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Final Accounts
Topic 3.5
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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.
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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
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Pro
fit
& L
oss
Acc
oun
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xam
ple
– I
B F
orm
at
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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
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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
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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’
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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
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Bal
ance
Sh
eet
Exa
mp
le –
IB
For
mat
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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
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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)
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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)
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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
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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)
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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’?
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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?
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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)
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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
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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
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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
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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
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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
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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
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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.
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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
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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.