All businesses must produce accounts at the end of year to show how much profit or loss they have made. These accounts are known as final accounts.
Different types of business produce their accounts for different purposes. A sole trader with a small business and employing no one may produce simple accounts so that he or she can report their earning to the tax authorities for income tax purposes. A private or public limited company must produce more complex accounts for both tax purposes and to send to shareholders.
Accounts are used in planning and controlling the activities of a business. They provide a measure of the success of a business in achieving its financial objectives. It is the role of the accounting function to gather financial information about the activities and performance of the business and to prepare, interpret and analyze the accounts. We look in detail at interpreting and analyzing accounts in unit 13.
Trading accounts
The first part of the final accounts is called the trading account. This shows the gross profit of the business. Gross profit is the amount left out of sales revenue after the direct costs (the costs of actually producing the goods sold: the labour, raw materials and components, called the cost of sales) have been deducted, but before other costs, such as administration and marketing are taken into consideration.
The profit and loss accountThe gross profit is not final profit of the company. The second part of the final accounts of a business is the profit and loss account. This extends the trading account to show the final profit, the net profit, of the business, taking into consideration all other items of income and expenditure.
What goes into the profit and loss account?While the major part of the income of a business comes from selling goods or services produced, some businesses may receive income from other sources such as: selling assets; dividends or interest from investments; rent from leasing unused land or premises to other businesses.
The expenses that have not been included in the trading account are overheads. These include items such as: salaries and wages (other than for direct labour); office expenses; advertising and marketing; rent and rates; heating and lighting; telephone and postage; insurance; vehicle expenses; depreciation; interest on loans; bank charges; professional fees.
Depreciation is charged to the profit and loss account for large capital items that are not fully written off to profit in the year they are purchased. For example, a car costing $20,000 may be expected to last for four years before the business traders it in and buys a new one. If the full cost of the car is written off against profit in the year it is purchased, this will not give a fair picture of the profit of the business.
Instead, the anticipated trade-in value of the car in four years’ time is deducted from the price paid, and the balance divided by four to arrive at an annual depreciation figure. This called the straight-line method of depreciation, since each year’s depreciation is the same. Therefore if the anticipated resale value of the car is $4,000, the annual depreciation is:
($20,000 - $4,000) $16,000
-------------------------- = ------------ = $4,000 per year
4 4
The appropriation account
Unfortunately, few businesses get to keep all the profit they make even after all their expenses have been deducted. A part of the net profit of a company has to be paid to the government as business tax. Another part must be paid out to the shareholders in the form of a dividend on the shares they own. Only when these items have been paid out can the business retain the remaining profit. These last calls on the profits of a company are added to the profit and loss account in the form of an appropriation account. The appropriation account for Southern Africa Engineering is shown in figure 12.3. The trading account, profit and loss account, and appropriation account are normally incorporated in a single document called the profit and loss account.
Figure 12.3
Southern Africa Engineering plc
Appropriation Account
Year ended 31 March 2001
$’000
1,038
Net profit
Less
Tax 225
Dividend paid 391
----------
Retained profit 422
The balance sheet
The last part of the final account of a business is the balance sheet. This shows the value of the business in financial terms at one moment in time (unlike the profit and loss account which shows the activities of the business over a period of a year). Items included on the balance sheet are:
• Assets – everything that the business owns that has a monetary value, including debtors, or money owed to the business.
• Liabilities – everything the business owes to other businesses or individuals and has a monetary value
• Capital – money that is invested in the business.The balance sheet for Southern Africa Engineering is shown in figure 12.4. Although there is no set format a balance sheet (as long as it includes all the appropriate items) the format of Southern Africa Engineering’s balance sheet is fairly standard.
Southern Africa Engineering plc
Balance Sheet
Year ended 31 March 2001 $’000 $’000
Fixed assets 1,556
Land and buildings 83
Plant and equipment 23
Furniture and furnishings 1,662
Current assets 53
Stocks 2
Debtors 5
------
Cash 60
Creditors failing due within 1 year 6
------
Net current assets 54
Creditors failing due after more than
1 year (bank loan) - 75
------
-21
---------
1,641
Capital and reserves
Called up share capital 1,219
Profit and loss account 422
(retained profit) ---------
Capital employed 1,641
What is the purpose of accounts?
Accounts are produced for several purposes: the business can assess its own performance and compare it with previous years and other companies; the tax authorities can use the accounts for taxation purposes; other companies can compare their own performance with the business; shareholders and lenders can see how well the company is doing and see how secure their investment or loan is.
Summary
• All businesses produce final accounts.
• The first part of the final accounts of a business is the trading account, which shows the gross profit.
• The profit and loss account extends the trading account to show the net profit of a business, taking into consideration all source of income and expenditure.
• The appropriation account shows how much of the net profit of a business is paid to the government as business tax, to investors as dividends, and retained within the business.
• The balance sheet is a statement of the net worth of the business, taking into consideration assets, liabilities and capital.
Glossary
Trading account: the first part of a profit and loss account, showing the gross profit of a business
Gross profit: sales revenue less cost of goods soldProfit and loss account: a statement of the amount of profit or loss made by a company over a period, taking into consideration all sources of income and expenditure
Net profit: sales revenue less total costs.Appropriation account: the last part of the profit and loss account, which shows how much of a company’s profit is paid in tax and dividends
Balance sheet: a statement of the worth of a company Resource: Chris J. Nuttall, IGCSE Business Studies, Cambridge University 2002
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