CHAPTER 10 Financial Statements NOTE

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1 NOTE In practice, accruals accounts and prepayments accounts are implied rather than drawn up. It is common for expense accounts to show simply a balance c/d and a balance b/d. The accrual or prepayment is implied and will be shown in the balance sheet. Insurance Account Date Details Date Details 1 st July Bank st Mar Balance c/d st Jan Bank st Mar Profit & Loss a/c st Apr Balance b/d However, it is recommended that you follow the basic principle before attempting to skip drawing up an accruals or a prepayments account. Balance Sheet The Balance Sheet (sometimes called a Statement of Financial Position) summarises the business s assets, liabilities and the net worth of the business. Unlike the P&L the Balance Sheet shows the financial condition of the business at a particular point in time (usually the last day of the business s financial year). The Balance Sheet is a statement of what the business owns and what the business owes. It is called a Balance Sheet because it must balance. The business will have assets which it pays for either by borrowing money (liabilities) or funds contributed by the owner (equity). The value of the assets must equal the funds used to buy the assets. As we saw at Level 1 there is the accounting equation: ASSETS equals LIABILITIES plus CAPITAL Depending on which format of Balance Sheet is used, this can be translated into ASSETS minus LIABILITIES equals CAPITAL As we have seen, the balance sheet shows the balance on the accounts which are not revenue accounts and have not been used for the P&L. A typical Balance Sheet is shown on the next page

2 Fixed Assets CHAPTER 10 Balance Sheet A Buhari As at 31 st December 2013 Cost Accumulated NBV Depreciation Freehold premises 80, ,000 Plant and Machinery 50,000 10,000 40,000 Vehicles 40,000 20,000 20, ,000 30, ,000 Current Assets Stock 19,287 Debtors 29,500 Less: Provision for doubtful debts 1,475 28,025 Prepayments 1,350 Cash at Bank 6,150 Cash in hand ,062 Current Liabilities Trade creditors 22,125 Accruals ,625 Net Current Assets (Working Capital) 32,437 Total Assets less Current Liabilities 172,437 Long term liabilities Bank loan 10,000 Net Assets 162,437 Capital as at 1 st January ,273 Net Profit for the year 30,164 47,437 Less: awings 25,000 Capital at 31 st December ,

3 You will notice that there are three columns. As with the P&L, there is not a lot of significance to the columns other than it makes it easier to read. In general the right hand column shows the totals, the middle column shows how the totals are made up, and the left hand column shows how the subtotals are made up. The exception is the fixed asset section, where the cost less the accumulated depreciation equals the NBV. Let us look at the entries in detail. Fixed Assets Fixed assets are also known as non-current assets. A fixed asset is a property of the business that the business uses in the production of its income. The property is not expected to be consumed or converted to cash any sooner than one year s time. Examples of common types of fixed assets include buildings, land, furniture and fixtures, machines and vehicles. Fixed assets are not items for resale but for production, supply, rental or administrative purposes. Assets that are held for resale must be accounted for as stock (inventory) rather than fixed asset. So, for example, if a company is in the business of selling cars, it must not account for cars held for resale as fixed assets but instead as stock. However, any vehicles other than those held for the purpose of resale may be classified as fixed assets such as delivery vans and company cars. We saw in Chapter 9 how fixed assets may be depreciated. The original cost of the asset is reduced by the accumulated (or provision for) depreciation to arrive at the Net Book Value (NBV). The NBV is the figure which is included in the Balance Sheet figures. Current Assets Current assets are assets which are reasonably expected to be converted into cash within one year. They are usually listed in reverse order of their liquidity. Liquidity is the ease with which you can convert into cash. Depending on the nature of the stock, this will usually be the first item. Stock must be sold before it can become cash. If it is sold on credit, it could be some time before its conversion to cash. Trade debtors will be the next item since cash should be forthcoming from them within weeks. The most liquid item is cash itself. You may have noticed a provision for doubtful debts. Many businesses will put aside an amount of money for credit customers who cannot or will not pay. We will look at this in more detail at Level 3. Current Liabilities Current liabilities are liabilities which become due within one year. Again they will be listed in reverse order of liquidity. Apart from trade creditors and accruals, a bank overdraft would be shown here (rather than in the current assets) as well as any VAT due

4 to be paid to HMRC. Any bank loans which are due to be paid off within the year will be transferred here from the Long Term liabilities. Net current assets Net current assets are also known as Working Capital. It is calculated as the current assets less the current liabilities. It shows the amounts of cash the business has to work with over the next 12 months. One would hope that the current assets are more than the current liabilities (i.e. a positive working capital). If the business has a negative working capital it will have problems paying its debts when they become due. Total assets less current liabilities This shows the value of the business apart from the long term liabilities (see below). The long term liabilities will not become due until at least 12 months so it is useful to see the probable value of the business for (at least) the next 12 months. Long term liabilities These are items which are due to be repaid after more than 12 months. Items will include bank loans and loans from other sources. Such loans will be transferred to the current liabilities when their term becomes less than 12 months. Capital Capital is the amount which has been invested by the owners of the business. It shows the net worth of the business. Any profit is added to the capital annually and any drawings are deducted. Remember that the owners of a company do not receive wages they receive drawings. Extended Trial Balance (ETB) (This will not be assessed in the ICB exam, but it is a most useful aid in drawing up a P&L and a Balance Sheet) Some businesses will use an Extended Trial Balance in order to facilitate the drawing up of the P&L and the Balance Sheet. It is basically a Trial Balance with categories extending to the right. These categories are adjustments, Profit & Loss and Balance Sheet. Each category has a column for debits and credits. (See p189). Suppose we have a Trial balance as shown on the next page:

5 Name of account Trial Balance 31 December 2013 Sales 162,700 Sales Returns 1,300 Purchases 80,000 Purchase Returns 1,150 Sales Ledger Control 10,000 Purchases Ledger Control 1,000 Heat & Light 900 Rent and rates 10,000 Office Stationery 650 Office Wages 40,000 Office Equipment 12,500 Office equipment accumulated depreciation 2,500 Vehicle 16,000 Vehicle accumulated depreciation 4,000 Stock (at 1 st Jan 2012) 7,000 Cash (till float) 200 Bank 7,500 VAT 9,600 Bank Loan 5,000 Capital 4,850 awings 4, , ,800 We now have to transfer these balances to the Extended Trial Balance (see next page)

6 Account Balance Adjustments Profit & Loss Balance Sheet Sales Sales Returns 1300 Purchases Purchase Returns Sales Ledger Control Purchase Ledger Control Heat & Light 900 Rent and Rates Office Stationery 650 Office Wages Office Equipment Acc Dep n (Office Equip) Vehicle Acc Dep n (Vehicle) Opening Stock Cash 200 Bank 7500 VAT 9600 Bank Loan 5000 Capital 4850 awings 4750 TOTAL

7 Before we draw up a balance sheet and a P&L we find the following adjustments:- 1. A customer has gone into liquidation and the amount owing of 1000 must be written off. (Ignore VAT). 2. Depreciation has not yet been accounted for. Equipment is depreciated at 20% per year using the straight line method and vehicles are depreciated at 25% per year using the reducing balance method. 3. Wages for 4500 are still owing. 4. A payment for rent of 4000 has been paid covering the period October 1 st to 31 st March. 5. Stock has been counted on 31 st December 2013 and it amounts to 10,000. We now need to show these adjustments in the adjustment columns of the ETB. Remember that each adjustment will need a double entry. The adjustment for item 1 will be Debit Bad Debts 1000 edit Sales Ledger control 1000 We don t have a bad debts account so we will need to create one. The adjustment for item 2 will need to be calculated. The equipment is depreciated at 20% per year using the straight line method. 20% of is The vehicle is depreciated at 25% per year using the reducing balance method. 25% of the original cost less the accumulated depreciation. 25% of ( ) is Therefore the adjustment will be Debit Depreciation 5500 edit Accumulate depreciation Office Equipment 2500 edit Accumulate depreciation Vehicle 3000 We don t have a depreciation account so we will need to create one. The adjustment for item 3 is an accrual. Debit Wages 4500 edit Accruals

8 The adjustment for item 4 is a prepayment. Only half the amount is a prepayment (3 months within the period and 3 months for the next period. Debit Prepayments 2000 edit Rent and Rates 2000 Note the treatment of the closing stock (item 5). There will be a new account for the closing stock and we should both debit and credit this account. We will see why when we come to extending the figures. Debit Closing Stock edit Closing Stock We need to put these adjustments into the ETB. We must total the figures to ensure the debits match the credits. Once the adjustments have been completed we must put the new totals into the P&L columns and the Balance Sheet columns. We must look at each account and extend it by the adjustment. We must add debits to debits and credits to credits. We must subtract credits from debits and debits from credits. This is where care must be taken to extend the figures to the right columns (P&L or Balance Sheet). Note the treatment of both the opening and closing stock. The opening stock is debited to the P&L and the closing stock is credited to the P&L. This is the adjustment required in the calculation of the Cost of Sales. The closing stock is also debited in the Balance Sheet. Once the figures have been extended we will find that the debits and credits do not balance on the P&L or the Balance Sheet. However, the amount it doesn t balance by will be the same for the P&L as for the Balance Sheet. This missing figure will be the profit figure. Looking at the Balance Sheet, if the missing figure is a credit a profit will have been made; if the missing figure is a debit a loss will have been made. The completed ETB is shown on the next page. Look at each entry and ensure you would be able to do this for yourself. Particularly make sure you know which accounts are P&L accounts and which are Balance Sheet accounts

9 Account Balance Adjustments Profit & Loss Balance Sheet Sales Sales Returns Purchases Purchase Returns Sales Ledger Control Purchase Ledger Control Heat & Light Rent and Rates Office Stationery Office Wages Office Equipment Acc Dep n (Office Equip) Vehicle Acc Dep n (Vehicle) Opening Stock Cash Bank VAT Bank Loan Capital awings Bad Debts Depreciation Accruals Prepayment Closing Stock Profit TOTAL

10 Once we have completed the ETB we can draw up the P&L and Balance Sheet Trading and Profit and Loss Account For the Year Ended 31 st December 2013 Sales 162,700 Less Sales Returns 1,300 Net Sales 161,400 Cost of Sales Opening stock 7,000 Purchases 80,000 Less Purchase Returns 1,150 Less Closing Stock 10,000 75,850 Gross Profit 85,550 Expenses: Heat & Light 900 Rent & Rates 8,000 Office Stationery 650 Office Wages 44,500 Bad Debts 1,000 Depreciation 5,500 60,550 Net Profit 25,

11 Fixed Assets CHAPTER 10 Balance Sheet As at 31 st December 2013 Cost Accumulated NBV Depreciation Office Equipment 12,500 5,000 7,500 Vehicles 16,000 7,000 9,000 28,500 12,000 16,500 Current Assets Stock (as at 31 st December 2013) 10,000 Debtors (Sales Ledger Control) 9,000 Prepayments 2,000 Cash at Bank 7,500 Cash in hand ,700 Current Liabilities VAT 9,600 Trade creditors (Purchase Ledger Control) 1,000 Accruals 4,500 15,100 Net Current Assets (Working Capital) 13,600 Total Assets less current liabilities 30,100 Long term liabilities Bank loan 5,000 Net Assets 25,100 Capital as at 1 st January ,850 Net Profit for the year 25,000 29,850 Less: awings 4,750 Capital at 31 st December ,

12 EXAM TIP You must use all the accounts in the TB in either the P&L or the Balance Sheet. If possible it is a good idea to mark off each account from the TB as it is used in the. Chapter Summary All the accounts from a Trial Balance are brought together into two financial statements; the Profit & Loss account and the Balance Sheet. The Profit & Loss account shows all the revenue accounts. It takes the net sales and deducts production costs to show a Gross Profit. Expenses are then deducted from the Gross Profit to show a Net Profit (or loss). The Balance Sheet shows what a business owns and what it owes. As the name suggests, the Balance Sheet must balance. Adjustments are made to accounts so that what is recorded is the amount due in the period rather than what is actually paid. These adjustments are called accruals and prepayments An Extended Trial Balance may be used as a tool to help prepare the P&L and the Balance Sheet