Introducing Financial Statements

ACCA Director Author

Introducing Financial Statements

Introducing Financial Statements

6.1 Examples of Financial Statements

In this chapter, I will introduce two sets of Financial Statements including the statement of financial position and the statement of profit or loss. In later studies, we can also see another two sets of Financial Statements including the statement of changes in equity and the statement of cash flows.

As I mentioned in the last chapter, Financial Statements show how the entity is operated. For instance, they show the profits the business earned and the asset and liability value of the entity. Let’s now take look at the format of these Financial Statements.

Statement of Profit or Loss for the year ended 31/12/20X8

Statement of Financial Position as at the year end 31/12/20X8

6.2 Elements in the Statement of Profit or Loss

Let’s look at what each element in the statement of profit or loss means.

• Revenue: this is the sales revenue the business earned by selling goods or providing services to customers. Transactions can be cash or credit, either of these increasing sales revenue.
• Cost of sales: this is to match the costs of those products sold to their sales revenues, so profits can be calculated. The cost of sales is calculated by using the opening inventories—the unsold inventories from last year—plus inventories bought by the business this year, and then removing any inventories remaining unsold at the current year end. The reason for removing any unsold inventories is based on the matching principle, i.e., we only calculate the profits for inventories which are sold.
• Gross profit: this is calculated by taking sales revenue and subtracting the costs of sales. This is the profit for those goods or services before considering other administrative expenses such as management salaries as well as interest and tax expense. The higher the gross profit, the more competitive those products or services in the market.
• Sundry income: this is also known as other income to the business. In the above statement of profit or loss, it includes:
• Discount income: this means if the business settles debts owed to the supplier before the specified date, the business could pay less. The amount saved is recorded as discount income.
• Commission received: this is the income received from another party by selling products on its behalf.
• Rent received: this is the income received by letting out property for others to use.
• Interest received: this is the income received for funds lent to others.
• Expenses:
• Rent expense: the is the expense paid when the business rents properties such as office space and warehouse from the landlord.
• Rate expense: this is the expense incurred when renting properties. For example, if the entity rents an office, it may also incur extra costs when using the meeting room. These are the rates charged to the entity. In most circumstances, we call these rent & rates instead of separating them out.
• Lighting and heating expense: these are the expenses paid for the lighting and heating services that the business used.
• Telephone, postage, insurance and stationary expenses: these are expenses for telephone bills, postage, property insurances and office stationery such as letterheads and brochures.
• Payroll expense: this is the staff expense. Examples include wages and salaries as well as bonuses.
• Depreciation expense: this is the accounting expense which does not involve the actual cash outflows paid by using non-current assets. This is an artificial expense to reflect non-current assets used by the business. We will see this concept again in later studies.
• Accountancy and audit fees: for some small businesses, instead of employing accountants, the accounting department is outsourced to an accountancy firm, i.e., allowing the accountancy firm to do the accounting work on behalf of the business. The business will need to pay a monthly or annual fee to the external accountancy practice. Lots of businesses nowadays outsource their payroll function to external accountancy firms due to the many administrative procedures involved in ensuring correct payroll records. Audit, on the other hand, means checking whether the Financial Statements prepared by the accountants are correct. In this case, the business engages (outsources to) an external audit firm such as one of the ‘big four’ accountancy names like PWC or KPMG, to be absolutely certain their Financial Statements are correct. A quick question here, can a business decide not to outsource their auditing to an external auditor? The answer is no. External audit work must always be conducted by an external, independent auditor instead of using staff within the business.
• Bank charges and interest: these are administrative fees and interest expenses charged by the bank.
• Irrecoverable debt expense: this is the owed amount which we expect certain credit customers are unlikely to pay us, as they have made us aware of a solvency or other problem.
• Allowance for doubtful debt adjustment: this is where we expect those credit customers may not pay us an amount owed. We will explain these concepts in later studies.
• Delivery costs: These are the transportation costs incurred by the business when products are sold. It may also include drivers’ salaries, petrol costs and vehicle road tax.
• Selling expenses: these are the expenses incurred in achieving sales. For instance, commission, salaries paid to sales staff and the costs of marketing materials such as brochures.
• Tax expenses: these are the expenses paid to the tax authority regarding the profits made.
• Profit or loss for the year: this is also called net profit or profit after tax. This figure is then taken across to the capital/equity in the statement of financial position, as cumulated profit or loss.

6.3 Elements in the Statement of Financial Position

Now let’s look at the statement of financial position.

Non-current assets: these are assets used by the business for more than one accounting year. Examples include land, plant, machinery, and motor vehicles. As you can also see on the right-hand side, there are three columns comprising the original cost of the asset when the business bought it, accumulated depreciation showing the accumulated value reduction of those assets, and finally, the carrying value, calculated by using the original historical cost (first column) and subtracting the accumulated depreciation (second column). Sometimes, the carrying value is also called the carrying amount or net book value.

• Current assets: these are generally assets that have been in the business for less than one year.
• Inventories: these are the unsold goods as at the current year end.
• Trade receivables: this includes the amount owed by customers after subtracting the allowance for doubtful debts and the irrecoverable debt expense. This is the management’s best estimate of how much cash is to be received from credit customers.
• Prepayment: this is a year-end adjustment to reflect the amount prepaid by the business regarding next year’s expense. An example of this is the insurance expense adjustment.
• Cash in hand and cash at bank: this is the cash the business currently holds or deposited in the bank account.
• Current liabilities: these are the short-term liabilities owed to others.
• Trade payables: this is the amount owed to credit suppliers.
• Accruals: this is a liability recognised by the business for services used but not paid.
• Net current assets: this is calculated by subtracting current liabilities from current assets, and this stands for the amount of ‘quick cash’ the business can use. Net current assets are also called working capital.
• Total assets less current liabilities: instead of calculating the ‘quick cash’ above, now we also add the non-current assets into the calculation, and this shows a ‘slower cash’ figure in the business because to sell those non-current assets would be slower than the sale of inventories.
• Non-current liabilities: these are liabilities owed for more than one accounting period. An example here is the 5% loan, i.e., the business borrowed money from investors for more than one accounting period. The business is required to pay 5% interest to investors each year.
• Net assets: this is calculated by taking total assets and subtracting total liabilities. This is the same as the net capital of the business, i.e., how much the business is worth from the ‘accounting book’ perspective.
• Capital: this calculated by taking the owner contribution plus net profits from the statement of profit and loss and subtracting the drawings amount. This figure should agree with the net asset figure above. This is also known as ‘proprietor’s funds’.

Now, let’s prepare the statement of profit or loss and the statement of financial position for Johnson from the previous trial balance.

The trial balance is taken from the last chapter:

The first step is to lay out the format of the statement of profit or loss and the statement of financial position:

Statement of financial position

The second step is to slot figures from the trial balance into the above Financial Statements.

The first figure is capital appearing on the credit side, i.e., increasing the capital introduced by $30,000. Hence, the following statement of financial position extract applies:

The second figure is the non-current asset van, showing as $3,000. It appears on the debit side of the trial balance, since to debit an asset, we increase it. Hence, the following statement of financial position extract is shown:

The third figure is the rental expense of $800, and this should be included in the statement of profit or loss as an expense. Hence, the extract from the statement of profit or loss is as follows:

So, you can slot the remaining figures into different Financial Statements, and the final statement of profit or loss and statement of financial position are thus:

Statement of profit or loss

Statement of financial position

Note:

*Opening inventories: we are not told that Johnson has any unsold inventories from last year. Hence, this figure is zero.

**Closing inventories: we are not told that Johnson has any unsold inventories this year. Hence, this figure is also zero.

***Inventory on the statement of financial position: since closing inventory from the statement of profit or loss is zero, the figure on the statement of financial position is also zero.

****Allowance for doubtful debts: we are not told that any customers may not pay us, so to simplify this scenario at the moment, this figure is zero.

*****Net profit for the year: this is the net profit taken from the statement of profit or loss.

6.4 Quick Summary of This Chapter

• Statement of profit or loss: this shows all income and expenses that took place in the current year. The net profit is taken into the statement of financial position.
• Statement of financial position: this shows all assets, liabilities and capital of the business as at a particular date.

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Categories: : Financial Accounting (FA)