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

Profit & Loss Account Example – IB Format

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

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'

Balance Sheet Example – IB Format

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 Depreciation The 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 Depreciation The 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 Brands What 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 valuation 1.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 example Gadgets are us makes gadgets for teenagers and charge an average price of $50 DateUnits bought/issued Price ($) 1/3Bought /5Issued /3bough /315

Solution 1. Using LIFO DateStock bought Stock issued Remaining stock StockValuation $

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 DateStock bought Stock issued Remaining stock StockValuation $

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.