Business Management 3.4 Final Accounts

Purpose and Structure of Final Accounts

• Definition of Final Accounts:

  • Final accounts consist of two primary statements:

    • The profit and loss statement (Statement of Profit or Loss).

    • The balance sheet (Statement of Financial Position).

  • All business organizations must maintain comprehensive records of their financial statements to ensure effective financial control and strategic planning.

  • For the vast majority of firms, maintaining and publishing final accounts is a legal requirement.

• Unit Content Overview & Assessment Objectives:

  • The purpose of accounts to different stakeholders ($\text{AO2}$).

  • Final accounts ($\text{AO2}, \text{AO4}$).

  • Profit and loss statement ($\text{AO2}$).

  • Balance sheet ($\text{AO2}, \text{AO4}$).

  • Different types of intangible assets ($\text{AO3}$).

  • Depreciation methods — HL only ($\text{AO2}, \text{AO4}$):

    • Straight line method.

    • Units of production method.

  • Appropriateness of each depreciation method — HL only ($\text{AO3}$).

  • Business Management Toolkit: Circular business models.

  • Final accounts and business management concepts.

Stakeholder Interests in Final Accounts

• Legal Obligation and Transparency:

  • Companies are legally obligated to prepare and present final accounts to ensure full transparency regarding how company funds are utilized when reporting to stakeholders.

• Internal Stakeholders:

  • Shareholders:

    • Examine final accounts to monitor where their invested capital has been spent.

    • Evaluate how well their financial investments have performed over the trading period.

  • Employees:

    • Assess the financial health of the business to gauge job security.

    • Evaluate the likelihood of future pay increments and bonuses.

  • Managers:

    • Judge operational efficiency across different departments.

    • Utilize financial data for target setting, budgeting, and strategic decision-making.

• External Stakeholders:

  • Competitors:

    • Compare financial performance, margins, and asset bases against rival firms.

  • Government / Tax Authorities:

    • Examine final financial records to calculate accurate corporate income tax liabilities.

  • Financiers (Lenders / Banks):

    • Evaluate the firm's credibility and solvency to assess the risk of debt repayment.

  • Suppliers:

    • Determine whether to grant trade credit and establish appropriate credit terms.

  • Potential Investors:

    • Analyze financial results to make informed investment decisions.

Profit and Loss Statement (Statement of Profit or Loss)

• Trading Performance Measurement:

  • A profit and loss account measures the net profit or net loss generated by a business entity over a specific trading period (e.g., a financial year).

• Profit and Loss Account Structure (Commercial Entity):

  • Sales Revenue: Total income earned from selling goods or services.

  • Cost of Sales (COS): Direct costs directly attributable to the production of sold goods or services.

  • Gross Profit: Calculated as $\text{Sales revenue} - \text{Cost of sales}$.

  • Expenses: Indirect overhead costs required to run the business.

  • Profit Before Interest and Tax (PBIT): Calculated as $\text{Gross profit} - \text{Total expenses}$.

  • Interest: Financing costs paid on outstanding debts.

  • Profit Before Tax (PBT): Calculated as $\text{Profit before interest and tax} - \text{Interest}$.

  • Tax: Corporate tax owed to the government.

  • Profit for Period (Net Profit): Calculated as $\text{Profit before tax} - \text{Tax}$.

  • Dividends: Portion of net profit distributed to shareholders.

  • Retained Profit: Calculated as $\text{Profit for period} - \text{Dividends}$. Reinvested back into the business.

• Sample Financial Statement: Codfather Seafood Ltd.:

  • Statement of profit or loss for the year ended 30 June 2022 (Figures in \text{m}\,\):

    • Sales revenue: $\$6\,\text{m}$

    • Cost of sales: \((\$2\,\text{m})\)

    • Gross profit: $\$4\,\text{m}$

    • Expenses:

      • Salaries: \((\$1.2\,\text{m})\)

      • Rent: \((\$0.8\,\text{m})\)

      • Advertising: \((\$0.5\,\text{m})\)

      • Utilities: \((\$1.0\,\text{m})\)

    • Profit before interest and tax: $\$1.5\,\text{m}$

    • Interest: \((\$0.2\,\text{m})\)

    • Profit before tax: $\$1.3\,\text{m}$

    • Tax: \((\$0.5\,\text{m})\)

    • Profit for period: $\$0.8\,\text{m}$

    • Dividends: \((\$0.5\,\text{m})\)

    • Retained profit: $\$0.3\,\text{m}$

Cost of Sales vs. Expenses

• Distinction Between Cost Types:

  • Both cost of sales and expenses represent business expenditures, but they are categorized separately on the profit and loss statement based on their direct relationship to output.

• Cost of Sales (Direct Costs):

  • Costs that a business can easily attribute directly to the specific good or service produced.

  • Coffee Shop Examples:

    • Raw materials (e.g., coffee beans, milk).

    • Packaging materials (e.g., disposable cups, lids, cup sleeves).

    • Salaries of baristas directly preparing products.

  • Laundry Service Examples:

    • Raw materials (e.g., laundry soap, dry cleaning chemicals).

    • Packaging materials (e.g., clothing hangers, protective plastic covers).

    • Salaries of operational employees who wash and dry clean garments.

• Expenses (Indirect Costs / Overheads):

  • Costs incurred to operate the business as a whole, which cannot be traced directly to a specific unit of production.

  • Coffee Shop Examples:

    • Salaries of cleaning staff.

    • Utility bills (e.g., water, gas, electricity).

    • Advertising and marketing costs.

    • Fuel/petrol for delivery vans.

  • Laundry Service Examples:

    • Utility bills (e.g., water and electricity).

    • Advertising expenses.

    • Fuel/petrol for delivery vans.

    • Salaries of delivery drivers.

Worked Examples: Profit and Loss Statement

• Profit-Making Entity: Arabicadabra Coffee Ltd.:

  • Financial Data for the year ended 31 March 2022 (in $\$000$

  • Sales revenue: $100$

  • Cost of sales: $25$

  • Salaries: $5$

  • Rent: $5$

  • Advertising: $3$

  • Utilities: $2$

  • Interest: $5$

  • Tax: $3$

  • Dividends: $2$

  • Step-by-Step Profit and Loss Statement Format:         \begin{array}{l r}\n        \text{Arabicadabra Coffee Ltd.} & \\\n        \text{Statement of profit or loss for the year ended 31 March 2022} & \text{\$(000)} \\\n        \hline\n        \text{Sales revenue} & 100 \\\n        \text{Cost of sales} & (25) \\\n        \hline\n        \mathbf{\text{Gross profit}} & \mathbf{75} \\\n        \text{Expenses} & \\\n        \quad \text{Salaries} & (5) \\\n        \quad \text{Rent} & (5) \\\n        \quad \text{Advertising} & (3) \\\n        \quad \text{Utilities} & (2) \\\n        \hline\n        \mathbf{\text{Profit before interest and tax}} & \mathbf{60} \\\n        \text{Interest} & (5) \\\n        \hline\n        \mathbf{\text{Profit before tax}} & \mathbf{55} \\\n        \text{Tax} & (3) \\\n        \hline\n        \mathbf{\text{Profit for period}} & \mathbf{52} \\\n        \text{Dividends} & (2) \\\n        \hline\n        \mathbf{\text{Retained profit}} & \mathbf{50} \\\n        \hline\n        \end{array}

  • Prescribed Formulas for Commercial Entities:

    • $\text{Gross profit} = \text{Sales revenue} - \text{Cost of sales}$

    • $\text{Profit before interest and tax} = \text{Gross profit} - \text{Total expenses}$

    • $\text{Profit before tax} = \text{Profit before interest and tax} - \text{Interest}$

    • $\text{Profit for period} = \text{Profit before tax} - \text{Tax}$

    • $\text{Retained profit} = \text{Profit for period} - \text{Dividends}$

• Non-Profit Entity: Caring for Classrooms:

  • Financial Data for the year ended 30 June 2022 (in $\$000$):

    • Sales revenue: $200$

    • Cost of sales: $50$

    • Salaries: $10$

    • Rent: $5$

    • Utilities: $4$

    • Insurance: $1$

    • Interest: $5$

    • Tax: $0$

  • Step-by-Step Statement Format for Non-Profit Entities:         \begin{array}{l r}\n        \text{Caring for Classrooms} & \\\n        \text{Statement of profit or loss for the year ended 30 June 2022} & \text{\$(000)} \\\n        \hline\n        \text{Sales revenue} & 200 \\\n        \text{Cost of sales} & (50) \\\n        \hline\n        \mathbf{\text{Gross surplus}} & \mathbf{150} \\\n        \text{Expenses} & \\\n        \quad \text{Salaries} & (10) \\\n        \quad \text{Rent} & (5) \\\n        \quad \text{Utilities} & (4) \\\n        \quad \text{Insurance} & (1) \\\n        \hline\n        \mathbf{\text{Surplus before interest}} & \mathbf{130} \\\n        \text{Interest} & (5) \\\n        \hline\n        \mathbf{\text{Surplus before tax}} & \mathbf{125} \\\n        \text{Tax} & 0 \\\n        \hline\n        \mathbf{\text{Surplus for period}} & \mathbf{125} \\\n        \hline\n        \mathbf{\text{Retained surplus}} & \mathbf{125} \\\n        \hline\n        \end{array}

  • Key Terminology and Structural Rules for Non-Profits:

    • The term profit is entirely replaced by the term surplus.

    • Dividends are not distributed.

    • The Retained surplus figure is identical to the Surplus for period figure because non-profit organizations reinvest all remaining balances into their social mission.

Strategies to Improve Profitability and Surplus

• Improving Gross Profit (Profit-Making Entities):

  • Increase Sales Revenue:

    • Increase product selling prices.

    • Sell higher volume quantities by applying targeted marketing strategies.

  • Reduce Cost of Sales:

    • Source raw materials from lower-cost suppliers.

    • Purchase raw materials in bulk to secure quantity discounts.

• Improving Gross Surplus (Non-Profit Entities):

  • Increase Overall Funding:

    • Secure corporate sponsorship agreements.

    • Execute public fundraising initiatives.

  • Increase Trading Sales Revenue:

    • Increase selling prices where applicable.

    • Expand transaction volumes through targeted promotional campaigns.

  • Reduce Cost of Sales:

    • Negotiate lower costs with suppliers.

    • Purchase supplies in bulk.

• Improving Net Margin (PBIT / Surplus Before Interest):

  • Reducing Expenses in Commercial Entities:

    • Relocate operations to a lower-rent location.

    • Install energy-efficient machinery to lower utility bills.

    • Procure cost-effective insurance coverage.

    • Shift promotion from above-the-line (mass media advertising) to lower-cost below-the-line activities.

  • Reducing Expenses in Non-Profit Entities:

    • Recruit volunteers to perform duties, reducing wage costs.

    • Relocate to cheaper premises.

    • Install energy-efficient equipment.

    • Switch to lower-cost insurance coverage.

    • Reallocate marketing focus from above-the-line to below-the-line promotion.

Balance Sheet (Statement of Financial Position)

• Purpose and Definition:

  • The balance sheet provides a static snapshot of the net financial worth of a business at a specific point in time (typically the final day of the financial year).

  • Audited balance sheets are a legal requirement for registered business entities.

• Core Balance Sheet Components:

  • Assets: Items of monetary value owned by the business; indicates how capital has been deployed.

  • Liabilities: Financial obligations owed by the business to external parties.

  • Equity: Capital supplied by owners/shareholders representing the underlying valuation of the entity.

• Detailed Breakdown of Assets:

  • Non-Current Assets: Operational assets retained and utilized for longer than $12\,\text{months}$.

    • Examples: Property, land, buildings, equipment, machinery, motor vehicles.

  • Current Assets: Short-term assets expected to be converted into cash within $12\,\text{months}$.

    • Cash: Liquid bank accounts and cash balances.

    • Debtors: Customers who have received goods or services on credit and owe payment.

    • Stock (Inventory): Unsold finished products, work-in-progress, and raw materials.

• Detailed Breakdown of Liabilities:

  • Current Liabilities: Short-term debts payable within $12\,\text{months}$.

    • Bank Overdraft: Short-term flexible credit facility extended by banks.

    • Trade Creditors: Suppliers owed money for items delivered on credit.

    • Other Short-Term Loans: Short-term commercial debt obligations due within one year.

  • Non-Current Liabilities: Long-term obligations payable after $12\,\text{months}$.

    • Examples: Commercial bank loans, property mortgages, debentures, other long-term loans.

• Equity Structure:

  • Commercial Profit-Making Entities:

    • Share Capital: Aggregate funds raised directly through issuing shares to investors.

    • Retained Earnings: Cumulative net profits retained from the profit and loss statement after deducting interest, corporate tax, and dividend payments.

  • Non-Profit Entities:

    • Retained Earnings: Cumulative net surpluses reinvested exclusively into the organization's mission.

    • Share Capital is completely omitted from non-profit balance sheets.

Asset and Liability Classifications

• Item Classification Table:

  • Land: Non-current asset

  • Stock: Current asset

  • Debtors: Current asset

  • Cash: Current asset

  • Creditors: Current liability

  • Profits Tax Bill: Current liability

  • Overdraft: Current liability

  • Mortgage: Non-current liability

  • Share Capital: Equity

  • Retained Profit: Equity

Worked Examples: Balance Sheet Layout and Calculations

• Profit-Making Entity: Arabicadabra Coffee Ltd.:

  • Raw Balance Sheet Data as at 31 March 2022 (in $\$000$):

    • Equipment: $500$

    • Accumulated depreciation: $(20)$

    • Cash: $10$

    • Debtors: $12$

    • Stock: $35$

    • Bank overdraft: $5$

    • Trade creditors: $15$

    • Short-term loans: $22$

    • Borrowings — long-term: $300$

    • Share capital: $110$

    • Retained earnings: $85$

  • Statement of Financial Position Structure:         \begin{array}{l r r}\n        \text{Arabicadabra Coffee Ltd.} & &\n        \text{Statement of financial position as at 31 March 2022} & \text{\(000)} & \text{\(000)} \\\n        \hline\n        \mathbf{\text{Non-current assets}} & &\n        \quad \text{Property, plant and equipment} & 500 &\n        \quad \text{Accumulated depreciation} & (20) &\n        \hline\n        \mathbf{\text{Total non-current assets}} & & \mathbf{480} \\\n        \mathbf{\text{Current assets}} & &\n        \quad \text{Cash} & 10 &\n        \quad \text{Debtors} & 12 &\n        \quad \text{Stock} & 35 &\n        \hline\n        \mathbf{\text{Total current assets}} & & \mathbf{57} \\\n        \hline\n        \mathbf{\text{Total assets}} & & \mathbf{537} \\\n        \hline\n        \mathbf{\text{Current liabilities}} & &\n        \quad \text{Bank overdraft} & 5 &\n        \quad \text{Trade creditors} & 15 &\n        \quad \text{Other short-term loans} & 22 &\n        \hline\n        \mathbf{\text{Total current liabilities}} & & \mathbf{42} \\\n        \mathbf{\text{Non-current liabilities}} & &\n        \quad \text{Borrowings -- long-term} & 300 &\n        \hline\n        \mathbf{\text{Total non-current liabilities}} & & \mathbf{300} \\\n        \hline\n        \mathbf{\text{Total liabilities}} & & \mathbf{342} \\\n        \hline\n        \mathbf{\text{Net assets}} & & \mathbf{195} \\\n        \hline\n        \mathbf{\text{Equity}} & &\n        \quad \text{Share capital} & 110 &\n        \quad \text{Retained earnings} & 85 &\n        \hline\n        \mathbf{\text{Total equity}} & & \mathbf{195} \\\n        \hline\n        \end{array}

  • Balance Sheet Standard Equations:

    • $\text{Net non-current assets} = \text{Gross non-current assets} - \text{Accumulated depreciation} = 500 - 20 = 480$

    • $\text{Total current assets} = \text{Cash} + \text{Debtors} + \text{Stock} = 10 + 12 + 35 = 57$

    • $\text{Total assets} = \text{Net non-current assets} + \text{Total current assets} = 480 + 57 = 537$

    • $\text{Total current liabilities} = 5 + 15 + 22 = 42$

    • $\text{Total liabilities} = \text{Current liabilities} + \text{Non-current liabilities} = 42 + 300 = 342$

    • $\text{Net assets} = \text{Total assets} - \text{Total liabilities} = 537 - 342 = 195$

    • $\text{Total equity} = \text{Share capital} + \text{Retained earnings} = 110 + 85 = 195$

    • Fundamental Balancing Rule: $\text{Net assets} = \text{Total equity}$

• Non-Profit Balance Sheet Structure: Classroom Cares:

  • The balance sheet format for non-profit entities is structurally identical to that of commercial companies, with the single exception that Share capital is completely absent.

  • For Classroom Cares as at 31 March 2022, Net Assets ($\$195\,\text{k}$) balance directly with Retained Earnings ($\$195\,\text{k}$) under Total Equity.

Intangible Assets

• Definition:

  • Intangible assets are non-physical, non-current assets owned by a business that hold financial value and generate income.

  • Although they frequently constitute a significant percentage of a modern business's overall asset base, objective market valuation can be challenging.

  • Intangible assets serve as formal legal instruments to protect intellectual property (IP).

• Five Major Types of Intangible Assets:

  1. Brands:

     • Legally registered commercial names used to market products and conduct corporate operations (e.g., Apple, Microsoft, Coca-Cola).

  2. Patents:

     • Legal protection granted to an inventor for novel hardware, technological components, or manufacturing processes (e.g., fingerprint recognition technology).

  3. Copyrights:

     • Legal protection prohibiting unauthorized copying of original creative works and intellectual property (e.g., computer operating systems like software, musical compositions, published works, artistic content).

  4. Goodwill:

     • The quantifiable commercial premium representing an enterprise's established brand reputation, customer loyalty, and strategic market position.

  5. Registered Trademarks:

     • Legal protection covering exclusive visual symbols, icons, and company logos (e.g., Apple corporate logo).

Methods of Depreciation (HL Only)

• Definition and Causes of Depreciation:

  • Depreciation represents the measure of the economic loss in value of a non-current asset over time. Land and buildings are exceptions that generally appreciate rather than depreciate.

  • Depreciation allows businesses to systematically write off and spread the original purchase cost of non-current assets over their useful economic lifespan.

  • Two Primary Drivers of Asset Depreciation:

    • Wear and Tear: Decline in physical operational capabilities caused by repeated continuous use over time.

    • Obsolescence: Loss of economic utility because technological advancements render the asset obsolete.

• Depreciation Terminology:

  • Lifespan: The estimated useful operational lifespan of a non-current asset in years.

  • Residual Value (Scrap Value / Trade-In Value): Estimated liquidation value of an asset at the end of its useful lifespan.

  • Accumulated Depreciation: Total combined depreciation expenses recorded against an asset from date of acquisition to date.

  • Net Book Value (NBV): Current carrying value recorded on the balance sheet, calculated as $\text{Historical cost} - \text{Accumulated depreciation}$.

• Method 1: Straight-Line Depreciation:

  • Formula:         $\text{Annual depreciation} = \frac{\text{Purchase cost} - \text{Residual value}}{\text{Lifespan}}$

  • Strength: Easy to compute and straightforward to comprehend.

  • Weakness: Assumes an identical depreciation rate each year, which is unrealistic because most assets (e.g., motor vehicles) experience rapid devaluation during their initial years of operation.

  • Worked Calculation Example (Commercial Bread Oven):

    • Purchase cost: $\\text{\$30,000}$

    • Residual value: $\\text{\$6,000}$

    • Expected lifespan: $3\,\text{years}$

    • Annual depreciation: $\frac{\$30,000 - \$6,000}{3} = \$8,000\,\text{per year}$

        \begin{array}{c r r r}\n        \text{Year} & \text{Annual depreciation (\)} & \text{Net book value (\)} & \text{Accumulated depreciation (\$)} \\\n        \hline\n        0 & - & 30,000 & 0 \\\n        1 & 8,000 & 22,000 & 8,000 \\\n        2 & 8,000 & 14,000 & 16,000 \\\n        3 & 8,000 & 6,000 & 24,000 \\\n        \hline\n        \end{array}

• Method 2: Units of Production Depreciation:

  • Formula:         $\text{Depreciation expense} = \text{Depreciation per unit} \times \text{Number of units produced}$         $\text{Depreciation per unit} = \frac{\text{Purchase cost} - \text{Residual value}}{\text{Expected total output over lifespan}}$

  • Strength: Delivers accurate alignment between asset depreciation expense and actual production volume output.

  • Weakness: Requires tracking unit production volumes, making calculations more complex than the straight-line approach.

  • Worked Calculation Example (Commercial Bread Oven):

    • Purchase cost: $\\text{\$30,000}$

    • Residual value: $\\text{\$6,000}$

    • Lifespan: $3\,\text{years}$

    • Expected output: Year 1 = $24,000\,\text{loaves}$; Year 2 = $20,000\,\text{loaves}$; Year 3 = $16,000\,\text{loaves}$ ($\text{Total} = 60,000\,\text{loaves}$).

    • Depreciation per unit: $\frac{\$30,000 - \$6,000}{60,000} = \$0.40\,\text{per loaf}$

        \begin{array}{c r r r r}\n        \text{Year} & \text{Output (units)} & \text{Annual dep. (\000)} & \text{Net book value (\000)} & \text{Accumulated dep. (\$000)} \\\n        \hline\n        0 & - & - & 30.00 & 0.00 \\\n        1 & 24,000 & 0.40 \times 24 = 9.60 & 30.00 - 9.60 = 20.40 & 9.60 \\\n        2 & 20,000 & 0.40 \times 20 = 8.00 & 20.40 - 8.00 = 12.40 & 9.60 + 8.00 = 17.60 \\\n        3 & 16,000 & 0.40 \times 16 = 6.40 & 12.40 - 6.40 = 6.00 & 17.60 + 6.00 = 23.60^* \\\n        \hline\n        \end{array}         (Note: Exact mathematical sum of $9.60 + 8.00 + 6.40 = 24.00$; listed as $23.60$ on original slide manual entries).

Business Management Toolkit and Ethical Considerations in Final Accounts

• Circular Business Models (CBMs):

  • Focus on four operational pillars: Reduce, Recycle, Reuse, Repair.

  • Product Life Extension CBMs: Extending asset working lives through refurbishment and repair influences balance sheet values (via reduced replacement capital expenditure and altered depreciation timelines) while generating sustainable long-term revenue streams.

• Ethical Accounting Practices — Luckin Coffee Fraud Case Study:

  • In 2020, Luckin Coffee, a major Chinese coffee chain, was caught inflating its 2019 sales revenue figures by approximately $\\text{\$310}\,\text{million}$ ($\$12.7\,\text{Billion}$ valuation impact).

  • Following its 2019 Initial Public Offering (IPO) on the New York Stock Exchange, executive officers manipulated sales figures to project artificial revenue growth.

  • Consequences: The fraudulent reporting led directly to the company being delisted from the stock exchange in 2020 and breached global ACCA (Association of Chartered Certified Accountants) professional ethical codes.

• Confidentiality and Insider Trading:

  • Financial officers and accountants hold unrestricted access to sensitive material non-public financial information.

  • Insider Trading: Occurs when internal personnel misuse confidential company financial information to buy or sell securities for personal financial gain, representing an illegal and unethical breach of fiduciary duty.