10 - Finance

and accounting
10.1 Financial statements
Learning objectives
• Analyse the need for businesses to keep accounts
• Analyse the main components of a statement of profit or loss
(income statement)
• Analyse the main components of a statement of financial position
• Evaluate the importance of inventory valuation
• Evaluate the importance of depreciation.

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Why keep financial (accounting) records?

Keeping financial records of every transaction a business makes is

essential. It is required to prepare financial statements complying with
the International Financial Reporting Standards (IFRS).

This encourages a more global approach to the presentation

of financial data, making comparisons and analysis more
straightforward.

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What is Profit?

Gross Profit: Obtained by deducting cost of sales from business’s sales revenue. Doesn’t take into
account other cost e.g. expenses.

Operating Profit: Better indicator of business performance as it takes into account most cost incurred
over a specific time period.

Profit for the year: This measure of profit takes into account a business’ income from all of its sources,
trading and non-trading, and the full range of costs incurred including taxes on profits and interest
charges. A business’ managers can decide how to utilise profit for the year, and they may decide to pay
dividends to shareholders or to retain profits within the business.
Statement of profit or loss
The statement of profit or loss can also be referred to as either an
income statement or a profit or loss account.
A detailed statement of profit or loss is produced for internal use
because managers need as much financial information as
possible. It should be produced as frequently as managers need
the information, perhaps once a month.
A less detailed summary statement of profit or loss is included in
the published accounts of companies for external users. It is
produced less frequently, but at least once a year. The content of
this is laid down by each country’s legislation on companies and
provides a minimum of information. This is because published
accounts are also available to competitors. Detailed data could
give competitors a real insight into their rivals’ strengths and
weaknesses.
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Statement of profit or
loss (Income statement)

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 The contents of a statement of
profit or loss
The statement of profit or loss comprises three main sections:
1 Firstly, gross profit is calculated. This is the difference between the revenue figure (sometimes called
sales revenue or turnover) and the cost of the goods that have been sold. The latter is normally
expressed simply as ‘cost of sales’. This element of the statement of profit or loss is sometimes called the
trading account. This form of profit is calculated by deducting cost of sales, such as materials and shop-
floor labour (also termed direct costs), from a business’ sales revenue. This gives a broad indication of
the financial performance of the business without taking into account other costs, such as expenses.
2 Secondly, operating profit is calculated. This is calculated by deducting the main types of expenses,
such as administration and selling costs. This is a further refinement of the concept of profit and is
revenue less cost of sales and expenses, such as rent and rates. This is a better indication of the
performance of a business over a period of time as it takes into account most costs incurred by a firm
over a trading period.
3 The final stage of the statement of profit or loss is to calculate profit for the year. This is arrived at by
deducting the amount of tax payable for the year and any interest paid while adding interest received.
The profit for the year figure shows the net amount that has been earned for the shareholders. If the
figure is negative (that is, all costs and expenses exceed revenues for the year, as in the case of Rolls-
Royce below), this is termed loss for the year.
 How might a business use its profits?

• Distributed profits
• Retained profits
Factors that can cause amendments in statement of profit or loss
Changes in selling prices
If a business raises or reduces its prices, it is almost certain that its sales revenue will alter as a
consequence. A key determinant of the effect on sales revenue following a price change is price
elasticity of demand. A business may be more inclined to raise its prices if it believes demand is price
inelastic.
Changes in the volume of products sold
If a product becomes more or less popular, the amount that is sold is likely to alter and so will the
business’ sales revenue. This may well be as a response to a price change, although other factors such as
changing fashions or the entry of new products onto a market may also change the quantity of products
that a business sells.
Changes in costs
A rise in cost of sales or expenses is likely to reduce the profit recorded on a business’ statement of profit
or loss, or it is likely to increase its losses.
 An example of amending a
statement of profit or loss

• Textbook page ( look at the case study;

PAGE 433)
 The impact on a
business’ profit or loss
of changes in costs and
prices
 Statement of financial position
A statement of financial position is a financial statement recording the assets (possessions)
and liabilities (debts) of a business on a particular day at the end of an accounting period.

What does a statement of financial position contain?

• Assets -
 Current assets
 Non – current assets
• Liabilities –
 Current liabilities
 Non – current liabilities
• Equity
• Reserves
 The format of a statement of financial
position

https://www.myaccountingcourse.com/financial-statements/statement
-of-financial-position
Net current assets and net assets

• Net current assets also known as the working capital are calculated using the
following formula:
Net current assets = current assets – current liabilities

• Business’ net assets can be calculated by totalling the business’ assets and
subtracting the business’ total
liabilities. Thus:
Net assets = (non-current assets + current assets) – (non-current liabilities +
current liabilities)

• This is one way of calculating the value of a business. Net assets represent what
would be left to the owners of a business if all its assets were sold and all its
liabilities paid.
Reserves
Reserves – also known as
retained earnings – are portions
of a business’s profits which
have been set aside to
strengthen the business's
financial position.
Amending statements of financial position

There is a range of actions a business might take which would

affect its statement of financial position. For example:
• The purchase of non-current assets
If a business purchases non-current assets, such as property or
vehicles, then the initial effect will be to increase the value of
its non-current assets on the statement of financial position. The
compensating amendment could take several forms:
The business’ cash balance may fall by the same figure, leaving
the figure for total assets unchanged. The business may
arrange a long-term loan to pay for the new assets, causing a
rise in liabilities to match the increased value of assets.
• The business repays a long-term loan
This action will initially reduce the company’s liabilities on its
statement of financial position. The compensating amendment
could be one of the following:
The business sells additional shares to raise the funds to repay
the loan. Thus, the two changes to the company’s liabilities will
cancel one another out on the statement of financial positionThe
business sells an asset to generate the finance to repay the loan.
This would lower the company’s assets by the same amount, as
its liabilities are reduced.
• The business reduces the value of some non-current assets
on its statement of financial position
INVENTORY VALUATION
Inventory valuation is an accounting practice that is
followed by companies to find out the value of unsold
inventory stock at the time they are preparing their
financial statements. Inventory stock is an asset for an
organization, and to record it in the balance sheet, it
needs to have a financial value.
 The lower of cost or net realizable value concept means
that inventory should be reported at the lower of its cost
or the amount at which it can be sold. Net realizable
value is the expected selling price of something in the
ordinary course of business, less the costs of
completion, selling, and transportation. Thus, if
inventory is stated in the accounting records at an amount
higher than its net realizable value, it should be written
down to its net realizable value

Inventory
How to Calculate the NRV:
valuation – lower The calculation of the NRV can be broken down into the
cost or NRV following steps:
1. Determine the market value or expected selling price
of an asset.
2. Find all costs associated with the completion and the
sale of an asset (cost of production, advertising,
transportation).
3. Calculate the difference between the market value
(expected selling price of an asset) and the costs
associated with the completion and sale of an asset. It
is a net realizable value of an asset
The Reason for the Lower of Cost or Net Realizable
Value Concept

• The lower of cost or realizable value rule is associated with the conservatism
principle.

• This principle holds that one should recognize expenses and liabilities as soon as
possible when there is uncertainty about the outcome, but only recognize revenues
and assets when they are assured of being received. This means that the inventory
asset will always be reported at a value representing at least the amount that can be
collected from its eventual sale.
Example of Net Realizable Value

• ABC International has a green widget in inventory with a cost of $50. The
market value of the widget is $130. The cost to prepare the widget for sale is
$20, so the net realizable value is $60 ($130 market value - $50 cost - $20
completion cost). Since the cost of $50 is lower than the net realizable value
of $60, the company continues to record the inventory item at its $50 cost.
• In the following year, the market value of the green widget declines to $115.
The cost is still $50, and the cost to prepare it for sale is $20, so the net
realizable value is $45 ($115 market value - $50 cost - $20 completion cost).
Since the net realizable value of $45 is lower than the cost of $50, ABC
should record a loss of $5 on the inventory item, thereby reducing its
recorded cost to $45.
Why Inventory Valuation is Important
• Impact on the Cost of Goods Sold
When a higher valuation is recorded for ending inventory, this leaves
less expense to be charged to the cost of goods sold, and vice versa.
Thus, inventory valuation has a major impact on reported profit levels.
• Impact on Multiple Periods
An incorrect inventory valuation will cause the reported profits in two
consecutive periods to be incorrect, because the incorrect ending
balance in the first period will be wrong, and it then carries over into the
beginning inventory balance in the next reporting period
Depreciation
Assets decline in value for two main reasons:
• normal wear and tear through usage
• technological change that makes the asset obsolete.

Role of depreciation in the accounts

Nearly all fixed/non-current assets will depreciate or decline in value over time. It seems reasonable,
therefore, to record only the value of each year’s depreciation as a cost on each year’s income
statement.

This will overcome both problems referred to above:

• The assets will retain some value on the statement of financial position each year until fully
depreciated or sold off. This is the net book value, calculated as follows:

original cost - accumulated depreciation.

Depreciation – straight line method
How depreciation is calculated: the straight-line method of depreciation
Annual depreciation is calculated by the formula:
• Original cost – expected residual value / expected useful life of asset (years)

To calculate the annual amount of depreciation, the following information is needed:

• the original or historical cost of the asset
• the expected useful life (in years) of the asset
• an estimation of the value of the asset at the end of its useful life (known as the residual value of the
• asset).
The formula given above is then used to calculate the annual depreciation charge.
Example: A business purchases three new computers costing $3 000 each. Experience with previous
computers suggests that they will need to be updated after four years. At the end of this period, the
second-hand value of each machine is estimated to be just $200. Using straight line depreciation, the
annual depreciation charge will be: $9000 - $600 / 4 = $2100
• For each of the four years of the useful life of these computers, a
depreciation charge of $2 100 should be made.
• This should be included as overhead expenses on the statement of
profit or loss.
• On the statement of financial position, the annual depreciation charge
is subtracted from the value of the computers.
• At the end of four years, each computer will be valued at $200 on the
statement of financial position. The table on the next slide shows how
the net book value of these computers falls over the four-year period.
Year Annual depreciation charge Net book value of the three
computers

Present 0 $9000

1 $2 100 $6900

2 $2 100 $4800

3 $2 100 $2700

4 $2 100 $600
• Net book value declines with each annual depreciation as seen on the
table above.
• If, at the end of the fourth year, the computers are sold for more than
their expected residual value, a profit will be recorded on the
statement of profit or loss.
• If they are sold for a total of $900, the business has made a profit of
$300. If, however, the computers are scrapped at the end of the fourth
year because they are obsolete, the business will record a loss on the
disposal of these assets of $600.