P14B28

International Accounting
Lecture 2
The Principal Financial Accounting Statements

Today, we will introduce:

Principal financial statements

Balance sheet, or statement of financial

position (SOFP)

Profit and loss (P/L), or Income statement (I/S), or

Statement of financial performance (SOFP)

Cash flow statement or Statement of cash

flow (SOCF)

The Major Financial Statements

Balance sheet
Income statement
Cash flow statement

shows how the wealth of

the business is made up
(assets less liabilities) at
a particular point in time
reports the profit or loss
(change in wealth of the
business) for the time
period
provides information on
cash (both cash in and
cash out of the company)
over a particular time
period

Class Activity
Paul is unemployed, but
sees a business opportunity
selling Christmas wrapping
paper in his local high street
in Manchester
He has 40 cash to start his
business
On Monday he buys
wrapping paper for 40 and
sells of it for 45
What cash movements
took place on Monday?
4

Cash flow statement for Monday

Opening cash balance (cash introduced)

40

Add Cash from sales of wrapping paper

45
85

Less Cash paid to buy wrapping paper

Closing cash balance

(40)
45
5

How much wealth (profit) was generated

by the business?
Income statement (profit & loss
account) for Monday

Sales revenue
Less Cost of goods sold (3/4 x 40)

Profit

45
(30)

15
6

What is the accumulated wealth at

Monday evening?
Balance sheet as at Monday evening
(statement of financial position)

Cash (closing balance)

45

Inventories of goods for resale (1/4 x 40)

10

Total business wealth

55
7

Tuesday
On Tuesday, Paul bought
more wrapping paper for
46 cash.
It rained hard (a typical
Manchester day)
After Paul had sold all of
the old inventories and
only half of his new
inventories for 78, he
stopped for the day.
What will the cash flow
statement, the income
statement and the balance
sheet be for Tuesday?
8

Cash flow statement for Tuesday

Opening cash balance (from Monday

evening)
Add Cash from sales of wrapping paper

Less Cash paid to buy wrapping paper

Closing cash balance

45
78

(46 )
77
9

How much wealth (profit) was generated

by the business?
Income statement (profit & loss
account) for Tuesday

Sales revenue
Less Cost of goods sold 46*1/2+40*1/4

78
( 33 )

- i.e. Opening stock (40*1/4) + Purchases (46) - Closing stock (46*1/2)

Profit

45
10

What is the accumulated wealth at

Tuesday evening?
Balance sheet as at Tuesday evening

Cash (closing balance)

77

Inventories of goods for resale (46*1/2)

23

Total business wealth

100
11

Relationship between the balance sheet, income

statement and cash flow statement
Balance sheet at the
beginning of Period 1

Balance sheet at the

end of Period 1

Balance sheet at the

end of Period 2

Income statement 1

Income statement 2

Cash flow statement 1

Cash flow statement 2

Period 1

Period 2

Time

12

Balance Sheet a template

A snapshot of the company - what the business owns and owes, with an accounting
book value of the equity interest

Balance sheet as at 31 December 20XX

ASSETS

Non-current assets
Tangible assets
Intangible assets

Current assets
Inventory
Receivables
Cash

Total assets

xxx
xxx
xxxx
xxx
xxx
xxx

xxxx

EQUITY AND LIABILITIES

Equity
Share capital
Retained earnings

xxx
xxx

Non-current liabilities
Loan

xxx

Current liabilities
Trade and other payables
Total equity and liabilities

xxx
xxx
xxxx

13

The balance sheet equation

plus

equals

Assets

Capital

Liabilities

14

Assets
Major characteristics

A probable future benefit exists

The business has an exclusive right
to control the benefit

The benefit must arise from some past

transaction or event
The asset must be capable of
measurement in monetary terms

Examples:
Buildings
Motor vehicles
Computer
equipment
Inventories
Trade receivables
(debtors, money
owed)
Cash
15

The classification of assets

The classification of assets may
vary according to the nature of
the business:

Current assets

Non-current assets

16

Current Assets
Assets that are held for the short term
Have ANY of the following
characteristics:
Held for sale or consumption in the
normal course of business
Expected to be sold within the next year
Held primarily for trading
Cash or near cash

Common examples
Inventories (stock)
Trade receivables (debtors)
Cash

17

Non-current Assets
Assets that are held for
the long term
Examples

Land
Buildings
Plant &equipment
Vehicles
Computers

18

Claims
There are essentially two
types of claim against
a business:

Capital

Liabilities

Resources put into the business

by the owner (Owners equity,
shares)
Profits earned in the business
Claims of other individuals and
organisations against the
business that have arisen from
past transactions or events.
Examples include loans and
trade payables (creditors)
19

The classification of claims

Current liabilities

Non-current liabilities

20

Current Liabilities

Non-current Liabilities

Amounts due to be paid in Amounts due to be

the short term
paid after more than
Have ANY of the following
1 year
characteristics:
Expected to be settled in
the normal course of
business
Expected to be settled
within the next year
Held primarily for trading

Examples
Long-term loans
Debentures

Examples

Trade payables (creditors)

Bank overdraft
21

Tom and Company

Tom and Company start a business by depositing 14,000 in a bank
account on 1st October. This amount was raised partly from the
owner (3,000) and partly from borrowing (11,000).
Assets
Cash at bank

Transactions
2 October
3 October
4 October
5 October

SOFP as at 1st October

Claims
14,000
Capital (owners equity)
_____
Liability (borrowings)
14,000

3,000
11,000
14,000

Bought 5,000 inventories on 1 months credit

Owner introduced 6,000 into business bank account
Bought 2nd hand car for 3,000, paid by cheque
Repaid lender 4,000 by cheque

Activity: Draw up SOFPs as at the end of each day

22

SOFP as at 2nd October (Bought 5,000 inventories on 1 months credit)

Assets
Inventories

Cash at bank

Claims
5,000 Capital (Owners equity)

14,000 Liability (trade payable)

3,000

5,000

______ Liability (borrowings)

11,000

19,000

19,000

SOFP as at 3rd October (Owner introduced 6,000 into business bank account)
Assets
Inventories
Cash at bank

Claims
5,000 Capital (Owners equity)
20,000 Liability (trade payable)

9,000
5,000

______ Liability (borrowings)

11,000

25,000

25,000
23

SOFP as at 4th October (Bought 2nd hand car for 3,000, paid by cheque)

Assets

Claims

Car

3,000 Capital (Owners equity)

9,000

Inventories

5,000 Liability (trade payable)

5,000

Cash at bank

17,000 Liability (borrowings)

11,000

25,000

25,000

SOFP as at 5th October (Repaid lender 4,000 by cheque)

Assets

Claims

Car

3,000 Capital (Owners equity)

9,000

Inventories

5,000 Liability (trade payable)

5,000

Cash at bank

13,000 Liability (borrowings)

21,000

7,000
21,000

Assets = Capital + Liabilities always hold

In practice, we dont draw up a balance sheet every day, we just draw one up at
the end of a suitable accounting period
Usually monthly/quarterly for management accounting, half-yearly/annually
for financial accounting

24

The effect of trading operations on the SOFP

On 7th October the business sells all the inventories for 7,000
cash, what is the effect on the balance sheet?
SOFP as at 5th October (Opening Balance)
Claims

Car

3,000 Capital (Owners equity)

9,000

Inventories

5,000 Liability (trade payable)

5,000

Cash at bank

13,000 Liability (borrowings)

21,000

Increase in wealth (profit)

Assets

7,000

21,000

SOFP as at 7th October

Assets
Car
Inventories
Cash at bank

Claims
3,000 Capital (Owners equity)
0 Liability (trade payable)
20,000 Liability (borrowings)
23,000

11,000
5,000
7,000
23,000

25

Relationship between the

income statement and the balance sheet
The Accounting/SOFP equation can be extended as follows:

Assets

Capital

+
()

Profit
(Loss)

Liabilities

The above equation can be extended to:

Assets

Capital

Sales
revenue

Expenses

+ Liabilities

26

Income statement a template

Gross profit

Income statement for

the year ended 31 Dec 20XX
Revenue
Cost of Sales
Gross profit
Expenses
Operating Profit (EBIT)
Interest charges
Profit before taxation
Taxation
Profit after taxation

The difference between

revenue and cost of sales

xxxxx
xxxx
xxxx
xxxx
xxx
xxx
xxx
xxx
xxxx

Operating profit
Gross profit less expenses
(overheads) incurred in
operating the business
Represents the wealth
generated from operating
(trading) activities

Profit for the year

Operating profit
+ any non-trading income
- costs of financing the
business

27

Income Statement - Measuring profit

Profit
(or loss)
for the
period

Total revenue for the period

less
Total expenses incurred in generating that revenue

28

Profit measurement and the recognition of revenue

Basic criteria that must be met before
revenue is recognised:

The amount of revenue can be measured

reliably.

It is probable that the economic benefits

will be received.

An additional criterion to be applied where the revenue

comes from the sale of goods:
Ownership and control of the item should
pass to the buyer.

Profit measurement and the recognition of

expenses
Application of the Matching Convention
Expenses should be matched to the revenue they
helped to generate
I.e. an income statement should include all
expenses incurred in generating the reported
revenue
This means that an expense item reported in the
income statement may be different to the figure
of cash paid for that item during the period

30

Prepayment - Expense paid is LESS THAN

cash paid during the period
Items such as rent and insurance tend to be paid in
advance
Example: AKA Ltd pays rent quarterly in advance. On
30.9.12, the last day of its accounting year, it paid
rent of 4,000.
This means that a total of 5/4s of rent have been
paid over the year
Applying the matching concept, this amount needs
to be removed from the current years expenses and
shown as a Prepayment on the balance sheet

31

Accounting for Prepayment

Income statement

Cash flow
statement

Rent payable expense

16,000

Balance sheet
at year end

Cash 20,000

Prepaid expense
4,000
32

Accruals - Expense paid is GREATER THAN

cash paid during the period
AKA Ltd pays its electricity bills on a quarterly basis
So far for the year ended 30.9.2012 it has paid bills amounting to
7,600
It has not yet received the bill for the final quarter (01.07.2012 30.09.2012), but expects it to be around 2,000

What figure should it show as an expense in its income

statement?
It shows 9,600, including the amount still to be paid, since the
electricity relates indirectly to the sales revenue generated during the
year
The amount of the outstanding bill (2,000) represents a liability at
the balance sheet date and must be recorded as an Accrued Expense
on the balance sheet. This treatment reflects the dual aspect of the
item and ensures the balance sheet equation is maintained.
33

Profit measurement and the calculation of

depreciation
Most non-current assets have a finite life as they get
used up in the process of generating wealth for the
business
Can anyone suggest one that doesnt?
Depreciation is an attempt to measure the
proportion of the non-current asset used up to
generate the revenue recorded for the current
accounting period
It is recorded as an expense of the period and applies
to both tangible and intangible non-current assets
34

Profit measurement and the calculation of depreciation

To calculate a depreciation charge for a period, four

factors have to be considered:

The cost (or fair value) of the asset

The useful life of the asset

The residual value of the asset

The depreciation method.

35

Depreciation method
The business must select a suitable method of
allocating the amount to be depreciated (cost
or fair value, less any residual value) over the
accounting periods covering the non-current
assets useful life
The two most commonly used methods are:
Straight line
Diminishing balance / Reducing balance

36

Example
Westbrook Ltd buys a car for
10,000. It expects to keep it
for 4 years and then sell it for
256.
Calculate the depreciation
expense under
(a) the straight line method
(b) the diminishing balance
method

37

Depreciation calculations
Straight line method
Same amount is charged each year
Depn expense = Cost - residual value
No. of expected years life
In example:
10,000 - 256
4

= 2,436 each year

38

Depreciation calculations
Diminishing balance method
Deducts a fixed percentage from the cost in the first year,
and from the reduced balance (i.e. cost less depreciation
already charged) in subsequent years
This means higher depreciation charges in earlier years
and lower charges in later years

P = (1 - nR/C) x 100%
Where
P = depreciation percentage
n = useful life of asset in years
R = residual (scrap) value of asset
C = cost or fair value of asset
39

Diminishing balance e.g.

P = (1 - nR/C) x 100% = (1 - 4256/10,000)
= 1 4/10 = 0.6 or 60%
Depreciation applied to each of the 4 years:
Cost
Year 1: Depreciation charge 60% x cost =
Carrying amount
Year 2: Depn charge 60% x carrying amount
Carrying amount
Year 3: Depn charge 60% x carrying amount
Carrying amount
Year 4: Depn charge 60% x carrying amount
Carrying amount

10,000
(6,000)
4,000
(2,400)
1,600
( 960)
640
( 384)
256
40

Cash flow statement a template

Provides a summary of the cash that has come in (receipts) and

the cash that has gone out (payments) in the accounting year
Cash flow statement for the year ended 31 Dec 20XX
Net cash from operating activities
xxxxx
Cash flows from investing activities
Purchases of property
Proceeds of sale of equipment
Net cash from investing activities

xxxx
xxxx
xxxx

Cash flows from financing activities

Proceeds from issue of shares
Dividends paid
Net cash from in financing activities

xxx
xxx
xxx

Net change in cash

Cash at the beginning of period
Cash at the end of period

xxx
xxx
xxxx

41

 You will be relieved to know that in the final exam

you will not be asked to prepare financial statements.
However you will have to analyse the financial
statements and this tends to be difficult if you have
no idea where the numbers come from. Also it is
compulsory to do at least one computational
question in the exam!
PRACTICE QUESTIONS in Collis et al. (2nd)
P153 Q4 & Q5
P179 Q4 & Q5
Solutions for the textbook practice questions can be
downloaded from Moodle
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