3.4. Final Accounts

  • Final accounts
    • Financial statements that inform stakeholders about the financial profile and performance of a business
    • Businesses need to keep detailed records of purchases, sales, inventory, and other financial transactions
  • Important terminology
    • Current assets
      • Liquid assets are assets that are easily turned into cash
      • Aside from cash
        • Debtors – money owed to the company
        • Stocks – unsold inventory
      • Current assets = Cash + Debtors + Stocks
    • Current liabilities
      • Money owed by the business, must be paid by 12 months
        • Overdrafts – short term loan to cover cash problems
        • Creditors – money owed to suppliers for goods bought on credit
        • Tax
      • Current liabilities = Overdrafts + Creditors + Tax
    • Working capital
      • Money needed by the business for its daily operations (running costs)
      • Also known as net current assets
      • WC = Current assets – Current liabilities
      • Working capital is needed as buffer for expected shutdown in cash flow
  • Principles and ethics of accounting practices
    • These are general rules and concepts that govern the field of accounting
    • Failure to uphold accounting ethics in businesses can result in legal challenges
    • Window dressing
      • Also called creative accounting; legal way of manipulating financial statements.
      • Manipulations include:
        • Different stock valuation (FIFO/LIFO Pricing)
        • Unrealistic valuation of intangible assets
        • Classifying current liabilities as long-term liabilities
        • Sale of fixed assets to improve working capital
        • Debtors may be included to boost profit
  • Profit and loss account/income statement
    • Shows the trading position of the business over a period of time, determining the income, profit or loss
    • Parts of an income statement
      • Heading: Profit and loss for (company name) for year ended (date)
      • Trading account – shows the difference between sales and direct costs
      • Profit and loss account
        • Shows operating or net profit after deducting operating expenses and interests
        • Depreciation is included as expense
      • Appropriation account – shows how net profit is distributed to tax, dividends and retained earnings
      • Trading account
        • Shows Gross Profit = Sales revenue – Cost of sales
        • Revenue = amount earned from sales
        • Cost of Sales/Goods Sold = Value of inventory + Purchases – Closing Stock OR Variable cost x Quantity sold
        • Remember: not all sales are from cash; sales revenue is not the same as cash received by the business.
      • Profit & loss account
        • Deduct overheads from gross profit to get operating profit (or net profit before tax and interest)
      • Appropriation account
        • Interest subtracted
        • Net profit before tax
        • Taxes – Compulsory income tax (levy on profits)
        • Net profit after tax
        • Subtract Dividends – share of profits distributed to shareholders
        • Retained Profit – how much of the profit is left in the business for future development
  • Balance sheet
    • Shows the overall value, thus financial position of a company at a specific date
    • Includes value of assets, liabilities, and capital employed
    • Shows where a firm’s money came from and how it was spent
    • Balance sheets are useful if there’s a prior balance sheet to compare with
    • Net assets = Liabilities + Owner/Shareholder’s equity
    • Balance sheets comprises
      • Title on top: Balance sheet for (Company) as at (Date)
      • Assets
        • Fixed
          • Items purchased for business use (not for sale in the near future)
          • Tangible – physical
          • Intangible – non-physical assets (e.g. brand name, goodwill, patents, etc.)
          • Investments – medium to long term investments or government bonds
        • Current assets
        • Current liabilities
        • Net assets = Working capital + Fixed assets
      • Capital and reserves (shareholder’s equity)
        • Share capital – money raised through the sale of shares
        • Retained profits – money left for business use (usually based on the current income statement)
        • Reserves – proceeds from the retained earnings from previous years; may also include capital gains on fixed assets
        • Loan capital
      • Net assets = long-term liabilities + owner’s equity
      • Therefore, the source of funds matches the use of funds

  • Types of intangible assets:
    • Trademarks
      • Intangible asset legally preventing others from using a business’ logo, name, or other branding
    • Copyrights
      • Protects the author’s ownership of his work
      • Legal right to publish one’s own work
    • Patents
      • Grants a company the sole right to manufacture and sell an invention for a period of time, usually 20 years
      • Only inventions that are new, not obvious, and not a combination of previous inventions, can be patented
    • Utility model
      • Grants a company the sole right to manufacture and sell a new item, but for a shorter period of time, usually 7 years
      • Different from a patent – a utility model can simply be a new way of using an existing item
      • e.g. using a bucket as Chickenjoy container
    • Branding
      • Set of intangible assets, impressions, and reputations associated with a name, brand, or logo, that differentiates it from competitors
    • Goodwill
      • The established reputation of a business regarded as a quantifiable asset
      • Represented by the excess of the price paid at a takeover for a company over its fair market value
  • Limitations of income statement and balance sheet
    • Takes time to prepare (could have lost on the way)
    • Needs comparison with historical records
    • The data is purely quantitative
    • Auditing – process of examining and validating financial accounts by an external entity to protect all stakeholders
  • Depreciation (HL only)
    • Fall in the value of fixed assets over time
    • Spreads the historic cost of an item over its useful lifetime
    • Opposite of depreciation is appreciation
    • Depreciation helps reflect the value of the business more accurately
    • Helps the business plan for asset replacement in the future
    • Depreciation is recorded as an expense, yet no money is actually spent (should show up in expenses in the income statement, but will not appear in cash flow forecast)
    • Calculating depreciation
      • Straight-line method
        • Constant amount of depreciation is subtracted from the value of the asset each year
        • Simple but unrealistic since assets usually depreciate faster at the start of the lifespan
        • Requires estimates on both life expectancy and residual value
        • Does not consider effect of obsolescence
        • Repairs and maintenance cost of assets usually increases with age, thus reducing the profitability of the asset
        • Annual depreciation = (Purchase cost – Residual value) / Lifespan
      • Reducing balance method
        • Calculates depreciation by subtracting a fixed percentage from the previous year’s net book value
        • More accurate than the straight-line method but more complex
        • By calculating a precise rate of depreciation, it suggests a level of accuracy for the process of depreciation, which is unjustified
        • Residual value and life expectancy are always estimates
        • Net book value = Historical cost – Cumulative depreciation

 

 

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