Explain how the Accrual basis assumption helps to ensure Relevance in the Accounting reports
By including information that is capable of making a difference to decision-making (i.e. exclude drawings, loan repayments or last year’s wages)
Explain the purpose of closing the ledger
- To transfer the revenue and expense amounts (temporary) to the Profit & Loss Summary Account to calculate profit for the current Period
- To reset revenue and expense accounts to zero in readiness for the next Period
Explain why ledger accounts are closed with reference to an Accounting Assumption
Period / Accrual basis
- Revenues earned and expenses must be transferred to the P&L Summary account in order to determine profit for the current Period
- Revenue and expense accounts must be reset to zero in readiness for the next Period to avoid including revenues and expenses from other periods in Profit calculation for the next period
Explain why asset and liability accounts are not closed
- Only revenues and expense are used to determine profit, and revenues and expenses exist only during a particular Period
- Assets (economic benefit carried forward) and liabilities (present obligation until it is paid for) will exist into the future so they are not closed but balanced so that they carry forward into the next period
Explain why the Drawings account is closed to the Capital account
So that the Capital account can show the net effect of all transactions with the owner
List 5 strategies to generate more revenues
- Change selling prices
- Market strategically and effectively
- Implement strategies to manage inventory (inventory mix, sale of complementary goods, up-to-date inventory, rotate inventory)
- Better location
- Improve customer service
List 3 strategies to control expenses
- Change inventory management practices
- Change staff management practices (have to be careful about industry awards, contracts and type of employee)
- Change non-current asset management practices
Explain the purpose of an Income Statement
Income Statement communicates information about a firm’s revenue, expenses and profit for a particular reporting period in a more informative manner.
Explain the purpose of Net Profit Margin
A profitability indicator that indicates expense control by calculating the percentage of Net sales revenue that is retained as Net Profit
Explain the purpose of Gross Profit Margin
A profitability indicator that measures the average mark-up by calculating the percentage of Net sales revenue that is retained as Gross Profit
Explain the treament of Inventory Gain
- Inventory gain is treated as a revenue because it results in an increase of Assets (Inventory) and thereby an increase in Owner’s equity
- It is listed as an Other revenue because it is related to the managment of inventory. In doing so, Adjusted Gross Profit Margin can reflect more accurately the effectiveness of inventory management practices
Explain the treatment of Discount revenue
- Discount revenue is a revenue because it decreases liability (Account Payable) and thereby causes an increase in Owner’s equity
- It is an Other revenue because it is not earned from the sale of inventory and therefore will not have a direct impact on Gross Profit and should not be included in the measure for mark-up
Referring to financial and ethical considerations, discuss whether the owner’s Drawings should be reported as part of Wages
- Yes: Owner is also an employee and is entitled to a wage. If this amount is withdrawn on a regular basis, it should not distort the evaluation of business profitability. Moreover, both Wage and Drawings will decrease Assets and Owner’s equity
- No: Drawings are excluded from the definition of Expense as it does not relate to business operation. Doing so would overstate Expenses and understate Profit and leads to poor financial decisions
- Explain the purpose of graphical representations with reference to a Qualitative Characteristic
Understandability as the user (the owner) is able to comprehend the information without relying on Accounting knowledge, leading to more informed and better decision-making
For instance, a pie chart can highlight problem areas (especially for the biggest piece of the pie) so decisions can be made to improve expense control within the business
Explain the treatment of Sales Return
- Sales returns is treated as a negative revenue item in the Income Statement because it reduces the sales revenue for a period. Sales is a revenue item because it causes an inflow of economic benefits, thereby increasing Owner’s Equity. Sales returns brings about a reduction in these inflows and is therefore a negative revenue that will cause a decrease in Owner’s Equity because a lower profit will be reported for the period as a result of Sales returns made.
- NOT an expense because when a sale is made, revenue is deemed to be earned. If a return is attempted by an account receivable, it is at the discretion of the business whether or not the return will be accepted. If it is accepted, the revenue earned is then cancelled by issuing of a credit note
Referring to Qualitative Characteristic, explain why business would prepare an Income Statement when the Profit and Loss Summary would provide the Net Profit amount
Income Statement is more easily read by individuals who may not have a thorough accounting background and is inline with the demands of Understandability.
