BAFS Study Notes: Financial Reporting for Different Business Ownerships
Hey everyone! Welcome to your study notes for a super important chapter in BAFS. We're going to dive into Financial Statements. Think of these as the "report card" for a business. They tell us how well a business is doing (making money?) and what its financial health looks like.
Why is this so important? Because whether it's a small tuck shop run by one person or a huge company like HSBC, everyone needs to understand the numbers to make smart decisions. Don't worry if this sounds complicated at first! We'll break it down step-by-step with simple examples. Let's get started!
Section 1: The 'Why' - Purpose and Users of Financial Statements
Before we learn how to *make* these reports, let's understand *why* we make them and *who* reads them.
Who Uses Financial Statements? (And What Do They Want to Know?)
Different people (we call them stakeholders) look at financial statements for different reasons. Imagine a business is a car...
- Owners/Shareholders: (The car's owner) They want to know if their investment is profitable. "Is my car winning races and increasing in value?" They check the profit and the overall value of the business.
- Managers: (The car's driver) They use the statements to make decisions. "Is the engine efficient? Do we need better fuel?" They look at performance to plan for the future, control costs, and improve results.
- Lenders (e.g., Banks): (The person who loaned money to buy the car) They want to know if the business can pay back its loans. "Is the owner responsible? Can they afford the monthly payments?" They check if the business has enough assets and cash to cover its debts.
- Potential Investors: (People thinking about buying the car) They want to decide if the business is a good investment. "Is this car likely to win future races? Should I invest my money in it?" They compare its profitability and financial health with other businesses.
- Government (e.g., Inland Revenue Department): (The transport department) They need to know how much profit the business made to calculate the correct amount of tax. "Has the owner declared the correct winnings to pay taxes?"
What Financial Statements Can Tell Us (Their Uses)
Financial statements are incredibly useful! They help us:
- Assess performance: The Income Statement shows if a business made a profit or a loss over a period (e.g., a year).
- Check financial position: The Statement of Financial Position gives a snapshot of what a business owns (assets) and what it owes (liabilities) on a specific day.
- Make informed decisions: Based on the numbers, stakeholders can decide whether to invest, lend money, expand the business, or make changes.
What Financial Statements *Can't* Tell Us (Their Limitations)
While useful, financial statements aren't perfect. They have some important limitations:
- They are historical: They report on what has *already happened*, not what will happen in the future. Past success doesn't guarantee future success!
- They ignore non-financial information: A company might have a great reputation, happy staff, and loyal customers, but these things don't appear as numbers in the main statements.
- They can be manipulated: Different accounting policies and estimates (e.g., how long an asset will last) can be used, which can change the final profit figure.
- They are based on estimates: Some figures, like the 'allowance for doubtful debts', are just educated guesses.
Key Takeaway for Section 1
Financial statements are essential reports that show a business's performance and position. Many different people use them to make important economic decisions. However, always remember they only tell part of the story and have limitations.
Section 2: The 'How' - Preparing the Main Financial Statements
Okay, time to get practical! We're going to learn how to prepare the two main financial statements for different types of businesses: Sole Proprietorships, Partnerships, and Limited Companies.
The Income Statement: Calculating Profit or Loss
The Income Statement's job is simple: to find out the net profit or net loss for a period of time (e.g., for the year ended 31 December 2024).
The Basic Recipe for Profit:
1. Find the Gross Profit: This is the profit from basic buying and selling.
$$Sales - Cost \ of \ Goods \ Sold = Gross \ Profit$$2. Find the Net Profit: This is the final, overall profit after all other incomes are added and all expenses are subtracted.
$$Gross \ Profit + Other \ Incomes - Expenses = Net \ Profit$$How it looks for different businesses:
- Sole Proprietorship & Partnership: The structure is almost identical. You calculate the net profit for the business. (For a partnership, this profit is then shared out in a separate statement called the Appropriation Account, which we'll see later!)
- Limited Company: The structure is very similar, but with one key difference: companies pay corporation tax. The Income Statement will show the profit *before* tax, then the tax amount, and finally the profit for the year (after tax).
Quick Review: Income Statement
Purpose: To show financial performance over a period.
Key Items: Sales, Cost of Goods Sold, Gross Profit, Expenses, Net Profit.
End Goal: Find the final Net Profit or Net Loss.
The Statement of Financial Position (SFP): A Financial Snapshot
The SFP shows the financial health of a business on a single day. It's based on the fundamental accounting equation.
$$Assets = Liabilities + Equity$$Analogy: Imagine your own finances. Your Assets are what you own (phone, laptop). Your Liabilities are what you owe (money you borrowed from a friend). Your Equity is what's left for you.
Structure of the SFP:
It's always presented in a standard way:
Non-current Assets (things the business keeps for over a year, e.g., buildings, machinery)
+
Current Assets (things that will be used or converted to cash within a year, e.g., inventory, cash in bank)
= Total Assets
Equity (the owner's stake in the business)
+
Non-current Liabilities (debts paid back over more than a year, e.g., bank loan)
+
Current Liabilities (debts due within a year, e.g., trade payables)
= Total Equity and Liabilities
Remember: Total Assets MUST EQUAL Total Equity and Liabilities. If they don't, you've made a mistake!
The Big Difference: The 'Equity' Section
The main difference in the SFP between business types is how the Equity section is presented.
- For a Sole Proprietorship:
Capital at start of year
+ Net Profit for the year
- Drawings (money the owner took out)
= Capital at end of year - For a Partnership:
This section is more detailed, showing separate accounts for each partner.
Capital Accounts: Partner A, Partner B
Current Accounts: Partner A, Partner B
(We will cover these in the next section!) - For a Limited Company:
Equity is called 'Shareholders' Funds'.
Share Capital (money from selling shares)
Retained Profits (profits kept in the business)
Key Takeaway for Section 2
The Income Statement measures profit over time, while the SFP is a snapshot of assets, liabilities, and equity on one day. The basic structure is similar across business types, but the Equity section of the SFP is presented differently for each.
Section 3: Focus on Partnerships
Partnerships have some unique accounting rules because everything – profits, assets, responsibilities – is shared between partners. Let's look at the special adjustments needed.
Sharing the Profits: The Appropriation Account
After finding the Net Profit in the Income Statement, we use an Appropriation Account to show how this profit is divided among the partners according to their agreement.
Step-by-Step Guide to the Appropriation Account:
- Start with the Net Profit from the Income Statement.
- Add: Interest on Drawings. (This is a penalty partners pay to the firm for taking money out, so it increases the profit available to share).
- Less: Interest on Capital. (This is a reward the firm pays to partners for their investment).
- Less: Partner Salaries. (If any partners are paid a salary for their work).
- The result is the Residual Profit. This is what's left to be shared.
- Divide the Residual Profit among partners according to their Profit-Sharing Ratio (PSR).
Example: If the PSR is 2:1 for partners A and B, and the residual profit is $30,000, A gets $20,000 and B gets $10,000.
Keeping it Separate: Capital vs. Current Accounts
Partnerships use two types of accounts to track each partner's equity:
- Capital Account: This is for the long-term investment by the partner. It usually stays fixed unless the partner invests more or withdraws capital permanently.
- Current Account: This is for day-to-day transactions. It's a fluctuating account that includes their share of profits, salaries, and interest, minus their drawings. A debit balance means the partner owes money to the firm!
When Partners Change (Admission, Retirement, PSR changes)
When a new partner joins, a partner leaves, or they just change the profit-sharing ratio, the partnership's assets need to be re-valued to be fair to everyone. This involves accounting for something called Goodwill.
What is Goodwill?
Goodwill is an intangible asset representing the value of a business's good reputation, brand name, and customer loyalty. It's the reason a business can earn more profit than a brand-new one. Factors affecting goodwill include:
- Good location
- Strong customer relationships
- Excellent reputation
- Skilled employees
Important: The DSE syllabus says valuation (calculation) of goodwill is NOT required. You just need to know what it is and that it must be accounted for when a partner change occurs, usually by crediting the old partners' capital accounts in the old PSR.
Steps for a Change in Partnership:
- Adjust assets and liabilities to their fair market value. Any profit or loss on this 'revaluation' is shared among the *old partners* in the *old PSR*.
- Account for Goodwill, sharing its value among the *old partners* in the *old PSR*.
- After these adjustments, the capital accounts reflect the true value of the old partners' stake before the change happens.
Note: The accounting entries for the dissolution (complete closure) of a partnership are not required for the DSE.
Key Takeaway for Section 3
Partnership accounting focuses on fairly distributing profits and ownership. The Appropriation Account splits the net profit. Current Accounts track daily partner transactions. When the partnership structure changes, Goodwill and Revaluation are used to ensure fairness to the existing partners.
Section 4: Focus on Limited Companies
Limited companies are legally separate from their owners (the shareholders). Their financing and profit distribution are more formal.
How Companies Raise Money: Capital Structure
- Share Capital: This is money raised by issuing shares to owners (shareholders).
- Ordinary Shares: The most common type. They carry voting rights and receive dividends that vary depending on the company's profit. They are the main risk-takers.
- Preference Shares: Receive a fixed rate of dividend, and they get paid *before* ordinary shareholders. However, they usually have no voting rights.
- Loan Capital (Debentures): This is long-term borrowing from the public or institutions. Debenture holders are lenders, not owners. They receive fixed interest payments, which must be paid even if the company makes a loss.
- Reserves: These are profits that are kept (retained) in the business for future growth or to cover unexpected losses. The most common is Retained Profits.
- Provisions: An amount set aside to cover a liability that is certain to exist, but the exact amount or timing is unknown. For example, a provision for warranties on products sold. This is an expense, whereas a reserve is an allocation of profit.
Issuing Shares and Debentures (Journal Entries)
The DSE syllabus keeps this simple! We only need to know about shares issued at no par value and debentures at par, fully paid on application.
Did you know?
"No par value" is a modern approach where shares don't have a face value printed on them. This simplifies the accounting because we don't need to worry about concepts like 'share premium'.
Step-by-Step Journal Entries for Issuing Shares:
Step 1: Receive application money from investors.
Dr Bank (Asset increases)
Cr Application - Ordinary Shares (Liability created to applicants)
Step 2: Allot the shares to the applicants.
Dr Application - Ordinary Shares (Liability to applicants is cancelled)
Cr Ordinary Share Capital (Equity is created)
What if there's an Oversubscription?
This happens when more applications are received than shares available. The company must refund the money to the unsuccessful applicants.
Journal Entry for the Refund:
Dr Application - Ordinary Shares (Cancels the remaining liability to applicants)
Cr Bank (Asset decreases as money is returned)
The process for issuing debentures is exactly the same, just replace "Ordinary Share Capital" with "Debentures"!
Distributing Company Profits: Appropriation Account (Limited Co. Version)
Just like for partnerships, this account shows what a company does with its profits. But the items are different.
Structure of the Appropriation Account for a Company:
Start with: Profit for the year (after tax)
Add: Retained profits from the previous year (b/f)
This gives you the total profit available for distribution.
Less:
- Transfer to General Reserve (Putting some profit aside for a rainy day)
- Dividends Paid/Proposed (Payments to shareholders)
The final figure is the Retained profits for this year (c/f), which is carried forward to the next year's SFP.
Key Takeaway for Section 4
Limited companies have a formal capital structure of shares and debentures. Journal entries for issuing them are straightforward. The company's Appropriation Account shows how profits are allocated to reserves and paid out as dividends, with the remainder becoming retained profits.
Chapter Summary
Well done for making it through! You've learned the purpose, uses, and limitations of financial statements. Most importantly, you can now see how the Income Statement and Statement of Financial Position are prepared for sole proprietorships, partnerships, and limited companies, and you understand the unique accounting adjustments for each one.
Keep practicing the formats and remember the key differences, especially in the Equity sections. You've got this!