3.4 Final accounts

Final accounts

The published annual financial statements that all limited liability companies are legally obliged to report

• Balance sheet

• P&L account

2 types of final accounts

• Balance sheet

• Profit + loss account

Why are final accounts important?

Ensures all payments + receipts of a business have officially been accounted for

• Legal requirement

Purpose of final accounts to shareholders

Profit + loss account / income statement

A financial record of a firm's trading activities over the past 12 months, showing all revenues, costs + revenues during this time

Main purpose of profit + loss account

Show the value of profit / loss for a business during a particular trading period

Profit

The positive difference betw a firms revenues + costs

Revenue

Inflows of money from trading activities

Costs

Outflows of money incurred by a business due to the production of g+s

What does profit act as for most business?

Incentive to do well

3 sections of profit + loss account

1. The trading account

2. The profit + loss account

3. The appropriation account

What does the trading account show?

Shows difference betw a firms SR + costs of producing goods sold

• Sales revenue

• Cost of goods sold

• Gross profit

Gross profit

The difference betw the SR of a business + its direct costs incurred in making or purchasing products sold to customers

Gross profit equation

Sales revenue - cost of goods sold

Cost of goods sold (COGS) / cost of sales (COS)

The direct costs of producing or purchasing stock that has been sold to customers

Cost of goods sold equation

Opening stock + purchases - closing stock

What does the profit + loss section of a profit + loss account show?

Net profit / loss of a business at the end of a trading period

(Net) profit

The surplus (if any) that a business earns after all expenses have been paid for from the firm's gross profit

• SR - COGS - expenses

Net profit equation

Gross profit - expenses = net profit

Expenses

The indirect or fixed costs of production

• Eg administration charges, management salaries, insurance premiums, rent

How a business increase net profit (using the equation)?

Reduce expenses

Methods to reduce expenses

What does the final section of the P+L account show (appropriation account)?

How net profit after interest + tax is distributed

• Dividends

• Retained profit

How is net profit after interest + tax distributed?

• Dividends

• Retained profit

Dividends

Amt of net profit after i+t is distributed to shareholders

Retained profit

The amt of net profit after i+t + dividends have been paid

• It’s then reinvested in the business for its own use as an internal SoF

What is retained ‘profit’ known as for a non-profit organization?

Retained surplus

Pros of P&L account

Shows profit / loss after all costs + expenses are accounted for

• Doesn’t just show GP- bc if expenses higher than GP → business makes an overall loss

• Business can’t survive in LT w/o making actual profit

Cons of P&L account

1. Shows historical financial performance → doesn’t show future performance

2. No international standard format for P&L account → difficult to compare P&L for diff firms in diff countries

3. Window dressing

Window dressing

The legal act of creative accounting by manipulating financial data to make the results appear more appealing

Cost of sales vs expenses

COS

• Costs that a business can easily connect to the g/s it has produced

• Aka direct costs

• RM, packaging

Expenses

• Costs that affect the business, not just the g/s

• Aka indirect costs

• Cleaning staff salaries, utilities, petrol for delivery vehicles

Balance sheet

Contains financial information about an organization's assets, liabilities + the capital invested by the owners, showing a snapshot of the firm's financial situation

3 parts of a balance sheet

1. Assets

2. Liabilities

3. Equity

Assets

Items of monetary value owned by a business

• Cash, stocks

Non current assets (fixed assets)

• Items of monetary value owned by a business

• Not intended for sale within the next 12 months

• Used repeatedly to generate revenue for the organization

• Eg property, plant, equipment

Current asset

Cash or any other liquid asset that is likely to be turned into cash within 12 months of the balance sheet date

3 main types of current assets

1. Cash

2. Debtors

3. Stocks (inventories)

Cash

Money held in the business / bank

Debtors

People that owe money to the business bc they have purchased goods on credit

• Value of debtors = CA bc money is owed to / belongs to the business

Stocks (inventories)

Unsold supplies of RM, semi-finished goods, finished goods

• Finished stocks relatively liquid compared to RM

Liability

A legal obligation of a business to repay its lenders / suppliers at a later date

• Amt of money owed by the business

Non current liabilities (LT liabilities)

The debts owed by a business, which are expected to take longer than a year from the balance sheet date to repay

Current liabilities

Debts that must be settled within 1 year of the balance sheet date

• Eg bank overdrafts, trade creditors, other ST loans

3 main types of current liabilities

1. Bank overdrafts

2. Trade creditors

3. Other ST loans

Bank overdrafts

ST SoF- business can withdraw more from its bank account than the amount that exists

• Need to be repaid quickly bc of high IR

Trade creditors

Creditors

Suppliers who allow a business to purchase g/s on trade credit.

Net assets

Show the value of a business to its owners by calculating the value of all its assets minus its liabilities

• Net assets ALWAYS EQUALS equity in the balance sheet

• Value of TA - TL

2 net asset equations

• NA = total assets - total liabilities = equity

• NA = (NCA + CA) - (NCL + CL)

An asset belongs to a business, but what does this not necessarily mean?

Doesn’t mean it has been paid for

Equity (capital + reserves)

The value of the business that belongs to the owners

2 parts of equity for limited liability companies

1. Share capital

2. Retained earnings

(sum of accumulated retained profit)

1 part of equity for sole traders + partnerships

Only retained earnings

• Bc no shareholders

Share capital

The amount of money raised through the sale of shares

• Shows the value raised when the shares were first sold, rather than their current market value

Retained earnings / profit

The amount of profit after interest, tax, dividends have been paid.

• Reinvested in the business for its own use

In what final account does retained profit appear in?

• Balance sheet

  • Appears as retained earnings

• Profit + loss account

  • Kept within the business for its own use (not distributed as dividends)

From a balance sheet:

Total assets - total liabilities =

TA - TL = net assets = total equity

• Means the owners own the value of the assets of the business after deductions have been made for all its debts

Balance sheet layout

1. NCA

2. CA

3. TA

4. CL

5. NCL

6. TL

7. NA

8. Equity

9. TE

Balance sheet of incorporated vs unincorporated business

Unincorporated business- no shareholders → share capital not part of equity

Balance sheet of unincorporated (ST, partnership) vs incorporated (LLC)

1. Sources of finance

2. Funds invested by owners

3. Dividends

Cons of balance sheets

1. Static documents

2. Figures only estimates of the value of assets + liabilities

• Market value not same as book value

3. No universal format → hard to compare financial position of diff firms

4. Not all assets included (intangible assets, value of human capital)

Intangible assets

NCA that don’t exist in a physical form but are of monetary value + can earn revenue for a business

• Legally protected by laws (intellectual property rights)

Examples of intangible assets

1. Goodwill

2. Copyrights

3. Brand names

4. Patents

5. Registered trademarks

How much of a firms asset value can intangible assets account for?

A large proportion

• But difficult to place an objective + accurate price on them

Goodwill

An intangible asset which exists when the value of a firm exceeds its book value (the value of the firm's net assets)

Why are intangible assets not always recorded in a firms balance sheet?

Bc their value is difficult to measure in an objective / scientific way

• Adding value of intangible assets on BS = window dressing to artificially inflate the value of a business

Cons of final accounts

1. Using only single years data in isolation → can’t find trends

2. HR ignored when examining final accounts

3. Doesn’t reveal firms non-financial priorities

4. Time consuming

5. Companies will limit the financial info they disclose

6. Historical accounts

Apreciation

The increase in the value of NCAs

Examples of NCA that appreciate

• Property

• Land

Depreciation

The fall in the value of NCAs over time due to wear and tear + obsolesence

Do NCA or CA depreciate?

NCA

2 reasons for depreciation

1. Wear + tear

2. Obsolescence

Wear + tear

Repeated use of an asset → eventually breaks down

• Eg computers, vehicles

• Increases maintenance costs

Obsolescence

Outdated, older versions

• As newer, better products become available, the demand + value of existing NCA will fall.

Historic cost

The purchase cost of a particular fixed asset

• Used to calc depreciation

How does depreciation represent the historic (purchase) cost of NCA?

Spreads the historic cost of fixed assets over their useful lifespan

On which final account is depreciation shown?

1. Balance sheet- accumulated depreciation

2. P&L- as an expense

Why does depreciation need to be recorded?

To:

1. Calculate the value of a business more accurately

2. Realistically assess the value of NCA over time

3. Plan for the replacement of NCA in the future

What do depreciating NCA do to the net asset value of a business?

Increase net asset value

2 methodsof calculating depreciation

1. Straight line method

2. Units of production method

Straight line method

A method of calculating depreciation that reduces the value of a fixed asset by the same value each year throughout its useful life

Which method is more commonly used to calculate depreciation?

Straight line method bc easier

3 key variables to calculate annual depreciation

1. Life expectancy of the NCA

2. Scrap value (residual value) of the NCA

3. Historic (purchase) cost

Life expectancy of NCA

How long it is intended to be used before it needs to be replaced

Scrap (residual) value

An estimate of the value of the NCA at the end of its useful life

Acummulated depreciation

The annual depreciation expense multiplied by the no. of years the asset has been in use