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Chapter 7

Notes to teachers
1 2 3 4 5

Financial Statements for Sole Proprietorships (I)

Start by showing real-life examples of income statements, which can be found from the Internet. Ask students what can be known about a business entity from its income statements and how the information can be used in decision-making. 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. 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. You should emphasise that in the previous curriculum, both the ledger account for closing off expense and revenue accounts at the end of an accounting period and the financial statement for reporting profits and losses are given the name of profit and loss account. The terminology 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 comprehensive 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 requirements. You should also point out that compared to the profit and loss account (a ledger account), 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. Although income statements can be prepared in either the horizontal or vertical format, 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. 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.

Q2

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Q3

(a) A  firm would incur a gross loss if the cost of goods sold is greater than sales. The firm might be selling its goods below costs. (b) A  firm would incur a net loss if total expenses exceed the sum of gross profit and other revenues. This may 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 dont have sales or cost of goods sold, they dont need to calculate gross profit.

Q5
Purchases Less Closing inventory Cost of goods sold Gross profit c/d Salaries Other expenses Net profit

Brian Lee Income Statement for the year ended 31 December 2006
$ 34,000 Sales (6,000) 28,000 33,000 61,000 12,000 Gross profit b/d 6,200 Deposit interest received 15,200 33,400 $ 61,000

61,000 33,000 400 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 unsold goods 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 carried forward to the next period as the opening inventory. Physically, the closing inventory for an accounting period and the opening inventory for the following accounting period refer to the same goods. Their quantities and amounts are the same. However, their accounting treatments are different. The opening inventory will be added to the cost of goods sold for the current accounting period, while the closing inventory will be deducted from current periods cost of goods sold.
Brian Lee Income Statement for the year ended 31 December 2006
$ Sales Less Cost of goods sold: Purchases Less Closing inventory Gross profit Add Other revenues: Deposit interest received Less Expenses: Salaries Other expenses Net profit $ 61,000

Q8

34,000 (6,000)

(28,000) 33,000 400 33,400

12,000 6,200

(18,200) 15,200

Q9
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Opening inventory

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, the
returns inwards account would be closed off and its closing balance would be deducted from sales.  eturns outwards refer to goods returned to suppliers. At the end of an accounting period, the returns R outwards account would be closed off and its closing balance would be deducted from purchases. (b) C  arriage inwards refers to the cost of transporting goods from suppliers. At the end of an accounting period, the carriage inwards account would be closed off and its closing balance would be added to the cost of goods sold.  arriage outwards refers to the cost of transporting goods to customers. At the end of an accounting C period, the carriage outwards account would be closed off, but its closing balance would be treated as an 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
Audit fee revenue Add Other revenues Less Expenses: Rent Staff salaries Printing and stationery Miscellaneous expenses Net loss

CPA Firm Income Statement for the year ended 31 March 2006
$ $ 440,000 24,000 464,000

100,000 342,000 8,670 14,850

(465,520) (1,520)

A2 A3 A4

Carriage inwards, import duties, insurance against loss during shipping (or other relevant examples) Interest received, rent received, discounts received (or other relevant examples) 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 usually smaller than gross profit.

A5

Managers, investors, banks, the Inland Revenue Department (or other relevant examples). For different reasons, these people need to know how much profit or loss a business has made or incurred during a certain period. (a) Horizontal style (b) Vertical style. It is because it shows what items are added or deducted, rather than showing what items are debited or credited. Readers of financial statements may not understand the principles of double entry. (c) Vertical style 77

A8

A9
2008 Jan 1 Dec 31 2009 Jan 1 Balance b/f Income statement

Inventory
$ 2008 6,500 Dec 31 5,400 " 31 11,900 5,400 Income statement Balance c/f $ 6,500 5,400 11,900

Balance b/f

A10
Date 2008 Dec 31 Details

The Journal
Dr $ 3,450 Cr $ 3,450

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.

"

31

2,100

2,100

"

31

1,950 1,950

"

31

1,330 1,330

A11 (a)

M Chan Trial Balance as at 31 December 2008


Dr Cr $

Shop premises Fixtures and fittings Accounts receivable Accounts payable Bank Cash Loan from C Ho (repayable in 2009) Drawings Capital Income statement (net profit for the year) Inventory

250,000 53,600 42,300 41,880 56,000 8,200 90,000 23,000 290,000 16,620 5,400 438,500 438,500

(b) The account balances of sales, purchases, returns inwards, returns outwards, carriage inwards, other revenues, all the other expenses will no longer appear in the trial balance after the preparation of the profit 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.

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A12 Managers need to know how well their firms are performing and then find out what can be done to
increase profits or improve efficiency. So they would analyse the income statements in order to extract relevant information about the operations of the business. The things that they need to know include the following: 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 is
incurred on purchase. So it is included in the cost of goods purchased, which is part of the cost of goods sold. Carriage outwards is incurred on sale. It is treated as a type of selling expense and is included in operating expenses, 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 income statement.

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.

Value of unsold executive chairs = (20 + 10 5 10 5 + 5 5) $200 = $2,000 Value of unsold desk chairs = (30 + 20 10 10 5 10 10) $100 = $500 Value of unsold desks = (30 + 10 15 10 5) $500 90% = $4,500 Value of unsold tables = (10 + 10 5 5 + 2 2) $600 90% = $5,400 Value of unsold filing cabinets = (20 10 5 2) $300 90% = $810 Value of unsold cupboards = (20 10 5) $400 90% = $1,800 Total value of inventories (at cost) = $(2,000 + 500 + 4,500 + 5,400 + 810 + 1,800) = $15,010

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May Furniture Income Statement for the month ended 31 October 2008
Sales Less Returns inwards Less Cost of goods sold: Purchases Less Returns outwards Less Closing inventory Gross profit Add Other revenues: Discount received Less Expenses: Petrol: Van Business trip expenses Rent Salaries Discounts allowed Net profit $ 70,750 (3,640) 52,400 (2,080) 50,320 (15,010) $ 67,110

(35,310) 31,800 1,925 33,725

1,000 2,000 8,000 17,000 2,425

(30,425) 3,300

Yes, May Furniture made a net profit of $3,300 for the month.

Promote sales Reduce the cost of goods sold, e.g., find cheaper sources of supplies Explore other sources of revenues Reduce expenses (Any reasonable answers)

ASSESSMENT

MCQ
1 B 6 D 2 D 7 B 3 A 8 C 4 B 9 A 5 C 10 D

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Exercises
11
(Horizontal)
L So Income Statement for the year ended 31 December 2008
Purchases Less Closing inventory Cost of goods sold Gross profit c/d Rent and rates Wages and salaries Postage and stationery Electricity expenses General expenses Net profit $ 241,900 Sales (43,100) 198,800 183,400 382,200 41,700 Gross profit b/d 53,900 8,400 7,100 3,700 68,600 183,400 $ 382,200

382,200 183,400

183,400

(Vertical)
L So Income Statement for the year ended 31 December 2008
$ Sales Less Cost of goods sold: Purchases Less Closing inventory Gross profit Less Expenses: Rent and rates Wages and salaries Postage and stationery Electricity expenses General expenses Net profit $ 382,200

241,900 (43,100)

(198,800) 183,400

41,700 53,900 8,400 7,100 3,700

(114,800) 68,600

12X (Horizontal)
C Hung Income Statement for the year ended 31 December 2008
Purchases Less Closing inventory Cost of goods sold Gross profit c/d Rent and rates Motor expenses Sundry expenses Travel expenses Office expenses Net profit $ 429,100 Sales (82,200) 346,900 224,000 570,900 49,900 Gross profit b/d 23,700 4,100 6,000 7,200 133,100 224,000 $ 570,900

570,900 224,000

224,000

81

(Vertical)
C Hung Income Statement for the year ended 31 December 2008
$ Sales Less Cost of goods sold: Purchases Less Closing inventory Gross profit Less Expenses: Rent and rates Motor expenses Sundry expenses Travel expenses Office expenses Net profit $ 570,900

429,100 (82,200)

(346,900) 224,000

49,900 23,700 4,100 6,000 7,200

(90,900) 133,100

13

(Horizontal)
W Wang Income Statement for the year ended 30 June 2007
Purchases Less Closing inventory Cost of goods sold Gross profit c/d Rent and rates Lighting expenses Salaries and wages Insurance General expenses Motor expenses Net profit $ 385,000 Sales (41,500) 343,500 425,500 769,000 147,000 Gross profit b/d 28,200 Interest revenue 160,000 30,500 5,060 21,330 68,410 460,500 $ 769,000

769,000 425,500 35,000

460,500

(Vertical)
W Wang Income Statement for the year ended 30 June 2007
$ Sales Less Cost of goods sold: Purchases Less Closing inventory Gross profit Add Other revenues: Interest revenue Less Expenses: Rent and rates Lighting expenses Salaries and wages Insurance General expenses Motor expenses Net profit $ 769,000

385,000 (41,500)

(343,500) 425,500 35,000 460,500

147,000 28,200 160,000 30,500 5,060 21,330

(392,090) 68,410

82

14X (Horizontal)
T Chung Income Statement for the year ended 31 December 2006
Purchases Less Closing inventory Cost of goods sold Gross profit c/d Postal expenses Rent and rates Management fees Salaries Insurance $ 183,850 Sales (49,600) 134,250 193,900 328,150 2,100 Gross profit b/d 106,000 Net loss 22,550 65,600 7,000 203,250 $ 328,150

328,150 193,900 9,350

203,250

(Vertical)
T Chung Income Statement for the year ended 31 December 2006
$ Sales Less Cost of goods sold: Purchases Less Closing inventory Gross profit Less Expenses: Postal expenses Rent and rates Management fees Salaries Insurance Net loss $ 328,150

183,850 (49,600)

(134,250) 193,900

2,100 106,000 22,550 65,600 7,000

(203,250) (9,350)

15X (Horizontal)
W Young Income Statement for the year ended 31 December 2008
Purchases Less Closing inventory Cost of goods sold Gross profit c/d Rent and rates Salaries Utilities charges Commissions Net profit $ 216,000 Sales (9,600) 206,400 263,400 469,800 100,000 Gross profit b/d 128,200 Interest received 2,300 4,500 57,000 292,000 $ 469,800

469,800 263,400 28,600

292,000

83

(Vertical)
W Young Income Statement for the year ended 31 December 2008
$ Sales Less Cost of goods sold: Purchases Less Closing inventory Gross profit Add Other revenues: Interest received Less Expenses: Rent and rates Salaries Utilities charges Commissions Net profit $ 469,800

216,000 (9,600)

(206,400) 263,400 28,600 292,000

100,000 128,200 2,300 4,500

(235,000) 57,000

16

(Horizontal)
T Mo Income Statement for the year ended 31 December 2006
$ Opening inventory Add Purchases Less Returns outwards Add Carriage inwards 310,000 (5,600) $ 56,900 Sales Less Returns inwards 304,400 361,300 17,000 378,300 (42,300) 336,000 187,000 523,000 50,100 Gross profit b/d 14,600 31,200 4,200 7,900 79,000 187,000 $ 527,900 (4,900) 523,000

Less Closing inventory Cost of goods sold Gross profit c/d Salaries and wages Rent and rates Motor expenses General expenses Carriage outwards Net profit

523,000 187,000

187,000

84

(Vertical)
T Mo Income Statement for the year ended 31 December 2006
$ Sales Less Returns inwards Less Cost of goods sold: Opening inventory Add Purchases Less Returns outwards Add Carriage inwards $ 527,900 (4,900) 56,900 310,000 (5,600) 304,400 361,300 17,000 378,300 (42,300) $ 523,000

Less Closing inventory Gross profit Less Expenses: Salaries and wages Rent and rates Motor expenses General expenses Carriage outwards Net profit

(336,000) 187,000

50,100 14,600 31,200 4,200 7,900

(108,000) 79,000

17X (Horizontal)
K Lung Income Statement for the year ended 31 December 2008
$ Opening inventory Add Purchases Less Returns outwards Add Carriage inwards 645,700 (15,800) $ 182,800 Sales Less Returns inwards 629,900 812,700 2,100 814,800 (173,600) 641,200 338,800 980,000 4,900 Gross profit b/d 62,500 17,500 3,600 250,300 338,800 $ 995,000 (15,000) 980,000

Less Closing inventory Cost of goods sold Gross profit c/d Carriage outwards Salaries and wages Rent and rates Sundry expenses Net profit

980,000 338,800

338,800

85

(Vertical)
K Lung Income Statement for the year ended 31 December 2008
$ Sales Less Returns inwards Less Cost of goods sold: Opening inventory Add Purchases Less Returns outwards Add Carriage inwards $ 995,000 (15,000) 182,800 645,700 (15,800) 629,900 812,700 2,100 814,800 (173,600) $ 980,000

Less Closing inventory Gross profit Less Expenses: Carriage outwards Salaries and wages Rent and rates Sundry expenses Net profit

(641,200) 338,800

4,900 62,500 17,500 3,600

(88,500) 250,300

18

(Horizontal)
Martin Lee Income Statement for the year ended 31 December 2008
Hair care materials Water and electricity Rent and rates Salaries and wages Sundry expenses Net profit $ 9,786 Service fees 64,520 Interest revenue 210,648 183,560 5,672 67,309 541,495 $ 540,620 875

541,495

(Vertical)
Martin Lee Income Statement for the year ended 31 December 2008
$ Service fees Interest revenue Less Expenses: Hair care materials Water and electricity Rent and rates Salaries and wages Sundry expenses Net profit $ 540,620 875 541,495

9,786 64,520 210,648 183,560 5,672

(474,186) 67,309

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19X (a) (Horizontal)


J Chan Income Statement for the year ended 31 December 2009
Rent and rates Salaries and wages Water and electricity Printing and stationery Miscellaneous expenses Net profit $ 245,800 Service fees 296,540 Interest revenue 16,873 15,489 6,282 79,086 660,070 $ 658,700 1,370

660,070

(Vertical)
J Chan Income Statement for the year ended 31 December 2009
$ Service fees Interest revenue Less Expenses: Rent and rates Salaries and images Water and electricity Printing and stationery Miscellaneous expenses Net profit $ 658,700 1,370 660,070

245,800 296,540 16,873 15,489 6,282

(580,984) 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. (Any relevant answers)

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