FAF Financial Accounting Lecture Notes 2024/25 PDF

10 UNIVERSITY OF BRISTOL FAF 2024 / 25 Financial Accounting Lecture Material 10  11 STUDENT STUDY UNIT WEEK...

10 UNIVERSITY OF BRISTOL FAF 2024 / 25 Financial Accounting Lecture Material 10  11 STUDENT STUDY UNIT WEEK 2 THE FINANCIAL STATEMENTS (RECAP) Financial reporting communicates accounting information to users, usually in a specified format. The Three Major Financial Statements: The Statement of Financial Position (SOFP - also known as The Balance Sheet). (TB1) Position or snapshot of the net assets at a point in time. So always "as at a relevant date". The Statement of Comprehensive Income (SOCI) or Income Statement (I/S and sometimes known as the Profit and Loss Account). (TB1) Performance over a period of time so always "for the year (or other period) ended …". The Statement of Cash Flows Movement of cash and cash equivalents over a period of time. (TB2) PLUS The Statement of Changes in Equity (SOCE) which is produced only for companies. This links the SOCI (I/S) to the SOFP for companies, by reflecting movements in retained earnings, reserves and / or equity over a period of time. THE STATEMENT OF FINANCIAL POSITION (SOFP or BALANCE SHEET) This statement is based on the Accounting Equation and shows the net worth of the business at a point in time. NET WORTH OF A BUSINESS = EQUITY (investment made by the owners (Capital), plus profits / losses to date (Retained Earnings), plus other reserves.) The owners of a business could be a sole trader, partners in a business, or shareholders in a company. The Equity figure at any point in time, is the ownership interest in the Assets of the business less any liabilities owed. THE ACCOUNTING EQUATION EQUITY (Net Worth) = ASSETS – LIABILITIES   OWNS OWES Or in Common European Format (which we will use for the examples on this course, but note that both / other formats are used) ASSETS = EQUITY + LIABILITIES    OWNS OWES (to owners only) OWES 11  12 The Statement of Comprehensive Income (SOCI) or Income Statement (I/S) This explains a change in the net worth of the business over a period of time, i.e. shows the profit generated over a period of time (for example it would be ‘for the year ended…’) Profitability: Income Statement (I/S) = All Income - All Expenses (All income and expenses incurred in the period, regardless of when cash is received/ paid) Follows the Accruals or Matching Concept and relates to all income and expenses incurred in the accounting period, regardless of whether cash is paid or received. The Statement of Cash Flows, or Cash Flow Statement (covered in TB2) This explains the changes in the cash and cash equivalents over a period of time, i.e. shows the movement in cash over a period of time (for example it would be ‘for the year ended…’). Liquidity: Statement of Cash Flows (SOCF) = Cash in - Cash out PROFIT AND CASH ARE OFTEN NOT THE SAME THING. RECAP: SOFP / BALANCE SHEET Assets = Equity + Liabilities (the Accounting Equation.) The SOFP shows the position of the business at a point in time. It shows the net worth (Equity) that belongs to the owners of the business. The Equity figure can grow over time if the owner(s) invests more into the business, and also when the business makes profits. The profits of the business ultimately belong to the owners, so all profits made each year are added to the Equity section of the SOFP. There will be differences in the Equity part for a Sole Trader, compared to a company which we will discuss later on. For now, note that only companies will produce a Statement of Changes in Equity (SOCE) which can break down the Equity part of its SOFP further. IS / SOCI Income and Expenses (over an accounting period) Income less expenses calculate the profit or loss of a business over a period of time. The profit or loss calculated each year in the IS / SOCI then gets added to the Equity section of the SOFP as it belongs to the owners. The cumulative profit or loss figure (profits and losses calculated since the commencement of the business to the SOFP date) is sometimes called the “Retained Earnings” or “Retained Profits” or “Reserves” under the Equity section of the SOFP. SOCE Shows the movement of the Equity section (over an accounting period) for companies only. It provides more information of the Equity section movement, from one SOFP date to another. (We will cover this in Week 3.) 12  13 STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 2024 (EXAMPLE) 2024 2023 ASSETS £’000 £’000 Non-current assets Property, Plant and Equipment Motor Vehicles Total non-current assets Current assets (in order of liquidity) Inventories Trade receivables Prepayments Bank (if a positive balance) Cash Total current assets Total assets EQUITY AND LIABILITIES £’000 £’000 Equity attributable to equity holders * Share capital ** Share premium ** Revaluation reserves *** Retained earnings Total equity Non-current liabilities Long-term borrowings (due > 1 Year) Total non-current liabilities Current liabilities (in order of liquidity) Trade and other payables Accruals and other short term liabilities Tax and Dividends payable Bank overdraft (if a negative balance) Total current liabilities Total liabilities Total equity and liabilities Notes: * If this was a sole trader, instead of “shares” under equity, there would be “proprietor’s capital” representing the owner’s investment in the business. ** Businesses may have other reserves, for example “share premium” (if a company issues shares for consideration greater than their nominal value), and “revaluation reserve” (if non-current assets are restated to a higher value). You will cover this in TB2. *** “Retained earnings” in the SOFP are the accumulated profits / (losses) over time to date. There may be more, or fewer items under each category heading depending on the assets, liabilities and equity of the business at the point in time when the SOFP is drawn up. 13  14 OWNER’S EQUITY IS THE NET WORTH OF THE BUSINESS AT A POINT IN TIME: 1. Total Assets = Total Equity and Total Liabilities (or Total 'claims' on the entity) 2. Net Worth = Owner’s Equity or investment in the business The Net Worth is the value of the owner’s investment at any point in time. (Assets – Liabilities) (May not be the real value of the business if sold. Remember that the figures you use above are at Historic Cost (with some exceptions which you will cover in TB2)). OWNER’S EQUITY : This is the investment the owner has put in + any profits to date - money the owner has drawn out. In the case of a company The investment is the share capital; Profits to date are called retained earnings; Monies drawn out and paid to shareholders are called dividends. There may be other reserves forming part of the equity. In the case of an unincorporated business (A sole trader or partnership) The investment is the capital put in by the owner(s); Profits to date are called retained earnings; Moneys drawn out by the owners(s) are called drawings. There may also be other reserves as with a company. NOTE: The sample layout earlier is as you might expect a PLC to use, operates under International Accounting Standards (IAS). There may well be additional headings and components in a PLC that are outside the scope of this course. Small companies, Partnerships and Sole Traders are not yet subject to all these rules but are likely to be in the future, and may still use older terminology such as ‘fixed assets’ instead of’ non- current assets’, ‘stocks’ instead of ‘inventories’, ‘debtors’ instead of ‘trade receivables’, and ‘creditors’ instead of ‘trade payables’. For the sake of this course, we suggest you stick to the above layout. It will be less confusing and easier to learn if we use one layout. You will find during the course that you need to add or delete items underneath the main headings, depending on the requirement in the question. 14  15 Impact on the SOFP for Different Business Forms The Equity part of the Statement of Financial Position / Balance Sheet looks different depending on the (ownership) form of the business: ----------------------------------------------------------------------------------------------------------------------------- ---- Sole Trader: £ £ Proprietor’s capital (note 1) XXX Add: Retained Profits XXX Less: Drawings (note 2) (XXX) XXX Capital carried forward XXX ==== Note 1: In the company’s first year of business, the owner will invest some money (‘capital’) in the business → include this here. He may invest more over time. Note 2: Drawings are cash or goods taken out of the business, by the owner, for personal use. If drawings are already deducted at the bottom of the Income Statement, do not deduct drawings here (i.e. deduct drawings only once from the profit figure.) ----------------------------------------------------------------------------------------------------------------------------- ----- Partnership: Partners: A B Total £ £ £ Capital brought forward XXX XXX XXX Add: Share of profits (note 3) XXX XXX XXX Less: Drawings (XXX) (XXX) (XXX) Capital carried forward XXX XXX XXX ===== ===== ===== Note 3: Split the equity to the partners. This split is determined by the ‘partnership agreement’. ----------------------------------------------------------------------------------------------------------------------------- ---- Company: £ Issued Share Capital (note 4) Ordinary Shares (note 5) XXX Preference Shares (note 6) XXX XXX Reserves: Share Premium (note 7) TB2 XXX Revaluation reserve TB2 Retained Profits/ Earnings (note 8) XXX XXX ==== Note 4: A company may issue any amount of shares up to its authorised limit. Note 5: Ordinary shareholders take the risk, up to the value of their shares. They have voting rights and will receive dividends, usually based on the performance of the company. Note 6: Preference shareholders typically have no voting rights and receive fixed dividends. They may, if the company liquidates, recover their investment before ordinary shareholders. Note 7: Issued share capital is shown at its “nominal value” (NV) but shares may actually be sold for more than their NV when they are issued. The difference is share premium. (TB2) Note 8: Retained Earnings is the sum of all profits / losses (less dividends) to date. Therefore, Retained Earnings as at 31 December 2024, (say for a company started in January 2023), will be profits made in 2023 and 2024, after deducting all dividends proposed and approved in 2023 and 2024 (We will cover this in the Statement of Changes in Equity). 15  16 Lecture example: Statement of Financial Position / SOFP / Balance Sheet from the TB A. VEGAN YUM CAKE TRIAL BALANCE (2ND EXAMPLE FROM WEEK 1) AT 31 JULY 2024: DR CR £ £ Ovens and kitchen utensils 26,000 Air Fryer 3,000 Loan 25,000 Trade Payables 1,200 Inventories 15,120 Trade Receivables 0 Cash 150 Owner’s investment 50,000 Bank Balance 120 Sales to Date 13,000 Cost of Cakes Sold to date 4,000 Rent and rates 12,000 Wages 5,000 Cleaning and repairs 700 Utilities 6,000 Furniture and fittings 17,350 TOTAL 89,320 89,320 Required: Vegan Yum Cake started trading on 1 January 2024. Draft a Statement of Financial Position as at 31 July 2024 using the above information. Note: You will notice that there are two columns on the next page (and three columns in example “B”) in the space provided for the answer. This is simply to enable the sub-totals for current assets and current liabilities to be shown in greater clarity. There are no set rules for this so don’t get bogged down with how many columns you need. You may just have one column if you prefer. When multiple years are put on one page for comparison purposes in a set of accounts, it is often clearer to have just one column for each year. 16  17 A. VEGAN YUM CAKE: Statement of Financial Position as at 31 July 2024 £ £ ASSETS Non-current Assets Ovens and kitchen utensils Furniture and fittings Air Fryer Current Assets Inventories Cash Total Assets EQUITY AND LIABILITIES Equity Owner’s investment Retained Earnings Non - Current Liabilities Loan Current Liabilities Trade Payables Bank Balance (Overdraft) Total Liabilities Total Equity and Liabilities 17  18 B. Partnership → attempt on your own in the space below (video & PDF answers on BB) Mr Fast and Mrs Furious started a grocery business on 1 March this year. They agreed to share profits and losses equally, and each contributed £1,000,000 in cash on 1 March. This cash along with cash from the long term loan below (taken out on 1 March too), was used to buy the assets listed below on 1 March: £’000 Furniture and Fittings, at cost 400 Inventories (stock), at cost 350 Motor van, at cost 180 Shop Premises, at cost 1,700 Secured loan due for repayment after 1 year 700 Bank figure at 1 March (after payments for the assets above) 70 Required: Draft a Statement of Financial Position / Balance Sheet to show the position of the partnership as at 1 March with the balances above. B. Partnership: Fast and Furious : Statement of Financial Position as at 1st March £’000 £’000 £’000 ASSETS Non-current Assets Current Assets Total Assets EQUITY AND LIABILITIES Fast Furious Total Owners’ Equity Non-current Liability Total Equity and Liabilities 18  19 C. A Limited Company → attempt on your own in below (video & PDF answers on BB) Cosmetics Ltd is a company dealing with wholesale beauty products. The following are the account balances shown in its ledger at 1 January of this year: £ ’000 Ordinary shares of £1 5,000 6% Preference shares of £1 5,000 Buildings 12,300 Inventory of cosmetics 5,040 Trade Receivables 3,026 Trade Payables 2,900 Bank (overdraft) 1,715 Loan on the buildings (payable > 1 year) 3,000 Motor vehicles 500 Bank Deposit Fixed Term (3 month) Savings Account 1,649 *Retained Earnings* (accumulated profits from previous periods) 4,900 Required: Prepare a Statement of Financial Position/Balance Sheet for the company as at 1 January. *This figure might sometimes be left out from the question, and you will need to realise that it is the missing figure required to make your SOFP balance. C. A Limited Company : Cosmetics Ltd: Statement of Financial Position as at 1st January £’000 £’000 ASSETS Non-current Assets Current Assets Total Assets EQUITY AND LIABILITIES Equity Non-current Liabilities Current Liabilities Total Equity and Liabilities 19  20 D. Another Limited Company : The Ashton Company Attempt on your own on pg 21 (video & PDF answers on BB) The Ashton Company has been manufacturing electrical switch gear for many years. In July 2024, the accountant of the company disappeared, and with him, disappeared the accounting records. You are approached by the owner of the business and asked to prepare a statement of the business assets and liabilities in the form of a Statement of Financial Position as at 31st August 2024. By checking with the bank, counting materials on hand, investigating the ownership of buildings and plant, circularising customers, and other investigations, you establish the following information as at 31st August 2024: £’000 Cash in hand 50 Balance at bank (overdrawn) 350 Inventory/Stock of raw materials 17,500 Inventory/Stock of finished goods 10,000 Amounts receivable from customers in respect of credit sales 30,000 Freehold Land 22,500 Buildings 35,000 Plant and Machinery 50,000 Bills received from suppliers indicate that £18 million is owed to trade creditors (payables). A mortgage / loan of £12.5 million (secured on the freehold land) is outstanding, and becomes repayable by the company in 2030. Ashton calculates, by referring to his own records, that he put £100 million into the business as capital. Required: Set out the Statement of Financial Position / Balance Sheet as at 31 August 2024 based on the information shown above. A note on Inventory (Stock) for Companies that manufacture goods: There could be three categories of inventory in play at the SOFP / Balance Sheet date. 1. Raw Materials (not yet used, so this is just the historic cost of the materials bought) 2. Work in Progress (ongoing production with some material / labour / overhead value) 3. Finished Goods (completed production, ready for sale with material / labour and overhead value. These inventory categories will all be recorded at historic cost. You could just add all three categories up and call it ‘Inventory’ but if the figure is incorrect, it would be difficult for the marker to allocate working marks. TIP: The Retained Earnings (RE) figure has intentionally been left out in this question. The reason is, for you to realise that the RE figure in the SOFP must be the balancing figure. This is because the company has been trading for many years and you would expect there to be cumulative profits to date. If the RE figure is not given (as in this scenario), set it as the balancing figure. 20  21 D. Lecture example (video and PDF answers are on BB) The Ashton Company : Statement of Financial Position/ Balance sheet as at 31 August 2024 ASSETS NON-CURRENT ASSETS £’000 £’000 Freehold land Buildings Plant and machinery _______ CURRENT ASSETS Inventories: raw material finished goods Trade Receivables Cash and cash equivalents _______ TOTAL ASSETS ======== EQUITY AND LIABILITIES EQUITY Share Capital Retained earnings ________ NON-CURRENT LIABILITIES Mortgage loan CURRENT LIABILITIES Trade payables Bank Overdraft _______ _________ TOTAL EQUITY AND LIABILITIES ========= 21  22 How transactions affect the Statement of Financial Position USING THE ACCOUNTING EQUATION For the Accounting Equation to hold, every transaction has to have a debit entry which has an equal and opposite credit entry. These entries can affect items in the Statement of Financial Position and / or items in the Statement of Comprehensive Income (I/S). You can have both entries in either statement, or one in each statement. Where the entries impact, depends on the transaction. Before we look at how transactions can affect the statements, we need to produce a simplified Income Statement. For that we shall use the same Trial Balance on page 16 (and below) but this time we will only produce an Income Statement for the period to 31 July 2024. VEGAN YUM CAKE TRIAL BALANCE (SAME 2ND EXAMPLE FROM WEEK 1) AS AT JULY 2024: DR CR £ £ Ovens and kitchen utensils 26,000 Air Fryer 3,000 Loan 25,000 Trade Payables 1,200 Inventories 15,120 Trade Receivables 0 Cash 150 Owner’s investment 50,000 Bank Balance 120 Sales to Date 13,000 Cost of Cakes Sold to date 4,000 Rent and rates 12,000 Wages 5,000 Cleaning and repairs 700 Utilities 6,000 Furniture and fittings 17,350 TOTAL 89,320 89,320 Required: Vegan Yum Cake started trading on 1 January 2024. This time, draft an Income Statement for the period to 31 July 2024 using the above information. All the income and expenditure above was for the 7 months to the end of July 2024. 22  23 VEGAN YUMMY CAKE: INCOME STATEMENT FOR THE PERIOD (7 months) TO 31 JULY £ £ Sales Revenue (Income from selling the products) Cost of Sales (Expenses to make the products sold) ( _________) Gross Profit Less Expenses: (All other administration, sales and distribution expenses) - Rent and rates - Wages - Cleaning and repairs - Utilities _________ (_________) Operating Profit __________ Profit / (Loss) for the period (to add to the SOFP Retained Earnings figure) ========== This shows how the increase / (decrease) in the net worth (the profits / losses) of the business over the whole period (from 1 January to 31st July) has arisen, i.e. how much profit (or loss) has been made in the accounting period. This profit (or loss) figure would be taken to the Equity section of the Statement of Financial Position at 31st July and added in the Retained Earnings row. The SOFP will balance because the Debit and Credit balances that do not go into it, but go into the Income Statement, will still end up in the SOFP. This is because all the items that go into each period’s Income Statement, will be totalled in the profit / (loss) figure, and taken to the “Retained Earnings” figure in the SOFP (while some SOFP balances will change as a consequence of the double entry on some Income Statement transactions.) We shall look at the Income Statement in more detail next week. For now you need to understand that the both the SOFP and the Income Statement can be produced using the information in the Trial Balance. 23  24 VEGAN YUM CAKE DOUBLE ENTRY EXAMPLE IN THE SOFP & INCOME STATEMENT: As we saw from the SOFP of Vegan Yum Cake (VYC) as at 31st July 2024, it had made a loss in its first seven months of trading. In August however, its social media platforms along with excellent reviews for its cakes, created a sudden increase in its sales figure. Transactions in August 2024: 1. Credit sales to large restaurants in August were £30,000. Cash sales were £4,000. Required: Show the double entry to this transaction below by showing two sides for each figure (one in the SOFP and the other in the Income Statement.) 2. In order to meet that increased demand, VYC increased its level of inventories by purchasing £8,000 worth of ingredients during the month. These were credit purchases. Required: Show the double entry to this transaction below by showing two sides in the SOFP. 3. The total cost of the inventory that VYC sold in August, was £9,000. Required: Show the double entry to this transaction below by showing two sides (one in the SOFP and the other in the Income Statement.) 4. Other expenses incurred and paid for in August were: a) Wages for £800 b) Rent and rates for £2,000 c) Cleaning costs of £500 d) Utilities of £1,500 Required: Show the double entry for each one of these transactions by showing two sides (one in the SOFP and the other in the Income Statement). Produce a Statement of Financial Position as at 31 August 2024 and an Income Statement for (only) the month of August 2024 for Vegan Yum Cake using the hints below and the formats provided in the next couple of pages. TIPS: For the SOFP: Start with the opening balances as at 31st July 2024 (using the SOFP you produced at 31st July 2024 on page 17) and then adjust them to include all the transactions above. You may show your workings in brackets as set out on the next page. As long as your workings don’t run into columns, full presentation marks will be awarded. For the Income Statement: Do one Income Statement calculating the profits or losses for just the month to 31 st August 2024. (If the requirement was for the year to 31 August 2024, you could start with the Income Statement for the period to 31st July 2024 and add the August income and expense adjustments as you are in the same accounting period; i.e. within its accounting year to the 31 December 2024 year-end). 24  25 VEGAN YUM CAKE: STATEMENT OF FINANCIAL POSITION AS AT 31 AUGUST 2024 £ £ ASSETS Non-current Assets Ovens and kitchen utensils [26,000 Furniture and fittings [17,350 Air Fryer [3,000 Current Assets Inventories [15,120 Trade Receivables [ Cash [150 Total Assets EQUITY AND LIABILITIES Equity Owner’s investment [50,000 Retained Earnings [(14,700) Non - Current Liabilities Loan [25,000 Current Liabilities Trade Payables [1,200 Bank Balance (Overdraft) [120 Total liabilities Total Equity and Liabilities 25  26 VEGAN YUMMY CAKE : INCOME STATEMENT FOR THE MONTH OF AUGUST 2024 £ Sales Revenue Cost of Sales _________ Gross Profit Expenses: _________ Profit for the period ========= We can see now that the business is profit making (for the 8 months to 31st August 2024) and the “Retained Earnings” figure in the SOFP is now showing a positive balance. Note that if a business had been trading for over a year, its Retained Earnings figure in the Statement of Financial Position will be the cumulative profits / (losses) from all the Income Statements since the business commenced (rather than just the profit / (loss) from the latest Income Statement.) You are now ready to attempt the Tutorial and Exercise Lecture questions for Week 3. In the next lecture we will link the Statement of Changes in Equity to the SOFP and look at the movements in the Statements in more detail. 26