Purpose of Financial Statements A company is a business organisation, created in law, which is owned by its members or shareholders.

Generally, for listed companies and larger unlisted ones, the shareholders appoint directors to manage the Company on their behalf, having little involvement in the day-to-day operations of such companies. The primary purpose of financial statements is to provide a medium enabling the directors to report to the shareholders on the performance of the company concerned. The financial statements are, however, frequently used by other interested parties, such as lenders, creditors, potential investors, tax authorities, the Government etc., to help them assess the returns they are receiving and the risks that they may face. The main components of a set of financial statements are 1. Balance Sheet. 2. Trading account 3. Profit and Loss Account.

Balance Sheet
OverviewThe balance sheet is a statement of the financial position of the business at a specific point in time, such as the year end. It represents both what the company has (assets less liabilities) and where the funds came from originally (source of funds). As a result it must always balance. The four categories we have outlined are as follows. 1. Assets These represent resources owned or controlled by the company and available for its use, such as stocks of goods for sale or production equipment. These can be sub-categorised under two headings, i. ii. Fixed Assets and Current Assets.

Fixed Assets Assets acquired for continued use in the business to earn profit, not for resale. Examples of such items would include office and production buildings and equipment. Clearly these are intended for long-term use, not simply to be sold on at a profit. These are be sub-classified into a. Intangibles b. Tangibles c. Investments The Companies Act requires that all fixed assets that have limited useful economic lives must be Depreciated. Depreciation is the method by which the cost of using the asset is matched against its related benefit. On the balance sheet fixed assets are usually stated at net book value (NBV), i.e. cost less the accumulated depreciation provision. Intangible fixed assets- Intangibles are literally assets without physical form. They frequently represent intellectual property rights of the company, or abilities of its staff, that enable it to operate and generate profits in a way that competitors cannot. The types of intangible assets that most frequently appear on the balance sheet are as follows. a.Research and development expenditure. b. Patents, licences and trademarks. c.Publishing rights and titles. d.Goodwill. e.Brands, etc.

Depreciation of intangible fixed assets is frequently referred to as amortisation. Tangible Fixed Assets These are physical assets that are used within the business over a number of years with a view to deriving some benefit from this use, e.g. through their use in the manufacture of goods for resale. Tangible fixed assets include items such as a. Freehold land and buildings (including buildings under construction). b.Leasehold land and buildings. c.Plant and machinery. d.Motor vehicles. e.Fixtures and fittings,etc Investments These represent long-term ownership of shares in other companies and are usually reported in the balance sheet at historical cost.

Current Assets Assets acquired for conversion to cash during the ordinary course of business. Examples of such assets would include stocks of goods available for sale to customers, or customers account balances which will be settled for cash. By convention, assets which are to be converted into cash within 12 months are deemed to be current. Current assets are sub-categorised in increasing order of liquidity as shown below. Stock goods held available for sale. Within this category, stocks can be further re-classified into

raw materials, work-in-progress (WIP) and finished goods. Debtors amounts owed to the company, perhaps as a result of selling goods on credit (this will include prepayments, see Section 9.2.7). Debtors will also include unpaid share capital, as well as debtors that are receivable in more than 12 months. Investments shares held in the short term with the intention of reselling, e.g. short-term speculative investments. Cash in hand and at bank. In valuing current assets the fundamental accounting principle of prudence is applied, in that they are valued at the lower of Costs; or Net realisable value (NRV), i.e. estimated selling price less any cost incurred in order to sell. 2. Liabilities (0verview) Liabilities represent amounts owed by the company to outside suppliers and lenders. These too are sub-categorised as Creditors: amounts falling due within one year. These are also known as current liabilities. Creditors: amounts falling due after more than one year. These are also known as long-term liabilities. The purpose of the above classification is to provide a clear indication of the timescales for settlement. 3. Share Capital This is money invested in the company by shareholders, i.e. money subscribed for shares. 4. Reserves These generally represent profits earned and retained by the company since it began trading, though there may be other types of reserves as we will see later.

Current Liabilities Current liabilities should fully reflect all liabilities payable within 12 months of the year end. They include Bank overdrafts (not bank balances in credit). a.Dividends payable. b. Corporation tax payable. c. Trade creditors. d. Accruals Accruals and Prepayments Accruals and prepayments arise in the balance sheet when the amount charged as an expense in the profit and loss account for the year is not the same as the amount paid out of the cash balance. Accruals An accrual is an amount due in respect of goods and services used during the year but not yet invoiced. Since the amount is owed even though it has not yet been invoiced for, it has to be shown as part of the liabilities. Accruals are therefore shown as part of current liabilities. Prepayments Prepayments are amounts paid before the balance sheet date which relate to the period after that date. Since we have paid the money over but not yet received the benefit due from the expenditure, we still have an asset at the balance sheet date. Prepayments are therefore shown as part of debtors, within current assets. Capital Employed The sum of total assets minus current liabilities is known as capital employed. It represents the total

amount of funds being used in the business, for the long term as fixed assets or for the short term as working capital. It can also be calculated by looking at where those funds came from, i.e. debt (long-term liabilities) or equity (shareholders' funds). Long-Term Liabilities This will typically include such items as Long-term bank loans. Loan stock and debentures issued by the company. Both of these must be repaid long term. It would also include any other known liabilities such as trade creditors that do not require settlement within the next 12-month period. Provisions for Liabilities and Charges These represent amounts set aside by the company to meet foreseeable future costs arising as a result of past events. An example of such a provision is the costs associated with the demolition and site clearance of a factory closed down during the year. The amounts are estimated because they are not yet known with certainty and will not be until the process is completed some time in the future. Their value is, therefore, less reliable than full creditors, such as bank loans, where it is known with certainty what is owed and when it is due to be paid. Included within this section would be amounts provided for deferred tax. This represents tax liabilities, which have been deferred to a later period, due to timing differences between accounting and taxable profit. Called-Up Share Capital This represents the total nominal value of the shares in issue at the year end, e.g. our company has in issue 100,000 shares, each with a 1 nominal value giving 100,000 share capital.

Under the Companies Act, UK companies must assign a nominal or par value to each share. This represents The minimum value at which shares can be issued. The company is not allowed to issue fully paid shares at a price below nominal value. The limits of the liability of the shareholder. If the company becomes insolvent, shareholders liability is limited to any unpaid element of this nominal value. Where the share is a fully paid share, the shareholder has no further liability. Share Premium Account Reserve If a company trades profitably and retains those profits to finance expansion, then its value will grow. As a result it will be able to raise cash in later years by issuing more shares at a price in excess of their nominal value, i.e. at a premium. . Note that it is not just the share premium account reserve that can be used to 1.finance a bonus issue any reserve will do. 2. To write off preliminary expenses of forming a company. 3. To write off expenses of issue of shares or debentures. 4. To charge the premium on repayment on debentures. 5. To charge the discount on issue of debentures. The share premium account reserve can never be reduced to pay dividends to the shareholders, as it is one of the companys non-distributable reserves. 9.2.13 Revaluation Reserve UK companies are permitted by the Companies Act to revalue all assets other than goodwill upwards, increasing net assets and shareholders funds. Where a company does revalue its fixed assets upwards, it would be imprudent to treat this increase in

shareholders funds as part of the companys realised profits for the year. It has not been generated by the operational performance of the company and it is certainly not represented by cash. It is, therefore, considered unrealised and non-distributable, i.e. the company cannot use the revaluation reserve to pay a dividend. In this situation, the increase in the net book value of the assets is reflected within shareholders funds in the revaluation reserve. Impact on net assets Fixed assets up Impact on shareholders funds Revaluation reserve up Other Reserves Any other reserves generally represent an apportionment or allocation of profits from the profit and loss account reserve. This is frequently done for the following reasons. To indicate that a certain element of profit is being retained for a specific reason. To indicate that a portion of profits will never be paid out as a dividend. To account for the treatment of unusual terms such as goodwill written off. Profit and Loss Account Reserve The profit and loss account reserve on the balance sheet represents the accumulated profits made by the company since it started to trade, which have not been paid out as dividends or transferred to other reserves. As such it is a distributable reserve under the Companies Act rules, i.e. it can be used to cover the payment of dividends to shareholders. The separate profit and loss account statement details the impact of this years trading activities on this accumulated figure. Any profits retained this year, which are detailed in the

separate profit and loss account statement, will be added to the accumulated retained profits (or reserves) brought forward, giving the accumulated position at the end of the year. This could be viewed like a bank statement, where the statement only shows the movements for the month, but these are added to the opening cash balance to arrive at the closing one

Profit and Loss Account Statement

Introduction The profit and loss account statement provides a detailed analysis of how the company has generated its profit or loss for the accounting period. As already noted, it reconciles the change in the balance sheet profit and loss figure (the profit and loss account reserve) from one year to the next. Terminology In accordance with the accruals or matching principle, income and expenses are recognised in the profit and loss account statement when earned regardless of when paid. Any difference between the recognition of these items and the corresponding cash flow will be reflected in a balance sheet debtor or creditor. 1 Turnover The turnover or sales figure represents the total value of goods or services provided to customers during the accounting period whether they have been paid for or not, in accordance with the accruals principle. 2 Cost of Sales The cost of sales represents the total cost to the business of buying or making the actual items sold. 3 Gross Profit

Gross profit is the difference between the value of the sales and the value of the cost of goods sold. One measure frequently used in determining the performance of the business is to consider its gross profit margin, which can be calculated as follows. Formula to Learn: Gross profit Gross profit margin = 100% Turnover Clearly, the higher the margin for a particular level of operations, the higher the profit. However, this does not mean that low margins result in low profits. A number of businesses generate very healthy profits through selling very large numbers of items (achieving correspondingly large turnover) at low margins. 4 Various Operating Costs These costs include all other expenses incurred in generating the turnover for the period by way of administrative involvement and delivery/distribution. 5 Exceptional Items Exceptional items are unusually large items of income or expense arising during the year. They are separately classified as exceptional items to highlight their one-off nature. An exceptional item i. ii. iii. Is material. Derives from events or transactions that fall within the ordinary activities of the business Needs to be separately disclosed by virtue of its size or incidence if the financial statements are to give a true and fair view.

6 Interest Payable In common with most other business expenses, any interest payable goes to reduce the companys profit before tax and hence taxable profit by the gross amount payable. For example, if a company has in issue 100,000 of 10% loan stock, then the interest charge in its accounts each year will be 10,000. 7 Tax on Profit on Ordinary Activities UK companies pay corporation tax on their taxable profits. The element of the total tax charge shown here is the tax on the ordinary activities of the business, excluding any extraordinary items. Extraordinary Item An extraordinary item is a large one-off item, similar to an exceptional item, that requires separate disclosure in order to ensure that the truth in the accounts (the trends, ratios, etc.) is not distorted. An extraordinary item i. ii. iii. Is material. Possesses a high degree of abnormality which arises from events or transactions that fall outside the ordinary activities of the business. Is not expected to recur.

Note that this definition is exceedingly restrictive and it is highly unusual that a profit and loss account statement will have an extraordinary item shown. For that reason our illustrative accounts have shown the positioning of the item in the accounts but given a nil amount. In such a case, a company would dispense with the line altogether. Tax is payable on extraordinary items. The figure that would be shown on the face of the profit and loss account would be a net of tax figure. Dividends These represent the cash dividends paid out or proposed to be paid out to shareholders net of starting rate income tax.

Most of the time companies pay out dividends which are less than their profits after tax, i.e. the dividend is being paid from this years profits and is said to be covered. However, it is not essential for a dividend to be covered. It may be financed from previously retained profits which, as we have seen, are accumulated in the balance sheet profit and loss account reserve balance. XYZ plcs dividend for 2002 is uncovered in our example. In most cases, UK companies pay dividends in two stages. Interim dividend paid this is paid out during the year based on the half years performance. Final dividend proposed this is paid to shareholders following the approval of the year end accounts at the AGM. Capital and Revenue Expenditure Capital Expenditure Capital expenditure is expenditure on acquiring or enhancing fixed assets or their operating capacity. As such, the benefits will be derived from this expenditure over the remaining life of the asset. Hence, this expenditure is added to the value of fixed assets (is capitalised) on the balance sheet and will subsequently be depreciated through the profit and loss account

Revenue Expenditure Revenue expenditure is expenditure incurred in Acquiring assets to be sold for conversion into cash, e.g. stock. Manufacturing, selling, distributing goods, e.g. wages. Day-to-day administrative expenses, e.g. electricity, telephone.

Maintenance of fixed assets, e.g. repairs. Revenue expenditure is charged directly against profits for the period to which it relates.