3.5 Final accounts

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Learning Outcome
Explain the purpose of accounts.
Construct and amend accounts from information given.
Evaluate the importance of final accounts to each stakeholder group. (Students will not be tested on the manufacturing account or double entry.)
Accounts for Limited Companies (Income Statements)
Accounting is one area that students of the IB Diploma in Business and Management avoid most. The IBO has therefore reacted by ensuring that this section is represented in the compulsory questions of Paper I. However, for the student wishing to do well in this area of their studies, it is wise to note that this is the least subjective topic among the others in the syllabus. With a little effort Accounting will not only be easily understood you, but it will also serve you on a day to day basis in everyday life.
Just as personal accounting helps you make decisions on what to save or spend, the main purpose of business accounts is to also provide external stakeholders with the relevant information needed to make decisions. There are three different types of final accounts that are prepared and you should be familiar with the distinctions between each one of them.
Management Accounting also referred to as Managerial Accounting, is the documentation of information for management. This type assists these internal stakeholders in making decisions that will improve operations.
Tax Accounting is exactly as the name infers. It is accounting for tax purposes. This type of accounting assists internal stakeholders by anticipating the effect of taxation on the business and thereby seeks to minimize the effect through proper tax planning. Tax Accounting is not the preparation of tax returns.
Financial Accounting is the area of accounting that the IB diploma student is concerned with. In Financial Accounting we will look at all the inflow and outflows related to the economic activity of the Business Organization. The resources and debts of the business are categorized and different techniques are used to measure these resources and their relation to the economic activity in the Business organization. Accounting is how these economic activities are measured and communicated to the stakeholders.
There are three Financial Sheets that exist in Financial Accounting. These are the Balance Sheet, the Cash Flow Statement and the Income Statement. In the IB Diploma for Business and Management, the Cash Flow Statement is not part of the syllabus. But as the name suggests it records the flow of cash in the Business. Do not be confused by the names given to the Accounting statements. Because different countries have different standards of accounting, the names also vary. Standardization of Accounting practices is the process by which all Accounting will reflect the same format. We begin by looking at the Income statement also referred to as the Profit and Loss Account. The Profit and Loss Account has two complimentary components that need to be understood, the Trading Account and the Appropriations Account.
Trading account
Let us begin with this simple means of recording Gross Profit in the business. Once a good is sold for a set price, the Sales revenue that has bee collected must be accounted or recorded. Sales Revenue is therefore the price of each good times the quantity sold.
Price of the Good x Quantity of the Good sold = Sales Revenue (Total Revenue)
One method of recording the transaction is by showing the sales revenue earned relative to the cost of producing the product, also referred to as the Cost of Sales. The Trading Account is a means of measuring profit. The Trading Account shows operating profit by subtracting cost of sales from Sales revenue.
Sales Revenue – Cost of Sales (production costs) = Gross Profit
We refer to profit as being Gross because not all expenses have been included. Remember that even though a Business will have expenses related to the Production of the goods (which we called cost of Sales), there are also other expenses, such as office rent or paying for advertisement. Although these expenses are not directly related to making the product, they are indirectly related. We therefore use the terms direct expenses and indirect expenses (or Overheads).
Profit and Loss account
The Profit and Loss Account also called the Income Statement is similar to the aforementioned Trading Account, while the Trading account calculates Gross Profit (the profit earned before all other expenses have been deducted) the Profit and Loss account calculates net profit (the profit after all indirect expenses have been deducted from the Gross Profit).
Gross Profit – Indirect Costs (Overheads) = Net Profit
Therefore the Profit and Loss Account takes into consideration all other expenses that the business has incurred included the Cost of Production (Cost of Sales). The P&L (an abbreviation for Profit and Loss) reflects a period of time in which the Business Organizations economic activity took place and reflected these inflows and outflows for a period ending on a specific date.
Profit and Loss Account
ABC Republic Stores Inc. Year ending 31st June 2011 ($'000's)
Sales
100
Cost of sales
50
Gross profit
150

Expenses
10
Depreciation
5
Net profit
135

Interest
10
Profit before tax
125
Taxation
5
Profit after tax
120
Dividends
20
Retained Profit (Articulation - Balance sheet)
100
Appropriation account
Once the net profit has been determined in the Profit and Loss account, the net profit is distributed. The role of the Appropriation Account is to record how the net profit is distributed (or appropriated). This distribution could be towards dividends or payment to shareholders and reserve accounts or retained earnings. Therefore the appropriations account is prepared after the Profit and Loss account.
Balance sheets
We have explored one final account thus far and now we move on to the second one that you are required to learn about. The Balance Sheet is best known as a snap shot of the accounts of the business, because it reflects the position of the company at a particular point in time. It is similar to a photograph of the financial status of a business.
The Balance Sheet reflects information on three elements of the Business Organization.
1) Assets
These are resources that the business owns and that can be used towards created additional productive activity. These are usually classified as Current Assets and Fixed Assets. Current Assets, such as raw materials and cash are the resources that are used towards production within the year. Fixed Asset, such as machines, buildings, desks and chairs are used repeatedly and also help in the production process.
2) Liabilities
These are the debts or obligations of the business. What is owed to other entities are used to created productive activity and must eventually be repaid. The repayment is either within the year, Current liabilities, such as a bank overdraft or short-term loan or long term, such as a mortgage or a long-term loan that is not due within the year.
3) Owners Equity
Also known as Share Capital, this is what has been provided by the owners of the business in the form of initial start-up capital. Owners Equity will also reflect the reserves of the business profit that has been retained.
The above information on the Assets, Liabilities and Owners Equity can be shown via two methods. Account Format and the Report Format. You will learn both formats but should be aware that in the even that a balance sheet is provided in the examination it will be in the Report Format.
Before we look at the format in which to structure the financial sheet, you will need to fully understand all its contents and how they are reported.
The Balance Sheet is a financial sheet that, as the name suggests, balances with the calculation of various parts. This is because of the double entry accounting approach used to make adjustments in order that
Assets = Liabilities + Owners Equity
Students of the IB Diploma do not need to be familiar with double entry accounting or with the accounting cycles accruals, deferrals and adjustment of entries. Journal entry and T-accounting are also not a part of the IB Syllabus. However, there is the expectation that students will be familiar enough with the entries that they are able to reconstruct the financial sheets in given exercises.
Once we are familiar with the entries, positioning them in their proper order will be followed by simple mathematical calculations of addition and subtraction. Therefore the task lies in being familiar with the structures and intimate with the entries.
The Account Format
In this format, the balance sheet assumes that the Assets are always to the left of the sheet and the Liabilities and equity to the right. Therefore the total claims of the owners and debtors will equal the value of all the assets.

Assets = Liabilities + Owners Equity
250,000 = 100,000 + 150,000

ABC Republic Stores Inc.
Balance Sheet
June 31, 2011
Assets
Liabilities and Owners Equity
Cash
15,000
Liabilities:

Accounts Receivable
10,000
Accounts payable
20,000
Stock
25,000
Long term Loan
80,000
Land
100,000
Owners Equity:

Buildings
100,000
Capital Stock
50,000


Retained Profit (Earnings)
100,000








Total
250,000
Total
250,000
If the Owners Equity is unknown but the Liabilities and Assets are provided, it is easy to determine the aforementioned through the formulation

Owners Equity = Assets - Liabilities
= 250,000 - 100,000
= 150,000

Assets also include other intangibles such as Goodwill, which we shall take a closer look at further in the reading.
The report format of the balance sheet is not difficult to understand. The structure is as follows.
ABC Republic Stores Inc.
Balance Sheet
June 31, 2011(000’s)
Fixed Assets


Land
100

Building
100

Total

200



Current Assets


Cash
15

Accounts Receivable
10

Stock
25

Total

50



Current Liabilities


Accounts Payable
20

Total

20



Net Current Assets

30 (CA – CL = Net CA)
Net Assets

230 (FA+CA – CL= Net Assets)



Share Capital

50
Loan Capital

80
Retained Profit

100
Capital Employed

230 (SC+LC+RP=CE)

To correctly construct the balance sheet in the report format the following steps need to be followed.
1. The fixed assets need to be identified, itemized and summed up.
2. The current assets in turn need to be identified and summed up.
3. Note the current liabilities and summed them up.
4. The value for the net current assets is the determined by subtracting the current liabilities from the current assets (50,000 – 20,000 = 30,000)
5. The total assets less current liabilities are determined by adding all the fixed assets and current assets and then subtracting the current liabilities (200,000 + 50,000 = 250,000 - 20,000 = 230,000)
6. Determine the Capital Employed by adding the long term share capital, loans, and retained profit (50,000 + 80,000+ 100,000 = 230,000)
The Total Assets Less current liabilities will be equal to the Capital Employed.
Depreciation
Learning Outcome
Calculate depreciation using straight line and reducing balance methods.

Evaluate the strengths and weaknesses of each method.
In trying to understand the concept of depreciation, consider the fact that all assets have a useful life span and that at a particular point they start losing value and usefulness. Eventually these assets will no longer function and we will discard them. A perfect example is a brand new car that over the years is used and serves the purpose of transporting you and your family wherever you want to go. However, after five or 10 years the car starts to develop engine trouble every once in a while and perhaps the doors stop opening and closing as well as they used to in the past. We can therefore say that the car has started to depreciate in its value and its usefulness has decreased.
In accounting, the concept of depreciation is applied to all assets that are used in the production process. The amount of depreciation is considered a cost that is spread over the useful life of the asset. Therefore, in accounting, the loss of usefulness is offset against the revenue in each period of the assets useful life.
It should be clear that depreciation is only an estimate. Certain assets depreciation is value faster than other. For example a car that is used as a taxi will depreciate in both value and usefulness faster than an office building, due to the very nature of wear and tear. Because of the loss in value, depreciation is allocated as an expense over the assets lifespan.
If you came upon the conclusion that Price times quantity equals revenue and revenue less costs or expenses equal profit, then the higher the costs or expenses the higher profits. Depreciation is a non-cash expense and sometimes represents that largest difference between net income and cash flow from operations. As an expense it is tax deductible and therefore, it becomes clear that the declaration of depreciation will increase the Business Organizations profitability.
In calculating the depreciating value of an asset, there are different methods used to estimate this loss of usefulness. Because of the temptation to overstate depreciation, there are published guidelines on the depreciation rates for various assets.
The most widely used method of calculating depreciation is the Straight Line method of depreciation.
The Straight-Line Method of Depreciation.
In this method the assets purchase cost is allocated to an equal proportion of the assets estimated useful life. In addition, because at the end of its usefulness the asset may have a scrap or residual value this must also be computed through a deduction of the scrap value from the cost. The formula is therefore as follows:

Cost − Salvage Value / Life in Number of Periods = Depreciation

If we were to assume that the family car was purchased at a cost of $19,000 and if we were to use it for the 8 years it would no longer function, but we could sell the junk for $2,000, our depreciation per year would be:

19,000 - 2,000 / 8 = $2,125 per year


Most accounting practices require that the depreciation method result in a rational determination of the assets useful life. However, because of the difficulty in estimation and shorter useful life spans, accelerated depreciation implies that a greater depreciation will take place in the earlier years of the assets useful life. Nevertheless, the total depreciation would be the same in both the straight-line and accelerated depreciation method.
There are various acceleration methods that will all produce various results. The Reducing balance method is a fixed-percentage-of-declining-balance depreciation.
The Reducing Balance Method
Again lets assume that our family car has an estimated life of 8 years and the purchase cost of $19,000. In this calculation we compute a specified percentage of the straight-line depreciation method. The annual percentage is then determined by applying the accelerated depreciation rate to the non-depreciated cost (or book value) of the asset.
The formula is as follows:
Depreciation Expense = Remaining Book Value x Accelerated Depreciation rate
Reducing Balance Depreciation Method
Year
Computation
Depreciation Expense
Accumulated Depreciation
Book Value
1
19,000 x 10%
1,900
1,900
17,100
2
17,100 x 10%
1,710
3,610
15,390
3
15,390 x 10%
1,539
5,149
13,851
4
13,851 x 10%
1,385
6,534
12,465
5
12,465 x 10%
1,246
7,780
11,219
6
11,219 x 10%
1,121
8,901
10,098
7
10,090 x 10%
1,009
9,910
9,081
8
9,081 x 10%
908
10,818
8,173
Total
10,818
As noted above the depreciation percentage rate remains constant for the entire lifespan of the asset. The book value decreases each year and is eventually calculated as costs less accumulated depreciation. This is what is referred to as the declining balance. Students of the IB Diploma in Business and Management will be tested for their ability to calculate for the Depreciation and ending Book Value using both methods.
In order to evaluate the depreciation methods that have been presented, students will need to understand the strengths and weaknesses of each method.
Strengths and weaknesses of the Reducing Balance Method
Because the accelerated depreciation methods can reflect a higher depreciation expense earlier in the life of the asset, the result is a lower reported net income as compared to the straight-line depreciation method. As an end result for income tax declarations, the accelerated depreciation method will result in the companies tax payments being lower. This is a distinct advantage towards increasing working capital since lower tax payments do account for greater cash flow.
This method takes into account that some assets lose value at a faster rate than others, therefore more accurately reflects book value.
Although depreciation is considered an expense, it is still only an estimate and therefore does not reflect the financial strength of the business.
Strengths and weaknesses of the Straight-Line Depreciation Method
This is a simple method of calculating book value and because a similar amount is deducted each year the accounting process is less complicated.
It is important to remember that assets lose value at different rates. Because the Straight-Line method holds depreciation as constant over the useful life of the asset, its weakness is that it does not accurately reflect the depreciable expense.
Similar to the other method, the Straight-line depreciation is still only an estimate and therefore does not reflect the financial strength of the business. Regardless of the depreciation method used. The fact that an estimate cannot fully reflect accuracy attests to the weakness in both methods.
Other methods of calculating depreciation methods include the Units-of-output method, MACRS (or Modified Accelerated Cost Recovery System), SYD (or Sum-of-the-years” digits and Decelerated Depreciation Methods. For the IB Diploma student, only the Straight-Line and declining or reducing balance method are required for the calculation of depreciation.


Intangible assets
Learning Outcome
Explain the meaning and value to the firm of different types of intangible assets.

Understand the difficulties associated with valuing intangible assets.
We have learned that a Business Organization has assets that are fixed and that are current. In addition, it should be now clear how these assets act as resources for the business. However, there are other forms of assets that we also need to identify. What we have continually referred to in the previous readings are assets that we can touch and feel. These are referred to as tangible assets. Raw materials such as those used in the production process are clearly tangible assets.
However we also have value that is associated with another form of asset that is intangible. These therefore have no discernible physical properties. Nevertheless, in the process of generating economic activity these intangible assets have value and play an important part in the Production and Marketing activity of the business.

Goodwill
Goodwill is the intangible asset that provides a competitive advantage for a business. There are various forms of goodwill and we generally associate them in the form of brands, such as Coca-Cola (valued at approximately $USD 58 billion), the Nike Swoosh symbol, and the MacDonalds golden arches in the form of an M (valued at approximately $USD7 Billion). Goodwill is calculated in various ways, however the accepted fundamental approach is a difference between the market value (or Purchase price) and the value of the net tangible assets.
Patents and copyrightsWhen an invention is prepared for the market through innovation, the business is interested in making a profit and ensuring that the costs of development and marketing are recovered. The government provides some assurance that the costs of innovation are recovered through protective acts of law. The primary motive for this protective act is in that governments have the interest of ensuring that Business Organizations continue being inventive and creative. As you would undoubtedly agree most inventions have contribute towards economic growth and raised the standards of living in society (most inventions not all).
With this in mind, the ideas of the inventor are referred to as intellectual property. Like the very notion of property itself, it can be owned and other claims to it are thereafter prohibited.
A Patent is one form of Intellectual property protection that is realized through the filing of documents and blue prints showing detailed explanations of physical product that has been invented (such as the Jet ski which was manufactured by Kawasaki heavy Industries but invented by Clayton Jacobson). The Jet Ski is now manufactured by other companies and is no longer under the protection of a patent. Although the patent has a limited protection period, it allows the inventor, manufacturers and business to recover and profit from the invention before competitors duplicate the product upon expiration of the patent.
A Copyright is also a different form of intellectual property, however it is in the protection of literary, musical, or artistic work. The symbolic © indicates that the intellectual property is protected by laws and that duplication is subject to legal consequences. However, with the advent of the Internet and proliferation of technology, these protections have proven difficult to enforce. Depending on the laws of any given country, copyrights expire after 20 or 70 years and can be renewed under certain conditions. Most copyrights protection acts that you are exposed to have to do with books, such as this one, Music, pictures and other artistic works.
Brands
The most recognizable form of intellectual property or goodwill is the Brand. Because business organizations pursue marketing objects aggressively, brand exposure occurs on a daily basis. Consider the fact that you are likely to find at least three brands on your desk, beginning with your computer. A brand is a name, logo, symbol, or any design or distinguishable feature that will allow you to identify a product or service from the competition. As mentioned previously the golden arches of MacDonalds alert everyone that their particular fast food is different from all others. Children, teenagers and adults alike respond to this by expressing loyalty and preference when they hear the tunes in marketing songs, see the golden arches, and over time find themselves comfortable with a visit, or more, to the fast food franchise.
As more revenue is generated from the marketing activities involving brands, the brand value increases.
Stock valuation

Learning Outcome
Make calculations of closing stock using LIFO and FIFO.

Calculate the effect of different stock valuations on profit.
As a firm engages in economic activity, resources known as raw materials are used to produce finished goods. In the process of preparing for production the raw material, also referred to as Stock or Inventory, is stored in a warehouse. Although we will also see that different methods of production apply in controlling the implicit and explicit costs associated with inventory, a value must be placed on the inventory at the beginning and end of the fiscal year.
Stock valuation is therefore the process of taking into account the quantity and value of inventory. Although the inventory goes through as raw materials, work-in-progress and finished goods, the stock valuation process takes place prior to production and the value of inventory is determined as historic costs or at the current realizable value. The valuation of the stock will be dependent on the methods used to record stock transactions.
Because the value of the stock will effect the gross profit of the year, must business’ will want to be selective when deciding which stock valuation method reflect the financial strength of the business most accurately. Most Business’ chose a method and do not change from the chosen method of stock valuation in order to comply with the principle of consistency. If a change in the method is made full disclosure must be made, meaning the effects of the change and explanations for changing methods must be given in the Final Accounts.
For very good reasons, students often find it difficult to remember and distinguish between the LIFO and FIFO method. Therefore, a simpler way is to consider FIFO for Wine inventory and LIFO for the Fashion Industry.

Last-in-first-out (LIFO)

The Last-In-First-Out method takes into account the value of the most recent delivery and thereby assumes that this recent delivery will be used before any inventory is used. Remember, as an example, that Fashion is only more valuable if the latest material or inventory is used!
LIFO Method of stock valuation
Date
Stock IN and Price
Stock OUT and Price
Stock Valuation



Goods in Stock
Total
June 1st 2010
200 @ $ 5

(200@$5=$1,000)
$1000
June 5th 2010
300 @ $ 6

(200@$5=$1,000)
(300@$6=$1,800)
$2,800
June 30th 2010

100@$6
(200@$5= $1,000)
(200@$6= $1,200)
$2,200
August 15th 2010

100@$6
(200@$5=$1000
(100@$6=$600)
$1,600
October 1st 2010
500@$8.50
100@$6
(200@$5=$1,000)
(500@$8.50=$4,250)
$5,250
November 12th 2010

200@$8.50
(200@$5=$1,000)
(300@$8.50=$2,550)
$3,550
January 5th 2011

100@$8.50
(200@$5=$1,000)
(200@$8.50=$1,700)
$2,700
March 1st 2011

100@$8.50
(200@$5=$1,000)
(100@$8.50=$850)
$1,850
April 3rd 2011

100@$8.50
(200@$5=$1,000)
$1,000
June 15th 2011

50@$5
(150@$5=$750)
$750

In the LIFO method the initial inventory purchased on June 1st 2010 is 200 units at a price of $5. Therefore the total stock valuation is 200 units x $5 = $1,000. On June 5th 2010 an additional amount of inventory is purchased of 300 units at $6. The goods in stock therefore amount to the previous amount and the current amount as no inventory OUT was used. On June 30th 2010 100 Units are sold (OUT). The LAST purchase at $6 is used in the LIFO method. Therefore, the goods in stock decrease to 200@$5=$1,000 + 300@$6=$1,800 for a stock valuation of $2,800.
As we clearly see, when using the LIFO method the most recently purchased items are sold first and the older stock stays in inventory. Just like in our example of the Fashion industry, consumers want the latest trend. This also means that the most current market prices are reflected in the stock valuation with current sales revenue being offset by the current cost of stock. However, because older inventory remains the LIFO method will result in the valuation of the asset inventory being based in the companies oldest stock purchase costs. Even during high inventory turnover the LIFO method will reflect the lowest valuation of stock and measurement of net income. LIFO is regarded as the most conservative of stock valuation methods. A business would use the LIFO method to reduce taxable income.


In order to more easily remember this method of stock valuation, consider that in the Wine industry the older the wine, the more valuable it is. Therefore, we can use Wine as a way in which to remember how to apply FIFO.

First-in-First-Out (FIFO)
FIFO Method of stock valuation
Date
Stock IN and Price
Stock OUT and Price
Stock Valuation



Goods in Stock
Total
June 1st 2010
200 @ $ 5

(200@$5=$1,000)
$1000
June 5th 2010
300 @ $ 6

(200@$5=$1,000)
(300@$6=$1,800)
$2,800
June 30th 2010

100@$5
(100@$5= $500)
(300@$6= $1,800)
$2,300
August 15th 2010

100@$5
(300@$6=$1,800)
$1,800
October 1st 2010
500@$8.50
100@$6
(200@$6=$1,200)
(500@$8.50=$4,250)
$5,750
November 12th 2010

200@$6
(500@$8.50=$4,250)
$4,250
January 5th 2011

100@$8.50
(400@$8.50=$3,400)
$3,400
March 1st 2011

100@$8.50
(300@$8.50=$2,550)
$2,550
April 3rd 2011

100@$8.50
(200@$8.5=$1,700)
$1,700
June 15th 2011

50@$8.50
(150@$8.50=$1,275)
$1,275

In the FIFO method the initial inventory purchased on June 1st 2010 is 200 units at a price of $5. Therefore the total Stock valuation is 200 x $5 = $1,000. On June 5th 2010 an additional amount of inventory is purchased of 300 units at $6. The goods in stock therefore amount to the previous amount and the current amount as no inventory OUT was used. Remember our example for FIFO is the Wine industry where older bottles are more valuable and are sold First. Therefore, on June 30th 2010 100 Units are sold (OUT). The stock purchased FIRST at $5 is used in the FIFO method. Therefore, the goods in stock decrease to 100@$5=$500 + 300@$6=$1,800 for a stock valuation of $2,300.
Because price levels (inflation) tend to go up, over time the purchase of inventory costs will rise. The FIFO method assigns the purchase costs of the older stock to production costs and the more recent, higher priced, goods remain in inventory. Because of this FIFO tends to overstate a business’ profitability and businesses tend to use this method to increase the amount of income reported to investors and creditors. This method will result in a higher income tax burden.
Using both the LIFO and FIFO method, attempt to determine the Value of closing stock at the end of June 2011.
Date (2011)
Purchases (Units) IN
Cost per Unit ($) OUT
Sales (Units)
January
130
155
76
February
50
153
82
March
150
160
100
April
55
158
90
May
140
165
110
June
90
160
136

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