• BETTER FINANCIAL CONTROL AND PLANNING

• TAX PURPOSES

• LEGAL REQUIREMENT TO ACCOUNT FOR THE MONEY

INCORPORATED BUSINESS
(LIMITED LIABILITY)

TRANSPARENCY IN THE USE OF FUNDS

IN MOST COUNTRIES FINAL ACCOUNTS ARE AUDITED BY INDEPENDENT ACOUNTANTS TO CERTIFY IT IS ACCURATE
 FINAL ACCOUNTS

PUBLISHED ACCOUNTS OF AN ORGANIZATION:

• STATEMENT OF PROFIT OR LOSS (INCOME STATEMENT)

• STATEMENT OF FINANCIAL POSITION (BALANCE SHEET)

USED BY DIFFERENT STAKEHOLDERS FOR DISTINCT PURPOSES

HOWEVER
In real life different formats are acceptable as long as they
include the key components
SHAREHOLDERS AND POTENCIAL INVESTORS
 The statement of profit or loss
shows the trading position of a business at the end of a specified accounting period
 TOOL TO HELP EVALUATE FINANCIAL SITUATION OF THE BUSINESS (THE WAY WE ORGANIZE INFORMATION)

PROFIT = TOTAL REVENUE – TOTAL COST

TOTAL REVENUE 100 000

LESS TOTAL COST 85 000

PROFIT AFTER PAYING EVERYTHING 15 000

THIS ONE IS THE ONE WE HAVE BEEN STUDYING
 INSTEAD OF SUBTRACTING TOTAL COSTS IN ONE GO,

WE WILL DO IT STEP BY STEP TO GET MORE INFORMATION

HOW MUCH IS LEFT AFTER THE BUSINESS:

- PAID THE DIRECT COSTS OF PRODUCTION?

- PAID INDIRECT COSTS THAT ARE CONTROLLED BY BUSINESS?

(EXPENSES: rent, advertising, etc)

- PAID INDIRECT COSTS NOT CONTROLLED BY BUSINESS?

(interest from loans and taxes)
HOW DO MY REVENUES COVER MY DIRECT PRODUCTION COSTS?

TOTAL REVENUE 100 000

LESS DIRECT COST 50 000

GROSS PROFIT 50 000

 HOW DO MY REVENUES COVER MY DIRECT PRODUCTION COSTS?

TOTAL REVENUE 100 000

LESS DIRECT COST 50 000

GROSS PROFIT 50 000

In Accounting we call it…

COSTS OF GOODS SOLD

OR
COST OF SALES
 TOTAL REVENUE 100 000
COSTS OF GOODS SOLD 50 000
GROSS PROFIT 50 000

COSTS OF GOODS SOLD = OPENING STOCK + PURCHASES - CLOSING STOCK

End of trading period

Opening Stock 20 000

Purchases 60 000
Closing stock 30 000

This means you are only affecting to costs the products you have sold, or you have a revenue from
HOW DO MY REVENUES COVER MY DIRECT AND INDIRECT PRODUCTION COSTS?

EXPENSES LESS INDIRECT COST 30 000

Controlled by the business:
Rent, advertising, etc
PROFIT 20 000
Before interest and taxes
Profit before interest and tax is important for historical comparisons

ALLOWS FOR MORE ACCURATE HISTORICAL COMPARISONS OF THE BUSINESS’ PERFORMACE

LESS INDIRECT COST 4000
External to the business
Interest
PROFIT 16 000
Before tax
HOW DO MY REVENUES COVER MY DIRECT AND INDIRECT PRODUCTION COSTS?

LESS INDIRECT COST 1000

External to the business
tax
PROFIT for the period 15 000
 3 sections (you do not have to know the sections)

What will the business do with the profit?

Dividends : the % of the profit of the period that is distributed to shareholders

Retained profit : the % of the profit of the period that stays in the business
(to finance growth)
LOOKING AT THIS TRADING ACCOUNT, HOW COULD IT INCREASE GROSS PROFIT?
(does not have the appropriation)
How can a business increase
Profit?
 LIMITATIONS OF THE P&L

IT IS FOR A PERIOD, THERE IS NO GUARANTEE THAT FUTURE PERFORMANCE WILL MATCH PAST PERFORMANCE

WINDOW DRESSING: MANIPULATION OF FINAL ACCOUNTS

NO STANDARDIZED FORMAT MAKES COMPARISIONS DIFFICULT (at international level)

Past Paper
Solutions
The statement of financial position (or balance sheet)

SNAPSHOT OF THE FINANCIAL POSITION

 ASSETS
Possessions of a business with monetary value

NON CURRENT CURRENT

(sometimes they will be called Fixed Assets)

• Used for business operations • Cash or other liquid assets

• Not for immediate sale • Likely to be turned into cash within 12 months
• Will last for more than 12 months on the Balance Sheet
LAND CASH (in premises or at the bank)
BUILDINGS DEBTOR (from selling to customer on
MACHINES trade credit)
VEHICLES STOCKS (inventories)
ILIQUID ASSETS – DIFFICULT TO SELL IN THE SHORT TERM

They will lose value with time = Depreciation will be on The Balance Sheet
 LIABILITIES
The debt of a business, the money owed to others

NON CURRENT CURRENT

• Due for payment after 12 months • Due for payment within 12 months
• (long term sources of finance)

Loans Overdrafts
Creditors (suppliers who sold to the business
(loan capital, mortgage, debentures) on credit)
Short term loans
 WE FOLLOW THE SAME PRINCIPLE…

USING THE ASSETS, HOW MUCH OF LIABILITIES CAN THE BUSINESS COVER?

ORGANIZE INFORMATION IN A WAY THAT HELPS UNDERSTANDING THE FINANCIAL SITUATION

Money to be received from customers who bought on credit

Inventory

Non current assets + Current assets

Use bank account beyond balance (previously agreed with bank)

Money owed to suppliers (bought from suppliers on credit)

Mortgages, debentures, loan capital, long term liabilities

 Total assets – total liabilities

Money raised when shares were sold (not their current market value)

Profit after interest and tax were paid

You may have noticed that Current Liabilities show up before Non Current Liabilities on the Balance Sheet, making it easier
to calculate WORKING CAPITAL

Calculating Net Assets shows that this firm’s assets are

higher than its liabilities

Net Assets = Total Assets – Total Liabilities

= $250 – $150 = $100

However, when calculating Working Capital …

Working Capital = Current Assets – Current Liabilities

Working Capital = $50 – $100 = - $50

This firm’s assets that are easily converted into cash in

the short term are not enough to cover the short-term
payments the firm has to make.

This means the firm has a LIQUIDITY PROBLEM

 Question from Past Paper

Non current assets

Answer
 KEY DIFFERENCES BETWEEN P&L AND BALANCE SHEET

PROFIT & LOSS ACCOUNT BALANCE SHEET

At the end of the financial period (1 year)

For a particular period
It is a statement
It is an account

It feeds into the Balance Sheet

Income, expenses, gains, and losses Assets, liabilities, and capital of shareholders
performance of the company. understand the organization financial stability, liquidity,
and solvency

However some assets are difficult to place a value/price to….

 • FIXED ASSETS
• NON –PHYSICAL
• WITH MONETARY VALUE TO THE BUSINESS
(have the ability to earn revenue )

They are legally protected by laws collectively known as intellectual property rights.

TYPES OF INTANGIBLE ASSETS:

• GOODWILL
• PATENTS
• COPYRIGHTS
• TRADEMARKS
• BRAND NAMES
Instead, the accounting standards mandate that a business cannot recognize any internally-generated
intangible assets (with some exceptions), only acquired intangible assets. This means that any intangible assets
listed on a balance sheet were most likely gained as part of the acquisition of another business, or they were
purchased outright as individual assets.
For example, if a company conducts expensive research for many years and eventually creates a valuable patent
from this research, all of the associated cost is charged to expense as incurred - no intangible asset can be
capitalized. However, if the same organization were to buy the patent from another company, it could recognize
the fair value of the patent in its balance sheet, because it bought the patent.
One effect of this accounting treatment is that many corporations that have spent inordinate amounts of cash
over the years to develop valuable brands and patents have not capitalized any of the associated costs; their
balance sheets do not reflect the real value of their intangible assets. This can be misleading when an outsider is
trying to gain an understanding of the value of a business by perusing its financial statements.
 GOODWILL

Goodwill is the value of the good name and reputation of an organization.

It includes the willingness of employees to go above and beyond the call of duty, as they are devoted to the
organization. It can also include the value of a business customer base, its loyalty, and the organization
business connections.

However, the value of goodwill is somewhat subjective (as the asset is intangible), so only truly materializes
when the business is sold.
Goodwill only shows up on a balance sheet when two companies complete a merger or acquisition.

When a company buys another firm, anything it pays above and beyond the net value of the target's
identifiable assets becomes goodwill on the balance sheet.

Say a soft drink company was sold for $120 million; it had assets worth $100 million and liabilities of $20
million.

The sum of $40 million that was paid over and above $80 million (the value of the assets minus the
liabilities) is the worth of goodwill and is recorded in the books as such.
2017
BRAND
Financial Times
 PATENT

Patents are the official rights given to a business to exploit an invention or process for commercial
purposes.
COPYRIGHT
Wales online…
 HIGHER LEVEL

Depreciation refers to the fall in the value of a fixed asset

Depreciation is not materialized until the asset is actually sold, so there is no actual cash outflow when the
value of a fixed asset declines over time.

However if we fail to account for depreciation the business’ fixed assets will be over-valued.

.
Many used assets can be sold for a second hand value, known as a residual value (or scrap value).

This is the value of the fixed asset at the end of its useful life, before it is replaced.

In some cases, the degree of wear and tear or the availability of newer technologies mean the residual value of
the asset is zero.
 most straightforward way to account for depreciation

the value of the assets falls by equal amounts each year

A business bought a new van for $30,000

Expects to use it for 5 years

by which time the vehicle has no market value

Annual depreciation is: $30,000 ÷ 5 = $6,000 per year.

 With residual value Year end Depreciatio Book value
n$ $
0 30 000
1 4000 26 000
A business bought a new van for $30,000
2 4000 22 000
Expects to use it for 5 years 3 4000 18 000
4 4000 14 000
by which time the vehicle has estimated residual value of $10000
5 4000 10 000

Annual depreciation is:

Assumes assets depreciate by a constant amount each year
(regardless of their utilization for instance)
 Applicable for calculating the fall in value of assets based on their usage rather than time

(Purchase cost – residual value)

Depreciation per unit = Total Depreciation
Expected number of units to be produced

Then, each year just multiply by the number of units produced

Business X bought a machine for $500,000 and expects it to last for 5,000
hours for a 5-year period before it needs to be replaced and sold for a scrap
value of $100,000.

Depreciation per HOUR = Purchase Cost – Residual value

Expected number of hours

Now, in Year 1 , Business X used the machine for 1000 hours - Total depreciation to write in Balance Sheet ?

In Year 2, only used the machine for 10 hours - ?

Depreciation is related to utilization of the asset

Harder to calculate (need to estimate utilization for the lifespan of the asset)