4.5.a. Final accounts (profit and loss account and balance sheet)
The profit and loss account
The profit and loss account also known, as income statement is a statement, which represents
the revenue received, expenses incurred and profit earned over a period of time (usually 1 year).
Format:
XYZ Ltd Profit and loss account for year ended 31/03/0
$000
Sales revenue
$000
1 000
Less cost of sales:
Opening stock
200
Purchases
500
Less closing stock
(100)
Gross profit
(600)
400
Less operating overheads/ indirect expenses:
Rent
50
Salaries
60
Depreciation
20
Administrative costs
80
Selling expenses
10
(220)
Net profit/operating profit
180
Add non-operating income
10
Less Finance costs (interest payable)
(30)
Profit before tax
160
Less tax
(60)
Profit after tax
100
Less dividends
(20)
Retained profit for the year
80
The first line is sales revenue, i.e. the funds from cash and credit sales
From this, we deduct the "Cost of goods sold or cost of sales" (O.St + P- C.St)
Sales revenue less Cost of goods sold is known as Gross profit.
Then, we deduct overheads or indirect expenses (selling and administrative costs, advertising,
distribution or carriage, salaries, rent, electricity, depreciation, repairs, etc.).
A 'depreciation charge' is non cash item, i.e. it is not paid for. It is the loss in value of a fixed asset.
Gross profit less expenses = operating profit. These refer to the profit made from normal
trading activities.
The next adjustment is to add on any income from other activities, known as non-operating
income (e.g. renting out premises, interest received, dividend received).
We then deduct a figure for interest charges. The resulting figure is known as profit before tax
or net profit.
The final part of the account is known as the appropriation account. It provides information on
the way in which the net profit is used.
Some is used to pay corporation tax, then, some is distributed to the shareholders as dividends
and the remainder is kept within the business for re-investment and is called retained profit.
Window Dressing
This is a form of creative accounting and it basically involves manipulating various figures in
the financial accounts of a business, to give a better picture.
Revenue or operating items: These appear on the profit and loss a/c.


Revenue receipts are receipts from sales revenue
Revenue expenditures are costs on the purchase of goods for resale and payment of
overheads.
Capital items: These appear on the balance sheet.


Capital expenditures are costs on the purchase of fixed assets.
Capital receipts arise from the sale of fixed assets
Balance sheet
A balance sheet is a statement of a firm's assets, liabilities and owners' equity at a specific date. It shows
the financial position of a business at a given date and is also known as a position statement.
Format: Balance sheet for “XYZ Ltd” as at 01/04/11
$000
$000
Fixed assets
$000
500
Current assets:



Stock
Debtors
Cash
50
150
100
300
Less current liabilities:


Creditors
Bank overdraft
140
20
(160)
Working capital or net current assets [300-160]
140
Net assets
640
Financed by:
Shareholders’ fund (owners’ equity)


Share capital
Reserves: retained profit
250
190
440
Long term liabilities:


Debentures
Bank loan
Capital employed
150
50
200
640
Net Assets = Capital employed: the two parts MUST always balance.
Remember, a balance sheet shows what a company owns (assets), what it owes (liabilities) and where the
company got its money (capital) from at a given date.
Assets
An asset is basically an item or money that the business owns. There are two types of assets - fixed assets
and current assets.
A fixed asset is a long term asset and is used by the business for a considerable period of time (more than
1 year). Examples include land buildings (Premises), Furniture and fittings, Machinery and equipment
and Motor vehicles.
A current asset is a short term asset and is likely to be converted in cash within 1year. Examples include:
Stock, Debtors (amount due by credit customers),Prepayment (an amount paid in advance, rent for
example),Cash at bank and Cash in hand
Liabilities
A liability is an item or money that the business owes to a third party. There are two main types of
liabilities: long term liabilities and current liabilities.
A long-term liability is a source of long-term borrowing and will be repayable in more than 1 year. There
are three categories of long-term liability:



Bank loans (re-payable after more than 1 year).
Mortgages (essentially a long-term loan to purchase land and buildings).
Debentures. (a loan which can be bought on the stock exchange)
A current liability is an amount of money owing to third parties which will be settled within I year.



Bank overdraft.
Trade creditors (amount due to credit suppliers)
Accruals (other amounts due, i.e. not yet paid).
Shareholders’ funds (also called 'owners equity') is Share capital + retained profit and other reserves
In a sense, owners' equity is a liability, (amounts owed to the owners of the business). It differs from other
liabilities in that it does not have a definite date for repayment.
Working capital or net current assets
This is the funds for the day-to-day running a business. It is used to pay immediate or running costs, i.e.
purchases of goods and expenses. It is calculated as current assets minus current liabilities.
The purpose of a Balance Sheet is to communicate information about the financial position of the
business at a given time. It indicates the financial strength of the business and the relative liquidity of the
assets. It also gives some information on the liabilities of the business and when they will fall due.
This information can assist the user in evaluating the financial position of the business. However, it is
only by collectively analysing the Balance Sheet, the Profit & Loss account and the Cash Flow Forecast
of a business that an overall impression can be gathered on the financial strength of the business.
Tangible vs. intangible assets
There are three categories of fixed assets:



Tangible fixed assets are physical items such as land, buildings, machinery, and vehicles.
Intangible fixed assets are non-physical items, such as brand names, goodwill and patents.
Financial fixed assets are investments on shares and debentures in other companies
Tangible fixed assets are physical assets (can be touched), which are used for the long term. Examples
include premises, furniture and fittings, plant and machineries and motor vehicles.
Intangible fixed assets (HL ext)
Intangibles assets are non physical assets (cannot be touched). They include brands, good will, Patents,
and copy rights, and are included in the balance sheet as fixed assets
Patents are a form of protection for inventors to prevent others from copying their invention for a period
of time, usually 20 years. They are registered and other firms have to pay a fee to copy the ideas,
processes or products of the inventor. Patents act as an incentive for inventors.
Copyrights give legal protection for the original work of a creator such as a writer, photographer painter
or a musician. They are registered, and anyone must seek permission from the copyright holder in order to
reproduce the work, usually for a fee.
Goodwill is the value of a firm’s image or reputation. It arises from the firm’s good location, good
products, loyal customer base, good management, excellent workforce, quality service, and so on.
It can be calculate as the difference between the value of a business as a whole and the value of its net
assets.
Brand or trademarks are signs, symbols, names, phrases, or image that uniquely identifies a product or
business. They are registered and provide legal protection against copying. They can be sold for an
appropriate fee.
Reasons to include intangibles in balance sheet
They help to generate future sales and therefore are similar to other tangible fixed assets
They can boost the balance sheet and make the firm less vulnerable to takeover
Difficulties
However, it is difficult to value intangibles is that there is no market value for most of them.
Practice questions
Example 1:
Hunter and Sons:
1998
1999
2000
$M
$M
$M
Sales revenue
788
754
706
Cost of sales
244
258
266
Overheads
368
356
364
Fixed assets
1880
2200
2340
Current assets
484
488
486
Current liabilities
288
483
548
Long term liabilities
1800
1880
1900
Prepare profit and loss account and balance sheet for each year.
M05 S2 Q5: Pre P&L; liquidity and profitability
M03 S2 Q3: P&L and B/S; efficiency, liquidity and profitability
M06 S2 Q2: P&L and B/S; improving profit
M01 S2 Q7: calculate; explain; profitability; limitations.
M02 S2 Q5: Define; calculate; evaluate
N08 H1 Q5: Define gross profit. P&L, B/S, G.P margin, N.P margin, current ratio, acid test ratio, 2
reasons for loss
N07 S1 Q4: Construct a full Profit and loss
M10 S2 Q1: Calculate the missing values in P&L a/c
N10 S2 Q2: Construct Balance Sheet
N12 H2 Q2: Construct a balance sheet
N12 S2 Q2: Calculate net profit before interest
M13 S2 Q2: construct a balance sheet
Spec H1 Q3: Define working capital
N09 H2 Q2a: Define fixed assets and share capital
M10 H2 Q4a: Define revenue
M10 S2 Q2: Define overheads N11 S2 Q1
N10 H2 Q2: Define copyright
M11 S1 Q4: Explain the purpose of final accounts
M11 H2 Q3: Define profit
N11 H2 Q5: Define current liabilities
N11 S2 Q4; Calculate gross profit
N11 H2 Q1a: Define working capital
M13 S2 Q2b: Define retained profit
Define:


Distinguish between capital and revenue expenditures
Gross profit
Give an example of capital receipt.