final accounts topic 3.5. purpose of accounts law requires these accounts. they are also a report to...

Final Accounts

Topic 3.5

Purpose of Accounts• Law requires these accounts. • They are also a report to the shareholders, the owners of

the company and all its assets and liabilities. • They are public documents and available to everyone. • They can be used for the following:

– By the firm, to see how the competition is doing. – By the competition, to see how the firm is doing. – By shareholders, to see how their investment is being used. – By potential investors, to see if such an investment would

be worth it. – By the government, to see if the tax is correct.

Profit and Loss Account

• This shows the net profit after interest and tax by subtracting business expenses and taxation from operating (or gross) profit

Net profit (after interest and tax) =

gross profit – expenses – interest - taxation

Pro

fit

& L

oss

Acc

oun

t E

xam

ple

– I

B F

orm

at

Trading Accounts

• This account shows operating profit, which is also called gross profit, and is calculated by subtracting the cost of sales from turnover

Gross (Operating) profit = turnover – cost of sales

Trading Account - Detailed Example

2000 2001£ £

Sales Revenue £150,000 £200,000Opening stock £20,000 £15,000Purchases £70,000 £125,000

£90,000 £140,000less closing stock £15,000 £30,000Cost of goods sold £75,000 £110,000Gross profit £75,000 £90,000

Appropriation Accounts

• This account (called a profit and loss appropriation account) shows how the profit after tax is distributed between shareholders and the business

• The share which goes to the shareholders is called a ‘dividend’ and the money kept by the business is called ‘retained profit’

Balance Sheets

• This account is a summary at one point in time, therefore it is described as a ‘static’ model

• It shows a businesses assets, liabilities and capital• It will be entitled:

Balance Sheet

XYZ Company

as at 'a date' 2007 2008

Bal

ance

Sh

eet

Exa

mp

le –

IB

For

mat

Assets (owned or owed to business)

• Fixed Asset - >12 months– Tangible fixed assets

• Physical assets• e.g. plant and machinery, MV, land and buildings• Apart from land and buildings most depreciate over time

– Intangible fixed assets• Non-physical assets • E.g. brand names, trademarks, copyrights, patents• Difficult to place value

– Investments• Shares/Debentures in other companies

• Current Assets – liquid e.g. cash, debtors, stock

Liabilities(owed by the business)

• Long-term liabilities – Fall due >12 months

– Sources of long-term borrowing

– E.g. debentures, mortgages, bank loans

• Current liabilities – Settled < 12 months

– E.g. creditors, overdrafts, tax payable, dividends payable, interest payable, accruals (expenses accumulated but not yet paid)

Capital and Reserves(aka Shareholders’ Funds or Owners’ Equity)

• Share Capital– Money raised through sale of shares

• Retained Profits – Amount of net profit after interest, tax and dividends– Reinvested in business

• Reserves– Proceeds from retained profits in previous trading years– Includes capital gains in value of fixed assets

“revaluation” – NB Depreciation recorded in Assets section (HL)

Depreciation (HL)

• Depreciation is shown in the profit and loss account.

• Depreciation is the reduction in value of an asset

For example: a new vehicle may have cost $25,000 but after a year the re-sale value may only be $18,000 so the vehicle has depreciated by $7,000

Calculating DepreciationThe Straight Line Method (HL)

• The straight line method which is the most common method used and assumes that value falls in equal quantities across the life of the asset

Depreciation allowance = original cost – residual value

(each time period) expected life (years)

Calculating DepreciationThe Reducing Balance Method (HL)

• The reducing balance method which assumes the value falls more quickly at the beginning of the assets life and is calculated by reducing the value by the same % each year

Net Book Value = Historical Costs – Cumulative Depreciation

Which of these two methods do you think is ‘better’?

Intangible Assets (HL)

• Intangible Assets are described as those which are ‘non-physical business assets’

The examples you need to be aware of are:• Goodwill• Patents and copyrights• BrandsWhat difficulties can you identify when trying

to value intangible assets?

Stock Valuation (HL)

• This is related to current assets which stock is part of and looks at how businesses can value their stock in order to add the figure to their final accounts.

• It is important for a business to accurately value their stock as this impacts on gross profit figures (and therefore other profit figures)

Stock Valuation (HL)

Methods of stock valuation1. LIFO (last in first out) – this assumes that

the most recent deliveries are issued before existing stock

2. FIFO (first in first out) – this assumes that stock rotation takes place so businesses use up the older stock first

For each method describe the consequences on profit

Worked exampleGadgets are us makes gadgets for teenagers and charge an average

price of $50Date Units

bought/issuedPrice ($)

1/3 Bought 30 25

5/5 Issued 20 25

8/3 bough20 30

10/3 15

Solution 1. Using LIFO

Date Stock bought

Stock issued

Remaining stock

Stock Valuation$

1/3 30@25 30@25 750

5/3 20@25 10@25 250

8/3 20@30 10@25

20@30

250

600

850

10/3 15@30 10@25

5@30

250

150

400

Try this!

1. Show the stock valuation using FIFO

1. Prepare a trading account using both LIFO and FIFO and comment on the difference in gross profit

Solution 2. Using FIFO

Date Stock bought

Stock issued

Remaining stock

Stock Valuation$

1/3 30@25 30@25 750

5/3 20@25 10@25 250

8/3 20@30 10@25

20@30

250

600

850

10/3 10@255@30

15@30 450 450

Consequences on profit

• LIFO gives lower value for closing stock hence COGS is high, which results in a lower value of gross profit (hence lower taxes!)

• Using FIFO gives a more realistic value of stocks.

• However FIFO boosts the value of GP hence leading to demand for higher taxes.

• Shareholders may also demand higher dividends

Choosing between LIFO and FIFO

• If there was no inflation, LIFO and FIFO would give the same results.

• Laws prevent businesses from switching between LIFO and FIFO (e.g. using LIFO when prices are rising or vice versa).

• In UK and Canada, businesses are not allowed to use LIFO for tax purposes

• Consistency has to be maintained, year after year.

Window Dressing(aka Creative Accounting)

• No single accounting standard that is universally accepted

• Legal manipulation of accounting statement to make it look more flattering or to reduce tax burden

• Examples:– Optimistic revaluation of intangible assets– Sale and leaseback sudden hike in liquidity in the short-

term– Use of depreciation methods

Limitations/Value of financial accounts

• Single account in isolation of no value. Series of accounts would be more useful to see trends.

• HR totally ignored. Not represented as an asset in financial accounts.

• Non-financial (qualitative) matters not revealed in accounts. E.g. ethical objectives, location of industry etc.

• Comparison with other businesses important e.g. performance benchmarking

• Whole truth may not be reported – some information may not be revealed, as they will be available to public and rivals.

• PL, BS and CF statements are a historical account of the financial performance. Mgt accounts (internal use only) are forward looking but not disclosed to external stakeholders or general public.