Accounting and Finance - Week 2 - Financial Statements

Week 2 - Financial Statements

Introduction

• This lecture introduces the three main financial statements: the Income Statement, the Cashflow Statement, and the Balance Sheet.

Accounting Period

• Firms typically produce financial statements annually, but they can also be produced semi-annually.
• An "Accounting period" is usually 12 months long.
• The accounting period does not necessarily have to coincide with the period from January 1st to December 31st; for example, it could be from May 1st to April 30th.
• The accounting period is important because it measures a company's financial performance and position during that specific period.

Three Major Financial Statements

• Balance Sheet (Statement of Financial Position - SOFP)
  • Shows the business's financial position (accumulated wealth) at the end of the period.
• Income Statement (Profit and Loss Account)
  • Shows how much wealth was generated during the period (business performance).
• Statement of Cash Flows (Cash Flow Statement)
  • Shows what cash movements took place during the period.

The Income Statement

• Reports on a business’s performance (i.e., profitability) over a period of time.
  • Example: Fashion XYZ: Statement of Profit or Loss for Year Ended 31st December 2025
• Comprised of:
  • Income
  • Expenses
  • Profit (= Income less Expenses)

Income

• Also known as ‘Sales’, ‘Revenue’, ‘Turnover’.
• Income is the inflow of wealth into the business from its ordinary operations.
  • Sales revenue from the business’s ordinary operations.
  • Example: sale of goods or provision of services.
• Income does not include funds received from issuing shares or receiving a bank loan.

Expenses

• Also known as ‘Expenditure’, ‘Costs’.
• Expenses are the outflow of wealth from the business from its ordinary operations.
  • The costs involved in the business’s ordinary operations.
  • Example: wages, rent, electricity, telephone, insurance, etc.
• Expenses do not include repayment of bank loans or paying dividends to shareholders.

Profit

• Profit is the increase in wealth attributable to the owners of the business that arises through business operations during the accounting period.
• The ‘Profit’ of the accounting period is the difference between income earned and the expenses incurred in the accounting period.
• $Profit = Income - Expenses$

Statement of Profit or Loss - Financial Accounting Format

• Example:

  • Sales Revenue: £100,000
  • Cost of Sales: (£40,000)
  • Gross Profit: £60,000
  • Selling & Distribution Costs: (£20,000)
  • Administration Costs: (£15,000)
  • Operating Profit: £25,000
  • Finance Income: Nil
  • Finance Costs: (£1,000)
  • Profit before Tax: £24,000
  • Taxation: (£4,800)
  • Profit after Tax: £19,200

• Financial accounting companies must use a standard format defined by Financial Reporting Standards in their annual accounts.

Cost of Sales

• Also referred to as Cost of Goods Sold (COGS).
• Cost of goods sold has been adopted to all types of businesses – trading and non- trading.
• COGS is the cost of acquiring (buying) the products that a trading company sells during a period.
• $Cost of Sales = Opening Inventory + Purchases - Closing Inventory$

Cost of Sales - Example

• Sales during 2019: £200,000

• Inventory as at 1 Jan 2019: £50,000

• Purchases during 2019: £72,000

• Inventory as at 31 Dec 2019: £25,000

• Gross Profit made during 2019

• Extract from Income Statement for year ended 31 Dec 2019:

  • Sales Revenue: £200,000
  • Cost of Sales: (£97,000)
    • Opening Inventory: £50,000
    • Purchases: £72,000
    • Closing Inventory: (£25,000)
  • Gross Profit: £103,000

Income Statement Example

• Cost of Sales $= Opening Inventory + Purchases - Closing Inventory$
• $= (140 + 20 - 55) = 105$

The Statement of Financial Position (SOFP) - Balance Sheet

• Reports on a business’s position (i.e., value) at a given point in time.
  • Example: “Fashion XYZ Statement of Financial Position as at 31st December 2025”
• Comprised of:
  • Assets
  • Liabilities
  • Equity

Assets

• What the Business Owns
• Current Assets [CA]
  • Expected to be ‘realised’ within 12 months
    • Cash
    • Inventory (aka ‘stock’)
    • Receivables (aka ‘debtors’)
• Non-Current Assets [NCA] (aka ‘Fixed Assets’ or ‘Capital Assets’)
  • Not expected to be ‘realised’ within 12 months
    • Land & Buildings
    • Plant & Machinery
    • Investments (an example of an ‘intangible asset’)

Liabilities

• What the Business Owes
• Current Liabilities [CL]
  • Expected to be ‘settled’ within 12 months
    • Payables (aka ‘creditors’)
    • Tax liability
    • Bank Overdraft
• Non-Current Liabilities [NCL] (aka ‘Long Term Liabilities or Debt’)
  • Not expected to be ‘settled’ within 12 months
    • 10-year bank loan
    • 25-year mortgage

Equity

• The ‘book-value’ of the business (according to accounting principles) which ‘belongs’ to the shareholders.
  • The value of the shareholders’ investment in the company.
• Equity is calculated by deducting what a business owes (its liabilities) from what it owns (its assets).
• Equity: The value of the business
• The Accounting Equation:
  • $Assets - Liabilities = Equity$
  • or
  • $Assets = Equity + Liabilities$

Example – How to Make a Balance Sheet

• Data is given to prepare a Statement of Financial Position as at 31st October 2020.

Example - How to make a Balance Sheet

I. Fraser
Statement of Financial Position as of 31 October 2020

• Non-current Assets
  • Machinery 4,200
• Current Assets
  • Closing inventory 600
  • Accounts receivable 1,780
  • Bank 3,940
  • 6,320
• Current Liabilities
  • Accounts payable (1.960)
• Working Capital (Current Assets - Current Liabilities)
  • 4,360
• 8,560
• Non-current Liabilities
  • Loan (2,000)
• Net Assets
  • 6.560
• Capital/ Owner's Equity/ Financed by:
  • Capital 6,000
  • Add Net Profit (calculated in the income statement) 2.120
  • 8,120
  • Less Drawings (1,560)
• Closing Capital
  • 6.560

Depreciation

• Depreciation is the part of the original cost of a non-current asset that is notionally consumed during its period of use by the business.
• Depreciation is charged to the income statement each year as an expense.
• The amount charged is based on an estimate of how much economic usefulness has been used up in the accounting period.
• The purpose is to spread the cost of non-current assets over the periods in which it is to be used

Depreciation Methods

There are two main depreciation methods:

• Straight line method (Focus of this module)
• Reducing balance method also called declining balance method

Straight Line Depreciation

• Straight line depreciation is calculated as the cost of the Noncurrent Asset, minus the estimated disposal value (residual value), divided by the number of expected years of use (estimated useful life).
• $Depreciation per annum (each year) = \frac{Cost - Expected Residual Value}{Estimated Useful Life}$

Cashflow Statements

• Question: "What’s the difference between profit and cash?"
• Answer: "The difference between success and bankruptcy!"
• Profit is a concept.
• Cash is a reality.

Profit vs Cash

• “Profit” is an accounting estimate of underlying business performance stated in accordance with the ‘accruals concept’

  • Sales are recorded when ‘earned’ (not when the cash is received)
  • Expenditure is recorded when ‘incurred’ (not when the cash is paid)
  • Inventory is charged to the P&L (as ‘cost of sales’) when it is sold (not when purchased)
  • The cost of capital assets are spread (‘depreciated’) over their life (not when purchased)
  • Accruals & Pre-payments are used to ‘match’ the timing of sales revenue & expenses

• “Cashflow” is simply stated when it happens!

• $Net Cashflow = Cash Received - Cash Paid$

• The differences between the two arise because of the timings of cashflows

  • Credit Sales
  • Credit Purchases
  • Year End Accruals & Prepayments etc
  • Depreciation of Capital Expenditure (often the biggest single factor)

• $Net Profit = Sales Earned - Expenses Incurred$

Example – Bob the Window Cleaner

• Bob sets himself up as a window-cleaner. On day 1 he invests £7,000 in a second- hand van & ladders, which he believes will last him for 5 years (60 months) by which time they will have a residual value of £1,000.

• He will charge £10 per house and will always collect the cash the following month when he returns to clean that house’s windows again.

• Month 1: Cleans 20 houses; £40 cash expenses

• Month 2: Cleans 60 houses; £110 cash expenses

• Month 3: Cleans 80 houses; £30 cash expenses

• Monthly Depreciation on Van & Ladders $= (7000 - 1000) / 60 = 100$ per month

BOB’S PROFIT

BOB’S CASHFLOW

• Net Profit after 3 months = £1,120
• Net cashflow after 3 months = (£6,380)

Links between Financial Statements

• The three financial statements are (1) the income statement, (2) the balance sheet, and (3) the cash flow statement.
• Each of the financial statements provides important financial information for both internal and external stakeholders of a company.
• The income statement illustrates the profitability of a company under accrual accounting rules.
• The balance sheet shows a company’s assets, liabilities, and shareholders’ equity at a particular point in time.
• The cash flow statement shows cash movements from operating, investing, and financing activities.

Links Between Financial Statements