Unit 3 Quick revision summary

3.1 Income statements

●● Making a profit is the primary motive of people who invest their time, effort and
money in businesses. It is the difference between the total income of a business and
its total costs.
●● A business will calculate and report two measures of profit at the end of an
accounting year in an income statement. To calculate profit it is important to match
revenue only to those costs or expenses incurred earning it.
●● If revenue (sales less sales returns) during an accounting year exceeded the cost of
the goods sold (the cost of sales) the business will have made a gross profit. It is a
measure of how successful the business has been at selling goods at a price greater
than their cost.
●● If the cost of goods sold is greater than the revenue earned from their sale the
business will have made a gross loss.
●● Unless there are unsold goods at the start or end of the accounting year the cost of
goods sold – or cost of sales – will be exactly equal to the cost of net purchases
(purchases add carriage inwards less purchases returns).
●● Carriage inwards are charges for the delivery of goods purchased from suppliers.
They will increase the total cost of goods purchased for resale and will therefore
reduce gross profit.
●● Purchases returns will reduce the total cost of goods purchased for resale.
●● Unsold goods at the end of an accounting year (closing inventory) will not
contribute to revenue or the cost of sales that year but will be available to sell in the
following year.
●● Opening inventory consists of unsold goods at the start of an accounting year. The
amount of opening inventory will be the same as the closing inventory from the
previous year. As the opening inventory is sold off it will contribute to revenue and
the cost of sales that year.
●● The cost of goods a business has available to sell in an accounting year will be equal
to its opening inventory plus net purchases during the year. The cost of sales made
during the year will be less than this value if there are unsold goods at the end of the
year (cost of sales = opening inventory add net purchases less closing inventory)
●● Profit for the year (or net profit) is the amount of gross profit remaining after all
business expenses incurred over the same period have been deducted. Profit for the
year is a measure of how successful a business has been at controlling its expenses.
●● If business expenses exceed gross profit the business will have made a loss for the
year (or net loss).
●● Profit for the year not drawn down by the business owners for their own use will
remain in the business. Retained profit increases the value of net assets of the
business. It increases cash in bank or can be used to invest in additional inventory
and non-current assets such as machinery and premises to expand the business.

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 ●● A loss for the year or net loss will reduce cash in bank and therefore reduce net
assets and owner’s capital.
●● It is important for a business with two or more departments to prepare
departmental accounts showing how much profit or loss each department has
made. This is because the losses made by one or more departments will be hidden by
the profits made by others.
●● A departmental income statement can be prepared with a separate column for
each department. To calculate the profit or loss for the year of each department it will
be necessary to allocate business expenses between them. This may be based on the
share of total sales they each generate or in proportion to the floor space each
department occupies.

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3.2 Statements of financial position
●● A statement of financial position (or balance sheet) provides a snapshot of the
financial health of a business at a given point in time. This is usually at the end of an
accounting year. It identifies everything of value the business owns and the total
amount of money it owes to other people and organisations on the same day.
●● The values of assets owned by a business are recorded on the left-hand side of a
horizontal statement of financial position. How they were financed, from owner’s
capital and liabilities, is recorded on the right-hand side. The two sides of a
horizontal statement of financial position must always be in balance.
●● Non-current assets, including machinery and equipment, remain useful for more
than one accounting year but they will lose value or depreciate over time as they
wear out.
●● Non-current assets should be valued at cost less accumulated depreciation between
the time they were purchased and the date of the statement. This is their net book
value.
●● Current assets including inventory, trade receivables and cash at bank and in hand,
will be used up relatively quickly within the next accounting year.
●● Current assets are listed in a statement of financial position in increasing order of
their liquidity – the ease and speed at which they can be converted into cash to
make payments. Cash in hand is the most liquid asset. Inventory is the least liquid
because unsold goods may take time to sell off.
●● Items in an inventory should be valued at cost or their net realisable value if this
is lower. Their net realisable value is the revenue expected from their sale less any
additional selling costs.
●● The value recorded for trade receivables should be net of provisions for doubtful
debts.
●● Current liabilities, such as trade payables and bank overdrafts, must be paid off
within an accounting year. Non-current liabilities are amounts payable or falling
due for repayment after more than one accounting year.
●● The difference between current assets and current liabilities is working capital or
the net current assets of the business. This is the money available to pay ongoing
running expenses. It is a vital indicator of the financial health of a business. A
business with negative working capital will not have enough current assets to
convert to cash to pay its current liabilities as they fall due or to finance ongoing
running expenses.
●● Total assets less current liabilities measures the amount of long-term capital
employed in business assets from owner’s capital and non-current liabilities.
●● The value of the net assets or book value of a business is the difference between its
total assets and total liabilities. It is a measure of the owner’s equity – the remaining
value of the business to its owners after all financial obligations have been met.
●● A business may be sold for more than the book value of its net assets. For example, a
buyer may pay a premium for a business with advantages including a successful
record of trading, a large customer base and good reputation. This premium is called
goodwill. As goodwill has a definite value it can be included in the statement of
financial position of the business as an asset when the sale has taken place.

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 ●● Goodwill is an example of an intangible asset. These are non-financial, non-
physical assets that are difficult to value but give a business a competitive advantage
over rival firms. Intangible assets also include patents, copyrights, registered trade
marks and brand names, Internet domain names and trade secrets.
●● The valuation of inventory is calculated from a physical quantity × its price (each,
per kg, per litre etc.), and this gives its value. Usually this amount will be what we
actually paid for the goods (raw materials or goods for resale). This enables us to
value inventory at its historic cost.
●● Where it is impossible or impracticable to establish a match between a physical
quantity and its actual price, we adopt one of three principal conventions to
establish the value of inventory.
●● First in first out (FIFO) assumes that when we use or sell goods we are using the
first ones to be purchased and any goods left in inventory at the end of the period
are therefore the last ones to be bought.
●● Last in first out (LIFO) assumes that when we sell or use goods we start by using
the ones purchased most recently, working our way back through earlier purchases;
so the ones left in inventory are those purchased in earliest batches.
●● Average cost (AVCO) takes the average cost of all purchases made in establishing
the value of the final inventory.
●● When prices are changing, each method will arrive at a different value. The highest
value of inventory will lead to the lowest cost of sales and highest profit as well
as the highest amount in current assets; the lowest value will deliver the opposite
results.
●● The use of all these methods is allowed in some countries for financial reporting,
while some methods are disallowed in others. In particular US Accounting Practice
allows the use of all methods including LIFO, while International Accounting
Standards do not allow the use of LIFO in published financial statements.

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