Business management | Final accounts

Welcome to Unit 3.4: Final Accounts – The Business Report Card!

Hello future business leaders!
Finance and accounts can sometimes feel like a scary world of numbers, but don’t worry! This chapter is incredibly important because it teaches you how businesses summarize their entire year's performance and financial health.

Think of final accounts as the official report card and financial snapshot of a business. They are used by everyone—from the CEO deciding on strategy to the bank deciding whether to grant a loan. Understanding these documents is crucial for both HL and SL students, as they form the foundation for all financial analysis (like the ratios you’ll study in Unit 3.5!).

Let's break down these essential financial statements into manageable pieces!

1. Introduction to Final Accounts

What are Final Accounts?

Final Accounts (or statutory accounts) are standardized financial statements prepared by businesses at the end of an accounting period (usually one year). They provide a clear summary of the organization’s financial performance and financial position.

There are two main statements you must know:

1. The Statement of Profit or Loss (often called the Income Statement): Shows performance over a period of time (e.g., how much profit was made from January 1st to December 31st).
2. The Statement of Financial Position (often called the Balance Sheet): Shows the financial position at a single point in time (e.g., what the business owns and owes on December 31st).

Why are Final Accounts Important? (Stakeholders)

These documents are not just required by law; they are vital decision-making tools for various stakeholders:

• Managers/Owners: To assess efficiency, calculate profitability, and make future decisions (e.g., should we cut costs? Should we invest more?).
• Shareholders/Investors: To decide if the business is worth investing in and to evaluate the returns they receive.
• Banks/Lenders: To determine if the business is financially stable enough to repay a loan (assessing risk).
• Government/Tax Authorities: To accurately calculate the amount of tax (corporation tax) owed by the business.

Quick Takeaway: Final accounts provide transparency and essential data that help stakeholders judge the health and performance of the business.

2. The Statement of Profit or Loss (Income Statement)

This statement answers the most important question for any business: Did we make money or lose money this year?

It is a dynamic account, meaning it tracks flows of money (revenue and expenses) over a whole period.

Step-by-Step Structure: Calculating Profit

The Statement of Profit or Loss follows a standard structure, moving down from sales revenue to the final net profit figure.

Step 1: Calculating Gross Profit

Gross Profit is the profit a business makes after only deducting the direct costs associated with making or buying the goods it sells.

Key Terms:

• Revenue (Sales Turnover): The total income generated from sales of goods or services before any costs are deducted.
  
• Cost of Goods Sold (COGS): The direct costs of production or the cost of purchasing the goods that were sold during the period. (This includes things like raw materials and direct labor.)

Formula:
\(Gross\ Profit = Revenue - Cost\ of\ Goods\ Sold\ (COGS)\)

Analogy: If you sell t-shirts, Gross Profit is the money you make after paying for the t-shirt blanks and the printing ink, but before paying for advertising or rent.

Step 2: Calculating Net Profit (Operating Profit)

Net Profit is the profit remaining after all costs and expenses—both direct and indirect—have been deducted from revenue. This shows the true profitability of the business's operations.

Key Terms:

• Expenses (Overheads): Indirect costs not directly tied to production. Examples include rent, salaries for office staff, utilities, insurance, and marketing costs.

Formula:
\(Net\ Profit\ (before\ Interest\ and\ Tax) = Gross\ Profit - Expenses\)

Step 3: Calculating Profit After Tax

After finding the operating profit, the business must account for interest paid on loans and corporation tax paid to the government.

The Final Sequence:

1. Net Profit (before Interest and Tax)
2. Minus Interest Payments
3. = Profit Before Tax
4. Minus Corporation Tax
5. = Profit After Tax (The money available to owners/shareholders)

Did you know? The official term for the amount shareholders receive from Profit After Tax is Dividends. Any profit not paid out as dividends is called Retained Profit, which is reinvested back into the business.

Key Takeaway: The Statement of Profit or Loss tracks money flow over time and clearly separates direct costs (COGS) from indirect costs (Expenses) to reveal true profitability.

3. The Statement of Financial Position (Balance Sheet)

While the Statement of Profit or Loss looks at the flow of money over a year, the Statement of Financial Position is a static picture—a snapshot of everything the business owns, owes, and the owner's stake on a specific day.

The entire statement is built around one fundamental rule: the Accounting Equation.

The Accounting Equation

This equation must always balance. It states that everything a business owns (Assets) must equal where the funding for those items came from (Liabilities and Equity).

\[Assets = Liabilities + Equity\]

Analogy: This is like looking at your personal finances. Everything you own (your car, your savings) must have been funded either by money you borrowed (a loan/debt - Liability) or money you put in yourself (your net worth/capital - Equity).

Breaking Down the Components

A. Assets (What the business OWNS)

Assets are resources controlled by the enterprise from which future economic benefits are expected to flow. They are split by how quickly they can be converted to cash (liquidity).

• Non-Current Assets (NCAs): Items of value held for more than 12 months, used repeatedly to generate income. They are difficult to quickly convert to cash.
  Examples: Land, buildings, machinery, vehicles, long-term investments.
• Current Assets (CAs): Items of value held for less than 12 months, usually cash or items easily converted into cash.
  Examples: Cash in the bank, Accounts Receivable (money owed to the business by customers—also called Debtors), Stock (Inventory).

B. Liabilities (What the business OWES)

Liabilities are financial obligations of the business to external parties.

• Non-Current Liabilities (NCLs): Debts that must be repaid over a long period (more than 12 months).
  Examples: Bank loans, mortgages, debentures (long-term bonds).
• Current Liabilities (CLs): Debts that must be repaid within 12 months.
  Examples: Accounts Payable (money the business owes to suppliers—also called Creditors), Overdrafts, short-term loans.

C. Equity (Capital/Owner’s Stake)

Equity represents the owners' residual claim on the assets after all liabilities are deducted. It is the internal funding source.

• Share Capital: Money invested directly by the owners or shareholders when they purchased shares.
• Retained Earnings (Reserves): The accumulated profit over the years that has been reinvested in the business, rather than paid out as dividends. (This links directly back to the Statement of Profit or Loss).

Understanding Working Capital

An important concept derived from the Statement of Financial Position is Working Capital (or Net Current Assets). This is the amount of liquid funds available to cover day-to-day running costs.

\[Working\ Capital = Current\ Assets - Current\ Liabilities\]

Why is this important? A positive working capital means the business can meet its short-term debts. If current liabilities exceed current assets, the business may face serious cash flow problems, even if it is making a profit!

Key Takeaway: The Statement of Financial Position confirms that the fundamental accounting equation always holds true: what you own must equal where that ownership was funded (by debt or equity).

4. The Role of Depreciation in Final Accounts

When preparing final accounts, particularly the Statement of Financial Position, businesses must recognize that Non-Current Assets (like machinery or vehicles) lose value over time due to wear and tear or obsolescence. This loss in value is called Depreciation.

Why Depreciate?

The accounting principle of matching (or accruals) requires that expenses be recognized in the same period as the revenue they helped generate. Since a machine helps generate revenue for 10 years, its cost should be spread out over those 10 years, not just deducted entirely in the year it was purchased.

Therefore, depreciation serves two critical purposes in the final accounts:

1. Statement of Profit or Loss: The annual depreciation charge is treated as an operating expense, reducing the Gross Profit to arrive at the Net Profit.
2. Statement of Financial Position: The asset's value is reduced on the balance sheet each year. The value shown is the Net Book Value (NBV).
   

   \[Net\ Book\ Value = Original\ Cost - Accumulated\ Depreciation\]

Simplified Depreciation Methods (IB Scope)

While there are complex methods, the two most common (and easiest to understand) are:

1. Straight-Line Method: The value is deducted evenly over the useful life of the asset.
   

   \[Annual\ Depreciation = (Original\ Cost - Residual\ Value) / Useful\ Life\ (Years)\]

2. Reducing Balance Method: A fixed percentage is deducted each year from the asset's *Net Book Value*. This means depreciation is high in the early years and lower later on.

Don't worry if the calculation seems tricky! For most IB applications, you need to understand what depreciation is (loss of value) and where it goes (an expense on P&L, a deduction on SFP).