Finance

Final accounts
Purpose of accounts

Financial reporting is a way to account for the money of the business,

whether it belongs to the owners, investors or lenders.

Producing Final Accounts ensures that all payments and receipts of a

business have to be officially accounted for.

All companies must provide a set of final accounts to its various

stakeholders.
Two accounting statements

Profit and Loss account -

Balance Sheet - shows the
shows the trading position
assets and liabilities of a
of a business at the end of
business at a particular
a specified accounting
point in time.
period.
The purpose of final accounts for different stakeholders 

1. Shareholders - to see where their money was spent and the return on their investments; decide
whether to hold, sell or buy the company’s shares.

2. Employees - to assess the likelihood of pay increments and the degree of job security.

3. Managers - to judge the operational efficiency of their organizations.

4. Competitors - to make comparisons of their financial performance.

The purpose of final accounts for different stakeholders: 

5. Government – to examine the accounts of businesses to ensure that they pay the correct
amount of tax.

6. Financiers - banks or business angels scrutinise the accounts of a firm before approving any
funds.

7. Suppliers – to decide the extent to which trade credit should be given.

8. Potential investors - to assess whether an investment would be financially worthwhile.

The principles • 1. Integrity - "straightforward and honest in all professional and
business relationships.”; implies fair and truthful behaviour.
and ethics of • 2. Objectivity - free from bias and any conflict of interest;
accounting should not be compromised by undue influence from other people.

practice: • 3. Professional competence and due care - accountants are obliged

to maintain their professional knowledge and skills to ensure they
provide a competent professional service.
• 4. Confidentiality - accountants must respect the
confidentiality of information they acquire in their professional
duties and must not disclose any of this information.
• 5. Professional behaviour - accounting practices must comply with
relevant laws and regulations.
 • Financial statement of a firm’s trading activities over a
period of time.
• Main purpose is to show the profit or loss of a
business.
• Profit - the positive difference between a
Profit and loss
firm’s revenues and its costs.
account
• Revenue - The inflow of money from ordinary trading
activities.
• Costs - the outflow of money from a business due to
its operations.
Three sections of P&L account

The trading account

The profit and loss account

The appropriation account

 • First section of the P&L account.
• Shows the difference between a firm’s sales revenue
and its costs of producing or purchasing those products
Trading account
to sell.
Trading account

• Shows the gross profit of a firm:

Gross profit = Sales revenue - Cost of goods sold
• The cost of goods sold (COGS) is the accountant’s term for the direct costs of the goods
that are actually sold:
COGS = Opening stock + Purchases - Closing stock 
 Example
• Opening stock = $5000
• Purchases = $25000
• Closing stock = $3800
• Sales revenue = $78600
Solution:
• 1) COGS = 5000 +25000 – 3800 = $26200
• 2) Gross profit = 78600 – 26200 = $52400
 • A business can improve its gross
profit by reducing costs and/or raising revenue, such
as:

Gross profit 1) Using cheaper suppliers

2) Increase selling price
3) Enhanced marketing strategies
 • Shows the net profit (or loss) of a business at the end of a
Profit & Loss trading period.

(P&L) Account • Net profit is the surplus from sales revenues after all
expenses are accounted for.
• Hence net profit is the actual profit made from a
firms normal trading activities.
• Net profit = Gross profit – Expenses
• Expenses are the indirect or fixed costs of production.
• Interest charges and taxes are shown as separate items
because they change over time and are beyond the control of
the business.
Example

• COGS = $230000
• Sales revenue =$460000
• Rent = $90000
• Utility bills = 60000$
• Overheads = $15000
• Interest = $10000
• Corporate tax = 10%
 • Dividends - Shows the amount of net
profit after interest and tax that is distributed to
the owners (shareholders) of the company.
Appropriation • R
​ etained profit - shows how much of the net
account profit after interest and tax is kept by the business for
its own use; reinvesting it in the company or
to expand the business.
 Example
• 30% of net profits is
allocated to
shareholders.
 • P&L shows the historical performance of a business;
no guarantee that future performance is linked to past
performance or success.

Limitations of • Window dressing can occur; the legal manipulation of

final accounts to make them look financially more
Profit & Loss attractive.
Account • As there is no internationally standardised format for
producing a P&L account, it might be difficult to
compare the profit or loss of different firms in different
countries.
Example
 • Annual financial statement that contains information
on the value of an organization’s assets, liabilities and
the capital invested by the owners.
• Financial position of a business on one day only,
Balance sheet described as a ‘snapshot’ of a firm’s financial situation.
• The document shows a firm’s sources of
finance (shown as the equity) and where
that money has been used (shown as the net assets).
A balance sheet must contain three parts:

ASSETS LIABILITIE EQUITY

S
Assets

• Items of monetary value that

are owned by a business, e.g. cash,
stocks and buildings.
• Assets can be classified as fixed
assets or current assets.
Fixed asset

• A fixed asset is any asset used for

business operations and is likely to last
for more than 12 months from the
balance sheet date.
Current asset

• A
​  current asset refers to cash or any
other liquid asset that is likely to
be turned into cash within twelve
months of the balance sheet date.
• CASH, STOCK, DEBTORS
Liabilities

Legal obligation of a business to repay its lenders or suppliers at a later date i.e. the

amount of money owed by the business. ​

Long-term Liabilities - debts that are due to be repaid after twelve months;

debentures, mortgages and bank loans.

Current liabilities - debts that must be settled within one year of the balance

sheet date; short-term loans, creditors and bank overdrafts.
Net assets

• The value of a firm’s net assets is the value of all assets minus its liabilities.
• This must be equal to its equity on the balance sheet.
 • Shows the value of the business belonging to the owners.
• It can appear in a balance
sheet as shareholders’ equity (for limited liability companies -
LLC) or as owners’ equity (for businesses other than limited
Equity liability companies).
Two sections of this part:

1. Share capital - amount of 2. Retained profit - amount of

money raised through the sale of net profit after interest, tax and
shares. dividends have been paid.
Balance sheet IB format
Differences between balance sheets of sole
traders/partnerships and limited companies:

Sources of finance will differ.

Shareholders’ funds is replaced with owner’s equity

Since there are not shareholders in a partnership or sole trader, dividends

will not appear under their current liability.
Limitations of • Static documents
balance sheets • Only “accurate” estimates of the value of assets and
liabilities
• No specific format required for producing balance
sheets
• Not all assets are included in a balance sheet,
especially intangible assets and the value of human
capital.
Intangible assets

• Non-physical fixed assets that have the
ability to earn revenue for a business.
• They are legally
protected by intellectual property rights.
• Account for a large proportion
of a firm’s asset value, although usually difficult
to place an objective and accurate price on
such assets.
Intangible assets

Brand - an indefinite asset as brand recognition and brand loyalty stay with the

company for as long as it operates.

Patents - provide legal protection for inventors, preventing others

from copying their creation for a fixed number of years.

Copyright (©) - provides legal protection for the

original artistic work of the creator, such as a painter or musician.
Intangible assets

4. Goodwill - value of an organization’s image and reputation; can also include

the value of the firm’s customer base and its business connections.

5. Registered trademarks (®) - distinctive signs that uniquely identify

a brand, a product or a business; can be expressed by names, symbols or phrases.
Depreciation

• The fall in the value of fixed assets

over time.
• Depreciation spreads the historic cost
(purchase cost) of fixed assets over
their useful lifespan.
Reasons of depreciation:

1. Wear and tear - fixed assets such as computers and

motor vehicles are used repeatedly over time, so they
tend to wear out and raise maintenance costs.
2. Obsolescence - as newer and better products become
available, the demand and hence the value of existing
fixed assets will fall.
Depreciation needs to be recorded:

Calculate the value of a business more accurately

Assess the value of fixed assets over time

Plan for replacement of assets In the future

Straight line method
• Life expectancy of the asset – how long it is intended to be used before it needs to be
replaced
• Residual value – how much it is worth at the end of its useful life
• Purchase cost – how much it is worth during initial purchase
Example
1. Bought for $25,000
• Expected to last five years
• Solution:
• Depreciation = 25,000/5 = $5,000

2. Bought for $25,000

• Expected value in 5 years = $5,000
• Solution:
• Depreciation = (25,000-5,000)/5 = $4,000
Reducing balance method

• Depreciates the value of an asset by a predetermined percentage for the durations of its
useful life.
• Reduces the value of an asset by a larger amount
Example

• Bought for $25,000

• Depreciation rate = 25%
Amortisation
Used to reduce the value of intangible assets on a balance sheet.