Final accounts

Final accounts, also known as financial statements, are the summary of a company's financial
transactions for a specific accounting period, typically a fiscal year. They provide an overview
of the company's financial performance and position, helping stakeholders understand its
profitability, liquidity, and overall health.

Key concepts:

Profitability: Profitability refers to the ability of a company to generate profit from

its operations. It measures the efficiency of the company in using its resources to
generate earnings. A profitable company earns more revenue than the costs it incurs
to produce goods or services. Profitability is typically assessed using metrics such as
net profit margin, return on investment (ROI), return on assets (ROA), and return on
equity (ROE).

Liquidity: Liquidity refers to the ability of a company to meet its short-term financial
obligations promptly and efficiently. It measures the company's ability to convert its
assets into cash quickly without significant loss in value. A liquid company has
sufficient cash or assets that can be readily converted into cash to cover its short-
term liabilities, such as bills, salaries, and loan repayments. Liquidity is commonly
evaluated using metrics such as the current ratio, quick ratio, and cash ratio.

Final accounts usually consist of three main statements:

1. Income Statement (Profit and Loss Account):

This statement shows the company's revenues, expenses, gains, and losses over a specific
period. The income statement calculates the net profit or loss by subtracting expenses from
revenues. It reflects the company's ability to generate profit from its core operations.

This is how P&L statements work:

 Revenue Recognition: The identification of income is the first entry in P&L statements. This
comprises revenue from any other sources in addition to those that result from the business’s
main business activities (e.g., sales of goods or services).
 Cost of Goods Sold (COGS): To determine the gross profit, the direct expenses related to the
production of goods or services are deducted from the overall revenue. Expenses that are
directly linked with the manufacture of a product, such as labour and basic materials, are
included in COGS.
 Gross Profit: Gross profit, which is the profit generated from the fundamental business
operations of a company, is the third component. Determined by deducting cost of goods sold
(COGS) from total revenue, it provides a fundamental evaluation of profitability before taking
into account the operating expenses.
 Operating Expenses: Operating expenses include a variety of expenses that are essential in the
operation of the business. These include research and development costs, selling and business
and administration expenses, and additional overheads. By deducting these expenses from the
total profit, the operating profit is calculated.
 Non-Operating Income and Expenses: This category includes non-operational items, which
includes interest income, asset sale gains or losses, and other activities that are not considered
main business activities. These items have an effect on the company’s final profit.
 Profit Before Tax: The profit before taxes (PBT) is calculated by deducting non-operating
expenses and total operating expenses from the operating profit. It signifies the profit generated
prior to the deduction of income tax.
 Income Tax Expense: This category includes both present and deferred income tax expenditures.
A percentage of the company’s profits must be set aside to satisfy its tax obligations.
 Net Loss or Profit (Net Profit): The net profit is the amount remaining after income tax expenses
have been subtracted from the Profit before Tax. It signifies the total financial gain of the
business over the chosen period. A negative result signifies a possible nett loss.

Why are Profit and Loss (P&L) Statement Important?

Profit and Loss (P&L) accounts are essential financial documents that present a brief summary of the
financial performance of a business during a particular time frame.

o Financial Health Evaluation: The use of profit and loss (P&L) statements permits companies to
assess their financial health through the complete declaration of revenues, costs, and expenses.
This evaluation allows stakeholders to get knowledge about the financial health of the
organisation.
o Decision-Making Tool: Profit and loss statements are used by management in order to arrive at
informed choices relating to the the company’s activities, pricing strategies, cost management
efforts, and future investments. It acts as an essential point of reference in the field of strategic
planning.
o Investor and Stakeholder Trust : P&L statements are used by investors and stakeholders, such as
prospective investors, creditors, and shareholders, to evaluate the financial condition of a
company. A P&L statement that is strong and constantly profitable has the potential to build
confidence and encourage investment.
o Budgeting and Planning : The use of P&L statements is essential in the process of budgeting and
preparing for prospective financial ventures. By studying past performance, companies can
establish achievable financial goals and efficiently distribute resources.
o The Identification of Trends and Patterns: It is possible to identify trends and patterns in
expenses, expenditures, and revenue when examining P&L statements for various time periods.
This analysis enables management’s understanding of market behaviour, enabling them to easily
modify their business strategies.

2. Balance Sheet (Statement of Financial Position):

The balance sheet presents a snapshot of the company's financial position at a specific point
in time, typically the end of the accounting period. It consists of assets (what the company
owns), liabilities (what the company owes), and shareholders' equity (the difference between
assets and liabilities). The balance sheet follows the fundamental accounting equation: Assets
= Liabilities + Shareholders' Equity.

There are two sides to a balance sheet, namely, the asset side (on the right side) and the
liabilities side (on the left side). The asset side of the balance sheet shows the debit balance
of the organization. However, the liabilities side of the balance sheet shows the credit
balances. The total of the asset side must always be equal to the total of the liabilities side.
The balance sheet of an organization is prepared after the preparation of the Trading and
Profit and Loss Account. The balance sheet includes the balances of all those ledger accounts,
which have not been transferred to the Trading P&L A/c and are yet to be carried forward to
the next financial year of the organization. The relevant items included in the balance sheet of
an organization are current liabilities, current assets, capital, fixed assets, investments,
drawings, long-term liabilities, etc.

Need for Balance Sheet

 Balance Sheet shows the business’s financial position at a glance at a particular time.
 Balance Sheet shows the financial position of the business in a systematic and standard
form.
 Balance Sheet states whether the business is solvent or not. If the value of the assets is
more than the liabilities, the firm is solvent and if the liabilities exceed over assets, the
firm is insolvent.
 Balance Sheet helps us to determine the purchase consideration of the business.
 To demonstrate a company’s creditworthiness to lenders and creditors, as financial
reports help them in evaluating the ability of a company in repaying their money.
 To facilitate the statutory audit.
 To disclose information about the economic resources of an entity claims to these
resources (liability and owner’s equity), and to show how these resources and claims have
undergone changes over a period of time.
 To provide information to prospective investors to attract them, so that they can take
rational decisions regarding their investment based on the reports.

Depreciation methods
Depreciation refers to the decrease in the value of assets of the company over the time
period due to use, wear and tear, and obsolescence.

In others words, it is the method to allocate the cost of an asset over its useful life.
Depreciation is always charged on the cost price of the asset and not on its market price. It is
charged every year to the extent of the depreciable amount. Examples of assets that can be
depreciated are Machines, Computers, Furniture, Vehicles, technological advancement etc.

Depreciation is an essential concept in accounting and financial management for several

reasons:

1. Allocation of Costs: Assets such as equipment, machinery, buildings, and vehicles have a
limited useful life. Depreciation allows businesses to allocate the cost of these assets over
their useful lives rather than expensing the entire cost in the year of purchase. This better
matches revenues with expenses, reflecting the consumption of the asset's economic
benefits over time.

2. Matching Principle: Depreciation helps uphold the matching principle in accounting,

which states that expenses should be recognized in the same period as the revenues they
help generate. By spreading the cost of an asset over its useful life, depreciation ensures
that the expense is matched with the revenue it helps generate during that time.
3. Asset Valuation: Accounting standards require that assets be reported at their historical
cost less accumulated depreciation on the balance sheet. Depreciation allows for a more
accurate representation of an asset's true value over time. This adjusted value provides a
more realistic representation of the asset's worth on the balance sheet.

4. Taxation: Depreciation also has tax implications. Governments often allow businesses to
deduct depreciation expenses from their taxable income, reducing the amount of income
tax they owe. Different depreciation methods and tax regulations can affect a company's
tax liability and cash flow management.

5. Financial Analysis: Depreciation affects various financial metrics and ratios used in
financial analysis. For example, it impacts net income, operating income, and profitability
ratios. Understanding depreciation allows investors, creditors, and management to assess
a company's financial health and performance accurately.

Examples: how Depreciation Affects Financial Analysis:

Net Income: Depreciation is a non-cash expense, meaning it doesn't involve actual cash
outflows. As a result, it reduces a company's reported net income on the income statement.
Lower net income affects profitability measures such as return on assets (ROA) and return on
equity (ROE).

Operating Income: Depreciation is often included in operating expenses, affecting operating

income. By adjusting for depreciation, analysts can assess a company's operating efficiency
and profitability more accurately.

Cash Flow: Although depreciation doesn't impact cash flow directly, it indirectly affects cash
flow through its tax implications. Higher depreciation expenses reduce taxable income,
resulting in lower income tax payments and potentially higher cash flows.

6. Replacement Planning: Depreciation helps businesses plan for the eventual replacement
or upgrade of assets. By recognizing the decline in the value of assets over time,
companies can anticipate the need for capital expenditures to maintain operational
efficiency.

Methods of Calculating Depreciation:

Businesses choose different methods for calculating depreciation according to their need.
The two most prominent methods for calculating depreciation are the Straight-Line Method
and the Diminishing Balance Method.

1. Straight Line Method:

Under this method of charging depreciation, the amount charged as depreciation for any
asset is fixed and equal for every year. The amount of depreciation is deducted from the
original cost of an asset and charged on the debit side of the Profit and Loss A/c as a loss.
The concerned asset is depreciated with an equal amount every year until the book value of
the asset becomes equal to the scrap value of the asset. It is also called the ‘Equal Installment
Method’ or ‘Fixed Installment Method’.
 Strengths:

 Simplicity: Straight-line depreciation is straightforward and easy to understand. It

requires minimal calculation.

 Stability: Provides consistent depreciation expenses over the asset's useful life,
making budgeting and financial planning easier.

 Weaknesses:

 Doesn't reflect asset usage: Doesn't account for the fact that some assets may be
used more heavily in the earlier years of their life, leading to potential inaccuracies
in the allocation of depreciation expenses.

 Not reflective of asset's actual decline in value: Assets may depreciate at a faster
rate in the earlier years and slower in the later years, but straight-line depreciation
assumes an even rate of decline.

Formula for Calculating Depreciation:

1. When Scrap Value is Given:

2. When Rate of Depreciation is Given:

Scrap value, also known as salvage value or residual value, is the estimated worth of an asset
at the end of its useful life.

When calculating depreciation, the scrap value is often subtracted from the original cost of
the asset to determine the depreciable base. The depreciable base is then divided by the
asset's useful life to determine the annual depreciation expense.

For example, if a company purchases a machine for $10,000 with an estimated scrap value of
$1,000 and a useful life of 5 years, the depreciable base would be $9,000 ($10,000 - $1,000).
Using straight-line depreciation, the annual depreciation expense would be $1,800 ($9,000 /
5 years).

Written Down Value or reducing balance Method:

Under this method of charging depreciation, the amount charged as depreciation for any
asset is charged at a fixed rate, but on the reducing value of the asset every year. The amount
of depreciation is deducted from the written down value (i.e., cost less depreciation) of an
asset and charged on the debit side of the Profit and Loss A/c as a loss. The concerned asset
is depreciated with an unequal amount every year, as the depreciation is charged to the book
value and not to the cost of the asset.

 Strengths:
  Reflects asset's actual decline in value: Recognizes that assets often lose value
more rapidly in the earlier years of their useful life.

 Tax advantages: Accelerated depreciation can result in higher depreciation

expenses in the earlier years, which can lead to higher tax deductions and lower
taxable income.

 Weaknesses:

 Complexity: The calculations involved in reducing balance depreciation can be

more complex than straight-line depreciation, requiring a deeper understanding
of accounting principles.

 Inconsistency: Depreciation expenses can vary widely from year to year, making
financial planning and budgeting more challenging.

 Potential for Overstatement: In some cases, accelerated depreciation may

overstate the depreciation expense, leading to lower asset values on the balance
sheet than their actual worth.

Formula for Calculating Depreciation:

1. When Scrap Value is Given (To find the rate of depreciation)

2. When Rate of Depreciation is Given:

For example, If we use reducing balance depreciation with the same machine that costs
$10,000, has an estimated scrap value of $1,000, and a useful life of 5 years, we need to
determine the depreciation rate. Let's assume a depreciation rate of 25% per year for this
method.

In reducing balance depreciation, the depreciation expense is calculated as a percentage of

the asset's net book value (cost minus accumulated depreciation) at the beginning of each
year.

Year 1:

 Beginning Net Book Value = $10,000

 Depreciation Expense = 25% * $10,000 = $2,500

 Ending Net Book Value = $10,000 - $2,500 = $7,500

Year 2:

 Beginning Net Book Value = $7,500

 Depreciation Expense = 25% * $7,500 = $1,875

 Ending Net Book Value = $7,500 - $1,875 = $5,625

Year 3:

 Beginning Net Book Value = $5,625

 Depreciation Expense = 25% * $5,625 = $1,406.25

 Ending Net Book Value = $5,625 - $1,406.25 = $4,218.75

Year 4:

 Beginning Net Book Value = $4,218.75

 Depreciation Expense = 25% * $4,218.75 = $1,054.69

 Ending Net Book Value = $4,218.75 - $1,054.69 = $3,164.06

Year 5:

 Beginning Net Book Value = $3,164.06

 Depreciation Expense = 25% * $3,164.06 = $791.02

 Ending Net Book Value = $3,164.06 - $791.02 = $2,373.04

After 5 years, the net book value of the machine would be approximately $2,373.04, which is
close to the estimated scrap value of $1,000.

In summary, reducing balance depreciation results in higher depreciation expenses in the

earlier years compared to straight-line depreciation, reflecting a faster decline in the asset's
value. This method can be advantageous for businesses looking to allocate more significant
depreciation expenses upfront.

the choice between straight-line and reducing balance depreciation methods depends on
factors such as the nature of the asset, its pattern of use, financial reporting requirements,
and tax considerations. Straight-line depreciation offers simplicity and stability but may not
accurately reflect the asset's actual decline in value, while reducing balance depreciation
provides a more accurate reflection of value decline but can be more complex and less
predictable.

3. Cash Flow Statement:

This statement tracks the inflows and outflows of cash and cash equivalents over the
accounting period, categorizing them into operating, investing, and financing activities. It
provides insights into how a company generates and utilizes its cash resources.

Objectives of Cash Flow Statement

 Short-term Planning: Helps companies plan their short-term cash needs, like paying bills
and buying assets.
 Cash Budgeting: Guides in creating cash budgets, showing when there will be extra cash
or shortages.
 Comparing Plans: Compares actual cash flows with budgeted ones to see if plans are
working.
 Tracking Cash Trends: Shows how quickly cash is coming in and going out, helping to
predict future cash levels.
 Explaining Cash vs. Profits: Explains why a company might have cash problems even if
it's making profits.
 Separating Cash Activities: Breaks down cash flows into different activities, like
operations, investments, and financing.
 Helps Everyone Understand: Not just for insiders, but also for outsiders like investors
and lenders to understand a company's money situation.
 Deciding Dividends: Helps decide if there's enough cash for paying dividends to
shareholders.
 Checking Managerial Decisions: Tests if management is following good financial rules,
like using long-term money for long-term investments.

Importance of Cash Flow Statement

o Know Cash Position: Gives a clear view of how much cash a company has.
o All Activities Included: Shows all the company's money movements, making it easier to
understand.
o Better than Other Statements: It's better than other statements for showing a
company's financial picture.
o Helps Plan Long-term: Useful for planning loan repayments, buying new equipment,
and other big money decisions.
o Find Cash Problems: Pinpoints reasons for cash shortages even when profits look good.
o Short-term Focus: Best for seeing if a company can pay its bills now, rather than later.
o Future Cash Predictions: Helps predict how much cash a company will have in the
future.
o Compare Past and Future: Lets companies compare past cash flows with future ones to
see if they're improving.
o Check Liquidity: Shows if a company is becoming more or less liquid over time, and how
it compares to others.

These final accounts are crucial for various stakeholders, including investors, creditors,
management, and regulatory authorities, as they provide valuable information for decision-
making, assessing financial health, and ensuring compliance with accounting standards and
regulations.

Internal Stakeholders:

1. Business Managers:

 Use financial statements to measure business performance against targets, previous

periods, and competitors.
 Utilize financial information to make decisions about investments, branch closures, and
product launches.

 Control and monitor departmental operations and set future targets based on actual
performance.

2. Workforce:

 Assess the company's financial health to ensure wages and salaries can be paid.

 Determine job security and potential for business expansion or reduction.

 Evaluate whether profit increases can support wage increases and compare average
wages with executive salaries.

External Stakeholders:

1. Banks:

 Assess financial statements to decide on lending money, increasing overdrafts, or

continuing loan facilities.

2. Creditors (Suppliers):

 Evaluate the business's ability to repay debts and determine credit risk.

 Decide on pressing for early debt repayment based on the company's financial health.

3. Customers:

 Evaluate business stability for future supply assurance and service availability.

4. Government and Tax Authorities:

 Use financial statements to calculate taxes owed, assess business expansion potential, and
ensure compliance with accounting regulations.

5. Investors:

 Assess business value, profitability trends, and share of profits to make investment
decisions.

 Compare financial details with other businesses before buying shares or selling holdings.

6. Local Community:

 Assess business profitability and expansion potential, which impacts the local economy.

 Determine potential for job creation or closure based on financial performance.

Principles and Ethics of Accounting Practice

Ethics in financial statements are crucial for stakeholders because they ensure trust, reliability, and
transparency in financial reporting. When accounting professionals adhere to principles and ethics in
their practice, stakeholders can rely on financial statements for accurate and unbiased information.
Here's why ethics in financial statements are important:

1. Integrity: Acting honestly in all dealings ensures that financial information is presented
truthfully and accurately, fostering trust among stakeholders.

2. Objectivity: Avoiding bias and conflicts of interest ensures that financial statements are
prepared without undue influence, maintaining their credibility and reliability.

3. Professional Competence and Due Care: Adhering to professional standards ensures that
financial statements are prepared with accuracy and precision, providing stakeholders with
reliable information for decision-making.

4. Confidentiality: Respecting confidentiality safeguards sensitive financial information,

protecting the interests of stakeholders and maintaining trust in the accounting profession.

5. Professional Behavior: Compliance with legal obligations and professional standards

demonstrates accountability and integrity, enhancing the reputation of the accounting
profession and instilling confidence in stakeholders.

Overall, ethics in financial statements uphold the integrity and credibility of financial reporting,
ensuring that stakeholders can make informed decisions based on accurate and transparent
information.

Limitations of Accounting Information to Stakeholders:

While stakeholders often assume that numerical data in financial accounts guarantees accuracy and
fairness, this perception is misleading. In practice, financial statements primarily present headline
figures, lacking the specific details necessary for comprehensive analysis. Therefore, stakeholders
must be mindful of various factors when interpreting business accounts:

1. Limited Detail and Comparison:

 Financial statements provide headline figures rather than specific details, limiting their
usefulness.

 A single year's accounts lack trend analysis, necessitating comparison over time and with similar
businesses.

Example: A company's income statement may show total revenue and expenses without breaking
down specific sources of revenue or types of expenses. Without this detail, stakeholders may
struggle to understand the company's revenue streams or cost structure fully. Additionally, a balance
sheet may only provide total assets and liabilities without detailing individual assets or liabilities,
making it challenging to assess the company's financial health comprehensively.

2. Non-Monetary Measurements Absent:

 Accounts do not capture non-monetary items like technological state or management skills,
crucial for assessing business viability.

 Intangible assets like reputation or employee value are not valued, impacting stakeholder
perception.
Example: A software development company's financial statements may accurately report revenue
and expenses but fail to account for the quality of its software products or the expertise of its
development team. These intangible factors, such as the state of technology within the business or
the skills of the management team, are critical for evaluating the company's long-term prospects but
cannot be quantified in monetary terms.

3. Inability to Compare Across Businesses:

 Effective assessment requires comparison with similar firms, but a single business's accounts lack
comparative data.

Example: Two companies in the same industry may have vastly different accounting methods or
reporting standards, making it difficult to compare their financial performance directly. For instance,
one company may use aggressive revenue recognition policies, while the other adopts more
conservative practices. Without standardized accounting practices or industry benchmarks,
stakeholders may struggle to make meaningful comparisons between businesses.

4. Minimum Legal Requirements:

 Published accounts only include legally required information, potentially obscuring a full
understanding of the business.

Example: A publicly traded company may disclose only the minimum financial information required
by securities regulators in its annual report. This limited disclosure may omit important details about
the company's operations, risks, or future plans, leaving investors with an incomplete understanding
of the company's financial position and prospects.

5. Historical and Non-predictive:

 Accounts are historic, offering no insight into future plans or budgets, limiting their predictive
value.

 Management accounts, which look forward, are not available to external stakeholders.

Example: A manufacturing company's financial statements for the previous fiscal year may show
strong profitability and healthy cash reserves. However, these historical figures do not guarantee
future success. The company's financial statements provide no insight into upcoming market trends,
competitive challenges, or strategic initiatives, limiting their predictive value for investors and other
stakeholders.

6. Window Dressing:

 Companies may engage in "creative accounting" to present a more favorable image, though not
necessarily illegal.

 Methods include timing transactions, manipulating expenditure, or inflating asset values,

impacting the accuracy of financial statements.

Example: A retailer may engage in window dressing by timing its inventory purchases and sales to
manipulate its reported profit margins. For instance, the company may delay purchasing inventory
until after the end of the fiscal year to reduce expenses and boost reported profits. Similarly, the
company may offer steep discounts or promotions to increase sales in the days leading up to the end
of the reporting period, artificially inflating revenue figures. These tactics create a distorted picture of
the company's financial performance, misleading stakeholders about its true profitability and
financial health.

In summary, The importance of reliable accounting information demands ethical conduct from
accountants. Fundamental ethical principles include integrity, objectivity, professional competence,
confidentiality, and professional behavior. Stakeholders must recognize the limitations of accounting
data, utilizing multiple years' accounts and comparing with similar businesses for more accurate
assessments.