Understanding financial statements Flashcards
Sole trader
- Owned and ran by one individual
- Fully liable for any losses business makes
Partnership
- Owned and ran by 2+ people
- Fully liable for any losses business makes
- Can be large & have unlimited partners
Company
- Owned by several shareholders but not ran by them
- Incorporated (shareholders are not liable for any losses business may incur)
- Has to keep accounts in accordance with Companies Act 2006
What 5 elements must financial statements summarise?
- Assets: resource controlled by entity as a result of past events from which future economic benefits are expected to flow to entity
- Liabilities: an obligation to transfer economic benefit as a result of past transactions/events
- Equity: ‘residual interest’ in a business and represents what is left when business is wound up, assets sold and liabilities paid
- Income: recognition of inflow of economic benefit to entity in reporting period
- Expenses: recognition of outflow of economic benefit from an entity in reporting period
What is shown on the profit & loss which shows performance?
Income and expenses
What is shown on the balance sheet which shows the position of company?
Assets, liabilities and equity
Examples of income:
- Sales made to customers
- Other sundry income such as interest income
Examples of expenses:
Utility bills, wages, rent, purchases of materials
Sales
‘revenue’
income generated from trade over accounting period
cost of sales
costs/expenses for sales made such as:
- opening stock (start of year)
- purchase (materials purchased during year
- less: closing stock (end of year)
gross profit
profit from trade in the year
sundry / other income
income received from non-trade sources
other expenses
expenses not included in cost of sales
distribution costs
expenses associated with getting product to customer
admin expenses
all other expenses not classed as distribution or cost of sales
net profit
profit for the year after all expenses have been distributed
can be profit before interest and tax, profit before tax ( after -ing interest) or profit after tax (-ing interest and tax)
What can interest be referred to in exam
Finance costs
What can interest be referred to in exam
Finance costs
non-current assets
any non/tangible asset acquired on long-term basis to be used in providing service to business
not held for resale
current assets
assets that are expected to be realised in the business normal course of trading
shown in stat. of financial position with least liquid item first such as inventory
How to calculate net book value
difference between cost of asset - any accumulated depreciation
What will affect non-current assets when shown at their net-book value on the statement of financial position
- Cost: original cost of asset
- Depreciation: systematic allocation of cost of asset over its life. Charged every year, reducing value of asset in balance sheet as accumulated depreciation (creating a yearly expense in P&L account)
- Revaluation: if asset is revalued, this will become new cost of asset
Liabilities
claims on business by outsiders
non-current liabilities
long term liabilities payable more than 12 months after reporting date
current liabilities
payable within 12 months of reporting date
Working capital equation (net current assets)
Working capital = Current assets - Current liabilities
Examples of short term assets
- Stock (includes raw materials, work in progress or finished goods)
- Debtors (money owed to us from customers who have purchased items on credit)
- Cash (in hand or in bank accounts)
Examples of short term liabilities
- Trade and other creditors (amounts owed to suppliers or those who we have purchased items from)
- Bank overdraft (short term -ve cash balance)
- Taxes owed (amounts owed to HMRC as tax liabilities)
Equity equation
Equity = Total assets - Total liabilities
What should the net asset figure always equal in the balance sheet?
Equity (for companies) or capital (for sole traders/partnerships)
Ordinary share capital
nominal amount of the shares
share premium
anything received in excess of nominal amount for sale of shares
general reserve
funds set aside by company for future purposes
retained profits
accumulated profits that haven’t been paid out as individuals
What is the UK GAAP and what do they do
UK Generally Accepted Accounting Practise
They’re the rules, regulations, concepts and conventions which govern accounting in UK
What is the UK GAAP made up of?
- UK accounting standards
- Company law
- Stock exchange requirements
- International accounting standards
What is the FRC and what do they do?
Financial reporting council
responsible for issuing UK accounting standards
Two main ways a company can use their profits
- Pay out as dividend which provides return to owners
- Retain and use for business needs such as invest in opp., retain as reserve for future needs, pay tax, pay salaries/bonuses
2 +ve’s and -ve’s of paying profit out as dividend
+ve
shareholders get cash return
consistently strong dividend may attract investors
-ve
can’t be used for other business investments which may restrict growth
lead to liquidity problems
2 +ve’s and -ve’s of retain & invest for profit
+ve
grow business more quickly
cheap and quick source of finance
-ve
no immediate cash return for shareholders
potential investment returns may not be achieved
2 +ve’s and -ve’s of profit being retained as a reserve
+ve
gives flexibility to use cash for business needs and new opp. when they arise
strong liquidity - company less risky
-ve
shareholders gon’t get return through cash OR share price growth
missed opportunities
How do directors use profits to consider how company has performed?
- analysis of profit growth year on year
- analysis of profit margins to assess efficiency of company
- comparing profits that those of key competitors
Other uses of profits:
Performance management
Evaluate performance of entity
Evaluate performance of managers
Profit sharing arrangements
3 +ve’s and -ve’s of using profit to evaluate performance
+ve
managers motivated to achieve them
promotes goal congruence between shareholder and employee objectives
key financial indicator
-ve
managers may focus to hit short term goals instead of long term
if profit targets are unachievable, may demotivate managers
profits could vary depending on accounting policies = unfair
