2-3 Mark Explain

Explain why an Income Statement is prepared, even though net profit is

known (3 marks)
Even though net profit can be identified through the Profit and Loss Summary
general ledger account, by preparing an Income Statement for the period it can
communicate to the owner how the net profit/loss has arisen, and individual
revenues earned and expenses incurred contributing to this. The preparation of
the Income Statement supports Relevance, as sections such as the Gross Profit
and Net Profit can be analysed to assess the adequacy of the firm’s mark-up and
expense control procedures respectively, which is capable in assisting decision-
making. Furthermore, the owner can compare actual performance to budgeted
performance to identify favourable and unfavourable outcomes, assisting in
taking corrective action to improve profit results. Preparing the Income
Statement also supports Understandability as it communicates financial
information in a readily comprehensible way, which can assist in decision-making
and performance analysis.
Explain why asset accounts are not closed (2 marks)
Asset accounts are not closed in preparation for the next reporting period as they
are not involved in the calculation of net profit. Rather, they’re balanced to carry
forward the expected economic benefits which are yet to be consumed.
Explain why revenue and expense accounts are required to be closed
with reference to a Qualitative Characteristic (3 marks)
Revenue and expense general ledger accounts only exist in the current reporting
period as they’re not ongoing accounts which need to be carried forward into the
next period. Rather, they’re closed to the Profit and Loss Summary general
ledger account to reset all accounts to zero in preparation for the next period.
Furthermore, they’re closed to calculate an accurate net profit by matching
revenues earned against expenses incurred for the period and thus supports
Relevance as information can be provided to decision-makers which is only
inclusive of information that is relevant to the period.
Explain why an Allowance for Doubtful Debts account must be made
with reference to an Accounting Assumption (3 marks)
An allowance for doubtful debts account is a negative revenue account which
must be made to ensure that a percentage of credit sales which are likely to be
written off as irrecoverable can be estimated. This is to ensure that any bad debt
is written off in the same period as the credit sale, ensuring that expenses are
recognised when incurred to follow the accrual basis of accounting. Therefore,
net profit can be calculated accurately by matching revenues earned with
expenses incurred.
Explain how the business can report a Net Loss while during the same
period the Net Cash Flows from Operating Activities can increase (4
marks)
Net cash flows from Operating Activities and Net Loss are two different measures
of performance and will likely not be the same in dollar amount. Net cash flows
from Operating Activities refer to cash inflows from receipts, less cash outflows
from payments that relate to day-to-day trading activities of the business. If cash
receipts are greater than cash payments, the business can report a cash surplus
from Operating Activities leading to an increase in net cash flows. Whereas net
profit refers to revenues earned less expenses incurred in a period, under the
accrual basis of accounting and the business can report a net loss if expenses
incurred for the period are greater than revenues earned. The business can
report the same two figures as some operating inflows are not revenues and also
because some expenses are not operating outflows. Since the business has
offered more attractive credit terms, credit customers can be encouraged to pay
earlier which can incur discount expense which is a non-cash expense and thus
contribute to reporting a net loss. At the same time, receipts from accounts
receivable may be greater than credit sales for that period if customers are
paying more frequently and thus a larger inflow can be reported compared to
revenue earned. Hence, within the same period, the business can report a Net
Loss whilst also reporting an increase in net cash flows from operating activities.
With reference to a qualitative characteristic explain why a business
should recognise bad debts at balance day (3 marks)
Bad debts expense is the expense incurred when an account receivable is
confirmed to be irrecoverable and written off due to insolvency. In alignment with
the qualitative characteristic faithful representation, bad debts expense should
be recognised on balance day to match revenues earned with expenses incurred
to calculate net profit accurately. To align with the accrual basis of accounting,
the bad debts expense is only recognised on balance day when the allowance for
doubtful debts ledger is made to write off the debt in the same period as the
credit sale. Thus, this ensures that the financial reports such as the Income
Statement are representative of real-world economic events and complete and
also to acknowledge that the business does not expect to collect all outstanding
debts in the current reporting period.

The manager of a business receives a bonus on all sales revenue

generated. In order to increase this commission he knowingly
continues to sell inventory to customers who have not paid
previous accounts.
Discuss the financial and ethical implications of the manager’s
decision. (4 marks)

If the manager continues to sell inventory to customers whom historically do not

pay accounts, then he would be increasing his revenue through earning
commission. However, as these customers do not pay their accounts by allowing
credit sales to these customers, the manager will simply be incurring more
expenses through bad debts expense in subsequent periods, decreasing net
profit and the financial position of the business. Thus, the revenue earned by the
business would not accurately reflect the financial position of the firm as these
revenues are not expected to be received through receipts from accounts
receivable and hence the manager is inflating sales revenue to make the firm’s
profit look more attractive but not representative of the actual situation. This is
unethical since the manager is providing misleading information in the financial
reports and is socially deceptive to users of financial reports which users could
use to base decision-making. Additionally, due to the business likely to not
receive cash their inflows their liquidity will worsen, reducing their ability to meet
short term debts as they fall due and could harm the business in general. The
extreme case would be that the business cannot continue as their liquidity is
poor and this will negatively impact employee livelihood, due to the manager’s
financial decision and the flow on effects, in turn, for wages of employees.

The owner of the business is concerned that the allowance for doubtful
debts conflicts with verifiability and he should not be providing an
allowance for them. Discuss. (4 marks)
An allowance for doubtful debts is a negative asset account which is created
when a business estimates that a percentage of net credit sales is unlikely to be
received in the future due to customer insolvency. Even though this percentage
is an estimate and does not align with Verifiability as it cannot be evidenced by a
source document, by providing an allowance for doubtful debts the business is
upholding Faithful Representation, rather than excluding the account. This is
because, if the allowance is not made then the accounts receivable balance and
asset value would be overstated in the Balance Sheet and also bad debts
expense would be understated in the Income Statement which overstates profit.
Thus these reports are misleading and inaccurate if the allowance is not made,
which could negatively impact decision-making if users use these reports.
Furthermore, the accrual basis of accounting will not be upheld if an allowance
for doubtful debts is not made, but a write off occurs. This is because the bad
debts expense must be incurred in the same period as the credit sale (revenue)
was earned, which is facilitated by creating the ledger account. Additionally, by
creating an allowance for doubtful the business is operating in a conservative
way, ensuring that financial information and reports will be suitable for decision-
making.
With reference to qualitative characteristics explain why a classified
Income Statement is prepared monthly by the business (4 marks)
A classified Income Statement details all revenues earned and expenses incurred
in a period to calculate net profit. It supports Understandability as it is readily
comprehensible to users with a reasonable knowledge of business and economic
events and is set out using a format which clearly details are relevant
information which can assist in decision-making. By clearly detailing revenues
earned and expenses incurred, the owner or any decision-maker can assess
performance in terms of profitability and make evaluations and take corrective
action where necessary. The preparation of an income statement monthly also
supports Timeliness as financial reports can be provided to decision-makers in
time to be capable of affecting decision-making. Since the more recent
information is more relevant, by preparing reports monthly the business can
ensure that all information provided can affect decision-making. Furthermore, by
preparing an Income Statement monthly, performance can be compared against
periods to identify favourable and unfavourable outcomes, which can assist in
taking corrective action to improve profitability.
Discuss one strategy Tom could implement to improve Inventory
Turnover without impacting the Gross Profit Margin (4 marks)
To improve the inventory turnover of the business, Tom could purchase less
inventory which would decrease average assets and thus reduce the average
number of days taken to convert inventory to sales. By purchasing less
inventory, the financial indicator of Gross Profit Margin is not affected as the
mark-up on cost is not changed. However, in implementing this strategy, Tom
could be limiting the business’ revenue-generating capacity as he is limiting the
number of sales that can occur due to the supply of inventory on hand. This
could hence reduce sales revenue and the Gross Profit and Net Profit, affecting
the business’ profitability.
Explain the purpose of a Pre-Adjustment Trial Balance (2 marks)
A pre-adjustment trial balance lists all general ledger accounts and their
respective balance, prior to any balance day adjustments. It is a double-checking
mechanism on the accuracy of the double entry accounting system as total
credits should be equal to total debits. If necessary, correcting entries can be
made to fix any errors in recording. It is prepared prior to the preparation of
financial reports as it has lists all general ledger accounts relevant to the
accounting reports.

The cash flows from operations has increased by $20,000 from 2024 to 2025,
which means that the business has improved their ability to generate cash
surplus’ from day-to-day trading activities. Even though this would usually result
in an improvement in meeting short term debts as they fall due, the cash flow
cover has become slower from 8 to 6 times, indicating otherwise. The business
has thus increased their average, current liabilities, which needs to be settled
within 12 months after the end of the reporting period. Hence, the average
liabilities has increased by a greater proportion than net cash flows from
operations has. The owner is incorrect in his analysis as the business now has
more current liabilities for which cash must be generated to settle, putting
further strain on operating cash flows in future periods. However, cash flow cover
is only one financial indicator and to analyse whether business performance has
improved or not, the owner must also consider profitability and non-financial
information.