BAFS Study Notes: Financial Statements

Hey everyone! Welcome to your guide on Financial Statements. Don't worry if this topic seems a bit intimidating. Think of financial statements as the report card for a business. They tell us how well a business is doing (making a profit?), what it owns, and what it owes. Understanding them is a super important skill, not just for your exams, but for understanding the business world around you. Let's break it down together, step-by-step!


Part 1: The Big Picture - What Are Financial Statements?

At their core, financial statements are formal records of a business's financial activities. They provide a structured overview of its performance and financial position. For your syllabus, we'll focus on the two main report cards:

1. The Income Statement: This is like a movie of the business's performance over a period of time (e.g., one year). It answers the question: "Did we make a profit or a loss?"

2. The Statement of Financial Position: This is like a snapshot photo of the business on a specific day (e.g., as at 31 December 2024). It answers the question: "What do we own, what do we owe, and what is the business worth?"

Quick Review: The Foundation

Remember the most important rule in accounting? The Accounting Equation! Everything we do is built on this.

Assets = Liabilities + Equity

Think of it this way: The things the business OWNS (Assets) are financed by either borrowing from others (Liabilities) or from the owner's own investment (Equity).


Part 2: Who Reads These Report Cards? (Users of Financial Statements)

Different people are interested in a business's financial statements for different reasons. Let's meet them:

Internal Users (People inside the business)

  • Management: They need the information to make smart decisions, plan for the future, and control business operations. (e.g., "Should we open a new branch? Can we afford to hire more staff?")

External Users (People outside the business)

  • Investors (Owners): They want to know if they are getting a good return on their investment and if the business is profitable and growing.
  • Lenders (e.g., Banks): They want to assess if the business can repay its loans. They look at the company's ability to pay its debts (solvency).
  • Suppliers (Trade Payables): They want to know if the business can pay for the goods or services supplied on credit.
  • Government (e.g., Inland Revenue Department): They need the information to calculate how much tax the business should pay.
  • Customers: They might want to know if the business is stable, especially if they rely on it for long-term service or warranties.
  • Employees: They are interested in the business's stability and profitability to see if their jobs and salaries are secure.
Key Takeaway

Financial statements are the main way a business communicates its financial health to everyone who has a stake in it, from the boss in the office to the bank down the street.


Part 3: Preparing the Financial Statements

This is where we get practical! The format changes slightly depending on the type of business, but the core ideas are the same. We'll start with the simplest and build up.

A. For a Sole Proprietorship (One-Owner Business)

This is the most straightforward. Think of a local corner shop or a freelance designer.

1. The Income Statement

Its goal is to find the net profit or net loss for the year.

Here's the structure:

Sales
Less: Cost of Goods Sold
= Gross Profit
Add: Other Revenues (e.g., rent income)
Less: Expenses (e.g., rent, salaries, electricity, depreciation)
= Net Profit (or Net Loss)

2. The Statement of Financial Position

This shows the assets, liabilities, and equity on the last day of the accounting period.

Here's the structure:

Non-current Assets (e.g., Property, Equipment)
Current Assets (e.g., Inventory, Trade Receivables, Cash at Bank)
Total Assets

Equity
Capital at start of year
Add: Net Profit (from Income Statement)
Less: Drawings
= Capital at end of year

Non-current Liabilities (e.g., Bank Loan > 1 year)
Current Liabilities (e.g., Trade Payables, Bank Overdraft)
Total Equity and Liabilities (This MUST equal Total Assets!)

Common Mistake Alert!

Don't forget that Net Profit from the Income Statement is needed to calculate the final equity in the Statement of Financial Position. The two statements are linked!

B. For a Partnership (2 or more owners)

Things get a bit more interesting here because profits have to be shared! This requires a few extra steps and accounts.

1. The Profit and Loss Appropriation Account

After finding the net profit in the Income Statement, we need to show how it's distributed among the partners. This is done in the Appropriation Account. It's not a new statement, but an extension of the Income Statement.

Here's the structure:

Net Profit for the year (from Income Statement)
Add: Interest on drawings (charged to partners)
Less: Interest on capital (paid to partners)
Less: Partners' salaries
= Residual Profit (to be shared)

This residual profit is then shared between partners according to their agreed profit-sharing ratio (e.g., 50:50, or 2:1).

2. Partners' Current Accounts

To avoid cluttering the main Capital Account, each partner has a Current Account. This account tracks their day-to-day transactions with the partnership.

  • Things that increase a partner's entitlement (credits): Interest on Capital, Partner's Salary, Share of Profit.
  • Things that decrease a partner's entitlement (debits): Drawings, Interest on Drawings, Share of Loss.
3. The Statement of Financial Position (Partnership Edition)

It's very similar to a sole proprietorship's, but the Equity section looks different.

Equity Section:
Capital Accounts:
Partner A
Partner B

Current Accounts:
Partner A
Partner B
Total Equity

Did you know?

A partnership agreement is a crucial document that sets out the rules for profit sharing, interest on capital/drawings, and salaries. If there's no agreement, the law says profits and losses must be shared equally, with no interest or salaries!

4. Changes in a Partnership

When a partnership changes (e.g., a new partner joins, a partner leaves, or they change the profit-sharing ratio), the value of the partnership's net assets needs to be adjusted. This often involves dealing with Goodwill.

What is Goodwill?
Goodwill is an intangible asset representing the good reputation and established customer base of a business. It's the value of the business over and above its physical assets. Factors affecting it include brand name, location, and customer loyalty.

For your exam, you need to understand what goodwill is and what affects its value, but you are not required to do the valuation calculations. You just need to know how to prepare the necessary adjustments to partners' capital accounts when these changes happen.

C. For a Limited Company

Limited companies are separate legal entities from their owners (shareholders). This leads to some key differences in their financial statements, especially in the bottom half of the Statement of Financial Position.

1. Key Terms for Companies
  • Share Capital: Money raised by selling shares.
    • Ordinary Shares: The most common type. They carry voting rights and receive dividends that vary with profit.
    • Preference Shares: Receive a fixed dividend before ordinary shareholders, but usually have no voting rights.
  • Debentures: A form of long-term loan to the company, making the holder a lender, not an owner. They receive fixed interest payments.
  • Reserves: Profits that have been kept in the company rather than paid out as dividends. (e.g., general reserve, retained profits).
2. Journal Entries for Issuing Shares & Debentures

When a company issues shares (at no par value) or debentures (at par value) that are fully paid on application:

Example: A company issues 100,000 ordinary shares. The public applies for 120,000 shares (this is called oversubscription).

Step 1: Record receipt of application money for ALL shares applied for.

Dr. Bank (120,000 shares x issue price)
Cr. Application - Ordinary Shares (120,000 shares x issue price)

Step 2: Allot the shares and transfer the money for the successful applications to share capital.

Dr. Application - Ordinary Shares (100,000 shares x issue price)
Cr. Ordinary Share Capital (100,000 shares x issue price)

Step 3: Refund the money to unsuccessful applicants.

Dr. Application - Ordinary Shares (20,000 shares x issue price)
Cr. Bank (20,000 shares x issue price)

3. Statement of Profit or Loss and Other Comprehensive Income (and Appropriation)

The top part (calculating profit) is similar to other businesses. A key difference is that companies pay Corporation Tax on their profits.

...
Profit before tax
Less: Income tax expense
= Profit for the year

After finding the profit for the year, we show how it's appropriated (used). For a company, this focuses on dividends and reserves.

Retained profits at start of year
Add: Profit for the year
= Total available for distribution
Less: Transfer to general reserve
Less: Dividends paid and proposed
= Retained profits at end of year

4. The Statement of Financial Position (Company Edition)

The top 'Assets' half is very similar. The bottom 'Equity and Liabilities' half is structured differently to show the company's financing.

... (Assets section) ...

EQUITY AND LIABILITIES
Equity
Share Capital
Reserves (e.g., General Reserve, Retained Profits)

Non-current Liabilities
Debentures
Bank Loan

Current Liabilities
Trade Payables
Accruals

Total Equity and Liabilities

Quick Review Box: Appropriation Differences
  • Partnership Appropriation: Focuses on sharing profit among partners through interest on capital/drawings and salaries.
  • Company Appropriation: Focuses on distributing profits to shareholders (dividends) or keeping them in the business (transfer to reserves).

Part 4: The Fine Print - Uses and Limitations

Financial statements are incredibly useful, but they don't tell the whole story. It's important to know their strengths and weaknesses.

Uses of Financial Statements

  • Decision Making: Helps management and investors make informed choices.
  • Performance Evaluation: Shows if the business is profitable and efficient. You can compare results with previous years or with competitors.
  • Assessing Financial Health: Shows the company's ability to pay its short-term and long-term debts.
  • Accountability: Managers are accountable to the owners for their performance, and financial statements are the primary way to report this.

Limitations of Financial Statements

  • Based on Historical Data: They report on the past, which is not always a guarantee of future performance.
  • Non-Monetary Items are Excluded: They cannot show important factors like staff morale, brand reputation (unless purchased as goodwill), or customer satisfaction.
  • Affected by Accounting Policies: Different companies might use different depreciation methods, making direct comparisons difficult.
  • Based on Estimates: Items like allowance for doubtful debts or the useful life of an asset are estimates, not exact figures.
  • Window Dressing: Management might manipulate the figures to make the company look better than it really is.
Key Takeaway

Financial statements are a powerful tool for analysis, but a smart user will always read them with a critical eye, understanding what they can and cannot reveal about a business.


Great job getting through this! It's a big topic, but by understanding the purpose of each statement and how they differ for each business type, you're building a strong foundation. Keep practicing the formats, and you'll master it in no time!