BUSINESS & MANAGEMENT

Unit 3.5 Final Accounts

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Standard Level

KEY TOPICS

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Higher Level

• Introduction to Final Accounts

• Profit & Loss Accounts• Balance Sheet• Window Dressing

• Depreciation – Straight Line & Reducing Balance

• Intangible Assets – Patents, Copyrights & etc.

• Stock Valuation – LIFO & FIFO• NB: - Students will not be tested on

Manufacturing Accounts or Double Entry

Introduction

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Businesses to have some way of knowing where there money

is going. Small businesses keep these so they can keep track of profit and spending.

Corporations (Private limited liability companies and Public

limited liability companies) need to legally keep these for a number of

years. In some countries, the period is as long as 7 years so as to

facilitate corporate governance.

Things that need to be kept by a corporation

Profit &

Loss Account

Balance

Sheet

Cash Flow Stateme

nt

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• Explains the “trading” that took place during a period of time.

• Assets and Liabilities of a business.

• Shows money coming in and money going out.

Businesses need to be audited from an

outside source so that everyone knows that

the accounts are correct.

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Stakeholders who look at the final accounts

Shareholders

Employee

s

Managers

Competitors

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• The owners of the company like to see where their money is being spent.

• They would like to see how secure their job is and to see if they might receive a pay raise.

• Use the accounts to see how well they are performing and to plan for the future.

• Other firms will look to see how businesses are performing compared to themselves.

Government

Financier

s

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Stakeholders who look at the final accounts

• Tax collectors will make sure that businesses are paying their fair share.

• Banks, business angels and suppliers will make sure a business is running sound before giving finance or credit.

Revenu

e

Cost

Profit

Profit

Quality

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Terminology

• Revenue is money that comes into a business from trading accounts.

• Cost is the money that flows out of a business for revenue expenditures like rent/mortgage payments, wages (payment to staff), costs of material.

• Profit is the difference between revenue and costs.

• Profit quality of a business refers to the long-term prospects of making money for a firm. Businesses with low quality products and high prices will have low profit quality.

P&L Account

or Income Statem

ent?

What informa

tion does a

P&L Account

give?

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Profit & Loss Accounts/ Income Statements

• P&L Account is used by profit-motivated organizations whereas Income Statements is used by non-profit organizations as there not profit-motivated.

• Usually works for one year and explains how much profit is being made (or not made).

P&L Account comprises of three parts

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Trading Account

Profit & Loss Account

Appropriation Account

Trading Account

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Cost of Goods Sold = Opening

Stock

+ Purchases - Closing Stock

Gross Profit = Sales

Revenue - Cost of Goods Sold

Trading Account for HIO $ $• 5,000

• 3,000

• 200

• 500• ________

• ________

Sales

Cost of goods sold

Opening stock

Add: Purchases

Less: Closing stockTotal Cost of Goods Sold

Gross Profit

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2,700

2,300

Trading account for CBO • $ $• 2200

• 1500

• 400

• 300• ________

• _____

Sales

Cost of goods sold

Opening stock

Purchases

Closing stock

Gross profit

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1,600

600

Ways to improve Gross Profit

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Use cheaper suppliers but try not to reduce quality

Increase selling price but try to not lose customers

Use marketing strategies – promotions and repackaging.

This might increase sales but will definitely increase expenses.

Gross Profit does not take into account the fixed costs of a business such as

production costs, rent and advertising costs.

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P&L Account:

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Shows the operating profit and net profit of a business.

Operating Profit =Gross Profit - Expenses

Expenses are listed on Pg. 393 box 3.5 (1st Edition) or Pg. 346

box 3.5a (2nd Edition).The operating profit is the

actual profit made by a business

List of Expenses• Income received by directors for directorship.Director Fees

• Monthly salaries, commission, incentives & bonuses.Salaries

• Fees paid to the secretarial firm.Secretary Fees

• Fees paid to the audit firm.Audit Charges

• Administration fees charged (e.g. by statutory boards.).Administration Charges

• Market Research, Market & Sales Promotions, Door Gifts & etc.Marketing Costs

• Personal Insurance (Life & Term), Fire Insurance for Property & etc.Insurance Premiums

• Interests incurred from bank loans, hire purchase, overdrafts, & etc.Interest Charges

• Rental charges (including management fee) of land and property.Rental

• Pen, paper, ink cartridges, boxes, stapler and etc.Stationery Costs

• Air & Sea freight, warehousing charges, land delivery charges & etc.Transportation and Distribution Costs

• Gas, heat, electricity, telephone and water charges.Utility

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Profit and loss account for PML $ $

Sales 40,000Cost of goods sold Opening stock 25,000 Purchases 5,000 Closing stock 16,000Cost of stock _______Gross profit _________

Expenses Salaries 3,000 Utilities 6,000 Transportation 2,000 Others 1,000Total Expenses _________

Operating Profit _________

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14,000

26,000

12,000

14,000

Some basic things businesses do to try and reduce expenses and increase profit

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Try to negotiate for lower rent or move. (this can be dangerous to some

businesses.)Reduce using air conditioning

and heating.

Cutting down on administrative personnel.

Non Operating Income

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Examples include interest earned at a bank, rent charged on property owned by business and dividends earned from shares in other companies. These are counted as non-operating income. It is

counted after operating profit.

Interest payments and taxes are counted after operating profit as well.

Profit and loss account for Larry’s $Chinese school

Sales Revenue 50000Cost of sales (30000)Gross Profit ________

Expenses (7000)Operating Profit ________Non-operating income 3000

Net Profit before interest and tax ________

Interest payments (5000)

Net Profit ________

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20,000

13,000

16,000

11,000

Appropriation Account

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This shows how profits are distributed between taxes, dividends(money paid to shareholders (shown as a current liability)) and Retained profit (money used by the business to grow(shown

as a capital reserve)).Businesses have no choice when it comes to taxation but they make

decisions on how much money should be paid in dividends and how much should be kept as retained profits

during shareholders meetings. (Most businesses pay out dividends twice a

year).

While there is no set rule on how these accounts

should be run in the end the trading; profit and loss account and appropriation account are all under the title PROFIT AND LOSS

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Profit and loss account for __________ $________________________________

Sales Revenue ________Less: Cost of sales __________Gross Profit ___________

Less: Expenses _________Profit before interest and tax (Operating Profit) ___________Add: Non-Operating IncomeLess: Interest paymentsNet Profit Before Taxes and Dividends ___________Less: Tax ___________

Net Profit after interest and tax ________

Less: Dividends _________Retained Profit _________

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Businesses have to be careful not to get excited about a big number in the

Gross Profit column because these numbers are derived before taxes and expenses.

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Limitations to Profit & Loss Accounts (P&L)

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Only can show past performance and can be difficult to say what will

happen in the future.

Window dressing – Some businesses will “play with their numbers” so that they can make it look more attractive

to shareholders.Because of a lack of standards it is hard to compare the profit and loss

accounts of different firms.

Balance Sheets

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Legally required record of a businesses financial position at the end of the trading

year. It shows a businesses assets, liabilities and the capital invested.

Basic function of a balance sheet is to show where money comes from and

where it goes.

Must contain three sections: Assets, Liabilities and Capital & Reserves.

Assets

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Money owned by a business or owed to a business.

Fixed assets will last for more than a year and will most likely

not be sold.Current assets – will be turned into working capital within a year. Cash and liquid assets.

Different types of Fixed Assets

Tangible Fixed Assets

Buildings, equipment,

vehicles, etc. Tend to

depreciate in value over time.

Intangible Fixed Assets

Non physical things but they

have a value that is hard to determine; e.g.

patents, copyrights, trademarks,

brand names, etc.

Long-term Investments

Long-term money that is

usually put into other businesses (e.g. stocks, debentures and

bonds).29/39

Legal obligations of Liabilities

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Long-term liabilities – paid under accounts payable money that will not be paid

back till after a year.Current liabilities – Money that needs to be paid within a year. Shown in the balance

sheet under creditors

Capital and Reserves (shareholders funds (limited companies)) Owners’ Equity for

other types of businesses

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Share capital – (called up capital) Money raised from the initial sale of

shares of a business. (NOT THE CURRENT SHARE PRICE)

Retained profit – The net profit that a business has after paying expenses,

taxes and dividends. Will match figures from profit loss account.

Reserves - proceeds from retained profits in previous trading years. Includes capital

gains in the value of fixed assets. (This happens when property goes up in value (revaluation)).

Depreciation is not calculated here.

Capital and Reserves

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Capital and Reserves are money owed to the owners so it is considered a liability. It is not considered long term or short term liability because there is no set

time that it needs to be repaid. It is also considered permanent capital (internal source of finance).

Owners of a business own the value of the assets after

deducting debt.Many countries require that

businesses report their balance sheet for two years.

Owners’ equity = Net Assets – Long term liabilities

Differences in Balance Sheet

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Balance sheets of unincorporated businesses (Sole traders, partnerships) will

be different from incorporated business (Public and Private) in the following ways:

Sources of funds are different (limited business have more options)

No shareholders funds for unincorporated businesses

Unincorporated businesses pay no shareholders so they may have drawing accounts to use the funds for personal use.

Uses of Balance Sheets

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From the Working Capital figure, businesses can see how much money they have to “play with”.

Asset Structure lets a business see if they have an increase in stocks which can mean “overtrading”.

Capital Structure helps to see where capital is coming from.

Capital Employed helps a business know how much money they are using.

Limitations of Balance Sheets

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Balance sheets do not change if they are not updated; the information or data could be well off.

When evaluating stock or other assets it can be hard to predict what the actual value is. Because the real price of something is not known until it is sold.

Because businesses run a balance sheet in different ways it can be difficult to compare them.

Intangible Assets are very hard to determine the value of. So many things like trained workers are left off a balance sheet.

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Creative Accounting or Window Dressing is a legal way to make accounts look

betterShow an overdraft that is repayable after 12 months as long-term liability.

Giving higher value to intangible assets.

Using lease back and straight selling of assets to show a profit. Moving around paying back loans so that the business can show lower profits before reporting income for tax reasons.

Declare sales revenue that is sold on credit as if it was paid in cash.

Delay declaring depreciation of fixed assets.

Using these methods can hide the real value of a firm.

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Other limitations of Final Accounts

Sets of final accounts are necessary for good analyzing (either intra firm or historical).

The skills of the workers are ignored .

Qualitative factors are ignored as well as ethical objectives.

Need to see the accounts of different businesses to make judgments about performance of the business.

Because they are public record many businesses will try to hide as much information as possible in their reports.

It can be dangerous to use past information to predict the future. Some managers have trouble keeping this in mind.

Keep in mind that Profit and Loss Accounts cover a period of time while Balance Sheets are focused on a frozen moment in a business.

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Final Accounts and Business Strategy

Auditing is the process of having outside people go over your “books”(final accounts). Many countries require this for two reasons: disclosure and accountability of financial matters of a business.

Today intellectual property rights (patents and copyrights and trade marks) are extremely important and for some businesses the most important thing they have.

Some countries do not recognize the intellectual property rights and this can cause major political problems.

Balance sheets are used to help businesses understand their needs day to day. Also these figures will help a business to know when they can expand.

Also the final accounts can let shareholders know where their money is being spent.

When looking for a balance sheet or other final accounts for a business a good place to start is the annual report.