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FINANCIAL STATEMENTS

FINANCIAL STATEMENTS

By the end of the topic, the learner should be able to:   a) identify the various financial statements   b) explain the importance of each of the financial statements   c) explain the concept of trading period   d) prepare simple Financial Statements   e) explain the various types of capital   f)  calculate basic ratios from financial statements   g) explain the importance of each of the basic financial ratios

These are prepared at the end of a given trading period to determine the profit and losses of the business, and also to show the financial position of the business at a given time.

They includes; trading account, profit and loss account, trading profit and loss account and the balance sheet.

They are also referred to as the final statements.

The trading period is the duration through which the trading activities are carried out in the business before it decides to determines it performances in terms of profit or loss. It may be one week, month, six months or even a year depending on what the owner wants.

Most of the business use one year as their trading period. It is also referred to as the accounting period.

At the end of the accounting period, the following takes place;

  • All the accounts are balanced off
  • A trial balance is extracted
  • Profit or loss is determined
  • The balance sheet is prepared

Determining the profit or loss of a business

When a business sells its stock above the buying price/cost of acquiring the stock, it makes a profit, while if it sells below it makes a loss. The profit realized when the business sell it stock beyond the cost is what is referred to as the gross profit, while if it is a loss then it is referred to as a gross loss.

It is referred to as the gross profit /loss because it has not been used to cater for the expenses that may have been incurred in selling that stock, such as the salary of the salesman, rent for the premises, water bills, etc. it therefore implies that the businessman cannot take the whole gross profit for its personal use but must first deduct the total cost of all other expenses that may have been incurred.

The profit realized after the cost of all the expenses incurred has been deducted is what becomes the real profit for the owner of the business, and is referred to as Net profit. The net profit can be determined through calculation or preparation of profit and loss account.

In calculating the gross profit, the following adjustments are put in place

  • Return inwards/Sales return: - these are goods that had been sold to the customers, but they have returned them to the business for one reason or the other. It therefore reduces the value of sales, and is therefore subtracted from sales to obtain the net sales

          Therefore Net sales = Sales – Return inwards

  • Return outwards/purchases return: - these are goods that had been bought from the suppliers to the business and have been returned to them for one reason or the other. It reduces the purchases and is therefore subtracted from the purchases to obtain the net purchases.
  • Drawings: - this refers to goods that the owner of the business has taken from the business for his own use. It reduces the value of purchases, and is therefore subtracted from purchases when determining the net purchases. It is different from the other drawing in that it is purely goods and not money
  • Carriage inwards/Carriage on purchases: - this is the cost incurred by the suppliers in transporting the goods from his premises to the customers business. It is treated as part of the purchases, and therefore increases the value of purchases. It is added to purchases to determine the actual value of purchases/Net purchases.

Therefore Net Purchases = Purchases + Carriage inwards – Return Outwards - Drawings

  • Carriage outwards/Carriage on sales: - this is the cost that the business has incurred in transporting goods from its premises to the customer’s premises. The cost reduces the business profit that would have been realized as a result of the sale, and is therefore treated as an expense and is subtracted from the gross profit, before determining the net profit.
  • Opening stock is the stock of goods at the beginning of the trading period, while the closing stock is the stock of the goods at the end of the trading period

Gross profit is therefore calculated as follows;

     Gross Profit = Sales – Return inwards – (Opening stock + Purchases + carriage inwards – Return outwards – Closing stock)

     Or

     Gross profit = Net sales – Cost of Goods Sold (COGS)

 

     COGS = Opening Stock + Net Purchases – Closing stock

 

Net Profit = Gross profit – Total expenses

 

Trading Account

This is prepared by the business to determine the gross profit/loss during that trading period

It takes the following format:

Name of the business

Trading Account

         Dr                                    For the period (date)                               Cr

ShsShs

Opening stock     xxxxxx

add Purchases              xxxxx

add Carriage inwards      xxx

less Return Outwards      xxx

less Drawings                   xxxxxxx

Goods available for sale         xxxxxx

Less Closing Stock                  xxx

Cost Of Goods Sold (COGS) xxxxxx

Gross profit c/d              xxxx

xxxxxx

 

ShsShs

Sales             xxxxxx

Less Return inwards  xxx

Net sales                    xxxxxx

 

 

 

 

 

xxxxxx

Gross profit b/d                           xxxx

The trading account is completed by the time the gross profit b/d is determined

For example

The following balances were obtained from the books of Ramera Traders for the year ending may 31st 2010

                   Sales                                       670 000

                   Purchases                               380 000

                   Return inwards                        40 000

                   Carriage outwards                 18 000

                   Return outwards                      20 000

                   Carriage inwards                   10 000

Additional information:

  1. During the year the owner took goods worth sh 5 000 for his family use
  2. The stock as at 1st June 2009 was shs 60 000, while the stock as at 31st May 2011 was shs 70 000

Required; Prepare Ramera Traders trading account for the period ending 31st May

2010

 

Ramera Traders

Trading Account

         Dr               For the period ending 31/5/2010                                                                         Cr

ShsShs

Opening stock                          60 000

add Purchases           380 000

add Carriage inwards 10 000

less Return Outwards 20 000

less Drawings              5 000 365 000

Goods available for sale    425 000

Less Closing Stock             70 000

Cost Of Goods Sold (COGS)355,000

Gross profit c/d                  275,000

630,000

 

ShsShs

Sales                     670 000

Less Return inwards40 000

Net sales         630 000

 

 

 

 

 

 

630 000

Gross profit b/d             275 000

NB:Carriage outwards is not an item of Trading account, but profit and loss account as an expense.

Importance of Trading account

  1. It is used to determine the gross profit/loss for a given trading period for appropriate decision making by the management.
  2. It is used in determining the cost of goods that was sold during that particular accounting period.
  3. It is used to reveal the volume of turnover i.e net sales
  4. May be used to compare the performance of the business in the current accounting period and the previous periods. It can also compare its performance with other similar businesses
  5. It facilitates the preparation of profit and loss account, since the gross profit is carried forward to the profit and loss account.

Profit and Loss account

In preparation of this account, the gross profit is brought down on the credit sides, with all other revenues/income of the business being credited and the expenses together with the net profit being debited. Net profit = Total Revenues (including Gross Profit) – Total expenses

 

 

 

 

Name of the business

Profit and Loss Account

         Dr                                    For the period (date)                               Cr

Shs

Expenses                                   

Insurance                                      xxx

Electricity                                     xxx

Water bills                   xxx

Carriage Outwards                       xxx

General expenses                          xxx

Provision for Depreciation  xxxx

Discount allowed                          xxx

Commission allowed           xxxx

Rent paidxxxx

Any other expense               xxxx

Net profit c/d                     xxxx

xxxxxx

 

Shs

Gross profit b/d         xxxxxx

Discount received                         xxx

Rent income                                  xxx

Commission received                   xxx

Any other income received           xxx

 

 

 

 

 

 

 

xxxxxx

Net profit b/d     xxxx

The Profit and Loss Account is complete when net profit b/d is obtained. In the trial balance, the revenues/incomes are always credited, while the expenses are debited, and the same treatment is found in the Profit and Loss Account. (Any item that is taken to the Profit and Loss Account with a balance appearing in the Debit (Dr) side of a trial balance is treated as an expense, while those appearing in the Credit (Cr) side are revenue e.g. discount balance appearing in the Dr Side is Discount Allowed, while the one on Cr side is Discount Received)

For example

The following information relates to Akinyi’s Traders for the period ending March 28th 2010. Use it to prepare profit and loss account.

Gross profit                            100 000               Discount received12 000

Salaries and wages                20 000                 Power and lighting       10 000

Opening stock                       150 000                   Rent income             10 000      

Commission allowed              15 000               Commission received  16 000

Repairs                                   10 000                 Discount allowed         8 000

Provision for depreciation   6 000                   Carriage outwards        4 000

 

 

 

Akinyi Traders

Profit and Loss Account

         Dr                    For the period ending 28th March 2010               Cr

Shs

     Expenses                                    

Power and lighting                  10 000

Carriage Outwards                     4 000

Salaries and wages                   20 000

Provision for Depreciation        6 000

Discount allowed                       8 000

Commission allowed               15 000

Repairs        10 000

Net profit c/d                           65 000

138 000

 

Shs

Gross profit b/d                     100 000

Discount received                    12 000

Rent income10 000

Commission received              16 000

 

 

 

 

 

138 000

Net profit b/d      65 000

In case the expenses are more than the income, then the business shall have made a net loss, and the loss will be credited.

Net profit/loss can also be found through calculation as follows;

Net profit/loss = Gross profit + Total other revenues – Total expenses

For the above example;

Total other revenues = 12 000 + 10 000 + 16 000= 38 000

Total expenses = 10 000 + 4 000 + 20 000 + 6 000 + 8 000 + 15 000 + 10 000

                              = 73 000

Therefore; Net profit = Gross profit + Total other revenues – Total expenses

                             = 100 000 + 38 000 – 73 000= 65 000

Importance of Profit and Loss account

  • It shows the revenue earned, and all the expenses incurred during the accounting period
  • It used to determine the net profit/net loss of a given trading period
  • It is a requirement by the government for the purpose of taxation
  • May be used by the employees to gauge the strength of the business, in terms of its ability to pay them well
  • It is vital for the prospective investor in the business, in terms of determining the viability of the business
  • The creditors or loaners may use it to assess the business ability to pay back their debts
  • It is used by the management to make a decision on the future of their business.

Trading, Profit and Loss Account

This is the combination of trading account and trading profit and loss account to form a single document. It ends when the net profit/loss brought down has been determined. That is;

Name of the business

Trading, Profit and Loss Account

         Dr                               For the period (date)                                                                          Cr

ShsShs

Opening stock         xxxxxx

add Purchases        xxxxx

add Carriage inwards xxx

less Return Outwards xxx

less Drawings           xx            xxxxx

Goods available for sale         xxxxxx

Less Closing Stock            xxx

Cost Of Goods Sold (COGS) xxxxxx

Gross profit c/d      xxxx

Xxxxxx

 

Expenses

Insurance                                      xxx

Electricity                                     xxx

Water bills                                    xxx

Carriage Outwards                        xxx

General expenses                          xxx

Provision for Depreciation     xxxx

Discount allowed                          xxx

Commission allowed       xxxx

Rent paid  xxxx

Any other expense            xxxx

Net profit c/d       xxxx

xxxxxx

 

ShsShs

Sales                  xxxxxx

Less Return inwards xxx

Net sales         xxxxxx

 

 

 

 

 

xxxxxx

Gross profit b/d     xxxx

 

 

Discount received                         xxx

Rent income                                  xxx

Commission received                   xxx

Any other income received           xxx

 

 

 

 

 

 

 

 

xxxxxx

Net profit b/d            xxxx

End Year Adjustments

The following items may require to be adjusted at the end of the trading period

  • Revenues/Income
  • Expenses
  • Fixed assets

Adjustment on revenues

The revenue may have been paid in advance in part or whole (prepaid revenue) or may be paid later after the trading period (accrued revenue).

Prepaid revenue is subtracted from the revenue/income to be received and the difference is what is treated in the profit and loss account or trading profit and loss account as an income, while the accrued revenue is added to the revenue/income to be received and the sum is what is treated in the above accounts as the actual revenue.

Only the prepaid amount and the accrued amounts are what are then taken to the balance sheet.

Adjustment on the expenses

The expenses may have been paid for in advance in part or whole (prepaid expenses) or may be paid for later after the trading period (accrued expenses).

Prepaid expenses is subtracted from the expenses to be paid for and the difference is what is treated in the profit and loss account or trading profit and loss account as an expense, while the accrued expenses is added to the expenses to be paid for and the sum is what is treated in the above accounts as the actual expenses.

NB: Only the prepaid amount and the accrued amounts are what are then taken to the balance sheet.

Adjustment on fixed assets

The fixed assets may decrease in value, due to tear and wear. This makes the value to go down over time, what is referred to as depreciation. The amount of depreciation is always estimated as a percentage of cost.

The amount that shall have depreciated is treated in the profit and loss account or T,P&L as an expense, while the value of the asset is recorded in the balance sheet, less depreciation.

For example;

  1. 1997 The following Trial balance was prepared from the books of Paka Traders as at 31st December 1995.  Trial balance December 31st 1995

                                  Dr. (shs)                        Cr. (shs)

                                 

Sales                                                          980,000

Purchases                      600,000

Returns                80,000                          20 000

Carriage in                                                 40,000

Carriage out                           3,000

Stock (Jan 1st 1999)              120,000

Rent                              60,000                          45 000

Discount                       15,000                          25 000

Motor vehicle                        150 000

Machinery                    250 000

Debtors                                   120,000

Salaries                                   18,000

Commission                           7,000                             12 000

Capital                                                                 178,000

Insurance                      15 000

Creditors                                                   240,000

Cash                              122 000

                                      1 540 000           1 540 000

Additional information

  1. Stock as at 31st December was 100,000
  2. the provision for depreciation was 10% on the cost of Motor vehicle, and 5% on the cost of Machinery

Required: Prepare trading profit and loss account for the period ending 31st December 1999

Adjustments: Provision for depreciation;

              Machinery = 5100 ×250 000 = 7 500

(New balance of machinery = 250 000 – 7 500 = 242 500. The 242 500 is taken to the balance as Machinery (fixed asset), while 7 500 is taken to the trading profit and loss account as expenses)

              Motor vehicle = 10100 ×150 000 = 15 000

(New balance of Motor Vehicle = 150 000 – 15 000 = 135 000. The 135 000 is taken to the balance as Motor Vehicle (fixed asset), while 15 000 is taken to the trading profit and loss account as expenses)

Paka Traders

Trading, Profit and Loss Account

Dr    For the period 31/12/1995          Cr

ShsShs

Opening stock   120 000

add Purchases      600 000

add Carriage inwards40 000

less Return Outwards20 000  620 000

Goods available for sale         740 00

Less Closing Stock                100 000

Cost Of Goods Sold (COGS)640 000

Gross profit c/d                     260 000

                                       900 000

Expenses                                   

Insurance                                  15000

Carriage Outwards                    30000

Salaries                                  18 000

Provision for Depreciation

Motor vehicle             15 000

Machinery              7 500         22500

Discount allowed                    15 000

Commission allowed               7 000

Rent paid            60 000

Net profit c/d                         174 500

                             342 000

 

ShsShs

Sales                      980 000

Less Return inwards 80 000

Net sales                    900 000

 

 

 

 

 

                                             900 000

Gross profit b/d                     260 000

Discount received                    25 000

Rent income                             45 000

Commission received              12 000

 

 

 

 

           342 000

Net profit b/d                        174 500

The net profit/loss may be taken to the balance sheet.

The items that have been adjusted will be recorded in the balance sheet less the adjustment.

The Balance Sheet

The balance sheet will show the business financial position in relation to assets, capital and liabilities. The adjustment that can be made will be on Fixed assets and capital only. That is;

Fixed assets are recorded less their depreciation value (should there be provision for depreciation) as the actual value.

              Actual value of assets = Old value – depreciation.

Capital is adjusted with the following; Net capital, Drawings and additional investment. i.e.

Closing Capital/Net capital (C.C) = Opening/initial capital (O.C) + Additional Investment (I) + Net profit (N.P) or (less Net Loss) – Drawings

                        CC = OC + I + NP – D

Where:

Opening Capital: - the capital at the beginning of the trading period

Closing capital: - the capital as at the end of the trading period

          Additional Investment: - any amount or asset that the owner adds to the business during the trading period

Net profit: - the profit obtained from the trading activities during the period. In case of a loss, it is subtracted.

Types of Capital

The capital in the business can be classified as follows:

  • Capital Owned/Owner’s Equity/Capital invested; - this is the capital that the owner of the business has contributed to the business. It is the Net capital/Closing capital of the business (C = A – L)
  • Borrowed capital: - the resources brought into the business from the outside sources. They are the long term liabilities of the business.
  • Working capital: - these are resources in the business that can be used to meet the immediate obligation of the business. It is the difference between the total current assets and total current liabilities

     Working Capital = Total Current Assets – Total Current Liabilities

  • Capital employed: - these are the resources that has been put in the business for a long term. i.e.

     Capital Employed = Total Fixed assets + Working Capital

Or

     Capital employed = Capital Invested + Long term liabilities

Name of the business

Balance Sheet

As at (date)

Shsshs

Fixed Assets

Land                              xxxxx

Buildings                        xxxxx

Motor Vehicle                xxxxx

Any other fixed assets   xxxxxxxxxxx

Current Assets

Stock                               xxxx

Debtors                            xxxx

Bank                                 xxxx

Cash                                 xxxx

Prepaid Expenses            xxxx

Accrued revenues            xxxx

Any other current assets  xxxxxxxxxx

 

 

 

Xxxxxx

Shs    shs

 

Capital                        xxxxx

Add Net profit               xxxx

Add additional investt    xxx

Less drawings               xxx

Net Capital       xxxxx

Long term liabilities

Long term loan            xxxx

Any other              xxxxxxxx

Current liabilities

Creditors                      xxxx

Short term loan            xxxx

Accrued expenses       xxxx

Prepaid revenues        xxxx

Any other                     xxxxxxxxx

xxxxxx

 

Example 00A: The following information were extracted from the trial balance of Mwema traders on 31st December 2010

Sales                    750 000               Furniture             288 000

Purchases            540 000               Electricity expenses     16 000

Sales return         24 000                 Motor vehicle              720 000

Return outwards 30 000                 Rent expenses              2 500

General expenses72 000                Capital                          842 500

Commission received  24 000       Bank Loan          250 000

Cash                    156 000               Creditors             216 000

Debtors               244 000

Additional Information

  1. Stock as at 31/12/2010 was ksh 72 000
  2. Electricity prepaid was shs 4 000
  3. Rent expenses accrued shs 3500
  4. Depreciation was provided for as follows

-Motor Vehicle 15% p.a. on cost  -Furniture 6% p.a. on cost

Required

  1. Prepare Trading, profit and loss account for the year
  2. Prepare a balance sheet as at 31st December 2012
  3. Determine the following:

-Owner’s equity       -Borrowed capital   -Working capital   -Capital employed

Adjustments:

Motor Vehicle = 15100 ×720 000 = 108 000

Therefore Motor vehicle = 612 000

Furniture = 6100 ×288 000 = 17 280

Therefore furniture = 270 720

 

Mwema Traders

Trading, Profit and Loss Account

         Dr                              For the period 31/12/2010                          Cr

ShsShs

Purchases                540 000

less Return Outwards30 000  510 000

Goods available for sale        510 000

Less Closing Stock                  72 000

Cost Of Goods Sold (COGS)438 000

Gross profit c/d                      288 000

                       726 000

                      Expenses                               General expenses                               72 000

Electricity expenses      16 000

Less Electricity prepaid  4 000          12 000

 

Rent expenses               2 500

Accrued rent exp3 500            6 000

 

Provision for Depreciation

Motor vehicle             108 000

Furniture            17 280         125 280

Net profit c/d                          96 720

             312 000

 

ShsShs

Sales                           750 000

Less Return inwards      24 000

Net sales                                           726 000

 

 

 

                                          726 000

Gross profit b/d                     288 000

Commission received             24 000

 

 

 

 

 

 

 

 

 

 

         312 000

Net profit b/d                          96 720

Mwema Traders

Balance Sheet

      As at 31/12/2010

Shsshs

Fixed Assets

Motor Vehicle          612 000

Furniture                  270 720     882 720

 

 

Current Assets

Stock                          72 000

Debtors                    244 000

Electricity prepaid       4 000

Bank                          50 000

Cash                 156 000     526 000

 

   1 408 720

Shsshs

Capital                      842 500

Add Net profit             96 720

Net Capital                                939 220

 

Long term liabilities

Bank Loan                               250 000

 

Current liabilities

Creditors                216 000

Accrued rent          3 500   219 500

 

       1 408 720

                                             

Importance of Financial Ratios

  1. Mark up and margin helps in the following; setting the selling price, calculating  profit or losses and determining the sales for a given period of time
  2. Working capital and acid test ratio help in showing whether the business is in a position to meet its short term obligations and checking whether the business is utilizing its resources properly. That is high working capital ratio shows that most of the resources are idle
  3. Return on capital shows the following;
  • The performance of the business in relation to other similar businesses
  • Comparison of the performance of the business over different periods
  • Whether the business finances have been invested or not
  • Help the potential investors on the decision on where to invest

Rate of stock turnover also help in determining how fast or slow the stock is moving. It also helps in computing the gross profit or loss.