3.4 Final accounts
Full video class on YouTube, summary and notes on Instagram, class extracts on TikTok, text below. Have fun!
The main point of this class is to learn to prepare profit & loss account and balance sheet.
Purpose
Explain the purpose of accounts to different stakeholders (AO2)
Final accounts are financial statements that are prepared regularly by the end of a certain period, usually fiscal (financial) year. Final accounts that you will learn in this class are balance sheet and profit and loss account. Very often final accounts are compared with those from previous year(s) or with those of competitors in order to assess relative performance of the organisation.
Usually final accounts serve a reporting function, but what is interesting here is that different stakeholder groups will pay attention to different elements of final accounts depending on their interests. Please quickly review 1.4 Stakeholders before proceeding to the next paragraph, where I briefly outline what kind of things different stakeholder groups are usually looking for in final accounts.
Shareholders (owners): they are particularly interested in market capitalisation (how much the company is worth) and dividends, so their particular attention is directed to how much dividends the company is paying and how much revenues and profits it makes. Keep in mind that shareholders are owners of limited liability businesses (companies), but final accounts are prepared by all kinds of business entities, including organisations that do not have shareholders. So, for unlimited liability companies that do not have any shares this stakeholder group is simply called “owners”. If you don't understand the previous sentence, you definitely have to review 1.2 Types of business entities.
Managers: they care mostly about their jobs and bonuses, thus the most important parts of final accounts for managers are expenses and costs and other elements that indicate managers’ performance. If costs are too high, it might mean that managers are not doing a good job of controlling expenses, which might negatively impact their employment.
Employees might also make judgements about how secure their jobs are by looking through final accounts. If an organisation is regularly demonstrating increase in profits, then it might indicate safe future to its employees. Also, looking through final accounts might help employees to see if it’s a good time to ask for a raise or not.
Government is mostly interested in taxes being paid fully and on time, and in the absence of fraudulent illegal practices. They verify it by audit (independent inspection) of the final accounts.
Competitors use each other’s final accounts (if they are available) in order to compare their own performance with other businesses in the industry and to understand their relative market standing.
Suppliers usually check their debtors’ final accounts to see if it’s a good idea to offer trade credit and what the appropriate length of trade credit period should be.
Customers are mainly interested in how organisations they buy from distribute their profits: do they donate money to NPOs and/or do they make any charitable contributions? If organisations only retain profits in order to make owners wealthier, then customers might be reluctant to purchase from these organisations.
Pressure groups (and other NGOs), unlike the government, are not just checking if organisations obey the law and pay tax on time. They go beyond law and see how ethical or unethical organisations are. If they found out that organisations spend money on supporting something that harms the environment or has other kinds of negative impact on social well-being, they might make this information public and use media to put pressure on organisations in order to change their behaviour.
As you can see, there are many things that different stakeholder groups can see from final accounts, even though final accounts look the same for all stakeholders. Regardless of stakeholders’ interests, final accounts have to be accurate and truthful. Even though final accounts are quantitative and mainly include numbers, there are still some ways to manipulate these numbers in favour of certain stakeholders. Very often companies increase their revenues and profits through the sale of assets (which is not the main trading activity of any company) or register their costs at wrong dates to make final accounts more pleasing for shareholders. Different governments have different requirements and standards of accounting practices, so please check the ones for your country. In addition, you might want to explore standards and values of independent organisations, such as ACCA and read about the world-famous scandals: Enron, Parmalat, Worldcom.
Final accounts
Comment on and prepare profit & loss account and balance sheet (AO2, AO4)
This is the most important part of this class where we learn to prepare balance sheet and profit and loss account for profit-making and non-profit entities.
Profit and loss account account (income statement) — financial statement of an organisation’s trading activities over one year. Actually, it doesn’t have to be for one year, but most of the time it’s prepared annually. Basically, this account shows how well organisation trades (sells it products and manages its costs). In accounting sense, the purpose of profit and loss account is to show profit or surplus (for for-profit and non-profit entities accordingly) or loss (in case the “profit” is negative).
There are 3 parts in the profit and loss account:
IB tip: when you prepare profit and loss account, mind the difference between accounts for for-profit and non profit entities and please label profit and loss account as a “statement of profit or loss”, as in the picture below:
Now let’s explore profit and loss account part-by-part. Keep in mind that when you read through the text below, it might seem confusing and unclear, but once you see the example, you should have the “aha” moment and things should be clearer. Please be patient and read thoughtfully.
Part 1. Trading account is the part of profit and loss account that shows gross profit (the difference between sales revenue and cost of producing/purchasing products sold). The formula for gross profit is:
Gross profit = Sales revenue – Cost of sales
Cost of sales is the value of goods/services sold in a period of time. For goods it’s usually called cost of goods sold (COGS). For services or in general you might say “cost of sales”. The formula is:
Cost of sales/COGS = Opening stock + Purchases – Closing stock
Opening stock is the cost of stock (raw materials, goods) at the start of the trading period. Purchases is the cost of supply/delivery of stocks. Closing stock is the cost of stock at the end of the trading period. Stocks here have nothing to do with shares! Stocks refer to goods or raw materials, i.e. to things that you will sell to customers later on.
Example. Imagine the trading period is one day. In the morning, Ivan’s fruit stall has $100 worth of fruit. At lunch time, he receives a supply of fruit worth $150. At night, Ivan closes with $80 worth of stocks. Calculate COGS for Ivan.
COGS = Opening stock + Purchases – Closing stock
COGS = $100 + $150 – $80 = $170
Now calculate gross profit for Ivan, assuming that on that day Ivan managed to sell fruit for the price that is 4 times of the stock value.
Gross profit = Revenue – COGS
Gross profit = $170 ⨉ 4 – $170 = $510
Part 2. Profit statement (or Loss statement, if things aren’t going well, haha) is the part of profit and loss account that shows net profit (the difference between gross profit and all expenses). The formula is:
Net profit = Gross profit – Expenses
Expenses are indirect and/or fixed costs of production (rent, salaries, etc.). Keep in mind that interest and tax are separate from expenses because the organisation has no control over them. So they are shown separately after expenses in the profit statement.
Example. In 2022, Ivan sold $60.000 of fruit stock with a market value of $230.000. He paid $40.000 rent that year and $30.000 for electricity and water bills. He also paid $25.000 for other overheads (such as internet fee and cleaning). Calculate net profit for Ivan.
Net profit = Gross profit – Expenses
Gross profit = $230.000 – $60.000 =$170.000
Expenses = $40.000 + $30.000 + $25.000 = $95.000
Net profit = $170.000 - $95.000 = $75.000
In addition, Ivan paid $12.000 interest to the bank and corporate tax is 13%. Calculate net profit after interest and text.
Part 3. Appropriation account is the last part of profit and loss account that shows dividends (portion of net profit after interest and tax that is distributed among shareholders) and retained profits (the difference between net profit and dividends).
Example. Assume that Ivan turned his fruit stall business into a privately held company and promised shareholders to pay 1/4 of the net profit yearly as dividend. Now prepare a full statement of profit or loss for Ivan Fruits for the year 2022.
Hopefully, now you have a good understanding of what profit and loss account is and how to prepare it, as well as of what its 3 parts are and what their purpose is. Now, before we move on to balance sheet, let’s spend a moment reflecting on profit and loss account as an accounting tool.
On the one hand, profit and loss account breaks down trading activity into the most important elements, making it easy to understand how the firm trades. In addition, comparisons of gross profit and net profit are really valuable and show how well an organisation is managing its expenses. So, overall, profit and loss account is a good indicator of the organisation’s trading activities.
On the other hand, profit an loss account is backwards-looking (i.e. it is based on the past data), which makes it hard to predict and forecast for the future. In addition, this account sometimes leaves some room for “window-dressing”, when organisations legally manipulate the numbers by recording profits that come from non-trading activities or manipulating dates. So, overall, profit and loss account isn’t a perfect accounting tools and it leaves opportunities for manipulating some figures and unethical or illegal practices.
Remember: ethics is a foundation of accounting.
Balance sheet is the financial statement of an organisation’s assets, liabilities and capital at a particular point in time. You can think of it as of a “snapshot” or photo of a financial situation of an organisation in a point in time: everything might change the moment after it’s taken but it’s still a good indicator. In addition, balance sheets are a legal requirement for all companies so preparing a balance sheet or not isn’t a choice but an obligation for companies (keep in mind that company is not the only type of business).
Why does balance sheet have to balance and what’s all the balance thing about? In organisations, sources of finance (equity) should balance with how they’re spent (net assets), or vice versa: net assets (assets minus liabilities) should balance with equity. Simply speaking, balance sheet should show that all the money spent is accounted for and how much the organisation is worth. It should all make more sense as you continue reading.
Similar to profit and loss account, balance sheets have 3 parts:
IB tip: when you prepare a balance sheet, mind the difference between accounts for for-profit and non profit entities and please label balance sheet as a “statement of financial position”, as in the picture below:
Part 1. Assets are items of property owned by the organisation. They can be current and non-current (or fixed). Current assets are short-term liquid assets that last for up to one year (cash, debtors, stock, etc). Non-current (fixed) assets are long-term assets that last for more than one year (machinery, buildings, cars, etc). So the main point here is that whatever an organisation owns for more than a year is recorded as a non-current assets, and whatever an organisation owns for less than a year is a current asset.
Total assets = Current assets + Non-current assets
Part 2. Liabilities are money owed by the organisation to its suppliers and lenders. The situation with liabilities is similar to that of the assets: they can also be current and non-current (long-term). Current liabilities are short-term debts that are paid for within one year (overdrafts, creditors, etc). Non-current (long-term) liabilities are long-term debts that payable after one year (mortgages, long-term loans, etc).
Total liabilities = Current liabilities + Non-current liabilities
Part 3. Equity is the value of all assets if they were liquidated. Liquidation is the process of converting all assets into cash. The most liquid asset is cash, which is like water in the business world. The easier it is to convert an asset into cash (i.e to sell it for cash), the more liquid an asset is. The harder it is, the less liquid an asset is. For profit-making entities equity is comprised of share capital and retained earnings. For non-profit entities equity consists of retained earnings only, because there are no shareholders in non-profit entities.
Now you know everything about balance sheets and the two formulae below should make perfect sense to you:
Net assets = Total assets – Total liabilities
Just think about it: net assets are everything that an organisation owns minus all the debts it has. At the same time, net assets (what company owns after all debts) are the same as equity (how much an organisation is worth). Isn't it beautiful and easy to understand now?
On the one hand, balance sheet, as an accounting tool, is a relatively quick way to assess financial standing at any point in time. In addition, it helps to make sure all assets and liabilities are accounted for. Overall, it’s a good way to check that equity and net assets balance and how much the organisation is worth.
On the other hand, balance sheet is static (like a “snapshot”), which is not representative of the reality, that might change a second after the balance sheet is prepared. In addition, all balance sheets are somewhat inaccurate because it is hard to know the real market value of assets. In a way, balance sheet is a rough estimation... Overall, balance sheets are not entirely accurate and leave some room for manipulation and window dressing, for example by recording a higher value of assets in order to impress shareholders.
Remember: ethics is a foundation of accounting.
Depreciation (HL only)
Explain, calculate and discuss the appropriateness of depreciation methods (AO2, AO3, AO4)
Over time, non-current assets can increase or decrease in value, which refers to appreciation and depreciation accordingly. Asset that usually appreciates is property. Think of an an office building in downtown: as time goes by, downtown property prices usually only increase. However, assets such as machinery and equipment tend to break down, wear and tear as they get older, In addition, once new models come up, the value of the older models drops instantly. Think of an iPhone: the moment the new generation is released, the previous generation loses its value instantly.
Depreciation should be accounted for in order to produce accurate accounts. It is usually recorded as an expense in profit & loss account and as a non-current asset in a balance sheet. Keep in mind, that even though depreciation is an asset, it's negative, so it has to be subtracted from other non-current assets, even though it is a non-current asset as well. Think of it as of a black hole: technically, it is a star, but a negative star. In the same way, depreciation is a non-current asset, but a negative one.
Before we learn how to calculate depreciation using these two methods, we have to understand the meaning of 5 key terms that are essential to understanding depreciation:
- Purchase cost is the cost of the asset at the time when it was bought.
- Lifespan is how long the asset can be used.
- Residual/scrap value is how much an asset is worth at the end of its lifespan.
- Book value the value of an asset in the balance sheet.
- Market value is the estimated price of an asset if it was to be sold.
There are several methods how to calculate depreciation. We’ll learn these two methods:
Calculating annual depreciation using straight line method is really straightforward and easy. If residual value is 0, then:
Annual depreciation = Purchase cost Ă· Lifespan
If residual value is more than 0, then:
Annual depreciation = (Purchase cost – Residual value) ÷ Lifespan
Let’s say, Andy bought a brand new laptop for $2500. He thinks he’ll use it for 5 years and then he’ll throw it away, because he is too rich to bother selling his second-hand laptop. If we calculated differentiation using straight line method, it would be $500 a year. See details in the picture below:
Now let’s assume Andy got more mature and knows the value of money, and he decided he’ll sell his laptop for $500 at the end of its lifespan. Then annual depreciation would be $400. See working out in the picture below:
On the one hand, this method is simple, easy, suitable for cheaper assets, and appropriate when time matters, as opposed to the intensity of usage. On the other hand, this method is inapplicable to expensive complex assets (factory, equipment) because their nature is complex (consists of many parts). Additionally, straight line method doesn’t take account of qualitative factors.
Straight line method takes account of time, but units of production method takes account of usage: the more the asset is used, the higher the depreciation. Please be mindful that there are several ways to calculate annual depreciation using this method! I am suggesting the one that personally I find the most straightforward and clear.
Annual depreciation = units of production rate (UPR) ⨉ actual quantity (Q) produced
UPR = (purchase cost – residual value) ÷ total quantity (Q) produced over lifespan
Now, let’s say Andy bought a printer for $1000 so that he can print amazing pictures that he edits on his brand new laptop. The manufacturer guarantees that the printer can produce 10.000 pictures over its lifespan. Andy expects to print 500 pictures a year and he plans to use the printer for 3 years and then sell it for $200. Here’s what annual depreciation would be if we calculated it using units of production method:
UPR = (purchase cost – residual value) ÷ total Q produced over lifespan
UPR = ($1000 – $200) ÷ 10.000 = $800 ÷ 10.000 = 0,08
Annual depreciation = UPR ⨉ actual Q produced
Annual depreciation = 0,08 ⨉ 500 = $40
Now imagine Andy prints the same amount of pictures annually during the entire lifespan of the printer. Let’s see what overall depreciation for the printer’s lifespan would be and let’s think whether purchasing that printer was a good investment.
Overall depreciation = annual depreciation ⨉ lifespan = $40 ⨉ 3 = $120
Residual value = $1000 – $120 = $880
Market value of second-hand 3-year-old printers is $200.
Answer: it’s a terrible investment. It’s a waste of $660!
As you can see, this method has proved really useful. Maybe next time you want to buy a new gadget, you can do this exercise:
Think about something you want to buy in order to “produce” something: maybe a hairdryer, or blender, or camera… Make a little research and see what the lifespan of this thing is and how much of “output” it can produce over lifespan. Think about how long you want to use it and what the market value of a similar products at the end of their lifespan is (for example, on eBay). Calculate depreciation using units of production method and think whether purchasing that thing is a good idea.
On the one hand, units of production method of depreciation is more reflective of reality and it’s more flexible because depreciation differs in different years, unlike straight line method that averages depreciation across the lifespan. So, units of production method allows you to calculate depreciation for each year separately. On the other hand, this method is quite complicated and is only applicable to assets that actually produce output.
Now, knowing the pros and cons of both depreciation methods, you can decide, depending on situation, which method would be more appropriate and what its limitations are. Good job!
Now let’s look back at class objectives. Do you feel you can do these things?
Make sure you can define all of these:
- Final accounts
- Audit
- Profit and loss account
- Trading account
- Profit statement
- Appropriation account
- Gross profit
- Cost of sales
- Cost of goods sold (COGS)
- Opening stock
- Purchases
- Closing stock
- Net profit
- Expenses
- Dividends
- Retained profits
- Window dressing
- Balance sheet
- Assets
- Current assets
- Non-current (fixed) assets
- Total assets
- Liabilities
- Current liabilities
- Non-current (long-term) liabilities
- Equity
- Liquidation
- Net assets
- Depreciation
- Purchase cost [HL]
- Lifespan [HL]
- Residual/scrap value [HL]
- Book value [HL]
- Market value [HL]
- Straight line method [HL]
- Units of production method [HL]