Profit, accruals and financial statements

Financial statements organise accounting information to show performance and financial position. A statement of profit or loss summarises income and expenses for a period. A statement of financial position shows assets, liabilities and equity at a particular date. The distinction between a period and a date is important: profit measures performance over time, whereas financial position is a snapshot.

For a trading business using a simple periodic system, cost of sales is opening inventory plus net purchases and relevant direct buying costs, less closing inventory. Gross profit is net sales less cost of sales. Operating expenses are then deducted, with other relevant income or expenses included as appropriate, to determine profit for the period. Purchases of goods still unsold at the end are not all treated as cost of sales; closing inventory remains an asset.

Accrual accounting recognises income when earned and expenses when incurred, subject to the applicable accounting rules, rather than merely when cash moves. An accrued expense has been incurred but remains unpaid. It increases the period's expense and creates a liability. A prepaid expense is a payment relating to a future period. The unused part is an asset and is excluded from the current period's expense.

Suppose a business pays ₦120,000 for twelve months of insurance beginning halfway through its accounting year. If six months relate to the current year and there are no other relevant balances, only ₦60,000 is the current expense; the remaining ₦60,000 is prepaid insurance. Writing down the coverage dates before calculating the adjustment helps avoid treating the whole payment as a current expense.

Profit and cash are different. A credit sale can increase profit before its customer pays, while buying equipment reduces cash without making its entire cost an immediate routine expense. An owner's capital contribution increases cash and equity but is not sales revenue. Drawings reduce equity but are not an expense in measuring the sole trader's profit. In an examination, classify each item, state the period to which it relates and then calculate. Clear classification prevents an apparently accurate total from combining fundamentally different accounting items.

Profit measures a period, not a cash balance

The statement of profit or loss reports income and expenses over a period, while the statement of financial position reports assets, liabilities and equity at a date. A cash balance is one asset at that date. A business can earn profit while cash falls because customers have not paid, inventory has increased or equipment was purchased. It can also receive cash from borrowing without earning profit. Always identify whether the question asks about performance, financial position or cash movement before selecting a calculation.

In a simple trading business using a periodic inventory system, net sales are sales less sales returns. Cost of sales equals opening inventory plus net purchases and relevant direct acquisition costs less closing inventory. Gross profit equals net sales less cost of sales. Operating expenses are then deducted and other relevant income included to arrive at profit for the period under the stated format. Closing inventory is deducted in the cost calculation because those goods have not yet been sold; it also appears as a current asset at the reporting date.

Inventory and expense adjustments

Suppose opening inventory is ₦40,000, purchases are ₦180,000, carriage inwards is ₦10,000 and closing inventory is ₦50,000. Cost of sales is ₦180,000. If net sales are ₦260,000, gross profit is ₦80,000. Carriage inwards helps bring goods into saleable condition or location and is included here in acquisition cost. Carriage outwards, used to deliver sold goods to customers, is normally treated as a selling expense in this elementary format. Do not interchange them merely because both involve transport.

An accrued expense belongs to the period but remains unpaid at the reporting date. A prepaid expense has been paid but relates to a future period. For a simple expense account, expense for the period = cash paid + closing accrual − opening accrual + opening prepayment − closing prepayment. Understand each adjustment rather than memorising signs without context. A closing accrual increases this period's expense and creates a liability. A closing prepayment reduces this period's expense and creates an asset for the unused benefit.

Income adjustments and receivables

Accrued income has been earned but not yet received, so it increases recognised income and creates an asset. Income received in advance relates to a future earning period, so it is excluded from current income and treated as a liability until earned. If a tenant pays next year's rent early, the landlord's bank balance rises immediately but that receipt is not automatically all current-period income. The dates and service period determine recognition under the stated accrual basis.

Irrecoverable debts are receivables no longer expected to be collected and are removed from the relevant customer balances. An allowance for doubtful receivables estimates an expected shortfall on remaining receivables under the simplified syllabus method. Calculate the allowance on the base specified after required write-offs. Distinguish the closing allowance, shown against receivables, from the change in allowance affecting the current profit calculation. Applying a percentage to the wrong balance can produce a plausible but incorrect figure.

Depreciation, capital and financial position

Depreciation allocates a depreciable amount over useful life in a systematic way. It is not a cash fund or an automatic measure of resale value. The charge reduces profit, while accumulated depreciation reduces the asset's carrying amount. An equipment purchase is not usually deducted in full as an expense when it provides benefits across several periods. If the question specifies a useful life, residual value and method, calculate using those assumptions rather than selecting whichever method gives the desired profit.

After determining profit, update the owner's capital for capital introduced and drawings. In the statement of financial position, classify assets and liabilities according to the required framework and presentation. Current assets commonly include inventory, receivables, prepayments and cash; non-current assets include resources used over longer periods. Current liabilities include trade payables and relevant accruals. The exact format can vary, so the essential check is that recognised assets equal liabilities plus equity after all adjustments.

Common mistakes and self-check

An overstated closing inventory understates cost of sales and overstates gross profit and assets, other things equal. Omitting an accrued expense understates both expense and liabilities and overstates profit. Recording drawings as wages understates profit and misclassifies a reduction in capital. These effects can be explained without preparing a complete set of statements. Trace the adjustment through the formula, then through the asset or liability and finally through equity.

Self-check: rent paid is ₦36,000, with a closing prepayment of ₦6,000 and no other adjustments. Rent expense is ₦30,000 and prepayments include ₦6,000. Self-check: gross profit is ₦80,000 and operating expenses after adjustments are ₦52,000, giving profit ₦28,000. Show each supporting calculation separately. A neat final statement cannot compensate for an unexplained adjustment, while clear workings allow another reader to identify exactly how each figure was obtained.