Financial statements

Profit and loss account

Now usually referred to as an income statement

Identifies profit for an accounting period

An alternative indicator of financial health

Balances are again extracted from the accounts

Largely in the form of costs or charges

Prepared on accruals basis

Profit = revenue - costs

Revenue

The income of the enterprise within period

Sales during the period on the accruals basis

Not actual cash inflows

The expectation is a truthful figure reported

•       overstate – mislead third parties

•       understate – reduce the tax bill

Strongly reliant on trust

Cost of sales

A self explanatory idea

How much it costs to make sales

Link with the balance sheet – stock value

•       add opening stock, deduct closing stock

Cost of sales differs by type of business

•       retailers – bought in goods

•       manufacturers – materials

•       service providers – a lower proportion

Operating expenses

The many different expenses/charges

Carefully recorded in the ledgers

Use cumulative total costs for period

Labour costs normally identified first

•       wages and salaries

•       ‘uplift’ costs – tax and social insurance

•       pension provisions

The additional charges against revenue

•       utilities

•       rent and rates/local taxes

•       telephone, postal, internet charges

•       insurance

•       lease payments

•       professional fees

Adjust for any prepayments or accruals

Depreciation

Charge for the use of fixed assets

Do not charge the whole cost at purchase

Write-down over time

•       flow through principle

Distinct from capital allowances

•       amounts allowed for taxation purposes

•       adjustment through balance sheet

Amortisation of intangible assets

A number of different approaches used

•       straight line – simple, equal write-downs

•       reducing balance – same % each year

•       usage – per hour, per mile, per activity

Need to consider both

•       useful (envisaged) life

•       residual value

Write-back any gain at sale through accounts

Interest

In addition charges for interest payments

•       overdrafts

•       bank loans

•       personal loans

•       debentures and preference shares

These charges are in addition to capital sums

Recognised costs of doing business

Profit

In practice many different profit concepts exist

•       gross profit

•       operating profit

•       profit for year

A fourth measure is highly insightful

•       PBIT – profit before interest and taxation

•       adjust for depreciation and interest charges

Allows comparison between different enterprises

Dividends

Payments to shareholders

The reward for being prepared to take a risk

Usually a nominal amount per share

Dividends are not charges but deductions

Deductions set against profit

Strict rules exist about how much dividend paid

Dividends result in cash outflow from enterprise

After dividends are paid

•       retained earnings

Transferred to the balance sheet

Has the effect of increasing the owners’ equity

In large enterprises impacts market value

Where losses occur, retained earnings reduce

Market values may also fall prompting sale

Drawings

An interesting financial convention

Removing ‘value’ from a (small) business

•       taking cash from a till or bank account

•       taking food, drink, clothes, etc

Their value must be added back to profit

Provides a true profit figure

Adjust any retained earnings and current assets

Cash

All businesses need cash to function

•       more specifically access to cash (at bank)

Constant need to make cash payments

•       to employees

•       to suppliers

•       to government

•       to shareholders

In the absence of cash a business will flounder

Accruals convention

Profit is the excess of revenue over expenses

Within a specific accounting period

As represented in the income statement

No suggestion this equates with cash position

•       revenue includes debtors

•       expenses include creditors

Matching in a period on accruals convention

You might ask why?

Accruals accounting is viewed as enabling

Reflects the reality of doing mature business

•       reasonable expectations

•       coupled with ‘trust’

Accounting periods are a social construction

They are imposed upon economic activity

Accruals convention allows accomodation

Cash and cash equivalents

Have already distinguished cash and bank

In addition there are cash equivalents

•       very liquid current assets

•       short-term investments

As well as being readily convertible (‘cashable’)

Should not reduce in value

Premium bonds are probably best example………

Statement of cash flows

A relatively recent requirement

Albeit with a long history

During my own qualification years we had SSAFs

Now long forgotten (an interesting attribute)

1992: International Accounting Standard (IAS) 7

Mandatory requirement from 1994

Must include a CFS within financial statements

Purpose is to identify (visualise) for a period

Change in cash/equivalent balances

Complements the B/S and P&L account

Identifies three different cash flows

•       cash flows from operating activities

•       cash flows from investing activities

•       cash flows from financing activities

In sum: net increase/decrease in cash/equivalents

Operating activities

Cash inflows and outflows for operations

•       actual revenue from cash sales

•       cash from debtors

•       actual payments for goods/inventory

•       payments to creditors

•       wages and salaries

•       taxes collected and forwarded

•       interest payments and dividends

Investing activities

This is where you find capital investments

•       outflows to purchase fixed assets

•       one-off cash payment or instalments

Also include income from sale of such assets

•       not profit on sale – through the P&L

In addition any investments in other businesses

Complemented by any income generated

Financing activities

Businesses also experience cash flows when

•       issuing shares (net inflow)

•       redeeming shares share (outflow)

•       taking on long term loans (inflow)

•       paying off long term loans

Might elect to include dividend payments here

Highlights long term health of a business

In combination

Each element provides a different visibility

Requirement to utilise all three

Later 1970s/1980s interest in a fourth statement

•       value added statement

Re-presents information to identify

How value added is distributed to stakeholders

In some quarters regarded as problematic