Ch. 33: Financial Statements Business 9609 – A2 Ms.

Saira Ansari

UNIT 5: FINANCE AND ACCOUNTING

CHAPTER 33: FINANCIAL STATEMENTS

Keeping financial records of every transaction a business makes is essential.

QUESTION WHY IS IT IMPORTANT?

Did the business make a profit or loss last year? Profit or loss is a measure of business
performance, and managers, shareholders and
government (for tax purposes) need to know
this.
How much do we owe our suppliers? Suppliers need to be paid on time or they may
refuse to send further deliveries.
How much do our customers owe the business? If customers do not pay on time and the
business has no record of whether they have
paid, then a cash flow crisis could result.
Is the business able to repay the bank loan? Banks loans have to be repaid by a certain date.
Failure to do this will make further loan finance
difficult to obtain.
Did the business pay wages to the workers last Not paying workers on time, and not knowing
week? whether they have been paid, could badly
damage relations between managers and
workers.
Is the business able to finance a dividend Shareholders may sell shares in the company if
payment to shareholders? dividends are not paid because the business is
unsure whether it has sufficient finance.

TYPES OF FINANCIAL STATEMENTS:

Financial Statement What it shows
Statement of profit or loss The gross profit and profit from operations of
the company. It includes details of how the
profit from operations is split up between
dividends to shareholders and retained earnings
(profit).
Statement of financial position The net worth or equity of the company. This is
the difference between the value of what a
company owns (assets) and what it owes
(liabilities).
Income statement: records the revenue, costs and profit (or loss) of a business over a given period of
time.
Gross profit: equal to sales revenue less cost of sales.
Revenue (formerly called sales turnover): the total value of sales made during the trading period =
selling price × quantity sold.

STATEMENT OF PROFIT OR LOSS: The statement of profit or loss can also be

referred to as either an income statement or a profit or loss account.

▪ A detailed statement of profit or loss is produced for internal use because managers need as
much financial information as possible.
▪ It should be produced as frequently as managers need the information, perhaps once a
month.
▪ A less detailed summary statement of profit or loss is included in the published accounts of
companies for external users. It is produced less frequently, but at least once a year.
▪ The content of this is laid down by each country’s legislation on companies and provides a
minimum of information. This is because published accounts are also available to
competitors.

The contents of a statement of profit or loss:

 The Trading Account: This account shows how gross profit (or loss) has been made from
the trading activities of the business.

▪ It is most important to understand that, as not all sales are for cash in most businesses, the
revenue figure is not the same as cash received by the business.
▪ Total Revenue = Selling price x Quantity Sold
▪ Revenue is not profit. Costs must be subtracted from revenue to calculate profit. There are
different measures of profit.

▪ The cost of sales figure is unlikely to be the same as the total value of goods purchased by
Cost of sales (or cost of goods sold): this is the direct cost of the goods that were sold during the financial
year

the company during this year.

▪ Gross Profit = Revenue – Cost of Sales
▪ Cost of sales = (Opening inventories + Purchases) – Closing inventories
Profit or Loss Account:
Operating profit (formerly referred to as net profit): gross profit minus overhead expenses.
Profit for the year (profit after tax): operating profit minus interest costs and corporation tax.

▪ The profit from operations (or operating profit) is calculated by subtracting expenses
(such as overheads) from gross profit.
▪ Profit before tax is calculated by subtracting interest costs from profit from operations.
▪ Profit for the year is calculated by subtracting profit (corporation) tax from profit before
Dividends: the share of the profits paid to shareholders as a return for investing in the company.
Retained earnings (profit): the profit left after all deductions, including dividends, have been made, this
is ‘ploughed back’ into the company as a source of finance.
 tax.
Appropriation Account: This final section of the statement of profit or loss shows how the
profit for the year is distributed between the owners, in the form of dividends to company
shareholders and as retained earnings.
USES OF PROFIT/ LOSS STATEMENT:
▪ It can be used to measure and compare the performance of a business over time or with
other firms, and ratios can be used to help with this form of analysis.
▪ The actual profit data can be compared with the budgeted profit levels of the business.
▪ Bankers and creditors of the business will need the information to help decide whether to
lend money to the business.
▪ Prospective investors will use the profit performance of the business as a guide to whether
to buy shares in it or not.

⋅ High profit figure resulting from the sale of a valuable asset for more than its expected
value might not be repeatable, which is low-quality profit.
⋅ Profits made from developing, producing and selling exclusive product designs are high
quality profits because these are likely to be a continuous source of profit for some time
to come.

AMENDING PROFIT/ LOSS STATEMENTS:

▪ Use the same format of presenting the statement of profit or loss as shown in the case
study.
▪ If a change to the number of units produced and sold occurs, this is most likely to lead to
changes in both revenue and cost of sales.
▪ Some overheads might change with a variation in the level of sales. Annual promotion or
transport costs might be affected by variations in the number of units sold.
IMPACT OF CHANGE IN PROFIT/ LOSS STATEMNT:
Statement of financial position (balance sheet): an accounting statement that records the values of a
business’s assets, liabilities and shareholders’ equity at one point in time.
Shareholders’ equity: total value of assets – total value of liabilities.
Asset: an item of monetary value that is owned by a business.
Liability: a financial obligation of a business that it is required to pay in the future.
Share capital: the total value of capital raised from shareholders by the issue of shares.

Statement of Financial Position: The statement of financial position records the net
wealth or shareholders’ equity of a business at one moment in time. In a company this net
wealth belongs to the shareholders. The aim business is to increase the shareholders’ equity
by raising the value of the assets owned by the business by more than any increase in the
value of liabilities.

▪ The first and original source was the capital originally invested in the company through the
purchase of shares, called share capital.
▪ The second source is the retained earnings of the company accumulated over time through
its operations.
Non-current assets: assets to be kept and used by the business for more than one year. Used to be
referred to as ‘fixed assets’. Intangible assets: items of value that do not have a physical presence, such as
patents, trademarks and current assets.
Current assets: assets that are likely to be turned into cash before the next balance-sheet date.
Inventories: stocks held by the business in the form of materials, work in progress and finished goods.
Trade receivables (debtors): the value of payments to be received from customers who have bought
goods on credit.
Current liabilities: debts of the business that will usually have to be paid within one year.
Accounts payable (creditors): value of debts for goods bought on credit payable to suppliers; also
known as ‘trade payables’. Non-current liabilities: value of debts of the business that will be payable after
Contents of Statement of Financial Position:
more than one year.
▪ Companies
Intellectual capital have tothe
or property: publish theby
amount statement
which theof value
profit of
or aloss
firmand the statement
exceeds of financial
its tangible assets less
liabilities – an intangible
position asset.
for the previous financial year as well to allow easy comparison.
Goodwill: arises when a business is valued at or sold for more than the balance-sheet value of its assets.
▪ The titles of both accounts are very important as they identify both the account and the
Window-dressing: company. presenting the company accounts in a favourable
light – to▪flatter the business
The statement performance
of financial position is a statement of the value of the company at one
moment in time, usually at the end of the financial year.
▪ Non-current assets: The most common examples of fixed assets are land, buildings,
vehicles and machinery. These are all tangible assets as they have a physical existence.
- Value of most of these assets declines over time
- Businesses can also own intangible assets. These cannot be seen but can contribute
value to the business.
- Examples are patents, trademarks, copyrights and goodwill.
▪ Intangible Assets:
- Intangible assets are difficult to value
- Statements of financial position, according to accepted accounting rules, do not record
intangible assets unless acquired through takeover or merger
- Intangible assets are the main source of future earnings, especially in a world
increasingly dominated by the knowledge-based economy
- Market value of companies with substantial intangible assets will be much greater than
the net asset value.
- Intangible assets such as patents and copyright are sometimes known as intellectual
capital.
- The reputation and prestige of a business that has been operating for some time also
give value to the business above the value of its physical assets, called goodwill of a
business.
- Goodwill normally only appears on a statement of financial position if a business takes
over another firm at a cost higher than the net assets of that firm.
- Disputes can arise between accountants about the valuation of intangible assets, called
window dressing of accounts.
▪ Current Assets: The value of current assets has a major impact on the liquidity of the
business.
 - Examples; Inventories, Trade receivables, cash/ bank balance
▪ Current Liabilities: Typical current liabilities include trade payables (suppliers who have
allowed the business credit), bank overdraft, unpaid dividends and unpaid tax.
▪ Working Capital: Also referred to as net current assets.
- Working capital = Current assets – Current liabilities
▪ Shareholders’ Equity: It comprises the capital originally paid into the business when the
shareholders bought shares (share capital) plus the retained earnings / profits of the
business.
- Referred to as shareholders’ funds or just equity
- Retained earnings are also known as reserves.
- Reserves = Shareholders’ Equity – Share capital
- Shareholders’ equity is the permanent capital of the business.
- Other reserves can appear on the statement of financial position if a company’s fixed
assets have increased in value (re-valuation reserve) or if it sells additional shares for
more than their nominal value (share premium reserve)
- Reserves are not cash reserves.
- Retained earnings arise due to profits being made that are not paid out in tax or
dividends and are already invested back into the business.
- The only cash funds available in the business are those indicated under ‘cash’ in the
current assets section.
▪ Non-Current Liabilities: These are the bank (long-term) loans owed by the business due
to be paid over a period of time greater than one year.
- Includes loans, commercial mortgages and debentures
- Value of non-current liabilities compared to the total capital employed by the business
is an important measure of the degree of risk being taken by the company’s
management

AMENDMENTS TO STATEMENTS OF FINANCIAL POSITION:

▪ It is common to start with the statement for the end of the previous financial year and then
make amendments to it
▪ There then has to be a balancing double entry adjustment to make sure that this statement
still balances (that is, total assets still equal shareholders’ equity + liabilities).

RELATIONSHIP BETWEEN FINANCIAL STATEMENTS:

INVENTORY VALUATION: Inventories are unsold goods. They might also be in the form
of raw materials and components that have not yet been made into completed units. Some
inventories will be in the form of work-in-progress.

▪ Accountants are quite clear on this: inventories should be recorded at their purchase price
 (historical cost) or their net realizable value (NRV), whichever is the lower.
▪ Net realizable value = Amount for which the existing inventory can be sold – Cost of
Depreciation: the decline in the estimated value of a non-current asset over time.
selling it
Net realisable value: the amount for which an asset (usually an inventory) can be sold minus
the cost of selling it – it is only used on Statements of financial position when NRV is estimated
to be below historical cost.

Net book value: the current Statement of financial position value of a non-current asset.
original cost – accumulated depreciation
Straight-line depreciation: a constant amount of depreciation is subtracted from the value of the asset
each year
original cost of asset-expected residual value/expected useful life of asset (years)

DEPRECIATION: Reduction in value of fixed asset. It is recorded as an expense,

to spread the cost of the asset over its useful life, and to keep calculating the net
book value of the asset.
▪ Assets decline in value because of:
- Normal wear and tear through usage
- Technological change that makes the asset obsolete
Role of Depreciation in Accounts:
▪ All fixed/non-current assets will depreciate or decline in value over time
▪ To record only the value of each year’s depreciation as a cost on each year’s income
statement
▪ To overcome both these problems:
- The assets will retain some value on the statement of financial position each year until
fully depreciated or sold off, called the net book value. Calculated as; Original cost –
Accumulated Depreciation
- The profits will be reduced by the amount of that year’s depreciation and will not be under-
or over-recorded.

▪ Straight Line Method of Depreciation:

- Annual depreciation is calculated through;

- To calculate depreciation, you need: original or historical cost of the asset, expected useful
life (in years) of the asset, and estimation of the value of the asset at the end of its useful
life

▪ Straight line depreciation: an evaluation:

- It is widely used by limited companies
- This method is easy to calculate and understand
- This method requires estimates to be made regarding both life expectancy and residual
value, any errors in these estimates lead to inaccurate depreciation charges being
calculated
- Some assets depreciate more quickly in the first two years which is not reflected in the
straight-line method.
- The method requires estimates to be made regarding both life expectancy and residual
 value which is not reflected in the straight line method.
IMPACT OF DEPRECIATION & FINANCIAL STATEMENTS:
▪ It is a business expense so it will reduce profit from operations on the statement of profit or
loss.
▪ Reduces the net book value of a non-current asset. As a consequence, value of non-current
assets will fall
NOTE: When senior managers take a decision to increase the capital equipment used by a
business, this strategy will have an impact on the annual depreciation figure on the
statement of profit or loss.

ACTIVITY 1:
Understanding statements of financial position
Indicate in which category the items in the first column would appear on a company’s statement
of financial position.
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