Cambridge AS & A Level9706

Financial statements (A Level)

Accounting 9706 Chapter Notes

What this chapter covers

Financial statements (A Level)Partnerships (A Level)Clubs and societies (A Level)Manufacturing businesses (A Level)Limited companies (A Level)
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Financial statements (A Level) notes

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In this chapter

  1. 1Introduction to Company Financial Statements
  2. 2The Statement of Profit or Loss (SPL)
  3. 3The Statement of Financial Position (SFP)
  4. 4The Statement of Changes in Equity (SOCIE)
  5. 5Equity vs. Debt Financing

1. Introduction to Company Financial Statements

Limited companies are required by law to produce and publish financial statements at the end of each accounting period. These statements provide a formal record of the company's financial activities and position. The primary users are external stakeholders, such as shareholders (the owners), potential investors, lenders (like banks), suppliers, and government agencies (e.g., for tax purposes). The main statements are the Statement of Profit or Loss, the Statement of Financial Position, the Statement of Changes in Equity, and the Statement of Cash Flows. They are prepared following a set of rules called International Financial Reporting Standards (IFRS) to ensure they are consistent and comparable.

Key term

Stakeholder: Any individual, group, or party that has an interest in an organisation and the outcomes of its actions.

Examiner insight

Examiners expect students to understand that financial statements are prepared for external users and must follow a prescribed format under IFRS/IAS.

Fun fact

The world's first modern, published company accounts were produced by the East India Company in the 17th century to inform its many investors about the profitability of its voyages.

Worked example 14 marks

Identify the four main financial statements prepared by a limited company and briefly state the purpose of each.

  1. 1
    1. Statement of Profit or Loss (SPL): Shows the company's financial performance (revenue, expenses, and profit) over a period of time.
  2. 2
    1. Statement of Financial Position (SFP): Presents a snapshot of the company's assets, liabilities, and equity at a single point in time.
  3. 3
    1. Statement of Changes in Equity (SOCIE): Details the changes in the owners' equity (share capital, retained earnings) over the accounting period.
  4. 4
    1. Statement of Cash Flows: Reports the cash generated and spent by a company from its operating, investing, and financing activities during a period.

Recap

  • Financial statements report a company's performance and position to external stakeholders.
  • The main statements are the SPL, SFP, SOCIE, and Statement of Cash Flows.
  • These statements are governed by International Financial Reporting Standards (IFRS).
  • The SPL shows performance over time; the SFP shows position at a point in time.
  • The SOCIE links the SPL and the SFP by explaining changes in equity.

Quick check

  1. Who are the primary users of a limited company's financial statements?2 marks
  2. What is the name of the accounting rules that public companies must follow?1 mark

2. The Statement of Profit or Loss (SPL)

The Statement of Profit or Loss (SPL), also known as the income statement, measures a company's financial performance over an accounting period (e.g., a year). It starts with revenue and subtracts all the costs and expenses incurred to generate that revenue. The final figure, 'Profit for the year', shows how profitable the company has been. The standard format requires expenses to be classified by function, typically as 'Cost of Sales', 'Distribution costs', and 'Administrative expenses'. This layout provides a clear analysis of profitability at different stages, such as Gross Profit and Profit before Tax.

Gross Profit = Revenue - Cost of Sales

Cost of Sales = Opening Inventory + Purchases - Closing Inventory

Profit before Tax = Gross Profit - Operating Expenses + Other Income - Finance Costs

Profit for the year = Profit before Tax - Corporation Tax

Key term

Gross Profit: The profit a company makes after deducting the costs associated with making and selling its products, or the costs associated with providing its services.

Examiner insight

Examiners award marks for the correct format and structure of the statement, not just the final profit figure. Clear workings are essential.

Common pitfall

Forgetting to classify expenses correctly into 'Cost of Sales', 'Distribution costs', and 'Administrative expenses', which loses presentation marks.

Worked example 115 marks

Using the trial balance and adjustments below, prepare the Statement of Profit or Loss for ABC Ltd for the year ended 31 December 20X1.

Trial Balance Extract at 31 Dec 20X1 ($) Revenue: 500,000 Purchases: 290,000 Opening Inventory: 40,000 Admin Expenses: 72,000 Distribution Costs: 30,000 10% Loan: 100,000

Adjustments:

  1. Closing inventory was valued at $50,000.
  2. Depreciation on non-current assets is $50,000 for the year and is an administrative expense.
  3. Loan interest for the full year is outstanding.
  4. Corporation tax for the year is estimated at $20,000.
  1. 1

    ABC Ltd - Statement of Profit or Loss for the year ended 31 December 20X1

  2. 2

    $ $

  3. 3

    Revenue 500,000

  4. 4

    Cost of Sales (W1) (280,000)

  5. 5

    ----------------------------------------------------------------

  6. 6

    Gross Profit 220,000

  7. 7

    Distribution costs (30,000)

  8. 8

    Administrative expenses (W2) (122,000)

  9. 9

    ----------------------------------------------------------------

  10. 10

    Profit from operations 68,000

  11. 11

    Finance cost (W3) (10,000)

  12. 12

    ----------------------------------------------------------------

  13. 13

    Profit before tax 58,000

  14. 14

    Corporation tax (20,000)

  15. 15

    ----------------------------------------------------------------

  16. 16

    Profit for the year 38,000

  17. 17

    Workings (W):

  18. 18

    W1: Cost of Sales

  19. 19

    Opening inventory 40,000

  20. 20

    Add: Purchases 290,000

  21. 21

    Less: Closing inventory (50,000)

  22. 22

    ----------

  23. 23

    280,000

  24. 24

    W2: Administrative expenses

  25. 25

    From trial balance 72,000

  26. 26

    Add: Depreciation for year 50,000

  27. 27

    ----------

  28. 28

    122,000

  29. 29

    W3: Finance cost

  30. 30

    Loan interest (10% x $100,000) 10,000

Recap

  • The SPL shows financial performance over a period.
  • The standard format is Revenue, less Cost of Sales, gives Gross Profit.
  • Operating expenses are subtracted to find Profit from Operations.
  • Finance costs and tax are deducted to arrive at Profit for the year.
  • Expenses must be classified by function (e.g., admin, distribution).
  • Always show your workings clearly for adjustments like depreciation and cost of sales.

Quick check

  1. What is the difference between gross profit and profit for the year?2 marks

3. The Statement of Financial Position (SFP)

The Statement of Financial Position (SFP), or balance sheet, provides a snapshot of a company's financial health at a specific moment in time. It lists what the company owns (Assets) and what it owes (Liabilities and Equity). The statement is a detailed representation of the fundamental accounting equation: Assets = Equity + Liabilities. Assets and liabilities are split into 'Non-current' (long-term, over one year) and 'Current' (short-term, within one year). Equity represents the shareholders' stake in the company, comprising Share Capital and reserves like Retained Earnings.

Assets = Equity + Liabilities

Net Book Value (NBV) = Cost of Asset - Accumulated Depreciation

Working Capital (Net Current Assets) = Current Assets - Current Liabilities

Key term

Net Book Value (NBV): The value of an asset as it appears on the balance sheet, calculated as the original cost of the asset minus any accumulated depreciation.

Examiner insight

Marks are heavily dependent on the correct format and classification. The two halves of the statement must be equal ('balance'), and failing to do so indicates an error in your calculations.

Common pitfall

Mixing up current and non-current items, for example, placing a long-term loan under current liabilities or inventory under non-current assets.

Worked example 115 marks

Using the trial balance, adjustments, and the calculated Profit for the Year ($38,000), prepare the Statement of Financial Position for ABC Ltd as at 31 December 20X1.

Trial Balance & Other Info ($) Non-current Assets at Cost: 500,000 Accum. Dep (start): 80,000 Trade Receivables: 60,000 Trade Payables: 50,000 Bank: 18,000 10% Loan: 100,000 Ordinary Share Capital: 200,000 Retained Earnings (start): 110,000 Dividends Paid: 30,000 Closing Inventory: 50,000 Depreciation for year: 50,000 Tax for year: 20,000 Loan interest due: 10,000

  1. 1

    ABC Ltd - Statement of Financial Position as at 31 December 20X1

  2. 2

    $ $

  3. 3

    ASSETS

  4. 4

    Non-current assets

  5. 5

    Property, plant and equipment (W1) 370,000

  6. 6

    Current assets

  7. 7

    Inventory 50,000

  8. 8

    Trade receivables 60,000

  9. 9

    Bank 18,000

  10. 10

    ----------

  11. 11

    128,000

  12. 12

    ----------------------------------------------------------------

  13. 13

    Total assets 498,000

  14. 14

    ----------------------------------------------------------------

  15. 15

    EQUITY AND LIABILITIES

  16. 16

    Equity

  17. 17

    Ordinary share capital 200,000

  18. 18

    Retained earnings (W2) 118,000

  19. 19

    ----------

  20. 20

    Total equity 318,000

  21. 21

    Non-current liabilities

  22. 22

    10% Loan 100,000

  23. 23

    Current liabilities

  24. 24

    Trade payables 50,000

  25. 25

    Accruals (Loan interest) 10,000

  26. 26

    Corporation tax payable 20,000

  27. 27

    ----------

  28. 28

    80,000

  29. 29

    ----------------------------------------------------------------

  30. 30

    Total equity and liabilities 498,000

  31. 31

    ----------------------------------------------------------------

  32. 32

    Workings (W):

  33. 33

    W1: Non-current assets (NBV)

  34. 34

    Cost 500,000

  35. 35

    Less: Accumulated depreciation (80,000 + 50,000) (130,000)

  36. 36

    ----------

  37. 37

    370,000

  38. 38

    W2: Retained earnings

  39. 39

    Opening balance 110,000

  40. 40

    Add: Profit for the year 38,000

  41. 41

    Less: Dividends paid (30,000)

  42. 42

    ----------

  43. 43

    Closing balance 118,000

Recap

  • The SFP is a snapshot of assets, liabilities, and equity on a specific date.
  • The accounting equation, Assets = Equity + Liabilities, must always balance.
  • Assets and liabilities are classified as either current (<= 1 year) or non-current (> 1 year).
  • Non-current assets are shown at Net Book Value (Cost less Accumulated Depreciation).
  • Equity includes share capital and retained earnings.
  • Retained earnings are updated with the profit for the year and reduced by dividends.

Quick check

  1. State the accounting equation.1 mark
  2. How is the Net Book Value of an asset calculated?1 mark

4. The Statement of Changes in Equity (SOCIE)

The Statement of Changes in Equity (SOCIE) provides a detailed reconciliation of the shareholders' equity from the beginning to the end of an accounting period. It acts as a bridge between the Statement of Profit or Loss and the Statement of Financial Position. The SOCIE is presented in a columnar format, with separate columns for each component of equity, such as Ordinary Share Capital, Share Premium, Revaluation Surplus, and Retained Earnings, plus a Total column. It shows how these balances have been affected by transactions like issuing new shares, the profit or loss for the period, revaluation of assets, and payment of dividends.

Closing Equity = Opening Equity + Total Comprehensive Income - Dividends + Share Issues

Key term

Share Premium: The excess amount received by a company when it issues shares above their nominal or par value.

Examiner insight

Examiners look for a clear, columnar presentation that correctly reconciles the opening and closing equity balances. The closing figures in the SOCIE must match the equity section of the SFP.

Common pitfall

Placing 'Profit for the year' in the 'Total' column but forgetting to also add it to the 'Retained Earnings' column.

Worked example 16 marks

Prepare the Statement of Changes in Equity for ABC Ltd for the year ended 31 December 20X1, using the relevant information from the previous examples. Assume no new shares were issued and no assets were revalued.

  1. 1

    ABC Ltd - Statement of Changes in Equity for the year ended 31 December 20X1

  2. 2

    Ordinary Share Retained Total

  3. 3

    Capital Earnings Equity

  4. 4

    $ $ $

  5. 5

    Balance at 1 January 20X1 200,000 110,000 310,000

  6. 6

    Profit for the year - 38,000 38,000

  7. 7

    Dividends paid - (30,000) (30,000)

  8. 8

    ---------------------------------------------------------------------------

  9. 9

    Balance at 31 December 20X1 200,000 118,000 318,000

Recap

  • The SOCIE explains the movement in each component of equity during the year.
  • It starts with the opening balances and ends with the closing balances shown in the SFP.
  • Key movements include profit for the year (from the SPL), dividends, and new share issues.
  • The format is a table with columns for each type of equity reserve.
  • Profit increases retained earnings, while dividends decrease them.

Quick check

  1. What two key items from the Statement of Profit or Loss and company actions affect the Retained Earnings column in the SOCIE?2 marks

5. Equity vs. Debt Financing

Companies finance their assets through a mix of equity and debt. Equity finance is capital provided by the owners (shareholders). The most common form is Ordinary Shares. Shareholders are the residual owners of the business, have voting rights, and receive a return in the form of dividends, which are not guaranteed and are paid out of after-tax profits. Debt finance is capital borrowed from third parties, such as a bank loan or by issuing debentures. Lenders are creditors, not owners. They have no voting rights and receive a fixed return in the form of interest, which is a business expense and must be paid regardless of profitability. Debt is typically repaid at a future date.

Key term

Debenture: A type of long-term loan, often secured against company assets, which pays a fixed rate of interest to the holder.

Examiner insight

Examiners often ask for differences between shares and debentures. High-scoring answers will contrast the two on points like return, risk, ownership, and security, using precise terminology.

Worked example 16 marks

Explain three differences between an ordinary share and a debenture.

  1. 1
    1. Ownership and Control: An ordinary shareholder is a part-owner of the company and has voting rights at company meetings. A debenture holder is a lender (creditor), not an owner, and has no voting rights.
  2. 2
    1. Return: The return to a shareholder is a dividend, which is a share of profits. The amount is not fixed and is only paid if the company is profitable and declares a dividend. The return to a debenture holder is fixed interest, which is a legal obligation and must be paid regardless of profit levels.
  3. 3
    1. Risk and Repayment: Ordinary shares are permanent capital and are not repaid by the company (they are sold to other investors). They are higher risk as shareholders are paid last if the company liquidates. Debentures are loans with a set repayment date. They are lower risk as interest must be paid, and debenture holders are paid before shareholders in a liquidation.

Recap

  • Equity represents ownership capital from shareholders.
  • Debt represents borrowed capital from lenders.
  • Shareholders get dividends (variable, not guaranteed); lenders get interest (fixed, compulsory).
  • Shareholders have voting rights; lenders do not.
  • Interest is a tax-deductible expense; dividends are an appropriation of after-tax profit.
  • In liquidation, lenders are paid before shareholders.

Quick check

  1. Is interest on a debenture an expense or an appropriation of profit?1 mark
  2. Who has a higher claim on a company's assets in a liquidation: a shareholder or a debenture holder?1 mark

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Explain the purpose of the Statement of Financial Position and how it relates to the accounting equation.4 marks
  2. A company has a non-current asset that cost $120,000. It is depreciated at 20% per annum using the reducing balance method. If the accumulated depreciation at the start of the year was $43,200, calculate the depreciation charge for the year and the asset's net book value at the end of the year.4 marks
  3. Distinguish between a current asset and a non-current asset, providing two examples of each.4 marks
  4. A company's trial balance shows retained earnings of $85,000 at the start of the year. During the year, it made a profit after tax of $42,000 and paid dividends of $15,000. It also issued 100,000 new $1 ordinary shares for $1.50 each. Calculate the closing balance on the retained earnings and share premium accounts.5 marks
  5. Explain the role of the Statement of Changes in Equity in linking the other financial statements.5 marks
  6. Why is interest on a loan treated as a 'finance cost' in the SPL, while dividends paid to shareholders are shown in the SOCIE?6 marks
  7. A business has opening inventory of $15,000 and closing inventory of $12,000. Purchases for the period were $180,000 and purchase returns were $5,000. Calculate the Cost of Sales figure to be shown in the Statement of Profit or Loss.3 marks
  8. The concept of 'materiality' states that financial statements should separately disclose items that are significant enough to influence the decisions of users. Give an example of a material item and an immaterial item for a large multinational company.4 marks
  9. From the following list of balances, calculate Total Equity: Ordinary Share Capital $500,000; 8% Debentures $200,000; Retained Earnings $155,000; Share Premium $75,000; Revaluation Surplus $50,000; Bank Loan $100,000.3 marks
  10. A company prepares its financial statements. It has a machine with a net book value of $10,000. The company has just lost its major customer and is likely to cease trading within six months. Explain the impact of this situation on the valuation of the machine in the financial statements, with reference to the 'going concern' concept.6 marks

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