Understanding financial statements

Question 1

Sole trader

Answer 1

• Owned and ran by one individual

- Fully liable for any losses business makes

Question 2

Partnership

Answer 2

• Owned and ran by 2+ people
• Fully liable for any losses business makes
• Can be large & have unlimited partners

Question 3

Company

Answer 3

• 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

Question 4

What 5 elements must financial statements summarise?

Answer 4

• 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

Question 5

What is shown on the profit & loss which shows performance?

Answer 5

Income and expenses

Question 6

What is shown on the balance sheet which shows the position of company?

Answer 6

Assets, liabilities and equity

Question 7

Examples of income:

Answer 7

• Sales made to customers

- Other sundry income such as interest income

Question 8

Examples of expenses:

Answer 8

Utility bills, wages, rent, purchases of materials

Question 9

Sales

Answer 9

‘revenue’

income generated from trade over accounting period

Question 10

cost of sales

Answer 10

costs/expenses for sales made such as:

• opening stock (start of year)
• purchase (materials purchased during year
• less: closing stock (end of year)

Question 11

gross profit

Answer 11

profit from trade in the year

Question 12

sundry / other income

Answer 12

income received from non-trade sources

Question 13

other expenses

Answer 13

expenses not included in cost of sales

Question 14

distribution costs

Answer 14

expenses associated with getting product to customer

Question 15

admin expenses

Answer 15

all other expenses not classed as distribution or cost of sales

Question 16

net profit

Answer 16

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)

Question 17

What can interest be referred to in exam

Answer 17

Finance costs

Question 18

What can interest be referred to in exam

Answer 18

Finance costs

Question 19

non-current assets

Answer 19

any non/tangible asset acquired on long-term basis to be used in providing service to business

not held for resale

Question 20

current assets

Answer 20

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

Question 21

How to calculate net book value

Answer 21

difference between cost of asset - any accumulated depreciation

Question 22

What will affect non-current assets when shown at their net-book value on the statement of financial position

Answer 22

• 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

Question 23

Liabilities

Answer 23

claims on business by outsiders

Question 24

non-current liabilities

Answer 24

long term liabilities payable more than 12 months after reporting date

Question 25

current liabilities

Answer 25

payable within 12 months of reporting date

Question 26

Working capital equation (net current assets)

Answer 26

Working capital = Current assets - Current liabilities

Question 27

Examples of short term assets

Answer 27

• 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)

Question 28

Examples of short term liabilities

Answer 28

• 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)

Question 29

Equity equation

Answer 29

Equity = Total assets - Total liabilities

Question 30

What should the net asset figure always equal in the balance sheet?

Answer 30

Equity (for companies) or capital (for sole traders/partnerships)

Question 31

Ordinary share capital

Answer 31

nominal amount of the shares

Question 32

share premium

Answer 32

anything received in excess of nominal amount for sale of shares

Question 33

general reserve

Answer 33

funds set aside by company for future purposes

Question 34

retained profits

Answer 34

accumulated profits that haven’t been paid out as individuals

Question 35

What is the UK GAAP and what do they do

Answer 35

UK Generally Accepted Accounting Practise

They’re the rules, regulations, concepts and conventions which govern accounting in UK

Question 36

What is the UK GAAP made up of?

Answer 36

• UK accounting standards
• Company law
• Stock exchange requirements
• International accounting standards

Question 37

What is the FRC and what do they do?

Answer 37

Financial reporting council

responsible for issuing UK accounting standards

Question 38

Two main ways a company can use their profits

Answer 38

• 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

Question 39

2 +ve’s and -ve’s of paying profit out as dividend

Answer 39

+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

Question 40

2 +ve’s and -ve’s of retain & invest for profit

Answer 40

+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

Question 41

2 +ve’s and -ve’s of profit being retained as a reserve

Answer 41

+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

Question 42

How do directors use profits to consider how company has performed?

Answer 42

• analysis of profit growth year on year
• analysis of profit margins to assess efficiency of company
• comparing profits that those of key competitors

Question 43

Other uses of profits:

Answer 43

Performance management
Evaluate performance of entity
Evaluate performance of managers
Profit sharing arrangements

Question 44

3 +ve’s and -ve’s of using profit to evaluate performance

Answer 44

+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