There are four primary financial statements in the UK:
(1) the profit and loss account (2) the balance sheet
(3) the cash flow statement
(4) the statement of total recognised gains and losses.
Only the first three would be found in accounts overseas.
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The profit and loss account
The profit and loss account shows whether the company has been selling its goods and ser- vices for more or less than it costs it to make and deliver them to the customer. It takes the income from sales made in the period and then deducts the costs that relate to those sales.
When looking at a profit and loss account it is important to remember three things:
(1) It is historical.All profit and loss accounts will tell you what has happened, not what is happening now. It usually takes a UK company three months, after the year end, to pub- lish its profit and loss account. To reinforce the fact that they are historical, profit and loss accounts always say something like ‘for the year ending … for the six months end- ing … for the period ending’.
(2) It does not include capital expenditure.The only impact that capital expenditure has on the profit and loss account is the depreciation charge. Consequently, a business can be profitable but run out of cash because of a capital expenditure programme.
(3) It is not concerned about whether the cash has been received from customers or paid to suppliers, just that the sale has been made.If I buy an apple for 5p and sell it for 8p, the profit and loss account records a profit of 3p. But I may have paid cash to buy the apple, and sold it on credit. The profit remains the same even though my cash is now at -5p. Thus, a business can be profitable, but run out of cash if the customers have not paid for the sales in the period. So, what looks like a ‘profitable’ business in the accounts may be making a loss today, and can easily go into liquidation because it runs out of cash!
The layout of the profit and loss account
The way a profit and loss account is laid out varies from one company to another. There are several different formats, and costs can be looked at in different ways. However, profit and loss accounts have a standard structure that is illustrated in Table 4.1.
The costs of materials, labour and overheads used in sales (the operating costs) can be cal- culated in two ways:
We can look at why we have incurred the costs – costs are analysed functionally:
● cost of sales
4 The financial statements
Standard structure for profit and loss accounts Table 4.1
Turnover
- Operating costs + Other operating income
= OPERATING PROFIT (This is a profit that companies show, but it is not required by the Companies Act)
+/- Share of associates and joint venture profits/losses +/- Profits and losses on sale of fixed assets or subsidiaries1 - Major restructuring costs1
+/- Interest1
= PROFIT BEFORE TAX +/- Tax2
= PROFIT AFTER TAX – Dividends
= RETAINED PROFIT Notes:
1 The company’s share of associates and joint venture will be shown on the profit and loss account.
2 This includes associate’s and joint venture’s tax, which will be separately disclosed.
● administration expenses
● selling and distribution expenses.
Alternatively we can look at what the company has spent the money on, such as:
● materials
● wages
● overheads.
Within the EU there are four different ways of presenting the profit and loss account, and these are reflected in the Companies Act. Only two formats are used in the UK; the others being more popular in continental Europe. Formats 3 and 4 are essentially horizontal pre- sentations of Formats 1 and 2.
A ‘Format 1’ profit and loss account
This is the most commonly used format in the UK, and classifies costs into:
● cost of sales
● administrative expenses
● distribution costs.
Unfortunately these terms are not defined in the Companies Act. Some companies include their sales and marketing costs in distribution costs, whereas others include these costs in administrative expenses. Some retailers define cost of sales as simply the cost of merchan- dise, others will also include distribution costs and store operating costs. Thus, it is not pos- sible to compare these costs between companies; only within a company over time.
An example of a Format 1 profit and loss account is given in Table 4.2.
Profit and loss account – ‘Format 1’
Table 4.2
£m £m..
Turnover 1000
Cost of sales .(600)
Gross profit 400
Distribution costs (140)
Administrative expenses (70)
Other operating income ...10
Operating profit 200
Share of associate’s operating profits ....20
Profit on sale of fixed assets ...10
Interest receivable – group ...10
Interest payable:
Group ...(50)
Associate ...(10) ...60
Profit on ordinary activities before taxation 180 Taxation on profit on ordinary activities* ..(40)
Profit on ordinary activities after taxation 140
Minority interests (10)
Dividend ..(40)
Retained profit for the financial year ...90
*Tax relates to the following: Group (38) Associate (2)
A ‘Format 2’ profit and loss account
This classifies operating costs as materials, staff costs (which include social security and pen- sion costs), other external costs and depreciation. As these are often the purchases that have been made in the period, rather than the costs that have been used in sales, two adjustments will have to be made to exclude:
● costs that relate to stock – ‘changes in stock and work in progress’;
● staff costs that have been spent on installing or improving capital items – ‘own work capitalised’.
Table 4.3 shows the same profit and loss account, but in a Format 2 presentation.
Most listed companies would take a profit after minority interests, and before dividends.
This is called the profit for the financial year.
If the company has sold assets that have previously been revalued, the profit and loss account will be followed by a note of historical-cost profits and losses. This shows what the profit would have been had there been no revaluations and is discussed in Chapter 14.
The profit and loss account is discussed in detail in Chapters 12–14.
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The balance sheet
This shows what the business is worth at the end of the year, given a set of assumptions that are detailed in the notes. The balance sheet represents a picture of the business on a certain day, identifying the assets and the liabilities. Like any photograph, it can be taken from dif- ferent vantage points. A UK balance sheet identifies how much the business is worth to the shareholders; we will see that other countries look at the business from a different perspective.
4 The financial statements
Profit and loss account – ‘Format 2’
Table 4.3
£m £m../
Turnover 1000
Raw materials and consumables (470)
Staff costs (195)
Other external charges (100)
Depreciation (90)
Changes in stock and work in progress ..20
Own work capitalised 25
Other operating income ..10)
Operating profit 200)
Share of associate’s operating profits ..20
Profit on sale of fixed assets ..10
Interest receivable – group 10
Interest payable:
Group (50)
Associate (10)
(60) Profit on ordinary activities before taxation 180 Taxation on profit on ordinary activities* ..(40)
Profit on ordinary activities after taxation 140
Minority interests ..(10)
Dividend ..(40)
Retained profit for the financial year . ...90)
*Tax relates to the following: Group (38) Associate (2)
The directors of the company know how important the balance sheet is. It will be used to determine things such as:
● how much credit the company will get
● how much money can be lent to the company
● the rate of interest that will be charged on borrowings
● whether someone is going to invest their life’s savings in this company.
As a snapshot of the business on a certain day, it can be ‘managed’. Companies will pick the best day in their year to take the snapshot, and always remember they have 364 days’ notice of that day arriving! It may well be as like the business for the rest of the year as our passport photographs represent true and fair views of us! Balance sheets should be read very carefully, and we should always remember to look for trends. Every year the company tries to show the best picture of itself. Is the best picture getting better or worse?
It is possible to prepare the balance sheet from different perspectives. The balance sheet’s content is broadly the same, no matter how it is presented. The degree of detail and the basis for valuations may vary from one country to another, but the information presented in the balance sheet will vary little. In Chapter 1 we discussed the two balance-sheet formats stip- ulated by the Companies Act. The layout of the two balance sheets is different, but the con- tent of each balance sheet is identical. Most UK companies prepare the balance sheet from the shareholders’ point of view, others from total assets and liabilities, looking at the busi- ness from the point of view of anyone who has put money into the business. Overseas, most companies use the asset and liabilities layout.
Examples of the two formats are shown in Tables 4.4 and 4.5.
Balance sheet – ‘Format 1’
Table 4.4
£m FIXED ASSETS
Intangible assets 50
Tangible assets 200
Investments ...75
325 CURRENT ASSETS
Stocks 80
Debtors 270
Investments 40
Cash ...10
400
CREDITORS: AMOUNTS FALLING DUE WITHIN ONE YEAR (300)
Net current assets .100
Total assets less current liabilities 425
CREDITORS: AMOUNTS FALLING DUE AFTER MORE THAN ONE YEAR (100)
PROVISIONS FOR LIABILITIES AND CHARGES (15)
MINORITY INTERESTS .. (25)
285
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The balance sheet is discussed in detail in Chapters 5–12.
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The cash flow statement
The cash flow statement shows the movement of cash in the business in the past year. It identifies where the money has come from and where the business has spent the money.
Cash flows are classified as arising from:
4 The financial statements
CAPITAL AND RESERVES
Share capital 50
Profit and loss account 175
Revaluation reserve 40
Share premium account ..20
285
Balance sheet – ‘Format 2’
Table 4.5
£m FIXED ASSETS
Intangible assets ...50
Tangible assets 200
Investments ...75
325 CURRENT ASSETS
Stocks 80
Debtors 270
Investments 40
Cash ...10
...400
TOTAL ASSETS .725
CAPITAL AND RESERVES
Share capital 50
Profit and loss account 175
Revaluation reserve 40
Share premium account ...20
.285
MINORITY INTERESTS 25
PROVISIONS FOR LIABILITIES AND CHARGES 15
CREDITORS * .400
TOTAL LIABILITIES .725
* A Format 2 balance sheet shows creditors as a single item. In the notes each component of the creditors must be analysed between those falling due within a year and in more than a year. The totals should also be shown.
● trading:these cash flows are shown under the heading of ‘operating activities’;
● dividends received from joint ventures and associates. These will be shown under this heading following the implementation of FRS 9 in June 1998;
● interest, dividends received and any dividends paid to ‘non-equity’ shares and minority interests: these cash flows are shown under the heading of ‘returns on investment and servicing of finance’;
● tax:these cash flows are shown under the heading of ‘taxation’;
● buying and selling fixed assets:these cash flows are shown under the heading ‘cap- ital expenditure and financial investment’;
● buying and selling businesses and trades: these cash flows are shown under the heading ‘acquisitions and disposals’;
● dividends paid to ordinary shareholders: these cash flows are shown under the heading of ‘equity dividends paid’;
● short-term investments that are shown as current asset investments:these cash flows are shown under the heading ‘management of liquid resources’;
● shares and loans:these cash flows are shown under the heading of ‘financing’.
Looking at the cash flow statement helps us see where the company has been spending and raising its money and whether the company is living within its means. This is probably the most important document of all; profit can be created, but you either have cash or you do not.
You can always spot a business that is engaging in creative accounting – the cash runs out!
The cash flow statement is discussed in detail in Chapter 16.
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The statement of total recognised gains and losses
This is a relatively new document, much burdened by its title. It forms a bridge between the profit and loss account and the balance sheet bringing together profit, asset valuations and currency adjustments. It shows any gain or loss that the company has shown in its accounts, regardless of whether it has been realised and taken through the profit and loss account. The information found in the statement of total recognised gains and losses is not new; it has always been in the accounts, but buried far away in the notes.
The statement of total recognised gains and losses is concerned with movements on reserves and profitability, acknowledging that a non-professional reader of the accounts may not read all the notes and, therefore, may not know of all the gains and losses taken by the business in the year. By looking at this statement the reader can see instantly:
● whether the company has made a profit, before paying dividends
● whether the fixed assets have been revalued during the year
● the impact of any currency movements on the overall worth of the company.
The statement of total recognised gains and losses is discussed in more detail in Chapter 17.