Business (9609) | Financial statements

Comprehensive Study Notes: Financial Statements (10.1)

Hello future Business guru! Welcome to the Finance and Accounting section. This chapter, Financial Statements, is crucial because it takes all the daily activities of a business and summarizes them into two main reports. Think of these statements as the business's annual health check and report card. Understanding them allows managers, investors, and creditors to see if the business is healthy, profitable, and able to pay its debts. Let's dive in!

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1. The Statement of Profit or Loss (SOPL)

What is the Statement of Profit or Loss?

The Statement of Profit or Loss (sometimes called the Income Statement) shows how much money a business has made or lost over a specific period (usually 1 year). It tracks all the revenues earned and all the costs incurred to reach the final profit figure.

Analogy: It's like watching a movie of the company's financial journey throughout the year.

The Purpose of the SOPL

• To measure the profitability of the business.
• To allow comparison with previous years or with competitors.
• To provide information for setting future objectives and strategies (e.g., pricing, cost control).
• To help calculate how much tax the business owes to the government.

Step-by-Step Breakdown of the SOPL Contents (The Profit Flow)

The SOPL follows a clear structure, deducting expenses stage by stage to reveal different profit levels:

Step 1: Calculating Gross Profit

This shows the profit made purely from buying and selling the goods/services (before considering administration costs or interest).

• Revenue (Sales): The total value of sales made during the period.
• Less: Cost of Sales (COS): The direct cost attributable to the goods or services sold (e.g., raw materials, direct labour).
• 
  = Gross Profit

Step 2: Calculating Profit from Operations

This shows the profit generated from the normal, core business activities (before any non-operating costs like interest).

• Less: Expenses (Overheads): All other costs associated with running the business, which are not directly linked to production (e.g., rent, salaries, depreciation, utilities).
• 
  = Profit from Operations (Operating Profit)

Step 3: Calculating Profit for the Year

This is the final profit remaining after all financial costs and obligations have been met.

• Less: Interest Payable: Costs associated with borrowing money (e.g., bank loan interest).
• Less: Taxation: The compulsory payment to the government based on the pre-tax profit.
• 
  = Profit for the Year (Net Profit)

Step 4: Allocating the Profit

The final profit must be allocated. What happens to it?

• Less: Dividends: Payments made to shareholders (owners) as a return on their investment.
• 
  = Retained Earnings: The portion of profit kept within the business for future investment or to build up reserves.

2. The Statement of Financial Position (SOFP)

What is the Statement of Financial Position?

The Statement of Financial Position (formerly called the Balance Sheet) is a snapshot of a business’s assets, liabilities, and owners' equity at a single point in time (e.g., 31st December). It demonstrates the fundamental principle of accounting: that everything the business owns was financed by either the owners or external parties.

The SOFP must always 'balance' according to the Accounting Equation:

\( \text{Assets} = \text{Liabilities} + \text{Equity} \)

Key Components of the SOFP

A. Assets (What the business owns)

• Non-Current Assets (NCA): Items owned for more than one year, used repeatedly to generate income.

  Example: Land, buildings, machinery, vehicles.

• Current Assets (CA): Items owned for less than one year or intended to be turned into cash within 12 months.

  Example: Inventory (stock), Trade Receivables (money owed by customers), Cash at bank.

B. Liabilities (What the business owes)

• Non-Current Liabilities (NCL): Debts that are payable after more than one year.

  Example: Long-term bank loans, Debentures.

• Current Liabilities (CL): Debts that must be settled within one year.

  Example: Bank Overdrafts, Trade Payables (money owed to suppliers).

C. Equity (Owners' Stake)

This represents the owners’ interest in the business.

• Share Capital: Money invested by shareholders when they bought shares.
• Reserves: Funds set aside, often including the accumulation of past retained earnings.
• Retained Earnings: The accumulated profit kept in the business from previous periods (crucial link to the SOPL!).

Important Calculations within the SOFP

The SOFP structure calculates Net Assets, which must equal Total Equity (Capital Employed).

1. Net Current Assets (Working Capital)

This figure is vital for assessing a company's ability to pay its short-term debts.
\( \text{Net Current Assets} = \text{Current Assets} - \text{Current Liabilities} \)

2. Net Assets

This is the true value of the business (what would be left if all debts were paid).
\( \text{Net Assets} = \text{Non-Current Assets} + \text{Net Current Assets} - \text{Non-Current Liabilities} \)

3. Capital Employed (Total Equity)

This is the long-term capital financing the business. In a limited company, this is:
\( \text{Capital Employed} = \text{Share Capital} + \text{Reserves} + \text{Non-Current Liabilities} \)

Remember: Net Assets must always equal Capital Employed!

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3. Adjustments Affecting Financial Statements

Financial statements need to be adjusted for several accounting concepts to give a 'true and fair view'. Two key adjustments you must understand are inventory valuation and depreciation.

3.1 Inventory Valuation (10.1.3)

How do we value the goods a business holds? This is tricky because the value of inventory can fall quickly (e.g., fashion items going out of style, or food expiring).

The Difficulty

If inventory is valued too high on the SOFP, the assets look inflated, and the Cost of Sales (and thus profit) in the SOPL looks too low. Accounting standards require prudence.

The Net Realisable Value (NRV) Method

The rule is simple and conservative: Inventory should be valued at the lower of Cost or Net Realisable Value (NRV).

• Cost: What the business paid to acquire the inventory.
• Net Realisable Value (NRV): The estimated selling price minus any further costs to complete the product or sell it (e.g., packaging, transport, sales commission).

Example: A business bought phones for $500 (Cost). A new model came out, and now the business expects to sell the old model for only $400, and it costs $20 to advertise and ship (NRV = $400 - $20 = $380). Since $380 is lower than $500, the inventory must be valued at $380. The $120 reduction is recorded as an expense, reducing profit.

3.2 Depreciation (10.1.4)

Depreciation is not about cash leaving the business. It is an accounting method that systematically spreads the cost of a Non-Current Asset (NCA) over its expected useful life. Why? Because it wouldn't be fair to record the entire cost of a machine in the year it was bought, when it will be used for 10 years!

Did you know? Depreciation follows the 'Matching Principle' – matching the expense of using the asset with the revenue it helps generate.

The Straight-Line Method (Required Method)

This method assumes the asset loses the same amount of value each year.

Key terms:

• Original Cost: What the business paid for the asset.
• Residual Value (Scrap Value): The estimated value of the asset at the end of its useful life.
• Useful Life: The number of years the business expects to use the asset.

Calculation Formula (MathJax):

\[ \text{Annual Depreciation} = \frac{\text{Original Cost} - \text{Residual Value}}{\text{Useful Life (Years)}} \]

The Impact of Depreciation

• Impact on SOPL: The annual depreciation charge is treated as an operating expense, which reduces the Profit from Operations and, subsequently, the Profit for the Year.
• Impact on SOFP: The accumulated depreciation (the total depreciation charged so far) is subtracted from the Original Cost of the Non-Current Asset. This reduces the value of the asset recorded on the Statement of Financial Position, reflecting its current book value.

Note: The calculation of depreciation (using the straight-line method) and its impact on both statements is a guaranteed exam application point. Practice these calculations!

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4. The Relationship Between the Statements

The Link is Retained Earnings

The two financial statements are not separate; they tell one continuous story.

• The Statement of Profit or Loss calculates the profit generated *during* the year.
• The Profit for the Year (after dividends are subtracted, leaving Retained Earnings) is carried across and added to the Equity section of the Statement of Financial Position.

If the SOPL shows a massive profit, the SOFP will show a much larger Retained Earnings figure (assuming dividends weren't huge), meaning the business has more accumulated wealth (equity) built up over time.

Impact of Changes (Amendments)

You must be able to assess how a specific change impacts the statements. This often comes up as an "amendment" question.

• Example 1: If an administration expense was mistakenly left out...

  The expense must be added, reducing *Profit from Operations* and *Profit for the Year* in the SOPL. This reduction in Profit reduces the *Retained Earnings* in the SOFP.

• Example 2: If the expected residual value of a machine is increased...

  Depreciation will be lower (since less value needs to be spread over the years). Lower depreciation means higher profit in the SOPL, and higher Retained Earnings in the SOFP.