Subunit

Subunit 3.4
3.4
Final
Final accounts
accounts
 Goals
➔ I can discuss the purpose of accounts to different
stakeholders
➔ I can prepare and interpret final accounts, namely the
profit and loss account and the balance sheet
➔ I can prepare and interpret final accounts, namely the
balance sheet
➔ I can describe the different types of intangible assets.
➔ I can calculate and examine the appropriateness of
the straight-line depreciation method.
➔ I can calculate and examine the appropriateness of
the units of use / units of production depreciation
 Purpose of accounts to
different stakeholders
➔ Final accounts are financial statements compiled by
businesses at the end of a particular accounting period
such as at the end of a fiscal or trading year.
➔ These records of accounts including transactions,
revenues, and expenses help to inform internal and
external stakeholders about the financial position and
performance of an organization.
➔ Internal stakeholders include shareholders, managers,
and employees, while examples of external stakeholders
are customers, suppliers, the government, competitors,
financiers, and the local community.
 Shareholders
➔ Shareholders will be interested in knowing how valuable
the business is becoming throughout its financial year.
➔ They check on the efficiency of the business in investing
capital in order to make a worthwhile return on their
investment.
Managers
➔ Final accounts are used by managers to set targets,
which they can use to judge and compare their
performance within a particular financial year or number
of years.
➔ These will help them in setting budgets,
 Employees
➔ A profitable business could signal to employees that their
jobs will be secure. This may also indicate that they
could get pay rises.
➔ However, an increase in profitability does not necessarily
lead to pay increases for employees, leading them to
involve trade unions to negotiate further on their behalf.
Customers
➔ Customers will be interested in knowing whether there
will be a constant supply of a firm’s products in the
future.
➔ This will determine how dependent they should be on the
business and how secure it is.
 Suppliers
➔ Suppliers can use final accounts to negotiate better cash
or credit terms with firms.
➔ The security of the business and thus its ability to pay off
its debts will be a key concern for suppliers.

The government
➔ The government and tax authorities will check on
whether the business is abiding by the law regarding
accounting regulations.
➔ They will be interested in the profitability of the business
to see how much tax it pays.
➔ A loss-making business will be of grave concern because
it could mean an increase in unemployment
 Competitors
➔ Businesses will want to compare with those of other
firms to see how well they are performing financially.
➔ They will look for the answers to key questions:
◆ Are their competitors’ profitability levels higher than
theirs or are the competitors struggling financially?
◆ How do the competitors’ sales revenues compare
with theirs?
Financiers
➔ These include banks that will check on the
creditworthiness of the business to establish how much
money they can lend it.
➔ This will also depend on the gearing of the business
because a high-geared business will have problems
soliciting funding from financial institutions
 The local community
➔ Residents living around a particular business will want to
know its profitability and expansion potential.
➔ This is because it may create job opportunities for them
and lead to growth in the community.
➔ However, the residents will also be concerned about
whether the businesses will be environmentally friendly
and whether their accounts consider costs such as air or
noise pollution.
The main final accounts
The profit and loss account
➔ Also known as the income statement
shows the records of income and
expenditure flows over a given time
period.
➔ It establishes whether a business has
made a profit or loss and how this was
distributed at the end of that period.
➔ It is divided into three parts:
◆ the trading account,
◆ the profit and loss account
 A.The trading account
➔ Sales revenue is the income earned from selling goods or
services over a given period.
➔ Cost of sales or cost of goods sold (COGS) is the direct
cost of producing or purchasing the goods that were sold
during that period.
➔ The formula for cost of sales is as follows:
 A.The trading account
➔ The trading account shows the difference between the
sales revenue and the cost to the business of those
sales.
➔ It is shown as the top part of the income
statement that establishes the gross profit of the
business
➔ In calculating gross profit the following formula is used:
 B. The profit and loss account
➔ This is the second part of the income statement that
shows the profit before interest and tax, profit
before tax, and profit for period
➔ To find out profit before interest and tax, expenses are
subtracted from the gross profit shown in the trading
account.
➔ These expenses comprise indirect costs or overheads
which are not directly linked to the units sold.
 B. The profit and loss account
➔ Profit before tax is calculated by subtracting interest
payable on loans from the profit before interest and tax
➔ Profit after interest and tax is found by deducting
corporation tax (tax on company profits) from profit before
tax
 C. The appropriation
account
➔ This is the final part of the profit and loss
account that shows how the company’s
net profit after interest and tax is
distributed
➔ This distribution is in two forms, either
as dividends to shareholders or as
retained profit (reinvested profit)
➔ Retained profit is calculated using the
following formula:
 Sample Profit and loss account
Profit and loss account/Income statement
Formula/description
Sales Revenue Price x quantity
opening stock or
Cost of goods sold
minus inventory + purchases - Trading account
or Cost of sales
closing stock
equals Gross profit
Overhead or indirect
minus Expenses
costs
Profit before
equals
interest and tax
minus Interest Profit and loss
account
equals Profit before tax
minus tax a % of profit before tax
Net profit after
equals
interest and tax
divided into Dividends
Appropriation
net profit after interest account
divided into Retained profit
and tax - dividends
In your notes and on your
own
 Assets
➔ These are resources of value a business owns or
that are owed to it.
➔ They include fixed assets and current assets.
➔ Non current assets, also called fixed assets are
long-term assets that last in a business for more
than 12 months.
➔ Tangible examples that are physical in nature include
buildings, equipment, vehicles, and machinery.
➔ Some of these assets, such as machinery, usually
depreciate (lose value) over time.
➔ In this case depreciation is deducted from fixed
 Assets
➔ Intangible assets that are non-physical in nature
tend to be difficult to value.
➔ Current assets are short-term assets that last in a
business for up to 12 months. They include cash,
debtors, and stock.
◆ Cash is money received from the sale of goods and
services which could be held either at the bank or by
the business.
◆ Debtors are individuals or other firms that have
bought goods on credit and owe the business money.
◆ Stock, also known as inventory, includes raw
materials, semi-finished goods, and finished goods
 Liabilities
➔ These are a firm’s legal debts or what it owes to
other firms, institutions, or individuals.
➔ They arise during the course of business operation and are
usually a source of funding for the firm.
➔ They are classified into non current liabilities and
current liabilities
➔ Non current liabilities are long-term debts or
borrowings payable after 12 months by the
business.
◆ They include long-term bank loans and
mortgages.
 Liabilities
➔ Current liabilities are short-term debts that are
payable by the business within 12 months.
◆ These include creditors (unpaid suppliers who sold
goods on credit to the firm), a bank overdraft, and
tax (money owed to the government such as
corporation tax)

Total liabilities= current liabilities + non

current liabilities
 Net assets

Net assets= total assets - total

liabilities
 Equity
➔ Also known as shareholders equity or shareholders
funds, equity includes two aspects, namely share
capital and retained profits.
➔ Share capital This refers to the original capital
invested into the business through shares bought
by shareholders.
➔ It is a permanent source of capital and does not
include the daily buying and selling of shares in a stock
exchange market or the current market value of shares.
➔ Retained profit is the profit ploughed back into the
business obtained from the profit and loss account.
➔ It is also known as reserves as it includes profit that
the business has made in previous years.
 Equity
For profit making businesses:

Equity = share capital + retained

earnings
For non profit making businesses:

Equity = retained earnings

In both profit making and nonprofit entities,
equity helps to finance the net assets of the
business and enables the balance sheet to
balance
Net assets = equity
 The balance sheet
➔ Also known as the statement of financial
position, this outlines the assets,
liabilities, and equity of a firm at a
specific point in time.
➔ It is a snapshot of the financial position of
a firm and is used to calculate a firm’s
net worth.
➔ It gives the rm an idea of what it owns
and owes, including how much
shareholders have invested in it.
➔ The basic requirement of a balance
sheet is that what a business owns
(total assets) must equal what it
Sample
Balance sheet/
Statement of
financial position
 Advantages of a Balance Sheet
➔ Provides a snapshot of liquidity
➔ It is used to understand overall leverage or gearing, when
comparing liabilities to equity
➔ Offers insight into a company's financial health on a single
day
 Disadvantages of a Balance
➔ Sheet
It has limitations as it doesn't show growth over time, so it
may not be best for predicting the future
➔ It is Is best used in conjunction with other financial
statements, not on its own
➔ Depreciation or the type of accounting method may shift
values on the balance sheet, making it appear more
profitable
 Intangible assets
➔ These are fixed assets that lack
physical substance or are non-
physical in nature.
➔ They are difficult to value, due to their
subjective nature and in many cases they
will not be shown in the balance sheet.
➔ Their value can fluctuate over time and
can either inflate or deflate a firm’s
value.
 Patents
➔ These provide inventors with the exclusive rights to
manufacture, use, sell, or control their invention of
a product.
➔ The inventors are provided with legal protection that
prevents others from copying their ideas.
➔ Anyone wishing to use the patent holder’s ideas must
apply and pay a fee to be granted permission to use it.
➔ The legal life for most patents is about 20 years;
however, this period also depends on the useful life
of the patent.
 Goodwill
➔ This refers to the value of positive or favourable
attributes that relate to a business.
➔ It includes a good customer base and relations,
strong brand name, highly skilled employees,
desirable location and the good reputation a rm
enjoys with its clients.
➔ Goodwill usually arises when one firm is purchased by
another.
➔ During an acquisition, goodwill is valued as the amount
paid by the purchasing firm over and above the book value
of the firm being bought.
 Copyright laws
➔ These are laws that provide a creator with the
exclusive right to protect the production and sale of
their artistic or literary work.
➔ Copyright laws will only apply if the original ideas are put
to use such as in the creation of a published novel, a music
album or developed computer software.
➔ Most copyright lasts for between 50 to 100 years
after the death of the creator.
➔ Anyone wishing to use a copyright holder’s works must
seek permission from them to do so.
 Trademarks
➔ These are a recognizable symbol, word, phrase or
design that is officially registered and that identifies
a product or business.
➔ Anyone who infringes the trademarks of others can be
sued by the trademark owners.
➔ Trademarks can be sold for a fee and most last for a
15-year renewable period, depending on their use.
 Depreciation
➔ This is the decrease in the value of a
fixed asset over time.
➔ It is a non- cash expense that is
recorded in the profit and loss
account in order to determine the net
profit before interest and tax.
◆ Wear and tear – the repeated use
of fixed assets may cause them to fall
in value and more money is needed
to maintain them.
◆ Obsolescence – existing fixed assets
fall in value when new or improved
versions are introduced in the
market.
 Straight-line method
Spreads out the cost of an asset equally over its
lifetime by deducting a given constant amount of
depreciation of the asset’s value per year.
➔ It requires the following elements in its calculation:
◆ the expected useful life of the asset, i.e. the
length of time it intends to be used before
replacement
◆ the original cost of the asset, i.e. its purchase or
historical cost
◆ the residual or scrap value of the asset, i.e. an
estimation of its worth or value over its useful life.
Straight-line method
 Advantages of straight-line
depreciation
➔ It is simple to calculate as it is a predictable expense
that is spread over a number of years.
➔ It is mostly suitable for less expensive items, such as
furniture, that can be written off within the asset’s
estimated useful life.
Disadvantages of straight-line
depreciation
➔ It is not suitable for expensive assets such as plant
and machinery as it does not cater for the loss in
efficiency or increase in repair expenses over the
useful life of the asset.
➔ It can inflate the value of some assets which may
have lost the greatest amount of value in their first
or second years, such as motor vehicles.
➔ It does not take into account the fast-changing
technological environment that may render certain
fixed assets obsolete very quickly.
 Units of production method
➔ Calculates the depreciation of the value of an asset
based on usage.
➔ It assumes that an asset’s useful time is more closely related
to its usage than just the passage of time.
➔ Depreciation will be higher when there is a greater
volume of activity during the year when an asset is
used a lot, and lower during times when the asset is
used less.
 Units of production method
➔ The following information is required to calculate
depreciation:
◆ The cost basis of the asset. The original value of the
asset.
◆ The salvage value of the asset. The estimated value
of the asset if it were to be sold at the end of its useful
life.
◆ The estimated total number of units to be
produced. The wear and tear on the machinery is
the result of the number of units it is expected to
produce over its useful life. This figures is usually
based on production estimates and historical information.
◆ Estimated useful life. Time an asset is expected to be
 Units of production method
(cost basis of asset - salvage value) = units of production rate
Estimated total units to be produced
over estimated useful life

(cost basis of asset - salvage value) X actual units produced =

depreciation expense
Estimated total units to be produced
over estimated useful life
Units of production rate x actual units produced =
depreciation expense
 Advantages of units of
production depreciation
➔ As depreciation is directly tied to the wear and tear
of the asset, it is based on usage as opposed to time.
➔ It is a more accurate reflection of the declining
physical value of the asset.
➔ It accurately matches revenue and expenses. Since it
is based on usage it is important to note that the
expenses fluctuate with customer demand.
➔ It provides a more realistic view when producing
financial statements.
Disadvantages of using units of
production depreciation
➔ It is only useful to manufacturers or producers. It
makes little sense to tie depreciation to asset usage
if a business does not manufacture or produce a
product.
➔ It is not allowed for tax purposes. It cannot be used
when a business computes its tax returns at the end
of the year.
➔ It can be complicated to compute the units of
depreciation. Also, measuring output can be tricky
and depreciation expense must be recalculated each