UNIT 3.5 FINAL ACCOUNTSLESSON 1: INCOME STATEMENTSPP. 389-398

IB Business and Management

1. Think about it…

“Nothing speaks move eloquently than money.” – French proverb Everyone knows a “picture is worth a

thousand words”…money talks as well. How does this money “talk”?

In the form of income statements and balance sheets.

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2. An overview

All businesses need to keep records of their finances. In the majority of countries around the world it is a legal

requirement. These records are also used to have better financial planning and

control. Final reporting also acts as a way to account for all monies made by the firm.

All companies must produce a set of final accounts in the form of three statements: 1. Profit and loss account (shows your position at the end of the accounting

period) 2. Balance sheet (shows assets and liabilities) 3. Cash flow statement (shows cash inflows and outflows)

Now, lets take a look at the purpose and users of final accounts…. Remember: incorporated businesses are legally obliged to produce final

accounts, which ensure transparency in the use of their funds. …

• Interested to see where their money was spent.• Will decide to hold, buy or sell their shares.Shareholders • Interested in their job security and pay increases.

Employees • Can use financial accounts to judge the operational efficiency.

• Used to set targets and strategic planning.Managers • Will use your accounts to compare to their accounts.

Competitors• To ensure you are paying the correct amount of tax.

Government • Will look over your accounts before approving any loans.Financiers

• Will use the accounts to assess whether am investment would be financially worthwhile.Potential

investors

4. Trading, Profit & Loss Accounts

Also know as: an income statement. Main purpose of an income statement is to show the amount of

profit or loss that a business has made in a trading period. As stated earlier, the different stakeholders will have different

uses for the income statement of a firm. It is also used to assess the profit quality of a business.

Example, firm’s that sell inferior products at a high price will have LOW profit quality.

There are three sections in an income statement: 1. the trading account (gross profit) 2. the profit and loss account (profit statement; operating and

net profit) 3. the appropriation account (shows how the net profit is

distributed)

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5. Trading Account (gross profit)

Represents the top section of a Profit & Loss account.

Shows the difference between: sales revenue and direct cost of trading.

So… Sales revenue – Cost of goods = GP

Cost of goods sold (COGS): Cost of sales = opening stock +

purchases – closing stock (in blue) The cost of goods actually sold.

How can you improve gross profit? Use cheaper supplies Increase sales price Use marketing strategies

Remember: Gross profit is NOT the profit a business gets to keep.

6. Profit and Loss Account (operating profit and net profit)

Shows the operating and net profit or loss of a company.

Operating & net profit = Gross profit – expenses.

The Net profit or operating profit is the surplus if any.

This is the actual profit made from trading / doing business.

So how can we reduce expenses? Rent fees could be re-negotiated. Fuel consumption could be reduced. Administration costs could be reviewed.

Some P&L accounts might show non-operating income. Income from other activities, such as

collecting rent, interest from savings, etc.

This would show as profit before interest and tax…text page 395.

7. Appropriation Account

Shows how the net profit is distributed into: Taxation (goes to government) Dividends (goes to shareholders) Retained profits (kept by the

business)

All three parts combined and termed the Profit and Loss Account.

There is no set format on how a firm reports their P&L accounts. Go online and practice reading from

several different Ltd. Companies. Yahoo finance is a great resource

for financial statements of public companies.

8. Limitations of the P&L Accounts

Shows the historical performance of a business. No guarantee that future performance will be any better.

Window dressing: legal manipulation of the account to make the company look financially attractive can take place. This means the true figures are hidden.

No standardized format for producing a P&L account. This can make it difficult to compare the profit and losses

of different firms. …

9a. Balance Sheets

They are annual financial statements that companies are legally required to produce for auditing purposes. It is a record of a company’s financial position at the end of the trading

year. The balance sheet will contain an organization’s:

Assets Liabilities Capital invested by the owners

It also shows the capital employed (firm’s sources of finance) and the assets employed (where the money has been spent).

Three very important parts of a balance sheet are: 1. Assets: Fixed; tangible, intangible and investments. 2. Liabilities: long term and current. 3. Capital and reserves: share capital, retained funds, and reserves.

Let’s take a look at these in more detail….

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9b. Assets

Items owned by or to a business that are valuable.

Fixed assets: Asset that is bought for

business use. Tangible (physical): machinery,

property, etc. Intangible (non-physical): brand

names, trademarks, copy rights, etc.

Investments: medium to long term,.

Current Assets: cash or any liquid asset that can be turned into cash within 12 months.

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9c. Liabilities

The amount of money owed by the business. The business is legally

responsible to repay its lenders.

Long-term Liabilities(accounts payable):

Debts due to be repaid after 12 months.

Current Liabilities(Creditors): Debts that must be settled

within one year. …

9d. Capital & Reserves

Appear at the bottom either as shareholder’s funds or owner’s equity.

There are usually three parts to this section. Share capital: money raised through

the sale of shares. Retained profit: an amount of net

profit after interest, tax, and dividends have been paid.

Reserves: any proceeds from retained profits from previous years.

Capital and reserves show the internal sources of funds for a business.

See the example on page 401 …

9e. Balance sheet Recap

Shows the difference between current assets and current liabilities.

Shows us the net current assets or the working capital (unit 3.3).

The short term liquidity position of the business.

Shows the amount of money for day to day operation of the business.

Asset structure can be analyzed. Increase in fixed assets may indicate an

expansion. Increase in value of stocks might suggest

overtrading.

Capital structure can be used to see the sources of finance. Shareholder capital, debentures, and current

liabilities.

Capital employed gives us an indication of it’s the firm’s size. Higher the firm’s capital employed, the greater

its market value might be.

Are static documents Value of capital and reserves

can change from day to day.

The figures given in the balance sheet are “accurate” estimates. Market value vs book value, we

won’t know the true value until the asset is sold.

No specific format required to produce a balance sheet.

Not all assets are included in a balance sheet. Intangible, human capital etc.

Used for several purposes:

The limitations:

10. Window Dressing

Also know as creative accounting The legal manipulation of accounting statements based on the

accounting principles, practices and rules of that country in order to make the numbers look more pleasing.

Some examples: Show an overdraft that is repayable after 12 months as a long

term liability. Will improve the working capital figure of the business.

How a firm values its intangible assets. Using sale or leaseback just before the final accounts are due,

will show the liquidity position of the company. Outstanding loans and other bills paid later Declared sales revenue for items paid on credit, this will boost

the profit figures of the company. …

11. Limitations of Final Accounts

Must use a set of final accounts to get the full picture of the financial well being of a business. Also look for trends over time periods.

Human resources are totally ignored in these accounts. Final accounts do not reveal anything about the organization’s non-

financial matters. Qualitative factors can be equally important when making

decision. For examples, does the company practice CSR? There needs to be access to the accounts of other businesses. Must be lawfully produced…watch out for creative accounting. Are a historical account of the financial position of a company.

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