Why Keeping Financial Records is Important Main Types of Financial Statements Statement of Profit/Loss (Income Statement) The contents of an income statement include three different sections: 1. Trading Account Section 2. Profit/Loss Section 3. Appropriation on Account Trading Account The trading account shows gross profit. This is calculated by subtracting Total Revenue – COGS = Gross profit. COGS = Starting inventory + Purchases – Ending Inventory Profit/Loss Section • The profit from operations (operating profit) is calculated by subtracting overhead expenses from gross profit. Overhead costs are expenses of the business that are not directly related to the number of items made or sold. These can include rent and business rates, management salaries, marketing costs and depreciation. • Profit before tax is calculated by subtracting interest costs from profit from operations. • Finally, profit for the year or quarter is calculated by subtracting corporation tax from profit before 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. The information contained in these statements can be used for: Use of Profit/Loss Statement • It can be used to compare the performance of a business over time or with other firms. • Profit data can be compared with the budgeted profit levels of the business. • Creditors of the business will need the information to help decide whether to lend money to the business. • Investors will use the profit performance of the business as a guide to whether to buy shares in it or not. Amending Statements of Profit/Loss • Accountants often have to make adjustments to the accounting statements they are preparing. When new financial data becomes available or when one of the key variables used in the final accounts changes, a revised statement has to be produced. Things to consider when amending a statement: • Format must be the same • Changes in units sold/produced directly affects sales revenue and variable costs • Overheads may change according to sales The Impact of a Change • The following table explains the impact on the statement of profit or loss following a change in one of its components (assuming no other change occurs). 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 of most businesses 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. • Shareholder equity comes from: 1. The original capital raised when selling shares 2. Retained earnings. Contents of a Financial Position Statement of Financial Position 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, but can also be intangible such as I.P. Current assets The value of current assets has a major impact on the liquidity of the business. The most common examples are inventories, cash and account receivable Current liabilities Typical current liabilities include accounts payables, bank overdraft, unpaid dividends and unpaid tax. Working capital Working capital can be calculated from the statement of financial position by the formula: working capital = current assets – current liabilities It can also be referred to as net current assets. Shareholders’ equity It comprises the capital originally paid into the business when the shareholders bought shares plus the retained earnings / profits of the business. These retained earnings are also known as reserves. Non-current liabilities Amending Financial Position When preparing a new statement 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. The table shows some of the amendments that are possible and the impact on the statement of financial position. Relationship between the Balance Sheet and Income Statement 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 workin-progress. Inventories should be recorded at their purchase price (historical cost) or their net realisable value (NRV), whichever is the lower. Net Realizable Value • Net realizable value = the amount for which the existing inventory can be sold – cost of selling it • It is only used on statements of financial position when NRV is estimated to be below historical cost. • Example 1: A shoe shop buys in ten pairs of shoes from a supplier for $10 a pair. At the end of the financial year, it has three pairs remaining unsold. The shopkeeper believes that they could only be sold at a reduced price of $8, below the price he paid for them. Therefore, the NRV of the 3 pairs of shoes is only $24. It is this value – not $30 – that should appear on the statement of financial position. Depreciation Assets decline in value for two main reasons: 1. normal wear and tear through usage 2. technological change that makes the asset obsolete. Importance of Depreciation Nearly all fixed/non-current assets will depreciate or decline in value over time. It seems reasonable, therefore, to record only the value of each year’s depreciation as a cost on each year’s income statement. This will overcome both of the problems referred to above: • The assets will retain some value on the statement of financial position each year until fully depreciated or sold off. This is the net book value, calculated as follows: • original cost less accumulated depreciation • The profits will be reduced by the amount of that year’s depreciation and will not be under- or over- recorded. How Depreciation Works 1. There are a number of different methods that accountants can use to calculate depreciation, but you only need to understand the straight line method for this course. The title of this method indicates the way in which depreciation is calculated. 2. Annual depreciation is calculated by the formula: (Original Cost – Expected Residual Value)/Expected Useful Life of Asset (years) 3. To calculate the annual amount of depreciation, the following information is needed: 1. the original or historical cost of the asset 2. the expected useful life (in years) of the asset 3. an estimation of the value of the asset at the end of its useful life (known as the residual value of the asset). Depreciation and Financial Statements The amount of the annual charge for depreciation affects the main financial statements as follows: • It is a business expense so it will reduce profit from operations on the statement of profit or loss. • It reduces the net book value of a non-current asset. The value of non-current assets on the statement of financial position will fall as a consequence. Evaluation of Straight-Line Depreciation 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. Cars, trucks and computers are examples of assets that tend to depreciate much more quickly in the first and second years than in subsequent years. This is not reflected in the straight line method calculation. Finally, the repairs and the maintenance costs of an asset usually increase with age and this will reduce the profitability of the asset. This is not reflected in the fixed depreciation charge of the straight line method.
