Cost of goods sold:
Purchases 34,000 Less Closing inventory (6,000) (28,000)
Q10 If it is the first year of trading or if there were no unsold goods at the end of the previous year.
Q11 (a) Returns inwards refer to goods returned from customers. At the end of an accounting period, thereturns inwards account would be closed off and its closing balance would be deducted from sales.
Returns outwards refer to goods returned to suppliers. At the end of an accounting period, the returnsoutwards account would be closed off and its closing balance would be deducted from purchases.
(b) Carriage inwards refers to the cost of transporting goods from suppliers. At the end of an accountingperiod, the carriage inwards account would be closed off and its closing balance would be added tothe cost of goods sold.
Carriage outwards refers to the cost of transporting goods to customers. At the end of an accountingperiod, the carriage outwards account would be closed off, but its closing balance would be treated asan expense and not part of the cost of goods sold.
(c) The amount of sales after deducting returns inwards is known as net sales.
The amount of purchases after deducting returns outwards is known as net purchases.
Q12 CPA FirmIncome Statement for the year ended 31 March 2006
$ $
Audit fee revenue 440,000
Add Other revenues 24,000
464,000
Less Expenses:
Rent 100,000
Staff salaries 342,000
Printing and stationery 8,670
Miscellaneous expenses 14,850 (465,520)
Net loss (1,520)
A2 Carriage inwards, import duties, insurance against loss during shipping (or other relevant examples)
A3 Interest received, rent received, discounts received (or other relevant examples)
A4 Net profit = Gross profit + Other revenues − Expenses
It is because in most situations expenses are higher than other revenues. That is why net profit is usuallysmaller than gross profit.
A5 Managers, investors, banks, the Inland Revenue Department (or other relevant examples). For differentreasons, these people need to know how much profit or loss a business has made or incurred during acertain period.
A8 (a) Horizontal style
(b) Vertical style. It is because it shows what items are added or deducted, rather than showing what itemsare debited or credited. Readers of financial statements may not understand the principles of doubleentry.
Jan 1 Balance b/f 6,500 Dec 31 Income statement 6,500
Dec 31 Income statement 5,400 " 31 Balance c/f 5,400
11,900 11,900
2009
Jan 1 Balance b/f 5,400
A10The Journal
Date Details Dr Cr
2008
Dec 31
" 31
" 31
" 31
Profit and loss
Returns inwards
Transfer of year-end balance of returns inwards account to the profit
and loss account.
Returns outwards
Profit and loss
Transfer of year-end balance of returns outwards account to the profit
and loss account.Profit and loss
Carriage inwards
Transfer of year-end balance of carriage inwards account to the profit
and loss account.
Profit and loss
Carriage outwards
Transfer of year-end balance of carriage outwards account to the profit
and loss account.
$
3,450
2,100
1,950
1,330
$
3,450
2,100
1,950
1,330
A11 (a) M Chan
Trial Balance as at 31 December 2008
Dr Cr $
Shop premises 250,000
Fixtures and fittings 53,600
Accounts receivable 42,300
Accounts payable 41,880
Bank 56,000
Cash 8,200
Loan from C Ho (repayable in 2009) 90,000
Drawings 23,000
Capital 290,000
Income statement (net profit for the year) 16,620
Inventory 5,400
438,500 438,500
(b) The account balances of sales, purchases, returns inwards, returns outwards, carriage inwards, otherrevenues, all the other expenses will no longer appear in the trial balance after the preparation of theprofit and loss account. The inventory balance shown in the trial balance will be the closing inventory.Net profit for the year will be shown as a credit balance in the trial balance.
A12 Managers need to know how well their firms are performing and then find out what can be done toincrease profits or improve efficiency. So they would analyse the income statements in order to extractrelevant information about the operations of the business. The things that they need to know include thefollowing:
• Is the firm profitable?
• Is net profit increasing or decreasing?
• Are sales expanding or shrinking?
• What types of expenses are too high and need to be reduced?
A13 The cost of goods sold refers to the costs at which the goods sold were purchased. Carriage inwards isincurred on purchase. So it is included in the cost of goods purchased, which is part of the cost of goodssold.
Carriage outwards is incurred on sale. It is treated as a type of selling expense and is included in operatingexpenses, which are not part of the cost of goods sold.
A14 Trading firm: Sales; Service firm: Service fees (e.g., consultation fees)
Service firms do not need to calculate the cost of goods sold and gross profit. They simply show all the
revenues earned, expenses incurred and the resulting net profit for the accounting period in the incomestatement.
1 • Count the quantity of each type of inventory: Quantity purchased − Quantity sold + Quantity returned inwards − Quantity returned outwards
• Find the value of each type of inventory:
Quantity remaining × Unit cost of purchase (less trade discount, if any)
• Find the total value of all types of inventories.
J ChanIncome Statement for the year ended 31 December 2009
$ $
Rent and rates 245,800 Service fees 658,700
Salaries and wages 296,540 Interest revenue 1,370
Water and electricity 16,873
Printing and stationery 15,489Miscellaneous expenses 6,282
Net profit 79,086
660,070 660,070
(Vertical)
J ChanIncome Statement for the year ended 31 December 2009
$ $
Service fees 658,700
Interest revenue 1,370
660,070
Less Expenses: Rent and rates 245,800
Salaries and images 296,540
Water and electricity 16,873
Printing and stationery 15,489
Miscellaneous expenses 6,282 (580,984)
Net profit 79,086
(b) • Trading firm: Sales, cost of goods sold and gross profit are shown in the income statement. Service firm: No sales, cost of goods sold or gross profit is shown in the income statement.
• Trading firm: Inventory is shown in the income statement. Service firm: No inventory is shown in the income statement.
