33 – Financial statements

 Statement of profit or loss: a statement that records the revenue, costs

and profit (or loss) of a business over a given period of time.
 Statement of financial position: a statement that records the values of a
business’s assets, liabilities and shareholders’ equity at one point in time.
 Assets: an item of monetary value that is owned by a business.
 Liabilities: a financial obligation of a business that it is required to pay in
the future.

33.1 Statement of profit or loss

The statement of profit or loss can also be referred to as either an income
statement of a profit of loss account.

A detailed statement of profit or loss is produced for internal use because

managers need as much financial information as possible. It should be produced
as frequently as managers need the information, perhaps once a month.

A less detailed summary statement of profit or loss is included in the published

accounts of companies for external users. It is produced less frequently, but at
least once a year. The content of this is laid down by each country’s legislation
on companies and provides a minimum of information. This is because
published accounts are also available to competitors. Detailed data could give
competitors a real insight into their rivals’ strengths and weaknesses.

The version of statements of profit or loss used in this chapter is based on the
published accounts of public limited companies.

The contents of a statement of profit or loss

The trading account
 Gross profit: revenue less cost of sales.
 Cost of sales: the direct cost of the goods that were sold during the
financial year.

This account shows how gross profit (or loss) has been made from the trading
activities of the business. The formula for calculating total revenue is: total
revenue = selling price x quantity sold.

Gross profit = revenue – cost of sales.

Cost of sales = (opening inventories + purchases) – closing inventories.

Profit or loss section

 Profit from operations: gross profit less overhead expenses (also known
as operating profit).
 Expenses: the overhead costs that arise in operating the business, which
are deducted from gross profit to calculate profit from operations.
 Profit before tax: profit from operations less interest.
 Profit for the year: profit before tax less profit (or corporation) tax.

This section of the statement of profit or loss calculates three profit figures:
 The profit from operations (or operating profit) is calculated by subtracting
expenses (such as overheads) from gross profit. Overhead costs are expenses
of the business that are not directly related to the number of items made or
sold. These can include rent and business rates, management salaries,
marketing costs and depreciation.
 Profit before tax is calculated by subtracting interest costs from profit from
operations.
 Finally, profit for the year is calculated by subtracting profit (corporation)
tax from profit before tax.

Appropriation account
 Dividends: the share of profits paid to shareholders as a return for
investing in the company.

This final section of the statement of profit or loss shows how the profit for the
year is distributed between the owners, in the form of dividends to company
shareholders and as retained earnings.
Uses of statements of profit or loss
 Low-quality profit: one-off profit can cannot easily be repeated or
sustained.
 High-quality profit: profit that can be repeated and sustained.

The information contained in these statements can be used in a number of ways:

 It can be used to measure and compare the performance of a business over
time or with other firms, and ratios can be used to help with this form of
analysis.
 The actual profit data can be compared with the budgeted profit levels of the
business.
 Bankers and creditors of the business will need the information to help
decide whether to lend money to the business.
 Prospective investors will use the profit performance of the business a guide
to whether to buy shares in it or not.

All of these users of profit data need to be aware of the limitations of published
accounting data referred to in section 36.2. in addition, these users should also
consider the quality of the profit being recorded. For example, a high profit
figure resulting from the sale of a valuable asset for more than its expected
value might not be repeatable. This is, therefore, said to be low quality profit.
However, profits made from developing, producing and selling exclusive
product designs are high-quality profits because these are likely to be a
continuous source of profit for some time to come.

Amending statements of profit or loss

Accountants often have to make adjustments to the accounting statements they
are preparing. When new financial data becomes available or when one of the
key variables used in the final accounts changes, a revised statement has to be
produced. As an A Level Business learner, it is important for you to remember
these few basic rules when adapting existing accounts:

 Use the same format of presenting the statement of profit or loss as shown in
the case study.
 If a change to the number of units produced and sold occurs, this is most
likely to lead to changes in both revenue and cost of sales.
 Some overheads might change with a variation in the level of sales. Annual
promotion or transport costs might be affected by variations in the number of
units sold.
 The impact of a change on the statement of profit or loss
Table 33.8 explains the impact on the statement of profit or loss following a
change in one of its components (assuming no other change occurs).

Change Impact on statement of profit or loss

Revenue, gross profit, profit from operations, profit before tax,
Increase in price: demand
profit for the year and retained earnings will all increase.
for product is inelastic
Cost of sales will increase; gross profit, profit from operations,
Increase in direct cost per
profit before tax and profit for the year will all fall.
unit
Profit from operations, profit before tax, profit for the year and
Increase in expenses retained earnings will all fall.

Reduction in the rate of

Profit after tax and retained earnings will both increase.
profit (corporation) tax

Directors decide to increase

Retained earnings will fall.
dividends

33.2 The statement of financial position: meaning and

purpose
 Shareholder’s equity: the total value of assets less the total value of
liabilities.
 Share capital: the total value of capital raised from shareholders by the
issuance of shares.

The statement of financial position records the net wealth or shareholder’s

equity of a business at one moment in time. In a company this net wealth
belongs to shareholders. The aim of most businesses is to increase the
shareholder’s equity by raising the value of assets owned by the business by
more than any increase in the value of liabilities. Shareholders’ equity comes
from two main sources:

 The first and argininal source was the capital originally invested in the
company through the purchase of shares. This is called share capital.
 The second source is the retained earnings of the company accumulated over
time through its operations. These are sometimes referred to as reserved,
which is rather misleading as they do not represent reserves of cash.
The contents of a statement of financial position
Table 33.9 shows an example of a statement of financial position with some
explanatory notes, which do not appear in companies’ published accounts. The
figures have been presented in two columns to help your understanding of how
subtotals are arrived at. In published accounts, all figures will be presented in
one column. Your own answers to questions requiring a statement of financial
position can also be presented in a single column.
Points to note:
 Companies have to publish the statement of profit or loss and the statement
of financial position for the previous financial year as well to allow easy
comparison. These have not been included in the above examples for reasons
of clarity.
 The titles of both accounts are very important as they identify both the
account and the company.
 Whereas the statement of profit or loss provides data for the whole financial
year, the statement of financial position is a statement of the value of the
company at one moment in time, usually at the end of the financial year.

Non-current assets
 Goodwill: arises when a business is valued at or bought for more than the
balance sheet value of its assets.
 Window dressing: techniques used by companies to manipulate financial
statements and reports to show more favourable results.

The most common examples of fixed assets are land, buildings, vehicles and
machinery. These are all tangible assets as they have a physical existence. The
value of most of these assets declines over time.

Businesses can also own intangible assets. These cannot be seen but can
contribute value to the business.

Examples are patents, trademarks, copyrights and goodwill.

There are some important points about intangible assets:

 Intangible assets are difficult to value.

 Statements of financial position, according to accepted accounting rules, do
not record intangible assets unless acquired through takeover or merger.
 For many companies, intangible assets are the main source of future
earnings, especially in a world increasingly dominated by the knowledge-
based economy. This includes scientific research companies, publishing and
music companies, and businesses with famous brand names.
 The market value of companies with substantial intangible assets will be
much greater than the net asset value.
Intangible assets such as patents and copyright are sometimes known as
intellectual capital. Intangible assets give a business a higher market value. This
is because they increase the total value of the business assets.
The reputation and prestige of a business that has been operating for some time
also give value to the business above the value of its physical assets.
This is called the goodwill of a business. It will normally only appear on a
statement of financial position if a business takes over another firm at a cost
higher than the net assets of that firm. At other times, goodwill will not appear
on company accounts. This is because business reputation and its good name
can disappear very rapidly, for example, if there is a scare over products that
could cause a risk to consumers’ health.

Disputes can arise between accountants about the valuation of intangible assets.
For example, there is a current debate amongst accountants regarding the asset
value of well-known brand names. There is scope for varying the value of these
and other intangibles on the statement of financial position in order to give a
better picture of the company’s position. This is one aspect of window dressing
of accounts that can reduce the objectivity of published accounts.

Current assets
These are very important to a business. The value of current assets has a major
impact on the liquidity of the business. The most common examples are
inventories, trade receivables (debtors who have bought goods on credit) and
the cash/bank balance.

Current liabilities
Typical current liabilities include trade payables (suppliers who have allowed
the business credit), bank overdraft, unpaid dividends and unpaid tax.

Working capital
 Net current assets: the amount of capital needed for day-to-day
activities, also called working capital.

Working capital can be calculated from the statement of financial position by

the formula:
working capital = current assets – current liabilities It can also be referred to as
net current assets.

Shareholder’s equity
 Reserves: accumulated retained profits and capital reserves from
revaluation of non-current assets.
This is sometimes referred to as shareholders’ funds or just equity. It comprises
the capital originally paid into the business when the shareholders bought shares
(share capital) plus the retained earnings /profits of the business. These retained
earnings are also known as reserves.

They are calculated by:

Reserves = shareholders’ equity – share capital.

Other reserves can also appear on the statement of financial position if a

company believes its fixed assets have increased in value (revaluation reserves)
or if it sells additional shares for more than the nominal value (share premium
reserve). Shareholders’ equity is the permanent capital of the business. It will
never be repaid to shareholders unless the company ceases trading altogether,
unlike loans that are repaid to creditors.

A common misunderstanding regarding reserves is to believe that they are cash

reserves that can be called upon as a source of finance. They are not. Retained
earnings arise due to profits being made that are not paid out in tax or dividends.
Retained earnings reserves have already been invested back into the business
when purchasing additional assets. Retained earnings are, therefore, no longer
available as a source of liquid funds. The only cash funds available in the
business are those indicated under ‘cash’ in the current assets section.

Non-current liabilities
These are the bank (long-term) loans owed by the business due to be paid over a
period of time greater than one year. They include loans, commercial mortgages
and debentures. The value of non-current liabilities compared to the total capital
employed by the business is an important measure of the degree of risk being
taken by the company’s management.

Amendments to statements of financial position

When preparing a new statement of financial position it is common to start with
the statement for the end of the previous financial year and then make
amendments to it. Table 33.14 shows some of the amendments that are possible
and the impact on the statement of financial position. There then has to be a
balancing double entry adjustment to make sure that this statement still balances
(that is, total assets still equal shareholders’ equity + liabilities).
Cause of amendment Impact on statement of Balancing entry in account
financial position
Sale of inventories for Value of inventories will fall. Cash balance will increase.
cash for the same price as
values in the accounts.
Sale of inventories for Value of inventories will fall. Cash balance will increase.
cash at a higher price than Shareholder’s equity will increase
valued in the accounts by the value of the profit
recorded.
Depreciation of Value of non-current assets Shareholders’ equity will fall as
equipment. will fall. the company is now ‘worth less’
than before.
Intangible assets, such as Value of non-current assets Shareholders’ equity will
intellectual property, are will increase. increase.
now re-valued.
Trade payables (creditors) Value of trade payables will Cash balance will decline.
ask for immediate fall.
payment.
Additional shares are sold Value of share capital will Value of property in non-current
and the share capital raised increase under shareholders’ assets will increase.
is used to buy property. equity.

Relationship between the financial statements

Change on statement of profit or loss. Change on statement of financial

position.
Retained earnings are made during the year. Shareholder equity increases.

Cash increases (if retained earnings are in cash

form).
Loss is made during the year. Shareholder equity falls.

Cash falls or non-current liabilities increase to

cover the loss.

Non-current assets are depreciated and this is Value of non-current assets falls.
recorded as an expense.
 Shareholder equity falls.
Value of closing inventory is reduced as it is Inventory valuation falls (current asset).
now out-of-date; this increases the cost of
sales. Shareholder equity falls.

Gross profit and retained profit will fall.

33.3 Inventory Valuation
 Net realisable value (NRV): the amount for which inventory can be sold
– the cost of selling it.

Inventories are unsold goods. They might also be in the form of raw material
and components that have not yet been made into completed units. Some
inventories will be in the firm od work-in-progress. How should these unsold
goods and materials be valued on the business statement of financial position?
Accountants are quite clear on this: inventories should be recorded at their
purchase price (historical cost) or their net realisable value (NRV), whichever is
the lower.

Net realisable value is calculated as follows:

Net realisable value = the amount for which the existing inventory can be
sold – the cost of selling it.

It is only used on statements of financial position when NRV is estimated to be

below historical cost. NRV sounds very complicated, but actually it is easy to
understand. Consider these examples:

Example 1: A shoe shop buys in ten pairs of shoes from a supplier for $10 a
pair. At the end of the financial year, it has three pairs remaining unsold. They
have now gone out of fashion. The shopkeeper believes that they could only be
sold at a reduced price of $8, below the price he paid for them. Therefore, the
NRV of the 3 pairs of shoes is only $24. It is this value – not $30 – that should
appear on the statement of financial position. The accounting principle known
as conservatism states that losses should be recorded as soon as they are
believed to occur.
Example 2: A furniture retailer has a dining table that has been in stock for six
months. It was bought from the manufacturer for $60. It has been damaged in
the shop and needs a repair costing $20. The shopkeeper believes that after the
repair the table could be sold for $70. The table should not be valued on the
statement of financial position at $70 as this assumes that a profit will be made.
It should not be valued at $60 as this ignores the fact that it is damaged. The
NRV is $70 – $20 = $50. As this is less than the historical cost of the asset, this
becomes its value on the statement of financial position.
33.4 Depreciation
Assets decline in value for two main reasons:
 Normal wear and tear through usage.
 Technological change that makes the asset obsolete.

Role of depreciation in the accounts

 Depreciation: the decline in the estimated value of non-current assets
over time.
 Net book value: the current statement of financial position value of a
non-current statement = original cost less accumulated depreciation.

Nearly all fixed/non-current assets will depreciate or decline in value over time.
It seems reasonable, therefore, to record only the value of each year’s
depreciation as a cost on each year’s income statement. This will overcome
both of the problems referred to above:

 The assets will retain some value on the statement of financial position each
year until fully depreciated or sold off. This is the net book value, calculated
as follows:
Original cost less accumulated depreciation
 The profits will be reduced by the amount of that year’s depreciation and
will not be under- or over-recorded.

How depreciation is calculated: the straight line method of depreciation

 Straight line: a constant amount of depreciation is subtracted from the
value of the asset each year.

There are a number of different methods that accountants can use to calculate
depreciation. One method is the straight line method. The title of this method
indicates the way in which depreciation is calculated.

Annual deprecation is calculated by the formula:

To calculate the annual amount of depreciation, the following information is
needed:
 The original or historical cost of the asset.
 The expected useful life (in years) of the asset.
 An estimation of the value of the asset at the end of its useful life (known as
the residual value of the asset)
Straight line depreciation: an evaluation
Compared to other methods of depreciation, the straight line method is easy to
calculate and understand. It is widely used by limited companies.

However, the method requires estimates to be made regarding both life

expectancy and residual value. Any errors in these estimated lead to inaccurate
depreciation charges being calculated.
In addition, cars, trucks and computers are examples of assets that tend to
depreciate much more quickly in the first and second years than in subsequent
years. This is not reflected in the straight line method calculation. All annual
depreciation charges are the same.

Finally, the repairs and the maintenance costs of an asset usually increase with
age and this will reduce the profitability of the asset. This is not reflected in the
fixed depreciation charge of the straight line method.

Impact of depreciation and the financial statements

The amount of the annual charge for depreciation affects the main financial
statements as follows:

 It is a business expense so it will reduce profit from operations on the

statement of profit or loss.
 It reduces the net book value of a non-current asset. The value of
non-current assets on the statement of financial position will fall as a
consequence.