Provision for unrealised profit

 

A business which uses factory profit may also value its inventory of finished goods on a cost plus % basis – this creates true comparisons with potential ‘replacement’ suppliers and shows the value added to the product through the transformation process.

However the retail element of the business has not sold them and thus not made any profit yet!  This creates a problem: - How should inventory be valued??

IAS 2 says that “Inventory should be valued at the lower of historic cost or Net Realizable Value”

The solution is to create a provision for unrealised profit and take it off in the balance sheet.  Otherwise profits and assets will be overstated (going against prudence and IAS 2) which prevents a true and fair view of the accounts being shown.  Since the inventory is not sold thus realisation concept means it cannot be claimed.  This is done in a similar way to the provision for doubtful debts (see here)

A Business has no opening inventory but has a closing inventory valued at £6500 plus factory cost of 10% - total value

Finished Goods + Factory Profit = Closing Inventory

Therefore £6500+650 = £7150

The unrealised profit (i.e. profit margin included in the closing inventory) is £650.  In the first year this whole amount is written off as an expense taken off the Factory/Manufacturing profit figure.  In the balance sheet the total PUP is deducted from the inventory of finished goods to give a cost figures (meeting IAS2).

What if you are not given the original figures?

Formula (revise this): -

Inventory figure (including 10% Profit)   * Profit %

                (100 + Profit %)                                                    = £ unrealised profit figure

Worked Example

                7150                       * 10 

                (100+10)                                                              = £650

What do we do in the financial statement when the PUP changes?

The following year if the cost of finished goods went up to £7500 then the provision needs to go up from £650 to £750 then only the difference needs to be written off as an expense in the IS and the FULL provision taken off in the Balance Sheet.

Nial Satis Extract from Income Statement for year ended 31^st December 2013

Manufacturing Profit                               £xxxx

Add Increase (change) in PUP                 £100

                                                                                £xxx

 

Nial Satis Balance Sheet extract at 31^st December 2013

Current Assets

Closing inventory of Raw Materials                      10,100

Closing inventory of Work in Progress                  13,400  

Closing Inventory of Finished Goods       £8250

Less Total PUP                                       £750

                                                                            £7500                                                                                                                                                                                                               31,000

Statement of Changes in Equity

A statement of changes in equity does exactly as it says on the tin!  It shows the changes to the shares and reserves of the company over the financial year.  The headings across the top could be remembered by the term I Should Really Get Revising Tonight!

The changes to equity are listed down the left hand side.  These could include a number of things (see here)

• Opening capital are the values at the start of the year
• Revaluation reserve is the increase (decrease) of any property valuations
• Dividends paid are deducted from retained earnings.  Multiply the number of shares entitled to a dividend by the dividend per share to be paid
• Bonus issue is where shares are given to shareholders for free (see bonus and rights issue here).  The issued shares goes up and the share premium is deducted by the same amount.  If there is insufficient funds in the share premium deduct from revaluation reserve and keep going to the right until you have deducted the same amount
• Rights issue is where shares are sold.  The nominal amount per share goes in the issued share capital whilst the premium goes in the share premium.  This needs to be done for every share sold.  (see bonus and rights issues here)
• Retained Earnings for the year is the amount of profit after tax the firm has made. 
• The total for each column is then calculated at the bottom!

Below is a sample Statement of Changes in Equity  with entries to show where the figures would be made.  Negative figures are shown in brackets. If the company makes a loss then it is a retained loss for the year and is shown in brackets.

Rights and Bonus Issues

Rights and Bonus Issues of Shares

Rights Issues

•          A rights issue offers your existing shareholders the right to buy further shares in your business, usually at a discount to the market price (how much they sell for currently). This is a cheaper way to do this over a full public offering (i.e. to everyone).  We know that they are already shareholders and may be interested in buying more. This is a way of raising finance allowing it to use the funds to purchase non-current assets, repay debts etc.

•          Shares may be sold at a premium to the market price – the difference goes in the share premium a/c

•          Shares are usually offered on a x to y basis (known as pro-rata) – e.g. 1 for 2 basis. If so multiply the current issued value of the shares by ½ to find out how many new shares (in £) is to be added.  Should the shares be sold at a premium then take the nominal price from the issued price and multiply by the number of shares sold.

•          Exam Tip - Watch out for shares being 50p rather than £1 – This means that twice as many shares were sold!!!

Bonus Issue

•          This is used as a way of keeping shareholders happy.  If a firm is unable to offer dividends (e.g. due to insufficient funds or wishes to retain the money) then it may give shares for free on an x to y basis. A bonus issue does not raise finance.

•          If shares are given away on a 1 for 3 basis multiply the issued share capital (in £) by 1/3 to find out how many shares you have given away.

•          However since the value of the business (i.e. total capital) does not change another capital must go down – take it from Capital Reserves (such as Share Premium or Revaluation reserve) and then, if there is still not enough the Revenue Reserves.

Bonus issues can also be used to reduce the share price (a share split) to make shares appear more attractive to potential shareholders.  For example a 1 for 9 bonus issue will recapitalise reserves making £50 shares fall to approximately £5 whilst reducing some other reserves.

Cash Budgets / Cash Flow Forecasts

This blog is purely for cash budgets.  For all other budgets click here

A cash budget (or cash flow forecast) is a forecast of predicted revenues and expenditures.  They have benefits in that they allow firms to: -

• Plan ahead by arranging finances if needed (look at any closing balances which are negative – they are overdrawn – not making a loss!!!)
• Control expenditure if things are not going to plan
• Monitor performance and take corrective action if needed
• Motivate staff (bonuses?) if the targets are challenging but achievable (SMART targets). 
• Target setting so that employees have similar goals to work towards which should benefit the company overall
• Variance analysis can be performed.  You can compare actual figures with expected ones and then make changes for the future base on this past information
• Perform ‘what if’ scenarios to evaluate potential issues

However cash budgets

• Are based on historic data – things change such as the external environment (interest rates, new government, competitors actions)
• May be unrealistic and thus may demotivate staff who may not attempt to achieve them
• Are only a forecast and can still  be wrong!  They are only as good as the data used by the people setting them.
• Can be made too easy so that people will not have to push to achieve it.  Alternatively they could be so hard that people do not even try.
• Could mean that staff may only work towards the target rather than the true goal – e.g. sales targets over profitability especially if they receive bonuses based around the targets.

To complete a very simple cash budget:-

Opening balance

Add inflows (list them separately)

Minus outflows (list them separately

Closing Balance (this is next month’s opening balance)

Notes: -

1. Some budget layouts will have a net inflow which is the difference between the inflows and outflows.  This is added to the opening balance (a negative figure will reduce the closing balance.
2. The inflows and outflows are when cash is paid or received – not when a sale or purchase is made or when any income or expense is accrued.
3. Watch out for non cash expenses such as depreciation or bad debts.  These do not go in the cash budget as no cash has flowed in or out.

Credit sales or payments

•          Watch out for credit sales and purchases!  In a cash budget the amounts go in the month you receive or pay for it!

•          For example January’s Credit sales of £100, 20% is cash and the rest credit sales (1 month's credit) February’s sales is £150.  March’s cash sales go in March but credit sales not till April.  Only do the number of months needed!!!

                                           Jan                         Feb                        March

Cash Sales                           20                         30

Credit Sales                                                       80                        120

Look at the colours above  to match up with when it was sold!

A sample cash budget for a new Business – Nial Satis Sports

Commentary on the cash budget

Nial Satis is overdrawn at the end of each of the first 3 months (negative bank balance).  This is cause by high purchases (probably to set up the business and have enough initial inventory and paying for the equipment when he begins trading in January  These are known as set up costs.  The net cash flow for each month after this are all positive meaning he has more flowing in than out each month.  By the end of April Nial has a positive bank balance.

Nial must ensure he negotiates an overdraft of up to around  £6000.  This is because this is a forecast and may not be accurate.  If the outflows are higher or the inflows lower then he may have a higher overdraft each month and may still be overdrawn at the end of April if the figures are worse by more than £180.  Overall Nial’s liquidity is improving.

Note that there is no mention of profit.  A cash flow forecast / budget does not show this (although it may be possible to work out).  You need an income statement for this